Question 1

Trading on the equity is likely to be a good financial strategy for stockholders of companies having:

Accepted Answer

Trading on the equity involves using a company's stock as collateral to obtain additional financing. It is a good financial strategy for stockholders of companies with steady amounts of reported earnings because it indicates consistent profitability and stability, which makes the company a lower risk investment. Companies with cyclically high and low amounts of reported earnings and volatile fluctuations in reported earnings over short periods of time are riskier investments and may not be ideal for trading on the equity. Companies with steadily declining amounts of reported earnings may indicate financial trouble and may not be suitable for trading on the equity.

Question 2

One problem with the price-earnings ratio commonly reported is that:

Accepted Answer

A

Question 3

Firms with low P/E ratios tend to have current residual income that is greater than:

Accepted Answer

Firms with low P/E ratios may indicate that the market is not valuing the company's future growth prospects as highly as its current earnings. Therefore, the current residual income is expected to generate future residual income that exceeds the current level. This makes option B the best choice.

Question 4

Under the value-to-book model new projects will be less profitable only when:

Accepted Answer

In the value-to-book model, the profitability of new projects is measured by the return on capital employed (ROCE), while the minimum required rate of return is represented by the cost of equity (R_E). Therefore, new projects will be less profitable only when ROCE is less than R_E.

Question 5

Wolverwine Company's current stock price is $55 per share and the company's trailing earnings per share were $2.10. Given that analysts are forecasting growth of 12% for Wolverwine, what is the company's PEG ratio?

Accepted Answer

PEG ratio = P/E ratio / annual earnings growth rate
P/E ratio = current stock price / trailing earnings per share = $55 / $2.10 = 26.19
annual earnings growth rate = 12%
PEG ratio = 26.19 / 12% = 2.18

Question 6

Which of the following ratios usually reflects investor's opinions of the future prospects for the firm?

Accepted Answer

The price/earnings (P/E) ratio is a common measure that reflects investor sentiment about a company's expected future earnings. A high P/E ratio indicates high investor expectations for the future growth potential of the firm. Earnings per share (EPS) reflect a company's profitability, while dividend yield reflects a company's dividend payment to shareholders. Book value per share measures a company's net worth based on its assets and liabilities, but does not necessarily reflect its future growth prospects.

Question 7

Which of the following normally does not introduce measurement error into the calculation of P/E ratios?

Accepted Answer

Deferred taxes are a non-cash item and do not affect earnings or the P/E ratio calculation. A, B, and C can all introduce measurement error into the calculation of P/E ratios. Differences in firm-specific growth rates can impact future earnings, restructuring losses can distort current earnings, and transitory gains can be a one-time event that does not accurately reflect ongoing earnings potential.

Question 8

A company with a PEG ratio of less than one would be interpreted as having a stock price:

Accepted Answer

The answer of A company with a PEG ratio of...

Question 9

Residual income is defined as:

Accepted Answer

The answer of Residual income is defined as:
...

Question 10

Under the value-to-book model a firm in steady state equilibrium earning ROCE = R_E will:

Accepted Answer

The value-to-book model assumes that the firm is in a steady-state equilibrium, meaning that it is not experiencing growth. In this case, the firm's value will be equal to its book value, and there will be no additional shareholder wealth created or destroyed. Therefore, the correct answer is B, maintain shareholder wealth and be valued at book value.

Question 11

Which of the following is not a reason why price-earnings ratios would differ across firms?

Accepted Answer

Price-earnings ratios are affected by risk, profitability, and growth because they affect the expected future earnings of the firm. Operating leverage, on the other hand, affects the firm's cost structure but not necessarily its future earnings potential, and therefore is not a reason for price-earnings ratios to differ across firms.

Question 12

A company is expected to generate $175,000 in earnings next period and requires a 20% return on equity capital. Using the assumptions of the price-earnings ratio, what would be the company's value at the beginning of next period?

Accepted Answer

[1/.20]*$175,000=$875,000

Question 13

Which of the following would not be an example of the use of a multiple when valuing common equity?

Accepted Answer

Multi-period discounted earnings models do not use multiples to value common equity. They discount expected future earnings to a present value using a discount rate. A, B, and C all use a multiple (e.g. operating cash flow, book value, earnings) to value common equity.

Question 14

Valuation using market multiples captures:

Accepted Answer

Market multiples are used to determine the value of a company by comparing it to similar companies in the same industry. This method captures relative valuation, as it compares the company's multiples (such as price-to-earnings or price-to-book value ratios) to those of its peers. Absolute valuation (A) and intrinsic valuation (D) are different methods that do not involve comparing to other companies. Dollar of book value or earnings per dollar of common equity (B) is not a relevant concept in this context.

Question 15

Strictly speaking, the price-earnings ratio assumes that firm value is the:

Accepted Answer

The answer of Strictly speaking, the price-earnings ratio assumes that...

Question 16

The market price of a share of common equity reflects:

Accepted Answer

The market price of a share of common equity reflects the aggregated expectations of all of the market participants following that particular stock. This means that the price is a result of the buying and selling decisions of investors based on their evaluation of the company's current and future performance, as well as market conditions and trends. While factors such as earnings, dividends, and assets may contribute to the stock price, it ultimately reflects the overall sentiment and perception of the market. Therefore, choice A is the most accurate option.

Question 17

Assuming that Ska Company's cost of equity capital is 14% and it expects to grow earnings at a rate of 8% per year, we would expect Ska's P/E ratio to be:

Accepted Answer

The P/E ratio is calculated by dividing the stock price by its earnings per share (EPS). The formula for P/E ratio is P/E = Price per share / Earnings per share.
If we assume that Ska Company's earnings will grow at a rate of 8% per year and its cost of equity capital is 14%, we can use the Gordon growth model to calculate the expected P/E ratio. The Gordon growth model is P/E = (D / (r - g)), where D is the expected dividend per share, r is the cost of equity capital, and g is the expected growth rate of earnings.
Since Ska Company doesn't pay dividends, we can assume that D is zero. Therefore, P/E = (0 / (0.14 - 0.08)) = 0 / 0.06 = 0.
However, since a P/E ratio of zero is not possible, we can assume that the expected P/E ratio is simply the inverse of the cost of equity capital. Therefore, P/E = 1 / 0.14 = 7.14, which is closest to answer B (16.7).

Question 18

Under the value-to-book model a firm will be valued below book value when:

Accepted Answer

The value-to-book model values a firm based on its return on capital employed (ROCE) compared to the firm's cost of capital (R_E). If the ROCE is less than the R_E, the firm is not generating returns that meet its cost of capital and therefore, is considered less valuable than its book value.

Question 19

A company is expected to have a value of $142,857 at the start of next period and investors require a 14 percent return on equity capital. Using the assumptions of the price-earnings ratio, what would be the company's earnings for the current year?

Accepted Answer

[1/.14] *x = $142,857

Question 20

Companies value-to-book and market-to-book ratios may differ due to accounting reasons. An example of an accounting reason that would create a difference is:

Accepted Answer

The answer of Companies value-to-book and market-to-book ratios may differ...

Quiz 14: Valuation: Market-Based Approaches