Financial Reporting And Analysis 7th Ed By Revsine – Test Bank

Financial Reporting And Analysis 7th Ed By Revsine – Test Bank

Chapter 6 The Role of Financial Information in Valuation and Credit Risk Assessment

True/False

[QUESTION]
1. The discounted cash flow valuation approach expresses current value of a firm as the discounted present value of expected future cash flows.
Answer: True
Learning Objective: 06-01
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Understand
AICPA: FN Measurement
Topic: Discounted cash flow―Approach to valuation

[QUESTION]
2. In applying the free cash flow valuation model, the discount rate used is the weighted-average cost of capital.
Answer: True
Learning Objective: 06-01
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Remember
Topic: Discounted cash flow―Free cash flow model

[QUESTION]
3. Accrual accounting produces an earnings number that depicts the effects of economic events on cash flows in the period in which the effects occur and provides an estimate of sustainable long-run future free cash flows.
Answer: True
Learning Objective: 06-02
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Remember
Topic: Earnings―Role in valuation

[QUESTION]
4. In the flows to equity model of valuation, and using simplifying assumptions, the current stock price estimate can be expressed as a capitalization rate (1 × r) multiplied by a perpetuity equal to cash flow after paying debtholders and preferred shareholders.
Answer: False
Feedback: The capitalization rate is (1 ÷ r).
Learning Objective: 06-01
Difficulty: 3 Hard
AACSB: Analytical Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Analyze
Topic: Discounted cash flow―Flows to equity model

[QUESTION]
5. The two most significant explanations for variations in the earnings multiple are risk differences and maturity of the firm.
Answer: False
Learning Objective: 06-04
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Risk Analysis
Blooms: Understand
Topic: Price/Earnings multiples―Variation factors

[QUESTION]
6. The value of the future growth opportunities of a firm can be determined by considering the firm’s potential earnings from reinvesting current earnings in new projects that will eventually earn a rate of return more than the cost of equity capital.
Answer: True
Learning Objective: 06-04
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Remember
Topic: Price/Earnings multiples―Variation factors

[QUESTION]
7. Return on assets (ROA) can be used to assess whether a firm is likely to earn a return on reinvested earnings that exceeds its cost of equity capital.
Answer: False
Feedback: Return on common equity (ROCE) can be used for this purpose.
Learning Objective: 06-02
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Understand
Topic: Earnings―Abnormal earnings approach

[QUESTION]
8. A component that is unrelated to future free cash flows or future earnings and is not pertinent to assessing current share price is a noise component.
Answer: True
Learning Objective: 06-04
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Remember
Topic: Price/Earnings multiples―Variation factors

[QUESTION]
9. The degree of conservatism associated with a firm’s accounting choices will have a direct bearing on the relationships among share price, earnings, and the firm’s equity book value components of the abnormal earnings valuation approach.
Answer: True
Learning Objective: 06-02
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Understand
Topic: Earnings―Abnormal earnings approach

[QUESTION]
10. Much of the information needed for assessing the quality and value-relevance of a company’s reported accounting numbers cannot be found in the company’s Form 10-K.
Answer: False
Learning Objective: 06-05
Difficulty: 3 Hard
AACSB: Analytical Thinking
AICPA: BB Critical Thinking
Blooms: Analyze
Topic: Quality of earnings

[QUESTION]
11. Under the GAAP hierarchy of approaches used in measuring fair value, Level 3 uses quoted prices from active markets for identical assets or liabilities to determine fair value.
Answer: False
Feedback: Level 1 uses quoted prices from active markets for identical assets or liabilities to determine fair value.
Learning Objective: 06-03
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Remember
Topic: Fair value measurements

[QUESTION]
12. Because income from discontinued operations is not likely to be recurring, it would be considered transitory earnings and be valued at a lower multiple than recurring components (such as income from operations).
Answer: True
Learning Objective: 06-04
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Understand
Topic: Price/Earnings multiples―Components of earnings

[QUESTION]
13. If securities markets are rational and efficient in that they fully and correctly include all available information into a company’s stock price, the resulting price will reflect investors’ unbiased expectations about the company’s future earnings and cash flows.
Answer: True
Learning Objective: 06-06
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Understand
Topic: Stock returns and earnings surprises

[QUESTION]
14. Lenders form opinions about a firm’s credit risk by comparing current and future debt-service requirements to the estimates of the firm’s current and expected future cash flows.
Answer: True
Learning Objective: 06-07
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Understand
Topic: Credit risk assessment―Types of lending

[QUESTION]
15. The starting point for developing comprehensive financial statement forecasts is a detailed understanding of the company, its recent financial performance and its health.
Answer: True
Learning Objective: 06-08
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: FN Measurement
Blooms: Understand
Topic: Appendix B―Forecasts of financial statements

Multiple Choice

[QUESTION]
16. The fundamental valuation approach to business valuation uses basic accounting measures to assess the amount, timing and
a. certainty of a firm’s past operating cash flows or earnings.
b. certainty of a firm’s future non-operating cash flows or earnings.
c. uncertainty of a firm’s future operating cash flows or earnings.
d. uncertainty of a firm’s future non-operating cash flows or earnings.
Answer: c
Learning Objective: 06-01
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
AICPA: FN Measurement
Blooms: Understand
Topic: Basic steps in business valuation

[QUESTION]
17. The steps involved in business valuation are forecasting the future values of a financial attribute that drives a company’s value, determining the risk associated with that forecasted value and determining the
a. future values of the value-relevant attribute.
b. certain future value of earnings.
c. present value of a firm’s earnings.
d. discounted present value of the expected future amounts using a discount rate that reflects the risk or uncertainty.
Answer: d
Learning Objective: 06-01
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Understand
Topic: Basic steps in business valuation

[QUESTION]
18. Cash flow assessment plays a central role in analyzing
a. the credit risk of a company.
b. management’s effectiveness.
c. the future earnings potential of a company.
d. the firm’s investment potential.
Answer: a
Learning Objective: 06-01
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: BB Resource Management
AICPA: FN Risk Analysis
Blooms: Remember
Topic: Basic steps in business valuation

[QUESTION]
19. Valuing an entire company, an operating division of that company or its ownership shares involves three basic steps. These steps include all of the following except:
a. Forecasting future amounts of a value-relevant attribute.
b. Determining the risk or uncertainty associated with the forecasted future amounts.
c. Determining the discounted present value of the expected future amounts using an appropriate discount rate.
d. Determining the dividends the company will pay in the future based on the company’s dividend policy and expected future earnings.
Answer: d
Learning Objective: 06-01
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Remember
Topic: Basic steps in business valuation

[QUESTION]
20. When using the discounted flows to equity valuation model, the market value of common shares depends upon investors’
a. future expectations about the future economic prospects of cash flows before payments to debtholders and preferred shareholders.
b. current expectations about the future economic prospects of cash flows after payments to debtholders and preferred shareholders.
c. future expectations about the current economic prospects of cash flows to both debtholders and preferred shareholders.
d. current expectations about the current economic prospects of cash flows to both debtholders and preferred shareholders.
Answer: b
Learning Objective: 06-01
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Understand
Topic: Discounted cash flow―Flows to equity model

[QUESTION]
21. A simplified version of the discounted free cash flow valuation model assumes a zero-growth perpetuity for future cash flows. This assumption is best applied to
a. start-up firms with stable cash flow patterns.
b. growth firms with increasing cash flow patterns.
c. growth firms with stable cash flow patterns.
d. mature firms with stable cash flow patterns.
Answer: d
Learning Objective: 06-01
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Understand
Topic: Discounted cash flow―Free cash flow model

[QUESTION]
22. To apply the discounted free cash flow model, the analyst needs to estimate
a net cash flows from operations for each future period, starting one period from now.
b. free cash flows for each future period, starting one period from now.
c. free cash flows for approximately ten years as the present value of cash flows occurring beyond that point are insignificant.
d. net cash flows from operations for approximately ten years as the present value of cash flows occurring beyond that point are insignificant.
Answer: b
Learning Objective: 06-01
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Understand
Topic: Discounted cash flow―Free cash flow model

[QUESTION]
23. The FASB stresses that the primary objective of financial reporting is to provide information useful to investors and creditors in assessing the amount, timing and uncertainty of future net cash flows. The FASB contends that
a. users pay attention to firms’ accounting earnings because this accrual measure of periodic firm performance improves their ability to forecast future cash flows.
b. information about current cash receipts and payments is the best indicator for this task.
c. users pay attention to managements’ estimates of free cash flows because this information improves their ability to forecast future cash flows.
d. current cash flows outperform current earnings in predicting future cash flows.
Answer: a
Learning Objective: 06-02
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Understand
Topic: Earnings―Role in valuation

[QUESTION]
24. By using accruals and deferrals, accrual accounting
a. produces a cash flow number that reflects only cash earnings.
b. produces information about current cash receipts and payments.
c. enables management to estimate future free cash flows.
d. produces an earnings number that depicts the effects of economic events on cash flows.
Answer: d
Learning Objective: 06-02
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Understand
Topic: Earnings―Role in valuation

[QUESTION]
25. Research indicates that stock returns correlate better with
a. accrual earnings than realized operating cash flows.
b. cash basis earnings than realized operating cash flows.
c. realized operating cash flows than accrual earnings.
d. future operating cash flows than accrual earnings.
Answer: a
Learning Objective: 06-02
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Resource Management
Blooms: Understand
Topic: Earnings―Role in valuation

[QUESTION]
26. The reciprocal of the risk-adjusted equity cost of capital used to discount future earnings is the
a. return on assets.
b. return on common equity.
c. price/earnings ratio.
d. profit margin on sales.
Answer: c
Learning Objective: 06-02
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Understand
Topic: Earnings―Role in valuation

[QUESTION]
27. If a company currently earns $5.00 per share, and has a risk-adjusted equity cost of capital of 9%, a share of common stock should theoretically sell for approximately
a. $0.45
b. $5.00
c. $48.00
d. $55.55
Answer: d
Feedback: The earnings multiple is 1 ÷ 0.09 = 11.11. $5.00 x 11.11 = $55.55.
Learning Objective: 06-02
Difficulty: 2 Medium
AACSB: Knowledge Application
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Apply
Topic: Earnings―Role in valuation

[QUESTION]
28. If a company currently earns $6.00 per share and has a risk-adjusted equity cost of capital of 12.5%, a share of common stock should theoretically sell for
a. $0.75
b. $6.00
c. $48.00
d. $75.75
Answer: c
Feedback: The earnings multiple is 1 ÷ 0.125 = 8. $6.00 x 8 = $48.00
Learning Objective: 06-02
Difficulty: 2 Medium
AACSB: Knowledge Application
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Apply
Topic: Earnings―Role in valuation

[QUESTION]
29. If most firms’ price/earnings ratios are between 10 and 15, what is the range of the risk-adjusted interest rate?
a. 6.67% to 10%
b. 6.67% to 15%
c. 10% to 15%
d. 10% to 16.67%
Answer: a
Feedback: P/E = 1 ÷ r; 10 =1 ÷ r; r = 1 ÷ 10; r = 10%. 15 = 1 ÷ r; r = 1 ÷ 15; r = 6.67%
Learning Objective: 06-04
Difficulty: 2 Medium
AACSB: Knowledge Application
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Apply
Topic: Price/Earnings multiples―Variation factors

[QUESTION]
30. Risky firms have a higher risk-adjusted cost of capital. Which one of the following factors would contribute to a risky firm also having a relatively high price/earnings ratio?
a. The firm has a high earnings per share.
b. The firm has a low earnings per share.
c. The firm has strong growth opportunities.
d. The firm has a significant amount of long-term debt.
Answer: c
Learning Objective: 06-04
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Resource Management
AICPA: FN Risk Analysis
Blooms: Understand
Topic: Price/Earnings multiples―Variation factors

[QUESTION]
31. To obtain a better current price, the net present value of future growth opportunities (NPVGO) can be calculated and
a. added to the price per share calculated from the P/E ratio.
b. subtracted from the price per share calculated from the P/E ratio.
c. multiplied by the price per share calculated from the P/E ratio.
d. divided into the price per share calculated from the P/E ratio.
Answer: a
Learning Objective: 06-04
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Understand
Topic: Price/Earnings multiples―Variation factors

[QUESTION]
32. The net present value of future growth opportunities (NPVGO) will contribute to an above average P/E multiple when the additional share value created is
a. positive and the return on new investment is lower than the cost of equity capital.
b. positive and the return on new investment is greater than the cost of equity capital.
c. negative and the return on new investment is lower than the cost of equity capital.
d. negative and the return on new investment is greater than the cost of equity capital.
Answer: b
Learning Objective: 06-04
Difficulty: 2 Medium
AACSB: Analytical Thinking
AICPA: BB Resource Management
Blooms: Analyze
Topic: Price/Earnings multiples―Variation factors

[QUESTION]
33. In general, the growth rate in earnings will depend on the portion of earnings reinvested each period and
a. the earnings retention rate.
b. the rate of return earned on new investment.
c. the firm’s cost of equity capital.
d. the firm’s weighted average cost of capital.
Answer: b
Learning Objective: 06-04
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Understand
Topic: Price/Earnings multiples―Variation factors

[QUESTION]
34. A component that is valuation-relevant, but is not expected to persist into the future is a
a. permanent earnings component.
b. transitory earnings component.
c. noise component.
d. quiet component.
Answer: b
Learning Objective: 06-04
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Remember
Topic: Price/Earnings multiples―Components of earnings

[QUESTION]
35. Income from continuing operations, excluding special or nonrecurring items, is generally regarded as
a. permanent earnings.
b. transitory earnings.
c. value-irrelevant earnings.
d. abnormal earnings.
Answer: a
Learning Objective: 06-04
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Remember
Topic: Price/Earnings multiples―Components of earnings

[QUESTION]
36. Income or loss from discontinued operations is regarded as
a. permanent earnings.
b. transitory earnings.
c. value-irrelevant earnings.
d. abnormal earnings.
Answer: b
Learning Objective: 06-04
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Remember
Topic: Price/Earnings multiples―Components of earnings

[QUESTION]
37. An adjustment to income due to a non-recurring item is regarded as
a. permanent earnings.
b transitory earnings.
c. value-irrelevant earnings.
d. abnormal earnings.
Answer: b
Learning Objective: 06-04
Difficulty: 1 Easy
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
AICPA: FN Measurement
Blooms: Remember
Topic: Price/Earnings multiples―Components of earnings

Use the following to answer questions 38 – 43:
REFERENCE: Ref. 06_01
Firm A Firm B Firm C
Reported EPS $12 $15 $18
Analyst’s EPS composition:
Permanent component (P = 5) 80% 60% 75%
Transitory component (T = 1) 10% 35% 25%
Value-irrelevant component (0 = 0) 10% 5% 0%

[QUESTION]
REFER TO: Ref. 06_01
38. The implied share price of Firm A’s stock is
a. $12.00
b. $48.00
c. $49.20
d. $54.40
Answer: c
Feedback:
Permanent 0.80  $12 = $9.60  5 = $48.00
Transitory 0.10  $12 = $1.20  1 = 1.20
Value-irrelevant 0.10  $12 = $1.20  0 = 0.00
Implied share price $49.20
Learning Objective: 06-04
Difficulty: 3 Hard
AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Apply
Topic: Price/Earnings multiples―Components of earnings

[QUESTION]
REFER TO: Ref. 06_01
39. The implied share price of Firm B’s stock is
a. $15.00
b. $45.00
c. $50.25
d. $55.25
Answer: c
Feedback:
Permanent .60  $15 = $9.00  5 = $45.00
Transitory .35  $15 = $5.25  1 = 5.25
Value-irrelevant .05  $15 = $0.75  0 = 0.00
Implied share price $50.25

Learning Objective: 06-04
Difficulty: 3 Hard
AACSB: Knowledge Application
AICPA: BB Resource Management
AICPA: FN Measurement
Blooms: Apply
Topic: Price/Earnings multiples―Components of earnings