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LOS b: Calculate and interpret P/E, P/BV, P/S, and P/CF.
Q1. Which of the following statements regarding the value of the firm is most accurate?
A) The board of directors increases the dividend payout ratio, the value of the company will increase.
B) A company's legal and treasury departments act to reduce the tax rate from 37.5% to 37.0%, the value of the firm will increase.
C) The government engages in a restrictive monetary policy and the expected inflation rate decreases, the P/E ratio will decrease.
Q2. An increase in a firm’s stock price will, all else equal, cause the price to cash flow (P/CF) ratio to:
A) there is insufficient information to tell.
B) increase.
C) decrease.
Q3. Given the following information, compute the price/cash flow ratio for EAV Technology.
A) 8.3X.
B) 12.5X.
C) 9.1X.
Q4. Which of the following accounting variables is least likely to be manipulated?
A) Interest expense.
B) Sales.
C) Net income.
Q5. One advantage to using the price/book value (P/B) ratio over using the price/earnings (P/E) ratio is that P/B can be used when:
A) stock markets are volatile.
B) earnings or cash flows are negative.
C) the firm is in a slow growth phase.
Q6. The price to book value ratio (P/BV) is a helpful valuation technique when examining firms:
A) with older assets compared to those with newer assets.
B) with the same stock prices.
C) that hold primarily liquid assets.
Q7. The current price of XYZ, Inc., is $40 per share with 1,000 shares of equity outstanding. Sales are $4,000 and the book value of the firm is $10,000. What is the price/sales ratio of XYZ, Inc.?
A) 0.010.
B) 4.000.
C) 10.000.
Q8. Given the following information, compute price/book value.
A) 2.0X.
B) 5.5X.
C) 2.5X.
Q9. Given the following information, compute price/sales.
A) 2.50X.
B) 0.50X.
C) 2.00X.
Q10. General, Inc., has net income of $650,000 and one million shares outstanding. The profit margin is 6 percent and General, Inc., is selling for $30.00. The price/sales ratio is equal to:
A) 2.77.
B) 0.65.
C) 10.83.
LOS b: Calculate and interpret P/E, P/BV, P/S, and P/CF.fficeffice" />
Q1. Which of the following statements regarding the value of the firm is most accurate?
A) The board of directors increases the dividend payout ratio, the value of the company will increase.
B) A company's legal and treasury departments act to reduce the tax rate from 37.5% to 37.0%, the value of the firm will increase.
C) The government engages in a restrictive monetary policy and the expected inflation rate decreases, the P/E ratio will decrease.
Correct answer is B)
A decrease in the tax rate would increase the company’s EPS and thus would increase the value of the firm. (The equation for EPS includes the term (1 ? t).)
The other statements are incorrect.
Increase in dividend payout/reduction in earnings retention. In this case, an increase in the dividend payout will likely decrease the P/E ratio because a decrease in earnings retention will likely lower the P/E ratio. The logic is as follows: Because earnings retention impacts both the numerator (dividend payout) and denominator (g) of the P/E ratio, the impact of a change in earnings retention depends upon the relationship of ke and ROE. If the company is earning a higher rate on new projects than the rate required by the market (ROE > ke), investors will likely prefer that the company retain more earnings. Since an increase in the dividend payout would decrease earnings retention, the P/E ratio would fall, as investors will value the company lower if it retains a lower percentage of earnings.
Decrease in the expected inflation rate and decrease in the required rate of return. The expected inflation rate is a component of ke (through the nominal risk-free rate). ke can be represented by the following: nominal risk-free rate + stock risk premium, where nominal risk-free rate = [(1 + real risk-free rate) × (1 + expected inflation rate)] – 1.
§ If the rate of inflation decreases, the nominal risk-free rate will decrease.
§ ke will decrease.
§ The spread between ke and g, or the P/E denominator, will decrease.
§ P/E ratio will increase.
Q2. An increase in a firm’s stock price will, all else equal, cause the price to cash flow (P/CF) ratio to:
A) there is insufficient information to tell.
B) increase.
C) decrease.
Correct answer is B)
An increase in a firm’s stock price will, everything else being equal (i.e., the CF does not change), cause the P/CF ratio to increase.
Q3. Given the following information, compute the price/cash flow ratio for EAV Technology.
A) 8.3X.
B) 12.5X.
C) 9.1X.
Correct answer is B)
Cash Flow = Net income per share + Depreciation per share = $6 + $2 = $8
Price/cash flow = $100 / $8.0X = 12.5X
Q4. Which of the following accounting variables is least likely to be manipulated?
A) Interest expense.
B) Sales.
C) Net income.
Correct answer is B)
Sales is the accounting variable considered least likely to be manipulated.
Q5. One advantage to using the price/book value (P/B) ratio over using the price/earnings (P/E) ratio is that P/B can be used when:
A) stock markets are volatile.
B) earnings or cash flows are negative.
C) the firm is in a slow growth phase.
Correct answer is B)
When earnings are negative, P/E ratios cannot be used but P/B ratios can be used. The firm's rate of growth and use of leverage and the volatility of markets do not suggest advantages of using P/B ratios rather than P/E ratios.
Q6. The price to book value ratio (P/BV) is a helpful valuation technique when examining firms:
A) with older assets compared to those with newer assets.
B) with the same stock prices.
C) that hold primarily liquid assets.
Correct answer is C)
P/BV analysis works best for firms that hold primarily liquid assets.
Q7. The current price of XYZ, Inc., is $40 per share with 1,000 shares of equity outstanding. Sales are $4,000 and the book value of the firm is $10,000. What is the price/sales ratio of XYZ, Inc.?
A) 0.010.
B) 4.000.
C) 10.000.
Correct answer is C)
The price/sales ratio is (price per share)/(sales per share) = (40)/(4,000/1,000) = 10.0. Alternatively, the price/sales ratio may be thought of as the market value of the company divided by its sales, or (40 * 1,000)/4,000, or 10.0 again.
Q8. Given the following information, compute price/book value.
A) 2.0X.
B) 5.5X.
C) 2.5X.
Correct answer is A)
Book value of equity = $550,000 - $500,000 = $50,000
Market value of equity = ($100)(1000) = $100,000
Price/Book = $100,000/$50,000 = 2.0X
Q9. Given the following information, compute price/sales.
A) 2.50X.
B) 0.50X.
C) 2.00X.
Correct answer is B)
Market value of equity = ($100)(1000) = $100,000
Price / Sales = $100,000 / $200,000 = 0.5X
Q10. General, Inc., has net income of $650,000 and one million shares outstanding. The profit margin is 6 percent and General, Inc., is selling for $30.00. The price/sales ratio is equal to:
A) 2.77.
B) 0.65.
C) 10.83.
Correct answer is A)
6% profit margin = $650,000/x; x (sales) = $10,833,333.
Sales per share = $ffice:smarttags" />
P/Sales = $30.00/$10.83 = 2.77.
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