Q&A Hero

Q: Which of the following are true concerning the index recommended for use in the CAPM? I. It should include both traded and untraded investments. II. The S&P 500 is the most common proxy for U.S. stocks. III. The S&P 500 and the MSCI World index will produce very different results for U.S. stocks. IV. For less developed countries, a local market index is recommended. a) I and II. b) I and IV. c) II and III. d) III and IV.

Q: In computing the cost of equity for a firm, which of the following are recommended steps in estimating the CAPM beta using regression analysis? I. Use a sample size equal to or greater than 60. II. Use daily returns. III. Use a diversified value-weighted index. IV. Watch for possible distortions from market bubbles. a) I, II, and III only. b) I, III, and IV only. c) II and IV only. d) II, III, and IV only.

Q: Which of the following is/are FALSE regarding risk-free rates? I) The 30-year Treasury bonds match the cash flow streams of a company better, and therefore should be used over 10-year bonds in estimating the risk-free rate. II) One should use government bond yields denominated in the same currency as the company’s cash flow to estimate the risk-free rate. III) One should ensure that the inflation rate embedded in the cash flows is consistent with the inflation rate embedded in the government bond rate being used. a) I only. b) II only. c) III only. d) I and III only.

Q: Theoretically, one should discount each year’s cash flow at a cost of equity that matches the maturity of the cash flow. However, for practical purposes, analysts typically choose a single yield to maturity that best matches the cash flow stream being valued.

Q: To estimate the risk-free rate in developed economies, the analyst should use: a) Short-term commercial paper. b) Short-term government discount instruments. c) Long-term coupon-paying government bonds. d) Long-term government zero-coupon bonds.

Q: What challenges did the financial crisis of 2008 and its aftermath pose for estimating a firm’s cost of capital? How should one handle these challenges?

Q: One should create a synthetic risk-free rate by adding the expected inflation rate to the long-term historical average real risk-free rate for the period following the financial crisis.

Q: Briefly explain the two methods of estimating market returns.

Q: The cost of capital must include the cost of capital for all investors—debt, preferred stock, and common stock.

Q: An analyst should use the pretax cost of equity and the pretax cost of debt to estimate the cost of capital.

Q: A firm has 1,200,000 shares of stock outstanding with a price per share equal to $14. There are 10,000 bonds outstanding, priced at $1,125 each. The cost of equity is 14 percent, the cost of debt is 8 percent, and the corporate tax rate is 40 percent. What is the WACC? a) 10.3 percent. b) 10.8 percent. c) 9.8 percent. d) 8.8 percent.

Q: A firm has a target debt-to-equity ratio of 3. Its cost of equity equals 12 percent, its cost of debt is 9 percent, and the tax rate is 34 percent. What is the WACC? a) 7.46 percent. b) 8.97 percent. d) 10.00 percent. d) 10.49 percent.

Q: A firm has a target debt-to-equity ratio of Its cost of equity equals 12 percent, the cost of debt is 8 percent, and the tax rate is 30 percent. What is the weighted average cost of capital (WACC)? a) 10.0 percent. b) 10.8 percent. c) 9.8 percent. d) 8.8 percent.

Q: Describe the best estimate to use for a company’s growth rate in the steady state and why it is the best.

Q: Using today’s P/E multiples to estimate continuing value is recommended.

Q: As a good general rule, analysts should make the competitive advantage period the explicit forecast period.

Q: In making forecasts to estimate the value of a company, at the point where competition has eliminated abnormal returns, then it is appropriate to set RONIC equal to WACC.

Q: In the continuing-value formula for a company, NOPLAT should reflect an average level associated with the midpoint of the business cycle.

Q: In the continuing-value formula for a company, the growth rate g should be based on long-term real interest rates.

Q: Increasing competition is likely to lower the return on new invested capital below the return on total invested capital.

Q: As a firm begins to grow and faces increasing competition as it expands, which of the following are the most likely relationships among ROIC on base capital, RONIC, and ROIC on total capital? a) ROIC on base capital < RONIC < ROIC on total capital. b) ROIC on base capital > RONIC > ROIC on total capital. c) ROIC on base capital > ROIC on total capital > RONIC. d) ROIC on base capital < ROIC on total capital < RONIC.

Q: If NOPLATt+1 = $200, g = 4%, RONIC = 10%, WACC = 8%, then continuing value in year t is closest to: a) $667 b) $1,333 c) $3,000 d) $5,000

Q: Which of the following are common pitfalls or mistakes in estimating continuing value? I. Naive base-year extrapolation. II. Naive overconservatism. III. Purposeful overconservatism. IV. Liquidation value overconservatism. a) I and II only. b) I, II, and III only. c) II, III, and IV only. d) III and IV only.

Q: The value of a company’s operations equals the sum of all of the following EXCEPT: a) Invested capital. b) The market value of nonoperating assets. c) The present value of economic profit from continuing value. d) The present value of economic profit of the explicit forecast period.

Q: Given the following inputs, compute the continuing value (CV) at time t in the economic-profit model. At time t invested capital equals $2,000 and ROIC equals 12 percent. The forecast for NOPLATt+1 is $240. The growth rate equals 2 percent, RONIC is 10 percent, and the WACC is 7 percent. The continuing value at time t is closest to: a) $1,840.0 b) $1,428.6 c) $822.8 d) $414

Q: Changing the dividend payout ratio will change the value of the firm and the firm’s equity.

Q: Which of the following is the preferred method to forecast the financing items on the balance sheet? a) Assume that debt and equity are constant. Sum all forecasted assets except excess cash, and all liabilities and existing debt and equity. Plug the model using newly issued debt or excess cash. b) Financing items should be forecasted first, taking into consideration the future funding needs of the company. Correspondingly, the assets that the raised capital will fund should then be adjusted. c) Assume that all liabilities and equity will grow at the same rate as revenue growth. d) Assume that debt and equity will grow at the same constant rate in all years going forward.

Q: Which is the recommended way to forecast items such as inventory and accounts payable? a) Inventory and accounts payable should be forecasted based on revenues, since most other working capital items are forecasted based on revenues. b) Inventory and accounts payable should be forecasted based on COGS, because these items are more correlated with input prices than with output prices. c) Inventory and accounts payable should be the plug once total operating assets and operating liabilities have been forecasted. d) Inventory and accounts payable should be forecasted based on total assets, as these tend to scale together.

Q: Which of the following is the recommended approach to forecast COGS, and why? a) Forecast COGS based on revenue growth, since it provides flexibility in the model. b) Forecasting COGS based on the forecast ratio of COGS to sales allows for possible improvements in COGS relative to sales. c) Forecast COGS based on revenue growth since COGS and revenues have a direct relationship. d) Forecasting COGS based on inventory is recommended because inventory prices and COGS are correlated.

Q: In industries where prices are changing or technology is advancing, forecasters should: a) Use only financial drivers such as revenue. b) Use only nonfinancial drivers such as productivity and volume. c) Use both financial and nonfinancial drivers. d) Use national real aggregates such as real GDP.

Q: Which of the following is the best estimate of retained earnings in year t? a) Retained earningsT+1 + Net incomeT–1 – DividendsT–1 b) Retained earningsT + Net incomeT+1 – DividendsT–1 c) Retained earningsT–1 + Net incomeT – DividendsT d) Retained earningsT + Net incomeT + DividendsT

Q: To forecast the balance sheet, it is best to first forecast invested capital and nonoperating assets and then forecast excess cash and sources of financing separately.

Q: Complete the following table by entering the typical forecast driver in the third column and the typical forecast ratio in the last column. Typical Forecast Drivers for the Income Statement Line item Typical forecast driver Typical forecast ratio Operating Cost of goods sold (COGS) Selling, general, and administrative expense (SG&A) Depreciation Nonoperating Interest expense Interest income

Q: The recommended approach for forecasting cash flows of a parent company arising from investments in subsidiaries where the parent owns less than 20 percent of the subsidiary is to use the relationship between income from these subsidiaries and overall firm revenues.

Q: The recommended method to forecast taxes is as a percentage of earnings before taxes.

Q: When using PP&E as the forecast driver for depreciation, which of the following is most accurate? a) From both an ideal and a practical standpoint, the driver should be net PP&E. b) From both an ideal and a practical standpoint, the driver should be gross PP&E. c) Ideally, the driver should be net PP&E, but practically the driver should be gross PP&E. d) Ideally, the driver should be gross PP&E, but practically the driver should be net PP&E.

Q: In forecasting the income statement, it is recommended to tie all items directly to revenue.

Q: If a company forecasts that its capital expenditures will be smooth, then in forecasting depreciation, it is better to use the percentage of revenues approach than the percentage of property, plant, and equipment (PP&E) approach.

Q: Large Corporation owns less than 20 percent of Small Corporation. Which of the following are true? I. Large Corp. records asset sales of Small Corp. II. The investment in Small Corp. is marked to market. III. Large Corp. records dividends received from Small Corp. IV. In forecasting entries for Small Corp., Large Corp. should use a traditional driver like cash flows. 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 are true concerning forecasting interest income? I. It is a nonoperating measure. II. Its typical forecast driver is revenue. III. It is typically the same from year to year for firms that generate high cash flow. IV. The typical forecast ratio is interest income in the current period divided by excess cash in the previous period. a) I and II only. b) I and IV only. c) II and III only. d) III and IV only.

Q: List the three steps in making a top-down forecast of revenue and the three inputs for making a bottom-up forecast of revenue.

Q: The top-down approach cannot be applied to companies in mature industries.

Q: The explicit forecast period must be long enough for the company to reach a steady state. List the two characteristics that define that steady state.

Q: A bottom-up approach for forecasting revenues relies on projections of customer demand.

Q: Which of the following are steps in making a top-down forecast? I. Forecasting prices. II. Sizing the total market. III. Determining market share. IV. Estimating customer turnover. a) I and II only. b) I, II, and III only. c) II, III, and IV only. d) III and IV only.

Q: It is recommended in the financial modeling process to collect raw data on a separate worksheet and record the data as originally reported.

Q: Which of the following is the best recommendation for forecasting performance? a) Use an explicit forecast period of two to five years and longer for cyclical companies or those experiencing very rapid growth. b) Use an explicit forecast period of two to five years and shorter for cyclical companies or those experiencing very rapid growth. c) Use an explicit forecast period of 10 to 15 years and longer for cyclical companies or those experiencing very rapid growth. d) Use an explicit forecast period of 10 to 15 years and shorter for cyclical companies or those experiencing very rapid growth.

Q: The explicit forecast period must be long enough for the company to reach a steady state. Which of the following is NOT a desirable property of that steady state? a) The growth rate rises above the required return on capital. b) The company earns a constant rate of return on existing capital. c) The company earns a constant rate of return on new capital invested. d) The company reinvests a constant proportion of its operating profits into the business each year.

Q: An analysis of a company’s historical financial performance should go back a maximum of five years.

Q: Given that ROIC, the interest rate on debt, and the debt-to-equity ratio are constant, how will increasing the tax rate affect ROE? a) Decrease it. b) Not affect it. c) Increase it. d) There is no set relationship.

Q: For a given company, the return on invested capital (ROIC) is 13.5 percent, the tax rate is 34 percent, and the pretax cost of debt is 8.8 percent. If its debt-to-equity ratio is equal to 2.0, what is the return on equity (ROE)? a) 16.30 percent. b) 17.80 percent. c) 28.88 percent. d) 25.30 percent.

Q: Use the following data to answer the question: What are the three interest coverage ratios based on pretax income and interest expense? 2015 2016 Current assets $860 $896 Current liabilities 710 818 Debt in current liabilities 1 39 Long-term debt 506 408 Total assets 2,293 2,307 Capital expenditures 111 117 Change in deferred taxes –29 –20 Sales 4,100 4,200 Operating expenses 3,307 3,260 Rental expense 0 248 General expenses 562 528 Depreciation 139 136 Interest expense 39 30 Income taxes 5 8 a) For 2016, interest coverage ratios based on EBIT, EBITDA, and EBITDAR are 5.47, 5.47, and 1.48, respectively. b) For 2016, interest coverage ratios based on EBIT, EBITDA, and EBITDAR are 2.36, 5.92, and 13.73, respectively. c) For 2016, interest coverage ratios based on EBIT, EBITDA, and EBITDAR are 0.93, 5.47, and 1.48, respectively. d) For 2016, interest coverage ratios based on EBIT, EBITDA, and EBITDAR are 0.93, 5.47, and 13.73, respectively.

Q: With regard to the interest coverage ratio, which of the following is the most accurate? a) If near-term bankruptcy is an issue, EBITDA can be used to measure survival only over the short term. b) EBITDA should be used to measure survival over both the short and the long term. c) EBITA should be used to measure survival only in the short term (vs. long term). d) None of the above are true.

Q: By using the debt-to-EBITDA ratio, one can build a more comprehensive picture of the risk of leverage.

Q: The company’s ability to meet short-term obligations is measured with ratios that incorporate three measures of earnings. Which of the following is NOT one of those measures of earnings? a) Earnings before interest, taxes, and amortization (EBITA). b) Earnings before interest, taxes, depreciation, and amortization (EBITDA). c) Earnings before interest, taxes, amortization, and preferred dividends (EBITAD). d) Earnings before interest, taxes, depreciation, amortization, and rental expense (EBITDAR).

Q: Leverage measures the company’s ability to meet obligations over the long term.

Q: Liquidity measures the company’s ability to meet obligations over the short term.

Q: Assuming that both the acquiring and target firms have fiscal years ending on December 31, if the target is acquired on December 1, 2015, which of the following is the most accurate? a) Revenues of the target would be consolidated from 2016 onward. b) Revenues of the target would be consolidated 100 percent for 20 c) Revenues of the target would be consolidated post-acquisition—that is, one month of revenues of the target for 20 d) No consolidation of revenues will happen.

Q: In order to get a more accurate forecast of revenue growth, an analyst should remove the effects of which of the following? I. Deferred taxes. II. Changes in currency values. III. Mergers and acquisitions. IV. Changes in accounting policies. a) I and II only. b) I and III only. c) III and IV only. d) II, III, and IV only.

Q: 2015 2016 Current assets $860 $896 Current liabilities 710 818 Debt in current liabilities 1 39 Long-term debt 506 408 Total assets 2,293 2,307 Capital expenditures 111 117 Change in deferred taxes –29 –20 Sales 4,100 4,192 Operating expenses 3,307 3,260 Rental expense 0 248 General expenses 562 528 Depreciation 139 136 Interest expense 39 30 Income taxes 5 8 Using the preceding table, if receivables, inventories, and other current assets are $520 in 2015, then what is the number of days in cash? a) 28 days. b) 29 days. c) 30 days. d) 31 days.

Q: Which of the following is the best method of determining whether the financial performance between competitors is sustainable? a) Linking operating drivers directly to return on capital. b) Comparing the respective ROE and ROA measures. c) Breaking ROE down into ROIC, tax, interest rate, and leverage effects. d) Distinguishing between pretax ROIC and the operating-cash tax rate.

Q: A company’s ROIC is driven by its ability to maximize profitability (EBITA divided by revenues or the operating margin), optimize capital turnover (measured by revenues over invested capital), or minimize operating taxes.

Q: ROIC excluding goodwill is useful when measuring underlying operating performance of the company and its businesses, and it is useful for comparing performance against peers and to analyze trends.

Q: An analyst would include goodwill in invested capital when measuring aggregate value creation for a company’s shareholders.

Q: You are an equity analyst and have computed the following figures for two cement companies. The first, CementCo, has NOPLAT of $1,550 million, invested capital without goodwill of $15,000 million, and goodwill of $1,950 million. The second, CementExports, has NOPLAT of $1,750 million, invested capital without goodwill of $16,000 million, and no goodwill. If the cost of capital for both firms is 10 percent, what is the ROIC for each company? Which company is creating value in this year? a) ROIC excluding goodwill is 10.3 percent for CementCo and 10.9 percent for CementExports; both companies are creating value. b) ROIC including goodwill is 9.1 percent for CementCo and 10.9 percent for CementExports; both companies are creating value. c) ROIC including goodwill is 9.1 percent for CementCo and 10.9 percent for CementExports; only CementExports is creating value. d) ROIC including goodwill is 9.1 percent for CementCo and 10.9 percent for CementExports; neither of the companies is creating value.

Q: Compute ROIC given the following information: EBITA = $800, revenues = $2,200, invested capital = $4,000, operating cash tax rate = 34%. a) 6.8 percent. b) 12 percent. c) 24.0 percent. d) 36.3 percent.

Q: With respect to the performance measures return on invested capital (ROIC), return on equity (ROE), and return on assets (ROA), which of the following is most accurate concerning the relative superiority of the three as analytical tools for understanding a company’s performance? a) ROE is better than ROA, which is better than ROIC. b) ROA is better than ROIC, which is better than ROE. c) ROIC is better than ROA, which is better than ROE. d) ROE is better than ROIC, which is better than ROA.

Q: What are Dolphin’s NOPLAT and ROIC for the current year, using average invested capital? a) $82, 13.6 percent. b) $108.9, 18.1 percent. c) $92, 15.4 percent. d) $85, 14.1 percent.

Q: What is the average invested capital (IC) for Dolphin for the current year? a) $609 b) $600 c) $667 d) $527

Q: Based on the above same table, what are the ROICs for Companiesy A, B, and C, respectively? a) 18 percent, 12 percent, 19 percent. b) 19 percent, 17 percent, 21 percent. c) 18 percent, 16 percent, 20 percent. d) 19 percent, 17 percent, 24 percent.

Q: Based on the above same table, what are the returns on equity (ROEs) for Companiesy A, B, and C, respectively? a) 15 percent, 14 percent, 31 percent. b) 19 percent, 15 percent, 36 percent. c) 17 percent, 15 percent, 35 percent. d) 21 percent, 9 percent, 45 percent.

Q: Based on the above preceding table, what are the returns on assets (ROAs) for Companiesy A, B, and C, respectively? a) 17 percent, 14 percent, 19 percent. b) 15 percent, 14 percent, 18 percent. c) 11 percent, 10 percent, 20 percent. d) 16 percent, 13 percent, 18 percent.

Q: List the three components into which an analyst should reorganize financial statements to better assess economic performance and three common traps that the analyst wants to avoid in the assessment.

Q: In computing return on invested capital, operating liabilities should be subtracted from operating assets to determine invested capital.

Q: In computing free cash flow, include investments in capitalized operating leases in gross investment.

Q: Pension assets are considered an operating asset and part of invested capital.

Q: Nonconsolidated subsidiaries and equity investments should be measured and valued separately from invested capital.

Q: In order to adjust for currency fluctuations, one should conduct a line-by-line removal of the currency effects.

Q: Which of the following are sources of financing? I. Equity equivalents. II. Debt equivalents. III. Hybrid securities. IV. Noncontrolling interest. a) I and II only. b) I, II, and III only. c) III and IV only. d) I, II, III, and IV.

Q: How will an increase in invested capital (IC) in a given year affect free cash flow (FCF) and ROIC if all other things are kept equal? a) It will decrease both FCF and ROIC. b) It will increase both FCF and ROIC. c) It will increase FCF but decrease ROIC. d) It will decrease FCF but increase ROIC.