Q&A Hero

Q: Identify warranty reserves as operating or nonoperating and as an asset or a liability. Explain how the required treatment of warranty reserves determines the relationship between cash and accrual-based taxes.

Q: Usually, a company will record a DTL during the year of an acquisition and then draw down the DTL as the intangible amortizes.

Q: The income tax footnote is a good source of information for deferred tax liabilities.

Q: It is not correct to use the company’s effective tax rate with no adjustments when estimating operating taxes.

Q: Operating taxes are computed as if the company were financed entirely with equity.

Q: The effects of research and development should be removed from operating taxes.

Q: As a general rule, deferred tax assets and deferred tax liabilities are considered part of invested capital.

Q: In estimating a firm’s cost of capital and value, which of the following is most accurate concerning marginal tax rates on nonoperating items? a) Both GAAP and the IFRS require that marginal tax rates on nonoperating items be reported, so it not a problem. b) Marginal tax rates on nonoperating items are usually not reported, but in most cases an analyst can ignore them because they are so small. c) Marginal tax rates on nonoperating items are usually not reported, and an analyst will have to make an assumption about the tax jurisdiction in which nonoperating items are held. d) IFRS requires that marginal tax rates on nonoperating items be reported, and an analyst estimating the value of a company that uses GAAP can use approximations from similar firms using IFRS for such marginal tax rates.

Q: All deferred tax liabilities (DTLs) are classified as debt.

Q: Multinational Co. (MNC) generated $1,000 million in domestic earnings before interest, taxes, and amortization (EBITA). MNC amortizes intangible assets at $200 million per year and takes a $300 million interest expense. MNC’s statutory (domestic) tax rate is 34 percent on earnings before taxes, but only 24 percent on foreign operations. MNC had $100 million of pretax foreign income and generates $20 million in ongoing research and development (R&D) tax credits. What is its effective tax rate on pretax profits? a) 26.7 percent. b) 29.0 percent. c) 31.5 percent. d) 33.3 percent.

Q: Which of the following concerning deferred taxes classified as nonoperating are true? I. They will not be included in a discounted free cash flow (FCF) valuation. II. They can be valued as part of their corresponding accounts (as in the case of pensions). III. They can be valued separately (as in the case of net operating loss carryforwards). IV. They can be ignored as accounting conventions (as in the case of nondeductible amortization). a) I and II only. b) II and III only. c) II and IV only. d) I, II, III, and IV.

Q: Which of the following are deferred tax assets (DTAs)? I. Warranty reserves. II. Tax loss carryforwards. III. Nondeductible intangibles. IV. Pension and postretirement benefits. a) I and II only. b) I and III only. c) II and III only. d) III and IV only.

Q: Which of the following concerning operating taxes are true? I. With full information, operating taxes can be computed without error. II. The effects of research and development (R&D) should be removed from operating taxes. III. Operating taxes are computed as if the company were financed entirely with equity. IV. Making estimates of operating taxes based on tax rates in individual jurisdictions is not recommended. a) I and II only. b) I and III only. c) II and III only. d) III and IV only.

Q: Since many firms’ valuations by a sum-of-the-parts multiples methodology are greater than the current market valuation of these firms, one can conclude that a breakup of these firms would add value for shareholders.

Q: Using EBITA instead of NOPLAT is a best practice for testing the sum-of-the-parts valuation based on multiples of peers.

Q: Eliminating outliers is a best practice for testing the sum-of-the-parts valuation based on multiples of peers.

Q: As CFO, you are trying to allocate investment funds across your three-division firm. You observe the revenues last year for Divisions A, B, and C as $1.0 billion, $4.0 billion, and $5.0 billion, respectively. You should therefore allocate investment budgets of 10, 40, and 50 percent, respectively, of the overall firm’s investment budget to Divisions A, B, and C.

Q: If an analyst estimates the NOPLAT for each of the divisions in a three-division firm at $50 million, $30 million, and $20 million, respectively, it’s safe to assume that the divisions contribute 50, 30, and 20 percent, respectively, to overall firm value.

Q: There is undisputed evidence that conglomerate firms trade at a discount relative to a portfolio of pure-play firms.

Q: Financing subsidiaries should be valued separately from other business units.

Q: Human resources costs should be allocated to business units based on the number of employees in the units.

Q: CEO salaries should be allocated to business units based on the number of employees in the units.

Q: Which of the following are issues an analyst typically encounters when creating financial statements for business units? I. Allocating corporate overhead costs. II. Dealing with intercompany transactions. III. Understanding financial subsidiaries. IV. Processing overwhelming amounts of public information. a) I and II only. b) II and III only. c) I, II, and III only. d) I, II, III, and IV.

Q: Which of the following are steps in valuing a multibusiness company by parts? I. Building financial statements by business unit, based on incomplete information if necessary. II. Allocating CEO salaries to business units. III. Estimating the weighted average cost of capital (WACC) by business unit. IV. Testing the value based on multiples of peers. a) I and II only. b) I and III only. c) I, III, and IV only. d) I, II, III, and IV.

Q: Which of the following correctly describes how to determine the beta for a business unit within a multiple-business corporation? a) Use the average of the equity betas for the industry. b) Use the beta of the multi-unit enterprise. c) Relever the unlevered sector median beta using the capital structure of the unit. d) Relever the unlevered sector median beta using the capital structure of the entire multiple-business corporation.

Q: For multibusiness units, consolidated corporate results: a) Must eliminate internal revenues, costs, and profits. b) Are not possible. c) Are computed by summing the inputs for each accounting entry across units. d) Are computed by top-down algorithms that give estimated values based on the economic profit or cost of each entry.

Q: Which of the following are issues in the creation of the financial statements for business units? I. Allocating corporate overhead costs. II. Dealing with intercompany transactions. III. Estimating unit betas. IV. Dealing with incomplete information when using public information. a) I and II only. b) II and IV only. c) I, II, and IV only. d) II, III, and IV only.

Q: Chapter: Chapter 17: Valuation by Parts

Q: The EV-to-revenue multiple is useful in valuing some companies.

Q: The enterprise value (EV)-to-revenue multiple is useful in valuing most companies.

Q: ComboCo, a large U.S. company, operates in two areas: high tech and retail clothing. To value this firm using multiples analysis, one should use a peer group of other large U.S. diversified companies.

Q: Nonfinancial ratios such as value to web site hits, value to unique visitors, and value to number of subscribers had some explanatory power for assessing Internet company stock prices in the early years of the wave of Internet companies.

Q: In estimating value creation, analysts should use EBITA rather than EBITDA, because depreciation is a noncash item whereas amortization is not.

Q: In estimating and comparing value, empirical evidence shows that forward-looking multiples are more accurate predictors of value than are historical multiples.

Q: Increasing growth and ROIC by the same amount while holding taxes and WACC constant will decrease the value-to-EBITA ratio.

Q: A firm has $600 market value of equity and $300 market value of debt. The firm also has $100 in nonconsolidated subsidiaries and $50 in excess cash. If the firm’s expected EBITA is $100, what is the value-to-EBITA ratio? a) 7.5 b) 9.0 c) 11.0 d) 6.9

Q: Which of the following are reasons that the value-to-EBITA ratio is superior to the price-to-earnings ratio as a multiple to aid in valuation? I. The P/E is distorted by capital structure. II. The P/E is distorted by inflation. III. The P/E is distorted by nonoperating gains and losses. IV. The P/E is distorted by dividend payouts. a) I and III only. b) II and III only. c) II and IV only. d) I, III, and IV only.

Q: Given the following inputs, compute the value-to-EBITA ratio: tax rate = 34%, growth rate = 4%, ROIC = 10%, and WACC = 9%. a) 5.40 b) 7.92 c) 8.83 d) 11.20

Q: Given the following inputs, compute the value-to-EBITA ratio: tax rate = 34%, growth rate = 5%, ROIC = 12%, and WACC = 8%. a) 3.14 b) 9.17 c) 12.83 d) 17.00

Q: Given that the value-to-EBITA ratio of a company is 11.2 and the projected EBITA growth is 2 percent, what is the P/E-to-growth (PEG) ratio? a) 2.67 b) 70 c) 3.75 d) 6.86

Q: In estimating and comparing value, the price-to-earnings (P/E) multiple has two major flaws. Which of the following are those flaws? I. It is in squared currency units. II. The P/E is affected by a company’s capital structure. III. The earnings (net income) are calculated after nonoperating items. IV. The market measure of price usually has significant error. a) I and II only. b) I and III only. c) II and III only. d) III and IV only.

Q: Which of the following is true in using EBIT, EBITA, or EBITDA when estimating a firm’s value? a) EBIT is superior to both EBITA and EBITDA. b) EBITA is superior to both EBIT and EBITDA. c) EBITDA is superior to both EBIT and EBITA. d) There is not a clear superiority of one measure over the others. It depends on the type of firm being analyzed.

Q: Assuming the tax rate remains constant, what will be the effect on the value-to-EBITA ratio of doubling the following inputs: growth, ROIC, and WACC? a) The value-to-EBITA ratio will fall, but the amount is uncertain. b) The value-to-EBITA ratio will decrease by 50 percent. c) The value-to-EBITA ratio will increase, but the amount is uncertain. d) The value-to-EBITA ratio will double.

Q: Chapter: Chapter 16: Using Multiples

Q: In creating scenarios that will determine a firm’s future cash flow and present value in a sensitivity analysis, list the four categories of assumptions the analyst should critically review.

Q: When estimating a company’s value, falling within a range of plus or minus 15 percent of the actual valuation is appropriate, as market valuations of this amount for individual stocks are fairly common.

Q: A colleague recommends a shortcut to value the company in the preceding question. Rather than compute each scenario separately, the colleague recommends averaging each input, such that growth equals 5 percent and ROIC equals 15 percent. This will lead to the same enterprise value as found in that question.

Q: In a scenario analysis, which of the following are considerations when reviewing the assumptions of a model? I) The sensitivity of the results to broad economic conditions. II) The level of competitiveness of the industry. III) The internal capabilities of the company to achieve the forecasts of output and growth. IV) The ability of the company to raise the necessary capital from the markets. a) I and II only. b) II and III only. c) I, III, and IV only. d) I, II, III, and IV.

Q: When making forecasts, increasing one variable usually means decreasing another. Which of the following are possible common trade-offs that should be considered in making such forecasts? I. Product volume and prices. II. Lower inventory and higher sales. III. Higher growth and lower margin. a) I and II. b) I and III. c) II and III. d) All of the above.

Q: The forecasts in the prior question used several assumptions. Repeat the forecasts where (scenario A) costs increase with inflation, but all other assumptions hold (costs are $90.0, $91.8, and $97.1 per unit in each of the next three years, respectively); and (scenario B) sales units remain constant, but all the other assumptions hold (including constant costs). What is the ROIC under each assumption? Which assumption is responsible for a significant increase in ROIC? a) In scenario A, ROIC is 15.0 percent, 15.6 percent, and 16.8 percent for the next three years, respectively. ROIC significantly increases under this assumption versus the constant costs assumption. b) In scenario B, ROIC is 15.0 percent, 16.3 percent, and 21.5 percent for the next three years, respectively. ROIC significantly increases under this assumption versus the increasing costs assumption. c) In scenario B, ROIC is 15.0 percent, 15.6 percent, and 16.8 percent for the next three years, respectively. ROIC significantly increases under this this assumption versus the increasing costs assumption. d) In scenario A, ROIC is 15.0 percent, 16.3 percent, and 21.5 percent for the next three years, respectively. ROIC significantly increases under this this assumption versus the increasing costs assumption.

Q: An analyst is estimating the ROIC of a company that has zero fixed costs per unit and pays no taxes. The analyst makes the following forecasts: Sales next year will equal 250 units and will increase at 10 percent for each of the two following years. Prices per unit will be $102, $104, and $110, which simply embody inflation forecasts. Costs per unit will be constant at $90. Current capital invested is $20,000, and the firm will reinvest 50 percent of profits. What is the ROIC for each of the three years? If this is a competitive industry, are the results realistic? a) ROICs in the next three years are 15.0 percent, 17.9 percent, and 25.8 percent, respectively; results are realistic for a competitive industry. b) ROICs in the next three years are 15.0 percent, 16.5 percent, and 13 percent, respectively; results are realistic for a competitive industry. c) ROICs in the next three years are 15.0 percent, 16.5 percent, and 13 percent, respectively; results are not realistic for a competitive industry. d) ROICs in the next three years are 15.0 percent, 17.9 percent, and 25.8 percent, respectively, results are not realistic for a competitive industry.

Q: To prioritize strategic actions, the analyst should: a) Take a vote from the major players. b) Build a sensitivity analysis that tests multiple changes at a time. c) Follow the priorities of leaders in the industry. d) Follow Porter’s five forces analysis.

Q: If one arrives at a company value based on the valuation model that is significantly different from the market value, the default assumption should be that the market valuation is incorrect.

Q: To ensure that the model is economically consistent, the continuing value formula should be applied when company operations are in a steady state.

Q: Which of the following are questions an analyst should ask when assessing the economic consistency of a model? I. Are the patterns chartable? II. Are the patterns intended? III. Are the patterns reasonable? IV. Are the patterns consistent with industry dynamics? a) I and II only. b) I and IV only. c) III and IV only. d) II, III, and IV only.

Q: An adjustment in the dividend payout ratio should change the value of the firm under the recommended valuation approach in the text.

Q: Adjustments in the dividend payout ratio should be used to ensure that the model is technically correct.

Q: Indicate in which cases book value is a reasonable approximation for evaluating the asset or liability. Answer “Yes” if book value is a reasonable approximation and “No” if it is not. A. Floating-rate debt. B. Outstanding bonds that are secure and actively traded. C. Discontinued operations. D. Stake in a publicly traded subsidiary. E. Excess real estate. F. Loans to nonconsolidated subsidiaries and other companies (assume interest rates and credit risk have not changed). G. An outstanding convertible bond deep in the money. H. Employee stock options.

Q: Given the following list, put a “+” if it increases a firm’s equity value or a “–” if it decreases the firm’s value per share of common stock. Excess real estate Preferred stock Noncontrolling interest Tax loss carryforward Unfunded pension liabilities Nonconsolidated subsidiaries

Q: For equity stakes in subsidiaries where the stake is between 20 and 50 percent of the subsidiary, the holding is recorded on the balance sheet at: a) Market value, and the parent’s portion of the subsidiary’s profits are shown below operating profit on the parent company’s income statement. b) Historical cost plus reinvested income, and the parent’s portion of the subsidiary’s profits are shown in the regular operating profit of the parent company. c) Market value, and the parent’s portion of the subsidiary’s profits are shown in the regular operating profit of the parent company. d) Historical cost plus reinvested income, and the parent’s portion of the subsidiary’s profits are shown below operating profit on the parent company’s income statement.

Q: Company X controls Company Y so that Company Y’s financial statements are fully consolidated in the group accounts. With respect to Company X’s financial statements, third-party stakes in Company Y: a) Are not of concern. b) Are to be deducted and are called noncontrolling interest. c) Are to be added in and are called noncontrolling interest. d) Are illegal.

Q: In evaluating employee stock options, the exercise value approach provides: a) A lower bound of valuation, and using it can undervalue the firm. b) An upper bound of valuation, and using it can undervalue the firm. c) A lower bound of valuation, and using it can overvalue the firm. d) An upper bound of valuation, and using it can overvalue the firm.

Q: An analyst is applying an integrated-scenario approach to evaluate operations as well as equity, and the analyst essentially treats equity as a call option on the enterprise value. It is most likely the analysis is of a company that: a) Is highly levered. b) Has securitized receivables. c) Uses income smoothing. d) Has excess pension assets or liabilities.

Q: The multiples valuation of a subsidiary is most appropriate when the subsidiary is publicly traded and the parent owns less than 20 percent of the subsidiary.

Q: Which of the following is best categorized as a hybrid claim against a company as opposed to a debt equivalent? a) Employee stock options. b) Securitized receivables. c) Unfunded pension liabilities. d) Long-term operating provisions.

Q: Which of the following approaches are methods for evaluating convertible debt? I. Market value. II. Multiples value. III. Black-Scholes value. IV. Conversion value. a) I and II only. b) I and III only. c) I, III, and IV only. d) II, III, and IV only.

Q: A corporation has 5 million shares outstanding. Using the following information, calculate the value per share. DCF of operations = $858m Financial subsidiary = $66m Employee stock options = $6.6m Bonds = $366.3m Securitized receivables = $3m Operating leases = $12.1m The value per share is closest to: a) $97.4 b) $107.1 c) $101.0 d) $105.4

Q: A corporation has 5 million shares outstanding. Using the following information, calculate the value per share. DCF of operations = $780m Financial subsidiary = $60m Employee stock options = $6m Bonds = $333m Securitized receivables = $3m Operating leases = $11m The value per share is closest to: a) $85.4 b) $97.4 c) $99.6 d) $101.0

Q: In estimating value per share of common stock of a company, for which of the following is book value a reasonable approximation for evaluating the asset or liability? I. Excess real estate. II. Discontinued operations. III. Floating rate debt. IV. Employee stock options. a) I and II only. b) I and III only. c) II and III only. d) III and IV only.

Q: Which of the following is NOT a property necessary for a consistent estimate of the WACC? a) It uses book-value-based weights. b) It includes the opportunity cost of all investors. c) It includes related costs/benefits such as the interest tax shield. d) The duration of the securities used in estimating the WACC equals the duration of the free cash flows.

Q: If interest rates have changed since the company’s last valuation or if the company has entered into financial distress, book value is a reasonable approximation of market value.

Q: If an observable market value is not readily available, book value of debt can be used to calculate capital structure.

Q: While estimating the cost of debt for a firm, one should always use market prices for publicly traded debt.

Q: Yield to maturity should be calculated on liquid, option-free, short-term debt.

Q: Which of the following practices are appropriate in estimating a firm’s cost of debt? I. Use the coupon rate on outstanding debt that is investment grade. II. Use the yield to maturity on outstanding debt that is investment grade. III. Use the yield to maturity on outstanding debt that is below investment grade. IV. Use the adjusted present value (APV) method to value firms that have debt that is below investment grade. a) I and IV only. b) III and IV only. c) II and III only. d) II and IV only.

Q: An analyst gathers the following information for Firm A and Firm B. Use the information to compute the industry unlevered beta and the appropriate beta for Firm B to use in the WACC. Firm A: CAPM beta = 1.6; debt-to-equity ratio = 1.2 Firm B: CAPM beta = 1.0; debt-to-equity ratio = 0.8 The appropriate beta for Firm B is closest to: a) 1.026 b) 1.154 c) 1.170 d) 1.163

Q: An analyst gathers the following information for Firm A and Firm B. Using the information to compute the industry unlevered beta, what is the appropriate beta for each company for use in the WACC? (Assume that the debt beta for each firm equals zero.) Firm A: CAPM beta = 0.9; debt-to-equity ratio = 0.4 Firm B: CAPM beta = 1.2; debt-to-equity ratio = 2 a) 0.73; 1.56 b) 0.90; 1.20 c) 0.52; 0.52 d) 1.12; 1.65

Q: To estimate a company’s beta, using an industry-derived unlevered beta relevered to the company’s target capital structure is preferred to directly estimating a company-specific beta.

Q: Bloomberg’s recommended adjustment to a firm’s beta will: a) Lower beta in all cases. b) Increase beta in all cases. c) Move the beta toward 1. d) Either increase or decrease beta, but it depends on the size of the standard error of the estimated beta.

Q: Which of the following is NOT true concerning the index recommended for use in the CAPM? a) It should include both traded and untraded investments. b) The S&P 500 is the most common proxy for U.S. stocks. c) The S&P 500 and the MSCI World index will produce fairly similar results for U.S. stocks. d) For less developed countries, a local market index is recommended.