Reading 40- LOS h ～ Q1－4

1.Assume a simple service firm earns only service revenue and incurs depreciation as its most significant expense. In the current year, there is 3 percent inflation. However, due to government regulations, the firm is unable to pass on any of the inflation to its customers. In real terms, the firm’s net income is:

A)   understated.

B)   overstated.

C)   correctly stated.

D)   misstated by an indeterminable amount.

The correct answer was C)

Depreciation expense is an example of historical cost accounting (no inflation taken into account). If there is also no inflation reflected in the service revenue, then from an economic and real standpoint, the net income is correctly stated.

2.Which of the following statements about inflation and share value is TRUE? All other things being equal:

A)   the higher the inflation flow-through rate, the lower the value of the firm.

B)   the higher the inflation flow-through rate, the higher the value of the firm.

C)   a lower price-to-earnings value will result if a firm passes on 100% of inflation through its earnings.

D)   in a situation of less than 100% inflation pass-through, a higher inflation rate will results in a higher value of the firm.

The correct answer was B)

The more inflation that a firm is able to pass on to its customers (higher inflation flow-through rate), the less negative impact inflation has on earnings and therefore, the value of the firm would increase. Also, the higher the inflation rate, the lower the value of the firm’s shares if full inflation pass-through does not occur (i.e., the inflation flow-through rate is less than 100 percent), all else equal.

3.Firm 1 and Firm 2 are both based in countries with a 3 percent rate of inflation. The real rate of return required by investors from both companies is 4 percent. Firm 1 can pass on 70 percent of inflation through its earnings and firm 2 can pass on 90 percent.

Based on the above information, which of the following statements is TRUE?

A)   Firm 1’s estimated P/E ratio is 16.39.

B)   Firm 1’s estimated price-to-earnings (P/E) ratio is 20.41.

C)   Firm 1’s estimated P/E ratio is higher than Firm 2’s.

D)   Firm 2’s estimated P/E ratio is 14.93.

The correct answer was B)

Firm 1’s P/E ratio = 1 / (4% + (1 – 70%) x 3%) = 20.41

Firm 2’s P/E ratio = 1 / (4% + (1 – 90%) x 3%) = 23.26

Therefore, Firm 1’s estimated P/E ratio is lower than Firm 2’s.

4.Thomas Riolo is considering adding either Multifactory Ltd. or Analogesous Corp. to his equity portfolio. He has concluded that Multifactory is likely to have a higher valuation than Analogesous because of two factors:

Factor #1: Multifactory has a higher franchise factor than Analogesous.

Factor #2: Multifactory has a lower inflation pass-through than Analogesous.

Is Riolo correct with respect to:

A)             Yes                                       Yes

B)              No                                         No

C)              No                                        Yes

D)             Yes                                      No

The correct answer was D)

The more positive the franchise factor and the higher the inflation pass-through, the higher the valuation of the firm.