VCM - Finals Long Quiz Part I - Answer For Theory Questions

POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
CAF – DEPARTMENT OF ACCOUNTANCY AND MANAGEMENT ACCOUNTING

ACCO 40013: VALUATION CONCEPTS AND METHODS
FINALS LONG QUIZ PART I ANSWERS
I. TRUE OR FALSE (1 point each). Choose TRUE if you believe that the statement is true and choose FALSE if the statement is inconsistent with
truth and facts.
Answer and Rationale

1. Weighted average cost of capital (WACC) is used to False. Cost of equity is used to discount FCFE to arrive at equity value
discount free cash flows to the equity (FCFE) to arrive at
equity value
2. Decrease in changes in net working capital is equivalent False. Increase in changes in required net working capital (as discussed,
to a deduction to EBIT to arrive at net cash flows this is like “puhunan”) is equivalent to a deduction to EBIT to arrive at net
cash flows
3. Terminal value is always discounted using the present False. Terminal value is always discounted using the present value (PV)
value (PV) factor of 5th year of projection. factor of the LAST YEAR of projection / discrete cash flows which can be
Year 5 but also other year such as Year 10, depending on the number of
years used in the discrete cash flows.
4. Net cash refers to instances wherein cash and cash True. As illustrated during class, if the value of cash and cash equivalents >
equivalents are greater than interest-bearing liabilities. interest-bearing liabilities. It is equivalent to net cash, which is added to
This is added to enterprise value to arrive at equity enterprise value to arrive at equity value.
value.
5. Conceptually, a DCF analysis consists of a “near future” True. The “near future” value or discrete forecast consists of the projected
value (over 5-10 years) and a “far future” value (the Free Cash Flows over the next 5 to 10 years (or depending on a company
company’s value past the discrete period), both of which when the cash flows will stabilize), until the company reaches a steady
are discounted back to their present values and summed state. The “far future” value represents the Free Cash Flows generated in
up. the final year of the projection until perpetuity, and is approximated by the
Terminal Value. Both values are discounted back to present and added
together to determine Enterprise (or Equity) value, depending on which type
of Free Cash Flows is projected.
6. Audited financial statements are the most ideal reference False. Audited financial statements (AFS) are the most ideal reference for
for the future performance of a company. the HISTORICAL performance of a company, not its future as AFS does not
have projected financial statements.
7. The cost of preferred stock financing is generally higher True. As preferred stock carries higher risk than debt financing, preferred
than that of debt financing because unlike the payment shareholders are compensated with higher required rate of return,
of interest to bondholders, the payment of dividends to equivalent to higher cost. Note also that dividends paid to preferred
preferred stockholders is not guaranteed, and interest on shareholders are not tax-deductible making it more costly than debt
financing.
Prepared by: Isabelle Callejo

debt is tax deductible whereas preferred stock dividend

is not. However, cost of preferred stock financing is lower as compared to cost of
ordinary/common stock financing which carries the highest risk between the
three (3).
8. Capitalized earnings represent the assets that actually False. Capitalized earnings does not consider the value of idle assets,
generate income or earnings and also includes value of accordingly, we need to add the non-operating assets and liabilities (NOAL)
the idle assets. or idle assets to the value we arrive in computation of capitalization of
earnings
9. Changes in long-term debt are considered in the False. Changes in net working capital considered in free cash flows
computation of free cash flows to the firm. includes only OPERATING CURRENT assets and liabilities. Accordingly,
changes in long-term debt is not considered in the computation of free cash
flows to the firm.
10. A decrease in accounts payable is deducted against True. Recall that an increase in overall NWC is a deduction to EBIT
EBIT when calculating free cash flows to the firm (increase in overall “puhunan” is a “cash outflow”, thus, deducted to arrive at
the FCFF)
When analyzing it on a per account basis:

• Increase in current assets (e.g., accounts receivable, inventories) is
a deduction to EBIT to arrive at free cash flows -> Inverse
• Increase in current liabilities (e.g., accounts payable) is an addition
to EBIT to arrive at free cash flows -> Directly proportional
II. MULTIPLE CHOICE THEORIES (1 point each). Choose and shade the letter of the best answer for each statement or question.
Answer and Rationale

11. The following are non-cash charges that should be added D. Accrual of expenses not yet paid. This is not a non-cash charge
back to arrive at free cash flows, except: added back to arrive at free cash flows. Accrual of expenses, especially

a. Expected credit losses those part of accounts payable or operating payables are part of net
b. Provision for doubtful accounts working capital.
c. Restructuring charges
d. Accrual of expenses not yet paid
12. The following are typical components of free cash flows to A. Interest. Interest is not part / considered in computation of free cash
the firm, except: flows to the firm (FCFF) since FCFF does not consider any capital
a. Interest structure yet (e.g., debt and debt-like items). The rest are components of
b. Income taxes FCFF.
c. Capital expenditures For tax-impact of depreciation, recall that we need to base income taxes
d. Tax-impact of depreciation on EBIT/EBT. Accordingly, FCFF considers the tax savings impact of
depreciation.
13. Which of the following statements is true about the B. As the terminal value growth rate in cash flows increases, the
discounted cash flow valuation? value of an asset increases. Recall our discussion on the scenario
a. As the discount rate increases, the value of an analysis that having an increased terminal value resulted to higher equity
asset increases. value. You can refer to the data table in our illustrative case study.
b. As the terminal value growth rate in cash flows
increases, the value of an asset increases.
c. As the uncertainty about the expect cash flow
increases, the value of an asset increases.
d. As the life of an asset is shortened, the value of that
asset increases.
You can also see here what is the effect of WACC / discount rate ->
higher discount rate (e.g., 16.0%) results to a lower value (e.g., 3.32 vs.
3.99 [the one we computed during class])
14. This refers to the theoretical value of the core operating A. Enterprise Value. Enterprise value is also the total company/firm
activities of a company/business/firm as reflected in its net value. EV considers only operating assets and liabilities of an entity.
cash flows.
a. Enterprise value
b. Equity value
c. Shareholder value
d. Core value

15. The following are examples of investment in operating B. Intercompany payable. Investment in operating capital is other term
capital, except: for net working capital or NWC. NWC is OPERATING current assets and
a. Trade accounts receivable current liabilities. Intercompany payables meaning payable to a related
b. Intercompany payable party such as a subsidiary, parent company etc. These are usually non-
c. Inventories trade and are non-operating.
d. Accounts payable
16. When computing net cash flows from EBITDA, which of the C. After-tax non-cash charges.
following items should be added back to EBITDA?
a. Investment in working capital • A is incorrect as investment in working capital can be either
b. Investment in fixed capital deducted or added to EBITDA. Note also that even using Net
c. After-tax other non-cash charges Income or EBIT, this is either deducted or added depending on
d. Tax impact on EBITDA the level of net working capital (e.g., if the changes in net
working capital is increasing then it is deducted)
• B is incorrect as investment in fixed capital is always deducted
against EBITDA. Note that even using Net Income or EBIT, this
is always a deduction
• C is correct as other after-tax non-cash charges (aside from
depreciation and amortization) is added back to EBITDA. Same
with the 1st two (2), this is added back even in Net Income, EBIT,
EBITDA).
o Note that depreciation and amortization does not need to
be added back to EBITDA, since EBITDA is excluding
depreciation and amortization
• D is incorrect as tax impact is deducted against EBITDA. Further,
tax impact should be based on EBIT/EBT and not on EBITDA.
17. How is a dividend discount model different from a B. Cost of equity is used as the discount rate instead of WACC.
conventional discounted cash flow analysis? • A is incorrect as dividend discount model (DDM) uses a growth
a. Dividend discount model does not use a growth rate. Recall that the formula of dividend discount model follows
rate while terminal value of conventional discounted Gordon growth model which is similar with the formula of
cash flow analysis uses a growth rate perpetual terminal value.
b. Cost of equity is used as the discount rate • B is correct because in a DDM we only discount cash flows at
instead of WACC Cost of Equity, NOT the overall WACC – since dividends only go
c. Dividends are used for both cases

d. None of the above to equity investors. Thus, we are calculating Equity Value and
using Cost of Equity for Dividend Discount Model
• C is incorrect since only DDM uses dividends while conventional
DCF uses free cash flows
18. To calculate free cash flows to the firm (FCFF) from cash A.Add after-tax interest expense and subtract fixed capital
flows from operating activities, you will need to: investment
a. Add after-tax interest expense and subtract • A is correct. Starting from cash flows from operating activities,
fixed capital investment formula is:
b. Subtract working capital investment
c. Subtract both fixed capital investment and working Cash flows from operating activities
capital investment Less: Fixed capital investment (or cash flows from investing
d. Subtract both after-tax interest expense and fixed activities)
capital investment Add: After-tax interest expense – recall our discussion that cash
flows from operating activities start at net income. Since we are
calculating free cash flows to the FIRM, we should not consider
the effect of interest. Accordingly, we need to add back interest,
including its related tax savings.
• B is incorrect as working capital investment is already
considered as part of cash flows from operating activities. Recall
that using indirect method of computing statement of cash flows,
it starts with net income, then non-cash charges are added back.
Afterwards, changes in current assets and current liabilities are
considered which are also the changes in net working capital.
• C and D is incorrect, see explanation in the 1 st two (2) bullet
points.
19. Which of the following statements is FALSE? D. When using the discounted free cash flow model, we should
a. The firm’s weighted average cost of capital (WACC) always use the firm’s equity cost of capital
is the cost of capital that reflects the risk of the
overall business, which is the combined risk of the • A and C is correct
firm’s equity and debt • B is correct. Unlevered means “without leverage” ir without debt.
b. For an unlevered firm, the cost of capital can be Accordingly, if a firm does not have debt, cost of capital is
determined by estimating the cost of equity using equivalent to cost of equity. Thus, can use CAPM which is used
Capital Asset Pricing Model (CAPM)

c. We interpret WACC as the expected return the firm to estimate cost of equity to ultimately estimate their cost of
must pay to investors to compensate them for the capital
risk of holding the firm’s debt and equity together • D is incorrect as we use cost of equity if we are using free cash
d. When using the discounted free cash flow flows to the equity while we use cost of capital / WACC if we are
model, we should always use the firm’s equity using free cash flows to the firm
cost of capital
Additional note: Please recall / note that other term of net cash flows to
the firm / free cash flows to the firm is unlevered free cash flows -> since
these cash flows does not consider debt or debt-like items
20. Which of the following does NOT always increase a A.Increasing the expected growth rate of sales
company's stock price?
a. Increasing the expected growth rate of sales • A is correct as increasing the expected growth rate of sales will
b. Increasing the expected operating profitability. do increase equity value. However, increase in sales have
c. Decreasing the investment (increase) in fixed corresponding increase in cost of goods sold, and other variable
assets without affecting sales operating expenses. Thus, increasing the expected growth rate
d. Decreasing the weighted average cost of capital. of sales will NOT ALWAYS lead to increase.
• B is incorrect as increasing the expected operating profitability
(e.g., from 30% operating margin to 50% operating margin) will
always increase equity value, therefore, increasing its stock price
• C is incorrect as decreasing the investment in fixed assets or
capital expenditure WILL INCREASE equity value, thus, stock
price. Further, the question qualified the choice by stating that
the decrease in fixed assets will not affect sales. Thus, in this
case, it will ALWAYS equity value.
• D is incorrect as lower weighted average cost of capital (WACC)
or discount rate will always increase equity value, thus,
increasing stock price
21. Drivers for growth used in financial modelling are suggested D.All of the above are sources of information for financial modelling
to be those validated and is represented by authorities like
government or experts. The following government agencies
provide this information except:
a. Philippine Statistics Authority
b. Bangko Sentral ng Pilipinas

c. Research Centers funded by Local Government

Units
d. All of the above are sources of information for
financial modelling
22. Why is terminal value an essential component in discounted B. It accounts for the value generated beyond the explicit forecast
cash flow (DCF) analysis? period.
a. It provides an estimate of the business's current
market value. • A is incorrect as terminal value does not provide estimate of the
b. It accounts for the value generated beyond the business current market or equity value. Discounted cash flows
explicit forecast period. of BOTH discrete or explicit forecast period and terminal value is
c. It determines the liquidation value of the business. the one that provides estimate of equity value
d. It represents the book value of the business. • B is correct as this is the key purpose of terminal value – to
account for the value beyond the discrete period or explicit
forecast period (e.g., in our illustrative case study, recall that the
terminal value represented the value after Year 5 which is the
last year of forecasted cash flows or explicit forecast period)
• C is incorrect as terminal value has two (2) types: liquidation
value and perpetual terminal value. Thus, while terminal value
may sometimes represent liquidation value of a business, it is
not always the case.
• D is incorrect as it does not represent in any way the book value
of a business
23. What is the primary purpose of using sensitivity analysis in B. Assessing the impact of changes in key assumptions on
business forecasting? financial outcomes
a. Identifying the company's market share
b. Assessing the impact of changes in key The rest are incorrect as it does not relate in any way to sensitivity
assumptions on financial outcomes analysis
c. Predicting future economic trends
d. Analyzing competitors' financial statements
24. Which of the following components is subtracted from Free C.After-tax interest expense
Cash Flows to the Firm (FCFF) to calculate Free Cash
Flows to Equity (FCFE)? • A is incorrect as Capital Expenditures is already deducted when
a. Net capital expenditures computing for FCFF (recall the components)

b. Changes in net working capital • B is incorrect as changes in net working capital is also already
c. After-tax interest expense considered in computing for FCFF
d. New debt principal • C is correct as after-tax interest expense is deducted to arrive
FCFE
• D is incorrect as new debt principal is added from FCFF to arrive
at FCFE. This is added since this is technically a cash inflow
Note also that repayments of debt principal and payments of preferred

shares dividends is deducted against FCFF to arrive at FCFE. Please
remember this.
25. This refers to the incremental return that investors demand D. Equity risk premium. Another term for equity risk premium is market
for investing in equities/stocks rather than investing in a risk premium which is the difference between expected rate of return on
risk-free asset market portfolio and risk free rate. This represents incremental return that
a. Market return investors demand for investing in equities/stocks rather than investing in
b. Cost of equity a risk-free asset.
c. Beta
d. Equity risk premium Note: Reminder again for problems, if the given is market risk premium
or equity risk premium, then you do not have to less it anymore against
risk free rate. Since MRP/ERP is = to Rm - Rf
26. A firm's overall cost of equity is: C. Highly dependent upon the growth rate and risk level of the firm
a. Is generally less that the firm's WACC given a
leveraged firm • A is incorrect as cost of equity will always be higher than the
b. Unaffected by changes in the market risk premium firm’s WACC given a leveraged firm (meaning there is debt
c. Highly dependent upon the growth rate and risk component). The cost of equity will be higher as it will still be
level of the firm multiplied to a weight lower than 100% since there is a debt
d. Inversely related to changes in the firm's tax rate component (e.g., If cost of equity is 15%, cost of debt is 8%, debt
component is 20%, equity component is 80%. In this case,
WACC is 13.6% in this case)
• B is incorrect as cost of equity is directly affected by changes in
the market risk premium. An increase in market risk premium /
equity risk premium (provided all other factors are unchanged)
will lead to a higher cost of equity. See our slide below before for
the formula

• C is correct as this will affect the beta used in the cost of equity.
Increase in beta (holding other factors unchanged) will increase
cost of equity
• D is incorrect as cost of equity it is not directly affected by tax
rate. Check the formula in the slide placed above.
27. The elements that must be considered in using EVA are: C.I and III only.
I. Appropriate cost of capital
II. Equal mix of capital structure Recall the formula for EVA which is as follows:
III. Reasonableness of earnings
a. I and II only
b. II and III only
c. I and III only
d. d. I, II and III

Based on this formula, the relevant elements are only:

i. Earnings – represented by letter III reasonableness of earnings
ii. Investment value – not in choices
iii. WACC – represented by letter I or appropriate cost of capital
28. Which of the following statements is CORRECT? A. When calculating the cost of debt, a company needs to adjust for
a. When calculating the cost of debt, a company taxes, because interest payments are deductible by the paying
needs to adjust for taxes, because interest corporation
payments are deductible by the paying
corporation • A is correct, recall that we always calculate cost of debt after tax.
b. When determining cost of debt, we should look at See our previous slide below for reference
historical cost
c. Because of tax effects, an increase in the risk-free
rate will have a greater effect on the after-tax cost
of debt than on the cost of common stock.
d. If a company's beta increases, this will increase the
cost of equity used to calculate the WACC, but only
if the company does not have enough retained
earnings to take care of its equity financing and
hence needs to issue new stock. • B is incorrect. Refer to slide above. When determining cost of
debt, we look at recent borrowings of the company. If none, we
look at average lending rate from BSP. If still none, we use debt
margin/spread, refer to slide below.
• C is incorrect as any increase in risk-free rate will proportionately

increase cost of equity and cost of debt. Provided that we are
using the debt margin/spread to compute for cost of debt

• D is incorrect. It is correct that as beta increases, cost of equity

will increase. However, it is not affected by the absence of
enough retained earnings / need to issue new stock.
29. Which of the following is the best statement of the efficient C. With competition, the price that an investor would pay for a stock
markets hypothesis? (or a bond) equals the PV of cash flows he expects to receive from
a. Investors with information that a stock had an owning the asset.
expected return greater than the required return will
buy it, while investors with information that a stock
had an expected return less than the required
return will sell it.
b. Investor's decisions are dependent on complete
current information of a firm's cash flows and
accurate predictions of future cash flows.
c. With competition, the price that an investor
would pay for a stock (or a bond) equals the PV
of cash flows he expects to receive from
owning the asset.
d. A share's price only reflects some of the past
available information.
30. On a certain date, Hasbro has a stock price of PhP37.50, C. Yes, since the constant dividend growth rate gives a stock
pays a dividend of PhP0.64 at the end of this year, and has estimate less than PhP37.50. Refer to Excel file: Income
an equity cost of capital of 8%. An investor expects the Approach_Long Quiz_Answers and Potential Solutions.xlsx for the
dividend rate to increase by 6% per year in perpetuity. He answer and solution
then sells all stocks that he owns in Hasbro. Was this a
reasonable action?
a. No, since the constant dividend growth rate gives a
stock estimate of PhP37.50.
b. No, since the constant dividend growth rate gives a
stock estimate greater than PhP37.50.
c. Yes, since the constant dividend growth rate
gives a stock estimate less than PhP37.50.

d. Yes, since the constant dividend growth rate gives a

stock estimate greater than PhP37.50.

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POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

CAF – DEPARTMENT OF ACCOUNTANCY AND MANAGEMENT ACCOUNTING

Answer and Rationale

Prepared by: Isabelle Callejo

debt is tax deductible whereas preferred stock dividend

When analyzing it on a per account basis:

Answer and Rationale

Prepared by: Isabelle Callejo

Prepared by: Isabelle Callejo

Prepared by: Isabelle Callejo

Prepared by: Isabelle Callejo

Prepared by: Isabelle Callejo

c. Research Centers funded by Local Government

Prepared by: Isabelle Callejo

Note also that repayments of debt principal and payments of preferred

Prepared by: Isabelle Callejo

Prepared by: Isabelle Callejo

Based on this formula, the relevant elements are only:

• C is incorrect as any increase in risk-free rate will proportionately

Prepared by: Isabelle Callejo

• D is incorrect. It is correct that as beta increases, cost of equity

Prepared by: Isabelle Callejo

d. Yes, since the constant dividend growth rate gives a

Prepared by: Isabelle Callejo

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