Business Valuations Questions and Answers

Business Valuations Questions and Answers An advocate: Introduces subjective factors and attempts to rely more heavily on qualitative factors. What are the three main reasons for tax related valuations? Estate tax, gift tax, and allocation of purchase price The major point(s) of Internal Revenue Code §2703 is/are... 1. An exception to restrictions on property exists for any option, agreement, right or restriction which (1) is a bona fide business arrangement, (2) is not a device to transfer property for less than its fair market value, (3) is comparable to similar arm's length arrangements; and (4) these safe harbors must be independently satisfied. 2. For estate, gift and other tax purposes, the value of any property is determined without regard to any right or restriction relating to the property 3. Each right or restriction must be tested separately. The Internal Revenue Service first introduced the concept of goodwill and excess earnings when they issued: ARM 34 Which of the following factors should be considered when valuing a closely held business under Revenue Ruling 59-60? i. Nature and history of the business ii. Economic outlook and industry condition iii. Methods to calculate preferred stock iv. The earnings capacity of the company i, ii and iv If a valuator is retained to value a company for estate tax purposes, it is acceptable for the valuator to value the business as a/an: independent expert IRC Section 401(a)(28)(C) requires the use of an "independent appraiser." For ESOP valuations to be independent, the following conditions must be met: The valuator is qualified, performs appraisals on a regular basis, and is not a related party True or False: Under Sarbanes-Oxley, an independent auditor is explicitly forbidden to provide "appraisal valuation services, fairness opinions or contribution-in-kind reports" for any of its audit clients. True The first step an analyst must determine is: the purpose of the valuation Which of the following cases provides guidance on the admissibility of expert testimony in appraising a business: Daubert v. Merrill Dow The United States Department of Labor issues regulations specifically pertaining to business valuations for which of the following? Employee Stock Ownership Plans (ESOPs) Value equals the benefit stream divided by a required rate of return is an example of what principle? Investment value principal An investor would expect the higher rate of return from: a) a publicly traded stock compared to a 5- year treasury bond b) a treasury note compared to large fundamental relationship exists between rate of return from an investment and the amount of risk company stock c) a publicly traded company compared to a privately held company d) a six month CD compared to a 5-year treasury bond a) a publicly traded stock compared to a 5- year treasury bond The definition of Strategic/Investment value is... The value to a particular investor based on individual investment requirements and expectations Revenue Ruling 93-12 allowed which of the following? a) Contributions of non-cash property for federal income tax purposes shall always be valued based on the historical cost of the property b) Valuation of an ownership interest in a business for gift tax purposes would always allow rates of return on tangible assets between 8% and 10% c) Adoption of the "family attribution" rule, which states that no minority interest discount is available for blocks of stock transferred to family members when the family holds a controlling interest in the entity d) Valuation of a minority (i.e., non-controlling) interest in an entity will not have to consider either the transferor or the transferee as they relate to control of the entity d) Valuation of a minority (i.e., non-controlling) interest in an entity will not have to consider either the transferor or the transferee as they relate to control of the entity INTERNAL LIQUIDITY RATIOS Current Ratio = CA / CL Quick Ratio = (Cash + Marketable Securities + Receivables)/ Current Liabilities Cash Ratio = (Cash + Marketable Securities) / Current Liabilities Receivable Turnover = Net Sales / ((Beginning A/R + Ending A/R) ÷ 2) Payables Turnover = Cost of Goods Sold / ((Beginning AP + Ending AP) ÷ 2) Cash conversion cycle = inventory turnover period + days to collect receivables - payable payment period OPERATING EFFICIENCY RATIOS Net Fixed Asset Turnover = Net Sales / ((Beginning FA + Ending FA) ÷ 2) Total Asset Turnover = Net Sales / ((Beginning Total Assets + Ending Total Assets) ÷ 2) OPERATING PROFITABILITY RATIOS Cost of Sales % = Cost of Sales / Net Sales Gross Margin % = (Net Sales - Cost of Sales) / Net Sales Operating Expenses/ Sales % = Operating Expenses / Net Sales Operating Margin % = Income from Operations / Net Sales ROA % = Net Income / ((Beg. Total Assets + Ending Total Assets) ÷2) ROE % = Net Income / ((Beg. Common Equity + Ending Common Equity) ÷ 2) FINANCIAL RISK (LEVERAGE) RATIOS Debt/Equity = (Long-Term Debt + Deferred Tax Liabilities) / Total Equity Debt/Capital = (Current Liabilities + Long-Term Debt) / (Total Liabilities + Total Capital) Total Debt-to-Total Assets Ratio = (Current Liabilities + Long-Term Debt) / Total Assets Interest Coverage = Earnings Before Interest and Taxes (EBIT) / Interest Expense OCF Ratio = OCF / Current Liabilities The conversion of the balance sheet and income statement line items to percentages based on total assets or total sales is often referred to as: Common Size Analysis Ratio analysis will assist the valuation analyst in determining the following: Both the financial condition of the company and the relative operating risks of the company The most conservative ratio in measuring a company's liquidity is the: The cash ratio is the most conservative measure of solvency because it includes only cash and marketable securities in its measurement of liquidity. A high inventory turnover can indicate all of the following EXCEPT: Obsolete Inventory (A low inventory turnover can indicate poor liquidity or obsolete inventory.) What type of ratios may a valuation analyst generally use to evaluate management performance? Operating profitability ratios are used in the evaluation of management performance. These ratios include Cost of sales/Sales and Gross margin analysis. Which statement is correct? a) A high inventory turnover and a low gross profit may indicate that a higher volume is necessary to produce a satisfactory return on total assets. b) If a company's cost of sales/sales ratio is decreasing, it may indicate competition is forcing the company to cut profit margins or it may indicate the company is unable to pass its increasing costs to its customers. c) The net fixed asset turnover ratio is crucial when appraising a service business. d) Companies with significant fixed operating costs in proportion to variable costs can better weather an economic downturn. a) A high inventory turnover and a low gross profit may indicate that a higher volume is necessary to produce a satisfactory return on total assets. explanation: A high inventory turnover and a low gross profit may indicate that a higher volume is necessary to produces a satisfactory return on total assets. Which ratio measures the ability to service total interest-bearing debt? Operating cash flow to total debt ratio What is the purpose of dividing a receivable or inventory turnover ratio by 365? To determine the number of days it may take to convert a current asset into cash. The valuation analyst needs historical performance data in order to: Analyze and compare various years in the company history to identify trends, strengths, weaknesses, and look for potential adjustments to normalize if adjustments are necessary and/or deemed appropriate Advanced Product's accounting shows various items of machinery that were purchased three years ago for $100,000. Their net book value today is $50,000. To replace the machinery today would cost $130,000. The estimated market value today (if sold as is today) is $100,000. Would a balance sheet adjustment be advised? Yes. The valuation analyst should adjust the balance sheet to fair market value and consider adjustment of depreciation expense on the income statement as well as the related tax affect on both the balance sheet and income statement. Net Income can be based on GAAP (Generally Accepted Accounting Principles) or TBA (Tax Basis Accounting), but neither may be economic reality. This is true as corporations (all kinds), public companies, partnerships, sole proprietorships, privately held family businesses, and any varying degrees in between, all have different rules and principles under which they are found. These affect fiscal statements, and the valuation analyst must know what the underlying concept of any given company is as opposed to what it may state in the numbers. True or False: When a valuation analyst is able to obtain audited GAAP compliance financial statements, most likely, normalized adjustments will not be necessary because of the high level of confidence placed on these issued financial statements. False The main objective for adjusting the financial statements of a closely held company is: To adjust the financial statements of a business to more closely reflect its true economic financial position and results of operations on a historical and current basis Which one of the following potential normalizing adjustments would generally NOT be made? a) Bad debt adjustment for a significant write off due to an unexpected bankruptcy filing by a major customer b) Inventory adjustment when inventory is recorded on a FIFO basis c) Removal of excess cash b) Inventory adjustment when inventory is recorded on a FIFO basis According to NACVA, which of the following are considered "control" adjustments? a) Discretionary spending and depreciation adjustments b) Depreciation adjustments and bad debt adjustments c) Officers' compensation and depreciation adjustments d) Discretionary spending and officers' compensations d) Discretionary spending and officers' compensations A pending lawsuit, unrecorded pension liabilities, and capital gains tax on unrealized appreciation of assets are what type of normalizing adjustments? Contingent liability adjustments The cost to replace an asset under a particular fact situation is known as: Replacement Cost In 2006, a company purchased a new operating press costing $300,000. The company elected Section 179 depreciation for this piece of equipment. An appropriate normalization adjustment would be: Adjust the income statement to add back the Section 179 depreciation and adjust the balance sheet to reflect the fair market value of the asset Cash flows that are calculated as: net income after tax plus non-cash charges, less applicable capital expenditures, less additions to net working capital to support operations, plus changes in long-term debt from borrowings required for operations, less changes in long-term debt for repayments: Equals net cash flow to equity The formula for net cash flow to invested capital can be calculated as Net income after tax, plus non-cash charges, less capital expenditures, less additions to net working capital for operations, plus interest expense (tax-affected) Bell Landscape Company has the following historical earnings: Year Earnings 1 $75,400 2 $65,200 3 $87,600 4 $90,500 5 $53,900 Which method of projecting earnings would appear most appropriate to estimate future benefits? Unweighted average method Start-up Jennings Baker Company provided you the following historical data: Year Earnings 1 ($15,300) 2 $32,400 3 $89,600 Which method of projecting earnings would appear most appropriate to estimate future benefits? Weighted Average Method Net cash flow to equity will result in what type of value Equity When discounting cash flow to invested capital, the appropriate discount rate is: Weighted average cost of capital (WACC) Generally, an estimated future benefit stream is based on historical economic income when: The future benefit stream is estimated to be linear True or False: A linear benefit stream is a stream of future benefits that is expected to grow or decline at a variable rate. False Two most commonly used methods to estimate future benefits based on a linear benefit stream are: Weighted average method and unweighted average method Using a weighted average method to determine a future benefit stream, a valuation analyst assigns more weight to the most recent years. This indicates: The valuation analyst determined the most recent year is the most indicative of future years Using the Trend Line Projected Method, growth or data is Increasing at a declining rate When utilizing projected or forecasted financial information, the adequate number of years to be included in the analysis is: The number of years until it is assumed the benefit stream becomes linear True or False: Projected economic income in constant real dollars is based on real dollars in the first year without regard for inflation. True What is a capitalization rate? Divisor (or multiplier) used to convert a defined stream of income to present value. What is the discount rate? A rate of return used to convert a series of future income amounts to their present value. True or False: A capitalization rate and a discount rate are essentially the same thing. False The primary formula for the Capital Asset Pricing Model (CAPM) is: Expected return = risk-free rate plus beta multiplied by the expected return on a market portfolio less the risk-free rate. To calculate the weighted average cost of capital (WACC): Calculate the after-tax weighted cost of debt and add the weighted cost of equity. An estimate of a long-term sustainable growth rate should: Equal inflation plus the real volume of growth that can be achieved without additional capital investment Earnings per share is: The net income less preferred stock dividends divided by the number of common shares outstanding. To convert a pre-tax capitalization rate to after-tax capitalization rate: Multiply the pre-tax capitalization rate by 1 minus the expected tax rate. General expectations of the particular business being valued, the size of the business being valued, and the nature of the business being valued are examples of: Internal factors that may influence the capitalization or discount rate It is generally accepted that the capitalization rate is equivalent to the discount rate less: Long-term sustainable growth rate Which variable below is NOT included in the Ibbotson Build-Up Method? Risk free rate of return Beta Size premium Specific company risk Beta Which component of the Ibbotson Build-Up Method relates to the "unsystematic risk" associated with a particular business entity? Specific company risk premium Which of the following is not an assumption of the Capital Asset Pricing Model (CAPM)? a. All investors do not have identical investment holding periods b There are no taxes and no transactional costs c. The rate received from lending money is the same as the cost of borrowing d. Investors are risk averse a) All investors do not have identical investment holding periods Using the Modified Capital Asset Pricing Model a valuation analyst determines beta = 1.08, this means: The subject company is more volatile than the industry True or False: WACC can add versatility to the valuation, in that a valuation analyst could change the capital structure of an entity when valuing a non-controlling (i.e., minority) interest. False If a valuation analyst uses the weighted average cost of capital (WACC) and is valuing only the equity of the company, the valuation analyst would: Capitalize invested capital then subtract existing debt