Chapter 6

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Chapter 6
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  1. 1. Stock valuation involves estimating the worth of a company, one of its operating units, or its ownership shares. (T/F)
    FALSE
  2. 2. Corporate valuation involves estimating the intrinsic value of a company, or one of its operating units. (T/F)
    TRUE
  3. 3. Fundamental analysis uses basic accounting measures to assess the amount, timing, and uncertainty of a firm's future operating cash flows or earnings. (T/F)
    TRUE
  4. 4. Cash flow assessment plays a central role in analyzing the credit risk of a company. (T/F)
    TRUE
  5. 5. Lenders compare their cash flow projections for a company to the firm's future dividend commitment as stated in the firm's dividend policy. (T/F)
    FALSE
  6. 6. When determining the discount rate to apply to a firm's expected future cash flows, analysts should select a rate that reflects the risk (or uncertainty) associated with these cash flows. (T/F)
    TRUE
  7. 7. Operating cash flow minus cash outlays to replace existing operating capacity is free cash flow. (T/F)
    TRUE
  8. 8. The "free cash flow valuation approach" expresses current stock price as the discounted present value of expected future distributable cash flows. (T/F)
    TRUE
  9. 9. The amount available to finance planned expansion of operating capacity, reduce debt, pay dividends, or repurchase stock is distributable (or free) cash flow. (T/F)
    TRUE
  10. 10. In applying the discounted free cash flow valuation model, the discount rate used is the average cost of capital. (T/F)
    FALSE
  11. 11. One popular approach used to estimate a firm's equity cost of capital is the capital asset pricing model, which expresses the equity cost of capital as the sum of the return on a riskless asset plus an equity risk premium multiplied by the company's systematic risk. (T/F)
    TRUE
  12. 12. 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 growth companies with stable cash flow patterns. (T/F)
    FALSE
  13. 14. The details of free cash flow valuation are important only for stock analysts and investors. (T/F)
    FALSE
  14. 15. Earnings are a proxy—imperfect but the best we have—for free cash flow. (T/F)
    TRUE
  15. 16. The FASB believes that the most useful predictor of future cash flows is future accrual accounting earnings. (T/F)
    FALSE
  16. 17. Accrual accounting produces an earnings number that smoothes out the unevenness in year-to-year cash flows, and provides an estimate of sustainable annualized long-run future free cash flows. (T/F)
    TRUE
  17. 18. Research shows that stock returns correlate better with accrual earnings than with realized operating cash flows. (T/F)
    TRUE
  18. 19. Analysts combine information about the company's current earnings, its business strategy, and the industry's competitive dynamics to forecast future free cash flows. (T/F)
    TRUE
  19. 20. Using simplifying assumptions, the current stock price estimate can be expressed as a capitalization rate (1 r) multiplied by a perpetuity equal to current earnings. (T/F)
    FALSE
  20. 21. Based on a number of research studies, current earnings explain virtually 100% of the variation in current stock prices between companies. (T/F)
    FALSE
  21. 22. The two most significant explanations for variations in the earnings multiple are risk differences and maturity of the firm. (T/F)
    FALSE
  22. 23. Riskier firms have a lower risk-adjusted cost of capital resulting in lower share prices for those companies. (T/F)
    FALSE
  23. 24. In addition to valuing earnings generated from existing assets, the market values growth opportunities. (T/F)
    TRUE
  24. 25. The value of the future growth opportunities of a firm can be determined considering the firm's potential earnings from reinvesting current earnings in new projects that will eventually earn a rate of return in excess of the cost of equity capital. (T/F)
    TRUE
  25. 26. The growth rate in earnings generally depends on the earnings retention rate and the rate of return earned on new investment. (T/F)
    TRUE
  26. 27. 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. (T/F)
    FALSE
  27. 28. A component that is valuation-relevant and expected to persist into the future is a permanent earnings component. (T/F)
    TRUE
  28. 29. 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. (T/F)
    TRUE
  29. 30. A transitory earnings component is unrelated to future free cash flows or future earnings and, therefore, is not pertinent to assessing current share price. (T/F)
    FALSE
  30. 31. Extraordinary gains and losses are regarded as value irrelevant earnings. (T/F)
    FALSE
  31. 32. Income (or loss) from discontinued operations is viewed as a transitory component of earnings. (T/F)
    TRUE
  32. 33. Earnings are considered high quality when they are reliable. (T/F)
    FALSE
  33. 34. As transitory components become a more important part of a firm's reported earnings, the reported earnings are more quality enhanced. (T/F)
    FALSE
  34. 35. Earnings are deemed to be of high quality when they are sustainable; earnings quality is also affected by management's choice of accounting methods. (T/F)
    TRUE
  35. 36. Firms that earn less than the cost of equity capital have a share price below book value. (T/F)
    TRUE
  36. 37. A firm generates a return that exceeds the cost of debt financing if the return on equity exceeds the return on assets. (T/F)
    TRUE
  37. 38. In theory, the abnormal earnings approach and the free cash flow approach never produce the same valuation estimate. (T/F)
    FALSE
  38. 39. The cost of capital, expressed in dollars, reflects the level of earnings investors demand from the company as compensation for the risks of investment. (T/F)
    TRUE
  39. 40. Companies with ROEs that consistently exceed the industry average generally will have shares that sell for book value. (T/F)
    FALSE
  40. 41. The degree of conservatism associated with a firm's accounting choices will have a direct bearing on the relationship among share price, earnings, and the firm's equity book value. (T/F)
    TRUE
  41. 42. 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. (T/F)
    FALSE
  42. 43. An earnings surprise results from incorrect estimates of future earnings. (T/F)
    TRUE
  43. 44. "Unbiased" means that, on average, the market's earnings expectations will be correct. (T/F)
    TRUE
  44. 45. If securities markets are rational and efficient in the sense that they fully and correctly impound all available information into a company's stock price, then the price will reflect investors' unbiased expectations about the company's future earnings and cash flows. (T/F)
    TRUE
  45. 46. Stock prices only move up or down when financial reports are released and used by investors to update their expectations about the company's future earnings and cash flows. (T/F)
    FALSE
  46. 47. Companies that report good news earnings tend to have an upward drift in stock returns before the actual earnings announcement date. (T/F)
    TRUE
  47. 48. Companies that report bad news earnings surprises tend to have an upward drift in stock returns before the actual earnings announcement date followed by a sharp decrease in stock returns at the announcement date. (T/F)
    FALSE
  48. 49. Companies that report good news earnings surprises tend to have an upward drift in stock returns before the actual earnings announcement date followed by an increase in stock returns at the announcement date. (T/F)
    TRUE
  49. 50. For accounting purposes, "fair value" is an entry price, not an exit price. (T/F)
    FALSE
  50. 51. Fair value of an asset must reflect its "highest and best use" by others and not how it is used by the company. (T/F)
    TRUE
  51. 52. Critics of mark-to-model fair value accounting claim that it is a license for management to invent the financial statements to be whatever they want them to be. (T/F)
    TRUE
  52. 53. A sensitivity analysis of valuation estimates involves constructing best case and worst case scenarios for a business that incorporate alternative assumptions about sales, costs, competitor behavior, etc. (T/F)
    TRUE
  53. 54. A term lending agreement has an original maturity of more than 1 year with maturities ranging from two to five years being the most common. (T/F)
    TRUE
  54. 55. A bond that has collateral to protect the bondholder is referred to as a debenture bond. (T/F)
    FALSE
  55. 56. The written agreement between the borrowing company and its creditors is referred to as the indenture. (T/F)
    TRUE
  56. 57. Creditors are primarily concerned with determining the value of a firm's shares. (T/F)
    FALSE
  57. 58. Lenders form opinions about a company's credit risk by comparing current and future debt-service requirements to estimates of the company's current and expected future cash flows. (T/F)
    TRUE
  58. 59. Seasonal lines of credit are occasionally used by companies with seasonal sales cycles and provide the cash needed to support increases in current assets during the peak selling period. (T/F)
    FALSE
  59. 60. Commercial paper consists of short-term notes sold directly to investors by large and financially sound companies. (T/F)
    TRUE
  60. 61. An estimate of the company's future financial condition is indispensable to most lending decisions. (T/F)
    TRUE
  61. 62. A comprehensive risk analysis involves evaluating and summarizing the various individual risks associated with a loan. (T/F)
    TRUE
  62. 63. A lender is protected against anticipated credit risks by the loan's covenant provisions as interest rates are fixed by the Federal Reserve Bank. (T/F)
    FALSE
  63. 64. A more streamlined approach to credit analysis than costly scrutiny of financial statement details, ratios, etc. is to rely on credit reports issued by third-parties. (T/F)
    TRUE
  64. 65. In the U.S., there are a large number of companies that assess and grade the credit-worthiness of companies and public entities that sell debt to investors by issuing letter-based grades that express the rating agency's opinion about default risk. (T/F)
    FALSE
  65. 66. Greater default risk is believed to exist when there is significant organizational reliance on an individual, especially one who may be nearing retirement. (T/F)
    TRUE
  66. 67. Credit risk is unaffected by aggressive application of accounting standards as cash flows are unaffected by financial reporting choices. (T/F)
    FALSE
  67. 68. High quality financial statements help credit analysts see what is really going on at a company; low quality statements mask true performance and financial condition. (T/F)
    TRUE
  68. 69. Certain financial statement ratios are quite useful in predicting loan default. (T/F)
    TRUE
  69. 70. The corporate valuation approach uses basic accounting measures to assess the amount, timing, and
    C. uncertainty of a company's future operating cash flows or earnings.
  70. 71. The steps involved in corporate valuation are forecasting future values of some financial attribute that drives a company's value, determining the risk associated with that forecasted value, and determining the
    D. discounted present value of the expected future amounts using a discount rate that reflects the risk or uncertainty.
  71. 72. Cash flow assessment plays a central role in analyzing
    A. the credit risk of a company.
  72. 73. 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:
    D. Determining the dividends the company will pay in the future based on the company's dividend policy and expected future earnings.
  73. 74. According to the discounted free cash flow valuation model, the market value of common shares depends upon investors'
    B. current expectations about the future economic prospects of free cash flows.
  74. 75. 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
    D. mature firms with stable cash flow patterns.
  75. 76. To apply the discounted free cash flow approach, the analyst needs to estimate
    B. free cash flows for each and every future period, starting one year hence.
  76. 77. 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 companies' future cash flows.
  77. 78. Through the use of accruals and deferrals, accrual accounting
    D. produces an earnings number that smoothes out the unevenness in year-to-year cash flows.
  78. 79. Recent research indicates that stock returns correlate better with
    A. accrual earnings than realized operating cash flows.
  79. 80. The reciprocal of the risk-adjusted equity cost of capital used is the
    C. price earnings ratio.
  80. 84. Risky firms have a higher risk-adjusted cost of capital. Which one of the following factors would contribute to that firm also having a high price/earnings ratio?
    C. Growth opportunities
  81. 85. 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.
  82. 86. The net presentvalue of future growth opportunities will contribute to an above average P/E multiple when the retention rate (k) is
    B. positive and the return on new investment is greater than the cost of equity capital.
  83. 87. In general, the growth rate in earnings will depend on the portion of earnings reinvested each period and
    B. the rate of return earned on new investment.
  84. 88. A component that is valuation-relevant, but is not expected to persist into the future is a
    B. transitory earnings component.
  85. 89. Income from continuing operations, excluding special or nonrecurring items, is generally regarded as
    A. permanent earnings.
  86. 90. Income or loss from discontinued operations is regarded as
    B. transitory earnings.
  87. 91. An adjustment to income due to an extraordinary item is regarded as
    B. transitory earnings.
  88. 98. Reported earnings numbers often contain three distinctly different components, each subject to a different earnings capitalization rate. Which of the following is not one of these components?
    C. A restructured earnings component.
  89. 99. Which one of the following is an example of sustainable earnings?
    C. Earnings from repeat customers.
  90. 100. As transitory components become a more important part of a firm's reported earnings, the reported earnings
    D. are a less reliable indicator of sustainable cash flows.
  91. 101. The assessment of earnings quality is best accomplished through the use of which one of the following?
    C. Multi-step income statement, balance sheet, and cash flow statement.
  92. 102. 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?
    B. The firm's stock price rises in the year such compenents are reported proportionate to their impact on income.
  93. 103. According to the abnormal earnings approach of equity valuation, investors willingly pay a premium for those firms that
    C. produce positive abnormal earnings.
  94. 104. Firms that earn less than the cost of equity capital have a share price
    D. below book value.
  95. 105. The price of equity at time 0 is equal to the
    C. book value of equity at time 0 plus expected abnormal earnings in all future periods divided by discount factors for all future periods.
  96. 112. A company with a return on equity that consistently exceeds the industry average ROE will generally have shares that sell at a
    C. higher market-to-book ratio than the industry average.
  97. 113. Prior to the announcement of bad news earnings (a negative earnings surprise), stock returns exhibit
    A. a negative drift downward.
  98. 114. An earnings surprise
    D. occurs when earnings deviate from investors' expectations.
  99. 115. The fact that a company's stock price does not change when earnings are announced indicates that
    C. the information contained in the earnings release was fully anticipated by investors.
  100. 116. The interest rate on a revolving loan will usually
    D. float.
  101. 117. Short-term notes sold directly to investors by large, highly rated companies are called
    A. commercial paper.
  102. 118. A bond that is considered unsecured is referred to as a
    A. debenture.
  103. 119. A qualitative assessment of the business, its customers and suppliers, and management's character and capability is known as
    B. due diligence.
  104. 120. The degree to which cash needs can be satisfied during periods of fiscal stress is known as
    D. financial flexibility.
  105. 121. Operating cash flows are typically negative for
    B. emerging companies.
  106. 122. As per SFAS No. 157, fair value—for accounting purposes—is
    B. an exit price.
  107. 123. The interest rate charged on bank loans must be sufficient to cover all of the following except
    A. a risk premium when loans are personally guaranteed by the borrower.

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