Series 86 - Exam 3
When examining electrical power output, which of the following would not be useful in applying regression analysis? A- Population B- Temperature C- Stock market D- Economic development
Population and temperature are drivers for power consumption. Economic development is one of the keys for long-term construction and expansion of plants. The regulated status and services provided by this industry make it far less cyclical than the stock market.
Which of the following industries is least likely to be affected by an increase in interest rates? A- A transportation firm B- A utility company C- An accounting firm D- An automotive company
Service industries are less capital intensive, and are therefore less susceptible to interest rate changes.
In which of the following situations would an analyst use EV / Sales? A- The company is highly leveraged B- Companies within the sector have significant differences in profit margins C- The company has negative cash flow D- The company has high capital expenditures but low depreciation
A company that has negative cash flow may be evaluated based on its enterprise value divided by sales. Since the cash flow is negative, discounted cash flow valuation is compromised. The negative cash flow may result from the sale of low profit margin products and a decline in sales. This is useful when comparing companies that have differences in financial structure rather than differences in profit margin. For example, Company L borrows funds on a short-term basis to increase sales and Company C consistently has a lower level of sales, but has very little debt.
The Balance Sheet for Company Z (All numbers in thousands) Cash and Equivalents — $3,214,000Inventory — $5,638,000Property, Plant, and Equipment — $11,314,000Total Assets — $23,815,000Long-Term Debt and other Long-Term Liabilities — $2,986,000Shareholder Equity — $10,829,000 Based on the preceding information, this balance sheet is most representative of a company from which of the following sectors? A- Discount variety store B- Chip manufacturing C- Telecommunications D- Financial service company
A discount variety store, such as Costco, Target or Wal-Mart, typically has a balance sheet that is dominated by a large amount of inventory as a percentage of total assets. A chip manufacturer does not have a high percentage of its assets in inventory. Financial service companies have little or no inventory on their balance sheets. They have a large percentage of their assets listed on the balance sheet as cash and cash equivalents, and investments. Telecommunications companies typically have a balance sheet that is dominated by a large amount of fixed assets, long-term debt, and long-term liabilities. Inventory is insignificant as a percentage of total assets.
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? A- Floor-Mart's price is unlikely to be affected B- Floor-Mart's price will likely go up as it achieves collateral price efficiencies C- Floor-Mart's price will follow the direction of price changes of its supplier D- Floor-Mart's price will likely go down due to pressure by the supplier
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.
Which of the following events would be a red flag to an analyst evaluating a company's quality of earnings? A- An increase in accounts payable B- An increase in deferred tax liabilities C- Lower than normal reserves for bad-debt expenses D- An increase in accounts receivable
A red flag for analysts would be lower than normal reserves for bad-debt expenses. The reduction of these reserves increases reported profitability (or reduced levels of loss) by reducing expenses. If bad-debt expenses increase, a low reserve will cause a significant decline in the quality of the earnings.
All of the following situations would indicate inflationary pressure on the economy, EXCEPT: A- Falling weekly jobless claims B- Rising retail sales figures C- Falling industrial production D- A rising consumer price index
A rising CPI is the definition of inflation. If retail sales figures are going up or jobless claims are falling, consumer demand should rise. These two situations are therefore inflationary. If industrial production is declining, the assumption is that the economy is slowing down.
Which of the following events would lower the risk of investing in Genero Drugs, a manufacturer of generic pharmaceutical products? A- Genero Drugs invests significant capital in research and development for new drugs B- The head of R&D for Genero Drugs leaves the company C- An announcement is expected regarding Medicare reimbursements D- A competitor has won a lawsuit involving the marketing of a generic drug
A successful lawsuit permitting the marketing of a generic drug would be beneficial for other manufacturers of generic drugs. This may reduce the risk of investing in this type of company. The development and testing cycles of new drugs last for several years, without any assurance that the drugs will (1) be effective (2) be approved or (3) penetrate the market if approved. The head of R&D leaving would increase the risk of investing in the company. An announcement that is expected regarding Medicare reimbursements could be good news (expanded coverage), or bad news (reduced coverage).
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.
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.
In theory, the lowest cost of financing corporate expansion is by issuing debt since shareholders demand additional returns for risk assumption on equity issues. In considering this concept, why wouldn't management always finance expansion through debt rather than equity? A- Debt is more difficult to issue than equity B- Shareholder approval is required to issue debt instruments C- Debt limitations reduce the company's ability to finance projects D- Debt is more risky to the providers of capital
As a corporation finances new projects through the use of debt, it uses up its ability to borrow additional funds. At some point, the company will have borrowed as much as it is able to and it will reach its debt limit. Future projects must then be financed through equity issued.
Within the supply chain of an industry, widget manufacturers sell their product to the XYZ Company. XYZ sells its product to the ABC Company XYZ purchases 70% of the widget production output ABC purchases 90% of the output from XYZ Regulations have previously restricted ABC's capital investment in facilities. It is now unregulated. This will permit ABC to increase capital expenditures within its facilities. What is the initial effect on widget pricing and the demand for widgets? A- Demand for widgets would increase and the prices of widgets would increase B- Demand for widgets would decrease and the prices of widgets would increase C- Demand for widgets would increase and the prices of widgets would decrease D- Demand for widgets would decrease and the prices of widgets would decrease
Assuming ABC was experiencing sufficient consumer demand and deregulation would allow ABC to increase capacity, ABC's demand for widgets from its suppliers would be expected to increase. This shift in the demand for widgets would permit widget manufacturers such as XYZ to initially raise prices. As the price of widgets rises, new widget manufactures may enter into the widget industry creating additional supply and driving down prices in the long-term. This question asks, about the initial effect on widget pricing not the long-term effect.
All of the following are TRUE of cost analysis, EXCEPT: A- Over the long-term, all costs are variable B- Average total cost is equal to average fixed costs plus average variable costs C- Diminishing returns occur when average variable costs exceed average fixed costs D- Diminishing returns will not occur as long as average variable costs is greater than marginal costs
Average variable costs plus average fixed costs equal average total cost. Diminishing returns occur when average total costs begins to rise.
A company's return on equity would increase if it: A- Sells real estate for a gain B- Sells one of its division for a loss C- Issues common stock D- Swaps assets with another entity
Selling assets for a gain increases profitability and, although the profit may be a one-time event, the return on equity (ROE) would rise.
You are evaluating two companies in the same sector. Which of the following choices describes why net sales would be used, rather than net income? A- Net income eliminates the effects of depreciation and amortization B- Net sales eliminates the effects of depreciation and amortization C- Net sales will provide a higher ratio calculation D- Net sales eliminates the payment of taxes
By using net sales rather than net income, an analyst can neutralize or eliminate different methods of depreciation or amortization. It makes comparing two companies more equitable.
Where would an analyst likely use EV / EBITDA as a valuation tool? A- Truck manufacturing B- Biotech C- Publishing D- Craft stores
Capital intensive industries are frequently evaluated using an EV / EBITDA approach. EV is an abbreviation for enterprise value (market value of shares plus debt minus cash). EBITDA is sometimes viewed as core profitability, removing the influences of interest, taxes, depreciation and amortization.
Mae Bear Corp. has increased sales in the last quarter by 33%. In the past, the company has been involved in channel stuffing. As an analyst following this company, which TWO areas should be reviewed to gain a better understanding of the quarter? I. Footnotes and the disclosure statement of nonrecurring items II. Accounts receivable growth exceeding sales growth III. Days sales outstanding (DSO) IV. Revenue recognition policy A- I and II B- I and IV C- II and III D- III and IV
Channel stuffing is a deceptive business practice used by a company to inflate its sales and earnings figures by deliberately sending retailers along its distribution channel more products than they are able to sell to the public. Through channel stuffing, distributors temporarily increase accounts receivables. However, if unable to sell the excess products, retailers will return the excess items to the distributor. The distributor must adjust accounts receivable and its bottom line. Channel stuffing ultimately catches up with the company. It cannot maintain sales at the rate it is stuffing. This is usually done fraudulently to raise the value of the stock. Channel stuffing is illegal. An analyst would want to carefully review a company's financial statements to see if the accounts receivable growth rate exceeds the sales growth rate and analyze any significant changes in a company's Days Sales Outstanding (DSO).
A company with a low P/E and a high dividend payout ratio has a: A- High dividend yield B- Low dividend yield C- High debt-to-equity ratio D- Low debt-to-equity ratio
Companies with a low P/E ratio have high earnings compared to price. A high dividend payout ratio indicates a high payout in view of earnings; therefore, a company with a low P/E and a high dividend payout ratio will have a high dividend yield.
When attempting to value an initial public offering of securities, an analyst would NOT use: A- Sum-of-the-parts analysis B- Discounted cash flow analysis C- Comparable company analysis D- Comparable transaction analysis
Comparable transaction analysis, or M&A comparable analysis, is a valuation method used to value a company by comparing it to the transactional value of other companies in the same or similar industry sector. It is used to value the price an acquirer may offer a target company and would generally not be used to value an IPO. The other valuation methods may be used to value a company in order to determine its intrinsic value.
Which TWO of the following actions would cause money to become tight? I. The Federal Reserve Board decreases the discount rate II. The Federal Reserve Board increases reserve requirements of member banks III. The Federal Reserve Board buys securities in the open market IV. The Federal Reserve Board sells securities in the open market A- I and II B- I and III C- II and III D- II and IV
Credit is tightened when money is removed from the system and less is available for loans. When the Fed sells securities in the open market, money is withdrawn from the system. An increase in reserve requirements will decrease excess reserves and reduce the amount available for loans.
A company's senior management is compensated based on EPS performance. If a research analyst believes this represents a conflict of interest, which of the following persons should she contact to discuss the situation? A- The board of directors B- The company's CEO C- The company's CFO D- The company's internal audit department
Day-to-day corporate leadership and management consist of the CEO, CFO, and other senior management personnel. The research analyst needs to contact someone, or a group of persons, with an objective view of compensation and EPS measurement. In this case, the board of directors (BOD) might attempt to address these concerns. The BOD usually is made up of a majority of independent directors, who usually are more objective than senior management.
Which TWO of the following statements are TRUE? I. Free cash flow is an important measurement for creditors of a company. II. EBIT is an important measurement for creditors of a company. III. Free cash flow is an important measurement for shareholders of a company. IV. EBIT is an important measurement for shareholders of a company. A- I and III B- I and IV C- II and III D- II and IV
EBIT is a measure of the cash available for creditors. Free cash flow is a measure of the cash available to shareholders.
Which of the following BEST defines EBITDA? A- Net income + interest + taxes + depreciation and amortization B- Net income + interest - taxes + depreciation and amortization C- Net income - interest + taxes + depreciation and amortization D- Revenue + interest - taxes + depreciation and amortization
Earnings before interest and taxes (EBIT) is a GAAP measure. Adding back depreciation and amortization (EBITDA) is a non-GAAP measure. Subtracting taxes and interest from EBIT equals net income, so EBITDA can also be defined as net income + interest + taxes + depreciation and amortization.
The Tarmac Co. and Madone Co. are in the same industry and have similar capital structures. One of the main differences is that the Tarmac Co. is projected to have a deteriorating working capital over the next few years. Based on this fact, which valuation method would lead to a higher share price for the Madone Co.? A- A discounted cash flow analysis (DCF) B- A sum-of-the-parts analysis (SOTP) C- The PEG ratio D- The enterprise value to sales ratio
Discounted cash flow (DCF) valuation assumes that a company can be valued based on the present valuation of its projected free cash flows over a given period using the appropriate cost of capital as the discount rate. DCF analysis is heavily dependent on estimating cash flows, which takes into consideration a company's working capital. An accountant's definition of working capital is the difference between current assets and current liabilities. From a DCF valuation perspective, a better definition is the difference between noncash current assets and nondebt-related current liabilities. If noncash working capital increases, the firm is tying up cash, causing cash flows to be reduced. This would lead to a lower valuation. On the other hand, if noncash working capital decreases, cash flows would increase, leading to a higher valuation. The term worsening or deteriorating working capital condition would refer to an increase in noncash working capital. Sum-of-the-parts would be used if a company had different operating units in which each one would have different valuation methods. PEG, or price/earnings divided by the expected growth rate, or EV/sales, would not be used since changes in noncash working capital would not have a major impact on these two valuation methods.
Which of the following features is a disadvantage of DCF analysis? A- The evaluation rendered is based only on the current earnings power of a company B- The WACC is often assumed to be a constant C- The evaluation of cash flows is a less accurate measurement of performance than net income D- The analysis is only applicable to U.S.-based companies since GAAP measurements are used
Discounted cash flow (DCF) valuation assumes that a target company can be valued based on the present valuation of its projected free cash flows (over a given period). Cash flows are used in lieu of Generally Accepted Accounting Principles (GAAP) earnings. GAAP earnings can be distorted due to goodwill impairment (or lack thereof), asset write-downs, depreciation, and numerous other noncash charges. DCF analysis considers both the current and future earnings power of the target. DCF analysis has its limits. It is not a suitable metric when examining companies that have little or no sales. Additionally, if the expected rate of return, or the size and timing of cash flows are not estimated, the fair value result will be in error. Another potential bias in the valuation is based on the discount rate selected for the present value of the future cash flows. A discount rate that is too high or too low will skew the valuation of the company. An additional drawback of DCF analysis is the assumption of a constant (stable) capital structure (a.k.a. constant WACC), although some sophisticated practitioners may attempt to model the potential capital structure changes following the acquisition. As is the case with any valuation metric, DCF analysis is only as good as its assumptions.
The calculation for Enterprise Valuation is: A- Market capitalization plus debt minus cash and cash equivalents B- Add the adjusted net asset value and the present value of future profits of a firm C- Market Capitalization minus Interest Bearing Debt plus Preferred Stock Excess Cash D- Take the difference between total shareholders' equity and preferred equity and divide by the number of common shares outstanding
Enterprise Value, also known as EV, is a useful measure of a company's value. Enterprise value is the theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company's debt and book its cash.
Assuming that interest rates are rising, a company that uses a FIFO inventory method will have all of the following, EXCEPT: A- Lower cost of goods sold B- Lower taxes C- Higher inventory valuation D- Higher profits
First-in, first-out (FIFO) accounting will reflect a lower cost of goods sold. The oldest inventory will be produced at a lower cost and therefore result in a higher profit and higher (not lower) taxes. Since this inventory is used first, it is cheaper than the last-in, first-out (LIFO) inventory during an inflationary or rising interest rate environment.
You are evaluating two companies. You have noticed that one of the companies uses LIFO while the other uses FIFO. Inflation has been rising. You would conclude that: I. The company using FIFO has a more aggressive accounting method and would inflate earnings II. The company using LIFO has a more aggressive accounting method and would inflate earnings III. The cost of goods sold (COGS) would appear lower under FIFO IV. The cost of goods sold (COGS) would appear lower under LIFO A- I and III only B- I and IV only C- II and III only D- II and IV only
First-in, first-out accounting would reflect lower cost of goods sold. The oldest inventory would be produced at a lower cost. Since this inventory is used first, it is cheaper than the last-in inventory during an inflationary period. This is an aggressive accounting method since it will have the effect of elevating earnings in the short run. LIFO would show lower EPS and is considered to be more conservative.
A privately held financial training company has contacted your firm in order to put itself up for sale. The managing director of your group has asked you to review the fixed and variable costs of the company in order to suggest methods to increase the company's profit margins. Which of the following expenses is considered a variable cost? A- Compensation paid to the five partners of the firm B- Salaries paid to the administrative staff C- Rent paid for the firm's four offices D- The cost of the printed materials used in its training programs
Fixed costs for this company would include compensation for management and support staff as well as their health care expenses, rent paid for office space, and outside classroom expenses. The cost of written materials would be variable, depending on the number of participants in the training classes.
If Company A has a lower gross margin than Company B, but both companies have an identical EPS, you would conclude: A- Net income is identical for both companies, but Company A has lower revenue B- Revenues are identical for both companies, but Company B has a lower tax rate C- Net income is identical for both companies, but Company B has a lower tax rate D- Net income is identical, but Company A has a lower tax rate
Given a lower gross margin, perhaps the result of A's lower revenue, net income could not be identical. A's income would be lower, not identical. If revenues were identical, with B's higher margin, it would produce higher, not identical, EPS if it had a lower tax rate. A would have to have a higher gross margin for net income to be identical because B has a lower tax rate. The correct answer is: Net income could be identical with B, given A's lower gross margin, if A had a lower tax rate.
A company's operating income and tax rate are flat from the previous year. If the net income of the company increased by 7%, which of the following statements is TRUE? A- The company's operating expenses have increased B- The company's interest expense has decreased C- The company's preferred dividend payments have increased D -The depreciation expenses of the company have decreased
If operating income and the tax rate remain flat, and the net income has increased, the only possible answer is that the company's interest expenses have decreased. Since we are not given the total sales or revenue, we cannot conclude whether depreciation or operating expenses have increased or decreased. Preferred dividends are subtracted after, not prior to, calculating net income.
In a mature company, if WACC increases, which of the following results would be expected? A- The terminal value decreases and the valuation of the company increases B- The terminal value decreases and the valuation of the company decreases C- The terminal value increases and the valuation of the company decreases D- The terminal value and company value remain the same
If the weighted average cost of capital (WACC) increases, the valuation of a company (including terminal value) decreases. Using a DCF approach in calculating the terminal value, the formula is, the last expected cash flow / (WACC - terminal growth rate). If WACC increases, the terminal value would decline. Since the valuation of the company is based upon the terminal value, it would also decline.
A broker/dealer has been approached by a client who wants to sell his company. The firm has determined that, prior to the sale, it should improve its total enterprise value to EBITDA (TEV / EBITDA). Which TWO of the following choices would help MOST to achieve this result? I. Change the method of depreciation in order to reduce the company's taxes II. Accelerate sales growth by marketing and launching a new product III. Reduce administrative costs by outsourcing certain Human Resources functions IV. Change the inventory method from FIFO to LIFO A- I and III B- I and IV C- II and III D- II and IV
In order to improve its TEV / EBITDA, the company can focus on its EBITDA growth strategy (increase revenue and decrease costs). Of the choices listed, accelerating sales growth by marketing and launching a new product, and reducing administrative costs by outsourcing certain Human Resources functions could accomplish this goal. Other methods could include general business expansion and growth through acquisitions, as well as other types of cost reductions and restructuring, for example, selling off a losing business unit. Changing the method of depreciation in order to reduce the company's taxes would have no effect on EBITDA, since it is a pretax number. Changing the inventory method from FIFO to LIFO would increase expenses, not reduce expenses, since we assume a rising price environment. First-in, first-out accounting would reflect a lower cost of goods sold. The oldest inventory would be produced at a lower cost. With this inventory method, it is cheaper than the last-in inventory during an inflationary period. LIFO would show a lower operating profit. (16990)
Which of the following statements is TRUE when calculating tangible book value per share? A- All intangibles are deducted from the calculation. B- Intangibles with an identifiable market value may be included in the tangible book value per share. C- Goodwill is always included in the tangible book value per share. D- Intangibles will not have a market value if the company is sold.
Intangibles such as copyrights and patents may have a separate and definable market value. They may be identified and sold separately from the other assets of the company. Therefore, they may be included in the tangible book value of the company.
In which of the following situations would an analyst expect regression analysis to be the LEAST useful? A- Rainy days and retail sales B- Computer printer sales and auto sales C- GDP and alcoholic beverage consumption D- New business formation and landline communications
In regression analysis, the emphasis is on predicting one variable from the other. Historical data is used, but there is an attempt to determine to what extent one variable depends on the other. It is unlikely that computer printer sales and auto sales depend on one another. Rainy days influence retail sales (e.g., one would expect limited retail activity during a hurricane). General economic growth influences most types of consumption. Business formation enhances the need for communications links.
Which of the following choices is considered a leading economic indicator? A- Changes in wholesale prices of raw materials B- Industrial production C- Average duration of unemployment D -Commercial and industrial loans outstanding
Industrial production is considered a coincident indicator, while average duration of unemployment and commercial/industrial loans outstanding are lagging indicators.
Company X's earnings have risen by 15%, while the earnings of the suppliers used by Company X have declined by 5%. Which of the following is the most relevant to the forward earnings projections of Company X? A- Review Company X's Form 10-K. B- Interview the distributors of Company X's product. C- Interview the suppliers to Company X. D- Interview the companies with the largest market share in the same sector as Company X.
Interviews with the distributors will provide an idea of where the company will be in sub- sequent quarters. This will help to determine if the distributors are experiencing shrinking margins and/or if costs are increasing. Interviewing suppliers would only allow an analyst to determine potential costs to be passed on to Company X. Interviewing the companies with largest market share in the same sector is somewhat limited. It's an overview of the sector perceptions. Lastly, a review of Company X's financial statements will only provide the historic results of the company. It doesn't provide the best gauge to project future results.
Which of the following statements is TRUE of an industry with zero economic profit? A- The industry will eventually cease to exist. B- Individual companies may still generate normal profits. C- Capital expenditure exceeds normal profit. D- Revenues exceed costs.
Normal profit is considered a cost in economic terms, specifically, the cost of entrepreneurial effort. Economic profits are excess earning over and above capital expenditures and normal profit.
The U.S. economy is slowing and forecasters predict a mild hurricane season. Economists expect emerging market economies to show strong growth a year from now. What are the implications for the price of oil? A- No change B- Lower short term but rising long term C- Dwindling supplies are bullish in both the short and long term D- Electric cars will cut demand for fossil fuels; bearish
Oil is economically sensitive. In a recession there is lower demand and prices fall. A mild hurricane season will not have a significant effect on drilling, so supply is less likely to be disrupted, and not likely to affect prices. However, if emerging market economies are expected to experience strong growth in the future, demand for oil will rise in the long-term causing prices to increase.
Company X intends to increase operating cash flow under generally accepted accounting principles. This would be accomplished through: A- A reduction of current assets B- A reduction of current liabilities C- Lowering capital expenditures D- The sale of an investment
Operating cash flow is part of the Statement of Cash Flows. It may be described as revenues minus operating expenses. If current assets decline, this is a source of cash for the company. For example,if balance sheet entries for inventories decline from Period 1 to Period 2, this reduction of inventory indicates increased cash flow due to the sale of the inventory. The same would be true of a reduction of accounts receivable. Conversely, a decline in current liabilities indicates a use of cash. Lower capital expenditures would be part of investing cash flows. The sale of an investment would increase investment cash flows, rather than operating cash flows.
All of the following companies would have a high degree of operating leverage, EXCEPT: A- A company with an extensive use of fixed costs B- A company that uses a high degree of part-time hourly employees C- A company that uses a high degree of fixed assets to produce its products D- A company that has a lower percentage of variable costs to operate its business
Operating leverage is the degree to which a firm or a project relies on fixed costs, rather than variable costs. The key to this question is to look for the cyclical company with a high level of fixed costs.
One of the tools that the analyst uses to calculate relative common stock valuation is the price/earnings (P/E) ratio. Other methods of calculating relative value are also available. Which TWO of the following additional methods are used to value common stock? I. The price-to-book value ratio II. The price-to-cash flow ratio III. The price-to-total debt ratio IV. The debt/equity ratio A- I and II B- I and III C- II and III D- II and IV
Other methods for calculating relative stock value are the price-to-book value and price-to-cash flow ratios. The price-to-debt and debt/equity ratios are not indicative of relative equity value.
Recognition of income under the percentage-of-completion method is based on: A- Billings to date B- Costs incurred to date C- Collections to date D- Estimated value added to date
Recognition of income under the percentage-of-completion method is based on costs incurred to date.
Which of the following is a macroeconomic driver for the fast food industry? A- Changing beef prices B- Disposable income C- Customer satisfaction D- Low employee turnover
Restaurants are positively impacted when consumers have more disposable income.
Which company MOST LIKELY has the highest depreciation expense as a percentage of annual sales? A- Cyber security company B- Shipping C- Discount retailer D- Corporate consulting
Shippers have a very high fixed asset base with significant depreciation as a percentage of sales. Other companies with significant amounts of depreciation relative to revenue are energy exploration and utilities.
Binary, Inc. is a supercomputer manufacturer. Its revenues are earned from a relatively small number of sales of very expensive units. Each unit has a lengthy production period. Although a significant deposit is received at the time of order acceptance, the majority of revenue is realized when the computers become operational. Meeting payrolls and other immediate bills have been somewhat problematic, due to the time spans between product manufacture and final payment. Which of the following ratios would be the best test of Binary's ability to meet its current obligations? A- Bond ratio B- Net profit margin C -Fixed charge coverage ratio D- Quick asset ratio
Since Binary's problem is meeting current obligations, it is concerned with having cash available. The quick asset ratio (also called the acid test ratio) focuses on those assets that can be quickly turned into cash. It is calculated by dividing the sum of cash, marketable securities, and accounts receivable by current liabilities.
Which of the following is the BEST metric to analyze profitability between companies and industries? A-EBITDA B- EBIT C- Interest coverage ratio D -Working Capital
Since EBITDA adds back depreciation and amortization (D&A) to earnings before interest in taxes (EBIT), it neutralizes the difference in accounting decisions between firms and industries. In other words, EBITDA can more easily be compared between companies than EBIT. The interest coverage ratio and working capital are not profit measures.
While evaluating Company L, you notice a significant difference between the firm's tangible book value and stated book value. Which TWO of the following items could account for the difference? I. Finished goods II. Goodwill III. R&D expenses IV. Capitalized software development costs A- I and III B- I and IV C- II and III D- II and IV
Stated book value and tangible book value differ in that stated book value is calculated by subtracting from total assets all liabilities. It reveals the equity on the balance sheet (e.g., Assets - Liabilities = Equity). In contrast, tangible book value is calculated by subtracting from total assets all liabilities, goodwill and intangibles that do not have a stand alone market value (e.g., Assets - Liabilities - Goodwill - Intangibles with no market value). Because goodwill and intangibles with no market value are subtracted when calculating tangible book value, but are not subtracted when calculating stated book value, goodwill and capitalized software development could account for the difference in stated book value versus tangible book value. This assumes the capitalized software development has no market value, but its cost on the balance sheet has not been fully amortized. The value of finished goods in inventory would be the same when calculating stated book value and tangible book value. R&D expenses would not be a correct item choice, because if R&D is expensed then it is not capitalized. If it is capitalized then it will be amortized over its useful life, which will result in amortization expense. Book Value = Assets - Liabilities Tangible Book Value = Assets - Liabilities - Goodwill - Intangibles with no market value
An analyst is seeking detailed information concerning executive compensation plan proposals and ownership percentages of senior executives. Which of the following documents would be most helpful? A- Form 13D B- Form 144 C- Proxy Statement D- Audited financial statements
The SEC requires a company to provide shareholders with a proxy statement prior to its annual meeting. The proxy statement contains information that will be voted on during the annual shareholder meeting. Detailed information concerning proposed executive compensation and ownership percentages is required in this document.
A good measure of analyzing the ability of a company to pay off its debt is its: A- Debt-to-equity ratio B- Cost of debt C- Debt-to-EBITDA ratio D- Debt-to-total capitalization ratio
The debt-to-EBITDA ratio is calculated by adding short-term and long-term debt and dividing by the earnings before interest, taxes, depreciation, and amortization (EBITDA). The ratio that results is an indication of the company's leverage; that is, the higher the ratio, the greater the leverage. A high ratio is an indication of a greater likelihood that a company may default on its debt. A low ratio is an indication that a company may incur additional debt, without a significant increase in the risk of default. The debt-to-equity and debt-to-total capitalization ratios measure debt capital, but not a company's ability to pay it off.
Which of the following financial metrics is a measure of financial leverage? A- Net debt-to-equity ratio B- Enterprise value-to-sales ratio C- Operating profit margin D- Days sales outstanding
The debt-to-equity or net debt-to-equity ratio is a measure of a company's financial leverage (i.e., how much it has borrowed). Enterprise value-to-sales is a way to measure the value of a company. Operating profit margin measures the profitability of a company, while days sales outstanding is a liquidity measurement.
A corporation is engaging in a corporate restructuring which consists of a $25,000,000 write-off of inventory value and $35,000,000 in employee severance packages. The employees will be laid off during the next quarter. Which TWO of the following statements are TRUE? I. Cash flow is unaffected. II. Working capital will be reduced by $25,000,000. III. Net worth is reduced by $60,000,000. IV. Liabilities are unaffected until employee severance payments begin. A- I and II B- I and III C- II and IV D- III and IV
The following adjustments will be immediately made to the balance sheet: Net worth (retained earnings) will be reduced by $60,000,000, current liabilities will increase by $35,000,000 (employees' severance wages payable), current assets will decline by $25,000,000 (reduction of inventory value), working capital (Current Assets - Current Liabilities) will decline by $60,000,000. However, the operating cash flow will not change since the increase in accrued payables to the terminated employees and the decline in the inventory value are sources of cash and are offset by an income statement loss (as a use of cash). When the company pays severance in the next quarter, they will decrease the $35 million liability that was created when they committed to the restructuring. In other words, liabilities will be impacted immediately (increase) and in the next quarter (decrease). Although it's not addressed in the question, the corporation will also take a $60,000,000 restructuring charge on its Income Statement below the Income from Continuing Operations line (after tax), reducing Net Income for the year.
Analysts look at all of the following to analyze a company's cash collection cycle, EXCEPT for: A- Inventory turnover B- Accounts receivable turnover C- Trade payables turnover D- Depreciation
The goal of a business is to create/sell a product and turn the sale into cash so the business can repeat the cycle over and over. Analysts would be looking at how quickly the inventory sells, how quickly accounts receivable are collected and turned into cash, and how quickly a company is meeting its short-term obligations (trade payables). Depreciation does not enter into this analysis.
A research analyst would be MOST likely to use Funds from Operations when performing a relative valuation analysis in which of the following industry sectors? A- A real estate investment trust B- A transportation company C- A telecommunications company D -An oil and gas drilling company
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.
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
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.
Revenue recognition under the percentage-of-completion method recognizes revenues and expenses: A- At the end of the contract B- As a percentage of the work to be completed C- On the basis of work certified D- In proportion to the work completed
The percentage-of-completion method of revenue recognition recognizes revenues and expenses in proportion to the work completed.
The United States is experiencing a severe economic downturn. The Fed reacts and cuts rates 400 basis points. Which industry will outperform in the downturn? A- Building supplies B- Big pharmaceutical C- Capital equipment D- Video games
The pharmaceutical stocks are defensive and sales will be maintained during an economic downturn. The other choices have cyclical characteristics. Home building and construction will fall off. Eventually the interest rate change will benefit building supplies and capital equipment makers but during the downturn those sectors will suffer.
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
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.
Which of the following BEST defines the term public float? A- The number of shares held by retail investors B- The number of shares held by insiders C- The number of shares of outstanding stock plus the number of shares of restricted stock D- The number of shares of outstanding stock less the number of shares of restricted stock
The public float of a company represents the number of shares held by public investors—both retail and institutional. Public float excludes any stock that is owned by affiliated persons of a company and is found by subtracting restricted stock from the number of outstanding shares. By contrast, a company's market capitalization is determined by multiplying the number of outstanding shares by the current market price per share. Outstanding shares include restricted shares as well as those held by institutions, retail investors, and insiders, however, treasury stock (shares that are repurchased by the company) is not included.
Which of the following BEST defines the term public float? A- The number of shares held by retail investors B- The number of shares of restricted stock held by insiders C- The number of shares of restricted stock added to the number of shares of outstanding stock D- The number of shares of restricted stock subtracted from the number of shares of outstanding stock
The public float of a company represents the number of shares held by public investors—both retail and institutional. Public float excludes any stock that is owned by affiliated persons of a company and is found by subtracting restricted stock from the number of outstanding shares. By contrast, a company's market capitalization is determined by multiplying the number of outstanding shares by the current market price per share. Outstanding shares include restricted shares as well as those held by institutions, retail investors, and insiders, however, treasury stock (shares that are repurchased by the company) is not included.
One of the companies covered by an analyst has an ROIC-to-WACC ratio of 1.2. Which of the following statements regarding the company is TRUE? A- The company is destroying value for its investors. B- The company is creating value for its investors. C- The company is over-levered. D- The company is under-levered.
The return on invested capital-to-weighted average cost of capital (ROIC-to-WACC) is a way to measure how much value the firm is creating. A ratio greater than 1.0 is a sign that a company is creating value because the earnings (i.e., ROIC) are greater than the cost (i.e., WACC) of an investment. A ratio of less than 1.0 is a sign that the company is destroying value for its investors.
A cyclical company is characterized by which TWO of the following situations? I. Continuous revenue growth II. Erratic sales trends III. Peak profitability toward the latter stages of an expansion IV. Revenue concentrated around winter holidays A- I and III B- I and IV C- II and III D- III and IV
The revenue of a cyclical company is not concentrated around any particular time period. However, sales can increase dramatically during an expansion, but flatten or even drop during an economic contraction. Cyclical industries include automobiles, rubber, steel, paper, homebuilding, and cement.
While performing analysis, it is discovered that interest income, interest expense, and working capital have all increased during the past fiscal year. An explanation for these events might be that there was a: A- Retirement of bonds, through purchase, in the secondary market B- Conversion of debentures C- Public offering of bonds, the proceeds of which were invested in short-term instruments D- Public offering of common stock
The rise in interest expense implies an issuance of bonds. The rise in interest income implies increased investment in interest-bearing instruments. This is consistent with an increase in working capital.
The return on equity of a company will increase if: I. A gain is realized on the sale of an asset II. A loss is realized on the sale of an asset III. The company pays a stock dividend IV. The company issues debt A- I and III only B- I and IV only C- II and III only D- II and IV only
The sale of an asset for more than its book value creates a gain for the corporation. (Cash increases by more than the asset value.) This would increase shareholders' equity and increase the return on equity. The sale of an asset at a loss would have the opposite effect. It would reduce the return on equity. When a company pays a stock dividend, adjustments are made on the balance sheet but there is no change to the aggregate book value of the common equity; therefore, no change to ROE. When a company issues debt, the increase in leverage typically increases ROE as evidence by the formula ROE = Profit Margin x Asset Turnover x Leverage. In other words, an infusion of capital through borrowing increases risk and interest expense, but it also provides more capital for business expansion and if managed properly increases ROE.
Cyclical changes in the business cycle would most likely have the greatest effect on the stock of a: A-Utility company B- Food retailer C- Brewery D- Machine tool company
The stock price of a machine tool company is cyclical and fluctuates with the business cycle. The other choices are necessities or staples and are considered defensive due to their resistance to a recession
The Orbit Company has a WACC of 10% and a beta of 1.2. Which TWO of the following choices will increase the valuation of The Orbit Company using a discounted cash flow (DCF) model? I. The risk-free rate increases by 1%, while there is no change to the expected return of the market II. The long-term growth rate declines by 1% III. Depreciation increases, while capital expenditures and working capital remain unchanged IV. Working capital and depreciation increase by the same amount, while capital expenditures remain the same A- I and IV B- I and III C- II and III D- II and IV
The valuation of a firm using the DCF model can be found by dividing the free cash flow to the firm (used in this example as our measurement of cash flow) by 1 plus the discount rate (which in this example is the WACC). The influence of a beta greater than 1.0 will cause the cost of equity to decline if the risk-free rate increases, while the expected return of the market remains unchanged. This will cause the risk premium of the company to decline. For example, assume the cost of equity is 10%, risk-free rate is 4%, risk premium is 5% and beta is 1.2. The cost of equity is calculated as follows: .04 + (.05 x 1.2) which equals 10% (.04 + .06) assuming no change to the market rate. If the risk-free rate increases to 5%, the risk premium will decline to 4%, and the new cost of equity would equal .05 + (.04 x 1.2) = .098 or 9.8%. If we assume no change in the cost of debt, and the cost of equity decreases, the WACC will decrease. A smaller denominator will result in a higher valuation of the discounted cash flows. In the calculation of free cash flow to the firm, depreciation and amortization are added to the tax-adjusted EBIT. This level of cash flow is reduced by capital expenditures. If working capital has increased, the free cash flow to the firm is reduced by this change. If working capital has declined, the change is added. In choice (III), the increase in depreciation will result in a larger numerator used in the discounted cash flow model, increasing the valuation. In choice (IV), the increase in working capital and increase in depreciation will offset one another, without causing a change in free cash flow to the firm. If the growth rate applied to the cash flows declines, the cash flows will also decline, resulting in a lower valuation of the firm.
Where is the following statement found? "Certain statements in this filing relate to future events and expectations and are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as believe, estimate, will be, will, would, expect, anticipate, plan, project, intend, could, should or other similar words or expressions often identify forward-looking statements. All statements other than statements of historical fact are forward-looking statements, including, without limitation, statements regarding our outlook, projections, forecasts or trend descriptions. These statements do not guarantee future performance, and we do not undertake to update our forward-looking statements." A- Accounting opinion B- Prospectus C- 10-K D- Equity research report
This commentary is found in filings with the SEC by publicly traded companies when they remark about their future prospects. A sample is provided below. This annual report on Form 10-K (including documents incorporated by reference) and other written and oral statements we make from time to time contain certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. You can identify these forward-looking statements by the fact they use words such as should, expect, anticipate, estimate, target, may, project, guidance, intend, plan, believe and other words and terms of similar meaning and expression in connection with any discussion of future operating or financial performance. One can also identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. Such forward-looking statements are based on current expectations and involve inherent risks and uncertainties, including factors that could delay, divert or change any of them, and could cause actual outcomes to differ materially from current expectations. These statements are likely to relate to, among other things, our goals, plans and projections regarding our financial position, results of operations, cash flows, market position, product development, product approvals, sales efforts, expenses, performance or results of current and anticipated products and the outcome of contingencies such as legal proceedings and financial results, which are based on current expectations that involve inherent risks and uncertainties, including internal or external factors that could delay, divert or change any of them in the next several years. We have included important factors in the cautionary statements included in this Annual Report on Form 10-K, particularly under Item 1A. Risk Factors, that we believe could cause actual results to differ materially from any forward-looking statement.
If EBITDA is negative because of high start-up costs, a relevant valuation metric would be: A- Price/cash flow B- EV/sales C- Cash per share D- Earnings yield
Valuations using a multiple of sales gained increasing popularity in sectors with strong growth potential (but high upfront infrastructure or research and development costs) where positive cash flow or earnings could not be expected for many years. If EBITDA is negative, operating cash flow is probably negative.
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
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.
If an analyst wanted to calculate the market cap of a company, she would multiply the market price of the stock by the: A- Total outstanding shares, including those held by institutions, retail investors, and restricted shares held by insiders B- Total outstanding shares, including those held by institutions, retail investors, and restricted shares held by insiders plus treasury stock C- Public float, which is outstanding shares minus restricted stock D- Shares held by institutions only
To calculate the market capitalization of a company, the representative would multiply the current market price of the common stock by the total outstanding shares, including those held by institutions, retail investors, and restricted shares held by insiders.
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 increases and accounts payable declines D- Inventory declines and accounts payable increases
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
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? A- The valuation increases B- There is an increase in dividend payments C- The valuation decreases D- There is a decline in dividend payments
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.
