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Chapter: Chapter 11: Forecasting Performance
1. The explicit forecast period must be long enough for the company to reach a steady state. Which
of the following is NOT a desirable property of that steady state?
a) The growth rate rises above the required return on capital.
b) The company earns a constant rate of return on existing capital.
c) The company earns a constant rate of return on new capital invested.
d) The company reinvests a constant proportion of its operating profits into the business each year.
2. Which of the following is the best recommendation for forecasting performance?
a) Use an explicit forecast period of two to five years and longer for cyclical companies or those
experiencing very rapid growth.
b) Use an explicit forecast period of two to five years and shorter for cyclical companies or those
experiencing very rapid growth.
c) Use an explicit forecast period of 10 to 15 years and longer for cyclical companies or those
experiencing very rapid growth.
d) Use an explicit forecast period of 10 to 15 years and shorter for cyclical companies or those
experiencing very rapid growth.
3. It is recommended in the financial modeling process to collect raw data on a separate worksheet
and record the data as originally reported.
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Multiple Choice
4. Which of the following are steps in making a top-down forecast?
I. Forecasting prices.
II. Sizing the total market.
III. Determining market share.
IV. Estimating customer turnover.
a) I and II only.
b) I, II, and III only.
c) II, III, and IV only.
d) III and IV only.
5. A bottom-up approach for forecasting revenues relies on projections of customer demand.
6. The explicit forecast period must be long enough for the company to reach a steady state. List the
two characteristics that define that steady state.
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7. The top-down approach cannot be applied to companies in mature industries.
8. List the three steps in making a top-down forecast of revenue and the three inputs for making a
bottom-up forecast of revenue.
9. Which of the following are true concerning forecasting interest income?
I. It is a nonoperating measure.
II. Its typical forecast driver is revenue.
III. It is typically the same from year to year for firms that generate high cash flow.
IV. The typical forecast ratio is interest income in the current period divided by excess cash in the
previous period.
a) I and II only.
b) I and IV only.
c) II and III only.
d) III and IV only.
10. Large Corporation owns less than 20 percent of Small Corporation. Which of the following are
true?
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I. Large Corp. records asset sales of Small Corp.
II. The investment in Small Corp. is marked to market.
III. Large Corp. records dividends received from Small Corp.
IV. In forecasting entries for Small Corp., Large Corp. should use a traditional driver like cash flows.
a) I and II only.
b) I and III only.
c) II and III only.
d) III and IV only.
11. If a company forecasts that its capital expenditures will be smooth, then in forecasting
depreciation, it is better to use the percentage of revenues approach than the percentage of
property, plant, and equipment (PP&E) approach.
12. In forecasting the income statement, it is recommended to tie all items directly to revenue.
13. When using PP&E as the forecast driver for depreciation, which of the following is most
accurate?
a) From both an ideal and a practical standpoint, the driver should be net PP&E.
b) From both an ideal and a practical standpoint, the driver should be gross PP&E.
c) Ideally, the driver should be net PP&E, but practically the driver should be gross PP&E.
d) Ideally, the driver should be gross PP&E, but practically the driver should be net PP&E.
14. The recommended method to forecast taxes is as a percentage of earnings before taxes.
15. Which of the following is NOT one of the steps in the forecast of individual line items related to
the income statement?
a) Determine the economic relationships that drive the model.
b) Model the business cycle.
c) Estimate the forecast ratios.
d) Forecast the drivers and multiply times the respective ratios.
16. The recommended approach for forecasting cash flows of a parent company arising from
investments in subsidiaries where the parent owns less than 20 percent of the subsidiary is to use
the relationship between income from these subsidiaries and overall firm revenues.
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in nonoperating income or by examining the revenue and profit forecasts of publicly traded
companies that are comparable to the equity investment.]
17. Complete the following table by entering the typical forecast driver in the third column and the
typical forecast ratio in the last column.
Typical Forecast Drivers for the
Income Statement
Line item
Typical forecast driver
Typical forecast ratio
Operating
Cost of goods sold (COGS)
Selling, general, and
administrative expense
(SG&A)
Depreciation
Nonoperating
Interest expense
Interest income
18. To forecast the balance sheet, it is best to first forecast invested capital and nonoperating assets
and then forecast excess cash and sources of financing separately.
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19. In industries where prices are changing or technology is advancing, forecasters should strictly use
financial drivers such as revenue.
20. Which of the following is the best estimate of retained earnings in year t?
a) Retained earningsT+1 + Net incomeT–1 – DividendsT–1
b) Retained earningsT + Net incomeT+1 – DividendsT–1
c) Retained earningsT–1 + Net incomeT – DividendsT
d) Retained earningsT + Net incomeT + DividendsT
21. In industries where prices are changing or technology is advancing, forecasters should:
a) Use only financial drivers such as revenue.
b) Use only nonfinancial drivers such as productivity and volume.
c) Use both financial and nonfinancial drivers.
d) Use national real aggregates such as real GDP.
22. Since severance costs are a cost of doing business, they should be forecast within free cash
flows.
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Multiple Choice
23. Which of the following is the recommended approach to forecast COGS, and why?
a) Forecast COGS based on revenue growth, since it provides flexibility in the model.
b) Forecasting COGS based on the forecast ratio of COGS to sales allows for possible improvements
in COGS relative to sales.
c) Forecast COGS based on revenue growth since COGS and revenues have a direct relationship.
d) Forecasting COGS based on inventory is recommended because inventory prices and COGS are
correlated.
24. Which is the recommended way to forecast items such as inventory and accounts payable?
a) Inventory and accounts payable should be forecasted based on revenues, since most other
working capital items are forecasted based on revenues.
b) Inventory and accounts payable should be forecasted based on COGS, because these items are
more correlated with input prices than with output prices.
c) Inventory and accounts payable should be the plug once total operating assets and operating
liabilities have been forecasted.
d) Inventory and accounts payable should be forecasted based on total assets, as these tend to scale
together.
25. Which of the following is the preferred method to forecast the financing items on the balance
sheet?
a) Assume that debt and equity are constant. Sum all forecasted assets except excess cash, and all
liabilities and existing debt and equity. Plug the model using newly issued debt or excess cash.
b) Financing items should be forecasted first, taking into consideration the future funding needs of
the company. Correspondingly, the assets that the raised capital will fund should then be adjusted.
c) Assume that all liabilities and equity will grow at the same rate as revenue growth.
d) Assume that debt and equity will grow at the same constant rate in all years going forward.
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True/False
26. Changing the dividend payout ratio will change the value of the firm and the firm’s equity.
