Chapter 6

1. Stock valuation involves estimating the worth of a company, one of its operating units, or its ownership shares. (T/F)

2. Corporate valuation involves estimating the intrinsic value of a company, or one of its operating units. (T/F)

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)

4. Cash flow assessment plays a central role in analyzing the credit risk of a company. (T/F)

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)

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)

7. Operating cash flow minus cash outlays to replace existing operating capacity is free cash flow. (T/F)

8. The "free cash flow valuation approach" expresses current stock price as the discounted present value of expected future distributable cash flows. (T/F)

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)

10. In applying the discounted free cash flow valuation model, the discount rate used is the average cost of capital. (T/F)

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)

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)

14. The details of free cash flow valuation are important only for stock analysts and investors. (T/F)

15. Earnings are a proxy—imperfect but the best we have—for free cash flow. (T/F)

16. The FASB believes that the most useful predictor of future cash flows is future accrual accounting earnings. (T/F)

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)

18. Research shows that stock returns correlate better with accrual earnings than with realized operating cash flows. (T/F)

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)

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)

21. Based on a number of research studies, current earnings explain virtually 100% of the variation in current stock prices between companies. (T/F)

22. The two most significant explanations for variations in the earnings multiple are risk differences and maturity of the firm. (T/F)

23. Riskier firms have a lower risk-adjusted cost of capital resulting in lower share prices for those companies. (T/F)

24. In addition to valuing earnings generated from existing assets, the market values growth opportunities. (T/F)

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)

26. The growth rate in earnings generally depends on the earnings retention rate and the rate of return earned on new investment. (T/F)

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)

28. A component that is valuation-relevant and expected to persist into the future is a permanent earnings component. (T/F)

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)

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)

31. Extraordinary gains and losses are regarded as value irrelevant earnings. (T/F)

32. Income (or loss) from discontinued operations is viewed as a transitory component of earnings. (T/F)

33. Earnings are considered high quality when they are reliable. (T/F)

34. As transitory components become a more important part of a firm's reported earnings, the reported earnings are more quality enhanced. (T/F)

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)

36. Firms that earn less than the cost of equity capital have a share price below book value. (T/F)

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)

38. In theory, the abnormal earnings approach and the free cash flow approach never produce the same valuation estimate. (T/F)

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)

40. Companies with ROEs that consistently exceed the industry average generally will have shares that sell for book value. (T/F)

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)

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)

43. An earnings surprise results from incorrect estimates of future earnings. (T/F)

44. "Unbiased" means that, on average, the market's earnings expectations will be correct. (T/F)

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)

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)

47. Companies that report good news earnings tend to have an upward drift in stock returns before the actual earnings announcement date. (T/F)

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)

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)

50. For accounting purposes, "fair value" is an entry price, not an exit price. (T/F)

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)

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)

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)

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)

55. A bond that has collateral to protect the bondholder is referred to as a debenture bond. (T/F)

56. The written agreement between the borrowing company and its creditors is referred to as the indenture. (T/F)

57. Creditors are primarily concerned with determining the value of a firm's shares. (T/F)

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)

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)

60. Commercial paper consists of short-term notes sold directly to investors by large and financially sound companies. (T/F)

61. An estimate of the company's future financial condition is indispensable to most lending decisions. (T/F)

62. A comprehensive risk analysis involves evaluating and summarizing the various individual risks associated with a loan. (T/F)

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)

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)

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)

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)

67. Credit risk is unaffected by aggressive application of accounting standards as cash flows are unaffected by financial reporting choices. (T/F)

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)

69. Certain financial statement ratios are quite useful in predicting loan default. (T/F)

70. The corporate valuation approach uses basic accounting measures to assess the amount, timing, and

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

72. Cash flow assessment plays a central role in analyzing

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:

74. According to the discounted free cash flow valuation model, the market value of common shares depends upon investors'

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

76. To apply the discounted free cash flow approach, the analyst needs to estimate

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

78. Through the use of accruals and deferrals, accrual accounting

79. Recent research indicates that stock returns correlate better with

80. The reciprocal of the risk-adjusted equity cost of capital used is the

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?

85. To obtain a better current price, the net present value of future growth opportunities (NPVGO) can be calculated and

86. The net presentvalue of future growth opportunities will contribute to an above average P/E multiple when the retention rate (k) is

87. In general, the growth rate in earnings will depend on the portion of earnings reinvested each period and

88. A component that is valuation-relevant, but is not expected to persist into the future is a

89. Income from continuing operations, excluding special or nonrecurring items, is generally regarded as

90. Income or loss from discontinued operations is regarded as

91. An adjustment to income due to an extraordinary item is regarded as

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?

99. Which one of the following is an example of sustainable earnings?

100. As transitory components become a more important part of a firm's reported earnings, the reported earnings

101. The assessment of earnings quality is best accomplished through the use of which one of the following?

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?

103. According to the abnormal earnings approach of equity valuation, investors willingly pay a premium for those firms that

104. Firms that earn less than the cost of equity capital have a share price

105. The price of equity at time 0 is equal to the

112. A company with a return on equity that consistently exceeds the industry average ROE will generally have shares that sell at a

113. Prior to the announcement of bad news earnings (a negative earnings surprise), stock returns exhibit

114. An earnings surprise

115. The fact that a company's stock price does not change when earnings are announced indicates that

116. The interest rate on a revolving loan will usually

117. Short-term notes sold directly to investors by large, highly rated companies are called

118. A bond that is considered unsecured is referred to as a

119. A qualitative assessment of the business, its customers and suppliers, and management's character and capability is known as

120. The degree to which cash needs can be satisfied during periods of fiscal stress is known as

121. Operating cash flows are typically negative for

122. As per SFAS No. 157, fair value—for accounting purposes—is

123. The interest rate charged on bank loans must be sufficient to cover all of the following except