Verified Test Bank Analyzing The Results Chapter.15

Chapter: Chapter 15: Analyzing the Results

Short Answer

1. List the criteria for assessing whether a model is technically robust with respect to the following three perspectives: unadjusted financial statements, rearranged financial statements, and statement of cash flows.

2. Rearranged financial statements: The sum of invested capital plus nonoperating assets equals the cumulative sources of financing. NOPLAT is the same when calculated from the top down or from the bottom up.

3. Statement of cash flows: The excess cash and debt line up with the cash flow statement.]

True/False

2. Adjustments in the dividend payout ratio should be used to ensure that the model is technically correct.

Response: [The dividend payout ratio should be adjusted to check that the model is technically consistent. Since payout will change funding requirements, the company’s capital structure will change. Because NOPLAT, invested capital, and free cash flow are independent of capital structure, these values should not change with changes in the payout ratio. If they do, the model has a technical flaw.]

3. An adjustment in the dividend payout ratio should change the value of the firm under the recommended valuation approach in the text.

Response: [The change in the dividend payout ratio will change funding requirements and, thus, the company’s capital structure. However, NOPLAT, invested capital, and free cash flow are independent of capital structure. Thus, these values should not change with changes in the payout ratio. The estimation of the WACC is done completely separately, based on an assumed capital structure going forward.]

Multiple Choice

4. Which of the following are questions an analyst should ask when assessing the economic consistency of a model?

I. Are the patterns chartable?

II. Are the patterns intended?

III. Are the patterns reasonable?

IV. Are the patterns consistent with industry dynamics?

a) I and II only.

b) I and IV only.

c) III and IV only.

d) II, III, and IV only.

Response: []

True/False

5. To ensure that the model is economically consistent, the continuing value formula should be applied when company operations are in a steady state.

Response: [Following the explicit forecasting period, the continuing value formula should be applied when the company’s margins, returns on invested capital, and growth are stable. If this is not the case, the explicit forecast period should be extended until a steady state is reached.]

6. If one arrives at a company value based on the valuation model that is significantly different from the market value, the default assumption should be that the market valuation is incorrect.

Response: [If one’s value based on the valuation model is far from market value, one should not jump to the conclusion that the market is wrong. The default assumption should be that the market is right, unless there are specific indications that not all relevant information has been incorporated into the share price—for example, due to a small free float or low liquidity of the stock.]

Multiple Choice

7. To prioritize strategic actions, the analyst should:

a) Take a vote from the major players.

b) Build a sensitivity analysis that tests multiple changes at a time.

c) Follow the priorities of leaders in the industry.

d) Follow Porter’s five forces analysis.

Response: []

8. An analyst is estimating the ROIC of a company that has zero fixed costs per unit and pays no taxes. The analyst makes the following forecasts: Sales next year will equal 250 units and will increase at 10 percent for each of the two following years. Prices per unit will be $102, $104, and $110, which simply embody inflation forecasts. Costs per unit will be constant at $90. Current capital invested is $20,000, and the firm will reinvest 50 percent of profits. What is the ROIC for each of the three years? If this is a competitive industry, are the results realistic?

a) ROICs in the next three years are 15.0 percent, 17.9 percent, and 25.8 percent, respectively; results are realistic for a competitive industry.

b) ROICs in the next three years are 15.0 percent, 16.5 percent, and 18.3 percent, respectively; results are realistic for a competitive industry.

c) ROICs in the next three years are 15.0 percent, 16.5 percent, and 18.3 percent, respectively; results are not realistic for a competitive industry.

d) ROICs in the next three years are 15.0 percent, 17.9 percent, and 25.8 percent, respectively, results are not realistic for a competitive industry.

Response: [

These results are not realistic for a competitive industry, as the high ROIC will likely attract competition; as competitors enter the market, this will cause lower sales and/or depressed prices.]

9. The forecasts in the prior question used several assumptions. Repeat the forecasts where (scenario A) costs increase with inflation, but all other assumptions hold (costs are $90.0, $91.8, and $97.1 per unit in each of the next three years, respectively); and (scenario B) sales units remain constant, but all the other assumptions hold (including constant costs). What is the ROIC under each assumption? Which assumption is responsible for a significant increase in ROIC?

a) In scenario A, ROIC is 15.0 percent, 15.6 percent, and 16.8 percent for the next three years, respectively. ROIC significantly increases under this assumption versus the constant costs assumption.

b) In scenario B, ROIC is 15.0 percent, 16.3 percent, and 21.5 percent for the next three years, respectively. ROIC significantly increases under this assumption versus the increasing costs assumption.

c) In scenario B, ROIC is 15.0 percent, 15.6 percent, and 16.8 percent for the next three years, respectively. ROIC significantly increases under this this assumption versus the increasing costs assumption.

d) In scenario A, ROIC is 15.0 percent, 16.3 percent, and 21.5 percent for the next three years, respectively. ROIC significantly increases under this this assumption versus the increasing costs assumption.

Response: [

Scenario A:

Scenario B:

Based on these results, the constant costs assumption seems to be responsible for the high ROIC. When costs increase with inflation, ROIC increases to only 16.8 percent.]

10. When making forecasts, increasing one variable usually means decreasing another. Which of the following are possible common trade-offs that should be considered in making such forecasts?

I. Product volume and prices.

II. Lower inventory and higher sales.

III. Higher growth and lower margin.

a) I and II.

b) I and III.

c) II and III.

d) All of the above.

Response: []

11. In a scenario analysis, which of the following are considerations when reviewing the assumptions of a model?

I) The sensitivity of the results to broad economic conditions.

II) The level of competitiveness of the industry.

III) The internal capabilities of the company to achieve the forecasts of output and growth.

IV) The ability of the company to raise the necessary capital from the markets.

a) I and II only.

b) II and III only.

c) I, III, and IV only.

d) I, II, III, and IV.

Response: []

True/False

12. When using the scenario approach, an analyst should not shortcut the process by deducting the face value of debt from the scenario-weighted value of operations, because this would seriously underestimate the equity value, as the value of debt is different in each scenario.

Response: []

Multiple Choice

13. You decide to value a steady‐state company using probability‐weighted scenario analysis. In scenario 1, NOPLAT is expected to grow at 8 percent, and ROIC equals 20 percent. In scenario 2, NOPLAT is expected to grow at 2 percent, and ROIC equals 10 percent. Next year’s NOPLAT is expected to equal $100 million, and the weighted average cost of capital is 12 percent. Using the key value driver formula, what is the enterprise value in each scenario? If each scenario is equally likely, what is the enterprise value for the company?

a) Value in scenario 1 is $1,500m; value in scenario 2 is $800m; weighted value = $1,150m.

b) Value in scenario 1 is $800m; value in scenario 2 is $1,500m; weighted value = $1,150m.

c) Value in scenario 1 is $800m; value in scenario 2 is $1,500m; weighted value = $2,300m.

d) Value in scenario 1 is $1,500m; value in scenario 2 is $800m; weighted value = $2,300m.

Response: [Value in scenario 1 = 100 * (1 – 8%/20%)/(12% – 8%) = 1,500

Value in scenario 2 = 100 * (1 – 2%/10%)/(12% – 2%) = 800

Since each scenario is equally likely (50% probability for each), value is (1,500 * 0.5) + (800 * 0.5) = 1,150]

True/False

14. A colleague recommends a shortcut to value the company in the preceding question. Rather than compute each scenario separately, the colleague recommends averaging each input, such that growth equals 5 percent and ROIC equals 15 percent. This will lead to the same enterprise value as found in that question.

Response: [Since valuation is not a linear function, you cannot average the inputs to determine the expected value. Each input must be calculated specifically to that scenario, and equity value must be tied directly to the individual inputs. Therefore, the colleague’s approach would result in an incorrect value.]

15. When estimating a company’s value, falling within a range of plus or minus 15 percent of the actual valuation is appropriate, as market valuations of this amount for individual stocks are fairly common.

Response: []

Short Answer

16. In creating scenarios that will determine a firm’s future cash flow and present value in a sensitivity analysis, list the four categories of assumptions the analyst should critically review.

2. Competitive structure of the industry and the implications that the level of competition will have on the firm’s market share.

3. Internal capabilities of the company to develop its products on time and manufacture them within the expected range of costs.

4. Financing capabilities of the company relative to possible conditions in financial markets.]