JonnyKay

Robin Alberts, CFA, is the head of research for Worth Brothers, a large investment company based in New York. Next week, a group of analysts who have just completed the Worth Brothers’ management training program will begin rotating throughout the various departments and trading desks at the firm. The trainees will be split into small groups, and each group will spend four weeks in each area to learn the basic operations of each department through “hands on” experience. Also, in that time period, each department head is expected to fully evaluate each candidate in order to determine their future placement within the firm.
Alberts decides that she should begin every rotation in the research department by giving each candidate a brief review exam to test their knowledge of the general principles of credit analysis. She asks each candidate to analyze the following three scenarios and to answer two questions on each scenario.

Scenario One
	Firm A	Firm B	Firm C	Firm D
Payout Ratio	75%	--	--	--
Required Rate of Return	12%	12%	12%	12%
Return on Equity (ROE)	20%	15%	30%	14%
Price-to-book Value (PBV) Ratio	--	3.00	0.70	3.50

Scenario Two Cost of Capital Measures for Brown, Inc.
Risk-Free Rate	5%
Expected Return on the Market	12%
Beta	1.5
Tax Rate	40%
Cost of Debt	10%
Proportion of the Firm Financed with Debt	20%
Proportion of the Firm Financed with Equity	80%

Scenario Three The Donner Company as of December 31, 2003 (in $ millions)
Cash	38		Current Liabilities	52
Accounts Receivable	120		Long-term Bonds	123
Inventory	57		Common Stock	75
Property, Plant & Equip.	218		Retained Earnings	183
Total Assets	433		Total Liabilities & Equity	433

	2001	2002	2003
Operating Profit (EBIT)	42	38	43
Interest Expense	16	17	20
Relevant Industry Ratios
Long-term Debt-to-equity Ratio: 0.52
Current Ratio: 3.20
Interest Coverage Ratio: 2.10

Using the information in scenario one which of the following items would increase firm A's PBV?

A) Decrease ROE.

B) A larger spread between ROE and the required rate of return (r).

C) Increase r.

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To increase the PBV do one of the following:

• Increase ROE.
• Decrease r.
• Increase the spread between ROE and r.

(Study Session 12, LOS 41.d)

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Using the information from scenario one which of the following items would decrease Firm A's PBV?

A) Increase r.

B) Increase ROE.

C) Increase the spread between ROE and r.

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To decrease the PBV do one of the following:

• Decrease ROE.
• Increase r.
• Decrease the spread between ROE and r.

(Study Session 12, LOS 41.d)

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Using the information in scenario two, what is the cost of equity capital of Brown, Inc.?

A) 12.0%.

B) 15.5%.

C) 10.5%.

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Use the capital asset pricing model (CAPM) to compute the cost of equity capital as follows:
Kequity = 5% + (1.5)(12% - 5%) = 15.5%.
(Study Session 11, LOS 38.d)

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Using the information in scenario two, what is the weighted-average cost of capital (WACC) of Brown, Inc.?

A) 9.86%.

B) 13.60%.

C) 14.40%.

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WACC = (proportion of firm financed with equity)(cost of equity) + (proportion of firm financed with debt)(cost of debt)(1 − tax rate) = (0.8)(15.5%) = (0.2)(10%)(1 − 0.4) = 13.6%.
(Study Session 11, LOS 38.d)

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Using the information in scenario three, what should Mansted observe about Donner’s solvency and debt capitalization?

A) Both Donner's solvency and debt capitalization ratios are better than the industry average.

B) Donner's solvency ratio is worse but its debt capitalization is better than the industry average.

C) Donner's solvency ratio is better but its debt capitalization is worse than the industry average.

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Donner’s current ratio of (38 + 120 + 57) / 52 = 4.13 is higher (better) than the industry average of 3.2. Donner’s long-term debt-to-equity ratio of 123 / (75 + 183) = 0.48 is lower (better) than the industry average of 0.52. (Study Session 14, LOS 48.c)

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Using the information in scenario three, what should Mansted observe about Donner’s ability to make its interest payments? Donner’s interest coverage ratio is:

A) declining (worsening) over time but is still above the industry average.

B) declining (worsening) over time and is below the industry average.

C) rising (improving) over time and is above the industry average.

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Donner’s interest coverage ratio (42 / 16 = 2.625 in 2001, 38 / 17 = 2.235 in 2002, and 2.150 in 2003) is declining from year to year but is still above the industry average of 2.10. (Study Session 14, LOS 48.d)

JonnyKay

Underlying earnings may be defined as earnings:

A) that exclude non-recurring components.

B) that include non-recurring components.

C) net of capital expenditures needed to keep the business productive.

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Underlying earnings are earnings that exclude non-recurring items. They are also known as persistent, continuing, or core earnings.

JonnyKay

Glad Tidings Gifts (GTG) recently reported a representative annual earnings per share (EPS) of $2.25, which included an extraordinary loss of $0.17 and an expense of $0.12 related to acquisition costs during the accounting period, neither of which are expected to recur. Given that the most recent share price is $50.00, what is a useful GTG’s trailing price to earnings (P/E) for valuation purposes?

A) 19.69.

B) 22.22.

C) 25.51.

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Using an underlying earnings concept, an analyst would add back the temporary charges against earnings: $2.25 + $0.17 + $0.12 = $2.54. The resulting trailing P/E = 50.00 / 2.54 = 19.69.

JonnyKay

Alpha Software (AS) recently reported a representative annual earnings per share (EPS) of $1.75, which included an extraordinary loss of $0.19 and an expense of $0.10 related to acquisition costs during the accounting period, neither of which are expected to recur. Given that the most recent share price is $65.00, what is a useful AS’s trailing price to earnings (P/E) for valuation purposes?

A) 37.14.

B) 44.52.

C) 31.86.

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Using an underlying earnings concept, an analyst would add back the temporary charges against earnings: $1.75 + $0.19 + $0.10 = $2.04. The resulting trailing P/E = 65.00 / 2.04 = 31.86.

JonnyKay

The goal of normalizing earnings is to adjust for:

A) seasonal elements.

B) non-cash charges.

C) cyclical elements.

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The goal of normalizing earnings is to adjust for cyclical elements.

JonnyKay

Which of the following statements about cyclical firms is least accurate?

A) The price-to-earnings (P/E) multiple of a cyclical firm normally peaks at the depths of recession and bottoms out at the peak of economic boom.

B) The problems encountered when using the price-to-earnings (P/E) multiples of cyclical firms can be completely eliminated by using average or normalized earnings.

C) Cyclical firms have volatile earnings, and their price-to-earnings (P/E) multiple is not very useful for valuation.

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The P/E multiples for cyclical firms are not very useful for valuation. Earnings will follow the economy, and prices will reflect expectations about the future. Thus, most of the time, the P/E multiple of a cyclical firm will peak at the depths of recession and bottom out at the peak of an economic boom. This problem can be minimized to some extent by using average or normalized earnings but will not be eliminated completely.

JonnyKay

A method commonly used to normalize earnings is the method of:

A) comparables.

B) historical average earnings per share (EPS).

C) average return on assets.

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A common method in normalizing earnings uses the historical average EPS.

JonnyKay

The average return on equity (ROE) earnings normalization method relies on:

A) average ROE over the most recent cycle.

B) average earnings per share (EPS) over the most recent cycle.

C) the earnings yield.

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The average return on equity normalization method normalizes EPS as the average ROE over the most recent full cycle multiplied by book value per share.

JonnyKay

A common pitfall in interpreting earnings yields in valuation is:

A) using underlying earnings.

B) look-ahead bias.

C) using negative earnings.

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A common pitfall is look-ahead bias, wherein the analyst uses information that was not available to the investor when calculating the earnings yield.

JonnyKay

The observation that negative price to earnings (P/E) ratios are meaningless and prices are never negative is used to justify which valuation approach?

A) Dividend discount model.

B) Earnings yield.

C) Dividend yield.

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The observation is used to justify the earnings yield approach. Negative P/E ratios are meaningless. In such cases, it is common to use normalized earnings per share (EPS) and/or restate the ratio as the earnings yield or E/P because price is never negative. Price to earnings (P/E) ranking can then proceed as usual.