Unit 6 Corporate Valuation Questions and Answers

Unit 6 Corporate Valuation Questions and Answers Which of the following are issues in the creation of the financial statements for business units? I. Allocating corporate overhead costs. II. Dealing with intercompany transactions. III. Estimating unit betas. IV. Dealing with incomplete information when using public information. I, II, and IV only. Which of the following questions relate to the economic consistency of a model? I. Are the patterns intended? II. Are the patterns reasonable? III. Are the patterns consistent with industry dynamics? I, II, & III Which of the following correctly describes how to determine the beta for a business unit within a multiple-business corporation? c. Relever the unlevered sector median beta using the capital structure of the unit. In a scenario analysis, which of the following are considerations when reviewing the assumptions of a model? I. The sensitivity of the results to broad economic conditions. II. The level of competitiveness of the industry. III. The internal capabilities of the company to achieve the forecasts of output and growth. IV. The ability of the company to raise the necessary capital from the markets. I, II, III, and IV. When estimating a company's value, it is advisable to estimate a range of plus or minus 15 percent, which is similar to the range used by many investment bankers. T or F TRUE Sometimes business units provide goods and services to one another. To arrive at consolidated corporate results, accountants eliminate the internal revenues, costs, and profits to prevent double counting. Only revenues and costs from external sources remain at the consolidated level. T or F TRUE In calculating and interpreting results when estimating invested capital, start with total assets by business unit, add estimates for non-operating assets, and then add estimates of non-interest-bearing operating liabilities. T or F To estimate invested capital, start with total assets by business unit and subtract estimates for non-operating assets and non-interest-bearing operating liabilities. FALSE When valuing a company by summing the business unit values, an analyst should use a corporate-wide cost of capital to value each unit. T or F The cost of capital should be computed for each business unit using the beta of its industry. FALSE List the criteria for assessing whether a model is technically robust with respect to the following two perspectives: 1. Unadjusted Financial Statements 2. Rearranged Financial Statements 1. Unadjusted financial statements: The balance sheet should balance each year, and the dividends and retained earnings should be congruous with net income. 2. Rearranged financial statements: The sum of invested capital plus non-operating assets equals the cumulative sources of financing. NOPLAT is the same when calculated from the top down or from the bottom up. When analyzing scenarios in a scenario analysis, an analyst should review the assumptions of a model with respect to four variables. List and explain the four variables. 1. Broad economic conditions and the sensitivity of the firm's operations to swings in the economy. 2. Competitive structure of the industry and the implications the level of competition will have on the firm's market share. 3. Internal capabilities of the company to develop its products on time and to manufacture them within the expected range of costs. 4. Financing capabilities of the company relative to possible conditions in financial markets. When making forecasts, increasing one variable usually means decreasing another. List three of the several possible common trade-offs that should be considered in making such forecasts. 1. Sales and prices. 2. Lower inventory and higher sales. 3. Higher growth and lower margin. Which of the following is not a method for evaluating convertible debt? Multiples valuation. An analyst is applying an integrated-scenario approach to evaluate operations as well as equity, and the analyst essentially treats equity as a call option on the enterprise value. It is most likely the analysis is of a company that: Is highly levered. In evaluating employee stock options, the exercise value approach provides: A lower bound of stock option valuation, and using it can overvalue the equity. Company X controls Company Y so that Company Y's financial statements are fully consolidated in the group accounts. With respect to Company X's financial statements, third-party stakes in Company Y: Are to be deducted and are called minority or non-controlling interest. For equity stakes in subsidiaries where the stake is between 20 and 50 percent of the subsidiary, the holding is recorded on the balance sheet at: Historical cost plus reinvested income, and the subsidiary's profits are shown below operating profit on the parent company's income statement. A corporation has 2 million shares outstanding. Using the following information (all value in millions), what is the value per share? DCF of operations = $320 Financial subsidiary = $25 Equity investments = $45 Bonds = $185 Employee stock options = $6 Unfunded pension liabilities = $40 The value per share is closest to: Value of the firm = DCF of operations + Financial subsidiary + Equity investments - Bonds - Employee stock options - Unfunded pension liabilities = $320M + $25M + $45M - $185M - $6M - $40M = $159M; value per share = $159M/(2M shares) = $79.50/share Given the following list, put a "+" if it increases a firm's value per share of common stock or a "-" if it decreases the firm's value per share of common stock. Excess Real Estate Preferred Stock Minority Interest Tax Loss Carry Forward Unfunded pension Liabilities Nonconsolidated Subsidiaries A. Excess real estate → (+), B. Preferred stock → (-), C. Minority interest → (-), D. Tax loss carry-forward → (+), E. Unfunded pension liabilities → (-), F. Nonconsolidated subsidiaries → (+) Indicate in which cases book value is a reasonable approximation for evaluating the asset or liability. Select "Yes" if book value is a reasonable approximation and "No" if it is not. A. Floating-rate debt: B. Outstanding bonds that are secure and actively traded: C. Discontinued operations: D. Stake in a publicly traded subsidiary: E. Excess real estate: F. An outstanding convertible bond: G. Employee stock options: A. Floating-rate debt: → Yes, B. Outstanding bonds that are secure and actively traded: → No, C. Discontinued operations: → Yes, D. Stake in a publicly traded subsidiary: → No, E. Excess real estate: → No, F. An outstanding convertible bond: → No, G. Employee stock options: → No For a convertible bond that is deep in-the-money, the conversion value approach is a reasonable approximation of the value of this bond. T or F When the bond is deep in-the-money, nearly all of its value is coming from intrinsic value. In other words, the time value portion is very small. TRUE Part 1 of 2: An analyst is evaluating a corporation's subsidiary by multiplying the value of the stake in the subsidiary when it was acquired times 1 plus the percentage change in a portfolio of comparable stocks over the same holding period. Based on this information, answer the following question: What are the conditions when this is a preferred method of valuation for the stake? The subsidiary is not publicly traded, and the stake is less than 20 percent of the value of the subsidiary. Part 2 of 2: An analyst is evaluating a corporation's subsidiary by multiplying the value of the stake in the subsidiary when it was acquired times 1 plus the percentage change in a portfolio of comparable stocks over the same holding period. Based on this information, answer the following question: What is the name of the method? The tracking portfolio method. Which two of the following are likely to vary the most among companies within an industry? I. Tax rates. II. Growth. III. ROIC. IV. WACC. II & III Which of the following are reasons that the value-to-EBITA ratio is superior to the price-to-earnings ratio as a multiple to aid in valuation? I. The P/E is distorted by capital structure. II. The P/E is distorted by inflation. III. The P/E is distorted by non-operating gains and losses. IV. The P/E is distorted by dividend payouts. I and III only. Comparison of a company's multiples to the arithmetic averages of an industry: Is not recommended. Increasing growth and ROIC by the same amount and holding taxes and WACC constant will: Increase the value-to-EBITA ratio. You are analyzing a firm that has a tax rate of 34 percent, growth rate of 4 percent, ROIC of 10 percent, and WACC of 9 percent. Given this information, what is the value-to-EBIT ratio? Value / EBIT = ((1-Tc)*(1-(G/ROIC))/(WACC - G) 7.92 In estimating and comparing value, the price-to-earnings multiple has two major flaws. Which of the following are those flaws? I. It is in squared currency units. II. The price-to-earnings (P/E) ratio is affected by a company's capital structure. III. The earnings or net income is calculated after non-operating items. IV. The market measure of price usually has significant error. II & III In estimating and comparing value, empirical evidence shows that forward-looking multiples are more accurate predictors of value than are historical multiples. T or F TRUE Given the following inputs, compute the value-to-EBIT ratio: tax rate = 34 percent, growth rate = 5%, ROIC = 12%, and WACC = 8 percent. Value / EBIT = ((1-Tc)*(1-(G/ROIC))/(WACC - G) 12.83 In estimating value creation, analysts should use EBITA rather than EBITDA because depreciation is a noncash item whereas amortization is not. T or F Both are non cash items FALSE Nonfinancial ratios such as stock value to web site hits, to unique visitors, and to number of subscribers had some explanatory power for assessing Internet company stock prices in the early years of the wave of Internet companies. T or F TRUE List the three requirements for carrying out a useful analysis of comparable multiples. Use the right multiple, which is value-to-EBITA in most cases, when comparing valuations across companies. Calculate the multiple in a consistent manner, which means basing the numerator (value) and denominator (earnings) on the same underlying assets. Use the right peer group; the best set is a set of industry peers, at least to start. For each of the following characteristics that help determine growth and ROIC, list contrasting types of the characteristics to consider when composing appropriate peer groups. Production Methodology Distribution Channel Research & Development Production methodology → Capital intensive versus capital light, Distribution channels → Online versus bricks and mortar, Research and development → Internal versus acquired Provide an argument for why EBITA may be superior to EBIT when computing multiples. EBITA may be superior to EBIT because amortization is a measure determined by past acquisitions. It does not affect future cash flows, and therefore it should not be included in the operating earnings measure. Provide an argument for why EBITA may be superior to EBITDA when computing multiples. EBITA may be superior to EBITDA because the earnings measure should include depreciation. Although analysts often exclude depreciation because it is a noncash measure reflecting past cash outflows, depreciation is important in this case because it gives an indication of what will have to be invested in the future to replace the existing assets. One critical operating assumption (profits) embedded in this forecast method? Cost of sales will drop only if all costs are variable (or management reduces fixed costs) One critical operating assumption (Capital) embedded in this forecast method? The value of PPE drops $20 m. Since depreciation equals $10 m the remaining $10 m drop must come from either an asset sale or write-off. Be sure to check if these are plausible.