Concept questions

H1
C 1.1 Fundamental risk is inherent to the business , it is the chance of losing money
because of the outcome of business activities . Price risk on the other hand
concerns the risk of losing value from buying or selling investments at prices that
differ from the intrinsic value.
The difference between them is that fundamental risk considers changes in the
future payoffs of an investment due to changes in the business, whereas price risk
considers the difference between the value of the future payoffs and the price of
the investment.
You can protect yourself from fundamental risk by diversification, you can
diminish price risk by performing a fundamental analysis of financial statements.
C 1.2 An alpha technology looks at abnormal returns over the expected return for the
risk taken. A beta technology, such as the CAPM, gives an estimate of the required
return as the sum of the risk free rate and a risk premium. This premium consists
of a risk premium on a risk factor, multiplied by the sensitivity to this risk factor.
Alpha technologies are used to identify price risk and possibly trade against it,
whereas beta technologies are used to diversify fundamental risk.
C 1.3 An index investor would agree with this statement because the historical S&P 500
average annual return to stocks has been 12.3 percent, compared to 6 percent for
corporate bonds and 3.5 percent for treasury bills. The fundamental investor
recognizes these statistics but notes that these returns are not guaranteed.
C 1.4 A passive investor assumes that markets are efficient and prices are correct. He
requests fundamental risk from analysts, calculated with beta technologies, and
then uses these to create a diversified portfolio that diminishes total fundamental
risk. (extreme: index investor)
An active investor uses alpha technologies to identify price risk and to possibly
trade against it, he assumes that stocks are not always priced correctly. He
separates price from value and tries to find the intrinsic value that needs to be the
market price.
C 1.5 E/P = 10 % and P/E = 10 could be a normal market P/E compared with a normal
stock return of 10 %.
C 1.6 No, the open market would have far less information, the firm knows the
fundamental value of the shares. If the open market overestimates share value you
want to sell to the open market, if it underestimates share value you want to sell to
the firm.
C 1.7 If all investors would be agreeing fundamental investors, no one could earn
abnormal returns. If a stock is undervalued, everyone would buy it, which drives
the price up to the correct price. If a stock is overvalued, everyone would sell it,

which would drive the price down to the correct price. It seems impossible to
outperform the market if everyone agrees on the valuations. That is why, if this is
not the case, fundamental investors could outperform passive investors, because
passive investors might buy an overvalued or sell an undervalued stock, due to a
lack of information.
C 1.8 If they would all be passive investors, stocks can be over or undervalued, and they
would remain this way because no one would trade against these valuations.
Prices would depend on betas provided by analysts.
C1.9 a. This indicates that on average, prices were close representations of intrinsic
value.
b. In theory I believe it would have, because you bought when it was cheap and
sold when it was expensive.
c. This indicates the creation of a bubble: more and more people buy an overpriced
stock, expecting it to go up even more. = Momentum investing.

H2
C 2.1 Changes in shareholders equity are determined by total earnings minus net pay-out
to shareholders, but the change in shareholders equity is not equal to net income (in the
income statement) minus net pay-out to shareholders. Why?
Because you have to add other comprehensive income to net income in order to become
comprehensive income. Comprehensive income net pay-out to shareholders = change
in equity.
C2.2 Dividends are the only way to pay cash out to shareholders. True or false?
No, you can also repurchase shares.
C2.3 Explain the difference between net income and net income available to common.
Which definition of income is used in earnings-per-share calculations?
Net Income preferred dividends= Net income available to common. The latter is used
for EPS calculations.
C2.4 Why might a firm trade at a price-to-book ratio (P/B) greater than 1.0?
There might be a positive intrinsic/market premium.
C2.5 Explain why firms have different price-earnings (P/E) ratios.
The P/E ratio reflects anticipated earnings growth.
C2.6 Explain the difference between accounting value added (earnings) and shareholder
value added.

Shareholder value added is a speculative value while accounting value is only added
when revenue is booked.
C2.7 Give some examples in which there is poor matching of revenues and expenses.

Estimating long useful lives for plant so that depreciation is understated

Underestimating bad debts from sales so that income from sales is overstated.
Overestimating a restructuring charge

C2.8. Price-to-book ratios are determined by how accountants measure book value. Can
you think of accounting reasons for why price-to-book ratios were high in the 1990s? What
other factors might explain the high P/B ratios?
Intangible assets were recorded at historical cost. There also might be unrecorded
assets. Vb Dell halt veel value uit direct-to-consumer process. Dit is niet opgenomen in
de balans omdat de fair value hier heel moeilijk van de evalueren is en dit zou leiden tot
speculatieve cijfers.
C2.9 Why are dividends not an expense in the income statement?
The income statement reports how shareholders equity increased or decreased as a
result of business activities. Dividends are not an expense but a distribution of value.
C2.10 Why is depreciation of P&E an expense in the income statement?
Because of the matching principle: Expenses are recognized in de income statement by
their association with revenues for which they have been incurred. Incurring the cost of
plant & equipment directly as an expense at the date of acquiring goes against the
principle.
C2.11 Is amortization of a patent right an appropriate expense in measuring value added
in operations?
Yes, if this patent provides revenue over the same amount of time the right is amortized
over.
C2.12 Why is the matching principle important?
The difference between revenue and matched expenses is the measure of value added
from trading with customers. If you violate this principle, this could lead to incorrect
earnings.
C2.13 Why do fundamental analysts want accountants to follow the reliability criterion
when preparing financial reports?
Forecasts are only reliable when the reliability criterion is respected. This way the
analyst has hard information to base his forecasts on.

H3
C3.1: Price to sales ratio equals (p/e) * (e/s) where (e/s) is defined as each dollar of sales that
end up in earnings. Differences in p/s explain differences in the profitability of sales.
C3.2: (p/s) and (p/ebit) ratios should be calculated as unlevered ratios because leverage does
not produce sales or earnings before interest and taxes. Hence, it is useful to control for
differences in leverage between the target firm and comparison firms. Danger: it leaves out
interests and taxes.
C3.3: (p/ebitda) adjusts for both leverage and the accounting of these expenses (depreciation
and amortization measures can differ). It can be a better way to compare the underlying
businesses of companies with different amounts of debt. Ebitda is not only a real economic cost
but also an approximation of cash flow. Danger: it leaves out interests, taxes, depreciation and
amortization.
C3.4: Price in the numerator of the trailing P/E is affected by dividends: dividends reduce share
prices because value is taken out of the firm. Earnings in the denominator are not affected by
dividends, so P/E ratios can differ because of differing dividend payouts.
C3.5: p/s = p/e * e/s. p/s = 12 * 6% = 0.72
C3.6: p/s = p/e * e/s p/e = 25 / 8% = 312.5
We would expect that there was a mistake in the computation of the p/s ratio because a p/e of
that magnitude is very unlikely and uncommon.
C3.7: A glamour (growth) stock is a stock that is fashionable and trades at high multiples
(viewed by contrarian investors as overvalued). Value (contrarian) stocks are stocks that trade
at low multiples (viewed by value investors as undervalued).
C3.8: An asset based valuation is feasible in a few instances, for example for main assets that are
natural resources (such as a forest). An asset based valuation does not incorporate intangible
assets, furthermore market values may not be available or efficient, nor might it represent the
value in the particular use. In Dells case, intangible assets is the major source of the difference
between market value and book value. The firm has a brand name that may be worth more than
its tangible assets combined.
C3.9: False. The yield on a bond represents the required return on the bond or the cost of capital
for debt. The required payoff rate depends on the cash flows that the bond will generate, which
depends on the coupon rate.
C3.10 & 11: Dividends dont create value for shareholders, the investors cum-dividend payoff is
not affected. Share repurchases can only create value for shareholders if shares are repurchased
at a price greater than the market value (which is unlikely). Shares are often repurchased when
management sees that market value is below the intrinsic value, which will increase the share
price. Share repurchases do increase eps because the number of outstanding shares decrease,
however primary reasons to repurchase shares are to increase shareholder wealth and counter
undervaluation.
C3.12: False. According to the dividend discount model, the value of a share is based on expected
dividends; however, dividend pay out ratio depends on a firms strategy as well as its net
income.

H4
1. False: Dividend payout over the foreseeable future doesnt mean much (recall ch.
3 homemade dividend). Dividends are usually not tied to value creation, only
when there is a fixed payout ratio of earnings do they represent value. Dividends
are value distribution, not creation.
2. Cash Is not king. Free cash flow is the mean fundamental that the equity analyst
should focus on. Pure cash is biased too much by interest payments,
amortization, depreciation, etc..
3. If cash receipts were matched in the same period with cash investments then we
would get a correct view of the NPV of the investment. But DCF analysis doesnt
work that way so it could give a wrong image because it violates the matching
principle. Possible solution: very long forecast horizon (not practical).
4. GE is a typical growth company which invests more cash in operations than it
takes in from operations. So FCF is negative because these investments are
treated as bad. When suddenly its FCF become positive this could indicate that
GE hasnt found new positive NPV investment opportunities. So could be bad
news because this will reduce future CF.
5. Accrual revenue minus COGS because these match value inflows and outflows the
best.
6. Different CF from operations versus earnings is due to income statement
accruals, the non-cash items in net income. Net income minus these accruals
(adjusted for after-tax interests) = CF from operations.
7. Earnings accruals new investments in operations = FCF
FCF(C-I) i + accruals + I = earnings
8. They are investments in excess cash until it can be invested in operations later
9. Levered CF is the reported CF in the CF statement of the firm. This includes the
interest from leverage through debt financing. What we really need is the
unlevered CF from operations where the adjustments for net interest payments
and investments in interest-bearing-securities have been made.
10. Because interest receipts are taxable and interest payments are deductable from
taxable income, the net interest payments must be adjusted for the tax payments
they attract or save.

H5
1. True,
V(E) = B0 + RE1/ re + RE2/re+ and residual earnings are determined by
(ROCE - required return on equity)*beginning of period book value of
common equity. This shows us that with residual earnings the value has to
be higher than the book value and therefore the shares are mispriced.
2. /
3. The market views this ROCE as normal. This proven by the fact that P/B is
around one which means a correct valuation of the firm.
4. A P/B ratio lower than one means that market judges the value of a firm
lower than that of its operatings assets. This can only be the case if the
firms operations destroy value. However by the expected RE of 2% each
year the firm will create value and therefore its overall value will rise and
exceed that of its assets. In an efficient market this will be recognized by
the investors and thus the value of the shares will rise. The advice to hold
shares is correct.
5. True,
The required return is based on the CAPM and WACC. Both formulas take
as well risk as the price of capital into account. If a company earns less than
its required return, investors will turn to investments with (larger) RE for
the same risk or the same pay-off for less risk.
6. RE are determined by ROCE- required and book value. If ROCE is higher
than the required return value will be added to firms book value each
year. Therefore the RE will keep rising. The result has to treated with
cautiousness because the PV of the RE remains almost the same over the
years.
7. False,
8. The higher return of the intangible assets will be reflected by the higher RE
earnings the firm will achieve. If the brand is really that strong, it will be a
reason of a very high return on the required return on equity (which can
be low in comparison with the value of the intangible asset).
9. If the analyst would forecast net income, the firm would be valued in a
wrong way. The value of a company is dependent not only on net income
but also on other factors.
10. The statement isnt correct at all. FCF does not measure value added from
operations over a period. It is measured by the cash flow from operations
flowing into firm minus cash investment. Normally speaking a company is
worth more if it invests in profitable projects. It can therefore be useful for
a company to have negative cashflow due to heavy investments in order to
be more profitable in the future.

H6
1) This is because Dividend payout is irrelevant to valuation, for cum-dividend
earnings growth is the same irrespective of dividends.
2) This is solved at follows, firms in the S&P 500 pay dividens; indeed, the historical
dividend payout ratio has been about 45 percent of the earnings. This 8.5%
growth is an ex-dividend growth rate. The cum-dividend growth rate wih 45%
payout is about 13%.
3) It is wrong because it is applied with forecasts of ex-dividend growth rates rather
than cum-dividends growth rates. Ex-dividend growth rates ignore growth from
reinvesting dividends. Second, the formula clearly does not work when the
earnings growth rate is greater than the required return.
4)
Normal forward: 1/0,12= 8,33
normal trailing: 1,12/0,12= 9,33
5) This represent that one current dollar remains earning at the required return
fora n extra year. Just as a normal P/E implies that forward earnings are expected
to grow, cumdividend, at the required rate of return after the forward year. So a
normal trailing P/E implies that current are expected to grow, cum-dividend, at
the required rate of return after the current year.
6) In the formula you se that the discounted value of abnormal earnings growth
supplies the extra value over that from capitalized forward earnings. Reinvest
dividends in the firm at the 10 percent rate. Subsequent earnings within the firm
will increase by the amount of reinvested dividends. Cum-dividend earnings- the
amount of earnings earned in the firm plus that earned by reinvesting the
dividends outside the firm will be exactly the same as if the SH reinvested the
dividends in a personal account. Exibit 6.2
7) Yes, pag 208.
8) They expect that it is different because the risk of bonds and stocks is different.
Can be false or true depends on how much Abnormal earnings you incalculate,
when a lot the statement is true and stocks have higher P/E. And vice versa.
9) No it is possible when you anticipate a lot of abnormal earnings, but you should
be careful with this valuation. Because the abnormal earnings arent absolutly
certain.
10) The PEG ratio compares the P/E ratio to a forecast of percentage earnings
growth rate in the following year. If Ratio is smaller than 1. The screener
concludes that the market is underestimating earnings growth. And vice versa.
11)
12) when prices increase the P/E ratio will increase this is a contradiction when they
say that the P/E is decreasing.
13)
14)

H7

H8
C 8.1. It is called dirty-surplus income because the net income in the income statement is
not clean, not complete.
C 8.2. Not all gains are included in the net income, there is other comprehensive income :
dirty surplus items (gains that are not yet realized) and hidden dirty expenses (when
transactions occur at prices other than market prices)
C 8.3. They are real gains and losses. Altough they are noticed when statements are
consolidated, they create real value.
C 8.4. The market value method, because it recognizes the losses on the conversion.
C.8.5.
C 8.6. a) They cause dillution for current shareholders if the exercice price < market
price
b) Share repurchases can create value if the repurchase price > market price
c) A lot of cash is needed to do a stock repurchase, firms often have to borrow
and borrowing can be expensive.
C 8.7. This tax benefits are related to a loss from the exercise of stock options, so no
value is destroyed and not created.
C 8.8. It will be really expensive for Boots to do this reform.
C 8.9. If the acquisition is not a success, Microsoft its stock will go down. Buying Visio
with stock will be cheaper in this case than paying it with cash.

H9
C 9.1. Reformulated statements distinguish operating and financial assets and
obligations. If financing items are classified as operating items in the reported income
statement, the operating profitability will be incorrectly measured.
C 9.2. a) OA
b) OA
c) FA
d) FA
e) FA
f) FA (OA)
g) OA
h) OA
i) OA
j) OA
C 9.3. a) OL
b) OL
c) FL
d) OL
e) FL
f) FL
C 9.4. It is nota an obligation, it is treated as a seperate line item that shares with the
common equity in the operating and financial assets and liabilities.
C 9.5. Paying interest on debt generates a tax benefit, also referred to as a tax shield.

C 9.6. When financial income > financial expenses

C 9.7. The percentage of sales revenue that generates an operating income.

H10
C 10.1 Cash flow analysis is important for valuing firms when the analyst uses the DCF
valuation method. It is also necessary for liquidity analysis and financial planning.
Comparing earnings with cash flow is also important in evaluating the quality of
financial statements.
C 10.2 FCF determines the ability of the firm to pay off its debt and equity claims.
C 10.3 In a pure equity firm, FCF is disposed of by net dividends.
C 10.4 This can give the wrong impression of a firms liquidity. A firm faced with cash
shortfall can sell securities in which it is storing excess cash to satisfy the shortfall.
Under GAAP reporting it looks as if it is increasing free cash flow by doing so,
making it look less serious than it is. GAAP reporting mixes the cash flow deficit
with the means employed to deal with the deficit.
C 10.5 Yes, it discloses the different sources of cash and the different outflows.
C 10.6 No, Cash interest payments/receipts for financing activities should be included in
the financing section of the CF statement. Interest capitalized during construction
should be classified as a financing flow. Unfortunately disclosure may not allow
this, reclassifying will show a higher FCF.
C 10.7 Because DCF valuation is best used when calculating a liquidation value, i.e. a
limited horizon. If a firm were to have to liquidate right now, the free cash flow
shows how many cash is available to give immediately to the claimants of the firm.
C 10.8 Because there normally is no autocorrelation between FCF in time
C 10.9 Cash flow from operations.
C 10.10 Firms can increase cash flow by selling or securitizing receivables. This does
not however represent an ability to generate cash from sales of products. So, yes, I
agree with the statement of the CFO of Lear Corp.

H11
C11.1 Under what conditions would a firms return on common equity ( ROCE ) be equal to
its return on net operating assets ( RNOA)?
When a firm has zero financial leverage.
ROCE= RNOA + ( FLEV x ( RNOA NBC))
C11.2 Under what conditions would a firms return on net operating assets ( RNOA ) be
equal to its return on operating assets ( ROOA).
RNOA = ROOA + (OLLEV x OLSPREAD)
If there is no operating liability, OLLEVx OLSPREAD =0 and RNOA= ROOA
C11.3 State whether the following measures drive return on common equity ( ROCE)
positively, negatively, or depending on the circumstances:
a) Gross margin depending on the circumstances
b) Advertising expense ratio negatively
c) Net borrowing cost negatively
d) Operating liability leverage positively
e) Operating liability leverage spread positively
f) Financial leverage positively
g) Inventory turnover positively
C11.4 Explain why borrowing might lever up the return on common equity.
ROCE= RNOA + ( FLEV x SPREAD)
If a firm has financial leverage ( i.e. the firm borrows) , then the difference between
ROCE and RNOA is determined by the amount of the leverage and the operating spread
between RNOA and the borrowing cost. If a firm earns an RNOA greater than its after-tax
borrowing cost, it is said to have favourable financial leverage or favourable gearing.:
the RNOA is levered up or geared up. Leverage is a component of risk. Financial
leverage generates a higher return for shareholders if the firm earns more on its
operating assets than its borrowing cost, but the financial leverage hurts shareholders if
it doesnt. ( zie evt fig 11.2 p 366)
C11.5 Explain why operating liabilities might lever up the return on net operating assets.
RNOA= ROOA + (OLLEV x OLSPREAD)
Just as financial liabilities can lever op ROCE, so can operating liabilities lever up the
return on NOA. Operating liabilities reduce the net operating assets that are employed
and so lever the RNOA. To the extent that the firm can get credit in its operations with
no explicit interest, it reduces its investment in net operating assets and levers its RNOA.
Thus, if ROOA is greater than the short-term borrowing rate the effect is favourable
operating liability leverage.

C11.6 A firm should always purchase inventory and supplies on credit rather than paying
cash. Correct?
Incorrect. Credit comes with a price. Suppliers who provide credit without interest also
charge higher prices for the goods and services they supply than would be the case if the
firm paid cash. Operating liability leverage, like financial leverage, can be unfavourable
as well as favourable.
C11.7 A reduction in the advertising expense ratio increases return on common equity and
share value. Correct?
Correct.
Advertising expense ratio = advertising expense/ sales
Sales PM= gross margin ratio expense ratios
The lower the expense ratio, ceteris paribus, the higher sales PM.
The higher sales PM, the higher RNOA and consequently ROCE.
C11.8 A firm states that one of its goals is to earn a return on common equity of 17-20
percent. What is wrong with setting a goal in terms of return on common equity?
There are several distinct drivers of ROCE. Each of these drivers refers to an aspect of
business activity though. It would be better to set a specific goal , for example align PM
and turnover drivers so that the RNOA is increased and subsequently the ROCE.
C11.9 Why might operating losses increase after-tax borrowing cost.
( niet zeker)
If OI is negative, ceteris paribus, implicit interest is higher.
Implicit interest= short term borrowing rate (after tax) x operating liabilities.
+
+
C11.10 Some retail analysts use a measure called Inventory yield, calculated as gross
profit-to-inventory. What does this measure tell you?
Inventory yield measures the return on dollars invested in inventory, or the
profitability of inventory. The goal for managers is to increase gross profits without
increasing inventories. This is accomplished through successful inventory management.
C11.11 Return on total assets ( ROA) is a common measure of profitability. The historical
average is about 7.0 percent. The historical yield on corporate bonds is about 6.6%. Why is
ROA so low? Would not investors expect more than a 0,4 % higher return on risky
operations?
ROA is a poor measure of operating profitability. It understates profitability.
The ROA calculation mixes up financing and operating activities. To analyse profitability
effectively, two procedures must be followed:
1. Income must be calculated on a comprehensive basis

2. There must be a clean distinction between operating and financing items

in the IS and BS.
C11.12 Low profit margins always imply low return on net operating assets. True or false?
False. RNOAs drivers are PM and asset turnover. A higher asset turnover could
compensate for lower margins.

H12
C12.1: A growth firm is a firm that grows residual earnings, that is, it has abnormal earnings
growth.
For the next three questions:
Residual earnings is the relevant growth measure when evaluating the p/b ratio.
Abnormal earnings growth is the relevant growth measure when evaluating the p/e ratio.
C12.2: Abnormal earnings growth is equal to the change in residual earnings. Hence, because
growth in residual earnings and abnormal earnings growth are related, the analysts should focus
on both.
C12.3: If a firm has no growth in residual earnings, its abnormal earnings growth must be zero.
(The key question is whether past growth can be sustained in the future.)
C12.4: If a firm as residual earnings growth, it must also have abnormal earnings growth: the
firm is a growth company.
C12.5: Sustainable earnings (or core earnings) are earnings that can repeat in the future and
grow. Thus an analyst will make a distinction because core earnings are the base for growth.
C12.6: Earnings based on temporary factors are called transitory earnings or unusual items. Eg.:
Earnings from a one-time special contract cannot grow & earnings from gains on asset sales or
restructurings will probably not be repeated in the future.
C12.7: Unrealized gains and losses are transitory, except when they offset a component of core
income.
C12.8: The sensitivity of income to changes in sales is called the operating leverage. The
operating liability leverage ratio gives an indication of how the investment in net operating
assets has been reduced by operating liabilities.
C12.9: Incorrect. The contribution margin is the difference between sales and variable costs. A
high contribution margin ratio (= 1 var.costs/sales) is related to low variable costs and/or high
sales. However, if a firms sales increases, the rise in the corresponding variable costs will offset
an increase in the contribution margin ratio. Hence the effect on operating leverage will be
minimal:
OLEV = (contribution margin ratio) / (profit margin).
C12.10: Sustainability of the profit margin depends heavily on the business strategy: if the firm
will expand and therefore also increase marketing (which increases its advertising costs), we
dont expect the profit margin of 7% to be sustainable if corresponding sales dont rise /
corresponding cost of goods sold dont decline. (zie vb coca cola p398)

C12.11: There are three drivers for growth in shareholders equity:

- growth in sales (primary driver!)
- change in NOA that support each dollar of sales
- change in the amount of net debt that is used to finance the change in NOA rather than equity
C12.12: If the expected (future) cum-dividend earnings growth rate is less than the required
rate, there will be negative abnormal earnings growth, thus the change in residual earnings is
negative. (This doesnt necessarily implies that the residual earnings are negative.) However,
this implies that current residual earnings are higher than future residual earning which is not
feasible if p/e ratio is high. Hence, the statement is incorrect.
C12.13: Correct. (zie table 12.3, p414)
C12.14: Yes, this is the case when we expect the future residual earnings to be low (and
negative), but the current residual earnings is even lower.
Thus, there will be growth in residual earnings from the current level (high p/e), but future
residual earnings is expected to be negative which determines the low p/b.
C12.15: Incorrect. Sustainable earnings analysis focuses on the future, so it makes sense that a
P/E valuation should focus on the forward P/E. Forward earnings are considerably less affected
by the transitory items that do not contribute to permanent growth. Hence: firms with high
unsustainable earnings should have low forward P/E ratios.

H13
1. Correct, the intrinsic value of these assets is the value reported on the balance
sheet. It already incorporates the value of income generated by these assets.
2. Correct, if book value equals intrinsic value, then RE are expected to be zero.
3. First of all the market value of assets might differ from their fair value if the
market is not efficient. Furthermore their market values might not reflect the
value in use to a particular firm.
4. ReOI is driven by the amount of net operating assets and the profitability of these
assets relative to the cost of capital.
5. Yes, when ReOI increases but at the same time residual financial expenses
increase by a greater magnitude, the REs will decrease. This is only possible
when NFOs arent recorded at market value, which is quite exceptional.
6. The financing risk premium is the extra required return asked by the
shareholders because of the financing rick that arises from leveraging debt and
the possibility of that leverage to become unfavorable. The financing risk
premium turns negative when the firm has negative leverage (net financial
assets).
7. No, these firms will typically have a required return for equity that is smaller
than the required return for its operations because financial assets are typically
less risky than operations.

8. Managers could increase the EPS rate by increasing the leverage of the firm (as
long as the operating spread is positive). It is better to tie these bonuses to the
residual operating income which concentrates on the source of value creation.
9. Operating income will not change since NOA is not affected. When the shares are
repurchased at market value this transaction will not affect shareholder wealth.
10. Another effect of the increased leverage is an increase in the required return of
equity because of the increased financial risk. This implies that the discount rate
of REs increases. These two effects tend to offset each other so leverage has no
effect on the value of equity.
11. No, when unleveraged P/B ratio is below one introducing leverage will reduce
the leveraged P/B ratio.
12. ROCE and EPS increases significantly, the downside however is increased risk (so
increased required return). With the crisis of 2008 these high levered firms
struggled to cover their debt and lost a lot of shareholder value.
13. Yes I think so.
14. Increase in financial leverage will decrease the levered P/E ratio
15. Yes I think so.

H14
1. FS1 is not a good forecast if there are RE (which is very frequent with all
kinds of operating assets). This forecast does work if the relevant balance
sheet amount is booked at fair value. In practice this means that it is
usually a good forecast for financing activities and a poor forecast for
operating activities.
2. This is true for the assets that are already in place. It is assumed that they
will maintain the current RE. For other assets (that will come in place after
the beginning period) is assumed that they earn the required rate of
return.
3. SF2 forecasts predict that assets that are in place will earn their RE in
perpetuity. Those that are added later will earn the required rate of return.
SF3 says that both (the ones that are already in place + the ones that are
added) will earn the current rate of return.
4. The same conditions as for SF2 hold. (ben ik niet zeker van)
5. This condition holds if the growth rate of NOA is the same as the growth
rate of operating income. This follows from the formula of ReOI.
6. A firm with high sales growth CAN be growth firm but isnt necessarily one.
A growth firm has high RE residual earning which it (most of the time)
invests back in operations in order to sustain growth and profitability. Due

to this heavy investments it can occur that a growth firm has negative cash
flows as well.
7. Correct. Unlevered P/B ratio: (value of net operating assets)/ net operating
assets. The value of net operating assets is determined by its future return.
Thus is the value (which is in the nominator) grows faster than NOA itself
(denominator), the Unlevered P/B rises.

H15
1) Knowing the business is a prerequisite to valuation and strategy analysis.
Because you have to know everything about a business before valuating it. But
you need a way of translating this information into measures that lead to
valuation, Economic factors are often expressed in qualitative terms that are
suggestive but that do not immediately translate into concrte dollar numbers.
2) The diagram forms a base of the last 5 years, so it gives more then the temporaly
effects of some changes in the market. It filters them, this gives a clear look on the
future. Because it fades out all the exceptional events.
3) Sales, core sales profit margin, turnover efficiency, core other operating income
and unusual items.
4) Pro forma uncovers the value generation. Thus it is also a means of investigating
management strategies that generate value.
5) This is because the accounting-based valuation avoids forecasting when mark-tomarket accounting suffices, as with the valuation of financing ativities and the
cost of stock options.
6) Red flag indicator is a piece of information that can be found in the financial
statement and indicates that there will be a problem with future earings.
7) Is a strategy that is not specific enough to evaluate with pro forma analysis.
8) Because most of the value generated in mergers and acquisitions typically goes to
the shareholder of the acquiree
9) Buyout is a stock repurchase of larger scale. It is used for creating shareholder
value when the shares are undervalued.
10) Because the market feels that it is overpaying for the acquisitions, but also
because the market interprets the bid as a signal that the acquierers shares are
overpriced.

H16

H17
C17.1:Yes, you can increase future income by increase expenses, or decrease revenues, so by
decreasing NOA (OA-OL) . Increasing bad debt increases OL, so decreases NOA. (see also question
17.16) (weet niet zeker of dit klopt..)
C17.2: one expects depreciation to grow with income. Low depreciation indicate low income, in the
case that there is no manipulation.
C17.3: yes: Net sales = cash from sales + net accounts receivable - allowance for sales returns and
discounts -unearned revenue - warrantly liabilities. As the difference is negative, this will increase
net sales.
C17.4: PM= OI(after taxes)/sales. Underestimating expenses OI is higher, so PM is higher. NOA=
OA-OL. OL is lower than normal (underestimated) so Yes, NOA will be higher.
C17.5: Change in ATO implies income may be too high/low
C17.6: To look at the accrual component to earnings.
C17.7: Because this is a situation where manipulation is more likely.
C17.8: deferred charges (like taxes) implies that the firm classifies too much current expense as
deferred expense. The effect on income is that there is a lower SG&A expense.
C17.9: increase in income, decline in sales: this is a red flag!
ATO= Sales/NOA. As sales decrease, ATO will also decrease. A decrease in ATO implies income
may be too high: too few expenses are booked to income and there may be too much of sales in low
quality receivables.
C17.10: It could be that this write-down reduce expenses via a bleed back. Immediate write-downs
could also imply that there are continuing problems.
C17.11: effective tax rate = (tax as reported + tax benefit) / (operating income before tax, equity
income, ). When revenues increase, OI before tax will increase, but also the taxes will increase. As
the effective tax rate is decreased, I expect the nominator (taxed) is decreased or stay the same, while
the denominator increased, and that is strange!
C17.12: A deferred tax liability occurs when taxable income is smaller than the income reported on
the income statements. One has to asks where the larger income on the income statement is coming
from. This is a red flag!
C17.13: When depreciation / Capital expenditure is less than 1, future depreciation is likely to
increase.
Here, Capital expenditure = 1,6 and depreciation = 1 so the ratio is less than 1.
C17.14: No, These could be points where there is manipulation.
C17.15: This is an area that is prone to manipulations.
C17.16: Yes. There are two directions of manipulation:
1. Borrowing money from the future
- increase in current revenue
- decrease in current expense both increase current NOA

2. Saving income to the future

- decrease in current revenue
- increase in current expenses both decrease current NOA
When you recognize revenues at point of sale, there is no manipulation.
C17.17: One expects depreciation and costs to grow with income. When this is not the case, people
think there is something wrong.