BEC 13 - Financial Valuation Flashcards
Identify and briefly describe the three component levels of the United States Generally Accepted Accounting Principles (GAAP) hierarchy of inputs used for determining fair value.
Level 1: Quoted prices in active markets for identical items.
Level 2: Quoted prices in inactive markets or for items similar (but not identical) to those being valued; observable inputs other than quoted prices relevant to the item being valued.
Level 3: Unobservable inputs relevant to valuing an item (e.g., assumptions, estimates, etc.).
Identify and briefly describe the three approaches to determining fair value as specified by United States Generally Accepted Accounting Principles (GAAP).
- Market approach: Information generated by market transactions for identical or similar items.
- Income approach: Converts future amounts of benefit or sacrifice to determine current value.
- Cost approach: Determines the amount required to acquire or construct a comparable item
How is “fair value” defined and determined for United States Generally Accepted Accounting Principles (GAAP) purposes?
Fair value for United States Generally Accepted Accounting Principles (GAAP) purposes is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.
What are some of the factors that must be considered in assigning value?
The following factors must be considered in assigning value: 1.The specific item or items (asset, liability, equity, etc.) being valued;
- The condition of the item(s);
- The location of the item(s);
- The time at which the valuation is occurring;
- The economic environment in which the valuation is occurring.
Briefly describe the nature of level 3 inputs identified in the United States Generally Accepted Accounting Principles (GAAP) fair-value framework.
Level 3 of the U.S. GAAP fair value framework consists of inputs that are not observable but are based on an entity’s assumptions and estimates.
Briefly describe the nature of level 1 inputs identified in the United States Generally Accepted Accounting Principles (GAAP) fair-value framework.
Level 1 of the U.S. GAAP fair value framework consists of quoted market prices in active markets for identical assets or liabilities.
Briefly describe the nature of level 2 inputs identified in the United States Generally Accepted Accounting Principles (GAAP) fair-value framework.
Level 2 of the U.S. GAAP fair value framework consists of inputs that are either directly or indirectly observable, including: 1.Quoted prices for similar items in active markets and in markets that are inactive;
- Quoted prices for identical items in inactive markets;
- Observable inputs other than quoted prices;
- Inputs not directly observable but which are derived from or corroborated by observable market data.
an economic model that determines the relationship between risk and expected return and uses that measure in assigning value to securities, portfolios, capital projects and other assets.
Define/describe the “capital asset pricing model (CAPM)”.
Identify and describe the three (3) possible alternative values of beta.
Beta (B) = 1: The individual asset being valued changes in the same proportion as the entire class of the asset being valued; the asset has average systematic risk for the entire class. Beta (B) > 1: The individual asset being valued changes greater than the entire class of the asset being valued; the asset is more volatile than the entire class.
Beta (B)
What are the major assumptions and limitations of the capital asset pricing model (CAPM)?
- All investors have equal access to all investments and are using a one period time horizon;
- Asset risk is measured solely by its variance from the asset class benchmark;
- There are no external cost - commissions, taxes, etc.;
- There are no restrictions on borrowing or lending at the risk-free rate of return;
- There is a market and market benchmark for all asset classes;
- Uses historical data.
Give the capital asset pricing model formula and describe its components.
RR = RFR + B(ERR - RFR) Where: RR = Required rate of return. RFR = Risk-free rate of return. B = Beta, a measure of volatility. ERR = Expected rate of return for a benchmark for the entire class of the asset being valued.
a measure of the systematic risk associated with an investment as reflected by its volatility as compared with the volatility of the entire class of the investment.
“Beta”
What are some major advantages of the original Black-Scholes option pricing model?
- Assigns probability factor to the likelihood that the price of the stock will pay off within the time to expiration;
- Assigns probability factor to the likelihood that the option will be exercised;
- Discounts the exercise price to present value.
What are some major limitations of the original Black-Scholes option pricing model?
- Appropriate only for European call options, which permit exercise only at the expiration date;
- Assumes options are for stocks that pay no dividends;
- Assumes options are for stocks whose price increases in small increments;
- Assumes the risk-free rate of return remains constant during life of the option;
- Assumes there are no transaction costs or taxes associated with the options.
What is the Black-Scholes option-pricing model?
The Black-Scholes model is a mathematical formula for valuing stock options, which are derivative instruments (and certain other instruments). The original model was developed to value European-style options, which permit exercise only at the expiration date of the option.
