Sessions #7#12: Practice Problems Session #7 – Reformulation (4)
Which of the following is NOT an objective when reformulating the Statement of Cash Flows?
1) To separate equity and debt financing cash flows
2) To calculate the firm’s free cash flow (FCF), and to show how it is both generated and used
3) To ensure that the firm has a positive free cash flow (FCF)
4) To separate items within the reported Cash Flows from Investing section into investments from/to operating assets from those from/to financial assets.
Which of the following statements about a firm’s free cash flow (FCF) is TRUE?
1) If a firm’s free cash flow (FCF) is negative, it will have funds to invest in financial assets
2) Uses of free cash flow classified under the ‘Debt financing cash flows’ include the following:
investments in financial cash, interest paid, and interest income.
3) If a firm’s free cash flow (FCF) is negative, it has invested too much in long-term operating
assets such as property, plant, and equipment
4) Uses of free cash flow (FCF) classified under the ‘Equity financing cash flows’ include each
of the following: payment of dividends to common shareholders, payment of dividends to preference shareholders, and share repurchases.
The reformulated Income Statement for a company with a 30% tax rate is presented below.
Core Operating Income from Sales (before tax) 1,000 Core Other Operating Income (before tax) 400 Unusual Operating Income (before tax) 200 Net Financial Expenses (before tax) 250 Profit Before Tax 1,350
Income tax expense 450
Based on this information, what is the tax allocation to Core Operating Income from Sales? 1) 345
2) 270
3) 195
4) 450
Condensed versions of the reformulated 2020 and 2019 Balance Sheet and Income Statement for a company which pays no tax are presented below.
Balance Sheet
2019
2020
2019
2020
Operating Assets (OA)
250
275
Financial Assets (FA)
12
15
Operating Liabilities (OL)
(70)
(83)
Financial Obligations (FO)
(122)
(132)
Net Financial Obligations (NFO)
110
117
Net Operating Assets (NOA)
180
192
Shareholders’ Equity
70
75
Income Statement
2019
2020
Operating Income (after tax)
142
164
Net Financial Expenses (after tax)
(10)
(15)
Comprehensive Income (after tax)
132
149
Based on this information, what is company’s free cash flow (FCF) for 2020? 1) 144
2) 152
3) 176
4) 164
Session #8 – Earnings Management (4)
Which of the following in NOT a reason that CFO’s identify as a consequence of failing to meet earnings benchmarks?
1) It reduces information risk
2) It creates uncertainty about the firm’s future prospects
3) Management will have to take time away from managing the business to explain why the benchmarks were missed
4) Missing benchmarks may be suggestive of other previously unidentified problems
Which of the following is NOT an example of an accounting-based earnings management (EM) strategy?
1) Unusually high (Level 3) fair value estimates
2) Unusually low warranty liability estimates
3) Unusually low cash flow from operations
4) Unusually low deferred revenues
Which of the following is NOT an example of a situation where earnings management (EM) is more likely?
1) When the firm is ‘in play’ as a takeover target
2) The firm has very low positive earnings
3) When there has been a change in the firm’s management
4) The firm conducts all of its business with unrelated parties
Which of the following statements about earnings management is NOT true?
1) If accruals are overstated by earnings management this year, they will be understated in some
future period or periods
2) An unusual decrease in the provision for employee benefits is a red flag that the company
might be overstating its operating assets to increase earnings
3) An unusual increase in inventories is a red flag that the company might be overstating its
operating assets to increase earnings
4) An unusual increase in net operating assets is a red flag that the company might be managing
its operating accruals in order to increase earnings.
Session #9 – Financial Statement Analysis (7)
At the end of its fiscal year, a company has a quick ratio of 0.6, a current ratio of 0.8, and the balance of its current asset accounts is $3 million. Its sales for the year were $15 million and the associated cost of goods sold (COGS) is equal to 60% of sales. What is the company’s inventory turnover ratio based on average-of-year values, if its beginning inventory balance was $2 million? 1) 4.50
2) 6.55 3) 7.50 4) 9.45
Your firm received a $1 million purchase order on the last day of its fiscal year, which it immediately filled with $600,000 of inventory. The customer paid $250,000 in cash and you firm invoiced the customer for the balance. Based on this information, which of the following statements is TRUE?
1) The firm’s current ratio will remain unchanged
2) The firm’s current ratio will increase
3) The firm’s current ratio will decrease
4) The firm’s quick ratio will decrease
Which of the following would typically lead to an increase in a firm’s current ratio?
1) The sale of inventory
2) The purchase of additional inventory for cash
3) Taking out a bank loan to pay suppliers
4) A customer paying an outstanding bill
The following financial information is drawn from General Mills reformulated 2010 financial statements:
Net Operating Assets (NOA)
Net Financial Obligations (NFO) Operating Income (OI) (after tax)
Net Financial Expenses (NFE) (after tax)
11,632 6,099 1,177
251
Based on this information and using end-of-year figures, what is General Mill’s return on common
equity (ROCE) for 2010? 1) 0.213
2) 0.101
3) 0.167
4) 0.041
GL Ltd. is a manufacturer of small appliances. Following is a condensed AASB/IFRS Income Statement for the most recently completed fiscal period:
Sales
Cost of Goods Sold
Gross Profit
Rental Income
Interest Expense Depreciation
Net Profit before Tax Income Tax Expense (30%) Net Profit After Tax (NPAT)
$1,500,000 (600,000)
900,000 50,000 (125,000) (275,000) 550,000 (165,000) 385,000
Based on this information, what is GL’s times-interest-earned ratio and its operating profit margin (after tax)?
1) Its times-interest-earned ratio is 4.400 and its operating profit margin is 0.315
2) Its times-interest-earned ratio is 4.400 and its operating profit margin is 0.450
3) Its times-interest-earned ratio is 5.400 and its operating profit margin is 0.450
4) Its times-interest-earned ratio is 5.400 and its operating profit margin is 0.315
The following turnover ratios for individual operating assets and operating liabilities have been calculated using end-of-year figures based on Trail Inc.’s reported 2020 Balance Sheet:
Cash turnover 6.0 Accounts receivable turnover 4.0 Inventory turnover 3.0 Property, plant & equipment turnover 2.0 Accounts payable turnover 7.5 Provisions turnover 3.0
Based on this information, what is Trail’s asset turnover ratio (= sales / NOA)? 1) 25.500
2) 1.277
3) 0.583
4) 0.800
The following financial information is drawn from Crazy Horse Inc.’s reformulated 2019 financial statements:
Operating Assets (NOA) 10,000 Operating Liabilities (OL) 7,000 Operating Income (OI) (after tax) 1,800 Net Financial Expenses (NFE) (after tax) 150 Stated short-term borrowing rate 6% Tax rate 30%
Based on this information and using end-of-year figures, what is General Mill’s return on net operating assets (RNOA) for 2010?
1) 0.209
2) 0.698
3) 0.600 4) 0.042
Session #10 – Financial Statement Analysis; Forecasting (5)
Which of the following ratios is NOT in the ‘DuPont System’?
1) Operating profit margin
2) Asset turnover
3) Current ratio
4) Financial Leverage
Which of the following changes will lead to an increase in ROCE for a profitable company?
1) An increase in Shareholders’ Equity (S/E), all else remaining unchanged
2) A decrease in the amount of long-term debt outstanding, all else remaining unchanged
3) A decrease in the corporate tax rate, all else remaining unchanged
4) A decrease in operating income (after tax), all else remaining unchanged
Which of the following calculations is correct if sales are $5,600, operating profit after tax is $2,090, the tax rate is 30%, there are no ‘other comprehensive income’ items, net financial obligations (NFO) are $30,900 and shareholders’ equity (S/E) is $16,500?
1) operating profit margin = 0.358
2) asset turnover = 0.156
3) financial leverage = 1.572
4) ROCE = 0.127
Which of the statements about the forecasting exercise is TRUE?
1) The appropriate forecast horizon will typically be shorter for a firm in a mature industry than
for a firm in an emerging industry sector
2) The ‘regression to the mean’ phenomenon confirms that poor performing firms will not
survive in the longer term
3) When a company has reached its ‘steady state’ growth rate, its operating profit margin will
grow at the terminal growth rate
4) The sustainable growth rate, g*, is the growth rate in sales that the firm can achieve if it is
able to issue new debt and/or new equity.
Which of the statements arising from a ‘third level’ break down of ROCE is NOT true?
1) An increase in Accounts Receivable turnover will result in an increase in ROCE, assuming all
else remains unchanged
2) A reduction in the Accounts Payable balance will result in an increase in ROCE, assuming all
else remains unchanged
3) A reduction in production costs will result in an increase in ROCE, assuming all else remains
unchanged
4) A decrease in the inventory balance will lead to an increase in ROCE, assuming all else
remains unchanged.
Session #11 – Forecasting and Valuation (5)
Which of the following statements about the process of forecasting a firm’s pro forma Financial Statements is NOT true?
1) The focus of the forecasting process should be on the firm’s sustainable (core) earnings
2) A firm’s core sales profit margin relates its operating income to the level of its investment in
net operating assets
3) The extent to which a firm’s operating costs are fixed helps to determine its core sales profit
margin
4) A firm’s core sales profit margin captures its ability to generate operating profits from sales
Which of the following factors does NOT influence the extent to which Shareholders’ Equity (S/E) grows?
1) The growth rate in the firm’s sales
2) A change in the firm’s degree of financial leverage
3) A change in the firm’s investment in net operating assets (NOA)
4) A change in the cost of the firm’s financial obligations (net borrowing cost)
You have been provided the following actual financial information from the reformulated 2020 financial statements of Castlegar Ltd. and forecasts of the same figures for 2021
Based on these actual and forecasted values, which of the following statements is TRUE?
1) Both the firm’s operating profit margin and its asset turnover are forecasted to increase
2) Both the firm’s operating profit margin and its asset turnover are forecasted to decrease
3) The firm’s operating profit margin is forecasted to increase and its asset turnover to decrease
4) The firm’s operating profit margin is forecasted to decrease and its asset turnover to increase
Based on the reformulated financial statements for its most recently completed fiscal year (2020), a firm has net operating assets (NOA) of $250,000 and net financial obligations (NFO) of $175,000.
As an analyst, you have already forecasted a 8% growth in the firm’s shareholders’ equity. You are now trying to decide how to forecast the firm’s net financial obligations (NFO) and then its net financing expenses (NFE) for 2021. While you are comfortable with your forecast of the firm’s net borrowing costs (NBC) of 4% after tax, you are uncertain about how best to forecast the firm’s net financial obligations (NFO).
One approach you are considering is to forecast an increase in net financial obligations equal to your forecast of the growth in the firm’s property, plant & equipment (p,p&e) of 2.5% because these assets are leased and the lease obligation will be recorded as a NFO. Thus, from this perspective, NFOs should grow at the same rate as p,p&e.
The other possible approach that you are considering is to base your forecast of the firm’s net financial obligations on your forecast of the firm’s degree of financial leverage (FLEV). Here, you believe that the firm is at its optimal capital structure and as such, FLEV will remain constant.
2020 Actual
2021 E
Sales revenue
37,408
38,776
Operating Income (OI) (after tax)
1,288
1,362
Net Operating Assets (NOA)
12,205
13,102
Based on this information, which approach to forecasting net financial obligations (NFO) will lead to a higher net financing expense (NFE), the approach based on the growth rate in p,p&e of 2.5%, or the approach based on the assumption that FLEV will remain constant?
1) The approach based on the 2.5% growth rate in p,p&e will lead to a higher NFE
2) The approach based on a constant FLEV will lead to a higher NFE
3) The two approaches will lead to the same NFO and hence the same NFE
4) It is not possible to determine which approach will result in a higher NFE based on the
information provided
You have been provided the following actual financial information from the reformulated financial statements of Mission Beach Ltd. for the years 2019 and 2020, and then a set of forecasted financial information for the three period, 2021 – 2023.
2020 Actual
2019 Actual
Net Operating Assets (NOA)
7,750
7,500
Net Financial Obligations (NFO)
1,750
1,750
2021 E
2022 E
2023 E
Sales forecasts
10,000
10,500
11,000
Operating profit margin (after tax)
0.20
0.20
0.20
Asset turnover
1.25
1.25
1.25
Net Financing Expenses (after tax)
175
175
175
Using the Abnormal Earnings (Residual Income) valuation model, what is the intrinsic value of a common share of Mission Beach Ltd. based on the forecasts above if the appropriate cost of equity capital is 7.5%, net financial obligations (NFO) remain unchanged from their value in 2020, there are no Other Comprehensive Income (OCI) items, Mission Beach has 1,000 common shares outstanding, and abnormal earnings are forecasted to grow at 2% after 2023?
1) $26.55 2) $32.55 3) $33.32 4) $34.23
Session #12 – Forecasting and Valuation (5)
Based on its reformulated Financial Statements for the fiscal year 2020, WaveJumper (WJ) Inc. had net operating assets (NOA) of $100,000, net financial obligations (NFO) of $25,000, and sales revenue of $200,000. An analyst has recently made the following forecasts for the 3-year period 2021 – 2023:
Based on these forecasts and using the Abnormal Earnings (Residual Income) valuation model, the analyst then valued WJ’s 200,000 common shares using a weighted average cost of capital (WACC) of 6% and assuming that residual operating income would grow at 3% after 2023.
2021 E
2022 E
2023 E
Sales growth forecasts
5%
5%
5%
Operating profit margin (after tax)
0.25
0.25
0.25
Asset turnover
2.0
2.0
2.0
You have now had the chance to examine the analyst’s forecasts and agree with all of them except the operating profit margin forecasts which you believe should be 20% and not 25%. Based on this one difference in forecasts, how much would your estimate of the intrinsic value of a common share of WJ differ from the analyst’s estimate?
1) lower by $1.82 ($6.60 versus $8.42)
2) lower by $0.20
3) higher by $1.82
4) the estimates will be the same
Which of the following factors typically will NOT influence the magnitude of the price-earnings (P/E) ratio?
1) a permanent change in earnings
2) the firm’s business risk
3) the anticipated growth in the firm’s future earnings
4) the firm’s choice of accounting policy
Which of the following statements about the price-earnings (P/E) and market-to-book (M/B) ratios is TRUE?
1) If a firm has a high (above normal) P/E and a high (above normal) M/B, its future abnormal earnings are expected to be constant
2) If a firm has a high (above normal) P/E and a low (below normal) M/B, its abnormal earnings are expected to decrease
3) If a firm has a low (below normal) P/E and a high (above normal) M/B, its future abnormal earnings are expected to be constant
4) If a firm has a high (above normal) P/E and a low (below normal) M/B, its future abnormal earnings are expected to increase
An analyst has provided you with the following actual and forecasted financial information for Ferny Ltd.:
The analyst has also provided the following additional information:
the forecasted growth rate in residual comprehensive income (CI) after 2022 is 2%
the firm’s net borrowing cost (NBC) after tax is 3%
the firm’s cost of equity capital is 6%
the firm has no other comprehensive income (OCI) items
Having received the analyst’s report, you are now trying to determine whether the estimate of the intrinsic value of Ferny’s common equity is more sensitive to a 0.5% decrease in the terminal growth rate to 1.5% or a 1% decrease in the operating profit margin to 19%. Based on the information provided, which of the following statements is TRUE?
1) The estimated intrinsic value is more sensitive to the decrease in the terminal growth than to the decrease in the operating profit margin
2) The estimated intrinsic value is more sensitive to the decrease in the operating profit margin than to the decrease in the terminal growth rate
2020 Actual
2021 E
2022 E
Sales
$500,000
$550,000,000
$575,000,000
Operating profit margin (after tax)
20%
20%
20%
Net Operating Assets (NOA)
200,000
220,000
230,000
Asset turnover
2.5
2.5
2.5
Net Financial Obligations (NFO)
125,000
130,000
135,000
3) There is no difference in the sensitivity of the estimated intrinsic value to the changes in the terminal growth rate and the operating profit margin
4) The estimated intrinsic value is not sensitive to changes in either the terminal growth rate or the operating profit margin
An analyst has provided you with the following actual and forecasted financial information for White Rock Inc.:
As confirmed by their forecasts, while the analyst believes that the firm’s sales will grow, they also believe that its operating profit margin and asset turnover will remain constant.
Having received the analyst’s report, you have now conducted your own investigation into the financial prospects of White Rock Inc. While you agree with the analyst’s forecast for a terminal growth rate in residual operating income of 4% after 2022 and that the required rate of return on the firm’s operations is 8%, you do not agree with either their forecasted operating profit margin or asset turnover figures. Based on your own investigation, you believe that White Rock’s operating profit margin will be slightly higher at 21% in both 2021 and 2022, but that its asset turnover will be somewhat lower at 1.8 in both years. Given this information, which of the following statements is TRUE?
1) Your estimate of the intrinsic value of White Rock’s common shares will be lower than the analyst’s estimate
2) Your estimate of the intrinsic value of White Rock’s common shares will be the same as the analyst’s estimate
3) Your estimate of the intrinsic value of White Rock’s common shares will be higher than the analyst’s estimate
4) Based on the information provided, it is not possible to determine whether your estimate or the analyst’s estimate of the intrinsic value of White Rock’s common shares will be higher
2020 Actual
2021 E
2022 E
Sales
$25,000,000
$30,000,000
$35,000,000
Operating profit margin (after tax)
20%
20%
20%
Asset turnover
2.0
2.0
2.0
Net Operating Assets (NOA)
12,500,000
15,000,000
17,500,000