ch10

1. The forecasting and valuation process has four stages. The stage in which values are estimated for assumptions by considering historical relationships, trends, and expected changes in business is known as:

a.   modeling the free cash flows

b.   sensitivity analysis

c.   setting the model assumptions and computing the results

d.   refining the model

1. The first step in developing a free cash flow forecast is to model the components of free cash flow. The model is a set of equations, each of which:

a.   defines the value of a particular line item in the forecast

b.   defines the value of a particular line item in the forecast, given the values of other forecast items

c.   defines the value of a particular line item in the forecast, given the values of other forecast items and prior-year values

d.   defines the value of a particular line item in the forecast, given the values of other forecast items, prior-year values, and additional assumptions

1. A free cash flow forecast must be both reasonable and internally consistent. One of the elements of reasonableness is that the forecasted numbers are:

a.   logical in relation to each other

b.   good estimates of the present values of line items on the firm’s financial statements

c.   good estimates of the future values of the forecasted items

d.   None of the above answers are correct.

1. The cost of sales is another key forecast component in a free cash flow forecast. For a forecast to be internally consistent, forecasted amounts are logical in relation to each other. The cost of sales forecast is internally consistent if:

1. the cost of sales forecast depends on operating expenses computed as a percentage of revenues
2. the cost of sales forecast depends on revenue
3. the cost of sales is partially static
4. None of the above answers are correct.

1. An internally inconsistent forecast occurs when:

1. a parameter is changed in one equation and not the other equation
2. operating expenses depend on revenue levels
3. the cost of sales forecast must depend on revenue
4. the cost of sales are entirely variable

1. In the forecast formula for the operating expenses cash flow variable, the net revenue projection for the firm:

a.   is multiplied by gross profit as a percentage of net revenue

b.   is multiplied by operating expenses as a percentage of net revenue

c.   is subtracted from operating expenses as a percentage of net revenue

d.   is added to the net revenue growth rate

1. Components from the free cash flow statement are used in the forecast formula for net operating profits after taxes (NOPAT). Which statement below regarding this formula is incorrect?

a.   The capital expenditures and changes in the working capital of the firm are included in NOPAT.

b.   Because it is not a cash flow, depreciation expense is an item that is reversed in NOPAT.

c.   Cash flows related to core operations are not included in NOPAT.

d.   Because it is not a cash flow, amortization is an item that is reversed in NOPAT.

1. Analysts assume that depreciation is a reasonable estimate of maintenance capital expenditures, which are required to maintain the existing level of productive capacity. Several key assumptions are made when we assume that depreciation is a reasonable estimate. Which key assumption about depreciation is incorrect?

1. The firm uses an accurate estimate of the useful life to calculate depreciation.
2. The asset will be replaced evenly over its life.
3. The analyst assumes that the cost of a unit of productive capacity will change.
4. All of the assumptions above are correct.

1. When working with the free cash flow model, analysts are faced with the problem of forecasting free cash flow for an infinite number of periods. To solve the problem, analysts forecast a finite number of periods explicitly and then assume a regular pattern of cash flows after that point, which is called the:

a.   terminal value

b.   net present value of smooth cash flows

c.   perpetuity value

d.   Answers a and c are both correct.

1. Using the free cash flow model, the problem of forecasting free cash flow for core operations is solved by:

a.   using a pattern of regular cash flows, the infinite series of cash flows can be valued without summing an infinite number of terms

b.   estimating only the net present value of free cash flows during the forecasting period

c.   estimating only the terminal value without using a constant growth rate

d.   separating the value of core operations into two parts, one of which represents the value of free cash flows during the forecasting period and the other part represents the terminal value

1. The question of the number of years to forecast explicitly before assuming a regular pattern of cash flows can be reasonably determined based on two principles. Which statement below is incorrect regarding these principles?

a.   The firm’s net present value projects have no bearing on the forecast horizon.

b.   The explicit forecast should be long enough for the analyst to expect a regular pattern of cash flows beginning at the point of terminal value.

c.   There is no right answer to the question of how many years the explicit forecast should be in length before assuming a regular pattern of cash flows.

d.   All of the answers above are correct.

1. Historical relationships are considered a starting point for setting forecast assumptions. Which statement about historical relationships and forecasting is false?

a.   To forecast sales growth, an analyst might look at historical sales growth rates.

b.   A first step for setting forecast assumptions is to compute the historical values of all ratios used that will be used as assumptions.

c.   The free cash flow statement is used to calculate the historical values of the firm’s forecast ratios.

d.   There is no requirement that the forecast use historical values.

1. When an analyst prepares a business and financial statement analysis of a firm for use in a valuation, it is important to remember that all of the quantitative data compiled are just measurements of the business results. The analyst must concentrate on understanding the business using the numbers generated as a guide. The analyst can keep focused on the firm’s business issues by:

a.   using a log of business questions and issues uncovered during the analysis as a “reality check” when finalizing the firm’s forecast and valuation

b.   limiting the search for information about competitors of the firm

c.   not considering specific questions and issues about the firm during sensitivity analysis

d.   limiting the search for information about the industry in which the firm operates

1. After an initial free cash flow model has been built, the analyst may want to refine the model by doing more detailed analysis on one or more parts of the model. Assume that the analyst is considering whether to separate revenues and operating income forecasts by product line. In making such a decision, the analyst needs to consider if:

a.   a ratio should be separated into two or more parts

b.   different product lines will have different revenue growth rates or margin percentages

c.   the analysis should be separated into two or more business units using segment data

d.   linking the analysis to external or economy-wide forecasts will generate the desired information

1. After an initial free cash flow model has been built, the analyst may want to refine the model by doing more detailed analysis on one or more parts of the model. Assume that the analyst is considering whether to separate the analysis into two or more business units. To forecast by business unit, the analyst will want to:

a.   determine if different product lines will have different revenue growth rates or margin percentages

b.   study the firm’s historical results by business unit

c.   link the analysis to external or economy-wide forecasts to generate the desired information

d.   The analyst will not perform any of the above tasks in this situation.

1. SFAS No. 131 requires firms to disaggregate historical sales and margins by business unit. Firms subject to this GAAP standard must meet at least one “10% test.” Which statement below is correct regarding the “10% tests”?

a.   The segment’s assets are less than 10% of the combined assets of all operating segments.

b.   The absolute amount of the segment’s income or loss is less than 10% of the absolute amount of the combined profit of all segments reporting a profit.

c.   The segment’s revenue is at least 10% of the combined revenues of all operating segments.

d.   The absolute amount of the segment’s income or loss is less than 10% of the absolute amount of the combined loss of all segments reporting a profit.

1. An analyst may want to refine a free cash flow model by doing more detailed analysis on one or more parts of the model. Further analysis that is linked to external or economy-wide forecasts is generally useful:

a.   when the analysis is dividend into two or more business units

b.   when the analysis separates ratios into two or more parts

c.   for forecasting the firm’s sales

d.   for forecasting the firm’s net income growth over time

Sensitivity analysis is a critical part of the valuation process. The analyst may calculate many sensitivities as part of the valuation. The type of sensitivity analysis in which the analyst determines the assumptions that would justify the current stock price for the firm and then base the investment decision on whether such assumptions are reasonable is known as:

a.   single-assumption sensitivity analysis

b.   reverse valuation

c.   scenario-based sensitivity analysis

d.   combined sensitivity analysis

Sensitivity analysis is a critical part of the valuation process. An analyst finds out that a change in a firm’s advertising budget affects sales volume and operating expenses. The type of sensitivity analysis that would help the analyst in this situation is:

a.   single-assumption sensitivity analysis

b.   reverse valuation

c.   scenario-based sensitivity analysis

d.   combined sensitivity analysis

An analyst calculates what would happen if revenues were higher or lower than that was projected in the base case forecast. This type of sensitivity analysis is called:

a.   single-assumption sensitivity analysis

b.   reverse valuation

c.   scenario-based sensitivity analysis

d.         combined sensitivity analysis

Using sensitivity analysis, an analyst assesses how every assumption might change in the base case forecast given a different set of circumstances. This type of sensitivity analysis is called:

a.   single-assumption sensitivity analysis

b.   reverse valuation

c.   combined sensitivity analysis

d.   scenario-based sensitivity analysis

Which type of sensitivity analysis lends itself to using matrices?

a.   single-assumption sensitivity analysis

b.   reverse valuation

c.   combined sensitivity analysis

d.   scenario-based sensitivity analysis

Using sensitivity analysis, an analyst calculates a range of values given both optimistic and pessimistic values for an assumption. This type of sensitivity analysis is called:

a.   reverse valuation

b.   single-assumption sensitivity analysis

c.   combined sensitivity analysis

d.   scenario-based sensitivity analysis