Chapter 6 Commonly Used Methods of Valuation Questions and Answer

Chapter 6 Commonly Used Methods of Valuation Questions and Answer The three general approaches that need to be considered by the valuation analyst in each valuation engagement include: a. Income, Asset Based, and Excess Earnings b. Market, Treasury, and Income c. Income, Going Concern, and Market d. Income, Asset Based, and Market D is Correct— Income, Asset Based and Market refer to the three general approaches to valuation which a valuation analyst must consider in each valuation engagement. As a component of the capitalization of future earnings or cash flows method, the future earnings or cash flows as estimated by the valuation analyst: a. Are always calculated on an after-tax basis b. Exclude any income or expense items generated from non-operating assets and liabilities c. Are based only on the historical results of operations in the fiscal year closest to the valuation date d. Exclude any compensation to the owner(s) of the business B is Correct—As their name implies, non-operating assets and liabilities do not contribute to the operations of a business, and any income or expense items related to them should not be included in the benefit stream in the capitalization of earnings/cash flows method. The value of any non-operating assets or liabilities are added back to the calculated value of the operating business to determine the overall. In the discounted earnings/cash flows method, the Gordon Growth Model is used: a. To determine the period of stabilized earnings/cash flows of the company b. To determine the number of periods (years) needed in the projection period c. To calculate the "terminal value" of the company d. To calculate the present value factor based on an assumed rate of return B is Correct—The valuation analyst, in their financial analysis, will need to use his/her professional judgment in the determination of how many historical years are relevant in the calculation of the estimate of future earnings/cash flows. If the capitalization of future earnings/cash flows method is used in a valuation engagement for U.S. Gift Tax purposes, the valuation analyst is required to include how many historical years in the estimate of the future earnings/cash flows? a. At least three years, based on Treasury Regulations b. As many years as the valuation analyst deems appropriate, based on his/her professional judgment c. Five years, based on requirements of the Internal Revenue Service d. Two to five years, based on Treasury Regulations C is Correct— The Gordon Growth Model is one possible method used to calculate the "terminal value" in the discounted earnings/cash flows method. To find useful and relevant comparable guideline publicly traded companies to use in the market approach is: a. Relatively easy because numerous comparable guideline publicly traded companies exist for the privately held businesses that are the subject of the valuation analysts valuation engagements b. Relatively easy because finding comparable guideline publicly traded companies is quick and inexpensive as the information is readily available from public sources c. Relatively difficult because the methodology relies on explicit financial forecasts which are not readily available for the comparable companies d. Relatively difficult because company size differential, management depth, product and services diversity and access to debt capital will seldom match the privately held company being valued D is Correct—These reasons and others require the valuation analyst to understand, reconcile, and adjust for any perceived differences and similarities between the guideline comparable publicly traded companies and the company being valued. The primary methods used to calculate the value of privately held business interests in the income approach are: a. Capitalization of Earnings/ Cash Flows Method and Excess Earnings/Treasury Method b. Excess Earnings/Treasury Method and Discounted Earnings/Cash Flows Method c. Capitalization of Earnings/Cash Flows Method and Discounted Earnings/Cash Flows Method d. Discounted Earnings/Cash Flows Method and Price/EBITDA Method C is Correct—These are the two primary methods within the income approach. According to Russel L. Parr in Investing in Intangible Assets, there are ten essential characteristics of an intangible asset. One such essential characteristic is: a. To provide an economic advantage in the form of lower manufacturing or operating costs such as substituting high cost high quality materials for low cost materials enabling a higher quality product b. To provide an economic advantage in the form of lower manufacturing or operating costs such as reducing the amount of labor required to manufacture, inspect, package or account for a product c. To provide an economic advantage in the form of lower manufacturing or operating costs such as lowering high manufacturing speeds by reducing fuel or electric power requirements d. To provide an economic advantage in the form of lower manufacturing or operating costs such as reducing shipping costs by eliminating manufacturing environmental hazards B is Correct—This is one of the ten essential characteristics of an intangible asset per Parr's Investing in Intangible Assets. The Financial Accounting Standards Board (FASB) has issued Accounting Standards Codifications that address valuation considerations for goodwill and other intangible assets. Which of the following is correct? a. ASC 830 did not affect valuations based on arms-length bargaining. b. ASC 59-60 does affect valuations, and the valuation analyst must take care to follow the eight factors outlined in ASC 59-60. c. ASC 66-49 outlined procedures to all types of non-cash property for which an appraisal is required for gifting and/or charitable contribution. d. ASC 350 addresses how intangible assets acquired with a group of assets (but not those required in a business combination) should be accounted for upon their acquisition. D is Correct—ASC 350 discusses accounting for intangible assets outside a business combination, and its oft-stated companion ASC 805 discusses accounting for intangible assets in a business combination. When valuing the stock of a real estate holding company, most likely the valuator will give the greatest weight to which method? a. Capitalization of earnings method b. Book value method c. Adjusted net assets method d. Rule of thumb C is Correct—The Adjusted Net Assets Method is a sound method for estimating the value of a non-operating business such as a real estate holding company Using the adjusted net asset method, the valuation analyst only values the tangible assets of the company. a. True b. False B is Correct—Both tangible and identifiable intangible assets are valued in determining total adjusted net assets. The adjusted net assets method generally sets a ______________ for determining total entity value. a. floor value b. high value c. forced liquidation value d. investment value A is Correct—The adjusted net assets method generally sets a floor or the minimum value for determining the total entity value. Which one of the following adjustments would be a normalized adjustment to the balance sheet in the adjusted net assets method? a. Convert inventory from FIFO to LIFO b. Remove excess cash c. Adjust owner's compensation d. Remove expenses related to fire damage of a Company's manufacturing plant B is Correct—If the valuator identifies excess cash, the excess cash would be considered a non operating asset and removed from a normalized balance sheet. Which method is based on the theory that the total value of a company is the present value of its projected future earnings plus the present value of the terminal value? a. Capitalization of earnings b. Discounted cash flows c. Excess earnings d. Adjusted net assets method B is Correct—The Discounted cash flow method is based on the theory that the total value of a company is the present value of its projected future earnings plus the present value of the terminal value. The mid period method of discounting should be used when the equity holder: a. Has access to cash flows at the end of the year (or period) b. Has access to cash flows throughout the year (or period) c. Does not have access to any cash flows d. Both a and b B is Correct—The mid period discounting method should be used when the equity holder has access to the cash flow throughout the year to receive dividends Advantages of the market approach include: a. It uses actual data, it is relatively simple to apply, and it is inexpensive to determine. b. It uses actual data, it is inexpensive to determine, the data obtain via transaction databases are very reliable. c. It uses actual data, it is relatively simple to apply, and it does not rely on explicit forecasts. d. It is user friendly, relatively inexpensive to determine, and simple to apply. C is Correct—The market approach uses actual data for comparison purposes, it can be relatively simple to apply and does not rely on explicit forecasts. Which two private company transactional databases cover relatively small companies? a. IBA Market Database and Done Deals b. BIZCOMPS and IBA Market Database c. IBA Market Database and Mergerstat d. Mergerstat and BIZCOMPS B is Correct—The BIZCOMPS and IBA databases cover transactions of relatively small companies. Using the market approach, "price" should be matched to the appropriate parameter based on which providers of capital in the numerator will be paid with the monies given in the denominator. Market value of invested capital (MVIC) is usually the numerator that is paired with _____________ in the denominator. a. EBITDA b. pretax income c. net income d. book value of equity A is Correct—Any denominators that exclude interest should usually be matched with a corresponding numerator of invested capital. Which method combines the income and asset based approaches to arrive at a value of a closely held business? a. Adjusted net assets value method b. Discounted cash flows method c. Guideline public companies method d. Excess earnings method D is Correct—The excess earnings method incorporates elements of both the income and asset approaches to arrive at the value of a privately held company. A "pass-through" entity is one which: a. Passes the value of the entity to the owners in a taxable transaction b. Pays no entity-level income taxes, but passes through any income or losses to the owners of the entity c. Calculates its entity-level tax liability and passes it through to the owners of the entity d. Pays the individual taxes of the owners as a pass through item B is Correct—This is a proper definition of a pass-through entity Which model for valuing a minority interest in a pass-through entity assumes 100% of the company's earnings is being distributed? a. Mercer b. Grabowski c. Van Vleet d. Treharne C is Correct—This model assumes that the subject S Corporation is distributing 100% of its earnings and if this is not the case then any appropriate discount for lack of marketability should be adjusted. The S election allows a shareholder to avoid which individual level tax? a. Capital gain tax b. Income tax c. Dividend tax d. Foreign tax C is Correct—The S election allows a shareholder to avoid the dividend tax. There are four recognized models for valuing a minority interest in a pass-through entity. Which of the following statements is INCORRECT? a. All four models recognize distributions impact value. b. All four models recognize there is potential value in retained net income. c. All four models assume the same holding period. d. All four models consider the dividend tax on C corporation dividends. C is Correct—All four models recognize a different holding period. Treharne's model assumes the interest is held into perpetuity, Van Vleet assumes the ownership interest can be liquidates at the option of the shareholder, Mercer assumes a selected holding period and Grabowski considers two holding perio