Chapter 12

Question 1

Factors affecting value of a business

Answer 1

Reported sales, profits and asset value
Forecast sales, profits and asset value
Type of industry
Level of competition
Range of products sold
Breadth of customer base
Perspective

Question 2

What should be used as a starting point when valuing a quoted company?

Answer 2

Stock market share price

Question 3

Three basic valuation methods

Answer 3

Asset based valuation
Earnings based valuation
Cash flow based valuation

Question 4

Asset based valuation

Answer 4

Business net assets form the basis for the valuation

Question 5

Earnings based valuation

Answer 5

Projected future earnings for a business will give an indication of the value of that business

Question 6

Cash flow based valuation

Answer 6

Business value should be equal to the PV of its future cash flows, discounted at an appropriate cost of capital

Question 7

Alternative asset valuation bases

Answer 7

Book Value
Replacement Value
Breakup value/Net reliasable value

Question 8

Strengths of asset based valuation

Answer 8

Valuations are generally readily available
Provide a minimum value for an unlisted company
Particularly relevant for valuing businesses in liquidation

Question 9

CIV Method

Answer 9

Compares the total return that the company generating against the return that would be expected based on industry average returns on tangible assets

Question 10

Earnings based valuation starting point and adjustments

Answer 10

Start: The current post-tax earnings, or EPS

Adjust for:
One off items which will not recur
Director salaries

Question 11

Strengths of the P/E valuation method

Answer 11

Commonly used and are well understood
Relevant for valuing a controlling interest in an entity

Question 12

Weaknesses of the P/E valuation method

Answer 12

Based on accounting profits rather than cash flows
Difficult to identify a suitable P/E ratio, particularly when valuing the shares of an unquoted entity
Difficult to establish the relevant levels of sustainable earnings

Question 13

DVM theory

Answer 13

Value of share is present value of the expected future dividends, discounted at the shareholders rate of return

Question 14

Strengths of DVM

Answer 14

Sound theoretical baiss
Useful for valuing minority shareholdings where the shareholder only receives dividends from the entity, over which he, she or they have no control

Question 15

Weaknesses of DVM

Answer 15

Very difficult to forecast dividends and dividend growth, especially in perpetuity
Particularly for unquoted companies, it can be difficult to estimate the cost of equity
For unquoted companies, a consistent dividend policy with constant growth rate is unlikely

Question 16

Free cash flows to entity

Answer 16

Similar to post tax, post financing cash flows, except they include average sustainable levels of capital and working capital net cash flow investments over the long term rather than this year figures

Question 17

Use of cost of equity as a discount rate in free cash flows

Answer 17

Cost of equity can be used in order to value the equity in a company directly

Question 18

Use of WACC as a discount rate in free cash flows

Answer 18

WACC can be used when valuing a project or an entity.

Question 19

Discounting forecast free cash flows to equity

Answer 19

Use cost of equity

Question 20

Discounting forecast free cash flows to all investors

Answer 20

Discount using WACC
Deduct value of debt

Question 21

Strengths of discounted cash flow method

Answer 21

Theoretically the best method
Used to place a maximum value on the entity
Considers time value of money

Question 22

Weaknesses of discounted cash flow method

Answer 22

Difficult to forecast cash flows accurately
Difficult to determine an appropriate discount rate
Model assumes that the discount rate and tax rates are constant in the period

Question 23

CAPM

Answer 23

Enables us to calculate the required return from an investment given the level of risk associated with the investment

Question 24

2 types of risk

Answer 24

Systematic risk
Unsystematic risk

Question 25

Systematic risk

Answer 25

Caused by general macro-economic factors

Question 26

Unsystematic risk

Answer 26

Caused by factors specific to the company or industry

Question 27

CAPM criticisms

Answer 27

Single period method
Beta values are calculated based on historic data
Risk free rate may change over time
CAPM assumes an efficient market where it is possible to diversify away unsystematic risk, and no transaction costs

Question 28

Beta factor

Answer 28

Measure of systematic risk of an entity relative to the market

Question 29

How is beta factor measured?

Answer 29

Comparing the volatility of an entity’s share price to the volatility of the market as a whole

Question 30

Four very important implications of beta

Answer 30

Company’s equity beta will always be greater than its asset beta UNLESS
if it is all equity financed when its equity beta and asset beta will be the same
Companies in the same ‘area of business’ will have the same asset beta, BUT
Companies in the same area of business will not have the same equity ebta unless they also happen to have the same capital structure

Question 31

When is asset based method suitable?

Answer 31

Most appropriate when valuing capital intensive businesses with plenty of tangible assets

Question 32

When is DVM most appropriate?

Answer 32

Suitable when valuing a minority shareholding

Question 33

When is P/E method and DCF appropriate?

Answer 33

Methods are based on forecasts of the future, and often use proxy information.
For service businesses, these methods are generally preferred to asset based methods

Question 34

Efficient market

Answer 34

One in which security prices fully reflect all available information
New information is rapidly and rationally incorporated into share prices in an unbiased way

Question 35

Three forms of efficiency

Answer 35

Weak
Semi Strong
Strong

Question 36

Weak efficieny

Answer 36

Past share price movements

Question 37

Semi strong efficiency

Answer 37

All public information

Question 38

Strong efficiency

Answer 38

All information (public and private)