Finman4e Test Bank Mod12 051614. Module 12 Analyzing and Valuing Equity Securities

Analyzing and Valuing Equity Securities Learning Objectives – coverage by question True/False Multiple Choice Exercises Problems Essays LO1 – Identify equity valuation models and explain the information required to ...

Analyzing and Valuing Equity Securities Learning Objectives – coverage by question True/False Multiple Choice Exercises Problems Essays LO1 – Identify equity valuation models and explain the information required to value equity securities. 1, 2 1-3 1-4 1 1, 2 LO2 – Describe and apply the discounted free cash flow model to value equity securities. 3-12 4-15 5-14 2-8 3, 4 LO3 – Describe and apply the residual operating income model to value equity securities. 9-15 4-9, 16-23 5, 15-23 2-4, 9-11 3, 5, 6 LO4 – Explain how equity valuation models can inform managerial decisions. 16 24, 25 24, 25 12 7, 8 ©Cambridge Business Publishers, 2015 Test Bank, Module 12 12-1Module 12: Analyzing and Valuing Equity Securities True/False Topic: Valuation Models in General LO: 1 1. Valuation models are typically based on payments investors expect to receive in the future. Answer: True Rationale: Most valuation models discount expected future streams. Common models include expected dividends, expected free cash flows, or expected residual earnings. Topic: Valuation Models: Debt vs. Equity LO: 1 2. The chief difference between valuing debt securities and equity securities is that the latter includes an assessment of non-financial information whereas the former relies only on financial information. Answer: False Rationale: Valuing either debt or equity involves assessing some non-financial information such as the quality of the management team and the external market forces that affect future profits and cash flows. Topic: Free Cash Flows to the Firm LO: 2 3. One definition of free cash flows to the firm is net cash flows from operations+/- net cash flows from investing activities. Answer: True Rationale: FCFF is typically defined as net cash flows from operations +/- net cash flows from investing activities. The sum of the two represents the net cash flows available to all providers of capital to the firm, both its creditors and shareholders. Topic: Discounted Cash Flow (DCF) Valuation Model LO: 2 4. One advantage of the DCF model is that it only recognizes value evidenced by cash flow, which is less easily manipulated by accrual accounting practices. Answer: True Rationale: The DCF model is based on accrual accounting principles. In fact, free cash flow is defined as NOPAT – change NOA. Cash flow is not affected by accrual accounting practices, which recognize revenue when earned and the matching of expenses when incurred. ©Cambridge Business Publishers, 2015 12-2 Financial & Managerial Accounting for MBAs, 4th EditionTopic: Free Cash Flow LO: 2 5. Firms can increase free cash flow to the firm (FCFF) in the short run by cutting back on investment in fixed assets. Answer: True Rationale: Capital expenditures are a deduction in the computation of FCF. As a result, firms can increase FCF in the short run by cutting back on CAPEX. Long-run FCFF may be lessened by the failure to invest in PPE. Topic: Terminal Value LO: 2 6. The higher the expected growth rate of the terminal free cash flow to the firm, the lower the present value of the terminal value becomes. Answer: False Rationale: The terminal value is given by FCF/(r-g) where g is the growth rate and r is the discount rate. As g increases, the terminal value increases as well. Topic: Stock Price, Cash Flow and Discount Rate LO: 2 7. The price one is willing to pay for a common stock is positively related to expected free cash flows to the firm (FCFF) and negatively related to the required rate of return. Answer: True Rationale: Higher expected FCFF and lower required rate of return will lead to a higher valuation. Topic: DCF Valuation Model LO: 2 8. The DCF valuation of a firm’s equity involves the following three steps: a. Forecast free cash flows to the firm (FCFF) for the horizon period. b. Forecast discount FCFF for the terminal period. c. Sum the horizon and terminal periods to yield firm value. Answer: False Rationale: To value the firm’s equity, we sum the present values of the horizon and terminal periods. Topic: DCF Model and Accounting Policies LO: 2 & 3 9. The Discounted Cash Flow model of valuation is superior to ROPI in that it addresses investors’ increasing concern with perceived earnings management by companies. Answer: False Rationale: The ROPI model is immune to the effects of differing accrual accounting practices. ©Cambridge Business Publishers, 2015 Test Bank, Module 12 12-3Topic: NOPAT LO: 2 & 3 10. Net operating profit after tax (NOPAT) is equal to net income less interest expense incurred during the year. Answer: False Rationale: NOPAT is computed from the income statement and equals operating revenues less operating expenses, all of which is expressed on an after-tax basis. Topic: Weighted Average Cost of Capital LO: 2 & 3 11. The weighted average cost is computed as: WACC=(rd × % of debt) + (re × % of net income) Answer: False Rationale: Discount rate WACC = (rd × % of debt) + (re × % of equity) Topic: RNOA, WACC, and Company Value LO: 2 & 3 12. All else equal, when WACC is higher than RNOA, the company’s market value is increasing. Answer: False Rationale: For a given level of NOA, company value increases when RNOA > WACC. Topic: Residual Operating Income (ROPI) Valuation Model LO: 3 13. Differing accrual accounting policies have an impact on the estimated value of equity when using the ROPI model. Answer: False Rationale: Expected ROPI offsets different levels of NOA resulting from differing accounting policies, leaving estimated value unaffected by accounting policies. Topic: Company Value under ROPI Model LO: 3 14. The residual operating income (ROPI) model estimates firm value as the current book value of net operating assets plus the present value of expected residual operating income. Answer: True Rationale: The ROPI model estimates firm value as the current book value of net operating assets plus the present value of expected ROPI. Topic: ROPI Valuation Model LO: 3 15. The residual operating income (ROPI) model focuses on net income which is a more accurate measure of future profitability than expected cash flows. Answer: False Rationale: NOPAT is the key value driver of the ROPI model. ©Cambridge Business Publishers, 2015 12-4 Financial & Managerial Accounting for MBAs, 4th EditionTopic: Insights from ROPI Model LO: 4 16. The power of the residual operating income (ROPI) model is that it allows managers to focus on either the income statement or balance sheet to increase firm value. Answer: False Rationale: The ROPI model focuses managers’ attention on both the income statement and the balance sheet.