Additional (Part 2) Flashcards
Which of the following factors is the largest inhibitor to revenue growth of a biotech company?
A. Falling interest rates
B. Increasing valuations of private corporations
C. Decreasing CFs allocated to CAPEX
D. A slowdown of FDA approvals for new medical techniques
C. Companies in the biotechnology industry require a significant amount of capital as well as the reinvestment of current cash flows to develop new medical technologies. Firms that lack sufficient cash flows to spend on new capital projects are at risk of not being able to grow their revenues. Even if a biotechnology firm doesn’t have the cash flows to use on CAPEX, it could get funding from the issuance of securities in the private markets. Falling interest rates and increasing valuations of private companies would make it viable to issue new securities to increase revenue growth. The FDA not approving new medical techniques would likely decrease biotech valuations. Although revenue growth may suffer, it’s unlikely to have as dramatic an impact as decreasing CAPEX.
Economies of scope are realized through:
A. Integration of related product distribution
B. Maximizing production to reduce a product’s cost
C. Vertical integration of production capacity to minimize the costs of producing a single product
D. Maximizing value by buying a product in bulk
A. Economies of scope relate to minimizing costs across product line production, marketing, and/or distribution. The marketing department of a consumer products company employs economies of scope by using the same personnel to sell different products produced by the company, often bundling products to sell as a group. All of the other choices describe economies of scale.
When is it advantageous to use residual income to value an investment opportunity?
- When it’s difficult to estimate terminal values
- When CFs are negative
- When the company doesn’t pay dividends
The RMA Corporation regularly issues commercial paper to fund its operations. The company has reached a terminal growth rate of 5%. An analyst studying the RMA Corporation has applied a terminal multiple of 11 for the steady state of cash flows expected. If the rate on the T-bill decreases by 40 basis points, the analyst would expect the:
A. Terminal value to increase
B. Terminal value to decrease
C. Terminal multiple to remain unchanged
D. Terminal multiple to decrease
A. The discount rate applied to the cash flows uses a measure of the company’s cost of capital, either the WACC (in the case of free cash flow to the firm), or the equity cost of capital (in the case of free cash flow to equity). Given the decrease in interest rates and the short-term funding requirements of the company, a decrease in the WACC is expected. This would increase the present value of the cash flows, and the terminal value of the company should be higher. The terminal multiple describes the expected period of steady state cash flows for a company. In general, as interest rates decrease, there’s an increase in the terminal multiples for industry sectors.
What’s the effect on a company’s financial statements if depreciation declined by $50 million and the company paid out a dividend of $8 million?
A. Retained earnings increase on the balance sheet
B. Cash flows from financing activities increase
C. Net income decreases on the income statement
D. Retained earnings will not change on the balance sheet
A. The reduction in depreciation will increase net income, which normally leads to an increase in retained earnings. Although the dividend payments are deducted from net income to determine retained earnings, since the dividend is so much lower than depreciation, it’s likely that retained earnings will rise. The dividend payment will cause cash flows from financing activities to decrease.
True or false: Amortization of bond premiums reduces the bond interest expense and a similar treatment applies to the amortization of financing fees. Neither entry would be added back to determine EBITDA?
True
A company headquartered in the United States manufactures and markets its products in Europe. The price of a basket of foreign currencies increases. Which of the following statements is TRUE?
A. Operating margin remains flat and the operating profit remains flat
B. Gross margin remain flat and the operating profit increases
C. Operating margin rises and the operating profit falls
D. Operating margin falls and the operating profit increases
B. The company’s income statement is reported in U.S. dollars. In this question, we are stating that the price of a basket of foreign currencies increases, which means the dollar has weakened against several currencies. When foreign-based sales and expenses are converted into dollars, both rise proportionately, so margins would remain the same. However, the actual operating profit amount would increase.
The Tarmac Co. and Madone Co. are in the same industry and have similar capital structures. One of the main differences is that the Tarmac Co. is projected to have a deteriorating working capital over the next few years. Based on this fact, which valuation method would lead to a higher share price for the Madone Co.?
A. A discounted cash flow analysis (DCF)
B. A sum-of-the-parts analysis (SOTP)
C. The PEG ratio
D. The enterprise value to sales ratio
A. Discounted cash flow (DCF) valuation assumes that a company can be valued based on the present valuation of its projected free cash flows over a given period using the appropriate cost of capital as the discount rate. DCF analysis is heavily dependent on estimating cash flows, which takes into consideration a company’s working capital. An accountant’s definition of working capital is the difference between current assets and current liabilities. From a DCF valuation perspective, a better definition is the difference between noncash current assets and nondebt-related current liabilities. If noncash working capital increases, the firm is tying up cash, causing cash flows to be reduced. This would lead to a lower valuation. On the other hand, if noncash working capital decreases, cash flows would increase, leading to a higher valuation. The term worsening or deteriorating working capital condition would refer to an increase in noncash working capital. Sum-of-the-parts would be used if a company had different operating units in which each one would have different valuation methods. PEG, or price/earnings divided by the expected growth rate, or EV/sales, would not be used since changes in noncash working capital would not have a major impact on these two valuation methods.
Company W issued a nonconvertible bond at par that pays 6% interest semiannually. The bonds are currently trading at 98 and mature in 10 years. It pays taxes at a rate of 21%. What is Company W’s cost of debt for the bond issue?
A. 4.74%
B. 4.04%
C. 6.12%
D. 12.0%
A. To determine the cost of debt, it is necessary to adjust the nominal yield (the coupon rate) by the tax rate, rather than the current yield of the bond. Multiply the nominal yield by (100% - tax rate) or (100% - 21% = 79%). Although the coupons are paid semiannually, the annual coupon rate for the bond is 6%; therefore, the cost of debt is 4.74% (6% x 79%).
With respect to Company X’s earnings per share (EPS), which of the following has a dilutive effect?
A. Company X announces the acquisition of Company C and it’s expected to be neutral on net income through an exchange of common stock
B. $500,000,000 of short-term debentures that Company X previously issued have matured
C. Call options on Company X’s stock were issued on an SEC-registered exchange
D. A competitor of Company X announces a share buyback plan
A. Since the acquisition of Company C is neutral on net income, but would increase the number of shares outstanding, it would have a dilutive effect on EPS. The maturity of debentures (a type of unsecured bond) would reduce the company’s cash position. In addition, Company X’s net income would increase, since interest would no longer need to be paid. Exchange-traded call options are not issued by Company X and don’t impact the shares outstanding or EPS. Another company buying back its shares will not have an effect on Company X.
The Orbit Company has a WACC of 10% and a beta of 1.2. Using a discounted cash flow (DCF) model, what will increase the valuation of The Orbit Company?
A. The risk-free rate decreases by 1%, while there’s no change to the expected return of the market.
B. Depreciation increases, while capital expenditures and working capital remain unchanged.
C. The long-term growth rate declines by 1%.
D. Working capital and depreciation increase by the same amount, while capital expenditures remain the same.
B. Using the DCF model, the valuation of a firm can be found by dividing the free cash flow to the firm (in this example, used as the measurement of cash flow) by 1.0 plus the discount rate (which is the WACC in this example). The influence of a beta greater than 1.0 will cause the cost of equity to decline if the risk-free rate increases, while the expected return of the market remains unchanged. This will cause the risk premium of the company to decline. For example, let’s assume that the cost of equity is 10%, the risk-free rate is 4%, the risk premium is 5%, and the beta is 1.2. The cost of equity is calculated as follows: .04 + (.05 x 1.2) which equals 10% (.04 + .06). If the risk-free rate decreases to 3%, the risk premium will increase to 6%, and the new cost of equity will equal .03 + (.06 x 1.2) = .102 or 10.2%. If no change in the cost of debt is assumed, and the cost of equity increases, the WACC will also increase. A larger denominator will result in a lower valuation of the discounted cash flows.
Which of the following BEST defines the term public float?
A. The number of shares held by retail investors
B. The number of shares of restricted stock held by insiders
C. The number of shares of restricted stock added to the number of shares of outstanding stock
D. The number of shares of restricted stock subtracted from the number of shares of outstanding stock
D. The public float of a company represents the number of shares held by public investors—both retail and institutional. Public float excludes any stock that is owned by affiliated persons of a company and is found by subtracting restricted stock from the number of outstanding shares. By contrast, a company’s market capitalization is determined by multiplying the number of outstanding shares by the current market price per share. Outstanding shares include restricted shares as well as those held by institutions, retail investors, and insiders, however, treasury stock (shares that are repurchased by the company) is not included.
Which of the following statements is TRUE regarding the impact of finance leases over the life of the lease?
A. Total expenses increase
B. Operating cash flow increases
C. Taxable income falls
D. Int. coverage declines
B. A finance lease has declining expenses since interest on the lease obligation declines over the life of the lease. As a result, the declining interest expense will cause operating cash flows to increase over the lease’s life. It also increases the net income of the company and taxable income. Assuming revenues remain unchanged, the interest coverage will rise as the interest expense declines.
True or false: An increase in depreciation is a use of cash?
False, an increase in D&A is a source of cash
Which of the following actions will cause a company’s enterprise value to rise?
A. It issues new debentures
B. The price of its common stock increases
C. It buys back its stock
D. It retires outstanding debt
B. When bonds (debentures) are issued, debt rises, but so do cash and cash equivalents. As a result, one offsets the other. When the company’s common stock is repurchased, the total market capitalization falls since a smaller number of shares are outstanding. This decline is offset by a reduction in cash since cash is used to repurchase the stock. Debt retirement provides a similar offset since cash is used to retire debt. A rise in the stock price increases the market capitalization of the company. This event causes enterprise value to rise.
Where is interest expense reported in the cash flow statement?
The cash flow statement does not directly capture interest expense, but interest expense is recorded on the income statement and affects the net income.
True or false: The sale of the debentures would be reflected under CFO?
False, CFF
The Zeta Corporation regularly issues commercial paper, and the corporation has reached a terminal growth rate of 4%. If an analyst for Zeta has applied a terminal multiple of 12 for the steady state of cash flows expected, what would the analyst expect if the rate on the T-bill increases by 50 basis points?
A. The terminal value would increase.
B. The terminal value will not change.
C. The terminal multiple would increase.
D. The terminal multiple would decline.
D. The discount rate applied to the cash flows uses a measure of the company’s cost of capital, either the WACC (in the case of FCFF), or the equity cost of capital (in the case of FCFE). An increase in the WACC is expected, given the increase in interest rates and the short-term funding requirements of the company. This would reduce the present value of the cash flows and would lower the terminal value of the company. The terminal multiple describes the expected period of steady state cash flows for a company. In general, as interest rates increase, there’s a decline in the terminal multiples for industry sectors.
The Ellipse Company has a WACC of 11.5% and a beta of .85. Which of the following changes will increase the valuation of Ellipse using the discounted cash flow (DCF) model?
A. The risk-free rate decreases by 1%, while there’s no change in the expected return of the market.
B. The long-term growth rate decreases by 1%.
C. Depreciation decreases, while capital expenditures and working capital remain unchanged.
D. Working capital and depreciation decrease by the same level, while capital expenditures increase.
A. The influence of a beta of less than 1.0 will cause the cost of equity to decline if the risk-free rate decreases, while the expected return of the market remains unchanged. This will cause the risk premium of the company to increase. If the growth rate applied to the cash flows declines, the cash flows will also decline, thereby resulting in a lower valuation of the firm.
At times, the market price of a company’s stock may be trading at less than its book value per share. Why may this situation occur?
A. Because the company is considered blue-chip
B. Because the company’s assets are undervalued
C. Because the company will soon issue preferred stock
D. Because the company’s earnings are excessively low in relation to its assets
D. If the assets of a company are significantly overvalued, or if its earnings are excessively low in comparison to its assets, the market price of the stock may trade below the book value of the company. In such a case, there’s little demand for the stock and a resultant decline in its market price could occur.
Which of the following descriptions BEST defines the fair value of an asset?
A. Its acquisition cost less depreciation
B. Its fair market value
C. Its sale or purchase price in the absence of incentives
D. Its sale or purchase price including market discounts
C. The fair value of an asset is defined as what a buyer would pay or a seller would accept without any necessity to do so. Fair value is sometimes used as a standard for comparing various asset classes.
What factors have the biggest effect on the cyclical nature of the pharmaceutical services industry?
A. GDP
B. M&A and R&D spending
C. Advertising and marketing expenditures
D. The level of interest rates and fiscal policies enacted by Congress
B. Mergers and acquisitions as well as research and development spending both affect the cyclical nature of the pharmaceutical services industry. Research and development spending by pharmaceutical companies, which provide a pharmaceutical services company with business, can increase or decrease at any given time and are dependent on the need for research and product development. Mergers and acquisitions also have an effect on the spending of research and development funds. With the consolidation of pharmaceutical companies, the budgets of the companies combined may increase or decrease depending on the objectives of the newly organized company.
A corporation based in the United States imports components from a company based in China. The importer uses these components to assemble a finished product that it exports back to China. The U.S. dollar has recently been devalued against the Chinese yuan. All of the following items will increase in value, EXCEPT the:
A. Operating expenses
B. Revenue
C. Operating profit margin
D. COGS
A. The operating expenses of the company would be expressed in U.S. dollars. These expenses are unaffected by a devaluation of the dollar against the yuan. The cost of goods sold will increase since the dollar has declined in value against the Chinese yuan. The decline of the dollar, however, will also increase the revenue the company will receive once the yuans (received for the sale of the finished products) are converted into U.S. dollars. A portion of the cost of goods sold (assembly of the finished product) is payable in U.S. dollars. The devaluation of the dollar will not impact this portion of the cost of goods sold. Since the increase in the revenue would be a greater percentage than the percentage increase in cost of goods sold, the profit margin will increase.
True or false: Shareholders who elect to receive shares of EDR Energy stock would not have a taxable event until those shares are sold?
True
Company D has two business components. Business X generates 90% of the company’s revenue. Business Y generates 10%. Which of the following choices would justify using a sum-of-the-parts valuation method for Company D?
A. The company only has high pricing power due to the inelasticity of demand for its products
B. One of the business components is growing disproportionately
C. The company benefits from economies of scale within the business units
D. The company benefits from economies of scope within the business units
B. In the sum-of-the-parts valuation method, a different metric may be applied to the different business units of a company. If a business unit has a much higher growth rate than the other components of a company, a different valuation method is appropriate for that component. As such, the sum-of-the-parts valuation method is appropriate. When a company benefits from economies of scale, or economies of scope, the value of the company could be greater than the sum of its parts.
If a business is expanded by issuing debt instruments and the increased revenue equals the cost of the capital plus floatation costs, what will happen to the earnings per share of the company?
A. EPS will increase
B. EPS will decrease
C. EPS will remain the same
D. The shares outstanding will increase
C. If the debt issue covers the required cost of the capital for investment plus floatation costs, the earnings per share will remain unchanged.
You are research analyst analyzing a potential M&A transaction. You have been asked to prepare a valuation model for a food company that has had recent operating losses, but positive cash flow, if depreciation is added. Other characteristics include volatility of earnings, reduced product demand, flat revenue, and low profit margins. The valuation metric LEAST likely to be used is the:
A. P/E
B. EV/S
C. EV/EBITDA
D. DCF
A. Since the company has had operating losses and volatile earnings, the price to earnings ratio would not be a good valuation metric. The company has positive EBITDA, therefore, EV / EBITDA can be used as well as a DCF valuation using EBITDA to project the company’s free cash flow.
Which of the following statements is TRUE regarding leases?
A. A finance lease creates higher amortization expenses than an operating lease.
B. The interest expense is constant during the life of a finance lease.
C. An operating lease results in higher investing cash flows than a finance lease.
D. An operating lease increases the debt-to-equity ratio of the lessee.
A. A finance lease payment is split into interest and amortization portions. Operating leases are recognized as one lease expense in a company’s operating income. Typically, the interest expense on a finance lease will decline over the life of the lease. Operating leases will not impact investing cash flows or the debt-to-equity ratio of the lessee.
Which of the following is the BEST reason to use earnings yield as a valuation metric?
A. To compare the return on equity securities to the return on fixed income securities
B. To compare two stocks that have same price-to-earnings ratio
C. To compare the return on an equity security to the return on the S&P 500 Index
D. To compare the return of two fixed income securities
A. One of the reasons that earnings yield is used as valuation metric is to compare the yield on equity securities to the yield on fixed income securities. P/E ratios are used to compare equity securities, but stated as a multiple (e.g., a stock’s price is 10 times EPS). The earnings yield is the inverse of the P/E ratio and stated as a percentage. This means that the earnings yield can be directly compared to the yield on fixed income securities. For example, a company with a P/E of 18, also has an earning yield of 5.5%, and, if a bond is yielding 2%, then the stock’s EPS is larger than the bond’s interest payment relative to the respective prices of each investment.
It would be most appropriate to use linear regression as a statistical technique in equity research in which of the following cases?
A. A cyclical pattern of auto sales over a period of time
B. The relationship between a retailer’s sales and disposable income
C. The relationship between health care costs and GDP
D. Seasonal profit patterns in the jewelry industry
B. Linear regression is best used in relationships that tend to trend together or are opposite to each other. Retail sales tend to rise or fall along with the level of disposable income. It is less useful for analyzing cyclical patterns, though it could have some usefulness in identifying a trend in a long-term cyclical pattern. Health care costs tend to be less sensitive to GDP than retail sales would be to incomes. Regression analysis would not be used to detect seasonal patterns.
Which of the following events will affect EPS and the P/E ratio if the price of common stock remains unchanged?
A. Acquiring a company for cash that’s neutral to earnings
B. An increase in the rate of inflation in the overall economy
C. Issuing debt to build an office complex
D. Issuing debt at a rate that’s lower than WACC
D. Issuing debt will decrease the earnings of a business through higher interest costs. As a result, earnings per share (EPS) will fall and, if the stock price remains unchanged, the price-to-earnings (PE) ratio will rise. If a merger is done for cash and is neutral to earnings, the merger will have no effect on EPS or the PE ratio. Issuing debt to build a fixed asset (e.g., office complex) will not impact earnings immediately. Instead, the additional interest from the bonds will be capitalized during the construction period and increase the cost of the fixed asset. As the building is depreciated, the earnings of the company will be lower in subsequent years. Without knowing more about a business, it’s hard to be sure how higher inflation will impact a business’ earnings.
A research analyst is reviewing a press release which discloses a positive settlement of litigation for a company, thereby resulting in an after-tax gain for the next accounting period. What’s the MOST concerning aspect of the press release for the research analyst?
A. Earnings estimates
B. Sales growth
C. Implication of the litigation
D. Dilution
A. One-time events, such as the settlement of a lawsuit, will impact a company’s net income and earnings per share, but only in one accounting period. When projecting earnings for future periods, research analysts will need to adjust their estimates for one-time events. A gain from a litigation settlement is not dilutive and, while it affects net income, it’s not included in sales.
A corporation has been aggressively using its cash to repurchase its common shares from the marketplace. During the buyback period, the corporation’s market price has risen from $10 per share to $15 per share. If the company’s book value per share is currently $2, which of the following will result if the share buybacks continue?
A. The market price of the stock will decrease.
B. The ROE will increase.
C. The book value per share will increase.
D. The book value per share will not change.
B. When a company repurchases its own stock, its balance sheet will show a decrease in cash and a decrease in shareholders’ equity (i.e., it spends cash to retire/get rid of issued stock). Notice that the change to book value per share is more subtle. Since the book value per share of the repurchased stock is less than the market price per share, then book value per share will be lower after the buyback. If the book value per share was higher than the market price of the repurchased stock, book value per share would have been higher. Since return on equity is equal to the earnings available to common shares divided by the average common equity, ROE will increase. Unless the question states otherwise, assume that earnings available to common shares doesn’t change. Since the shareholders’ equity (including common equity) is falling, the ROE will increase. The market price of the stock is likely to increase, not only due to the additional buying pressure from the corporation, but also because the shares outstanding (i.e., supply) is falling.
Which the following statements is TRUE regarding accounts receivable and inventories, when the company recognizes revenue sooner than permitted under accrual accounting?
A. Accounts receivable is overstated, and inventory is overstated
B. Accounts receivable is overstated, and inventory is understated
C. Accounts receivable is understated and inventory is overstated
D. Accounts receivable is understated and inventory is understated
B. Accounts receivable will be overstated because sales are recognized earlier and inventory will be understated because inventories are charged earlier than permitted.
What would a research analyst use to obtain information regarding an industry’s barriers to entry and exit?
A. Discussions with industry participants
B. Annual reports
C. Patent filings
D. Financial media publications
B. Although most corporations don’t specifically mention barriers to exit or entry in their annual reports, they will discuss industry competition and risks to their business. This could include firms’ pricing power, customer loyalty, and government regulations, all of which relate to the barriers to entry or exit from an industry.
Annual report = 10K
Which of the following items is NOT considered part of the tangible book value of a company?
A. Copyrights and patents
B. Goodwill carried on the books of the company
C. Inventories of work in process
D. Investments in securities
B. When calculating the tangible book value of a company, certain intangible assets may still have a salable value. These assets can be identified on the books of the firm, extracted as separately marketable items, and sold individually. Among such assets are copyrights and patents. Goodwill, however, is not such an item and would be deducted from the tangible asset value of the company.
Which economic indicator should be monitored to analyze the residential real estate market?
A. Prime rate
B. Manufacturers’ new orders, nondefense capital goods
C. Housing starts
D. Building permits, new private housing units
D. Although manufacturers’ new orders for nondefense capital goods is a leading economic indicator, building permits for new private housing units is a leading economic indicator that is directly related to residential real estate. Building permits must be obtained before housing starts can take place. The prime rate is a lagging economic indicator.
One of the main considerations in the sum-of-the-parts analysis is that valuation is based on the concept that:
A. Separate segments of the company are discounted to their present values
B. Separate segments of the company may be worth more individually than combined
C. The separate segments of the company are totaled and discounted to present values
D. Each segment of the company will grow at the appropriate rate of return
B. The sum-of-the-parts analysis is based on the fact that the individual business segments of the company may be separated and sold by themselves. When added together, the total of these individual segments may be worth more than the company as a whole.
