Q&A Hero

Q: About one-third of all acquisitions create value, about one-third destroy value, and for the remaining third it is not clear whether value is created or destroyed.

Q: An all-equity firm worth $50 billion acquires for $4 billion cash a firm whose postacquisition value will be $6 billion. The acquiring firm had the cash and did not need to borrow. The current market value of the target is $3 billion. What is the estimated return to the shareholders of the acquiring firm? a) 2 percent. b) 4 percent. c) 6 percent. d) 8 percent.

Q: When an acquiring firm is making the decision to offer either cash or stock for a target, it should be more inclined to offer cash if: a) The target is larger. b) The target is smaller. c) The stock market is in a bubble. d) The acquiring firm has relatively low debt-to-equity ratios.

Q: Which of the following are usual costs associated with pursuing synergies from an acquisition? I. Severance pay. II. Rebranding campaigns. III. Decommissioning a plant. IV. Information technology integration costs. a) I and II only. b) I and III only. c) II, III, and IV only. d) I, II, III, and IV.

Q: The analysis of cost savings requires an industry-specific business system. Which of the following are requirements of an insightful industry-specific business system? I. It uses a top-down approach. II. It uses detail to identify the precise source of the savings. III. It assigns each cost item of the target to one segment of the business system. IV. It assigns the savings within the bidder’s organization in the appropriate segments in the business system. a) I and II only. b) I and III only. c) II, III, and IV only. d) I, II, III, and IV.

Q: In assessing a company’s long-term strategic health, it can be hard to identify specific metrics. Thus, these situations require more qualitative milestones.

Q: Assessing the ability to exploit new growth areas and potential new threats is the focus of short-term value drivers as opposed to long-term value drivers.

Q: Which set of metrics is best used to describe whether the company can sustain or improve its current revenue growth? a) Asset health. b) Commercial health. c) Strategic health. d) Core health.

Q: Which of the following is a value driver associated with improving long-term growth as opposed to return on invested capital (ROIC)? a) Asset health. b) Commercial health. c) Capital productivity. d) Cost structure health.

Q: Which of the following are aspects of the firm that diagnostics of organizational health typically measure? I. Its culture and values. II. The depth of management talent. III. The skills and capabilities of the company. IV. Its ability to retain employees and keep them satisfied. a) I, II, and III only. b) I, III, and IV only. c) II, III, and IV only. d) I, II, III, and IV.

Q: Which of the following value drivers is a short-term driver as opposed to a medium-term driver? a) Asset health. b) Commercial health. c) Capital productivity. d) Cost structure health.

Q: Chapter: Chapter 26: Performance Management

Q: Define corporate governance and describe the evidence of the role it can play in value creation from studies of the returns of private equity firms investing in companies.

Q: Better governance refers to the way the company’s owners (or their representatives) interact with the management team, and it is often a way private equity firms add value to acquisitions.

Q: With respect to owning and adding value to a consumer packaged-goods business, a firm with great manufacturing skills would probably be a better owner than a firm with distinctive skills in developing and marketing brands.

Q: Which of the following are true concerning diversification and/or diversified firms? I. Diversified firms have higher levels of debt. II. There is strong evidence that diversification adds value. III. Investors can diversify their portfolios at lower cost than companies can. IV. There is strong evidence that diversified firms have smoother cash flows. a) I and II only. b) I, II, and IV only. c) III only. d) I, II, III, and IV.

Q: Which of the following would be the LEAST likely way a private equity firm could add value to an acquired company? a) Recapitalization. b) Additional funds. c) Distribution channels. d) Managerial experience.

Q: Which of the following would be the LEAST likely way a conglomerate could add value to an acquired company? a) Innovation. b) Additional funds. c) Distribution channels. d) Managerial experience.

Q: Which of the following are valid reasons a given firm might be the best owner of a particular business? I. Unique links with other businesses (e.g., distribution lines). II. Distinctive skills such as advertising. III. Better governance. IV. Better insight and foresight. a) I and II only. b) I, II, and III only. c) II and IV only. d) I, II, III, and IV.

Q: Chapter: Chapter 25: Corporate Portfolio Strategy

Q: When calculating gross investments, it is appropriate to add the increase in the foreign-currency translation reserve to capital expenditures to obtain the actual cash spent on capital investments.

Q: When computing investment cash flows, all impairments should be subtracted to decrease property, plant, and equipment (PP&E), operating intangibles, and nonconsolidated investments.

Q: Tax loss carryforwards are unrelated to any other balance sheet item and are treated as a separate nonoperating asset in invested-capital calculations. They do not affect NOPLAT.

Q: Which of the following from the NOPLAT statement is NOT included in the amount of investments in goodwill and acquired intangibles? a) The implied interest rate on the goodwill and acquired intangibles. b) The annual change in the sum of goodwill and acquired intangibles. c) The reversal of intangibles value adjustments in the invested-capital statement. d) The sum of amortization of acquired intangibles and impairment of acquired intangibles and goodwill for the year.

Q: Which of the following would be the most likely change(s) to be included in NOPLAT? a) Changes in deferred taxes from tax rate revisions. b) Change in deferred taxes as a result of acquisitions. c) Change in deferred taxes as a result of the sale of a discontinued division. d) Changes in deferred taxes from depreciation differences in net property, plant, and equipment (NPPE).

Q: Which of the following are NOT recommended in the treatment of depreciation, amortization, and impairments in the calculation of NOPLAT? a) Separate any impairments from income on nonconsolidated investments. b) Combine depreciation of property, plant, and equipment (PP&E) with impairments. c) Separate the depreciation of property, plant, and equipment (PP&E) from amortization. d) Within amortization, separate amortization of acquired intangibles from operating amortization.

Q: List and describe the two methods for converting forecasted cash flows from one currency into another.

Q: Market data across countries do show differences in realized premiums, and this is mainly because the markets have distinct systematic risk factors.

Q: The cost of capital is best estimated from the perspective of a global investor and using both the market risk premium and beta measured against a global market portfolio and not against a local (foreign or domestic) market portfolio.

Q: Which of the following are issues to address when analyzing foreign companies? I. Making forecasts in foreign and domestic currencies. II. Estimating the cost of capital in a foreign currency. III. Incorporating foreign-currency risk in valuations. IV. Using translated foreign-currency financial statements. a) I and II only. b) I, II, and IV only. c) II and III only. d) I, II, III, and IV.

Q: Which of the following are categories of assumptions needed when making projections of and discounting cash flows in different currencies? I. Inflation assumptions. II. Cash flow projections. III. Forward exchange rates. a) I and II. b) I and III. c) II and III. d) I, II, and III.

Q: Which of the following are reasons the forward-rate method is more complex than the spot-rate method in estimating the value? I. Incomplete data. II. Extra calculations. III. The possibility of multiple solutions. IV. The use of more than one currency in the estimation process. a) I and II only. b) I and IV only. c) II and III only. d) III and IV only.

Q: An analyst is estimating the value of a subsidiary using International Financial Reporting Standards (IFRS), and the country of the subsidiary is experiencing moderate inflation. In this case, which of the following accounting techniques is recommended? a) Current method. b) Temporal method. c) Autoregressive method. d) Inflation-adjusted current method.

Q: An analyst is using U.S. Generally Accepted Accounting Principles (GAAP) to estimate the value of a subsidiary of a U.S. firm, and the country of the subsidiary is experiencing hyperinflation. In this case, which of the following accounting techniques is recommended? a) Current method. b) Temporal method. c) Autoregressive method. d) Inflation-adjusted current method.

Q: Chapter: Chapter 23: Cross-Border Valuation

Q: What are the two indirect cash flow effects of inflation that depress value?

Q: Inflation is often persistent and difficult to fix, stretching out over several years as in the 1970s and 1980s, because suppressing it requires strict and unpopular government measures.

Q: An analyst should make financial projections of income statements and balance sheets for a valuation in a high-inflation environment by simply projecting all items on a nominal basis.

Q: Which of the following are true about inflation? I. It depresses market valuations. II. Investors tend to correctly perceive inflation. III. It does not affect the cost of capital in real terms. IV. It can affect the real-terms cash flows generated by companies. a) I and II only. b) I and IV only. c) II and III only. d) III and IV only.

Q: If the nominal weighted average cost of capital (WACC) is 24 percent and inflation is 16 percent, then the real WACC is closest to: a) 7 percent. b) 8 percent. c) 13 percent. d) 15 percent.

Q: For which of the following is a nominal modeling application preferred to a real modeling application? a) EBITDA. b) Financial statements. c) Investments in working capital. d) Capital expenditures.

Q: Given the following information, compute free cash flow (FCF) in real terms: real growth is 3 percent, real ROIC is 12 percent, real NOPLAT is $5,000, real net working capital from the previous year is $2,000, the inflation index last year was 164, and the inflation index this year is 192. a) $770.83 b) $2,958.33 c) $2,229.17 d) $3,458.33

Q: Expensing items with long-term benefits will usually mean that the accounting statements will overstate the company’s historical investment, which can artificially lower ROIC in later years, making a business appear less attractive than it really is.

Q: One benefit of capitalizing R&D is that reductions in current R&D will not affect current operating profits.

Q: In early years, for a given company with a positive profit, ROIC with capitalized R&D will be higher than that with expensed R&D.

Q: A firm that capitalizes R&D has more opportunity to manipulate short-term earnings compared to a firm that expenses R&D.

Q: If growth of a company is falling, expensing R&D will lead to an overestimation of the resulting drop in true performance.

Q: Will either measures of performance or valuation be affected by changing the accounting treatment of R&D? a) Both measures of performance and valuation will be affected. b) Neither measures of performance nor valuation will be affected. c) Measures of performance will be affected, but valuation will not be affected. d) Measures of performance will not be affected, but valuation will be affected.

Q: Concerning the impact on ROIC of capitalizing R&D, will increasing the asset life and/or the percentage of revenues spent on R&D increase ROIC? a) Increasing either the asset life or the percentage of revenues spent on R&D will increase ROIC. b) Neither increasing the asset life nor increasing the percentage of revenues spent on R&D will increase ROIC. c) Increasing the asset life will increase ROIC, but increasing the percentage of revenues spent on R&D will not. d) Increasing the asset life will not increase ROIC, but increasing the percentage of revenues spent on R&D will.

Q: According to U.S. Generally Accepted Accounting Principles (GAAP), which of the following must be expensed? I. A patent developed by the firm. II. A building. III. Equipment. IV. A distribution network. a) I and II only. b) I and IV only. c) II and III only. d) III and IV only.

Q: Which of the following company types is most likely to have operating leases as an off-balance-sheet liability? a) A financial services company. b) A company with few fixed assets. c) A company that uses large, easily transferable assets. d) An established company whose age is greater than 20 years.

Q: Over- or underfunded pension status must be incorporated into value as a nonoperating asset or as a debt equivalent.

Q: Since interest costs, expected returns on plan assets, and amortization of losses are part of the compensation expenses for a firm, they should be considered to be a part of NOPLAT.

Q: If there is no line item for prepaid pension assets or unfunded pension liabilities on a firm’s balance sheet, this means the firm’s pension plan is fully funded.

Q: Excess pension assets should be treated as operating assets, and unfunded pension liabilities should be treated as a debt equivalent. With respect to taxes, valuations should be done on a pretax basis.

Q: Using the present value of reported rental expenses systematically undervalues the asset, since it ignores the residual value returned at the end of the lease contract.

Q: Investors, lenders, and rating agencies tend to interpret operating leases the same as traditional debt.

Q: Researchers at Ohio State University found that interest rates on unrated, unsecured debt were explained better by credit statistics adjusted for operating leases.

Q: In their study of operating leases, Lim, Mann, and Mihov found that use of more operating leases led to agencies assigning companies lower credit ratings. These ratings and the use of operating leases led to higher required yields on new public bond issuances.

Q: Analysts in the investment banking industry multiply rental expenses by 8 times to approximate asset value. Although based on reasonable assumptions, the method is very simple and can both overvalue and undervalue the leased assets.

Q: The interest rate for operating lease adjustments is usually higher than the firm’s cost of debt.

Q: Since valuation is not affected by the treatment of operating leases, capitalizing operating leases is not a useful activity for analysts.

Q: When computing cash flows for a company with operating leases, an analyst should add back the lease depreciation to NOPLAT.

Q: What are (1) the WACC before adjustment for leases and (2) the WACC after adjustment for leases? a) WACC before adjustment for leases = 8.63 percent; WACC after adjustment for leases = 6.98 percent. b) WACC before adjustment for leases = 6.63 percent; WACC after adjustment for leases = 6.98 percent. c) WACC before adjustment for leases = 6.93 percent; WACC after adjustment for leases = 8.63 percent. d) WACC before adjustment for leases = 8.63 percent; WACC after adjustment for leases = 8.98 percent.

Q: What are (1) invested capital before adjustment for leases and (2) invested capital after adjustment for leases? a) Invested capital before adjustment for leases = $2,000; invested capital after adjustment for leases = $4,000. b) Invested capital before adjustment for leases = $4,000; invested capital after adjustment for leases = $3,000. c) Invested capital before adjustment for leases = $2,000; invested capital after adjustment for leases = $3,000. d) Invested capital before adjustment for leases = $4,000; invested capital after adjustment for leases = $4,000.

Q: Apex Industries expects to earn $25 million in operating profit next year. The company pays an operating tax rate of 30 percent. If the value of leased asset is $125 and the cost of debt is 10 percent, what is the approximate after-tax operating profit, adjusted for capitalized operating leases? a) $24 b) $25 c) $26 d) $27

Q: When a firm uses operating leases, an analyst should determine the firm’s equity value by subtracting traditional debt and the value of operating leases from enterprise value.

Q: Although a company’s ROIC will change following the adjustment for operating leases, its valuation should not change.

Q: With respect to operating leases, adjusting the financial statements makes ROIC and free cash flow independent of capital structure choices, specifically whether to lease, own, or borrow.

Q: An analyst’s appropriate adjustments for operating leases would be to increase assets, increase liabilities, and increase operating income.

Q: The most common forms of off-balance-sheet debt are operating leases, securitized receivables, and unfunded retirement obligations.

Q: List the three recommended steps in assessing the impact of nonoperating expenses and incorporating their information in cash flow forecasts.

Q: The size of a nonoperating expense or one-time charge mentioned in a management discussion and analysis (MD&A) note might determine if it should be included in the adjustment to NOPLAT.

Q: If litigation charges recur frequently and grow with revenue, the analyst should treat the charges as operating.

Q: Product returns and warranties are nonoperating provisions that do not affect NOPLAT.

Q: Which of the following is most accurate concerning plant decommissioning costs and unfunded retirement plans? a) They are both long-term operating provisions and should be treated as debt equivalents. b) They are both short-term operating provisions and should be treated as short-term liabilities. c) They are both long-term operating provisions. Plant decommissioning costs should be treated as a debt equivalent, and unfunded retirement plans should be treated as an equity equivalent. d) Plant decommissioning costs are not an operating provision and should not be included in value estimation. Unfunded retirement plans are long-term operating provisions and should be treated as an asset.

Q: Given the following entries, compute ROIC based on beginning-of-the-year investments. Assume that all invested capital entries are beginning-of-the-year entries and all income statement entries are for the entire year. Reported EBITA = 1,000 Reserve for plant decommissioning = 2,000 Interest associated with plant decommissioning = 200 Reserve for restructuring = 600 Equity = 4,000 a) 12.12 percent. b) 181 percent. c) 18.18 percent. d) 22.22 percent.

Q: With respect to the treatment of goodwill in the analysis of a company and determining the return on invested capital (ROIC), which of the following is most accurate? a) Treat goodwill impairments as operating and subtract cumulative impairments from goodwill on the balance sheet. b) Treat goodwill impairments as operating and add back cumulative impairments to goodwill on the balance sheet. c) Treat goodwill impairments as nonoperating and add back cumulative impairments to goodwill on the balance sheet. d) Treat goodwill impairments as nonoperating and subtract cumulative impairments from goodwill on the balance sheet.

Q: All of the following are related to the ongoing core business EXCEPT: a) Royalty expense. b) Restructuring charges. c) Selling, general, and administrative (SG&A) expenses. d) R&D expenses.

Q: Which of the following are typical nonoperating expenses? I. Amortization expense. II. Restructuring charges. III. Litigation expenses. IV. Purchased research and development (R&D). a) I and II only. b) I, II, and III only. c) III and IV only. d) I, II, III, and IV.