Financial Statement Analysis

Solutions

Chapter 1

Solutions to review questions

1. Knowing how much a company is worth is very useful. There are two major valuation approaches: cash flow and asset valuation. If one considers a business to be a going concern, the cash flow approach is appropriate.
2. Owners of businesses need valuation techniques to know their net worth, especially in cases where the business is up for sale. Obviously, potential owners need to know the value of a business. Security analysts use valuation techniques to recommend “buy and sell” to their clients. CPAs may be called upon to help their clients find a company’s value.
3. The cash flow approach to valuation is appropriate in all cases of going concern. Asset valuation approaches are appropriate when a company is to be liquidated. These approaches provide a valuation “floor.”
4. Value of a firm

   FCF₁ is the cash flow producing ability of the company after taxes, that is, its effective dividend.

   R is the company’s risk adjusted rate of return. As a firm’s risk increases, its cost of capital increases.

   G is the growth rate of the firm’s earnings.

5. Free cash flow is the excess cash flows of a business. Many businesses do not pay dividends, but they still have value. Do not think of free cash flow as the actual dividend. Instead, think of it as the dividend that could be paid.
6. We are speaking of growth in cash earnings. The larger the expected growth ...