FINA 421 Ch. 2
With regard to forming a company's peer group, which of the following state- ments is not correct? A. Comments from the management of the company about competitors are generally not used when selecting the peer group. B. The higher the proportion of revenue and operating profit of the peer com- pany derived from business activities similar to the subject company, the more meaningful the comparison. C. Comparing the company's performance measures with those for a potential peer-group company is of limited value when the companies are exposed to different stages of the business cycle.
A is correct because it is a false statement. Reviewing the annual report to find management's discussion about the competitive environment and specific com- petitors is a suggested step in the process of constructing a peer grou
Which type of equity valuation model is most likely to be preferable when one is comparing similar companies? A. A multiplier model. B. A present value model. C. An asset-based valuation mod
A is correct. Although all models can be used to compare various companies, multiplier models have the advantage of reducing varying fundamental data points into a format that allows direct comparisons. As long as the analyst applies the data in a consistent manner for all the companies, this approach provides useful comparative data.
An industry with high barriers to entry and weak pricing power most likely has: A. high barriers to exit. B. stable market shares. C. significant numbers of issued patents
A is correct. An industry that has high barriers to entry generally requires sub- stantial physical capital and/or financial investment. With weak pricing power in the industry, finding a buyer for excess capacity (i.e., to exit the industry) may be difficult.
Which of the following is most likely a reason for using asset-based valuation? A. The analyst is valuing a privately held company. B. The company has a relatively high level of intangible assets. C. The market values of assets and liabilities are different from the balance sheet values.
A is correct. Asset-based valuations are most often used when an analyst is valuing private enterprises. Both B and C are considerations in asset-based valuations but are more likely to be reasons to avoid that valuation model rather than reasons to use it
With respect to competitive strategy, a company with a successful cost leader- ship strategy is most likely characterized by: A. a low cost of capital. B. reduced market share. C. the ability to offer products at higher prices than competitors.
A is correct. Companies with low cost strategies must be able to invest in productivity-improving equipment and finance that investment at a low cost of capital. Market share and pricing depend on whether the strategy is pursued defensively or offensively.
An analyst has determined that the appropriate EV/EBITDA for Rainbow Company is 10.2. The analyst has also collected the following forecasted infor- mation for Rainbow Company: EBITDA = $22,000,000 Market value of debt = $56,000,000 Cash = $1,500,000 The value of equity for Rainbow Company is closest to: A. $169 million. B. $224 million. C. $281 million.
A is correct. EV = 10.2 × 22,000,000 = $224,400,000 Equity value = EV - Debt + Cash = 224,400,000 - 56,000,000 + 1,500,000 = $169,900,000
In the free cash flow to equity (FCFE) model, the intrinsic value of a share of stock is calculated as: A. the present value of future expected FCFE. B. the present value of future expected FCFE plus net borrowing. C. the present value of future expected FCFE minus fixed capital investment
A is correct. In the FCFE model, the intrinsic value of stock is calculated by discounting expected future FCFE to present value. No further adjustments are required.
The primary difference between P/E multiples based on comparables and P/E multiples based on fundamentals is that fundamentals-based P/Es take into account: A. future expectations. B. the law of one price. C. historical information.
A is correct. Multiples based on comparables are grounded in the law of one price and take into account historical multiple values. In contrast, P/E multiples based on fundamentals can be based on the Gordon growth model, which takes into account future expected dividend
Which of the following statements regarding the calculation of the enterprise value multiple is most likely correct? A. Operating income may be used instead of EBITDA. B. EBITDA may not be used if company earnings are negative. C. Book value of debt may be used instead of market value of debt.
A is correct. Operating income may be used in place of EBITDA when calculat- ing the enterprise value multiple. EBITDA may be used when company earnings are negative because EBITDA is usually positive. The book value of debt cannot be used in place of market value of debt.
If the technology for an industry involves high fixed capital investment, then one way to seek higher profit growth is by pursuing: A. economies of scale. B. diseconomies of scale. C. removal of features that differentiate the product or service provide
A is correct. Seeking economies of scale would tend to reduce per-unit costs and increase profit.
Which industry classification system uses a three-tier classification system? A. Russell Global Sectors. B. Industry Classification Benchmark. C. Global Industry Classification Standard
A is correct. The Russell system uses three tiers, whereas the other two systems are based on four tiers or levels
An equity analyst has been asked to estimate the intrinsic value of the com- mon stock of Omega Corporation, a leading manufacturer of automobile seats. Omega is in a mature industry, and both its earnings and dividends are expected to grow at a rate of 3 percent annually. Which of the following is most likely to be the best model for determining the intrinsic value of an Omega share? A. Gordon growth model. B. Free cash flow to equity model. C. Multistage dividend discount model.
A is correct. The company is a mature company with a steadily growing div- idend rate. The two-stage (or multistage) model is unnecessary because the divi- dend growth rate is expected to remain stable. Although an FCFE model could be used, that model is more often chosen for companies that currently pay no dividend
When conducting a company analysis, the analysis of demand for a company's product is least likely to consider the: A. company's cost structure. B. motivations of the customer base. C. product's differentiating characteristic
A is correct. The cost structure is an appropriate element when analyzing the supply of the product, but analysis of demand relies on the product's differenti- ating characteristics and the customers' needs and wants.
An analyst estimates the intrinsic value of a stock to be in the range of €17.85 to €21.45. The current market price of the stock is €24.35. This stock is most likely: A. overvalued. B. undervalued. C. fairly valued.
A is correct. The current market price of the stock exceeds the upper bound of the analyst's estimate of the intrinsic value of the stoc
An analyst gathers or estimates the following information about a stock: Current price per share = €22.56 Current annual dividend per share = €1.60 Annual dividend growth rate for Years 1-4 = 9.00% Annual dividend growth rate for Years 5+ = 4.00% Required rate of return = 12% Based on a dividend discount model, the stock is most likely: A. undervalued. B. fairly valued. C. overvalued.
A is correct. The current price of €22.56 is less than the intrinsic value (V0) of €24.64; therefore, the stock appears to be currently undervalued. According to the two-stage dividend discount model: nt V0 =∑D0(1+gS) + Vn andVn = Dn+1 tnr−g t = 1 (1 + r ) (1 + r ) L Dn+1 = D0(1 + gS)n(1 + gL) D1 = €1.60 × 1.09 = €1.744 D2 = €1.60 × (1.09)2 = €1.901 D3 = €1.60 × (1.09)3 = €2.072 D4 = €1.60 × (1.09)4 = €2.259 D5 = [€1.60 × (1.09)4](1.04) = €2.349 V4 = €2.349/(0.12 - 0.04) = €29.363 V0 = 1.744 + 1.901 + 2.072 + 2.259 + 29.363 12344 (1.12) (1.12) (1.12) (1.12) (1.12) = 1.557 + 1.515 + 1.475 + 1.436 + 18.661 = €24.64 (which is greater than the current price of €22.5
An analyst determines the intrinsic value of an equity security to be equal to $55. If the current price is $47, the equity is most likely: A. undervalued. B. fairly valued. C. overvalue
A is correct. The market price is less than the estimated intrinsic, or fundamen- tal, value.
An analyst makes the following statement: "Use of P/E and other multiples for analysis is not effective because the multiples are based on historical data and because not all companies have positive accounting earnings." The analyst's statement is most likely: A. inaccurate with respect to both historical data and earnings. B. accurate with respect to historical data and inaccurate with respect to earnings. C. inaccurate with respect to historical data and accurate with respect to earnings.
A is correct. The statement is inaccurate in both respects. Although multiples can be calculated from historical data, forecasted values can be used as well. For companies without accounting earnings, several other multiples can be used. These multiples are often specific to a company's industry or sector and include price-to-sales and price-to-cash flow
An analyst has gathered the following information for the Oudin Corporation: Expected earnings per share = €5.70 Expected dividends per share = €2.70 Dividends are expected to grow at 2.75 percent per year indefinitely The required rate of return is 8.35 percent Based on the information provided, the price/earnings multiple for Oudin is closest to: A. 5.7. B. 8.5. C. 9.4.
B is correct
A disadvantage of the EV method for valuing equity is that the following infor- mation may be difficult to obtain: A. Operating income. B. Market value of debt. C. Market value of equity.
B is correct. According to the reading, analysts may have not have access to market quotations for company debt
Which of the following industries is most likely to be characterized as concen- trated with strong pricing power? A. Asset management. B. Alcoholic beverages. C. Household and personal products.
B is correct. As displayed in Exhibit 4, the alcoholic beverage industry is con- centrated and possesses strong pricing powe
If over a long period of time a country's average level of educational accom- plishment increases, this development would most likely lead to the country's amount of income spent on consumer discretionary goods to: A. decrease. B. increase. C. not change.
B is correct. As their educational level increases, workers are able to perform more skilled tasks, earn higher wages, and as a result, have more income left for discretionary expenditures.
Which of the following is not a limitation of the cyclical/non-cyclical descrip- tive approach to classifying companies? A. A cyclical company may have a growth component in it. B. Business-cycle sensitivity is a discrete phenomenon rather than a continu- ous spectrum. C. A global company can experience economic expansion in one part of the world while experiencing recession in another par
B is correct. Business-cycle sensitivity falls on a continuum and is not a discrete "either-or" phenomenon
Which of the following statements about peer groups is most accurate? A. Constructing a peer group for a company follows a standardized process. B. Commercial industry classification systems often provide a starting point for constructing a peer group. C. A peer group is generally composed of all the companies in the most narrowly defined category used by the commercial industry classification system.
B is correct. Constructing a peer group is a subjective process, and a logical starting point is to begin with a commercially available classification system. This system will identify a group of companies that may have properties compa- rable to the business activity of interest.
Which of the following information about a company would most likely depend on an industry analysis? The company's: A. dividend policy. B. competitive environment. C. trends in corporate expenses.
B is correct. Determination of a company's competitive environment depends on understanding its industry.
Asset-based valuation models are best suited to companies where the capital structure does not have a high proportion of: A. debt. B. intangible assets. C. current assets and liabilities.
B is correct. Intangible assets are hard to value. Therefore, asset-based valuation models work best for companies that do not have a high proportion of intangi- ble assets.
In which sector would a manufacturer of personal care products be classified? A. Health care. B. Consumer staples. C. Consumer discretionary.
B is correct. Personal care products are classified as consumer staples in the "Description of Representative Sectors."
An analyst who bases the calculation of intrinsic value on dividend-paying capacity rather than expected dividends will most likely use the: A. dividend discount model. B. free cash flow to equity model. C. cash flow from operations model.
B is correct. The FCFE model assumes that dividend-paying capacity is reflected in FCFE
The Gordon growth model can be used to value dividend-paying companies that are: A. expected to grow very fast. B. in a mature phase of growth. C. very sensitive to the business cycle
B is correct. The Gordon growth model (also known as the constant growth model) can be used to value dividend-paying companies in a mature phase of growth. A stable dividend growth rate is often a plausible assumption for such companiesC is correct. The Gordon growth model is best suited to valuing mature com- panies. The two-stage model is best for companies that are transitioning from a growth stage to a mature stage. The three-stage model is appropriate for young companies just entering the growth phase.
When selecting companies for inclusion in a peer group, a company operating in three different business segments would: A. be in only one peer group. B. possibly be in more than one peer group. C. not be included in any peer group.
B is correct. The company could be in more than one peer group depending on the demand drivers for the business segments, although the multiple business segments may make it difficult to classify the company
A Canadian life insurance company has an issue of 4.80 percent, $25 par value, perpetual, non-convertible, non-callable preferred shares outstanding. The required rate of return on similar issues is 4.49 percent. The intrinsic value of a preferred share is closest to: A. $25.00. B. $26.7 C. $28.50
B is correct. The expected annual dividend is 4.80% × $25 = $1.20. The value of a preferred share is $1.20/0.0449 = $26.73.
When graphically depicting the life-cycle model for an industry as a curve, the variables on the axes are: A. price and time. B. demand and time. C. demand and stage of the life cycle
B is correct. The industry life-cycle model shows how demand evolves through time as an industry passes from the embryonic stage through the stage of decline.
Enterprise value is most often determined as market capitalization of common equity and preferred stock minus the value of cash equivalents plus the: A. book value of debt. B. market value of debt. C. market value of long-term deb
B is correct. The market value of debt must be calculated and taken out of the enterprise value. Enterprise value, sometimes known as the cost of a takeover, is the cost of the purchase of the company, which would include the assumption of the company's debts at market value
Two analysts estimating the value of a non-convertible, non-callable, perpetual preferred stock with a constant dividend arrive at different estimated values. The most likely reason for the difference is that the analysts used different: A. time horizons. B. required rates of return. C. estimated dividend growth rates.
B is correct. The required rate of return, r, can vary widely depending on the inputs and is not unique. A preferred stock with a constant dividend would not have a growth rate to estimate, and the investor's time horizon would have no effect on the calculation of intrinsic value.
An analyst is attempting to calculate the intrinsic value of a company and has gathered the following company data: EBITDA, total market value, and market value of cash and short-term investments, liabilities, and preferred shares. The analyst is least likely to use: A. a multiplier model. B. a discounted cash flow model. C. an asset-based valuation mode
B is correct. To use a discounted cash flow model, the analyst will require FCFE or dividend data. In addition, the analyst will need data to calculate an appro- priate discount rate
Which of the following is most likely considered a weakness of present value models? A. Present value models cannot be used for companies that do not pay dividends. B. Small changes in model assumptions and inputs can result in large changes in the computed intrinsic value of the security. C. The value of the security depends on the investor's holding period; thus, comparing valuations of different companies for different investors is difficult.
B is correct. Very small changes in inputs, such as required rate of return or dividend growth rate, can result in large changes to the valuation model output. Some present value models, such as FCFE models, can be used to value compa- nies without dividends. Also, the intrinsic value of a security is independent of the investor's holding period.
A population that is rapidly aging would most likely cause the growth rate of the industry producing eye glasses and contact lenses to: A. decrease. B. increase. C. not change
B is correct. Vision typically deteriorates at advanced ages. An increased num- ber of older adults implies more eyewear products will be purchased.
Hideki Corporation has just paid a dividend of ¥450 per share. Annual divi- dends are expected to grow at the rate of 4 percent per year over the next four years. At the end of four years, shares of Hideki Corporation are expected to sell for ¥9000. If the required rate of return is 12 percent, the intrinsic value of a share of Hideki Corporation is closest to: A. ¥5,850. B. ¥7,220. C. ¥7,670.
B. is correct V0 = 1 + 2 2 + 3 3 + 4 4 + 4 4 (1.12) 2 3 4 4 (1.12) (1.12) (1.12) (1.12) = ¥7,220
A sector rotation strategy involves investing in a sector by: A. making regular investments in it. B. investing in a pre-selected group of sectors on a rotating basis. C. timing investment to take advantage of business-cycle condition
C is correct. A sector rotation strategy is conducted by investors wishing to time investment in industries through an analysis of fundamentals and/or business-cycle condition
Which factor is most likely associated with stable market share? A. Low switching costs. B. Low barriers to entry. C. Slow pace of product innovation.
C is correct. A slow pace of product innovation often means that customers prefer to stay with suppliers they know, implying stable market share
An investor is considering the purchase of a common stock with a $2.00 annual dividend. The dividend is expected to grow at a rate of 4 percent annually. If the investor's required rate of return is 7 percent, the intrinsic value of the stock is closest to: A. $50.00. B. $66.67. C. $69.33.
C is correct. According to the Gordon growth model, V0 = D1/(r - g). In this case, D1 = $2.00 × 1.04 = $2.08, so V0 = $2.08/(0.07 - 0.04) = $69.3333 = $69.33.
An investor expects to purchase shares of common stock today and sell them after two years. The investor has estimated dividends for the next two years, D1 and D2, and the selling price of the stock two years from now, P2. According to the dividend discount model, the intrinsic value of the stock today is the present value of: A. next year's dividend, D1 B. future expected dividends, D1 and D2. C. future expected dividends and price—D1, D2 and P
C is correct. According to the dividend discount model, the intrinsic value of a stock today is the present value of all future dividends. In this case, the intrinsic value is the present value of D1, D2, and P2. Note that P2 is the present value at Period 2 of all future dividends from Period 3 to infinity.
In asset-based valuation models, the intrinsic value of a common share of stock is based on the: A. estimated market value of the company's assets. B. estimated market value of the company's assets plus liabilities. C. estimated market value of the company's assets minus liabilities
C is correct. Asset-based valuation models calculate the intrinsic value of equity by subtracting liabilities from the market value of assets
Which of the following companies most likely has the greatest ability to quickly increase its capacity? A. Restaurant. B. Steel producer. C. Legal services provider.
C is correct. Capacity increases in providing legal services would not involve several factors that would be important to the other two industries, including the need for substantial fixed capital investments or, in the case of a restaurant, outfitting rental or purchased space. These requirements would tend to slow down, respectively, steel production and restaurant expansion
Which of the following statements about commercial and government industry classification systems is most accurate? A. Many commercial classification systems include private for-profit companies. B. Both commercial and government classification systems exclude not-for- profit companies. C. Commercial classification systems are generally updated more frequently than government classification system
C is correct. Commercial systems are generally updated more frequently than government systems, and include only publicly traded for-profit companie
With respect to present value models, which of the following statements is most accurate? A. Present value models can be used only if a stock pays a dividend. B. Present value models can be used only if a stock pays a dividend or is expected to pay a dividend. C. Present value models can be used for stocks that currently pay a dividend, are expected to pay a dividend, or are not expected to pay a dividend.
C is correct. Dividend discount models can be used for a stock that pays a cur- rent dividend or a stock that is expected to pay a dividend. FCFE can be used for both of those stocks and for stocks that do not, or are not expected to, pay dividends in the near future. Both of these models are forms of present value models.
Economic value is created for an industry's shareholders when the industry earns a return: A. below the cost of capital. B. equal to the cost of capital. C. above the cost of capital.
C is correct. Economic profit is earned and value created for shareholders when the company earns returns above the company's cost of capital.
The market value of equity for a company can be calculated as enterprise value: A. minus market value of debt, preferred stock, and short-term investments. B. plus market value of debt and preferred stock minus short-term investments. C. minus market value of debt and preferred stock plus short-term investments.
C is correct. Enterprise value is calculated as the market value of equity plus the market value of debt and preferred stock minus short-term investments. Therefore, the market value of equity is enterprise value minus the market value of debt and preferred stock plus short-term investmen
Which of the following is most likely used in a present value model? A. Enterprise value. B. Price to free cash flow. C. Free cash flow to equity
C is correct. FCFE can be used in a form of present value, or discounted cash flow, model. Both EV and price to free cash flow are forms of multiplier models.
An industry that most likely has both high barriers to entry and high barriers to exit is the: A. restaurant industry. B. advertising industry. C. automobile industry.
C is correct. For the automobile industry, the high capital requirements and other elements mentioned in the reading provide high barriers to entry, and recognition that auto factories are generally only of use for manufacturing cars implies a high barrier to exit.
Book value is least likely to be considered when using: A. a multiplier model. B. an asset-based valuation model. C. a present value mode
C is correct. Multiplier valuation models (in the form of P/B) and asset-based valuation models (in the form of adjustments to book value) use book value, whereas present value models typically discount future expected cash flo
The Beasley Corporation has just paid a dividend of $1.75 per share. If the required rate of return is 12.3 percent per year and dividends are expected to grow indefinitely at a constant rate of 9.2 percent per year, the intrinsic value of Beasley Corporation stock is closest to: A. $15.54. B. $56.45. C. $61.6
C is correct. P0 = D1/(r - g) = 1.75(1.092)/(0.123 - 0.092) = $61.6
Which of the following is least likely to involve industry analysis? A. Sector rotation strategy. B. Top-down fundamental investing. C. Tactical asset allocation strategy.
C is correct. Tactical asset allocation involves timing investments in asset classes and does not make use of industry analysis.
The best model to use when valuing a young dividend-paying company that is just entering the growth phase is most likely the: A. Gordon growth model. B. two-stage dividend discount model. C. three-stage dividend discount model.
C is correct. The Gordon growth model is best suited to valuing mature com- panies. The two-stage model is best for companies that are transitioning from a growth stage to a mature stage. The three-stage model is appropriate for young companies just entering the growth phase
Which of the following statements about company analysis is most accurate? A. The complexity of spreadsheet modeling ensures precise forecasts of finan- cial statements. B. The interpretation of financial ratios should focus on comparing the compa- ny's results over time but not with competitors. C. The corporate profile would include a description of the company's business, investment activities, governance, and strengths and weaknesses.
C is correct. The corporate profile would provide an understanding of these elements.
Which of the following life-cycle phases is typically characterized by high prices? A. Mature. B. Growth. C. Embryonic
C is correct. The embryonic stage is characterized by slow growth and high prices.
In which of the following life-cycle phases are price wars most likely to be absent? A. Mature. B. Decline C. Growth
C is correct. The growth phase is not likely to experience price wars because expanding industry demand provides companies the opportunity to grow even without increasing market share. When industry growth is stagnant, companies may only be able to grow by increasing market share, e.g., by engaging in price competition.
A price earnings ratio that is derived from the Gordon growth model is inversely related to the: A. growth rate. B. dividend payout ratio. C. required rate of return.
C is correct. The justified forward P/E is calculated as follows: D 1 0=1 E1 r−g P/E is inversely related to the required rate of return, r, and directly related to the growth rate, g, and the dividend payout ratio, D/E
Which of the following is most likely a characteristic of a concentrated industry? A. Infrequent, tacit coordination. B. Difficulty in monitoring other industry members. C.Industry members attempting to avoid competition on price
C is correct. The relatively few members of the industry generally try to avoid price competition.
Which of the following factors would most likely be a limitation of applying business-cycle analysis to global industry analysis? A. Some industries are relatively insensitive to the business cycle. B. Correlations of security returns between different world markets are rela- tively low. C. One region or country of the world may experience recession while another region experiences expansion.
C is correct. Varying conditions of recession or expansion around the world would affect the comparisons of companies with sales in different regions of the world.
Which of the following industry characteristics is generally least likely to pro- duce high returns on capital? A. High barriers to entry B. High degree of concentration C. Short lead time to build new plants
C is correct. With short lead times, industry capacity can be rapidly increased to satisfy demand, but it may also lead to overcapacity and lower profit
An analyst is attempting to value shares of the Dominion Company. The com- pany has just paid a dividend of $0.58 per share. Dividends are expected to grow by 20 percent next year and 15 percent the year after that. From the third year onward, dividends are expected to grow at 5.6 percent per year indefinitely. If the required rate of return is 8.3 percent, the intrinsic value of the stock is closest to: A. $26.00. B. $27.00. C. $28.00.
C. Is Correct V0 = 1 + 2 2 + 2 2 (1+r) (1+r) (1+r) = 0.70 + 0.80 + 31.29 (1.083) (1.083)2 (1.083)2 = $28.01 Note that D1 = 0.58(1.20) = 0.70, D2 = 0.58(1.20)(1.15) = 0.80, and P2 = D3/(k - g) = 0.80(1.056)/(0.083 - 0.056) = 31.2
A company that is sensitive to the business cycle would most likely: A. not have growth opportunities. B. experience below-average fluctuation in demand. C. sell products that the customer can purchase at a later date if necessary
is correct. Customers' flexibility as to when they purchase the product makes the product more sensitive to the business cycle
