Financial Statement Analysis Test #2
In 2013, Macy's paid $359 million of cash dividends. These dividends reduced assets and reduced retained earnings.
True
Contingent liabilities that are 'probable' and can be reasonably estimated are recorded on the balance sheet as a liability and as an expense in the income statement.
True
Credit ratings are an opinion of a company's relative default risk.
True
Depreciation expense, determined as a percentage of actual property, plant, and equipment, is added back to net income in the operating cash flow section.
True
Equity carve-outs make it easier to evaluate the individual business units of a conglomerate.
True
If HJ Heinz loses its dominance in the ketchup market and eventually becomes bankrupt, its preferred shareholders carry senior positions as claimants in bankruptcy vis-à-vis common shareholders.
True
Johansen Corporation's stock option footnote discloses before tax stock option expense of $457 million for fiscal 2014. The after tax stock option expense is disclosed as $244 million dollars. Johansen must increase its deferred tax assets by $213 million on its balance sheet for 2014.
True
Market prices of bonds fluctuate because the company's obligation (in the form of principal and interest payments) remains fixed.
True
Stockholders' equity is not accounted for at current fair value.
True
The forecasting process assumes that the cash on the balance sheet reflects an economically appropriate balance that we forecast similarly for the next fiscal year
True
The fourth step in the stock valuation is using information for valuation. This step involves estimating the cost of capital; describe the two adjustments that need to be made in this estimation.
1. adjusting for the time value of money 2. adjusting for risk
Emma Inc. currently pays a dividend of $2.25, and the company's dividend is expected to grow by 3% per year. The company's has the following costs of capital: Cost of equity capital = 9%, Cost of debt capital = 6.5%, Weighted average cost of capital = 8.25%.
(2.25 x 1.03) / (.09 - .03) = $38.63
Assume that you are being interviewed for a job with an investment banking firm as a stock analyst. The interviewer is interested in how you would value a stock. In a concise manner describe the steps you would take in order to value a stock.
1. understand the business environment and accounting info 2. Adjust and asses financial and accounting info 3. Forecast financial info 4. Use info for valuation
When projecting the balance sheet, what happens when the initial balance sheet yields estimated total assets greater than the sum of total liabilities and equity? A) The company will need additional financing from external sources. B) The company will not be able to pay for expenses in the future. C) The company projected a loss. D) The company has negative stockholders' equity. E) None of the above
A
Which best describes par value for a stock? A) An arbitrary amount set by the company for each share of stock B) The value of the stock if it is not sold for a premium or discount C) The current market value of the stock D) The value at which stock shares were originally issued E) None of the above
A
Which of the following represents the present value of a terminal period FCFF if rw is the weighted average cost of capital? A) (FCFFt+1 / (rw-g)) / (1+rw) t B) (FCFFt+1 / (g- rw)) / (1+rw) t C) (FCFFt / (rw-g)) / (1+g)t D) (FCFFt / (g- rw)) / (1+g)t
A
Which one of the following would be considered a contingent liability? A) A company estimates that it will probably have to pay $55,000 to the EPA for a chemical spill. B) A company owes $15,000 on inventories purchased on credit. C) A company has access to a line of credit with a bank in the amount of $100,000. D) A company believes that it is reasonably possible it will lose a lawsuit and damages could be $80,000. E) None of the above
A
What is a stock split? Why do firms split their stock?
A stock split is the pro rata issuance of shares with a corresponding reduction in the par value of the shares. Since this is not a monetary transaction, total stockholders' equity is unaffected. Companies split their stock to reduce the per share stock price, which will presumably increase investor interest, which will in turn increase stock price.
. In its 2013 annual report, Lockheed Martin reported net earnings of $2,981 million and dividends paid of $1,540 million. Your forecast of net income for Lockheed Martin for 2014 is $3,130 million. What are projected dividends for the company for 2014? A) $1,617 million B) $1,540 million C) $1,467 million D) $1,000 million E) None of the above
A. $3,130 million × ($1,540 million / $2,981 million) = $1,617 million
In general, how do credit analysts determine the risk-free rate? A) The average corporate yield B) The yield on U.S. Government borrowings C) The rate defined by the largest U.S. banks D) The weighted-average corporate yield based on the preceding four quarters E) None of the above
B
The equity carve-out in which the parent company distributes the subsidiary's shares as a dividend to shareholders is called which of the following? A) Sell-Off B) Spin-Off C) Split-Off D) Stock Split E) None of the above
B
The proper discount rate when using the dividend discount valuation model is the: ©Cambridge Business Publishers, 2015 Test Bank, Module 12 12-3 A) Weighted average cost of capital B) Cost of equity capital C) Cost of debt capital D) Average borrowing rate
B
What does the market value of a company represent? Does this accurately represent the value of the firm? Why or why not?
B
When calculating the cost of debt capital you must multiply the average borrowing rate by: A) Marginal income tax rate B) 1 - Marginal income tax rate C) The effective tax rate D) 1 - Statutory corporate rate
B
Which one of the following items is not a component of contributed capital? A) Preferred stock B) Retained earnings C) Common stock D) Additional paid-in capital E) All of the above
B
The Capital Asset Pricing Model states that the expected return on a particular asset relates to all of the following components except: A) The risk-free rate B) The alpha risk C) The beta risk D) Stock specific risk
B - CAPM does not have an alpha factor
. When projecting the statement of cash flows, the following represent operating cash outflows (check all that apply): A) Decrease in accounts receivable. B) Increase in inventory C) Decrease in accounts payable D) Increase in wages payable E) Increase in property, plant, and equipment
B and C
Which of the following is an inconsistency of using market multiples to determine value? A) Using a market multiple assumes that the target company is correctly priced, while comparable companies are mispriced. B) Using a market multiple assumes that the target company is mispriced, while comparable companies are correctly priced. C) Using a market multiple assumes that all companies are mispriced. D) Using a market multiple assumes that the target company can be fully described by its summary performance measure.
B.
Becker Products is a manufacturer and distributor of numerous food products. The company has a book value of $19.15 per share. Becker Products is part of the food processing industry which has an industry PB ratio of 2.15. Using industry information, estimate the intrinsic value of Becker Products' equity per share? A) $ 8.91 B) $41.17 C) $17.81 D) $46.58
B. 19.15 x 2.15
PB ratios are higher than __________________ when companies carry debt. A) Price-to-NNO ratios B) Price-to-NOA ratios C) Residual Operating Income D) Price to Sales ratios
B. Levered PB ratios are higher than un-levered PB ratios
In an effort to improve cash flow, your supervisor suggests paying trade creditors more slowly. Is such a move always advantageous for a company?
By extending payables, companies can avail themselves of a source of low cost funds. They are, in effect, using other companies' funds to finance their operations. This is known as "leaning on the trade" and it is a way to use accounts payable to finance the working capital of a company. Leaning on the trade improves RNOA by reducing NOA with no effect on NOPAT so long as the company does not take undue advantage of its suppliers. If the company lengthens payables too much, the company's reputation may be impugned and in the extreme, the credit rating may worsen.
. In this form of equity carve-out, the parent company exchanges stock that it owns in the subsidiary for some of the parent shares owned by its shareholders: A) Sell-Off B) Spin-Off C) Split-Off D) None of the above
C
. Which of the following is a common method for forecasting nonoperating assets? A) Use prior-year common-sized balance sheet ratio B) Apply forecasted sales growth rate to historic balance C) Assume no change in the account balance D) Plug the amount based on other balance sheet accounts E) None of the above
C
Convertible preferred stock conveys what additional benefit over common stock? A) Convertible preferred stock has a fixed dividend yield exceeding the return for common stock. B) Unpaid dividends on convertible preferred stock are never paid before common stock dividends. C) Convertible preferred stock has a senior claimant position in bankruptcy. D) Convertible stock can be converted into the company's debt security. E) All of the above
C
Credit analysis concerns which of the following? A) The price of a company's stock B) The ability of a company to consistently pay dividends C) The probability a company will make timely payments D) An assessment of a company's credit-granting policies E) None of the above
C
Market beta is a statistical coefficient that reflects a company's historical stock price volatility relative to: A) All industry competitors in the world B) Risk free government bonds C) All securities in the market D) All firms of comparable market value
C
The average borrowing rate for interest bearing debt is calculated as: A) Interest Expense divided by Average Liabilities B) Interest Paid divided by Average Liabilities C) Interest Expense divided by Average Interest-bearing debt D) Interest Expense divided by Average Long-term Debt
C
The first step in stock valuation requires: A) Estimating the cost of capital B) Applying a valuation model C) Analyzing the business D) Creating financial statements
C
The weighted average cost of capital is used when valuing the payoffs... A) To equity holders B) To debt holders C) To both equity and debt holders D) To equity holders less the payoff to debt holders
C
When considering the residual operating income model, a company-value-to-netoperating-assets ratio equal to 1 would suggest: A) Future ROPI is equal to 0 B) Future ROPI is equal to 1 C) The expected present value of future ROPI is equal to 0 D) The expected present value of future ROPI is equal to 1
C
When forecasting balance sheet financials, an unusually high projected short-term investment balance suggests which of the following? A) Sales are projected to increase in coming years. B) The company will need to sell additional stock. C) The company could pay off debt in the next year. D) Account receivables have dipped to an unacceptable level. E) None of the above
C
Which of following is an advantage of the ROPI model? A) Well known and widely accepted valuation model B) Cash flows are not affected by accrual accounting C) Utilizes both the balance sheet and the income statement, and captures the information in accrual accounting D) Does not depend on an arbitrary discount rate. E) None of the above
C
Which of the following factors should not be considered when choosing comparable companies and using book value as the summary performance measure? A) Expected future profitability B) Expected future growth C) Expected equity growth D) Capital structure
C
Which of the following items is an advantage of the discounted cash flow (DCF) model, compared with the residual operating income (ROPI) model? A) It forecasts residual operating income which is easier than forecasting cash flow. B) It utilizes information from both the balance sheet and income statement for valuation model. C) It is well known and widely accepted model D) It focuses on value drivers such as margins and turnovers E) All of the above
C
Which of the following transactions is similar to a repurchase of stock in its accounting treatment? A) Sell-off B) Spin-off C) Split-off D) Carve-out E) None of the above
C
Gilgen Corporation has $185 million dollars of interest-bearing debt outstanding at the end of fiscal 2014 year. In addition, the company incurred $26 million dollars of interest expense in 2014. If the company has a marginal tax rate of 35% calculate Gilgen's cost of debt capital. A) 14.1% B) 9.1% C) 9.8% D) 11.1%
C. (26/185) x (1-.3)
Under which circumstance will Company A not sell at a higher PB ratio than Company B? A) Company A has higher profitability than Company B. B) Company A has higher expected growth than Company B. C) Company A has a higher discount rate than Company B. D) Company A has higher leverage than Company B.
C. Companies with lower discount rates will sell at a higher PB ratio
Which of the following factors should not be considered when choosing comparable companies and using net operating assets as the summary performance measure? A) Expected future profitability B) Expected future growth C) Capital structure D) Expected operating risk
C. RNOA, growth in NOA, and variance in operating income are what should be considered
Stock Issuance:
Companies generally issue stock to raise cash and other assets for operations or to retire debt. Stock issuances only affect the balance sheet and have no impact on the Income statement.
Why do some suggest that comprehensive income is a more inclusive measure of company performance?
Comprehensive income includes all changes to equity other than those arising from capital transactions (e.g., sales and purchases of stock). Many items bypass the income statement, such as foreign currency adjustments, unrealized changes in market values of available-for-sale securities and derivatives, minimum pension liability adjustments, and changes in the market value of certain security investments. Consequently, some assert that comprehensive income is a more inclusive measure of performance than net income.
Why would a corporate manager decide to use an equity carve-out to maximize shareholder value?
Consolidated financial statements often make it difficult to determine the performance of individual business units, thus complicating their evaluation by investors. Conglomerates will use sell-offs, spinoffs and split-offs to separate individual operating units from the remaining corporations, thus making it easier for the market to value these subsidiaries.
Which of the following descriptions of the residual operating income (ROPI) model is inaccurate? A) ROPI analysis focuses on the amount by which shareholder value is created during a period. B) ROPI is positive when NOPAT is higher than WACC × NOABeg. C) ROPI is useful as a management tool as it forces managers to pay attention to both the income statement and the balance sheet. D) One critique of the ROPI model is that it focuses managers' attention solely on short-term operating assets and neglects investment in long-term operating assets. E) None of the above
D
Google has a market beta of 1.16, if the market increases by 1.4% on a given day we would expect that Google's stock price would: A) Increase by 1.39% B) Increase by 2.36% C) Decrease by 1.86% D) Increase by 1.62%
D. 1.16 x 1.4
All of the following are attributes of the ROPI model except: A) ROPI utilizes both the balance sheet and the income statement, capturing information in accrual accounting. B) ROPI is immune from the effects of differing accounting policies. C) ROPI is falsely perceived as influenced by accrual accounting policies. D) ROPI model is accurately perceived as influenced by accrual accounting policies. E) None of the above
D. ROPI is immune from accounting policies
Which of the following items should not be included in net operating profit after tax (NOPAT)? A) Revenue B) Cost of Goods Sold C) Selling, General & Administrative Expenses D) Decrease in Accounts Receivable E) None of the above
D. Decrease in Accounts Receivable
Why might a company repurchase its own stock? A) It believes that the market undervalues its shares B) To offset dilutive effects of employee stock options granted C) To recognize an economic gain when the treasury shares are later sold for a profit D) To improve earnings per share by reducing the denominator E) All of the above
E
. Which of the following describes the analytic process to determine the depreciation expense included in the forecasted statement of cash flows? A) Depreciation is a non-cash expense, thus it is not included in the statement of cash flows. B) The year-over-year change in property, plant and equipment on the balance sheet is equal to depreciation expense. C) Property, plant, and equipment from the prior year multiplied by depreciation rate reported in the footnotes. D) Gross property, plant, and equipment from the prior year + Capital expenditures - Forecasted gross property, plant, and equipment E) None of the above
E. Depreciation expense is calculated from historical average depreciation expense, not the footnoted rates.
Discuss how growth, risk and profitability factors cause differences in price-earnings ratios across firms.
Expected growth in residual income leads to higher PE ratios. Risk will affect a company's cost of equity capital, so that all things being equal more risk firms will experience a lower market value and a lower PE ratio profitability will not affect a companys P/E ratio
The higher the expected growth rate of the terminal free cash flow to the firm, the lower the PV of the terminal value becomes
False
Differing accrural accounting policies have an impact on the estimated value of equity when using the ROPI model
False
If accrued liabilities are overestimated in the current period, the reported income in a following period will be lower than it should be.
False
Kimberly-Clark recently repurchased 12.4 million shares of common stock at a price of $97 per share. One plausible reason for this is that the company feels that its stock is overvalued at the current market price.
False
The adjusting process is useful for historical analysis, but not for prospective analysis
False
Secured debtholders have a preferred position over other creditors but not over preferred stock holders.
False Secured debtholders have a priority claim on those secured assets. These come before all stockholder claims, even those from preferred stockholders.
Unlike stock, once sold, bonds can only be traded in private transactions between arms' length parties.
False There are secondary markets for previously issued bonds
The residual operating income model (ROPI) focuses on net income which is a more accurate measure of future profitability than expected cash flows.
False - NOPAT is the key value
The power of the residual operating income (ROPI) model is that it allows managers to focus on either the income statement or the balance sheet to increase firm value.
False - both income statement and balance sheet
Projecting balance sheet items is most accurate if we use the most recent ratios
False. For accurate forecasts, we want to use the most stable and relevant ratios concerning the company's financial condition. Sometimes, the most recent ratios are not stable.
When stock options are granted, the contributed capital increase is equal to the number of options granted multiplied by the estimated fair-value of the stock on the grant date.
False. It is the estimated fair-value of the option on the grant date and not that of the underlying stock.
Higher credit-rated borrowers receive lower interest rates than lower credit-rated borrowers, but the differences are typically not significant.
False. The difference is significant. Highest credit-rated borrowers receive interest rates approximately ½ that of lowest credit-rated borrowers.
An unbiased approach to forecasting future revenues gives equal weight to historical organic revenue growth and revenue growth from mergers and acquisitions.
False. The most accurate forecast of future revenue is one that considers future organic versus M&A revenue growth. Historic numbers are informative to the extent that we expect past trends to continue.
The forecasted statement of cash flows uses either the forecasted income statement or the balance sheet.
False. The statement of cash flow uses both to explain the change in cash on the balance sheet.
The usual financial statement projection process is completed in the following order: balance sheet, income statement, statement of cash flows.
False. The usual projection process begins with the income statement, followed by the balance sheet, and finished with the statement of cash flows.
The advantage of the dividend discount model is that:
It is simple
Liquidity
Liquidity - This is an important indicator of the firm's ability to make short term financial obligations. The more liquid the firm, the more cash on hand to pay expenses and to create new business opportunities. Low liquidity indicates a higher risk investment.
Briefly describe how analysts typically forecast each of the following items: Sales, Cost of Sales, Inventory, and Tax expense.
Sales are forecast as prior-year sales increased by the expected sales growth for the coming year. We typically forecast cost of sales to be the same percentage as the prior year. Forecasted cost of sales is forecasted sales multiplied by the prior-year cost of sales percentage. Inventory is typically forecast as a constant percentage of sales. Tax expense is forecast using forecasted pretax income and the same effective tax rate as in prior years.
Solvency
Solvency - This is an important indicator of long-term ability to pay off debt. Firms with large amounts of long-term debt are riskier investments due to the higher financial goals they must achieve. Lower solvency indicates a riskier bond rating
Explain the concept behind the Residual Operating Income (ROPI) model.
The ROPI model is the idea that owners and non-owners each expect a certain amount of return in exchange for the money that they give
In a recent quarterly earnings announcement, Meridian Inc. announced that its earnings had markedly increased (up 20 cents per share over the prior year). Meridian's stock price dropped nearly 5% on the earnings report. Why do you believe that Meridian's stock reacted as it did?
The market likely experienced a greater earnings increase
How do expectations about future profitability and required return factor into the pricing of common stocks?
The price investors are willing to pay for the stock is positivity related to expectations about future profitability and negatively related to required return
Profitability
This measure is indicative of the ability of the company to generate positive free cash flows. The more profitable the company, the better the debt rating it should have.
Stock Repurchase
This transaction occurs when a company buys some of the shares back from the market at the prevailing market value. Stock repurchases represent a downsizing of the company. This transaction is recorded in the balance sheet as a reduction of cash and paid-in capital, with no effect on the income statement.
. Revenue forecasts derived from unit sales and current prices are usually more accurate than those derived from dollar sales.
True
The market rate of interest is equal to the risk-free rate plus a risk premium.
True
The residual operating income (ROPI) model estimates the firm value as the current book value of net operating assets plus the present value of expected residual operating income.
True
To forecast property, plant, and equipment (PPE) we first determine capital expenditures (CAPEX) and add that to historical PPE.
True
When Kimberly-Clark recently repurchased its stock, this action "downsized" the company. This has the opposite financial statement effects as stock issuance.
True
When a "large" stock dividend is paid out, retained earnings are reduced by the par value of the stock.
True
When there is a purchase and sale of stock, or a payment of dividends, there is never any gain or loss recorded.
True
Calculate the following present value amounts: a. An investor is expected to receive $2,000 5 years from today. What would its present value be today assuming a discount rate of 7%? b. An investor is expected to receive $1,000 each year for the next 7 years. What would its present value be today assuming a discount rate of 8%?
a. it would change at a rate greater than the market b. CAPM = .0375 + (1.63 x .065) = 14.35%
What does the market value of a company represent? Does this accurately represent the value of the firm? Why or why not?
could be higher or lower
The drawback of a multiyear forecast is that the same revenue growth assumption must be used for each year and this may not be the most accurate assessment of future revenue growth especially for firms that have not yet reached maturity.
false. Assumptions may vary
Retained earnings and accumulated other comprehensive income (AOCI) can be found in the contributed capital section of stockholders' equity
false. Retained earnings and AOCI are found in the "earned capital" portion of the stockholders' equity section of the balance sheet.
As __ increases the terminal value increases
g
