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55. What are the abnormal earnings for Firm C?
a. $(2,400)
b. $(4,800)
c. $4,800
[QUESTION]
REFER TO: Ref. 06_02
56. Assume that Firm A can increase earnings $4,000 by cutting costs. Abnormal earnings would
be
a. $(1,000)
b. $0
c. $1,000
d. $1,500
57. Assume that at the beginning of the year, Firm B divested itself of $20,000 of unproductive
capital and earnings for the year fell by only $3,000. Abnormal earnings are
a. $200
b. $400
c. $600
d. $800
58. A company with a return on equity that consistently exceeds the industry average ROCE will
generally have shares that sell at a
a. market-to-book ratio equal to the industry average.
b. lower market-to-book ratio than the industry average.
c. higher market-to-book ratio than the industry average.
d. higher market price than its competitors.
59. Per U.S. GAAP, fair value for accounting purposes is
a. an entry price.
b. an exit price.
c. the market price in a forced sale.
d. always easily determinable.
60. Carrying amounts in a GAAP balance sheet are measured using all the following except
a. historical cost.
b. net realizable value.
c. discounted present value.
d. projected ROI.
61. In the process of determining fair value, the exit price refers to
a. the amount the firm would receive if it sold a given asset.
b. the amount the firm would pay if it bought an asset of the same type and condition as the one
being valued.
c. the sum of the future cash flows expected to be generated by continuing to use the asset.
d. the expected sale price of the stock in a corporate buy-out.
62. When determining the fair value of an asset using an exit price approach,
a. fair value is determined by how the company uses the asset.
b. management may choose to reduce the fair value of the asset by the approximate amount of
expected transaction costs (i.e., costs to dispose of the asset) if such costs are deemed to be
material.
c. transaction costs do not reduce the asset’s fair value.
d. transaction costs reduce the asset’s fair value.
63. Prior to the announcement of unexpected bad earnings (a negative earnings surprise), a firm’s
stock price will generally exhibit
a. a negative drift downward.
b. no change in stock price.
c. a negative drift downward followed by an immediate upward drift.
d. a positive drift upward.
[QUESTION]
64. An earnings surprise
a. usually precedes a negative drift downward in a firm’s stock price.
b. means that some bias must exist since unbiased means that the market’s earnings expectations
will be correct.
c. demonstrates the inherent inefficiency of securities markets.
d. occurs when earnings deviate from investors’ expectations.
65. The fact that a firm’s stock price does not change when earnings are announced indicates that
a. per share earnings were the same as the previous quarter.
b. the securities markets are rational and efficient.
c. the information contained in the earnings release was fully anticipated by investors.
d. the earnings deviate from investors’ expectations.
66. The interest rate on a revolving loan will usually
a. be below the prime interest rate.
b. be equal to the prime interest rate.
c. remain fixed.
d. float.
67. Short-term notes sold directly to investors by large, highly rated companies are called
a. commercial paper.
b. secured notes.
c. bonds.
d. debentures.
68. A bond that is considered unsecured is referred to as a
a. debenture.
b. sinking fund bond.
c. senior bond.
d. callable bond.
69. A qualitative assessment of the business, its customers and suppliers, and management’s
character and capability is known as
a. covenant waivers.
b. due diligence.
c. indenture evaluation.
d. a debenture.
70. The degree to which cash needs can be satisfied during periods of fiscal stress is known as
a. credit availability.
b. credit worthiness.
c. working capital.
d. financial flexibility.
71. The two ways to implement the discounted cash flow valuation approach are
a. CAPM and the weighted average cost of capital.
b. the free cash flow model and the flows to equity model.
c. the price/earnings model and the cash flows model.
d. the weighted cash flows model and the capital assets model.
[QUESTION]
72. The interest rate charged on bank loans must be sufficient to cover all the following except
a. a risk premium when loans are personally guaranteed by the borrower.
b. the lender’s cost of borrowing funds.
c. the costs of administering, monitoring, and servicing the loan.
d. a premium for exposure to default risk.
[QUESTION]
73. Financial statement forecasts are
a. one of the required note disclosures found in each company’s annual report.
b. filed annually with the SEC by all public companies.
c. frequently used in determining management compensation.
d. essential ingredients of business valuation and credit risk analysis.
74. Preparing comprehensive financial statement forecasts involves six steps. Among these steps
are all the following except:
a. Forecast sales revenue for each period in the forecast horizon.
b. Forecast depreciation expense and tax expense for each period.
c. Forecast the company’s financial structure and dividend policy for each period.
d. Forecast the market price per share for the company’s common stock for each period.
75. Which of the following statements is false regarding the global vantage point of fair value
measurement?
a. The FASB revised ASC 820-10 to make the U.S. fair value disclosure rules more consistent
with IFRS.
b. IFRS 13 “Fair Value Measurement” is not in agreement with U.S. GAAP.
c. ASC Topic 820 provides fair value guidance for companies, investors, and company auditors.
d. The FASB and the IASB worked together on a joint convergence project for fair value
measurement and disclosure.
76. Common value-relevant attributes for determining the value of a company include all the
following except:
a. Fair value of fixed assets.
b. Balance sheet book values.
c. Accounting earnings.
d. Free cash flows.
77. Which of the following statements is false regarding the flows to equity model?
a. The forecasted cash flow stream to be discounted is reduced by flows to preferred
shareholders.
b. The flows are reduced by cash interest payments.
c. The flows are increased by debt repayments.
d. The flows calculation begins with free cash flow.
78. Which of the following statements is false regarding the FASB’S view on valuation?
a. The FASB believes that current cash flows are more useful than current accrual accounting
earnings in predicting future cash flows.
b. The FASB contends that users pay attention to a firm’s accounting earnings because this
measure improves their ability to forecast future cash flows.
c. The FASB believes that a reliable valuation needs to rely on more than an analysis of cash
receipts and payments during a certain period.
d. The FASB stresses that the primary objective of financial reporting is to provide useful
information to investors and creditors in assessing the amount, timing, and uncertainty of future
net cash flows.
79. Which of the following statements is false regarding the abnormal earnings approach to
valuation?
a. The method uses earnings and equity book value numbers as direct inputs in the valuation
process.
b. The method uses the cost of capital as a fundamental economic benchmark.
c. This approach produces results that are generally equivalent to the free cash flow model.
d. This approach is based on the notion that the value of a company is driven primarily by the
level of earnings.
80. Which of the following statements is false regarding credit risk analysis?
a. A comprehensive credit risk analysis involves evaluating and summarizing the various
individual risks associated with a loan.
b. Credit risk is not affected by the aggressive application of accounting standards since cash
flows are not impacted by financial reporting choices.
c. A simple alternative to credit risk analysis is to rely on credit reports issued by third parties.
d. Certain financial statement ratios are very useful in predicting loan default.
81. Which of the following statements is false regarding credit risk analysis?
a. A lender is protected against credit risks by a loan’s covenant provisions since the interest rate
is fixed by the Federal Reserve Bank.
b. High-quality financial statements help a credit analyst to see the true performance at a
company.
c. Greater default risk is determined to exist when there is significant organizational reliance on a
certain individual or customer.
d. An estimate of a firm’s future financial condition is very important to most lending decisions.
82. Which of the following statements is false regarding traditional lending products?
a. A term lending agreement has an original maturity of more than one year with maturities
ranging from two to five years being the most common.
b. The written agreement between the between the borrowing company and its lenders is referred
to as the indenture.
c. A bond that has collateral to protect the bondholder is referred to as a debenture bond.
d. A call provision allows the borrowing company to repurchase part or all the debt at a stated
price over a specific period.
83. Which of the following statements is false regarding the business valuation process?
a. Credit valuation involves estimating the worth of a company, one of its operating units, or its
ownership shares.
b. Business valuation involves estimating the intrinsic value of a company or one of its operating
units.
c. Fundamental valuation uses basic accounting measures to assess the amount, timing, and
uncertainty of a firm’s future operating cash flows or earnings.
d. Operating cash flow minus cash outlays to replace operating capacity represents free cash
flow.
84. Which of the following statements is false regarding the business valuation process?
a. If a company is currently generating a sustainable free cash flow of $10 per share and the
discount rate is 10%, the estimated share price is $100.
b. FASB contends that current accrual earnings are a proxy for free cash flow.
c. A simplified version of the discounted free cash flow valuation model assumes a zero-growth
perpetuity for future cash flows. This approach is best applied to growth companies with stable
cash flow patterns.
d. One popular approach to estimate a firm’s equity cost of capital is the capital asset pricing
model.
85. Which of the following statements is false regarding the business valuation process?
a. Income or loss from discontinued operations is considered a transitory component of a firm’s
earnings.
b. Forecasting future cash flows requires calculations using factors from future value tables.
c. A component of earnings that is unrelated to future free cash flows or future earnings and is
not pertinent to assessing current share price is considered a noise component.
d. Firms that earn less than the cost of equity capital produce negative abnormal earnings and
generally have a share price below book value.
Essay and Computational Questions
[QUESTION]
86. Briefly define “free cash flows” and describe the key features of the free cash flow model for
business valuation.
87. Describe the general role of accounting numbers in business valuation.
88. P/E ratios are a useful indicator and tool when performing valuation and comparing firms. List
three factors that should be considered or adjusted for when comparing P/E ratios among different
firms.
89. What is meant by sustainable earnings?
90. Briefly discuss how a firm’s P/E ratio is related to the firm’s choice of accounting methods,
estimates, and timing of discretionary expenditures.
91. Briefly discuss how a firm’s P/E ratio is related to the present value of growth opportunities
available to the firm.
92. Recent values of P0 (current stock price), X0 (current reported EPS), and r (equity cost of
capital) for Alpha Company follow:
P0
X0
r
$23.50
$1.47
0.150
Required:
Compute Alpha’s NPVGO (net present value of future growth opportunities).
93. One measure for determining expected earnings for the current quarter could be considering
earnings for the same quarter last year. List some of the disadvantages to using this measure.
94. List some possible techniques that management can use to improve a company’s reported
performance in the short run.
95. Give at least three examples of low-quality earnings items.
96. Below is data for calendar 2018 for two companies.
Company A
Company B
Actual earnings
$79,632
$176,341
BVt-1
$504,000
$943,000
Cost of equity capital
0.167
0.175
Required:
Calculate each firm’s abnormal earnings and indicate which firm was better managed during
calendar year 2018.
97. Briefly define “abnormal earnings” and describe the key features of the abnormal earnings
approach to valuation.
98. Why do the stock returns of firms reporting “good news” drift upwards before the earnings
announcement date?
99. Briefly define an earnings surprise and explain how the surprise can impact the value of a
firm’s equity.
100. The quarterly cash flows from operations for two technology companies are as follows:
2018
2019
Q1
Q2
Q3
Q4
Q1
Firm 1
$451.2
$220.8
$703.5
$475.5
$601.2
Firm 2
$165.9
$240.7
$698.8
$(91.8)
$(173.3)
Required:
Explain why Firm 2 has more credit risk than Firm 1.
