Q&A Hero

Q: The study of interpersonal relations is more interested in the "why" of human behavior and less on how the knowledge can be applied to address problems in our work and personal lives. a. True b. False

Q: Organizational culture is the collection of shared beliefs, values, rituals, stories, and myths that foster a feeling of community among organizational members. a. True b. False

Q: Elton Mayo discovered in the Hawthorne studies that employees create their own informal networks. a. True b. False

Q: In the next two years, the expected inflation rates are 1 percent and 2 percent, respectively, and the real interest rates are expected to be 4 percent and 4 percent, respectively. Using this information, calculate the two-year interest rate yield as of now. a) 1.88 percent. b) 2.74 percent. c) 4.94 percent. d) 5.56 percent.

Q: A firm begins with nominal net working capital NWCNt–1 = 200 and then increases it to NWCNt = 250. The price index increases from IXt–1 = 144 to IXt = 166. Based on this information, what is the real investment in NWC in year t? a) 9.51 b) 10.84 c) 30.12 d) 49.73

Q: Which metric is the best indicator of a company’s operating performance? a) ROE b) ROA c) ROIC d) EPS

Q: In the event tree used in the binomial approach to option valuation, at each node the value either increases or decreases by the proportion u or d, respectively. If the annualized volatility of the underlying asset’s value is 10 percent per year and the horizon is six months, what are the up-movement u and down-movement d values? a) 1.0488 and 0.9534 b) 1.0513 and 0.9511 c) 1.0733 and 0.9317 d) 1.2505 and 0.8000

Q: A project has a 50/50 chance of generating either a positive cash flow of $1 per year forever or a zero cash flow. The discount rate is 5 percent. If the initial cost is $10, what is the NPV with the option to stop after the first year? a) –$10 b) $0 c) $10 d) $20

Q: Which of the following most accurately lists the steps in the four-step process for valuing flexibility in the correct order? a) 1. Estimate NPV without flexibility. 2. Model uncertainty in event tree. 3. Model flexibility in decision tree. 4. Estimate contingent NPV. b) 1. Estimate NPV without flexibility. 2. Model flexibility in decision tree. 3. Model uncertainty in event tree. 4. Estimate contingent NPV. c) 1. Model uncertainty using real-option valuation. 2. Model flexibility using decision tree analysis. 3. Estimate NPV without flexibility. 4. Arithmetically weight the three results to estimate contingent NPV. d) 1. Model uncertainty using real-option valuation. 2. Model flexibility using decision tree analysis. 3. Estimate NPV without flexibility. 4. Geometrically weight the three results to estimate contingent NPV.

Q: Phased investments, such as a factory that can be built in stages where each stage is contingent on those that precede it and where, at each decision point, management can continue the project by investing additional funds (an exercise price) or abandon it for some estimated value, would best be categorized as: a) A swap. b) A follow-on option. c) A switching option. d) A case where option theory cannot apply.

Q: Construction of a replicating portfolio can be used to value an option embedded in an investment opportunity.

Q: Managing flexibility depends on manager’s ability to recognize, structure, and manage opportunities to create value from operating and strategic flexibility.

Q: The option to increase scope, such as A hotel designed so that the owner can easily diversify beyond lodging services, such as by adding conference facilities, is most similar to: a) A swap contract. b) A put option on a stock. c) A call option on a stock. d) A futures contract on a bond.

Q: The option to defer investment, such as the ability of a leaseholder of an undeveloped oil reserve to defer development and investment until oil prices have elevated the value of the reserves above their development costs, is most similar to: a) A swap contract. b) A put option on a stock. c) A call option on a stock. d) A futures contract on a bond.

Q: The option to abandon (or sell) a project, such as the right to abandon a coal mine, is most similar to: a) A swap contract. b) A put option on a stock. c) A call option on a stock. d) A futures contract on a bond.

Q: Which of the following is most accurate concerning how a change in interest rates can produce an increase in the value of a project with flexibility? a) It increases the present value of the cash flows. b) A higher interest rate increases the time value of the deferral of an investment. c) There is not any set relationship between interest rates and the value of flexibility. d) Higher interest rates are more stable than lower rates and produce more stable cash flows.

Q: A project’s contingent net present value (NPV) will always be greater than or equal to its standard NPV.

Q: List the three approaches that managers can take when flexibility is neither expected nor required to value assets or projects and the level of uncertainty under which each works best.

Q: Regardless of the level of uncertainty, it is possible to value assets or a project using a standard discounted cash flow (DCF) approach or a stochastic simulation. However, in cases when managers can decide among different alternatives in response to certain events, contingent valuation approaches are useful.

Q: Explain why analysts estimating the values of banks should not use the discounted cash flow from operations method. What method should an analyst use?

Q: Economic spread analysis allows for understanding how much value a bank is creating in its different product lines.

Q: Most banks have a maturity mismatch as a result of using short-term deposits as funding to back long-term loans and mortgages. In this case, the bank earns income from being on different parts of the yield curve: typically, borrowing for the short term costs less than what the bank can earn from long-term lending.

Q: Up until the financial crisis of 2008, which of the following was the usual ordering of the absolute values of the types of loan losses to banks? a) Credit card losses > mortgage losses > business loan losses. b) Mortgage losses > business loan losses > credit card losses. c) Credit card losses > business loan losses > mortgage losses. d) Mortgage losses > credit card losses > business loan losses.

Q: The best method for understanding how much value a bank is creating in its different product lines is: a) Free cash flow analysis. b) Ratio analysis. c) Economic spread analysis. d) Net income analysis.

Q: Which of the following will change the cost of equity? I. Asset composition. II. Liability composition. III. The expected market return. IV. The risk-free rate. a) I and II only. b) I, III, and IV only. c) III and IV only. d) I, II, III, and IV.

Q: Which of the following best describes maturity mismatch and its role in bank operations? a) It refers to banks selling old loans so they can take on new loans, which earns a capital gain. b) It refers to banks lending for the long term and borrowing for the short term, which earns positive net interest income. c) It refers to the outdated accounting rules that most banks must operate under. d) It refers to the inequality between accounting allowances for bad loans and the actual rate of losses on those loans.

Q: Which of the following is NOT true concerning loan losses for a bank? a) They are among the most important value drivers in retail banking. b) Default losses are strongly correlated with overall economic growth. c) They are among the most important value drivers in wholesale banking. d) A bank’s historical additions to loan loss provisions are a poor indicator of future loan losses.

Q: Which of the following are included in other comprehensive income? I. Hedging activities. II. Foreign-currency translation items. III. Unrealized losses on debt investments. IV. Unrealized gains on equity investments. a) I and II only. b) I and IV only. c) II, III, and IV only. d) I, II, III, and IV.

Q: Which of the following correctly ranks the sources of income for European banks over the period 1988–2013? a) Commission income > interest income > trading income. b) Interest income > commission income > trading income. c) Commission income > trading income > interest income. d) Trading income > interest income > commission income.

Q: Given the following information, determine the net income (NI) of the bank. The loan and deposit rates are 12 percent and 3 percent, respectively. The money rate is 2 percent, and it is the benchmark of the profitability of loans and deposits. It is also the measure used to debit the lack of earning ability of cash reserves at the Federal Reserve, and it is the opportunity cost of equity capital. Other expenses are $40 million. The balance sheet information is in millions of dollars. a) $11.46 b) $14.82 c) $15.48 d) $16.14

Q: Which of the following is most often the largest source, in absolute value terms, of loan losses for a bank? a) Mortgage losses. b) Credit card losses. c) Bond default losses. d) Business loan losses.

Q: For financial institutions, which of the following is NOT true concerning trading income? a) It has been on the decline over the past 30 years. b) It is typically fairly volatile from year to year. c) It can be derived from the trading of stocks and bonds. d) It can be derived from the trading of swaps and other derivatives.

Q: The four-step approach for valuing cyclical companies requires a minimum of two scenarios. If an analyst is using only two scenarios, how should they be constructed?

Q: A pessimistic forecast from an analyst may damage the relationships of the analyst with both the managers of the analyzed firm and the analyst’s employer.

Q: The discounted cash flow (DCF) valuations of companies with cyclical earnings tend to be more volatile than those of less cyclical companies. But their share prices are much more stable.

Q: Given the following list of patterns of expenditure timing, indicate the correct ordering of their resulting internal rates of return (IRRs) from lowest to highest. I. Typical spending pattern. II. Spending evenly over cycle. III. Optimally timed asset purchases. IV. Optimally timed capital spending. a) I, II, III, IV. b) II, I, IV, III. c) II, I, III, IV. d) I, II, IV, III.

Q: According to simulations of the prices of cyclical stocks, which of the following seems to best characterize how analysts appear to make forecasts? a) Analysts make naive, random-walk forecasts, which are not very accurate. b) Analysts naively make forecasts based on the extrapolation of recent trends. c) Analysts make forecasts based on the assumptions that historical cycles will repeat as they have in the past. d) Analysts make forecasts based on a 50/50 chance the firm will exhibit past cyclicality or break into a new trend.

Q: Which of the following is most accurate concerning predicting cycles and inflection points? a) It is easy to predict both cycles and their inflection points. b) It is easy to predict cycles, but it is difficult to predict inflection points. c) It is difficult to predict cycles and more difficult to predict their inflection points. d) It is hard to predict cycles, but once in a cycle, the inflection points are easy to predict.

Q: Which of the following are true concerning the properties of consensus earnings forecasts for cyclical companies? I. They account for the cyclical nature of the firm. II. Discounted cash flow (DCF) models are usually consistent with the facts. III. The forecasts usually show an upward-sloping trend. IV. The earnings and cash flow projections of the market are consistent with company performance. a) I and II only. b) I and III only. c) II and III only. d) II and IV only.

Q: Contrast the first step in the valuation process of an established company and a high-growth company. Explain the reason for the difference in approaches.

Q: For a high-growth company, accounting records of current performance are likely to mix together investments and expenses, so, when possible, capitalize hidden investments, even those expensed under traditional accounting rules.

Q: To estimate the size of a potential market for a high-growth company, start by assessing how the company fulfills a customer need. Then determine how the company generates (or plans to generate) revenue.

Q: When valuing a high-growth company, it is not recommended to begin with historical financial results; instead, begin with the future.

Q: Which of the following are correct concerning the approach the analyst should take when evaluating a high-growth company? I. Think in terms of probabilities. II. Begin the process by starting from the future rather than the present. III. Understand the economics of the business model compared with peers. IV. Remember that the DCF approach is an essential tool for understanding the value of high-growth companies. a) I and II only. b) I, II, and III only. c) I and IV only. d) I, II, III, and IV.

Q: An analyst computes the intrinsic values and probabilities for each of the indicated scenarios in the following table. Determine the expected value per share. a) 13.00 b) 16.00 c) 16.80 d) 17.50

Q: Which of the following is the recommended method for dealing with the uncertainty of high-growth companies? a) Real options. b) Risk premium approach. c) Monte Carlo simulation. d) Probability-weighted scenarios.

Q: When looking into the future, the analyst should define a point in the future where the company’s performance is likely to stabilize. The conditions at that point should be defined and bounded by measures of operating performance. Which of the following are those measures of operating performance? I. Amortization. II. Penetration rates. III. Sustainable gross margins. IV. Average revenue per customer. a) I and II only. b) I and IV only. c) II and III only. d) II, III, and IV only.

Q: In applying the CAPM in estimating the cost of capital in an emerging market, explain the three problems in estimating an appropriate risk-free rate and the recommended solution.

Q: As long as international investors have access to an emerging market’s local investment opportunities, local prices will be based on an international cost of capital.

Q: In a two-scenario model of an emerging market, it is recommended that the analyst create a base-case set of forecasts and a set of forecasts associated with a period of economic distress. Which of the following best represents the range of probability weights to assign the economic distress scenario? a) 5 to 10 percent. b) 10 to 20 percent. c) 20 to 30 percent. d) 30 to 40 percent.

Q: Using a scenario approach, an analyst finds that the estimated value of a company is $800. The business-as-usual scenario forecasts a cash flow of $40 starting next year and then growing at 6 percent forever. The cost of capital in that scenario is 10 percent. Given this information, what is the implied risk premium to add to the cost of capital to make the analyst’s results consistent with the country risk premium discounted cash flow (DCF) approach? a) 0.80 percent. b) 1.00 percent. c) 1.20 percent. d) 1.25 percent.

Q: Given the following information for a company in a developing market, estimate the value of the company. The cash for the next year is estimated to be either $200 in the business-as-usual scenario or $50 in the distress scenario. The probabilities of the scenarios are 80 percent and 20 percent, respectively. The expected perpetual growth rate in each case is 5 percent per year, and the cost of capital is 11 percent. The value of the company is closest to: a) $1,654.55 b) $2,500.00 c) $2,833.33 d) $3,333.33

Q: Which of the following best represents the relevance of purchasing power parity (PPP) when analyzing companies in emerging markets? a) PPP does not hold between emerging and developed economies. b) PPP holds over the long run, and exchange rates will adjust to inflation differentials. c) PPP holds over the long run, but exchange rates will not adjust to inflation differentials. d) It is not clear whether PPP holds, because there is not yet enough evidence one way or the other.

Q: Which of the following are reasons an analyst should allow for changes in cost of capital in an emerging market? I. Reforms in the tax system. II. Changes in the cost of debt. III. Evolving inflation expectations. IV. Changes in a company’s capital structure. a) I and II only. b) I, III, and IV only. c) II and IV only. d) I, II, III, and IV.

Q: For emerging markets, the recommended input for the risk-free rate for computing beta is: a) The domestic government bond rate. b) The average of the inflation rates of developed nations. c) The average of the government bond rates of developed nations. d) The U.S. Treasury bond rate plus the local inflation rate minus the U.S. inflation rate.

Q: For emerging markets, the recommended market input for computing beta is: a) A small-cap index. b) A median-cap index. c) A global market index. d) An index of non-investment-grade bonds.

Q: Describe the basic goal of good investor communications.

Q: Executives would do a better service to investors by providing guidance at the start of the financial year on the real short-, medium-, and long-term value drivers of their businesses, as opposed to guidance on earnings per share (EPS).

Q: The objective of investor relations should be the alignment of share price and intrinsic value. It should not focus on trying to maximize the share price.

Q: Which of the following is true with respect to earnings guidance? a) There is usually a change in total returns to shareholders in the first year that managers begin to offer earnings guidance. b) It has been proven that earnings guidance can increase liquidity. c) Firms that engage in earnings guidance have higher multiples such as enterprise value/EBITA. d) When a company begins to issue earnings guidance, it does not change the likelihood of higher or lower volatility in its share price relative to companies that do not issue earnings guidance.

Q: Which of the following is NOT a way that managers of most companies could improve their communication to investors? a) Increase their understanding of their investor base. b) Respond more actively to analysts’ comments and the changing P/E ratio of the firm. c) Tailor communications to the investors that matter most in determining share price. d) Engage in a systematic analysis to determine if there really is a material discrepancy between their company’s intrinsic value and its market value.

Q: Do managers respond to increases in transparency by other firms and/or increases in the demands for transparency from investors? a) No, managers do not respond to either. b) Yes, managers respond positively to both. c) Managers respond only to demands from investors but not to increases in the transparency of other firms. d) Managers respond only to increases in the transparency of other firms but not to demands from investors.

Q: In comparing growth versus value stocks, which of the following is NOT true? a) Most stocks labeled as growth stocks have higher ROICs. b) Most managers would like their firms to be growth stocks. c) Growth stocks are usually stocks that have higher book and earnings multiples. d) Most stocks labeled as growth stocks grow earnings and revenues faster than value stocks.

Q: Describe how leverage can cause business erosion.

Q: Leverage and coverage measure the same thing but over different time horizons.

Q: Although academic researchers have investigated the issue for decades, there is still no clear model for deciding a company’s optimal leverage ratio (i.e., the leverage that would create most value for shareholders).

Q: Which of the following is the most important factor in determining a company’s credit rating? a) Size. b) Coverage. c) Tax bracket. d) Use of a complex capital structure.

Q: Based on the observed distribution of credit ratings, which of the following ranges of debt ratings is an effective rating level, meaning it cannot clearly be improved upon in terms of creating value for shareholders? a) From BB+ to BBB. b) From BBB– to A+. c) From A to AA–. d) From AA– to AAA.

Q: Which of the following is the correct order of financing choices according to the pecking-order theory, starting with the most preferred choice? a) Internal funds, debt, equity. b) Debt, equity, internal funds. c) Internal funds, equity, debt. d) Equity, internal funds, debt.

Q: For a given firm, which of the following is most likely to be the result of lower leverage? a) Corporate overinvestment. b) Increased investor conflicts. c) Tax savings for the firm. d) Shareholders preferring higher-risk projects.

Q: Explain the reasons that a parent company may not want to give up control over a business unit it wants to divest and the preferred method of divestment in this case.

Q: The liquidity of the assets of the divested company does not play a role in the amount of value created.

Q: Executives seem to shy away from divestitures and usually delay them too long.

Q: Acquisitions occur in waves, but divestitures occur randomly.

Q: Which of the following are true concerning private transactions? I. Most are done to financial buyers. II. They tend to capture value more quickly. III. Fiscal implications may affect the decision. IV. They are usually a better choice if identifiable buyers exist. a) I and II only. b) I, II, and III only. c) II, III, and IV only. d) I, II, III, and IV.

Q: Which of the following is the best definition of a trade sale? a) Sale of part or all of a business to a strategic or financial investor. b) A trade of a subsidiary’s assets for other physical assets to avoid taxes. c) Sale of all shares of a subsidiary to new shareholders in the stock market. d) A combination of part or all of a business with other industry players, other companies in the value chain, or venture capitalists.

Q: Which of the following would be classified as a private divestiture? I. Split-off. II. Carve-out. III. Trade sale. IV. Joint venture. a) I and II only. b) I, II, and IV only. c) II and III only. d) III and IV only.

Q: Which of the following is the best name for a distribution of all shares in a subsidiary to existing shareholders of the parent company? a) Carve-out. b) Spin-off. c) Split-off. d) Tracking stock.

Q: Chapter: Chapter 28: Divestitures

Q: A large acquisition occurring is a good predictor of an increase in acquisitions.