Question 1

As of December 31, 2005, two otherwise identical companies in the same industry, East Company and West Company, have dividend payouts of 20% and 40%, respectively. Looking forward one year, which outcomes are least likely?

I. East Company requires debt financing.
II. West Company increases its dividend payout.
III. West Company's share price is twice that of East Company.
IV. East Company repurchases outstanding shares.

Accepted Answer

If East Company continues to pay out 20% dividends and West Company pays out 40%, it is unlikely that West Company's share price will be twice that of East Company. This is because dividend payouts affect share prices, and if West Company increases its dividend payout, its share price may increase, but not necessarily to twice the value of East Company's share price. Additionally, if East Company wishes to raise funds for growth, it may require debt financing, and if West Company continues to increase its dividend payout, it may not have the funds available for share repurchases. Therefore, the least likely outcomes are I, II, and III, making choice C the best choice.

Question 2

Financial statement analysis is an exact science.

Accepted Answer

Financial statement analysis involves interpretation and judgment, which can be subjective and not always exact. While there are standardized methods and ratios used in analysis, different analysts may come to different conclusions based on their interpretation of the data.

Question 3

Which of the following statements is incorrect?

Accepted Answer

Equity investors, unlike debt holders, have limited liability, meaning their downside risk in the event of a company's bankruptcy is limited to the amount of their investment in the company's stock. They do not have unlimited downside exposure, as their personal assets are not at risk.

Question 4

The explanatory notes (footnotes) accompanying the financial statements are generally of little value in aiding a financial analyst when interpreting the financial statements.

Accepted Answer

Explanatory notes, also known as footnotes, provide important information and details that help in analyzing the financial statements. These notes can provide information about the company's accounting policies, significant events, and their impact on financial statements, contingencies, and risks. Ignoring these notes can lead to incomplete and inaccurate analysis.

Question 5

The value of a bond is equal to the sum of the present value of future expected interest and principal payments, discounted at the coupon rate.

Accepted Answer

The value of a bond is equal to the sum of the present value of future expected interest and principal payments, but these are discounted at the market rate of interest (or yield to maturity), not the coupon rate.

Question 6

In a common-size balance sheet, total assets are expressed as 100 percent.

Accepted Answer

In a common-size balance sheet, all items are expressed as a percentage of total assets, which is typically set at 100 percent. Therefore, total assets are always expressed as 100 percent in a common-size balance sheet.

Question 7

Theoretically, the value of a stock should equal the sum of the present value of future expected dividends, discounted at the cost of equity.

Accepted Answer

This is known as the dividend discount model, a widely used valuation method in finance. It assumes that the value of a stock is primarily determined by the expected future cash flows in the form of dividends.

Question 8

Which of the following, if increased by 10%, results in a lower stock price?

Accepted Answer

An increase in dividend payout means the company is distributing more of its profits to shareholders, which could signify a decrease in funds available for reinvestment and potential growth. This could lead to a decrease in demand for the stock and ultimately a lower stock price.

Question 9

The statement of cash flows is separated into four parts: operating, investing, financing, and planning.

Accepted Answer

The statement of cash flows is divided into three parts: operating, investing, and financing activities. There is no planning section.

Question 10

Common-size statements are useful for intercompany comparisons.

Accepted Answer

Common-size statements express financial data as a percentage of a common base which makes it easier to compare companies of different sizes and industries.

Question 11

You wish to compare the performance of two companies. Which of the following statements is most likely to be incorrect?

Accepted Answer

Different auditors do not inherently hinder comparability between companies, as auditors are required to adhere to the same auditing standards. The key factors affecting comparability are operational, financial, and accounting differences, not who performs the audit.

Question 12

A company issues 12%, 10-year $1,000 bonds paying interest semiannually. Required return for bonds of this risk is 15%. At what price will the bond be sold (pick closest answer)?

Accepted Answer

First, we need to calculate the semi-annual coupon payment:
Coupon payment = 12% * $1,000 / 2 = $60
Next, we need to calculate the present value of the bond using the following formula:
PV = (C / (1+r)^1) + (C / (1+r)^2) + ... + (C + Par / (1+r)^n)
where:
C = coupon payment = $60
r = required semi-annual rate = 15% / 2 = 7.5%
n = number of semi-annual periods = 10 years * 2 = 20
Par = face value of the bond = $1,000
Using a financial calculator or Excel, we can find that the present value of the bond is $847. Therefore, the closest answer is C) $847.

Question 13

Which of the following is not an equity valuation model?

Accepted Answer

The payback period model is not an equity valuation model. It is a capital budgeting technique used to determine the length of time required to recoup the cost of an investment. The other options, residual income model, dividend discount model, and free cash flow to equity model, are all commonly used equity valuation models.

Question 14

$$\begin{array}{l}
\text { Rivaz Corporation }\
\begin{array} { l r } 
& 2005 \
\text { Net Income } & \$ 3,000 \
\text { Dividends } & \$ 1,000 \
\text { Total Assets } - 12 / 31 / 05 & \$ 35,000 \
\text { Total Liabilities } - 12 / 31 / 05 & \$ 21,225 \
\text { Number of shares outstanding } & 1,000 \
\text { Cost of Equity } & 12 \%
\end{array}
\end{array}$$
-Assuming total assets grew by $5,000 from 2004 to 2005, what is the return on assets of Rivaz Corporation for 2005?

Accepted Answer

Return on Assets = Net Income / Average Total AssetsAverage Total Assets = (Total Assets 12/31/05 + Total Assets 12/31/04) / 2Total Assets 12/31/04 = Total Assets 12/31/05 - Growth in Total AssetsTotal Assets 12/31/04 = $35,000 - $5,000 = $30,000Average Total Assets = ($35,000 + $30,000) / 2 = $32,500Return on Assets = $3,000 / $32,500 = 9.23%

Question 15

Two popular techniques of comparative analysis are year-to-year change analysis and index-number trend analysis.

Accepted Answer

Year-to-year change analysis compares the data from one period to the same period in the previous year, while index-number trend analysis compares the relative changes in values over a given time period. Both techniques are commonly used in comparative analysis.

Question 16

$$\begin{array}{l}
\text { Rivaz Corporation }\
\begin{array} { l r } 
& 2005 \
\text { Net Income } & \$ 3,000 \
\text { Dividends } & \$ 1,000 \
\text { Total Assets } - 12 / 31 / 05 & \$ 35,000 \
\text { Total Liabilities } - 12 / 31 / 05 & \$ 21,225 \
\text { Number of shares outstanding } & 1,000 \
\text { Cost of Equity } & 12 \%
\end{array}
\end{array}$$
-Using the dividend discount model, assuming dividends grow at 10% per year for the next two years and at 5% thereafter, what is the value per share of Rivaz Corporation at 12/31/05?

Accepted Answer

The answer of \[\begin{array}{l}
\text { Rivaz Corporation }\
\begin{array} { l...

Question 17

In a common-size income statement, net income is expressed as 100 percent.

Accepted Answer

In a common-size income statement, each line item is expressed as a percentage of total sales or revenue, not net income.

Question 18

Details of compensation paid to officers and directors can be found in proxy statements.

Accepted Answer

Proxy statements typically provide information about compensation paid to officers and directors of a company.

Question 19

The SEC requires that Management Discussion and Analysis found in the annual report (10K) contains, among other things, a discussion about the company's liquidity, capital resources, and results of operations.

Accepted Answer

This is correct according to SEC regulations. The Management Discussion and Analysis section of a company's annual report is required to cover various topics, including liquidity, capital resources, and results of operations.

Question 20

$$\begin{array}{l}
\text { Rivaz Corporation }\
\begin{array} { l r } 
& 2005 \
\text { Net Income } & \$ 3,000 \
\text { Dividends } & \$ 1,000 \
\text { Total Assets } - 12 / 31 / 05 & \$ 35,000 \
\text { Total Liabilities } - 12 / 31 / 05 & \$ 21,225 \
\text { Number of shares outstanding } & 1,000 \
\text { Cost of Equity } & 12 \%
\end{array}
\end{array}$$
-Net income is expected to increase by 10% for the next year, and dividend payout ratio is expected to remain constant. After 2006, retained earnings are expected to decrease to zero. Using the residual income method what is the value per share of Rivaz stock as of 12/31/05?

Accepted Answer

The correct answer is A.The residual income method values a company based on the present value of its future residual income. Residual income is calculated as net income minus the cost of equity multiplied by the book value of equity. In this case, the net income is expected to increase by 10% for the next year, and the dividend payout ratio is expected to remain constant. After 2006, retained earnings are expected to decrease to zero. Therefore, the residual income for the next year will be $3,000 * (1 + 0.1) - $1,000 * 12% * $35,000 = $2,400. The present value of the residual income for the next year is $2,400 / (1 + 0.12) = $2,143. The value per share of Rivaz stock as of 12/31/05 is $2,143 / 1,000 = $2.14.

Quiz 1: Overview of Financial Statement Analysis