Equity Valuation【Reading 42】Sample 2012

hariRaj

Market value added is calculated as:

A) net operating profit after taxes minus a charge for total capital.

B) market value of the company minus a charge for equity capital.

C) market value of the company minus total capital.

---

Market value added is the market value of the company minus total capital. It is used to measure the effect on value of management’s decisions since the firm’s inception.

invic

Big Sky Ranches reported the following for the end of its fiscal year:

• Book Value = $3.18
• ROE=22%
• Retention Ratio = 50%
• Required Return = 14.1%

The current share price is $11.28 per share. The shares (relative to a single-stage residual income model) are most likely:

A) undervalued.

B) overvalued.

C) correctly valued.

---

g = retention ratio × ROE = (0.50) × 0.22 = 0.11 or 11.00%

invic

general, firms making aggressive accounting decisions will report future earnings that are:

A) lower.

B) higher.

C) inflation-adjusted.

---

In general, firms making aggressive (conservative) accounting decisions will report higher (lower) book values and lower (higher) future earnings.
Firms may adopt aggressive accounting practices that overstate the value of earnings by, for example, accelerating revenues to the current period or deferring expenses to a later period. Current earnings will be higher, but future earnings will be lower.

invic

Reported accounting data are most likely to bias an estimate of residual income when:

A) the clean surplus relation holds.

B) standards allow charges directly to stockholders' equity while bypassing the income statement.

C) standards allow charges directly to stockholders' equity that are also reflected on the income statement.

---

Bias is likely when standards allow charges directly to stockholders’ equity while bypassing the income statement. Both remaining responses are consistent with the use of data that will not introduce a bias.

invic

Which of the following characteristics of a company would make it unsuitable for residual income valuation analysis?

A) Book-value estimates are not reliable.

B) The forecast of terminal value is not reliable.

C) Free cash flows are negative and likely to remain so for some time.

---

Residual income models can handle negative free cash flows and poor forecasts for terminal value. However, poor book-value estimates render the statistic less useful.

invic

Analyst Brett Melton, CFA, is looking at two companies. Happy Cow Dairies has volatile cash flows, and its free cash flow is often negative. The company pays no dividends. Glitter and Gold, a maker of girls’ clothing, has a fairly steady stream of earnings and cash flows but takes a lot of charges against equity. Is the residual income model suitable for valuing the two companies?

Happy Cow Dairies

Glitter and Gold

A) No Yes

B) Yes No

C) No No

---

Residual income models work for companies with no dividends and volatile or negative cash flows. They do not work, however, when the clean surplus relation does not hold, as is the case when companies take charges against equity.

invic

The residual income approach is NOT appropriate when:

A) a firm does not pay dividends or the stream of payments is too volatile to be sufficiently predictable.

B) the clean surplus accounting relation is violated significantly.

C) expected free cash flows are negative for the foreseeable future.

---

The residual income approach is not appropriate when the clean surplus accounting relation is violated significantly. Both remaining responses describe circumstances in which the approach is appropriate.

invic

The residual income approach is appropriate when:

A) expected free cash flows are negative for the foreseeable future.

B) a firm pays high dividends that are quite stable.

C) the clean surplus accounting relation is violated significantly.

---

The residual income approach is appropriate when expected free cash flows are negative for the foreseeable future. It is not appropriate when the clean surplus accounting relation is violated significantly. A firm that pays high dividends that are quite stable is also a poor candidate for the approach.

invic

An argument against using the residual income (RI) valuation approach is that:

A) terminal value does not dominate total present value as is the case in dividend and free cash flow valuation models.

B) the models rely on accounting data that can be manipulated by management.

C) the models focus on economic rather than just on accounting profitability.

---

An argument against using the RI approach is that the models rely on accounting data that can be manipulated by management. Both remaining responses are arguments in favor of the approach.

invic

A use of the residual income (RI) valuation approach is:

A) deferring value more than in competing valuation approaches.

B) providing more reliable estimates of terminal value.

C) providing a check of consistency between competing approaches like free cash flow of equity (FCFE) and dividend discount model (DDM) .

---

A RI model can be used along with other models to assess the consistency of results. FCFE and DDM models forecast future cash flows while RI models start with a balance sheet measure of equity and add the present value of expected future RI.