Deck 13: Using Financial Statements for Valuation

Question 1

Valuation models are typically based on payments investors expect to receive in the future.

Answer 1

True

Question 2

There is no difference between valuing debt securities and equity securities since the value of a debt security is the present value of the interest and principal payments that the investor expects to receive in the future and the valuation of equity securities is also based on expectations.

Answer 2

False

Question 3

One definition of free cash flows to the firm is net cash flows from operations+/- net cash flows from investing activities.

Answer 3

True

Question 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.

Question 5

Firms can increase free cash flow to the firm (FCFF) in the short run by cutting back on investment in fixed assets.

Question 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.

Question 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.

Question 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.

Question 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.

Question 10

Net operating profit after tax (NOPAT) is equal to net income less interest expense incurred during the year.

Question 11

The weighted average cost is computed as: WACC=(r_d × % of debt) + (r_e × % of net income)

Question 12

Differing accrual accounting policies have an impact on the estimated value of equity when using the ROPI model.

Question 13

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.

Question 14

The residual operating income (ROPI) model focuses on net income which is a more accurate measure of future profitability than expected cash flows.

Question 15

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.

Question 16

There are many types of equity valuation models. They differ mainly in:

A) The choice of length of horizon periods
B) The treatment of the terminal period
C) The choice of what is forecast
D) The interaction of income statement and balance sheet items
E) None of the above

Question 17

The advantage of the dividend discount model is that:

A) It is simple
B) Dividends are easily observable
C) Capital gains can be earned instead of dividends
D) Firms publish their dividend policies
E) All of the above

Question 18

Assume that Bank of America Corp. reported a net loss of $584 million for the fiscal quarter. That day, Bank of America's stock price climbed from $16.23 per share to $16.37.
This demonstrates that:

A) Equity valuation models are not related to company earnings
B) Dividends are unrelated to earnings
C) Equity valuation models can be irrational
D) The net loss was smaller than investors expected
E) All of the above

Question 19

Following is information from Skechers USA, Inc. for fiscal 2016 (in thousands).
Projected 2017 total revenue would be:

A) $3,634,577 thousand
B) $3,855,503 thousand
C) $3,324,568 thousand
D) $3,741,477 thousand
E) None of the above

Question 20

Following is information from Pinto Corporation for 2017.
Projected 2018 total revenue would be:

A) $1,043,623
B) $1,074,622
C) $1,088,054
D) $1,085,368
E) None of the above

Question 21

Following is information from Bava Industries for 2017.
Projected 2019 total revenue would be:

A) $2,751,485
B) $2,570,893
C) $2,621,802
D) $2,545,439
E) None of the above

Question 22

Following is information from Intel Corporation for 2016 ($ in millions).
Projected net operating profit after tax (NOPAT) for 2017 is:

A) $10,788 million
B) $ 3,118 million
C) $10,274 million
D) $ 2,969 million
E) None of the above

Question 23

Following is information from American Eagle Outfitters for 2016, the year ended January 28, 2017, ($ in thousands).
Projected net operating assets (NOA) for 2017 is:

A) $826,056 thousand
B) $859,098 thousand
C) $873,141 thousand
D) $832,405 thousand
E) None of the above

Question 24

Which of the following items should not be included in net operating profit after tax (NOPAT)?

A) Revenue
B) Cost of Goods Sold
C) Selling, General & Administrative Expenses
D) Decrease in Accounts Receivable
E) None of the above

Question 25

Which of the following represents the present value of a terminal period FCFF if r_w is the weighted average cost of capital?

A) (FCFF_t+1 / (r_w-g)) / (1+r_w)^t
B) (FCFF_t+1 / (g- r_w)) / (1+r_w)^t
C) (FCFF_t / (r_w-g)) / (1+g)^t
D) (FCFF_t / (g- r_w)) / (1+g)^t

Question 26

Alpine Corporation reported the following information for fiscal 2017 and 2016.
What are the company's free cash flows to the firm (FCFF) for 2017?

A) $28,430
B) $24,638
C) $28,907
D) $25,797
E) None of the above

Question 27

McMahon Company manufactures SIM cards for cell phones.
Based on the following information, what are the company's free cash flows to the firm (FCFF) for the year ended December 31, 2017?

A) $ 630
B) $2,640
C) $3,750
D) $3,640
E) None of the above

Question 28

A company can increase free cash flows to the firm (FCFF) by doing which of the following?

A) Increasing investments in receivables, inventories, and plant assets
B) Decreasing investments in receivables, inventories, and plant assets
C) Maintaining a steady level of net operating profit after tax
D) Decreasing the level of net operating profit after tax.
E) None of the above

Question 29

Which of the following descriptions of the free cash flow to the firm (FCFF) model is inaccurate?

A) FCFF analysis focuses on the amount by which shareholder value is created during a period.
B) FCFF is positive when NOPAT is higher than the decrease in NOA during the period.
C) With the FCFF valuation model, firm value is the sum of the present value of horizon and terminal period free cash flows.
D) Managers can increase FCFF by decreasing fixed-asset acquisitions.
E) None of the above

Question 30

Assume the following free cash flows for Aiello Inc. for 2016 and forecasted FCFF for 2017 onward (in millions):
The DCF value of the firm using the FCFF information above, a discount rate of 6%, and an expected terminal growth rate of 2%, is:

A) $176,900 million
B) $126,028 million
C) $145,189 million
D) $181,836 million
E) None of the above

Question 31

Which of the following descriptions of the residual operating income (ROPI) model is inaccurate?

A) ROPI analysis focuses on the amount by which shareholder value is created during a period.
B) ROPI is positive when NOPAT is higher than WACC × NOA_Beg.
C) ROPI is useful as a management tool as it forces managers to pay attention to both the income statement and the balance sheet.
D) One critique of the ROPI model is that it focuses managers' attention solely on short-term operating assets and neglects investment in long-term operating assets.
E) None of the above

Question 32

Heller Enterprises reports the following information. What is the company's residual operating income (ROPI) for 2017?

A) $9,072
B) $6,200
C) $9,312
D) $9,960
E) None of the above

Question 33

Barrington Corporation reports the following information. What is the company's residual operating income (ROPI) for 2017?

A) $ 864
B) $1,068
C) $1,215
D) $ 988
E) None of the above

Question 34

Which of the following descriptions of Residual Operating Income (ROPI) is incorrect?

A) The estimations of value per share of companies are the same when employing the ROPI and DCF model if the firm is growing at a constant rate.
B) ROPI = NOPAT- (WACC × NOA), and WACC × NOA is the dollar amount of return that lenders and shareholders expect the company to earn on their investment.
C) If a company utilizes overly conservative/aggressive accounting practices, its book value is understated/ overstated and will affect the estimate of the stock price using the ROPI model.
D) ROPI model uses information from both the income statement and balance sheet.
E) None of the above

Question 35

Which of the following is incorrect (r_w is the weighted average cost of capital)?

A) ROPI = NOPAT - (r_w × NOA)
B) NOPAT - (r_w × NOA) = (NOPAT/NOA - r_w) × NOA
C) RNOA = NOPAT / average NOA
D) ROPI = (RNOA × r_w) - NOA
E) None of the above

Question 36

The following are forecasted residual operating income (ROPI) for Reed Corporation for 2017:
Assume a discount rate of 6%, an expected terminal growth rate of 2% and 2017 NNO of $17,314. What is the firm's equity value using the ROPI valuation model?

A) $71,130
B) $53,816
C) $67,988
D) $17,314
E) None of the above

Question 37

All of the following are attributes of the ROPI model except:

A) ROPI utilizes both the balance sheet and the income statement, capturing information in accrual accounting.
B) ROPI is immune from the effects of differing accounting policies.
C) ROPI is falsely perceived as influenced by accrual accounting policies.
D) ROPI model is accurately perceived as influenced by accrual accounting policies.
E) None of the above

Question 38

Which of the following statements is true:

A) ROPI = NOPAT+ (r_w × NOA)
B) ROPI = NOPAT - (r_w × NOA)
C) ROPI = NOPAT - [(r_w - g) × Net operating assets]
D) ROPI = NOPAT - [NOA_t - NOA_t-1]
E) None of the above

Question 39

Which of the following items is an advantage of the discounted cash flow (DCF) model, compared with the residual operating income (ROPI) model?

A) It forecasts residual operating income which is easier than forecasting cash flow.
B) It utilizes information from both the balance sheet and income statement for valuation model.
C) It is well known and widely accepted model
D) It focuses on value drivers such as margins and turnovers
E) All of the above

Question 40

Which of following is an advantage of the ROPI model?

A) Well known and widely accepted valuation model
B) Cash flows are not affected by accrual accounting
C) Utilizes both the balance sheet and the income statement, and captures the information in accrual accounting
D) Does not depend on an arbitrary discount rate.
E) None of the above

Question 41

How do expectations about future profitability and required return factor into the pricing of common stocks?

Question 42

In a recent quarterly earnings announcement, Meridian Inc. announced that its earnings had markedly increased (up 20 cents per share over the prior year). Meridian's stock price dropped nearly 5% on the earnings report.
Why do you believe that Meridian's stock reacted as it did?

Question 43

Two public companies (Jensen and Jackson) operate in the same industry, will generate exactly the same operating profit, and have identical net operating assets.
What is the weighted average cost of capital for each company? Which company will have a lower stock price?

Question 44

Alton Enterprises has an after-tax cost of debt of 3.85%. Your online investigation reveals that the company has a beta of 0.90. Assume that the risk free rate in 2017 is 3.0% and an appropriate "spread" of equities over the risk-free rate is 3.5%. The company has 60% of its capitalization from equity.
Calculate the company's weighted average cost of capital for 2017.

Question 45

Assume that your company reports net operating working capital of $123,800, long-term operating assets of $365,700, long-term operating liabilities of $211,900, and net nonoperating obligations of $1,100.
What is the amount of your net operating assets (NOA)?

Question 46

Consider the following in relation to the (DCF) model:
a. What do positive free cash flows to the firm imply?
b. What do negative free cash flows to the firm imply?
c. Is it possible for a company to be experiencing positive earnings while having negative cash flows? Explain.

Question 47

Consider how free cash flows to the firm (FCFF) affect a company's equity market valuation. Assuming that a stock is "fairly" valued according to the DCF valuation method based upon consensus expectations, what would the following changes imply all else constant?
a. The company's leading competitor files for bankruptcy protection. This will allow the firm to increase its sales growth rate above consensus expectations by gaining substantial market share; the company will leverage its existing asset base to meet increased demand.
b. A new competitor has entered the market and the company must respond by upgrading its existing manufacturing processes via a large, multi-year capital expansion project.

Question 48

Konerko Corporation has a forecasted free cash flow to the firm (FCFF) of $13,800 per year in the terminal period, which begins in year 5. What is the present value of the terminal period FCFF assuming a weighted average cost of capital (WACC) of 7% and terminal growth rate of 2%?

Question 49

You are trying to value Madison Inc. and have forecasted free cash flows to the firm (FCFF) for the terminal period of $513.8 million. You want to perform some sensitivity analysis. In particular, you want to determine the effect that terminal growth rates will have on the present value of the terminal period FCFF. Assume that the horizon period is four years long and that the terminal period begins in year five. The company's WACC is 7%.
a. Calculate the present value of the FCFF for the terminal period using an expected growth rate of 1%.
b. Now assume that the growth rate went up to 2%. Calculate the new present value of the FCFF for the terminal period.
c. Using these two figures, make a general observation about the relation between the effect of differing growth rates on the present value of FCFF for a terminal period. Is the growth rate an important assumption? Explain.

Question 50

Following are financial statement numbers and select ratios for Target Corp. for fiscal year 2016 (dollars in millions).
Use the information to determine the free cash flow to the firm in 2017.

Question 51

Following are financial statement numbers and select ratios for Darden Restaurants Inc. for the year ended May 28, 2017 (dollars in millions).
Use the information to determine the free cash flow to the firm (FCFF) in 2018.

Question 52

Following is financial information for Washington Corporation for 2017 year-end.
What are the company's free cash flows to the firm (FCFF) for 2017?

Question 53

Assume the following expected free cash flows for Peterson Corporation for 2017:
The company has net nonoperating obligations (NNO) of $12,000 and 3,000 shares outstanding.
Calculate the per share stock price using the FCFF information above, a discount rate of 7%, and a terminal growth rate of 2%.

Question 54

Calculate the per share value of Rizzo Company if the cumulative present value of horizon period FCFF is $8,000, the present value of terminal period FCFF is $6,200, and the book value of net nonoperating obligations (NNO) is $2,400. The company has 200 shares outstanding.

Question 55

Calculate the per share value of Cornwell Company if the cumulative present value of horizon period ROPI is $15,700, the present value of terminal ROPI is $20,500, the net operating assets (NOA) are $85,600, and net nonoperating obligations (NNO) are $16,300. The company has 2,500 shares outstanding.

Question 56

Following are financial statement numbers and select ratios for Target Corp. for the fiscal year 2016 (dollars in millions). Use the information to determine the residual operating income (ROPI) in 2017.

Question 57

Following are financial statement numbers and select ratios for Darden Restaurants Inc. for the year ended May 28, 2017 (dollars in millions). Use the information to determine the residual operating income (ROPI) in 2018.

Question 58

Given the horizon period from 2018 to 2021, with the terminal year 2022, calculate the present value at December 31, 2017 of the terminal value of ROPI given the following additional information:

Question 59

Use the following information (in millions) and the residual operating income (ROPI) model, to value the equity of a small publicly-traded company. The company's stock is currently trading at $53 per share.
Would you purchase shares of this stock at $53? Why or why not?

Question 60

In its 2017 fiscal year report, a company reported the following information:
The company's WACC is 6%. What is the residual operating income (ROPI) for 2017? Is this an improvement over the previous year? Is this a good sign for investing in this company?

Question 61

In its 2017 fiscal year report, a company reported the following information:
At what weighted average cost of capital would the company report residual operating income (ROPI) of $0 in 2017?

Question 62

Given the following information, calculate the ROPI for the latest fiscal year. At what WACC will the company report zero ROPI?

Question 63

A firm has expected residual operating income of $20.1 million, the weighted average cost of capital (WACC) of 7%, and net operating assets (NOA) at the beginning of the period of $240 million. NOA is projected to grow to $252 million by the end of the year.
What is the projected return on net operating assets (RNOA) for the year?

Question 64

A company wants to assess the performance of its management using the ROPI-based analysis. At the beginning of the period, the company has net operating assets of $150 million, and its weighted cost of capital (WACC) for this period is 6%.
a. What is the minimum level of NOPAT the company will need in this year for management to report it has achieved an acceptable level of profit under the ROPI analysis?
b. Why is it often advantageous for a company to use ROPI analysis to evaluate managers?

Question 65

Consider a management team that has its incentive compensation package tied to residual operating income (ROPI). Discuss how the team can improve ROPI by 1) driving improvements in operating margin, and/or 2) reducing the company's operating asset base.

Question 66

Following is the balance sheet for Goldsmith Inc.
The company has pretax interest expense of $2,214 and a statutory tax rate of 37%. Your online investigation reveals that the company has a beta of 0.9. Assume that the risk free rate in 2017 is 3.5% and an appropriate "spread" of equities over the risk-free rate is 5%.
Calculate the company's weighted average cost of capital.

Question 67

The following is the balance sheet for Staples for 2017.
Required:
a. Calculate operating assets for 2017.
b. Calculate operating liabilities for 2017.
c. Determine net operating assets (NOA) for 2017.

Question 68

The following is the income statement for Mattel Inc. ($ thousands)
Required:
a. Assume that the company's statutory tax rate is 37%. Compute the tax shield for 2016 and the tax rate on operating profit.
b. What is the company's net operating profit after tax (NOPAT) for 2016?
c. Determine the net operating profit margin for the year.

Question 69

Following are the balance sheet and income statement for Goldsmith Inc.
Required:
a. Calculate net operating profit after tax (NOPAT) for 2017. Assume that the company's statutory tax rate is 37%.
b. Calculate net operating assets (NOA) for 2016 and 2017.
c. What is the free cash flows to the firm (FCFF) for 2017 for the Goldsmith?
d. What is the residual operating income (ROPI) for 2017 for the Goldsmith? The company's weighted average cost of capital is 8.0%.

Question 70

Following are financial statement numbers and select ratios for Target Corp. for the fiscal year 2016.
Forecast assumptions and other financial information for Target are as follows:
Required:
a. Use the discounted free cash flow (DCFF) model to estimate the value of Target's equity, per share at fiscal year-end 2016.
b. Target Corp. shares closed at $53.82 per share on March 8, 2017, the date the 10-K was filed with the SEC. How does your valuation compare with this closing price?

Question 71

Following are financial statement numbers and select ratios for American Eagle Outfitters for 2016, the year ended January 28, 2017.
Forecast assumptions and other financial information for AE Outfitters are as follows:
Required:
a. Use the discounted free cash flow (DCFF) model to estimate the value of AE Outfitters' equity, per share at January 28, 2017.
b. AE Outfitters' shares closed at $14.28 per share on March 10, 2017, the date the 10-K was filed with the SEC. How does your valuation compare with this closing price?

Question 72

Following are the income statements and balance sheets for Darden Restaurants, Inc. for the fiscal year ending May 28, 2017.
Continued next page
Required:
a. Calculate the following metrics for 2017:
$\bullet$ Net operating profit after tax (NOPAT)-assume the statutory tax rate is 37%
$\bullet$ Net operating assets (NOA)
$\bullet$ Net operating profit margin (NOPM)
$\bullet$ Net operating asset turnover (NOAT)
$\bullet$ Net nonoperating obligations (NNO)
b. Use the discounted free cash flow (DCF) model to estimate the per share value of Darden Restaurant's equity, at May 26, 2017. The company's weighted average cost of capital is 6%. Assume a sales growth rate of 5% for 2018-2021 with a terminal growth rate of 2%.
c. Darden Restaurant's shares closed at $85.83 per share on July 26, 2017, the date the 10-K was filed with the SEC. How does your valuation compare with this closing price?

Question 73

Following are financial statement numbers and select ratios for Target Corp. for the fiscal year 2016 (ending January 28, 2017).
Forecast assumptions and other financial information for Target are as follows:
Required:
a. Use the residual operating income (ROPI) model to estimate the value of Target's equity, per share at fiscal year-end.
b. Target Corp. shares closed at $53.82 per share on March 8, 2017, the date the 10-K was filed with the SEC. How does your valuation compare with this closing price?

Question 74

Following are financial statement numbers and select ratios for American Eagle Outfitters for 2016, the year ended January 28, 2017.
Forecast assumptions and other financial information for AE Outfitters are as follows:
Required:
a. Use the residual operating income (ROPI) model to estimate the value of AE Outfitters' equity per share at January 28, 2017.
b. AE Outfitters' shares closed at $14.28 per share on March 10, 2017, the date the 10-K was filed with the SEC. How does your valuation compare with this closing price?

Question 75

Following are the income statements and balance sheets for Darden Restaurants, Inc. for the fiscal year ending May 28, 2017.
Continued next page
Required:
a. Calculate the following metrics for 2017:
$\bullet$ Net operating profit after tax (NOPAT) - assume the statutory tax rate is 37%
$\bullet$ Net operating assets (NOA)
$\bullet$ Net operating profit margin (NOPM)
$\bullet$ Net operating asset turnover (NOAT)
$\bullet$ Net nonoperating obligations (NNO)
b. Use the residual operating income (ROPI) model to estimate the per share value of Darden Restaurant's equity, at May 28, 2017. The company's weighted average cost of capital is 6%. Assume a sales growth rate of 5% for 2018-2021 with a terminal growth rate of 2%.
c. Darden Restaurant's shares closed at $85.83 per share on July 26, 2017, the date the 10-K was filed with the SEC. How does your valuation compare with this closing price?

Question 76

Suppose you are an officer for Innovative Components, Inc. and are presented with the following information regarding your two operating divisions:
Required:
a. Compute the residual operating income (ROPI) for each division.
b. Compare the residual operating income (ROPI) for each division. Which division is performing better?
c. What would you recommend to each division's top manager to improve its performance?

Question 77

What is "Weighted Average Cost of Capital" and how is it used in equity valuation?

Question 78

Which is the better model for valuation when earnings quality is a major concern, DCF or ROPI? Explain.

Question 79

Is it a good idea to rate the performance of managers based solely on the DCF model, and what should you watch for if you do such an evaluation?

Question 80

Discuss why NOPAT is used in calculating the value of a company instead of net income in the ROPI equity valuation model.