CH 10

Question 1

The discounted free cash flow model ignores interest income and expense but adjusts for
cash and debt directly, if free cash flow is calculated based on EBIT.

Answer 1

TRUE

Question 2

Which of the following is the appropriate way to calculate the price of a share of a given
company using the free cash flow valuation model?
A) P0 = Div1/(rE - g)
B) P0 = PV(Future Free Cash Flow of Firm) / (Shares Outstanding0)
C) P0 = [Div1 / (rE - g)] / (Shares Outstanding0)
D) P0 = (V0 + Cash0 - Debt0) / (Shares Outstanding0)

Answer 2

D

Question 3

If you want to value a firm that consistently pays out its earnings as dividends, the
simplest model for you to use is the ________.
A) enterprise value model
B) method of comparables
C) dividend-discount model
D) discounted free cash flow model

Answer 3

C

Question 4

If you want to value a firm but do not want to explicitly forecast its dividends, the
simplest model for you to use is ________.
A) the discounted free cash flow model
B) the dividend-discount model
C) the enterprise value model
D) None of the above models can be used if you do not want to forecast dividends or use of
debt.

Answer 4

A

Question 5

Which of the following statements is FALSE?
A) The more cash a firm uses to repurchase shares, the less it has available to pay dividends.
B) Free cash flow measures the cash generated by a firm after payments to debt or equity
holders are considered.
C) We estimate a firm’s current enterprise value by computing the present value (PV) of the
firm’s free cash flow.
D) We can interpret the enterprise value of a firm as the net cost of acquiring the firm’s
equity, taking its cash, and paying off all debts.

Answer 5

B

Question 6

Which of the following statements is FALSE?
A) A firm’s weighted average cost of capital, denoted rwacc, is the cost of capital that reflects
the risk of the overall business, which is the combined risk of the firm’s equity and debt.
B) Intuitively, the difference between the discounted free cash flow model and the dividend-
discount model is that in the divided-discount model, a firm’s cash and debt are included
indirectly through the effect of interest income and expenses on earnings in the dividend-
discount model.
C) We interpret rwacc as the expected return a firm must pay to investors to compensate them
for the risk of holding the firm’s debt and equity together.
D) When using the discounted free cash flow model, we should use a firm’s equity cost of
capital.

Answer 6

D

Question 7

Which of the following statements is FALSE?
A) The long-run growth rate gFCF is typically based on the expected long-run growth rate of
a firm’s revenues.
B) Since a firm’s free cash flow is equal to the sum of the free cash flows from the firm’s
current and future investments, we can interpret the firm’s enterprise value as the total net
present value (NPV) that the firm will earn from continuing its existing projects and initiating
new ones.
C) If a firm has no debt, then rwacc equals the risk-free rate of return.
D) When using the discounted free cash flow model, we forecast a firm’s free cash flow up to
some horizon, together with some terminal (continuation) value of the enterprise.

Answer 7

C

Question 8

In the method of comparables, the known values of a firm’s cash flows are used to estimate
the unknown cash flows of a similar firm.

Answer 8

TRUE

Question 9

Several methods should be used to provide an estimate of a stock’s value since no single
method provides a definitive value.

Answer 9

TRUE

Question 10

Which of the following statements concerning the valuation of firms using the method of
comparables is FALSE?
A) If two different firms generate identical cash flows, the Law of One Price will imply that
both firms have the same value.
B) Comparables adjust for scale differences when valuing similar firms.
C) Valuation multiples take into account differences in the risk and future growth between
the firms being compared.
D) Two firms that sell very similar products or offer very similar services will have different
values if they are of different sizes.

Answer 10

C

Question 11

An investor estimates the value of a firm which manufactures cookware by examining the
cash flows of similar firms. Which of the following is assumed to be the same for these firms?
A) P/E
B) annual growth rates
C) payout rates
D) all of the above

Answer 11

D

Question 12

The table above shows the stock prices and multiples for a number of firms in the
newspaper publishing industry. Which of the following ratios would most likely be the most
reliable in determining the stock price of a comparable firm?
A) P/E
B) Price/Book
C) Enterprise Value/Sales
D) Enterprise Value/EBITDA

Answer 12

C

Question 13

Which of the following is NOT an advantage of the valuation multiple method as
compared to the discounted cash flow method?
A) calculations based upon widely available information
B) based upon actual stock prices of real firms
C) does not rely on estimates of future cash flows
D) takes into account important differences between different firms

Answer 13

D

Question 14

Which of the following statements is FALSE?
A) Even two firms in the same industry selling the same types of products, while similar in
many respects, are likely to be of different size or scale.
B) In the method of comparables, we estimate the value of a firm based on the value of other,
comparable firms or investments that we expect will generate very similar cash flows in the
future.
C) Consider the case of a new firm that is identical to an existing publicly traded company. If
these firms will generate identical cash flows, the Law of One Price implies that we can use
the value of the existing company to determine the value of the new firm.
D) A valuation multiple is a ratio of some measure of a firm’s scale to the value of the firm.

Answer 14

D

Question 15

Which of the following statements is FALSE?
A) The most common valuation multiple is the price-earnings ratio.
B) You should be willing to pay proportionally more for a stock with lower current earnings.
C) A firm’s price-earnings ratio is equal to the share price divided by its earnings per share.
D) The intuition behind the use of the price-earnings ratio is that when you buy a stock, you
are in a sense buying the rights to the firm’s future earnings, and differences in the scale of
firms’ earnings are likely to persist.

Answer 15

B

Question 16

Which of the following statements is FALSE?
A) We can estimate the value of a firm’s shares by multiplying its current earnings per share
by the average price-earnings ratio of comparable firms.
B) For valuation purposes, the trailing price-earnings ratio is generally preferred, since it is
based on actual not expected earnings.
C) Forward earnings are the expected earnings over the coming 12 months.
D) Trailing earnings are the earnings over the previous 12 months.

Answer 16

B

Question 17

Which of the following statements is FALSE?
A) As the enterprise value represents the entire value of a firm before the firm pays its debt,
to form an appropriate multiple, we divide it by a measure of earnings or cash flows after
interest payments are made.
B) We can compute a firm’s price-earnings ratio by using either trailing earnings or forward
earnings with the resulting ratio called the trailing price-earnings or forward price-earnings.
C) It is common practice to use valuation multiples based on a firm’s enterprise value.
D) Using a valuation multiple based on comparables is best viewed as a “shortcut” to the
discounted cash flow method of valuation.

Answer 17

A

Question 18

The table above shows the stock prices and multiples for a number of firms in the
newspaper publishing industry. Which of the following ratios would most likely be the most
reliable in determining the stock price of a comparable firm?
A) P/E
B) Price/Book
C) Enterprise Value/Sales
D) Enterprise Value/EBITDA

Answer 18

C

Question 19

Which of the following is NOT an advantage of the valuation multiple method as
compared to the discounted cash flow method?
A) calculations based upon widely available information
B) based upon actual stock prices of real firms
C) does not rely on estimates of future cash flows
D) takes into account important differences between different firms

Answer 19

D

Question 20

Which of the following statements is FALSE?
A) Even two firms in the same industry selling the same types of products, while similar in
many respects, are likely to be of different size or scale.
B) In the method of comparables, we estimate the value of a firm based on the value of other,
comparable firms or investments that we expect will generate very similar cash flows in the
future.
C) Consider the case of a new firm that is identical to an existing publicly traded company. If
these firms will generate identical cash flows, the Law of One Price implies that we can use
the value of the existing company to determine the value of the new firm.
D) A valuation multiple is a ratio of some measure of a firm’s scale to the value of the firm.

Answer 20

D

Question 21

Which of the following statements is FALSE?
A) The most common valuation multiple is the price-earnings ratio.
B) You should be willing to pay proportionally more for a stock with lower current earnings.
C) A firm’s price-earnings ratio is equal to the share price divided by its earnings per share.
D) The intuition behind the use of the price-earnings ratio is that when you buy a stock, you
are in a sense buying the rights to the firm’s future earnings, and differences in the scale of
firms’ earnings are likely to persist.

Answer 21

B

Question 22

Which of the following statements is FALSE?
A) We can estimate the value of a firm’s shares by multiplying its current earnings per share
by the average price-earnings ratio of comparable firms.
B) For valuation purposes, the trailing price-earnings ratio is generally preferred, since it is
based on actual not expected earnings.
C) Forward earnings are the expected earnings over the coming 12 months.
D) Trailing earnings are the earnings over the previous 12 months.

Answer 22

B

Question 23

Which of the following statements is FALSE?
A) As the enterprise value represents the entire value of a firm before the firm pays its debt,
to form an appropriate multiple, we divide it by a measure of earnings or cash flows after
interest payments are made.
B) We can compute a firm’s price-earnings ratio by using either trailing earnings or forward
earnings with the resulting ratio called the trailing price-earnings or forward price-earnings.
C) It is common practice to use valuation multiples based on a firm’s enterprise value.
D) Using a valuation multiple based on comparables is best viewed as a “shortcut” to the
discounted cash flow method of valuation.

Answer 23

A

Question 24

If you value a stock using a range of stock valuation methods and these valuations indicate
a stock price that is greater than its actual market price, it is most likely that the stock is
under-valued.

Answer 24

FALSE

Question 25

In an efficient market, investors will only find positive-NPV trading opportunities if they
have some form of competitive advantage over other investors.

Answer 25

TRUE

Question 26

Valuation models use the relationship between share value, future cash flows, and the cost
of capital to estimate these quantities for a given firm. Realistically, for a publicly traded firm,
what can we reliably use such models to determine?
I. the firm’s future cash flows
II. the firm’s cost of capital
III. the firm’s market price
A) I only
B) II only
C) III only
D) I and II

Answer 26

C

Question 27

Which of the following is the best statement of the efficient markets hypothesis?
A) Investors with information that a stock had a positive net present value (NPV) will buy it,
while investors with information that a stock had a negative net present value (NPV) will sell
it.
B) Investor’s decisions are dependent on complete current information of a firm’s cash flows
and accurate predictions of future cash flows.
C) Competition between investors works to make the net present value (NPV) of all trading
opportunities zero.
D) A share’s price is the aggregate of the information of many investors

Answer 27

C

Question 28

Which of the following should be done by a manager wishing to raise his stock’s price?
I. Focus on maximizing the present value (PV) of the free cash flow.
II. Focus on accounting earnings.
III. Focus on financial policy.
A) I only
B) II only
C) I and II
D) II and II

Answer 28

A

Question 29

On a particular day, a mining company reveals that, due to new extraction technology,
the extractable yield from several of its nickel/lead mines has risen by 15%. Which of the
following is the LEAST likely consequence of such an announcement?
A) The price of the stock would rise.
B) Investors would determine that the estimates of the firm’s value on the date prior to the
announcement were too high.
C) Investors would increase their forecast of future cash flows in that firm.
D) Investors would revise their estimates of the net present value (NPV) of the firm.

Answer 29

B

Question 30

Individual investors trade conservatively, given the difficulty of finding over-valued and
under-valued stocks.

Answer 30

FALSE

Question 31

Individual investors who grow up and live during a time of high stock returns are more
likely to invest in stocks.

Answer 31

TRUE

Question 32

Individual investors’ tendency to trade too much based on the mistaken belief that they can
pick winners and losers better than investment professionals is known as ________.
A) the disposition effect
B) the investor attention hypothesis
C) the investor overconfidence hypothesis
D) the excessive trading costs hypothesis

Answer 32

C

Question 33

A study of trading behavior of individual investors at a discount brokerage found that
individual investors ________.
A) trade very actively, despite the fact that their performance is actually worse because of
trading costs
B) trade very conservatively, despite the fact that their performance is actually worse because
of trading costs
C) trade very actively, partly because their performance is better than the professionals’ due
to low trading costs
D) trade very conservatively, partly because their performance is better than the
professionals’ due to low trading costs

Answer 33

A

Question 34

Disposition effect is the tendency of individual investors to ________.
A) trade too much based on the mistaken belief that they can pick winners and losers better
than investment professionals
B) buy stocks that have been in the news, advertised more, have very high trading volume, or
recently had extreme (high or low) returns
C) put too much weight on their own experience rather than considering historical evidence
D) hold on to stocks that have lost value and sell stocks that have risen in value since the time
of purchase

Answer 34

D