Chapter 1 - Introduction to valuation Questions and Answers

Chapter 1 - Introduction to valuation Questions and Answers What is the fair market value - the standard definition? The fair market value is the cash equivalent value at which a willing and unrelated buyer would agree to buy and a willing and unrelated seller would agree would agree to sell the company, when neither party is compelled to act, and when both parties have reasonable knowledge of the relevant available information What are the valuation context characteristics? 1. Arms length 2. Timeframe constraints 3. Information available 4. Specific use 5. Types of financing 6. Ongoing concern 7. Liquidation value 8. Breakup value What is breakup value? Breakup value is the valuation that presume that company will be broken up into pieces and the pieces will be operated as separate entities. What is liquidation value? Liquidation value (forced and orderly) is the valuation that presume that the company will not be operated any longer. True or False The value of a company's resources must be equal to the value of the contractual claims on its resources. True Value of Resources = Value of Claims on resources Value of the Firm = Value of Non-equity claims + Value of equity (residual interest) What is an economic balance sheet? An economic balance sheet is similar to the balance sheet in a company's reported financial statements but all assets and claims on those assets are: a. Valued at market value but not individually, instead: - Value of the company's operations - Value of excess assets - Value create from financing b. The value of assets minus the value of non-equity claims is the residual value or residual interest, which equals the value of the equity. What are the economic balance sheet's equalities? Value of Resources = Value of Claims on resources Value of the Firm = Value of Non-equity claims + Value of equity (residual interest) What makes up the value of a company's resources? The value of the unlevered firm and the value created from financing make up the value of a company's resources Value of firm = Value of unlevered firm + Value of financing What is the value of the unlevered firm? The value of the unlevered firm is what the company would be worth if it was entirely financed with common equity but had made all of the same investment decisions. Why does the value created from financing exist? The value created from financing arises in some tax jurisdictions because of the potential tax advantage of debt relative to the other forms of financing, such as equity financing (issuing common stocks). In many tax jurisdictions, payments to bondholders in the form of interest are tax deductible at the corporate level whereas payments or flows to stockholders are not tax deductible True or False The economic balance sheet shows the value of all individual components that make up the value of the unlevered firm. False The economic balance sheet does not show the value of all the individual components that make up the value of the unlevered firm What is the value of a company's ongoing business? This value includes the value of its current operations and the value of its potential businesses or fututre growth opportunities (all adjusted for uncertainty and risk) What are the value of a company's excess assets? The value of a company's excess access includes all resources that are not needed to operate the specific business being value. In other words, excess assets are assets that have value but are not needed to implement a company's strategic plan for its business. What are common excess assets? Cash or marketable securities Can you name some other excess assets? Other excess assets are over funding of pension liabilities or land not needed for the business. True or False Leases are a direct source of financing True Can you name some indirect sources of financing? 1. Pension liabilities 2. Other post-retirement health benefits Why does an asset have value to an investor? An asset has value to an investor because the investor believes that the asset will generate cash flows in the future. What does the value of an asset depend on? The value of an asset depends on: 1. The magnitude 2. The timing 3. The risk of the cash flows (or called free cash flows FCFs) What are free cash flows? Free cash flows or FCFs are the cash flows generated by the company after the collections of its revenues, payments of its expenses, and after making its investments, including investments in working capital What is the formula to calculate the FCFs? FCF = EBIT - TAX + NCEXP - NCREV - Change in RC - Change in WCO - CAPEX TAX = the income taxes the company would pay NCEXP = Non-cash expenses or losses NCREV = Non-cash revenues or gains RC = required cash balance WCO = Non-cash required operating working capital CAPEX = Capital Expenditure True or False The larger the magnitude of the cash flows of an asset is, the worst the value of an asset is/ False The larger the better Why do we call free cash flows? They are "free" because the company is "free" to distribute these cash flows to its investors without interfering with he execution of its strategy What is the DCF model? Discounted Cash Flow Valuation model (or DCF) adjusted the expected cash flows by using the time value of money principles to discount the expected cash flows to the date of the valuation, using a risk-adjusted discount rate that reflects the risk of the asset True or false Since a company does not have a contractual finite life but can exist forever, the DCF model normally does not discounts a company's free cash flows to infinity. False ince a company does not have a contractual finite life but can exist forever, the DCF model normally discounts a company's free cash flows to infinity. What is the unlevered cost of capital? The DCF model to measure the value of the firm simplifies for an all-equity financed company with a constant (risk-adjusted) cost of capital, which is termed the unlevered cost of capital. What is the continuing value or terminal value? We call the value at the end of the finite period of time the company's continuing value (CV) or terminal value or horizon value in the DCF model What are the two DCF methods used to measure the value of the firm? 1. The adjusted present value method (APV) 2. The weighted Average Cost of Capital method (WACC) True or False Both the APV and WACC methods value the company based on the combined value of the company's operations and the value created from financing. True What is the difference between the two methods APV and WACC? The difference between the two methods is how the methods incorporate the value created from financing. How does the APV method incorporate the value created from financing? The APV method incorporates the benefit directly, via forecasts of cash flows that are attributable to financing choices. How does the WACC method incorporate the value created from financing? The WACC method incorporates the benefit indirectly, through an adjustment to the discount rate True or Fasle The APV and WACC methods are substitutes for valuation False The APV and WACC methods are not substitutes. Given the information available and the valuation assumptions made, only one of the two methods is appropriate as the starting point for a particular valuation analysis. Which valuation method is used extensively by investment bankers and valuation experts? Market multiple valuation models are used extensively by investment bankers and other valuation experts. Can you name some common market multiple valuation methods? They are: 1. Earnings before interest and tax (EBIT) 2. Earnings before Interest, taxes, depreciation and amortization (EBITDA) 3. The market value of the firm to sales What are the general steps of using the market multiple valuation method? 1. Identify a characteristic of the company that we are perform valuation. - This characteristic should be a primary determinant or driver of the company's value 2. Identify a set of companies that are comparable to the company we are valuing. - Those companies should share same characteristics as well as their values. 3. For each comparable company, we calculate its market multiple by dividing its value by its characteristic. - For example, divided the market value of the firm by the EBIT multiple. 4. Based on the calculated multiple of the comparable companies, we choose the appropriate multiple for the company we are valuing. 5. Finally, we multiply that multiple by the characteristics of the company we are valuing to obtain its value What is the intuition underpinning market multiple valuation models? The intuition underpinning market multiple valuation models is the notion of the law of one price. What is the law of one price? That is, if 2 assets are identical in terms of magnitude, timing, and riskiness of their cash flows, they should sell for the same price. On the other hand, if 2 assets are identical in terms of timing and riskiness of their cash flows, but the cash flows of one asset are exactly two times as large as the cash flows of the other assets in every period, then that asset should sell for twice as much True of false If the value of firm A is $10,000 and its EBIT is $1,000, then the market multiple approach assumes that another firm that is identical in all other relevant respects, except its EBIT is $2,000 will have a value of $20,000. True Why is the market multiple valuation quite difficult to implement? While market multiple valuation is simple to understand, it is quite difficult to implement since it is quite difficult to make sure that companies are identical in all other relevant respects. What is a LBO transaction? Leverage buyout (LBO) or private equity transaction is a form of transaction in which a group of private investors acquires the company using extensive debt financing. To summarize, what are the most common methods used to value the firm? 1. DCF method 2. Discounted Excess Flow method (algebraically equivalent to the DCF method) 3. the market multiple valuation method 4. The LBO analysis What are real options Real options are options embedded in some investment opportunities that a firm takes on or that arise because of the contractual agreements with other parties. What is the valuation method used for financial options? Financial options, where there is typically a wealth of relevant data, are often valued using models such as the Black-Scholes Option Pricing Model and the Binomial Option Pricing Model. What is a control transaction? Control transaction is a term used to describe any transaction that results in a change of control of an entity True or False A control transaction has to involve the sale of the entire company False A control transaction does not have to involve the sale of the entire company What are change-of-control transactionS? Change-of-control transactions, i.e. LBOs and management buyouts (MBOs), are highly leveraged transactions that control the entity shifts. What is fairness opinion? In almost all change-of-control transactions, a consultant, typically an investment bank or other valuation specialist, issues an opinion (or fairness opinion) that indicates whether the price offered in the transaction is fair. What do companies do to increase the value of the firm and maximize the shareholders' value? Companies undertake a variety of asset and financial restructuring activities to increase the value of the firm and maximize the shareholder values. What are asset restructuring activities? Asset restructuring activities involve the sale of assets, businesses, or the stock of subsidiaries. What are the financial restructuring activities? Financial restructuring activities involve large changes in a company's capital structure. Management sometimes undertakes these activities proactively and sometimes reactively, such as in response to the threat of a takeover. What do management do in a proactively financial restructuring activity? In a proactive restructuring activity designed to maximize the shareholder value, management uses valuation models to better understand the economic consequences of a restructuring decision. What do management do in a reactively financial restructuring activity? In reactive restructuring, a response to a corporate raider or a threat of a hostile bid, management uses valuation models to analyze the economic consequences of the offer as well as the economic consequences of alternative defenses and strategies. What does a company do if another company can use its assets better? It should divest (sell off) some of those assets. True or False Divestiture is a form of business downsize True What do companies do in a spin-offs? In spin-offs, a company distributes shares of a subsidiary (a separate legal entity) to existing shareholders on a pro-rata basis. The subsidiary then becomes a new standalone company that is public traded and operates independently of the parent company. What is an equity carve-out transaction? Equity carve-outs involve the initial public offering (IPO) of the stock of a subsidiary