Question 1

Fristy Corporation has a book value of equity of $5,000 at the beginning of 2005, and net income of $1,000 for year ended 2005. It pays no dividends and its cost of equity capital is 10%. It expects return on beginning of year equity to remain constant for 2006 and 2007 and decrease to 10% thereafter. What should its price to book value be at the end of 2005 (pick closest number)?

Accepted Answer

D

Question 2

A profitable high-tech company would generally have

Accepted Answer

High-tech companies often have high growth potential, leading to high price/book and price/earnings ratios as investors are willing to pay a premium for future growth.

Question 3

ABC Corporation and DEF Corporation operate in the same industry. ABC has a P/E ratio that is 50% higher than DEF Corporation. Which of the following account for some of the difference in the observed P/E ratios?
I. ABC uses more conservative accounting principles
II. ABC has a higher cost of equity capital
III. ABC has higher expected future growth
IV. DEF uses FIFO and ABC uses LIFO

Accepted Answer

B

Question 4

If a company has a 100% dividend payout ratio and expected growth in earnings is zero. Cost of capital is 9%. Its P/E ratio would be expected to be:

Accepted Answer

The answer of If a company has a 100% dividend...

Question 5

Which of the following would not be considered a component of business risk?

Accepted Answer

Financial leverage is related to financial risk, not business risk, which involves operational aspects like demand variability, input costs, and regulatory changes.

Question 6

Which of the following statements concerning quality of earnings is correct?

Accepted Answer

The answer of Which of the following statements concerning quality...

Question 7

When considering the determinants of the price to book value ratio (P/BV) which of the following statements are correct?
I. The greater a company's return on common stockholders' equity the greater the P/BV ratio, all other things being equal
II. The greater a company's cost of equity the greater the P/BV ratio, all other things being equal
III. The greater a company's return on common stockholders' equity equals a company's cost of equity the P/BV ratio should equal 1.0
IV. The greater a company's current earnings the higher the P/BV ratio

Accepted Answer

I is correct, as a higher return on common stockholders' equity would indicate a more profitable company and therefore, a higher P/BV ratio.

II is incorrect, as a higher cost of equity would imply a lower valuation and ultimately, a lower P/BV ratio.

III is correct, as if a company's return on common stockholders' equity equals a company's cost of equity, then the P/BV ratio should be 1.0, indicating that the market is valuing the company based on its book value.

IV is incorrect, as the price is not directly correlated to the current earnings in the P/BV ratio calculation.

Question 8

Which of the following is not a form of earnings management?

Accepted Answer

Reporting fictitious transactions is not a form of earnings management; it is considered fraudulent accounting. Earnings management involves legal yet potentially misleading accounting methods to present financial statements in a more favorable light, without crossing into the realm of outright fraud.

Question 9

Which of the following should be attempted in order to gauge the quality of a company's earnings?
I. Assess adequacy of discretionary expenditures
II. Assessing degree of conservatism in reporting assets
III. Assessing degree of conservatism in reporting liabilities
IV. Assessing degree of conservatism in application of accounting principles

Accepted Answer

All the listed actions help in evaluating the quality of a company's earnings by examining how conservative or aggressive the company's accounting practices are, which can affect the reliability and sustainability of reported earnings.

Question 10

Alexas Corporation reports the following:
 $\begin{array}{|l|l|}
\hline
&\mathbf{2 0 0 5}\
\hline \text { Earnings per share } & \$ 1.80 \
\hline \text { Dividends per share } &  \$ 0.72\
\hline \text { Book Value per share-end of year } &  \$8.62\
\hline
\end{array}$
-If Price to book value at the end of 2005 equals 1.00, and return on beginning of year equity is expected to remain constant, then cost of equity (to nearest percent) equals:

Accepted Answer

Price to book value = Price per share / Book value per share
Given Price to book value = 1
Therefore, Price per share = Book value per share = $8.62
Given Dividend per share = $0.72
Therefore, Retention ratio = (Earnings per share - Dividend per share) / Earnings per share
Retention ratio = (1.80 - 0.72) / 1.80 = 0.6
Return on equity = Retention ratio x Return on equity + (1 - Retention ratio) x Return on assets
Assuming return on assets to be constant and equal to return on equity,
Return on equity = 0.6 x Return on equity + 0.4 x Return on equity
Return on equity = 24%
Cost of equity = Return on equity
Cost of equity = 24% (to the nearest percent)

Question 11

A growing company with disappointing profitability would generally have

Accepted Answer

A growing company with disappointing profitability would likely have a low price/book ratio due to undervaluation and a high price/earnings ratio due to low earnings relative to its price.

Question 12

Which of the following is not a typical form of earnings management?

Accepted Answer

Changing auditors is not a form of earnings management, as it does not involve any manipulation of financial statements. The other options - changing accounting estimates, offsetting one-time gains and losses, and changing accounting principles - are all common forms of earnings management.

Question 13

You are analyzing a stock. You expect that earnings will grow quickly relative to their current level, but the expected return on common stockholders' equity is low. What levels of the price earnings ratio (P/E) and price to book value ratio (P/BV) would you expect to see (relative to industry average)? $$\begin{array} { | c | c | c | } 
\hline & \text { P/E Ratio } & \text { P/BV Ratio } \
\hline \text { A) } & \text { Low } & \text { Low } \
\hline \text { B) } & \text { Low } & \text { High } \
\hline \text { C) } & \text { High } & \text { High } \
\hline \text { D) } & \text { High } & \text { Low } \
\hline
\end{array}$$

Accepted Answer

A high P/E ratio is expected due to the anticipated high earnings growth, while a low P/BV ratio is expected due to the low return on equity.

Question 14

Which of the following is not a factor in producing earnings forecasts?

Accepted Answer

Estimating the level of earnings is a direct part of producing earnings forecasts, whereas recognizing potential earnings management and income smoothing are considerations in analyzing the quality of earnings, not in the initial estimation process.

Question 15

Which of the following is not included the definition of earnings persistence?

Accepted Answer

Magnitude of earnings is not included in the definition of earnings persistence. Earnings persistence refers to the ability of a company to generate consistent and predictable earnings over time, and this is measured through factors such as stability, predictability, and trend. Magnitude, on the other hand, refers to the dollar amount of earnings, which is not necessarily an indicator of persistence.

Question 16

Pitfalls when forecasting earnings include failure to consider
I. capital adequacy
II. capacity constraints
III. anticipated return on equity
IV. new management

Accepted Answer

Failure to consider capital adequacy, capacity constraints, and anticipated return on equity can all affect earnings forecasts. While new management can also be a factor, it is not necessarily always a pitfall and therefore not included in the best choice of answer.

Question 17

Which of the following can affect earnings quality?
I. Management's choice of accounting principle
II. Management's choice of dividend policy
III. Management's estimates
IV. Management's discretionary expenditures

Accepted Answer

Management's choice of accounting principle, estimates, and discretionary expenditures all have the potential to affect earnings quality. Dividend policy, while important in determining shareholder returns, does not directly impact earnings quality.

Question 18

Which of the following factors is least likely to affect earnings persistence?

Accepted Answer

Usual operating costs are ongoing expenses that are incurred in the normal course of business and are not expected to significantly fluctuate from year to year. Thus, they are less likely to impact earnings persistence compared to other factors such as changing price levels, extraordinary items, and accounting methods used.

Question 19

When assessing earnings persistence it is important to analyze discretionary expenditures. Which of the following statements are correct?
I. Research and Development is generally considered a discretionary expenditure
II. Decreased discretionary expenditures should always be taken as a positive indicator that the company is getting costs under control
III. Advertising expenditures can be considered discretionary expenditures, which often have implications for future sales
IV. Absolute levels of discretionary expenditures are more important than the level of expenditures relative to sales

Accepted Answer

Research and Development and Advertising expenditures are generally considered discretionary and can impact future performance. Decreased discretionary spending is not always positive, as it might indicate underinvestment in future growth. Relative levels of expenditures to sales are often more insightful than absolute levels.

Question 20

A profitable mature company would generally have

Accepted Answer

The answer of A profitable mature company would generally have
...

Quiz 11: Equity Analysis and Valuation