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

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

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.

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

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

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

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

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.

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

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

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

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

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

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

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.

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.

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.

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

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

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

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.

Research shows that stock returns correlate better with accrual earnings than with realized operating cash flows.

Analysts combine information about the company's current earnings,its business strategy,and the industry's competitive dynamics to forecast future free cash flows.

Using simplifying assumptions,the current stock price estimate can be expressed as a capitalization rate (1 × r)multiplied by a perpetuity equal to current earnings.

Based on a number of research studies,current earnings explain virtually 100% of the variation in current stock prices between companies.

The two most significant explanations for variations in the earnings multiple are risk differences and maturity of the firm.

Riskier firms have a lower risk-adjusted cost of capital resulting in lower share prices for those companies.

In addition to valuing earnings generated from existing assets,the market values growth opportunities.

The value of the future growth opportunities of a firm can be determined considering the 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.

The growth rate in earnings generally depends on the earnings retention rate and the rate of return earned on new investment.

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.

Firms that earn less than the cost of equity capital have a share price below book value.

If a firm can earn a return on net assets (common equity book value)that exceeds its cost of equity capital,it will generate positive abnormal earnings.

Companies with ROEs that consistently exceed the industry average generally will have shares that sell for book value.

A component that is valuation-relevant and expected to persist into the future is a permanent earnings component.

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.

A transitory earnings component is unrelated to future free cash flows or future earnings and,therefore,is not pertinent to assessing current share price.

Extraordinary gains and losses are regarded as value-irrelevant earnings.

Income (or loss)from discontinued operations is viewed as a transitory component of earnings.

Earnings are considered high quality when they are reliable.

As transitory components become a more important part of a firm's reported earnings,the reported earnings are more quality-enhanced.

Earnings are deemed to be of high quality when they are sustainable;earnings quality is also affected by management's choice of accounting methods.

The degree of conservatism associated with a firm's accounting choices will have a direct bearing on the relationship among share price,earnings,and the firm's equity book value.

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.

Today's GAAP balance sheet contains a mixture of historical cost and other measurements to include fair value measurements.

There is more than one possible approach to measuring fair value.

For accounting purposes,"fair value" is an entry price,not an exit price.

GAAP defines fair value as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."

Fair value of an asset must reflect its "highest and best use" by others and not how it is used by the company.

Under the GAAP hierarchy that prioritizes the information used to arrive at fair value,Level 3 uses quoted prices from active markets for identical assets or liabilities to determine fair value.

Firms must disclose at each reporting date the hierarchy level at which the fair values were determined.

The IASB and FASB are working on a joint convergence project on fair value measurement and disclosure and are in general agreement on what fair value means and how to measure it.

Critics of mark-to-model fair value accounting claim that it is a license for management to invent the financial statements to be whatever they want them to be.

An earnings surprise results from incorrect estimates of future earnings.

"Unbiased" means that,on average,the market's earnings expectations will be correct.

If securities markets are rational and efficient in the sense that they fully and correctly impound all available information into a company's stock price,then the price will reflect investors' unbiased expectations about the company's future earnings and cash flows.

Stock prices only move up or down when financial reports are released and used by investors to update their expectations about the company's future earnings and cash flows.

Companies that report good news earnings tend to have an upward drift in stock returns before the actual earnings announcement date.

Companies that report bad news earnings surprises tend to have an upward drift in stock returns before the actual earnings announcement date followed by a sharp decrease in stock returns at the announcement date.

Companies that report good news earnings surprises tend to have an upward drift in stock returns before the actual earnings announcement date followed by an increase in stock returns at the announcement date.

A term lending agreement has an original maturity of more than 1 year with maturities ranging from two to five years being the most common.

A bond that has collateral to protect the bondholder is referred to as a debenture bond.

The written agreement between the borrowing company and its creditors is referred to as the indenture.

Creditors are primarily concerned with determining the value of a firm's shares.

Lenders form opinions about a company's credit risk by comparing current and future debt-service requirements to estimates of the company's current and expected future cash flows.

Seasonal lines of credit are used by companies with seasonal sales cycles and provide the cash needed to support increases in current assets during the peak selling period.

Commercial paper consists of short-term notes sold directly to investors by large and financially sound companies.

An estimate of the company's future financial condition is indispensable to most lending decisions.

A comprehensive risk analysis involves evaluating and summarizing the various individual risks associated with a loan.

A lender is protected against anticipated credit risks by the loan's covenant provisions as interest rates are fixed by the Federal Reserve Bank.

A more streamlined approach to credit analysis than costly scrutiny of financial statement details,ratios,etc.is to rely on credit reports issued by third-parties.

In the U.S.,there are a large number of companies that assess and grade the credit-worthiness of companies and public entities that sell debt to investors by issuing letter-based grades that express the rating agency's opinion about default risk.

Greater default risk is believed to exist when there is significant organizational reliance on an individual,especially one who may be nearing retirement.

Credit risk is unaffected by aggressive application of accounting standards as cash flows are unaffected by financial reporting choices.

High-quality financial statements help credit analysts see what is really going on at a company;low-quality statements mask true performance and financial condition.

Certain financial statement ratios are quite useful in predicting loan default.

While analysts may forecast only a single financial statement item,such forecasts may prove highly unreliable.

The starting point for developing comprehensive financial statement forecasts is a detailed understanding of the company,its recent financial performance,and health.

There is no need for an analyst to develop plausible predictions about future economic conditions in the target company's industry as these are readily available from the U.S.Commerce Department.

Preparing comprehensive financial statement forecasts involves six steps,the first one being to forecast depreciation expense and tax expense each period.

The fundamental valuation approach to business valuation uses basic accounting measures to assess the amount,timing,and A)certainty of a company's past operating cash flows or earnings. B)certainty of a company's future non-operating cash flows or earnings. C)uncertainty of a company's future operating cash flows or earnings. D)uncertainty of a company's future non-operating cash flows or earnings.

The steps involved in business valuation are forecasting future values of some 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 company's earnings. D)discounted present value of the expected future amounts using a discount rate that reflects the risk or uncertainty.

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 company's investment potential.

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 some financial attribute that ultimately determine how much a company is worth. B)Determining the risk or uncertainty associated with the forecast 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.

According to the discounted free cash flow valuation model,the market value of common shares depends upon investors' A)future expectations about the future economic prospects of free cash flows. B)current expectations about the future economic prospects of free cash flows. C)future expectations about the current economic prospects of free cash flows. D)current expectations about the current economic prospects of free cash flows.

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 companies with stable cash flow patterns. B)growth companies with increasing cash flow patterns. C)growth companies with stable cash flow patterns. D)mature firms with stable cash flow patterns.

To apply the discounted free cash flow approach,the analyst needs to estimate A)net cash flows from operations for each and every future period,starting one year hence. B)free cash flows for each and every future period,starting one year hence. 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.

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 companies' future cash flows. B)information about current cash receipts and payments is the most pertinent for this task. C)users pay attention to managements' estimates of free cash flows because this information improves their ability to forecast companies' future cash flows. D)current cash flows outperform current earnings in predicting future cash flows.

Through the use of accruals and deferrals,accrual accounting A)produces a cash flow number that smoothes out the unevenness in year-to-year 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 smoothes out the unevenness in year-to-year cash flows.

Recent 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.

The reciprocal of the risk-adjusted equity cost of capital used is the A)return on assets. B)return on common equity. C)price earnings ratio. D)profit margin on sales.

If a company currently earns $5.00 per share,and has a risk-adjusted cost of equity capital of 9%,a share of common stock should theoretically sell for A)$0.45. B)$5.00. C)$48.00. D)$55.55.

If a company currently earns $6.00 per share,and has a risk-adjusted cost of equity 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.

If most firms' price/earnings ratios are between 10 and 15,what is the range of average risk-adjusted equity cost of capital? A)6.67% to 10% B)6.67% to 15% C)10% to 15% D)10% to 16.67%

Risky firms have a higher risk-adjusted cost of capital.Which one of the following factors would contribute to that firm also having a high price/earnings ratio? A)High earnings per share B)Low earnings per share C)Growth opportunities D)High risk and high P/E ratio cannot occur simultaneously.

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.

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.

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 company's cost of equity capital. D)the company's weighted average cost of capital.

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.

Income from continuing operations,excluding special or nonrecurring items,is generally regarded as A)permanent earnings. B)transitory earnings. C)value-irrelevant earnings. D)quiet.

Income or loss from discontinued operations is regarded as A)permanent earnings. B)transitory earnings. C)value-irrelevant earnings. D)quiet.

An adjustment to income due to an extraordinary item is regarded as A)permanent earnings. B)transitory earnings. C)value-irrelevant earnings. D)quiet.

The implied share price of Firm A's stock is A)$12.00. B)$48.00. C)$49.20. D)$54.40.

The implied share price of Firm B's stock is A)$15.00. B)$45.00. C)$50.25. D)$55.25.

The implied share price of Firm C's stock is A)$18.00. B)$63.00. C)$72.00. D)$90.00.

The implied total earnings multiple of Firm A is A)1.00. B)4.10. C)5.00. D)10.00.

The implied total earnings multiple of Firm B is A)1.00. B)3.00. C)3.35. D)12.00.

The implied total earnings multiple of Firm C is A)1.00. B)3.75. C)4.00. D)15.00.

Reported earnings numbers often contain three distinctly different components,each subject to a different earnings capitalization rate.Which of the following is not one of these components? A)A permanent earnings component. B)A transitory earnings component. C)A restructured earnings component. D)A value-irrelevant earnings component.

Which one of the following is an example of sustainable earnings? A)Loss from debt retirement. B)Expenditures for advertising. C)Earnings from repeat customers. D)Gain from corporate restructuring.

As transitory components become a more important part of a firm's reported earnings,the reported earnings A)become a more reliable indicator of sustainable cash flows. B)are more quality enhanced. C)are a more reliable indicator of fundamental value. D)are a less reliable indicator of sustainable cash flows.

The assessment of earnings quality is best accomplished through the use of which one of the following? A)Single-step financial statements. B)Balance sheet and cash flow statement. C)Multi-step income statement,balance sheet,and cash flow statement. D)Single-step income statement,balance sheet,and cash flow statement.

As transitory or value-irrelevant components become a larger part of a firm's reported earnings,which of the following effects would you not expect to witness? A)The quality of those reported earnings is eroded. B)The firm's stock price rises in the year such components are reported proportionate to their impact on income. C)Reported earnings become a less reliable indicator of the company's long-run sustainable cash flows. D)Earnings are a less reliable indicator of the firm's fundamental value.

According to the abnormal earnings approach of equity valuation,investors willingly pay a premium for those firms that A)earn less than the cost of equity capital. B)produce negative abnormal earnings. C)produce positive abnormal earnings. D)earn an amount equal to the equity cost of capital.

Firms that earn less than the cost of equity capital have a share price A)above the market average. B)equal to book value. C)above book value. D)below book value.

The price of equity at time 0 is equal to the A)book value of equity at time 0. B)expected abnormal earnings in all future periods. C)book value of equity at time 0 plus expected abnormal earnings in all future periods divided by discount factors for all future periods. D)book value of equity at time 0 minus expected abnormal earnings in all future periods divided by discount factors for all future periods.

What will be the expected abnormal earnings of a firm which has earnings of $40,000 with a required equity cost of capital of 10%,when the book value at the beginning of period is $800,000? A)($40,000) B)($80,000) C)$40,000 D)$80,000

What are the abnormal earnings for Firm A? A)($4,000) B)($6,000) C)$4,000 D)$6,000

What are the abnormal earnings for Firm B? A)$1,000 B)$2,000 C)$12,000 D)$14,000

What are the abnormal earnings for Firm C? A)($2,400) B)($4,800) C)$4,800 D)$9,600

Assume that Firm A can increase earnings by $4,000,by cutting costs.Abnormal earnings would be A)($1,000). B)$0. C)$1,000. D)$1,500.

Assume that Firm B can divest itself of $20,000 of unproductive capital with earnings falling by only $3,000.Abnormal earnings are A)$200. B)$400. C)$600. D)$800.

A company with a return on equity that consistently exceeds the industry average ROCE will generally have shares that sell at a A)market-to-book ratio equal to the industry average. B)lower market-to-book ratio than the industry average. C)higher market-to-book ratio than the industry average. D)higher market price than its competitors.

As per GAAP,fair value-for accounting purposes-is A)an entry price. B)an exit price. C)the market price in a forced sale. D)always easily determinable.

Carrying amounts in a GAAP balance sheet are measured using all of the following except A)historical cost. B)net realizable value. C)discounted present value. D)fair value. E)All of these are carrying amounts that may be found in a GAAP balance sheet.

In the context of determining fair value,the exit price refers to A)the amount the firm would receive if it sold a given asset. B)the amount the firm would pay if it bought an asset of the same type and condition as the one being valued. C)the sum of the future cash flows expected to be generated by continuing to use the asset. D)none of these.

When determining the fair value of an asset using an exit price approach, A)fair value is determined by how the company uses the asset. B)management may choose to reduce the fair value of the asset by the approximate amount of expected transaction costs (i.e.,costs to dispose of the asset)if such costs are deemed to be material. C)transaction costs do not reduce the asset's fair value. D)transaction costs reduce the asset's fair value.

Prior to the announcement of bad news earnings (a negative earnings surprise),stock returns exhibit A)a negative drift downward. B)no change in stock returns. C)a negative drift downward followed by an immediate upward drift. D)a positive drift upwarD.

An earnings surprise A)usually precedes a negative drift downward in a company's stock price. B)means that some bias must exist (as unbiased means that the market's earnings expectations will be correct). C)demonstrates the inherent inefficiency of securities markets. D)occurs when earnings deviate from investors' expectations.

The fact that a company's stock price does not change when earnings are announced indicates that A)earnings were the same (per share)as in the previous quarter. B)the securities markets are rational and efficient. C)the information contained in the earnings release was fully anticipated by investors. D)earnings deviate from investors' expectations.

The interest rate on a revolving loan will usually A)be below prime interest. B)be equal to prime interest. C)remain fixed. D)float.

Short-term notes sold directly to investors by large,highly rated companies are called A)commercial paper. B)secured notes. C)bonds. D)debentures.

A bond that is considered unsecured is referred to as a A)debenture. B)sinking fund bond. C)senior bond. D)callable bonD.

A qualitative assessment of the business,its customers and suppliers,and management's character and capability is known as A)covenant waivers. B)due diligence. C)indenture evaluation. D)a debenture.

The degree to which cash needs can be satisfied during periods of fiscal stress is known as A)credit availability. B)credit worthiness. C)working capital. D)financial flexibility.

Operating cash flows are typically negative for A)established growth companies. B)emerging companies. C)mature companies. D)blue-chip companies.

The interest rate charged on bank loans must be sufficient to cover all of the following except A)a risk premium when loans are personally guaranteed by the borrower. B)the lender's cost of borrowing funds. C)the costs of administering,monitoring,and servicing the loan. D)a premium for exposure to default risk.

Financial statement forecasts (or projections)are A)one of the required footnote disclosures found in each company's annual report. B)filed annually with the SEC by all public companies. C)frequently used in determining management compensation. D)essential ingredients of business valuation and credit risk analysis.

Preparing comprehensive financial statement forecasts involves six steps.Among these steps are all of the following except A)Project sales revenue for each period in the forecast horizon. B)Forecast depreciation expense and tax expense for each period. C)Forecast the company's financial structure and dividend policy for each period. D)All of these are steps typically taken when preparing financial statement forecasts.

Briefly define "free cash flows" and describe the key features of the free cash flow approach to valuation.

Describe the role of accounting numbers in corporate valuation.

P/E ratios are a useful indicator and tool when performing valuation and comparing firms.List three factors that should be considered or adjusted for when comparing P/E ratios among different firms.

What is meant by sustainable earnings?

Briefly discuss how a firm's P/E ratio is related to the firm's choice of accounting methods.

Briefly discuss how a firm's P/E ratio is related to the present value of growth opportunities available to the firm.

Recent values of P₀ (current stock price),X₀ (current reported EPS),and r (equity cost of capital)for Alpha Company follow:

One measure for determining expected earnings this quarter (t)could be considering earnings for the same quarter last year (t-4).List some of the disadvantages to using this measure.

List the techniques that management can use to improve a company's reported performance in the short run.

Give at least three examples of low-quality earnings items.

Selected data are presented below for two companies.

Briefly define "abnormal earnings" and describe the key features of the abnormal earnings approach to valuation.

Why do the stock returns of firms reporting "good news" drift upwards before the earnings announcement date?

Briefly define an earnings surprise and explain how one impacts the value of a firm's equity.

The quarterly cash flows from operations for two technology companies are as follows: