Chapter 6 The Role of Financial Information in Valuation and Credit Risk Assessment
True/False
[QUESTION]
1. The discounted cash flow valuation approach expresses current value of a firm as the
discounted present value of expected future cash flows.
2. In applying the free cash flow valuation model, the discount rate used is the weighted-average
cost of capital.
[QUESTION]
3. Accrual accounting produces an earnings number that depicts the effects of economic events on
cash flows in the period in which the effects occur and provides an estimate of sustainable long-
run future free cash flows.
4. In the flows to equity model of valuation, and using simplifying assumptions, the current stock
price estimate can be expressed as a capitalization rate (1 × r) multiplied by a perpetuity equal to
cash flow after paying debtholders and preferred shareholders.
5. The two most significant explanations for variations in the earnings multiple are risk
differences and maturity of the firm.
6. The value of the future growth opportunities of a firm can be determined by considering the
firm’s potential earnings from reinvesting current earnings in new projects that will eventually
earn a rate of return more than the cost of equity capital.
7. Return on assets (ROA) can be used to assess whether a firm is likely to earn a return on
reinvested earnings that exceeds its cost of equity capital.
8. A component that is unrelated to future free cash flows or future earnings and is not pertinent
to assessing current share price is a noise component.
9. The degree of conservatism associated with a firm’s accounting choices will have a direct
bearing on the relationships among share price, earnings, and the firm’s equity book value
components of the abnormal earnings valuation approach.
10. Much of the information needed for assessing the quality and value-relevance of a
company’s reported accounting numbers cannot be found in the company’s Form 10–K.
11. Under the GAAP hierarchy of approaches used in measuring fair value, Level 3 uses quoted
prices from active markets for identical assets or liabilities to determine fair value.
12. Because income from discontinued operations is not likely to be recurring, it would be
considered transitory earnings and be valued at a lower multiple than recurring components
(such as income from operations).
13. If securities markets are rational and efficient in that they fully and correctly include all
available information into a company’s stock price, the resulting price will reflect investors’
unbiased expectations about the company’s future earnings and cash flows.
14. Lenders form opinions about a firm’s credit risk by comparing current and future debt-
service requirements to the estimates of the firm’s current and expected future cash flows.
15. The starting point for developing comprehensive financial statement forecasts is a detailed
understanding of the company, its recent financial performance and its health.
Multiple Choice
[QUESTION]
16. The fundamental valuation approach to business valuation uses basic accounting measures to
assess the amount, timing and
a. certainty of a firm’s past operating cash flows or earnings.
b. certainty of a firm’s future non-operating cash flows or earnings.
c. uncertainty of a firm’s future operating cash flows or earnings.
d. uncertainty of a firm’s future non-operating cash flows or earnings.
17. The steps involved in business valuation are forecasting the future values of a financial
attribute that drives a company’s value, determining the risk associated with that forecasted value
and determining the
a. future values of the value-relevant attribute.
b. certain future value of earnings.
c. present value of a firm’s earnings.
d. discounted present value of the expected future amounts using a discount rate that reflects the
risk or uncertainty.
18. Cash flow assessment plays a central role in analyzing
a. the credit risk of a company.
b. management’s effectiveness.
c. the future earnings potential of a company.
d. the firm’s investment potential.
19. Valuing an entire company, an operating division of that company or its ownership shares
involves three basic steps. These steps include all of the following except:
a. Forecasting future amounts of a value-relevant attribute.
b. Determining the risk or uncertainty associated with the forecasted future amounts.
c. Determining the discounted present value of the expected future amounts using an appropriate
discount rate.
d. Determining the dividends the company will pay in the future based on the company’s
dividend policy and expected future earnings.
20. When using the discounted flows to equity valuation model, the market value of common
shares depends upon investors’
a. future expectations about the future economic prospects of cash flows before payments to
debtholders and preferred shareholders.
b. current expectations about the future economic prospects of cash flows after payments to
debtholders and preferred shareholders.
c. future expectations about the current economic prospects of cash flows to both debtholders
and preferred shareholders.
d. current expectations about the current economic prospects of cash flows to both debtholders
and preferred shareholders.
21. A simplified version of the discounted free cash flow valuation model assumes a zero-growth
perpetuity for future cash flows. This assumption is best applied to
a. start-up firms with stable cash flow patterns.
b. growth firms with increasing cash flow patterns.
c. growth firms with stable cash flow patterns.
d. mature firms with stable cash flow patterns.
22. To apply the discounted free cash flow model, the analyst needs to estimate
a net cash flows from operations for each future period, starting one period from now.
b. free cash flows for each future period, starting one period from now.
c. free cash flows for approximately ten years as the present value of cash flows occurring
beyond that point are insignificant.
d. net cash flows from operations for approximately ten years as the present value of cash flows
occurring beyond that point are insignificant.
23. The FASB stresses that the primary objective of financial reporting is to provide information
useful to investors and creditors in assessing the amount, timing and uncertainty of future net
cash flows. The FASB contends that
a. users pay attention to firms’ accounting earnings because this accrual measure of periodic firm
performance improves their ability to forecast future cash flows.
b. information about current cash receipts and payments is the best indicator for this task.
c. users pay attention to managements’ estimates of free cash flows because this information
improves their ability to forecast future cash flows.
d. current cash flows outperform current earnings in predicting future cash flows.
24. By using accruals and deferrals, accrual accounting
a. produces a cash flow number that reflects only cash earnings.
b. produces information about current cash receipts and payments.
c. enables management to estimate future free cash flows.
d. produces an earnings number that depicts the effects of economic events on cash flows.
25. Research indicates that stock returns correlate better with
a. accrual earnings than realized operating cash flows.
b. cash basis earnings than realized operating cash flows.
c. realized operating cash flows than accrual earnings.
d. future operating cash flows than accrual earnings.
26. The reciprocal of the risk-adjusted equity cost of capital used to discount future earnings is
the
a. return on assets.
b. return on common equity.
c. price/earnings ratio.
d. profit margin on sales.
27. If a company currently earns $5.00 per share, and has a risk-adjusted equity cost of capital of
9%, a share of common stock should theoretically sell for approximately
a. $0.45
b. $5.00
c. $48.00
d. $55.55
[QUESTION]
28. If a company currently earns $6.00 per share and has a risk-adjusted equity cost of capital of
12.5%, a share of common stock should theoretically sell for
a. $0.75
b. $6.00
c. $48.00
d. $75.75
29. If most firms’ price/earnings ratios are between 10 and 15, what is the range of the risk-
adjusted interest rate?
a. 6.67% to 10%
b. 6.67% to 15%
c. 10% to 15%
d. 10% to 16.67%
30. Risky firms have a higher risk-adjusted cost of capital. Which one of the following factors
would contribute to a risky firm also having a relatively high price/earnings ratio?
a. The firm has a high earnings per share.
b. The firm has a low earnings per share.
c. The firm has strong growth opportunities.
d. The firm has a significant amount of long-term debt.
31. To obtain a better current price, the net present value of future growth opportunities
(NPVGO) can be calculated and
a. added to the price per share calculated from the P/E ratio.
b. subtracted from the price per share calculated from the P/E ratio.
c. multiplied by the price per share calculated from the P/E ratio.
d. divided into the price per share calculated from the P/E ratio.
32. The net present value of future growth opportunities (NPVGO) will contribute to an above
average P/E multiple when the additional share value created is
a. positive and the return on new investment is lower than the cost of equity capital.
b. positive and the return on new investment is greater than the cost of equity capital.
c. negative and the return on new investment is lower than the cost of equity capital.
d. negative and the return on new investment is greater than the cost of equity capital.
33. In general, the growth rate in earnings will depend on the portion of earnings reinvested each
period and
a. the earnings retention rate.
b. the rate of return earned on new investment.
c. the firm’s cost of equity capital.
d. the firm’s weighted average cost of capital.
34. A component that is valuation-relevant, but is not expected to persist into the future is a
a. permanent earnings component.
b. transitory earnings component.
c. noise component.
d. quiet component.
35. Income from continuing operations, excluding special or nonrecurring items, is generally
regarded as
a. permanent earnings.
b. transitory earnings.
c. value-irrelevant earnings.
d. abnormal earnings.
36. Income or loss from discontinued operations is regarded as
a. permanent earnings.
b. transitory earnings.
c. value-irrelevant earnings.
d. abnormal earnings.
37. An adjustment to income due to a non-recurring item is regarded as
a. permanent earnings.
b transitory earnings.
c. value-irrelevant earnings.
d. abnormal earnings.
38. The implied share price of Firm A’s stock is
a. $12.00
b. $48.00
c. $49.20
d. $54.40
[QUESTION]
REFER TO: Ref. 06_01
39. The implied share price of Firm B’s stock is
a. $15.00
b. $45.00
c. $50.25
d. $55.25
40. The implied share price of Firm C’s stock is
a. $18.00
b. $63.00
c. $72.00
d. $90.00
[QUESTION]
REFER TO: Ref. 06_01
41. The implied total earnings multiple of Firm A is
a. 1.00.
b. 4.10.
c. 5.00.
d. 10.00
[QUESTION]
REFER TO: Ref. 06_01
42. The implied total earnings multiple of Firm B is
a. 1.00.
b. 3.00.
c. 3.35.
d. 12.00
[QUESTION]
REFER TO: Ref. 06_01
43. The implied total earnings multiple of Firm C is
a. 1.00.
b. 3.75.
c. 4.00.
d. 15.00
[QUESTION]
44. Reported earnings numbers often contain three distinctly different components possibly
subject to different earnings capitalization rates. Which of the following is not one of these
components?
a. A permanent earnings component.
b. A transitory earnings component.
c. A restructured earnings component.
d. A value-irrelevant earnings component.
45. Which one of the following is an example of sustainable earnings?
a. Loss from debt retirement.
b. Expenditures for advertising.
c. Earnings from repeat customers.
d. Gain from corporate restructuring.
46. As transitory components become a more important part of a firm’s reported earnings, the
reported earnings
a. become a more reliable indicator of sustainable cash flows.
b. are more quality enhanced.
c. are a more reliable indicator of fundamental value.
d. are a less reliable indicator of sustainable cash flows.
47. The assessment of earnings quality to calculate an implied share price is best accomplished
using which of the following?
a. Single-step financial statement.
b. Multiple-step income statement.
c. Cash flow statement.
d. Single-step income statement, balance sheet, and cash flow statement.
48. As transitory or value-irrelevant components become a larger part of a firm’s reported
earnings, which of the following effects would you not expect to witness?
a. The quality of those reported earnings is eroded.
b. The firm’s stock price rises in the year such components are reported proportionate to their
impact on income.
c. Reported earnings become a less reliable indicator of the company’s long-run sustainable cash
flows.
d. Earnings are a less reliable indicator of the firm’s fundamental value.
49. Under the abnormal earnings approach of equity valuation, investors willingly pay a
premium for those firms that
a. earn less than the cost of equity capital.
b. produce negative abnormal earnings.
c. produce positive abnormal earnings.
d. earn an amount equal to the equity cost of capital.
50. One popular approach to estimating the equity cost of capital is
a. the asset pricing model (APM).
b. the equity costing model (ECM).
c. the cost of equity pricing model (CEPM).
d. the capital asset pricing model (CAPM).
[QUESTION]
51 When calculating forecasted cash flows available to common stockholders (CF) under the
flows to equity model,
a. cash interest payments and preferred dividends are added.
b. preferred dividends are added.
c. cash interest payments, debt repayments, and preferred dividends are subtracted.
d. cash interest payments, debt repayments, and preferred dividends are not included.
[QUESTION]
52. The expected abnormal earnings of a firm that has earnings of $40,000 with a required equity
cost of capital of 8% and a beginning book value of $800,000 is
a. $(24,000)
b. $(64,000)
c. $40,000
d. $104,000
53. What are the abnormal earnings for Firm A?
a. $(4,000)
b. $(6,000)
c. $4,000
d. $6,000
54. What are the abnormal earnings for Firm B?
a. $1,000
b. $2,000
c. $12,000
d. $14,000