Additional (Part 2)

Question 1

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

Answer 1

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.

Question 2

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

Answer 2

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.

Question 3

When is it advantageous to use residual income to value an investment opportunity?

Answer 3

1. When it’s difficult to estimate terminal values
2. When CFs are negative
3. When the company doesn’t pay dividends

Question 4

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

Answer 4

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.

Question 5

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

Answer 5

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.

Question 6

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?

Answer 6

True

Question 7

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

Answer 7

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.

Question 8

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

Answer 8

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.

Question 9

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%

Answer 9

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%).

Question 10

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

Answer 10

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.

Question 11

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.

Answer 11

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.

Question 12

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

Answer 12

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.

Question 13

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

Answer 13

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.

Question 14

True or false: An increase in depreciation is a use of cash?

Answer 14

False, an increase in D&A is a source of cash

Question 15

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

Answer 15

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.

Question 16

Where is interest expense reported in the cash flow statement?

Answer 16

The cash flow statement does not directly capture interest expense, but interest expense is recorded on the income statement and affects the net income.

Question 17

True or false: The sale of the debentures would be reflected under CFO?

Answer 17

False, CFF

Question 18

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.

Answer 18

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.

Question 19

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.

Answer 19

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.

Question 20

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

Answer 20

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.

Question 21

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

Answer 21

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.

Question 22

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

Answer 22

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.

Question 23

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

Answer 23

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.

Question 24

True or false: Shareholders who elect to receive shares of EDR Energy stock would not have a taxable event until those shares are sold?

Answer 24

True

Question 25

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

Answer 25

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.*

Question 26

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

Answer 26

C. If the debt issue covers the required cost of the capital for investment plus floatation costs, the earnings per share will remain unchanged.

Question 27

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

Answer 27

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.

Question 28

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.

Answer 28

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.

Question 29

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

Answer 29

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.

Question 30

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

Answer 30

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.***

Question 31

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

Answer 31

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.

Question 32

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

Answer 32

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.

Question 33

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.

Answer 33

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.

Question 34

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

Answer 34

B. Accounts receivable will be overstated because sales are recognized earlier and inventory will be understated because inventories are charged earlier than permitted.

Question 35

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

Answer 35

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

Question 36

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

Answer 36

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.

Question 37

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

Answer 37

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.

Question 38

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

Answer 38

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.

Question 39

What information would NOT be found in a company's annual proxy statement? A. Financial statements B. The names of the independent directors C. Last year's voting results on shareholder proposals D. The name of the independent public accounting firm performing the audit

Answer 39

A. A company's financial statements would be found in its annual 10-K filing or its quarterly 10-Q filings. (Note: A company publishes three 10-Qs and one 10-K a year.) ***The annual proxy statement contains the names of the members of the board of directors, executive compensation, ownership of securities by holders of five percent or more of the company's common stock (based on 13D and 13G filings), the name of the independent public accounting firm performing the audit, and other information related to any other matter that will be voted on at the annual shareholder meeting.*** Shareholder proposals will be presented with a supporting statement, and the BOD's response, either for or against. Sometimes the same shareholder proposal that was voted on at last year's meeting and the proxy will show the results of the vote.

Question 40

To determine the growth rate for a particular industry, which of the following actions will an analyst take? A. Calculate the 10-year compounded annual growth rate for the industry leader in the sector. B. Interview the management of the leading public and private customers of the industry. C. Examine the 10-Q and 10-K statements of companies in the industry. D. Calculate the five-year average annual growth rate for the worst performing company in the sector.

Answer 40

B. Interviews with the suppliers and customers of the industry provides a view of the expected supply and demand within the industry. Although the historical growth rates and SEC filings are useful in providing a historical view of the industry, they're not the best way to project future growth in the industry.

Question 41

The S&P 500 has an average P/E of 25. Grind and Muck Industries is trading at 8 times its trailing EPS. Which of the following observations is implied about Grind and Muck? A. The company's earnings are expected to increase B. An external influence, such as a major lawsuit, is depressing the price of the company C. As an industrial company, a low P/E is expected D. The company is highly leveraged

Answer 41

B. Grind and Muck has a P/E of 8. This is significantly below the S&P 500 average. This would normally indicate a significant influence outside of the normal conditions that affect the stock price. Such external influences include major lawsuits and governmental investigations. Industrial companies generally have a lower P/E than the S&P 500 Index, but not as low as is indicated in the question. If the S&P 500 Index average is 25, an industrial company may be expected to trade at 15 to 18. A low P/E ratio is an indication that the expected growth of earnings is lower than the industry average.

Question 42

Interest rates should rise if: A. The supply of money increases B. The economy is in a recession C. The demand for money increases D. The demand for money decreases

Answer 42

C. Interest rates are the price of money. When the supply of money decreases (i.e., it tightens), interest rates will rise. In addition, if the economy begins to expand, the demand for money will increase and interest rates will rise. During a recession, the demand for money falls and interest rates generally fall.

Question 43

In the Liquidity and Capital Resources section of the 10-K, what is discussed? A. Operating profit B. Cash, cash equivalents, and lines of credit C. Capacity utilization D. Effects of inflation and changing prices

Answer 43

B. In the 10-K, there is discussion of the cash, cash equivalents, and lines of credit at the company's disposal. The formal name of this portion of the 10-K is Liquidity and Capital Resources.

Question 44

If casual dining is more fragmented and less mature than fast food, it’s likely to exhibit all of the following, EXCEPT: A. More growth potential B. Less pricing power C. Less competition for market share D. Ability to exploit lifestyle and demographic trends

Answer 44

B. Casual dining should have more pricing power, relying less on promotional pricing (couponing) and can take advantage of two income couples and more food dollars spent outside the home.

Question 45

Episilon Financial currently has significant loan losses and holds reserves against those loans in the event that borrowers do not repay. Which of the following metrics is the BEST valuation tool for Episilon? A. EV/S B. Forward P/E C. Losses per million D. P/B

Answer 45

D. Loan loss reserves represent a certain percentage of loans that will not be repaid and appear as a noncash charge to earnings. The creation of reserves provides a cushion against nonpayment. These reserves shrink when loans are charged off. The balance sheets of financial service companies, such as banks, insurance, and reinsurance companies are presumably liquid and are marked to the market, so the book value becomes a strong consideration in valuing the company. One of the most often-used valuation metrics for these types of companies is the price-to-book ratio.

Question 46

Company H is in the widget industry, which has a high barrier to entry due to high costs. Recently, a few new companies have entered the market. These companies are more innovative and have lower costs. Which of the following risks should Company H disclose in its Form 10-K filing? A. The fact that the company's lack of innovation is causing its competitors to lower their costs. B. That competition in the industry has forced the industry to innovate. C. The fact that costs are falling and competitors may be able to innovate quicker. D. The fact that barriers to entry the industry have fallen.

Answer 46

A company is required to disclose its risk factors in its Form 10-K filing. Based on the information given, the best choice is the fact that costs are falling and competitors may be able to innovate quicker. A few examples of disclosures that may be found in a Form 10-K include, "emerging startups may be able to innovate quicker than we can," or "the market for our products can be met at lower costs by our competitors." Disclosing the fact that the company may not be innovating may be required, but not the fact that it's lack of innovation is causing its competitors to lower their costs.

Question 47

Of the choices listed, the term "percentage of earnings" can be found by using which of the following formulas? A. Dividends per share/earnings per share B. Net income - dividends/ number of shares outstanding C. Dividends paid/retained earnings D. Net income/common equity

Question 48

When the economy is coming out of a recession, what group recovers in the early part of the expansion phase? A. Retailers B. Home builders C. Supermarkets D. Beverage companies

Answer 48

A. Retailers are referred to as early business cycle stocks. As the economy emerges from a recession, increased consumer confidence leads to increased sales at a broad spectrum of retailers.

Question 49

A U.S. company owns a cycling business in Spain and sells its products throughout Europe. Recently, unlike the rest of the world, interest rates have risen in the United States. Assuming no other changes in the company's business, in dollar terms, what effect will this currency movement have on the company? A. Both revenue and gross margins will decline. B. Both revenue and gross margins will increase. C. Revenue will decline, but the gross margin will remain unchanged. D. Revenue will increase and the gross margin will decrease.

Answer 49

C. Rising interest rates in the U.S. will cause the U.S dollar to strengthen against the Euro. Since both sales and expenses are in Euros, the Euro will decline against the dollar and revenue will also decline. Since costs will decline by the same percentage, the gross margin will remain unchanged.

Question 50

Company X is a retailer and has excess inventory near its year end. In order to liquidate some of its inventory, Company X's executives have decided to cut the retail prices of its goods. What effect will this have on Company X's financials? A. Days sales outstanding will increase in the first quarter of the next fiscal year B. Net income for the fiscal year will decrease as it sells its excess inventory C. If the company cannot sell its excess inventory, the current ratio will decrease D. Gross margins will decrease in the fourth quarter of this fiscal year

Answer 50

D. If a company sells its goods or services at a reduced price, its gross margin [i.e., (Sales - COGS) ÷ Sales] will decline. If it cannot sell its excess inventory, its current ratio (Current Assets ÷ Current Liabilities) will increase since inventory is a current asset.

Question 51

A U.S. manufacturer imports steel from Japan. The company manufactures the steel into parts and exports them for sale into Japan. The yen has recently devalued. All of the following items will decrease, EXCEPT: A. Revenue B. Operating expenses C. Operating profit margin D. COGS

Answer 51

B. The operating expenses of the company are expressed in U.S. dollars. These expenses are unaffected by a devaluation of the yen against the dollar. The cost of goods sold will decrease since the yen has declined in value against the dollar. The decline of the yen, however, will also decrease the revenue the company will receive once the yen (received for the sale of the parts) are converted into U.S. dollars. A portion of the cost of goods sold (machinery and labor) is payable in U.S. dollars. The devaluation of the yen will not impact this portion of the cost of goods sold. Since the operating expenses will not be affected by the currency change and the decrease in the revenue would be a greater percentage than the percentage decrease in cost of goods sold, the profit margin will decrease.

Question 52

A company is experiencing an increase in its inventory turnover ratio. This may be indicative of: A. Improved credit evaluation and collection processes B. Decreasing sales C. More efficient purchasing and marketing D. A coincident decrease in payables turnover

Answer 52

C. Inventory turnover represents the ratio of the cost of goods sold to average inventory. If the ratio is increasing, it's most likely caused by increasing sales. Increased sales could be the result of a successful marketing campaign or more efficient purchasing methods leading to lower inventories. A more effective credit evaluation and collection process will lead to a higher accounts receivable turnover, not a higher inventory turnover.

Question 53

A company that's in an industry with high operating leverage is being evaluated. The company's capital structure is consists of 50% debt and 50% equity. What will have the biggest impact on the company's valuation? A. Falling interest rates B. Slowing sales growth C. Increasing variable costs D. Changes in industry regulations

Answer 53

B. Companies with high operating leverage have high fixed costs and are sensitive to changes in revenue or sales growth. If a company with high operating leverage cannot cover its fixed costs, the margins will fall dramatically. Of the answers given, slowing sales growth would have the largest impact on the company's valuation.

Question 54

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.

Answer 54

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.

Question 55

A company is required to make a payment in perpetuity of $200,000 per year. Assuming a 10% annual return, how much principal would the company need? A. $1.1mm B. $2.2mm C. $2.22mm D. $2mm

Answer 55

D. The company would need to deposit $2,000,000. To calculate the required principal, take the annual payment in perpetuity of $200,000 and divide it by the annual rate of return of 10% ($200,000 / .10 = $2,000,000). The phrase in perpetuity may also be referred to as a perpetual payment, meaning that payments will continue to be made forever.

Question 56

If a company has negative EBITDA due to high start-up costs, which of the following valuation metrics would be used? A. P/CF B. Sum-of-the-parts C. EV/S D. Earnings yield

Answer 56

C

Question 57

One of the benefits of using the enterprise value-to-EBITDA ratio is that: A. The analyst looks at overall value rather than just common stock value B. The EV / EBITDA ratio is always higher than the EPS ratio C. EBITDA will never generate negative numbers D. The EBITDA uses after-tax numbers for comparison

Answer 57

A. The EV / EBITDA ratio provides a better sense of the value of the overall corporation as compared to EPS which looks only at the value available to common shareholders.

Question 58

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

Answer 58

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.

Question 59

Geostrom Inc. and Hydrolinx Corporation are the third and fifth largest companies in the machinery drilling services sector. The companies are the two largest customers of Danarobics Incorporated. Geostrom and Hydrolinx have announced a merger, citing a greater opportunity for economies of scale. The combined entity will become the second largest company in the sector. Danarobics has not commented on the merger. What is the most likely reason for the lack of comment by the company? A. Danarobics is bound by Rule FD B. Danarobics' price is likely to decline if it comments on the merger C. Pricing pressure by its customers will reduce Danarobics' operating profit margins D. Danarobics' price is unlikely to be impacted by the merger

Answer 59

C. The merger of the two largest customers of Danarobics will create a new pricing dynamic for the merged companies. As indicated, the merger cites economies of scale. Geostrom and Hydrolinx would disclose the merger under Reg FD. Danarobics share price is likely to decline whether or not they make an immediate comment on the merger. Maybe they are just postponing an inevitable outcome, as they will have to address this issue in their next earnings conference call and under "Risk Factors" in their SEC filings. An analyst covering Danarobics would be expected to publish a note commenting on the negative impact of the merger on Danarobics' margins

Question 60

An analyst believes that the sector she covers is highly correlated with new building permits and housing starts. Which of the following choices would be the most useful to supplement the industry's trend forecast? A. The inflection point in interest rates B. The current P/E ratio of the S&P 500 compared to its historic average C. The inflection point in industrial production D. The fluctuation of the U.S. dollar vs. a basket of foreign currencies

Answer 60

A. An inflection point occurs at the top or at the bottom of a cycle and indicates a change in direction. The inflection point in interest rates represents the lowest point or the highest point in an interest-rate cycle (and also illustrates the point at which the cycle changes). Of the choices given, a change in interest rates is the most important factor for new building permits and housing starts. Since this sector is highly correlated with housing starts, this would be the most useful for forecasting its trend.

Question 61

Company X’s earnings have risen by 15%, while the earnings of the suppliers used by Company X have declined by 5%. Which of the following is the most relevant to the forward earnings projections of Company X? A. Review Company X’s Form 10-K. B. Interview the distributors of Company X’s product. C. Interview the suppliers to Company X. D. Interview the companies with the largest market share in the same sector as Company X.

Answer 61

B. Interviews with the distributors will provide an idea of where the company will be in subsequent quarters. This will help to determine if the distributors are experiencing shrinking margins and/or if costs are increasing. Interviewing suppliers would only allow an analyst to determine potential costs to be passed on to Company X. Interviewing the companies with largest market share in the same sector is somewhat limited. It’s an overview of the sector perceptions. Lastly, a review of Company X’s financial statements will only provide the historic results of the company. It doesn’t provide the best gauge to project future results.

Question 62

The MackLear Corporation has invested capital of $4 billion, its ROIC is 18%, it has a debt to equity ratio of 100%, a pretax cost of debt of 10%, a marginal tax rate of 40%, its WACC is 12%, $200 million of cash and 60 million shares outstanding. An estimate of MackLear's price per share is: A. $100 B. $67 C. $70 D. $14.66

Answer 62

C. With $4 billion of invested capital and a ROIC to WACC ratio of 150%, MackLear's enterprise value is estimated to be $6 billion. Notice that MackLear's estimated enterprise value is greater than the value of its invested capital of $4 billion. This is because the ROIC - WACC spread is positive. 18% - 12% = 6%. The company is adding 6 cents of value for every dollar invested. The company is earning a return that is greater than its cost of capital. In other words, providers of capital are getting a return on their investment that is greater than they expected. Equity value can be calculated from enterprise value by subtracting debt and adding cash. Because MackLear has invested capital of $4 billion and a debt to equity ratio of 100%, the debt is 50% of total capital. For example, if debt is 100% of equity, then there must be 100 units of debt for every 100 units of equity; therefore, total capital would be debt + equity or 100 units of debt + 100 units of equity, which equals 200 units of total capital. 100 units of debt as a percentage of 200 units of total capital, equals 50% of total capital (100 / 200). Given that MackLear has $4 billion of total capital, 50% of total capital equals $2 billion of debt. The estimated enterprise value of $6.0 billion, less the $2.0 billion of debt, plus the $200 million of cash results in an equity value of $4.2 billion. With 60 million shares outstanding the equity should be valued at $70 per share ($4.2 billion / 60 million shares = $70 per share.

Question 63

True or false: A PIPE offering will generally cause a stock to increase?

Answer 63

False, a PIPE offering will cause dilution and the shares are typically placed at a discount to the current market price, which generally causes the market price to fall.

Question 64

If Company A has a lower gross margin than Company B, but both companies have an identical EPS, you would conclude: A. Net income is identical for both companies, but Company A has lower revenue B. Revenues are identical for both companies, but Company B has a lower tax rate C. Net income is identical for both companies, but Company B has a lower tax rate D. Net income is identical, but Company A has a lower tax rate

Answer 64

D. Given a lower gross margin, perhaps the result of A's lower revenue, net income could not be identical. A's income would be lower, not identical. If revenues were identical, with B's higher margin, it would produce higher, not identical, EPS if it had a lower tax rate. A would have to have a higher gross margin for net income to be identical because B has a lower tax rate. The correct answer is: Net income could be identical with B, given A's lower gross margin, if A had a lower tax rate

Question 65

You are attempting to determine outliers within the retail sector. Which of the following valuation methods would an analyst apply when evaluating retail companies that have similar degrees of financial leverage? A. P/E B. Payout ratio C. Int. Coverage ratio D. P/S

Answer 65

D.

Question 66

Mercantile Charter Banc derives two-thirds of its profits from traditional banking, while its remaining profits are generated from credit card processing. You believe a fair valuation for traditional banking is ten times earnings. If companies that exclusively conduct credit card processing trade at 25 times earnings, what earnings multiple should be applied to Mercantile Charter Banc? A. 10 B. 15 C. 18 D. 21

Answer 66

B. Valuing each business component separately, based on the applicable earning multiples, and adding the results together, produces the following calculation. To calculate the traditional banking component, multiply 2/3 times the earnings multiple of 10 (2 x 10 / 3 = 6.67) and add 1/3 times 25 earnings for the credit card processing (1 x 25 / 3 = 8.33) = 6.67 + 8.33, or a 15 times earning multiple for the Mercantile Charter Banc.

Question 67

Company M shows consistent growth of revenues and earnings. If the company also increases its dividend payout ratio, which of the following metrics would provide the highest valuation? A. A DDM, since dividends are increasing relative to earnings B. Residual income, since most of the valuation will be in terminal value C. FCFE, if the dividend is a small amount relative to price D. Theoretically, all three metrics should provide the same valuation

Answer 67

A. In a dividend discount model (DDM), a higher dividend payout ratio will create a higher valuation of a company's price. In addition, a larger dividend will result in a higher valuation according to the DDM. Residual income is based on the excess profit earned above the cost of capital. Free cash flow to equity (FCFE) may increase, because working capital will decrease when a dividend is declared and a decrease in working capital is a source of cash. However, when a dividend is small, it is likely to have a less dramatic effect on FCFE.

Question 68

Which of the following statements is TRUE regarding the return on equity (ROE)? A. ROE measures a corporation's leverage. B. ROE measures how efficiently a corporation generates profits. C. ROE averages the net income of a company over two years to smooth out impacts from the business cycle. D. ROE is a useful valuation metric when comparing firms in different industries.

Answer 68

B. Return on Equity is calculated by dividing a company's net income by its average shareholder's equity (ROE = Net Income/Average Common Equity). ROE is a measure of corporate profitability from capital provided by the corporation's common shares. Corporations with high ROEs are efficient at generating profits from their equity capital. ROE averages shareholder's equity to smooth out changes in a corporation's balance sheet over one year. Net income is not required to be averaged since it measures income and expenses that occurred over the entirety of a year.

Question 69

In order for a company to add value for its equity stakeholders: A. Economic profit must be less than the required rate of return B. ROE must exceed the cost of equity C. The cost of capital should equal the economic profit D. The cost of capital should be less than the required rate of return

Answer 69

B. Economic Profit, also known as economic value (EVA) is generated when returns exceed the cost of capital.

Question 70

A research analyst is reviewing the earnings of a company based on the current nine months as compared to the previous nine months. The company has sales of $100 million during the current period, compared to sales of $90 million during the last period. Also, it has earnings per share of $0.50 per share during this period, compared to $0.40 per share during the last period. The current earnings period also includes a $5 million after-tax successful litigation payment from a competitor and a $5 million after-tax payment for the one-time sale of one of its businesses. Based on all of this information, which of the following is the greatest concern? A. The company's sale growth. B. The company's EPS growth. C. The impact of the litigation payment. D. The impact of the sale of the business.

Answer 70

B. The term quality of earnings is very important to the job function of a research analyst. This term refers to the proportion of a company's income that's derived from the core operation of its business. The company did have sales growth, but the EPS also included $10 million of after-tax income from one-time events. Without the $10 million adjustment in after-tax dollars, the net income, and therefore the EPS, would have been lower than $0.50. The concern is what will the next period's EPS growth be without these one-time events.

Question 71

A company's stock has a market price per share of $35, the number of shares outstanding is 12 million, and the current book value is $300 million. If the company buys $4 million of its stock back at the current market price, which of the following statements is TRUE? A. The book value per share will be slightly less after the purchase. B. The book value per share will be slightly higher after the purchase. C. The book value per share will be significantly less after the purchase. D. The book value per share will remain unchanged.

Answer 71

A. As a general rule, if the market price per share is greater than book value per share after the stock repurchase (buyback), the book value per share (BVPS) will decrease. Conversely, if the market price per share is less than the BVPS, the BVPS will increase. The BVPS before the repurchase is $25 ($300 million / 12 million). The number of shares repurchased is 114,285 ($4 million / $35), and the value of the equity will decline to $296 million ($300 million - $4 million). The number of outstanding shares declines to 11,885,715. The BVPS after the stock repurchase is $24.90 ($296 million / 11,885,715), which is slightly less than the BVPS ($25.00) before the share repurchase.

Question 72

Which of the following actions by a company would provide an additional source of liquidity? A. Changing the inventory valuation method from LIFO to FIFO B. Creating an accounts receivable securitization program C. Reducing the amount of the commercial paper program D. Paying off a portion of the long-term debt

Answer 72

B. An accounts receivable securitization program is created when a company transfers a portion of its accounts receivables to a trust and sells interests in that trust. The sale of the receivables to the trust allows the company to receive cash from investors, who then receive payments from the trust. This will lower the accounts receivables on the company's balance sheet. This is a way for a company to raise capital by borrowing funds (it is a type of debt) backed by an asset (accounts receivables). The investors usually will have no recourse against the company beyond the assets held in the trust. Reducing the amount of the commercial paper program will reduce, not increase, a company's liquidity. If a company pays off a portion of its long-term debt, it is using cash and, although it might benefit the company, it would reduce liquidity. Changing the inventory valuation method from LIFO to FIFO would have no impact on a company's liquidity.

Question 73

Company X has issued debt. This has increased its debt to equity ratio. Which of the following choices is likely to exhibit the greatest change? A. Company X's cost of the debt B. The amount of funds available to equity shareholders C. Company X's cost of equity D. The company's FCFF

Answer 73

A. ***If a company issues debt, the direct cost of interest expense is greater than either the change to the free cash flow to the firm (FCFF) or the amount of funds available to equity shareholders (free cash flow to equity shareholders - FCFE), due to the after-tax impact of interest in both FCFF and FCFE.***

Question 74

Company A competes with Company B in the same sector. Company A's price to sales ratio is 5, while Company B's is 4. What would explain the difference in value? A. Company B uses a more conservative method of accounting B. There is a discrepancy with forward sales projections C. Each company has a different capital structure D. Company A has higher margins

Answer 74

D. If one looks at sectors and isolates the best of the breed, the higher multiples tend to be associated with higher profitability.

Question 75

If the money supply is expanding rapidly and there is no increase in the price level, a monetarist might conclude: A. We have become a nation of hoarders B. Interest rates are not low enough to incentivize business C. Money velocity is falling D. We are in a deflationary spiral

Answer 75

C. Disciples of the quantity of money theory would claim that increases in the money supply should lead to an inflationary rise in the GDP. If this does not occur, it is because the velocity of money has fallen.

Question 76

In 2018, Company A had $610 million dollars of revenue on 200,000 units sold. Company B had $820 million of revenue on 280,000 units sold. In 2019, Company C entered the market and sold 240,000 units and had revenue of $255 million. In 2019 Company A had $625 million dollars of revenue on 205,000 units and Company B had $835 million of revenue on 285,000 units sold. Which of the following choices best explains this situation? A. Company C entered the market with lower prices and stole business from Companies A and B B. Company C entered the market with a lower-priced product and sold to a new client base C. Company C entered the market with higher-priced goods and was not able to capture significant market share D. Company C entered the market with lower prices and Companies A and B lowered their prices to compete

Answer 76

B. Company C entered the market and captured business. Dividing the revenue by units sold, Company C did sell for less per unit. However, since Companies A and B did not lose revenue, sell fewer units, or change the price per unit, the most likely explanation is that Company C found a new market to target with its less expensive products.

Question 77

A client has asked an equity analyst about the fixed-charge coverage ratio for Sinclair Corp. A proper response would be: A. Divide net income by interest B. Please speak with the corporate bond analyst C. Divide market cap by bond interest D. Divide cash flow by debt outstanding

Answer 77

B. The fixed-charge coverage ratio measures the ability to meet fixed charges such as interest and lease payments. This ratio is a solvency ratio that measures how many times a business can meet its fixed obligations. It is calculated on a pretax basis. The SEC has a precise formula that that must be utilized when a business makes a public bond offering. An equity analyst would not be expected to address those details but could defer to the fixed income analyst.

Question 78

Relevant information to answer this question follows. United Corporation's five-year EPS growth is above 10%. The dividend payout ratio is 2 times the industry average. The return on capital is 10%. Its competitor, National Corporation, has similar EPS growth and a return on capital of 15%. Which of the following statements LEAST likely explains the difference in the return on capital? A. National Corporation repurchases a greater amount of its common stock than United B. National Corporation has a higher operating margin C. United Corporation has a more lenient accounts receivable policy D. United Corporation has a more generous dividend payout ratio

Answer 78

C. The return on capital is based on either the after-tax EBITDA or net income, divided by total capital or equity capital. National Corporation chooses to use its cash to buy its shares back and this could reduce the value of its equity capital. This could contribute to a higher return on capital. The higher return on capital may also be attributable to a higher operating margin for National. The higher operating margins would result in higher income. United Corporation uses its cash to pay higher-than-average dividends, instead of repurchasing stock, which may explain the lower ROC for United. Having a more lenient accounts receivable policy by itself would not explain why United has a lower ROC or a higher dividend payout ratio.

Question 79

A research analyst goes to a conference attended by market professionals for the Smother Corporation where the company projects an 8% annual growth rate over the next five years. The analyst projects a 10% growth rate. What should the analyst use to create the price target in the research report? A. The more conservative company estimate B. The analyst's estimate, while mentioning the company estimate in the report C. The consensus estimates D. The company's historical growth rate

Answer 79

B. The research analyst may use a growth rate that is more pessimistic or optimistic than the company's, but should refer to company estimates in the report.

Question 80

Balboa Shipping has profits of $200 million, up from $100 million three years ago. In most years, it pays a cash dividend that equals its net income. How can Balboa sustain this practice? A. Borrowing funds B. Balboa is organized as a REIT C. Cash flow D. Balboa is actually returning capital

Answer 80

C. Businesses that are capital intensive rely on depreciation to enhance their cash flow. A shipping company has high depreciation expenses because its primary assets are fixed. This enables them to pay high dividends and increase payouts when times are good, still leaving some funds available for expansion, as Balboa has done. However, capital intensive businesses are cyclical, leaving the dividends in jeopardy during an economic slowdown.

Question 81

The Motus Company leases mass transit vehicles and regularly issues commercial paper. The company has reached a terminal growth rate of 3.0%. What would an analyst expect if the rate on the T-bill increases by 50 basis points? A. The company's WACC would decline. B. The FCFF would not change. C. The weighted average cost of equity would decline. D. The company's cost of debt would decrease.

Answer 81

B. A discount rate is applied to determine the present value of a company's future cash flows. The weighted average cost of capital is used when determining the discount rate applicable to the projected free cash flow to the firm (FCFF). An increase in the WACC is expected, given the increase in interest rates and the short-term funding requirements of the company. An increase in short-term interest rates would not be expected to reduce the weighted average cost of equity or cost of debt. Free cash flow to the firm describes the cash flow available to all providers of capital. It begins by examining the tax effect on earnings before interest and taxes, adding depreciation and amortization, and subtracting capital expenditures and increases in working capital. ***Since FCFF begins with EBIT (i.e., income before interest is paid), the additional interest expense associated with higher short-term interest rates would not reduce the FCFF.***

Question 82

The weighted average cost of capital is an important valuation method for capital budgeting. One of the reasons that firms use this method is that: A. Firms raise capital primarily through equity issues B. Most firms raise capital through debt issues C. Weighted average provides the lowest cost of raising capital D. Capital is raised through common and preferred equity as well as debt

Question 83

Consumer nondurable companies with a consistent track record would be evaluated on the basis of: A. Market share B. D/C C. Normalized earnings D. Forward P/E

Answer 83

D

Question 84

What's the LEAST likely explanation for why two firms in the same industry have a difference in their price-to-sales ratios? A. The two firms use different auditing firms. B. There's a difference in revenue recognition policies. C. There are differences in their capital structures. D. One firm has been publicly traded for a longer period.

Answer 84

C. The price-to-sales ratio is the market price of the stock divided by the sales or revenue (Price-to-Sales = Stock Price ÷ Sales). Since revenue or sales are at the top of the income statement, they're not effected by any expenses. Differences in the indebtedness (i.e., capital structure) would not show up in the price-to-sales ratio, since no interest is being deducted. Differences in revenue recognition would impact the price-to-sales ratio.

Question 85

Which of the following events signals sales growth in a company? A. Accounts receivable increase; account receivable turnover increases. B. Account receivables decrease; account receivable turnover increases. C. Inventory turnover increases; accounts payable declines. D. Inventory turnover declines; accounts payable increases.

Answer 85

A

Question 86

You have been asked to assist in the evaluation of two buyers' proposals. Both buyers are U.S. chocolate companies. Your client, a British chocolate company, is currently trading for 14.75 pounds. Sterling is trading at 1.67 dollars. One offer is an all-cash offer for 17.50 pounds. The other is a cash and stock offer equal to 18.10 pounds. Which of the following statements is TRUE? A. The cash offer would not have exchange-rate risk for your client B. The cash offer would be superior if the pound weakened C. The cash and stock offer has less exchange-rate risk D. The cash and stock offer would provide greater value if the dollar weakened significantly

Answer 86

A. The all-cash offer in sterling presents exchange-rate risk to the U.S. company (as buyer). This cash offer provides shareholders with a definitive value of 17.50 pounds, whether the sterling weakens, or strengthens. The cash and stock offer has exchange-rate risk, and would be lower if the sterling strengthens (a weakening of the U.S. dollar). For example, if the U.S. company is offering .50 shares of stock (trading at $40) and the exchange rate is currently 1.60 dollars, the stock portion of the acquisition is 12.50 pounds ($40 x .50 = $20 / 1.60). If sterling strengthens to an exchange rate of 1.70, the stock portion of the acquisition would be valued at 11.76 pounds ($40 x .50 = $20 / 1.70).

Question 87

PopUP.com is a leader in Internet advertising. Revenue has been rising at a level of 15% per year and the best expectation is that profitability is three years away. The most appropriate valuation tool in this scenario is the: A. PEG ratio B. Price/book value C. Price-to-sales ratio D. Discounted cash flows

Answer 87

C. Traditional measures such as P/E ratios and book value multiples have little relevance for new economic enterprises that may not generate accounting profits for several years. An alternative valuation tool uses the revenue multiple (price-to-sales ratio), which is easily calculated and is not influenced by depreciation, R&D, or extraordinary charges. A PEG ratio will not work in this scenario because the company does not have positive earnings.

Question 88

A project is being evaluated and the potential purchaser requires an internal rate of return (IRR) of 10%. Currently, the project has a positive net present value (NPV). Based on this information, the project's estimated internal rate of return (IRR) must be: A. Greater than 10% B. Equal to 10% C. Lower than 10% D. Impossible to determine based on the information provided

Answer 88

A. NPV is the calculation which compares the projected cash flow to be earned from a project (using a present value calculation) to the cost of the project (using present value). In other words, NPV compares projected inflows (revenues) to outflows (expenses). A positive NPV exists if a project's inflows exceed its outflows. For example, if a person invests $1 million today (present value) and she receives a cumulative return over a five-year period, these cash inflows need to be discounted to their present value. If the total present value for the five years exceeds $1 million the project will have a positive NPV. One of the key components of NPV is the discount rate being used to calculate the present value of cash flows. The lower the discount rate used, the greater the present value. The IRR is the discount rate which matches the present value of inflows and outflows. In other words, it is the interest rate which makes the NPV equal to zero (i.e., the project's return is equal to the 10% required rate). ***If the NPV is positive, then the rate of return earned on the project (IRR) is greater than the discount required. However, if the NPV is negative, then the rate of return earned on the project (IRR) is less than the discount rate required.***

Question 89

A corporation is considering raising capital by issuing new securities. Issuing debt securities as opposed to issuing preferred stock will result in which of the following? A. Higher taxes, but higher EPS B. Lower taxes and higher EPS C. Higher taxes and lower EPS D. Lower taxes, but lower EPS

Answer 89

B. The interest on debt securities is a pre-tax expense; however, the dividend on preferred stock is paid after-tax. For that reason, the issuance of debt securities will result in higher taxable deductions and then lower taxes than the issuance of preferred stock. The lower tax expense will result in a higher EPS if debt is issued, rather than issuing preferred stock.

Question 90

A company leases mass transit vehicles and regularly issues commercial paper. The company has reached a terminal growth rate of 3.07337. What's to be expected if the rate on the T-bill increases by 50 basis points? A. The company's cost of debt will decrease. B. The company's cost of debt will increase. C. The weighted average cost of equity will decrease. D. The FCFF will decrease

Answer 90

B. The profits of a company that frequently issues commercial paper (CP) are heavily tied to interest rates. If T-bill rates are rising, general interest rates are rising and the company will pay more on its commercial paper issuances. This will increase the company's cost of debt. Depending on a company's beta, its cost of equity could rise or fall if T-bill rates (i.e., the risk-free rate) are decreasing. As a result, it's not clear what would happen to the company's weighted average cost of capital (WACC). Free cash flow to the firm (FCFF) is a measure of profits, but it's based on earnings before interest and taxes (EBIT). ***Since FCFF is a pre-interest income measure, any changes to the company's cost of debt will not impact the company's FCFF.***

Question 91

A research analyst covers the retail sector. The sales of one of the companies he follows has dropped off significantly during the pandemic, but the analyst is anticipating a rebound in the coming year. Which of the following valuation methods would the analyst use to value this company? A. Price-to-tangible book value B. Forward price-to-earnings ratio C. Trailing price-to-earnings ratio D. Price-to-sales ratio

Answer 91

B. Of the choices listed, the forward P/E ratio would be the best valuation method since the analyst is expecting growth in earnings over the coming year. The price-to-sales- ratio is typically backward looking and is not the best valuation method to use if growth is projected in the future.

Question 92

A research analyst is concerned that a company will not be able to make its next dividend payout. Which of the following choices would be of MOST concern? A. The EPS is less than dividend per share B. The FCFF is less than dividend and interest payments C. There is a large increase in accounts payable D. The FCFE is equal to the dividend payout

Answer 92

B. Free cash flow to the firm represents cash flow available to the providers of capital, both bondholders and stockholders, after operating expenses have been covered. Bondholders have a higher priority claim than shareholders and they must be paid first. If FCFF is less than dividend and interest payments, future dividend payments are jeopardized. ***Many companies pay dividends equal to or greater than the EPS because of noncash items.*** A company is permitted to pay cash dividends in excess of its net income. In terms of financial accounting, cash dividends are paid out of retained earnings that are part of shareholders' equity. The company could have easily paid the cash dividend based on accrued retained earnings from past years. If FCFE is equal to dividends, that means that all available cash is being paid to shareholders and no cash is being retained for growth. This is not as alarming as FCFF being less than dividend and interest payments.

Question 93

Company D shows an increase in its deferred tax liability. How will this affect Company D's cash flow statement? A. Operational cash flow will increase B. Operational cash flow will decline C. Financing cash flow will increase D. Financing cash flow will decline

Answer 93

A. Under generally accepted accounting principles (GAAP), firms record tax expenses based on pretax net income. However, taxable income and pretax net income may differ due to depreciation expenses. Accelerated depreciation would create a deferred tax liability in the early years of an asset's life. This would increase the operational cash flow of the company since it is reporting a higher level of expenses for tax purposes. The amount of additional operational cash flow may be calculated by subtracting the expense for the straight-line method of depreciation from the accelerated depreciation and multiplying this by (1.0 - the tax rate).

Question 94

Company A and Company B are in the same industry. Company A has earnings per share of $2.67 and a price-to-earnings ratio of 15. Company B has earnings per share of $2.00, but trades at 17 times earnings. Which of the following statements explains why Company B has a higher earnings multiple? A. Company A has higher earnings growth. B. Company B has a higher weighted average cost of capital (WACC). C. Company A has higher cost for its debt. D. Company B has a lower risk-free rate.

Answer 94

C. Companies with lower cost of capital (e.g., WACC), including lower cost of debt, will have higher share prices and PE ratios. If Company A has a higher cost of debt, it would likely trade at a lower earnings multiple than Company B. Higher expected earnings (i.e., earnings growth) typically causes an increased share price and higher PE ratio. A risk-free rate is a hypothetical minimum rate of return and is typically estimated using short-term government securities (i.e., it's the same for all firms).

Question 95

Which of the following factors is MOST important when evaluating a computer retailer? A. The market share of the top five computer retailers B. The occupancy costs of the retailer C. The profitability of computer manufacturers D. The percentage of households that have home computers

Answer 95

B. The most significant of the four choices is the occupancy costs of the store. Occupancy costs are the total costs per unit to rent or occupy a store. It includes the lease payments and other costs such as utilities, maintenance, and insurance. Occupancy costs may also include a percentage of the sales generated by the store as part of the lease agreement. This is an important component for stores operating in shopping centers and malls.