Chapter 5
Return on Equity, Value Creation, and Firm Value
MULTIPLE CHOICE QUESTIONS
1. Which one of the following is a reason a company’s reported book value and its true
value may differ?
a. Management calculates net worth different than shareholders.
b. GAAP requires too many estimates.
c. Statements are forward-looking.
d. Statements do not reflect the company’s prospects within its business environment.
2. Book value fails to reflect true value primarily because:
a. financial statements are irrelevant.
b. financial statements are backward-looking.
c. financial statements are forward-looking.
d. financial statements are typically biased.
3. Which of the following is a fundamental way in which financial accounting numbers are
useful?
a. They can predict the way the stock price will behave.
b. They are used to assess the quality of a company’s products.
c. They can be used to predict a company‘s future earnings.
d. They identify the effect of inflation on the value of company’s assets.
4. Which one of the following is a step used in assessing whether a particular investment
should be made or not?
a. Determine the number of employees a company has.
b. Obtain an understanding of the company and its industry.
c. Determine the number of years the company has been in business.
d. Calculate the amount of advertising costs incurred by the company during the
previous year.
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5. The item that causes the greatest and most immediate effect on a company’s stock price
will generally be
a. cash on hand.
b. the company’s solvency.
c. profits.
d. dependent upon the industry in which the company operates.
6. The DuPont model is
a. a method of off-balance sheet financing.
b. a framework to analyze ROE changes and identify value drivers.
c. a method of preparing a balance sheet.
d. a solvency calculation.
7. The use of financial statements for predicting future earnings and cash flows is limited
due to
a. management bias, lack of forward-looking information, and certain inherent
limitations.
b. lack of judgment, management bias, and lack of inclusion of inflationary effects.
c. lack of forward and backward-looking information.
d. lack of backward-looking information, the likelihood of management bias, and the
omission of historical costs.
8. Which of the following may be a limitation of financial statements?
a. Subject to biases of management
b. Provides no information on the company’s accounting methods
c. Typically reflects the view of inherently unethical managers
d. Communicates only market values and no historical information
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9. Accounting numbers are useful in that they
a. are easy to manipulate by management and help predict a company’s future
earnings and cash flows.
b. allow users to see management’s predictions of future profits and help predict a
company’s future cash flows.
c. help investors and creditors influence and monitor management’s business decisions
and help predict a company’s future earnings and cash flows.
d. help investors and creditors influence, manipulate, and monitor management’s
business decisions so that future profits are high.
10. True value of a company is determined by
a. adding adjustments for the business environment, unrecorded events, and types of
shareholders to the book value of a company.
b. adding adjustments for the business environment, unrecorded events, and
cumulative profits to the book value of a company.
c. adding adjustments for the business environment, management bias, and
cumulative profits to the book value of a company.
d. adding adjustments for the business environment, unrecorded events, and
management bias to the book value of a company.
11. Investors who use accounting information to guide trading in foreign securities
a. should carefully compare expenses, but not revenues to companies in the same
industry in the United States.
b. must adjust the numbers of foreign-based companies’ financial statements and
thoroughly understand the foreign environment.
c. must contact the foreign CEO before any investment in stock occurs.
d. should contact the foreign company’s auditors to find out how much dividends will be
paid.
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SHORT ESSAY QUESTIONS
1. Indicate three reasons why reported book value and true value may differ.
Solution:
1. The financial statements do not reflect the company’s prospects within its business
environment.
2. The financial statements themselves are inherently limited.
3. Management tends to prepare the reports in a biased manner.
2. What must an analyst learn first prior to assessing a particular business environment?
3. In what ways might an investor use accounting information provided by a foreign
company differently from information provided by a domestic corporation?