Chapter: Chapter 15: Analyzing the Results
Short Answer
1. List the criteria for assessing whether a model is technically robust with respect to the
following three perspectives: unadjusted financial statements, rearranged financial statements,
and statement of cash flows.
Answer: [1. Unadjusted financial statements: The balance sheet should balance each year, and
True/False
2. Adjustments in the dividend payout ratio should be used to ensure that the model is
technically correct.
3. An adjustment in the dividend payout ratio should change the value of the firm under the
recommended valuation approach in the text.
McKinsey/Valuation
103
payout ratio. The estimation of the WACC is done completely separately, based on an assumed
capital structure going forward.]
Multiple Choice
4. Which of the following are questions an analyst should ask when assessing the economic
consistency of a model?
I. Are the patterns chartable?
II. Are the patterns intended?
III. Are the patterns reasonable?
IV. Are the patterns consistent with industry dynamics?
a) I and II only.
b) I and IV only.
c) III and IV only.
d) II, III, and IV only.
5. To ensure that the model is economically consistent, the continuing value formula should be
applied when company operations are in a steady state.
6. If one arrives at a company value based on the valuation model that is significantly different
from the market value, the default assumption should be that the market valuation is incorrect.
Response: [If one’s value based on the valuation model is far from market value, one should not
jump to the conclusion that the market is wrong. The default assumption should be that the
market is right, unless there are specific indications that not all relevant information has been
incorporated into the share price—for example, due to a small free float or low liquidity of the
stock.]
Multiple Choice
7. To prioritize strategic actions, the analyst should:
a) Take a vote from the major players.
b) Build a sensitivity analysis that tests multiple changes at a time.
c) Follow the priorities of leaders in the industry.
d) Follow Porter’s five forces analysis.
8. An analyst is estimating the ROIC of a company that has zero fixed costs per unit and pays no
taxes. The analyst makes the following forecasts: Sales next year will equal 250 units and will
increase at 10 percent for each of the two following years. Prices per unit will be $102, $104,
and $110, which simply embody inflation forecasts. Costs per unit will be constant at $90.
Current capital invested is $20,000, and the firm will reinvest 50 percent of profits. What is the
ROIC for each of the three years? If this is a competitive industry, are the results realistic?
a) ROICs in the next three years are 15.0 percent, 17.9 percent, and 25.8 percent, respectively;
results are realistic for a competitive industry.
b) ROICs in the next three years are 15.0 percent, 16.5 percent, and 18.3 percent, respectively;
results are realistic for a competitive industry.
c) ROICs in the next three years are 15.0 percent, 16.5 percent, and 18.3 percent, respectively;
results are not realistic for a competitive industry.
d) ROICs in the next three years are 15.0 percent, 17.9 percent, and 25.8 percent, respectively,
results are not realistic for a competitive industry.
McKinsey/Valuation
105
Year 1
Year 2
Year 3
Profit
$3,000
$3,850
$6,050
Invested capital
$20,000
$21,500
$23,425
ROIC
15.0%
17.9%
25.8%
These results are not realistic for a competitive industry, as the high ROIC will likely attract
competition; as competitors enter the market, this will cause lower sales and/or depressed
prices.]
9. The forecasts in the prior question used several assumptions. Repeat the forecasts where
(scenario A) costs increase with inflation, but all other assumptions hold (costs are $90.0, $91.8,
and $97.1 per unit in each of the next three years, respectively); and (scenario B) sales units
remain constant, but all the other assumptions hold (including constant costs). What is the
ROIC under each assumption? Which assumption is responsible for a significant increase in
ROIC?
a) In scenario A, ROIC is 15.0 percent, 15.6 percent, and 16.8 percent for the next three years,
respectively. ROIC significantly increases under this assumption versus the constant costs
assumption.
b) In scenario B, ROIC is 15.0 percent, 16.3 percent, and 21.5 percent for the next three years,
respectively. ROIC significantly increases under this assumption versus the increasing costs
assumption.
c) In scenario B, ROIC is 15.0 percent, 15.6 percent, and 16.8 percent for the next three years,
respectively. ROIC significantly increases under this this assumption versus the increasing costs
assumption.
d) In scenario A, ROIC is 15.0 percent, 16.3 percent, and 21.5 percent for the next three years,
respectively. ROIC significantly increases under this this assumption versus the increasing costs
assumption.
Year 1
Year 2
Year 3
Number of units
250
275
302.5
Price per unit
$102
$104
$110
Cost per unit
$90.0
$91.8
$97.1
Profit
$3,000
$3,355
$3,902.2
Invested capital
$20,000
$21,500
$23,177.5
ROIC
15.0%
15.6%
16.8%
McKinsey/Valuation
106
Year 1
Year 2
Year 3
Number of units
250
250
250
Price per unit
$102
$104
$110
Cost per unit
$90
$90
$90
Net income
$3,000
$3,500
$5,000
Invested capital
$20,000
$21,500
$23,250
ROIC
15.0%
16.3%
21.5%
Based on these results, the constant costs assumption seems to be responsible for the high
ROIC. When costs increase with inflation, ROIC increases to only 16.8 percent.]
10. When making forecasts, increasing one variable usually means decreasing another. Which
of the following are possible common trade-offs that should be considered in making such
forecasts?
I. Product volume and prices.
II. Lower inventory and higher sales.
III. Higher growth and lower margin.
a) I and II.
b) I and III.
c) II and III.
d) All of the above.
11. In a scenario analysis, which of the following are considerations when reviewing the
assumptions of a model?
I) The sensitivity of the results to broad economic conditions.
II) The level of competitiveness of the industry.
III) The internal capabilities of the company to achieve the forecasts of output and growth.
IV) The ability of the company to raise the necessary capital from the markets.
a) I and II only.
b) II and III only.
c) I, III, and IV only.
d) I, II, III, and IV.
McKinsey/Valuation
107
True/False
12. When using the scenario approach, an analyst should not shortcut the process by deducting
the face value of debt from the scenario-weighted value of operations, because this would
seriously underestimate the equity value, as the value of debt is different in each scenario.
13. You decide to value a steady‐state company using probability‐weighted scenario analysis. In
scenario 1, NOPLAT is expected to grow at 8 percent, and ROIC equals 20 percent. In scenario 2,
NOPLAT is expected to grow at 2 percent, and ROIC equals 10 percent. Next year’s NOPLAT is
expected to equal $100 million, and the weighted average cost of capital is 12 percent. Using
the key value driver formula, what is the enterprise value in each scenario? If each scenario is
equally likely, what is the enterprise value for the company?
a) Value in scenario 1 is $1,500m; value in scenario 2 is $800m; weighted value = $1,150m.
b) Value in scenario 1 is $800m; value in scenario 2 is $1,500m; weighted value = $1,150m.
c) Value in scenario 1 is $800m; value in scenario 2 is $1,500m; weighted value = $2,300m.
d) Value in scenario 1 is $1,500m; value in scenario 2 is $800m; weighted value = $2,300m.
0.5) = 1,150]
True/False
14. A colleague recommends a shortcut to value the company in the preceding question. Rather
than compute each scenario separately, the colleague recommends averaging each input, such
McKinsey/Valuation
108
that growth equals 5 percent and ROIC equals 15 percent. This will lead to the same enterprise
value as found in that question.
15. When estimating a company’s value, falling within a range of plus or minus 15 percent of
the actual valuation is appropriate, as market valuations of this amount for individual stocks are
fairly common.
16. In creating scenarios that will determine a firm’s future cash flow and present value in a
sensitivity analysis, list the four categories of assumptions the analyst should critically review.
Ans: [1. Broad economic conditions and the sensitivity of the firm’s operations to swings in the