Question 1

One popular approach used to estimate a firm's equity cost of capital is the capital asset pricing model,which expresses the equity cost of capital as the sum of the return on a riskless asset plus an equity risk premium multiplied by the company's systematic risk.

Accepted Answer

This statement is true. The capital asset pricing model (CAPM) is a widely used method for estimating the cost of equity capital for a company, and it includes the systematic risk of the company as a key factor in the calculation. The model assumes that investors require a risk premium for holding equity securities, and that this premium is proportional to the amount of systematic risk associated with the company's stock.

Question 2

Business valuation involves estimating the intrinsic value of a company,or one of its operating units.

Accepted Answer

Business valuation does indeed involve estimating the intrinsic value of a company or one of its operating units. This is typically done through a variety of methods, including analyzing financial statements, assessing market conditions, and considering company growth potential. The resulting valuation can be useful for a variety of purposes, such as mergers and acquisitions, private equity investments, or even internal decision-making within a company.

Question 3

The FASB believes that the most useful predictor of future cash flows is accrual accounting earnings.

Accepted Answer

The FASB (Financial Accounting Standards Board) does believe that accrual accounting earnings are the most useful predictor of future cash flows because it reflects the economic activity of a company over a period of time and provides a more complete picture of the company's financial performance.

Question 4

The amount available to finance planned expansion of operating capacity,reduce debt,pay dividends,or repurchase stock is distributable (or free)cash flow.

Accepted Answer

The statement accurately defines distributable (or free) cash flow as the amount of cash available after accounting for necessary capital expenditures to support existing operations. This excess cash can be used to finance growth, reduce debt, pay dividends, or repurchase stock.

Question 5

When determining the discount rate to apply to a firm's expected future cash flows,analysts should select a rate that reflects the risk (or uncertainty)associated with these cash flows.

Accepted Answer

This statement is true. The discount rate should reflect the degree of risk associated with the expected future cash flows because the higher the risk, the higher the required rate of return investors will demand to invest in the firm. Different methods can be used to calculate the appropriate discount rate depending on the specific risks associated with the cash flows, such as the capital asset pricing model (CAPM) or the weighted average cost of capital (WACC).

Question 6

Pro forma financial statements of a business,prepared by a credit analyst,would include constructing worst-case scenarios that incorporate alternative assumptions about sales,costs,competitor behavior,etc.

Accepted Answer

Pro forma financial statements prepared by a credit analyst may include scenarios that consider alternative assumptions, such as worst-case scenarios, to assess the potential risk of lending to a business. These scenarios may take into account factors such as sales, costs, and competitor behavior to provide a more comprehensive analysis of the business's financial outlook.

Question 7

Accrual accounting produces an earnings number that smoothes out the unevenness in year-to-year cash flows,and provides an estimate of sustainable annualized long-run future free cash flows.

Accepted Answer

Accrual accounting allows for the recognition of revenue and expenses when they are earned or incurred, regardless of when cash is received or paid. This can help smooth out fluctuations in cash flows from year to year and provide a more accurate picture of a company's performance over time. Moreover, by looking at a company's accrual-based earnings, investors can estimate its long-term, sustainable cash flows that can be used to produce free cash flow.

Question 8

The details of free cash flow valuation are important only for stock analysts and investors.

Accepted Answer

While free cash flow valuation is certainly important for stock analysts and investors, it is also important for business owners and managers who want to understand the financial health and value of their company. Understanding the concept of free cash flow and how it is calculated can help these individuals make informed decisions about investments, mergers and acquisitions, and other strategic moves.

Question 9

In applying the discounted free cash flow valuation model,the discount rate used is the average cost of capital.

Accepted Answer

The answer of In applying the discounted free cash flow...

Question 10

The "free cash flow valuation approach" expresses current stock price as the discounted present value of expected future distributable cash flows.

Accepted Answer

The statement accurately describes the free cash flow valuation approach.

Question 11

Cash flow assessment plays a central role in analyzing the credit risk of a company.

Accepted Answer

Cash flow is a critical factor when assessing the ability of a company to meet its financial obligations, and therefore plays an important role in analyzing credit risk. Understanding a company's sources and uses of cash, as well as its ability to generate positive cash flows, helps lenders and investors evaluate the company's financial health and its ability to repay debt.

Question 12

Operating cash flow minus cash outlays to replace existing operating capacity is free cash flow.

Accepted Answer

Free cash flow is the cash flow available for the company to use for new investments, debt repayment, dividend payments or share buybacks after accounting for necessary expenditures to maintain a company's current operations. This is calculated as operating cash flow minus capital expenditures.

Question 13

Lenders compare their cash flow projections for a company to the firm's future dividend commitment as stated in the firm's dividend policy.

Accepted Answer

Lenders compare their cash flow projections for a company to the firm's ability to make debt payments, not to its future dividend commitments.

Question 14

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 growth companies with stable cash flow patterns.

Accepted Answer

The zero-growth perpetuity assumption in a discounted free cash flow valuation model is best suited for companies with stable, non-growing cash flows, not for growth companies, which typically exhibit increasing cash flows.

Question 15

The cost of capital,expressed in dollars,reflects the level of earnings investors demand from the company as compensation for the risks of investment.

Accepted Answer

The cost of capital is the amount of return that a company must earn on its investments in order to satisfy its investors' expectations. This return is often expressed in dollar terms or as a percentage, and it reflects the level of earnings investors demand as compensation for the risks of investing in the company. Therefore, the statement is true.

Question 16

Earnings are a proxy-imperfect but the best we have-for free cash flow.

Accepted Answer

Earnings give us an indication of the cash generated by a company, which is a proxy or approximation for free cash flow. While it is not a perfect measure, it is considered the best we have for estimating free cash flow.

Question 17

Fundamental valuation uses basic accounting measures to assess the amount,timing,and uncertainty of a firm's future operating cash flows or earnings.

Accepted Answer

This is a correct statement about fundamental valuation - it is based on analyzing financial statements and using accounting measures to estimate a company's future cash flows or earnings.

Question 18

Stock valuation involves estimating the worth of a company,one of its operating units,or its ownership shares.

Accepted Answer

The answer of Stock valuation involves estimating the worth of...

Question 19

If a company is currently generating a free cash flow of $10 per share,which is expected to continue indefinitely,and if the discount rate is 10%,the estimated share price would be $100.

Accepted Answer

The estimated share price can be calculated using the formula: Share price = Free cash flow / Discount rate. Plugging in the values given: Share price = $10 / 0.1 = $100. Therefore, the statement is true.

Question 20

In theory,the abnormal earnings approach and the free cash flow approach never produce the same valuation estimate.

Accepted Answer

Both approaches can potentially produce the same valuation estimate if the assumptions and inputs used in the models (such as growth rates, discount rates, and terminal values) are consistent and reflect the same underlying economic realities of the business.

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