CFC Financial Analysis and Valuation 2 — Questions and Answers
Question 1: A company's price-to-book (P/B) ratio of 0.8 suggests the market values the company at:
- 20% above its book value
- 80% of its stated net asset value (Correct answer)
- 80% above book value
- 8 times book value
Correct answer: 80% of its stated net asset value
A P/B ratio below 1.0 means investors are willing to pay only $0.80 for each $1.00 of the company's net book value, possibly indicating distress or undervaluation.
Question 2: Which financial statement links the income statement to the balance sheet by explaining changes in equity?
- Statement of cash flows
- Statement of changes in stockholders' equity (Correct answer)
- Notes to financial statements
- Management discussion and analysis
Correct answer: Statement of changes in stockholders' equity
The statement of changes in stockholders' equity reconciles beginning and ending equity balances by incorporating net income, dividends, share issuances, and other comprehensive income.
Question 3: Operating leverage refers to the degree to which a firm's:
- Debt financing amplifies earnings volatility
- Fixed operating costs amplify the impact of revenue changes on operating income (Correct answer)
- Variable costs change with revenue
- Interest expense affects net income
Correct answer: Fixed operating costs amplify the impact of revenue changes on operating income
High operating leverage means a large proportion of fixed costs, so a given percentage change in revenue produces a larger percentage change in operating income (EBIT).
Question 4: The weighted average cost of capital (WACC) is used in DCF analysis as the:
- Growth rate for terminal value calculation
- Discount rate that reflects the blended cost of all capital sources (Correct answer)
- Expected return on equity only
- Risk-free rate benchmark
Correct answer: Discount rate that reflects the blended cost of all capital sources
WACC weights the after-tax cost of debt and cost of equity by their proportions in the capital structure, serving as the appropriate discount rate for free cash flows to the firm.
Question 5: Which accounting principle requires recognizing revenue only when it is earned and expenses when incurred, regardless of cash timing?
- Cash basis accounting
- Accrual accounting (Correct answer)
- Historical cost principle
- Going concern principle
Correct answer: Accrual accounting
Accrual accounting matches revenues and expenses to the periods they are earned or incurred, providing a more accurate picture of financial performance than cash basis.
Question 6: Goodwill on a balance sheet arises when:
- A company's stock price exceeds book value
- A company acquires another for more than the fair value of its identifiable net assets (Correct answer)
- A company writes down intangible assets
- A company records deferred tax assets
Correct answer: A company acquires another for more than the fair value of its identifiable net assets
Goodwill is recorded as the excess of acquisition price over the fair value of identifiable assets minus liabilities, representing intangible value like brand, customer relationships, and synergies.
CFC Financial Analysis and Valuation 2
A company's price-to-book (P/B) ratio of 0.8 suggests the market values the company at: