Deck 6: The Role of Financial Information in Valuation and Credit Risk Assessment

Question 1

One popular approach used to estimate a firm's equity cost of capital is the capital asset pricing model,which expresses the equity cost of capital as the sum of the return on a riskless asset plus an equity risk premium multiplied by the company's systematic risk.

Answer 1

True

Question 2

Business valuation involves estimating the intrinsic value of a company,or one of its operating units.

Answer 2

True

Question 3

The FASB believes that the most useful predictor of future cash flows is accrual accounting earnings.

Answer 3

True

Question 4

The amount available to finance planned expansion of operating capacity,reduce debt,pay dividends,or repurchase stock is distributable (or free)cash flow.

Question 5

When determining the discount rate to apply to a firm's expected future cash flows,analysts should select a rate that reflects the risk (or uncertainty)associated with these cash flows.

Question 6

Pro forma financial statements of a business,prepared by a credit analyst,would include constructing worst-case scenarios that incorporate alternative assumptions about sales,costs,competitor behavior,etc.

Question 7

Accrual accounting produces an earnings number that smoothes out the unevenness in year-to-year cash flows,and provides an estimate of sustainable annualized long-run future free cash flows.

Question 8

The details of free cash flow valuation are important only for stock analysts and investors.

Question 9

In applying the discounted free cash flow valuation model,the discount rate used is the average cost of capital.

Question 10

The "free cash flow valuation approach" expresses current stock price as the discounted present value of expected future distributable cash flows.

Question 11

Cash flow assessment plays a central role in analyzing the credit risk of a company.

Question 12

Operating cash flow minus cash outlays to replace existing operating capacity is free cash flow.

Question 13

Lenders compare their cash flow projections for a company to the firm's future dividend commitment as stated in the firm's dividend policy.

Question 14

A simplified version of the discounted free cash flow valuation model assumes a zero-growth perpetuity for future cash flows.This assumption is best applied to growth companies with stable cash flow patterns.

Question 15

The cost of capital,expressed in dollars,reflects the level of earnings investors demand from the company as compensation for the risks of investment.

Question 16

Earnings are a proxy-imperfect but the best we have-for free cash flow.

Question 17

Fundamental valuation uses basic accounting measures to assess the amount,timing,and uncertainty of a firm's future operating cash flows or earnings.

Question 18

Stock valuation involves estimating the worth of a company,one of its operating units,or its ownership shares.

Question 19

If a company is currently generating a free cash flow of $10 per share,which is expected to continue indefinitely,and if the discount rate is 10%,the estimated share price would be $100.

Question 20

In theory,the abnormal earnings approach and the free cash flow approach never produce the same valuation estimate.

Question 21

Return on assets (ROA)can be used to assess whether a firm is likely to earn a return on reinvested earnings that exceeds its cost of equity capital.

Question 22

Riskier firms have a lower risk-adjusted cost of capital resulting in lower share prices for those companies.

Question 23

In addition to valuing earnings generated from existing assets,the market values growth opportunities.

Question 24

The growth rate in earnings generally depends on the earnings retention rate and the rate of return earned on new investment.

Question 25

Income (or loss)from discontinued operations is viewed as a transitory component of earnings.

Question 26

A component that is valuation-relevant and expected to persist into the future is a permanent earnings component.

Question 27

As transitory components become a more important part of a firm's reported earnings,the reported earnings are more quality-enhanced.

Question 28

Based on a number of research studies,current earnings explain virtually 100% of the variation in current stock prices between companies.

Question 29

Using simplifying assumptions,the current stock price estimate can be expressed as a capitalization rate (1 × r)multiplied by a perpetuity equal to current earnings.

Question 30

A component that is unrelated to future free cash flows or future earnings and is not pertinent to assessing current share price is a noise component.

Question 31

Firms that earn less than the cost of equity capital have a share price below book value.

Question 32

Analysts combine information about the company's current earnings,its business strategy,and the industry's competitive dynamics to forecast future free cash flows.

Question 33

If a firm can earn a return on net assets (common equity book value)that exceeds its cost of equity capital,it will generate positive abnormal earnings.

Question 34

The value of the future growth opportunities of a firm can be determined considering the firm's potential earnings from reinvesting current earnings in new projects that will eventually earn a rate of return in excess of the cost of equity capital.

Question 35

The two most significant explanations for variations in the earnings multiple are risk differences and maturity of the firm.

Question 36

Research shows that stock returns correlate better with accrual earnings than with realized operating cash flows.

Question 37

Companies with ROEs that consistently exceed the industry average generally will have shares that sell for book value.

Question 38

Extraordinary gains and losses are regarded as value-irrelevant earnings.

Question 39

Earnings are considered high quality when they are reliable.

Question 40

A transitory earnings component is unrelated to future free cash flows or future earnings and,therefore,is not pertinent to assessing current share price.

Question 41

If securities markets are rational and efficient in the sense that they fully and correctly impound all available information into a company's stock price,then the price will reflect investors' unbiased expectations about the company's future earnings and cash flows.

Question 42

A term lending agreement has an original maturity of more than 1 year with maturities ranging from two to five years being the most common.

Question 43

GAAP defines fair value as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."

Question 44

Much of the information needed for assessing the quality and value-relevance of a company's reported accounting numbers cannot be found in the company's Form 10-K.

Question 45

Earnings are deemed to be of high quality when they are sustainable;earnings quality is also affected by management's choice of accounting methods.

Question 46

Companies that report bad news earnings surprises tend to have an upward drift in stock returns before the actual earnings announcement date followed by a sharp decrease in stock returns at the announcement date.

Question 47

Stock prices only move up or down when financial reports are released and used by investors to update their expectations about the company's future earnings and cash flows.

Question 48

"Unbiased" means that,on average,the market's earnings expectations will be correct.

Question 49

There is more than one possible approach to measuring fair value.

Question 50

Companies that report good news earnings surprises tend to have an upward drift in stock returns before the actual earnings announcement date followed by an increase in stock returns at the announcement date.

Question 51

Fair value of an asset must reflect its "highest and best use" by others and not how it is used by the company.

Question 52

The degree of conservatism associated with a firm's accounting choices will have a direct bearing on the relationship among share price,earnings,and the firm's equity book value.

Question 53

Today's GAAP balance sheet contains a mixture of historical cost and other measurements to include fair value measurements.

Question 54

Critics of mark-to-model fair value accounting claim that it is a license for management to invent the financial statements to be whatever they want them to be.

Question 55

Firms must disclose at each reporting date the hierarchy level at which the fair values were determined.

Question 56

An earnings surprise results from incorrect estimates of future earnings.

Question 57

For accounting purposes,"fair value" is an entry price,not an exit price.

Question 58

Companies that report good news earnings tend to have an upward drift in stock returns before the actual earnings announcement date.

Question 59

The IASB and FASB are working on a joint convergence project on fair value measurement and disclosure and are in general agreement on what fair value means and how to measure it.

Question 60

Under the GAAP hierarchy that prioritizes the information used to arrive at fair value,Level 3 uses quoted prices from active markets for identical assets or liabilities to determine fair value.

Question 61

The fundamental valuation approach to business valuation uses basic accounting measures to assess the amount,timing,and

A)certainty of a company's past operating cash flows or earnings.
B)certainty of a company's future non-operating cash flows or earnings.
C)uncertainty of a company's future operating cash flows or earnings.
D)uncertainty of a company's future non-operating cash flows or earnings.

Question 62

An estimate of the company's future financial condition is indispensable to most lending decisions.

Question 63

There is no need for an analyst to develop plausible predictions about future economic conditions in the target company's industry as these are readily available from the U.S.Commerce Department.

Question 64

The written agreement between the borrowing company and its creditors is referred to as the indenture.

Question 65

The starting point for developing comprehensive financial statement forecasts is a detailed understanding of the company,its recent financial performance,and health.

Question 66

A comprehensive risk analysis involves evaluating and summarizing the various individual risks associated with a loan.

Question 67

Greater default risk is believed to exist when there is significant organizational reliance on an individual,especially one who may be nearing retirement.

Question 68

A lender is protected against anticipated credit risks by the loan's covenant provisions as interest rates are fixed by the Federal Reserve Bank.

Question 69

A more streamlined approach to credit analysis than costly scrutiny of financial statement details,ratios,etc.is to rely on credit reports issued by third-parties.

Question 70

Commercial paper consists of short-term notes sold directly to investors by large and financially sound companies.

Question 71

High-quality financial statements help credit analysts see what is really going on at a company;low-quality statements mask true performance and financial condition.

Question 72

Certain financial statement ratios are quite useful in predicting loan default.

Question 73

In the U.S.,there are a large number of companies that assess and grade the credit-worthiness of companies and public entities that sell debt to investors by issuing letter-based grades that express the rating agency's opinion about default risk.

Question 74

Seasonal lines of credit are used by companies with seasonal sales cycles and provide the cash needed to support increases in current assets during the peak selling period.

Question 75

Credit risk is unaffected by aggressive application of accounting standards as cash flows are unaffected by financial reporting choices.

Question 76

Preparing comprehensive financial statement forecasts involves six steps,the first one being to forecast depreciation expense and tax expense each period.

Question 77

A bond that has collateral to protect the bondholder is referred to as a debenture bond.

Question 78

Lenders form opinions about a company's credit risk by comparing current and future debt-service requirements to estimates of the company's current and expected future cash flows.

Question 79

While analysts may forecast only a single financial statement item,such forecasts may prove highly unreliable.

Question 80

Creditors are primarily concerned with determining the value of a firm's shares.