Question

Which of the following does not properly describe the Altman Z-score?

Multiple Choice

• The Z-score is a multiple discriminant analysis using five financial ratios to estimate default risk.

• A high score is an indication of default risk.

• The Z-score was originally designed only for publicly traded manufacturing firms.

• Each ratio has its own unique weight in calculating the final score.

Cash flow assessment plays a central role in analyzing:

Multiple Choice

• the future earnings potential of a company.

• the credit risk of a company.

• management’s effectiveness.

• the firm’s investment potential.

Which of the following statements is false regarding the business valuation process?

Multiple Choice

• FASB contends that current accrual earnings are a proxy for free cash flow.

• A simplified version of the discounted free cash flow valuation model assumes a zero-growth perpetuity for future cash flows. This approach is best applied to growth companies with stable cash flow patterns.

• If a company is currently generating a sustainable free cash flow of $10 per share and the discount rate is 10%, the estimated share price is $100.

• One popular approach to estimate a firm’s equity cost of capital is the capital asset pricing model.

Under the abnormal earnings approach of equity valuation, investors willingly pay a premium for those firms that:

Multiple Choice

• earn less than the cost of equity capital.

• produce negative abnormal earnings.

• produce positive abnormal earnings.

• earn an amount equal to the equity cost of capital.

Answer 1

1)Which of the following does not properly describe the Altman Z-score?

Answer) A high score is an indication of default risk.

Reason: A score below 1.8 means it's likely the company is headed for bankruptcy, while companies with scores above 3 are not likely to go bankrupt. So a high score is a good sign whereas a low score is an indication of default risk.

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2) Cash flow assessment plays a central role in analyzing:

Answer) the credit risk of a company.

Reason: It indicates how effectively the company is managing its Cash Flows and whether company is generating cash or is losing cash. So a low cash generating company will indicate that company has a high credit risk whereas high cash generating company will indicate that company has a low credit risk.

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3) Which of the following statements is false regarding the business valuation process?

Answer) A simplified version of the discounted free cash flow valuation model assumes a zero-growth perpetuity for future cash flows. This approach is best applied to growth companies with stable cash flow patterns.

Reason: Discounted free cash flow valuation model takes into consideration the growth in future cash flows.

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4) Under the abnormal earnings approach of equity valuation, investors willingly pay a premium for those firms that:

Answer) produce positive abnormal earnings.

Reason: Investors pay a premium for those firms that produce positive abnormal earnings. Because they will earn more they are ready to invest more i.e. pay premium on equity shares with that will produce positive abnormal earnings.