SD6-THE ECONOMIC BALANCE SHEET AND AN OVERVIEW OF CASH FLOW BASED VALUATION MODELS

SD6-THE ECONOMIC BALANCE SHEET AND AN OVERVIEW OF CASH FLOW BASED VALUATION MODELS

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CHAPTER 6 THE ECONOMIC BALANCE SHEET AND AN OVERVIEW OF CASH FLOW BASED VALUATION MODELS LEARNING OBJECTIVES 1. The concept of an economic balance sheet and how it differs from a GAAP balance sheet. 2. How to create an economic balance sheet. 3. How to relate each of the five components of the economic balance sheet to the appropriate cash flow stream. 4. An overview of five valuation models. 5. That all five of the valuation models produce identical results given identical assumptions. 6. Why the models use different cash flow streams. TRUE/FALSE QUESTIONS 1. The GAAP balance sheet is a statement showing the estimated fair values of all items that represent an economic asset or liability for the firm, along with the implied value of the firm’s equity. (easy, L.O. 1, Section 1, false) 2. Economic balance sheets differ from GAAP balance sheets in three important respects. (moderate, L.O. 1, Section 1, true) 3. Core operations are assets and liabilities that are central to the business which can be easily separated from each other without affecting the cash-generating ability of the entity. (moderate, L.O.1, Section 1, false) 4. The value of core operations is estimated in the aggregate, line-by-line, on the economic balance sheet. (moderate, L.O. 1, Section 1, false) 5. During major litigation, stock returns can be associated with turning points in the case. (easy, L.O. 1, Section 1, true) 6. Commitments and contingencies are classified as nonoperating. (moderate, L.O. 2, Section 1, true) 7. The difference between the fair value of the core operations and its book value is likely to be very large. (moderate, L.O. 2, Section 1, true) 8. An analyst can value any of the components of the economic balance sheet as a present value. (moderate, L.O. 3, Section 1, true) 9. The economic balance sheet illustrates a fundamentally important concept: The total value of all claims is equal to the total value of all assets they claim. (difficult, L.O. 4, Section 2, true) 10. Estimates are generally better than the assumptions on which they are built due to more in-depth analysis. (difficult, L.O. 4, Section 2, false) 11. In the dividend discount model, the value of common equity ( COMEQUITY ) is estimated indirectly. (difficult, L.O. 4, Section 2, false) 12. The residual income model relies on the idea that the value of any security is the present value of cash flows that securities are expected to generate. (moderate, L.O. 5, Section 2, false) 35
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13. An analyst using identical assumptions will obtain the same value for common equity no matter which of the five valuation models are used. (moderate, L.O. 5, Section 2, true) 14. The residual income model is the most widely used model in practice.
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SD6-THE ECONOMIC BALANCE SHEET AND AN OVERVIEW OF CASH FLOW BASED VALUATION MODELS

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