CHAPTER 7 FINANCIAL STATEMENT ANALYSIS Questions and Answers

CHAPTER 7 FINANCIAL STATEMENT ANALYSIS Questions and Answers The fundamental approach to business valuation uses 1. Industry and economy-wide data. 2. Data from a firm's financial statements. __________ __________ assessment plays a central role in measuring a company's credit risk. Cash flow Rank the steps involved in valuing a company 1. Forecasting future amounts of some financial attribute. 2. Determining the risk associated with the forecasted future amounts. 3. Determining the discounted present value that reflects the risk. True or false: The discounted cash flow valuation approach expresses what a stock is worth as the future value of present cash flows. False Which of the following are reasons that the free cash flow model differs from cash flow from operations under GAAP? 1. Income from noncore investments and the related income tax expense are excluded under the free cash flow model. 2. Interest expense and the related income tax benefit are excluded under the free cash flow model. An approach that uses basic accounting measures to assess a company's worth is known as the Fundamental valuation approach. Cash flow assessment plays a central role in measuring a company's Credit risk Value-relevant attributes used in forecasting future amounts for a business valuation include Free cash flows The two ways to implement the discounted cash flow valuation approach include The free cash flow model and the flows to equity model. A company's operating cash flow and its free cash flow Differ in that free cash flow subtracts capital expenditures Estimating the worth, or intrinsic value, of a company is called Business valuation The forecasted cash flow stream to be discounted after subtracting payments to debt holders and preferred shareholders is called the Flows to equity model. The FASB argues that analyzing a firms'______ improves their ability to forecast future cash flows. Accounting earnings The FASB believes that __________ provide a much better measure of long-run expected operating performance than do current cash flows. Current earnings A measure of the relation between a firm's current earnings and its intrinsic share value is its __________/_________ ratio. Price/earnings Free cash flow Is calculated as operating cash flow plus interest expense after tax minus cash outflow for capital expenditures The flows to equity model Subtracts payments to debt holders and preferred dividends. The FASB believes that current earnings outperform current cash flows in predicting future cash flow and that belief stems from the forward-looking nature of Accrual accounting Research indicates that Current earnings are a better forecast of future cash flows than are current cash flows. If a company's equity cost of capital is 8% and they report current earnings of $6 per share, this implies a share price of 1/0.08 * $6 = $75 If a company has an earnings rate equal to the underlying book value of net assets, Investors are willing to pay only an amount equal to the book value of net assets. Assume the following for the Howard Saks firm: Actual earnings of $28,000, beginning book value of $250,000, ending book value of $350,000, and cost of capital of 6%. What are their abnormal earnings? $28,000 - (250,000 * 6%) = $13,000 Companies with shares that sell for a premium relative to their book value are companies with ROCEs that consistently exceed the industry average. True or false: The abnormal earnings approach and the free cash flow approach always produce the same valuation estimate. False The amount a firm would pay if it bought an identical investment is called The entry price True or false: Level 2 of the GAAP hierarchy of approaches used to measure fair value uses unobservable inputs such as management's estimates of expected future cash flows. False Assume the following for the Morgan Goldman firm: Actual earnings of $14,000, beginning book value of $250,000, and cost of capital of 8%. What are their abnormal earnings? $14,000 - (250,000 * 8%) = $(6,000) A firm can use which of the following to evaluate their prospects of generating abnormal earnings? 1. Comparing the ROCE to the cost of equity capital. 2. Comparing the ROCE to the ROCE of other companies in the same industry. Riskier firms have a higher risk-adjusted cost of capital which means that the discount rate for capitalizing their earnings will be Higher, resulting in lower share prices. The amount a firm would receive if it sold its investment is called The exit price Match the level of the hierarchy for measuring fair values on the left with its description on the right. Level 1: Uses quoted prices from active markets for identical assets or liabilities. Level 2: Uses quoted prices from similar assets or liabilities. Level 3: Uses unobservable inputs such as management's estimates of expected future cash flows. Most firms' P/E ratios range between 10 and 30 Earnings that are not expected to persist into the future are called Transitory earnings True or false: Different levels of risk or uncertainty associated with earnings can cause the share price for firms with the same level of current and future expected earnings to sell at different prices. True If there is no active market for an asset, fair value could be determined by 1. Using a valuation model. 2. Using market value for similar assets. A 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 are called Growth opportunities Earnings that are unrelated to future free cash flows and, therefore, not pertinent to assessing current share price are called ________ _______ earnings Value irrelevant Income from continuing operations, excluding special items, is known as Permanent earnings The divergence of a firm's publicly reported profit from its true operating earnings is known as ______ of ______ Quality of earnings High quality earnings are ______ earnings. Sustainable Earnings expected to persist into the future are called Permanent earnings Income or loss from discontinued operations are known as Transitory earnings Becker Corporation has the following components in its multi-step income statement: Reported EPS $15, Permanent component 60%, (earnings multiplier of 5), Transitory component 25%, (earnings multiplier of 1), and value-irrelevant component 15%, (earnings multiplier of 0). What is Becker's implied share price? ($15 60% 5) + ($15 25% 1) +($15 15% 0) = $48.75 Which of the following items is an example of sustainable earnings? Earnings generated from repeat customers An earnings surprise Occurs when earnings deviate from investor's expectations. Which of the following are true about short-term loans? 1. They are used primarily to finance working capital needs. 2. They may be unsecured. 3. They may be secured. Which of the following are true of long-term loans? 1. They are also called term lending agreements. 2. They have maturities of more than one year. Earnings that deviate from investors' expectations are referred to as a(n) Earnings surprise ________ _______ are considered a variation on a seasonal credit lines. Revolving loans ___________ ___________ includes short-term notes sold directly to investors by large and financially sound companies Commercial paper Seasonal lines of credit and special purpose loans are common types of Short-term loans Long-term forms of public debt financing include 1. Notes 2. Bonds Term lending agreements are ______ and have maturities of more than one year. Long-term loans The interest rate on a revolving loan Will usually change as the prime rate rises or falls over the life of the credit line. Which of the following are true of commercial paper? 1. It is sold directly to investors by large and financially sound companies. 2. It is usually secured by a bank credit line. 3. It includes an interest rate significantly below the rate a bank would charge. The first step in credit analysis is Understanding of the firm, its business, its key risk and success factors and dynamics of its industry. An unsecured debt, meaning no specific pledge of property is made, is called a __________ bond. Debenture A qualitative assessment of the business, its customers and suppliers, and management character and capability is known as Due diligence One way that investors assess credit risk is to rely on the opinion of a _____________-__________ agency. Credit-rating Match the Standard & Poor's credit rating on the left with its credit quality on the right. AAA: Extremely strong BBB: Adequate protection CCC: Currently vulnerable D: In default Which of the following are true regarding the financial statement ratios that credit analysts at Standard & Poor's track? 1. They each have a precise definition so that every credit analyst is consistent with computations. 2. They are compared to average ratios for corporate borrowers. Before approving a loan to a company, a commercial loan officer evaluates the borrower's ability to repay the proposed loan at maturity. This evaluation typically involves 1. Due diligence 2. Analysis of credit risk