Finance Flashcards
Chapter 8 - Investing and Portfolio Diversification
Calculate Variance and Standard Deviation
Calculate Covariance and Correlation
Situational
Boom = A -> (Return - Expected Return)^2*Weighting Recession = B -> (Return - Expected Return)^2*Weighting
Variance = A +B
Standard Deviation = Variance ^(1/2)
Situational
Boom = Stock1 Difference -> (Return - Expected Return)
Boom = Stock2 Difference-> (Return - Expected Return)
Product of difference Boom = (Stock1 Difference & Stock2 Difference)* Weighting
Recession = Stock1 Difference -> (Return - Expected Return)^2Weighting
Recession = Stock2 Difference-> (Return - Expected Return)^2Weighting
Product of difference Recession = (Stock1 Difference & Stock2 Difference)* Weighting
Product of difference Boom + Product of difference Recession = Covariance
Correlation = Covariance / (Standard Deviation Stock 1 * Standard Deviation Stock 2)
Chapter 17 - Valuations : Big Picture
What are things must be determined before considering an evaluation methods?
How do you determine if a entity is a going concern?
What are the types of Asset-Based Approaches? and when do you use them?
What are the types of Income-based Approaches? and when do you use them?
- What are things must be determined before considering an evaluation approach?
a. Understand what must be VALUED
b. The next step is to determine whether the entity being valued is a GOING CONCERN.
i. To determine whether the entity is a going concern, the valuator must perform an assessment of the future viability of
the business. In doing so, the valuator compares the entity’s level of income or cash flow to its operating assets. If the
business provides a sufficient return on its capital, it is likely a going concern.
ii. Some indicators that would imply that an entity is not a going concern are as follows:
1. Historically, the entity has sustained significant losses. (CONTINUOUS & SIGNIFICANT LOSSES)
2. The entity does not currently, or is not expected to, generate positive cash flows. (NO PROJECTED POSTIVE CASHFLOWS)
3. The ownership group of the entity intends to cease operations. (INTENTION TO DISCONTINUE)
c. Asset -Based Approaches
i. Liquidation Approach – not going concern
ii. Adjusted net asset approach – going concern but has no active operations
1. (used for holding companies),
2. also used to cal. floor value of going concern with active operations
3. active operations but does not have excess earnings and therefore no inherent goodwill
iii. Replacement Cost Approach
1. Rarely used b/c lacks economic validity; however commonly used for insurance purposes
d. Income-based Approaches (IS A GOING CONCERN AND HAS ACTIVE OPERATIONS)
i. Active operations and excess earnings
ii. All approaches the cash flows or earnings are normalized
iii. Capitalized cash flow approach/Capitalized earnings approach (definite time horizon)
1. Consistent cash flows that are reflective of the future operations
iv. Discounted Cashflow approach/Discounted earnings approach (indefinite time horizon)
1. Start-up, historical cash flow may be negative, which would not be reflective of the potential cash flow that the entity
could generate on a go-forward basis
2. Past cashflow is not representive of future cashflows of a company and future projections are provided.
v. Look at decision tree
e. Market-based approach
Applied with other income-based approaches
Market data is used to determine a valuation multiple to value company based on comparables.
The multiple is applied to EBITDA to obtain market-based value for the business
The multiple is applied to net earnings to obtain market-based value for the equity of the business
Chapter 18 - Valuations - Asset Based Evaluation
Explain Liquidation Approach?
Explain the Adjusted Net Asset Approach?
Explain the Replacement Approach?
- Liquidation approach
If an entity is not a going concern, it is not appropriate to use an income-based approach to valuation. Valuation of the entity must be based on the entity’s underlying assets. There are two types of asset-based valuation approaches that can be used in a liquidation scenario:
• Orderly (voluntary) liquidation - The liquidation is not forced on the entity by the courts; rather, it is undertaken by a voluntary act of the members.
• Forced liquidation - The assets are sold to the highest bidder, usually after a relatively short period of market exposure. A forced liquidation generally results in a lower net realizable value (NRV) of the assets.
The key difference between the two forms of liquidation is the degree of control retained by the business owner regarding the timing and manner of the disposition of assets.
The steps in performing a liquidation valuation are as follows:
Assets -> NRV
- Liabilities
- Tax implications of sale of assets
- Personal income taxes (proceeds available for distribution)
= liquidation value to the shareholders
Adjusted net asset approach (DO NOT NEED TO KNOW HOW TO CALCULATE FORGONE TAX SHEILD AND LATENT TAXES & SELLING COSTS)
An adjusted net asset valuation is used where (a) a company does not maintain active operations or (b) a company has active operations but does not have excess earnings. In both scenarios, the inherent value of the goodwill of the entity is nil.
he steps in performing an adjusted net asset valuation are as follows:
- Asset and liability adjusted to FV.
(i) Intangible assets resulting from goodwill, deferred charges, or anything else that is not a separately identifiable intangible asset should be valued at nil.
(ii) Redundant assets are included in the adjusted net asset approach.
(iii) Redundant liabilities are likewise deducted under the adjusted net asset approach.
DEDUCT: The forgone tax shield is deducted (explained below).
DEDUCT: Latent taxes and selling costs
associated with the sale of assets are deducted. Latent taxes are those that would arise from selling the assets, such as taxes on capital gains and/or recapture.
Replacement cost approach
Under the replacement cost valuation approach, the actual current cost to replace the assets of an entity is considered.
The replacement cost is usually higher than book value because depreciation is not taken into account. Using this approach, the asset values are adjusted up or down to their current replacement cost. Liabilities and any related tax consequences are then deducted from that replacement cost to arrive at the value of the business.
Chapter 19 - Valuations - Income-based Evaluation
Calculate Capitalized Cashflow Approach
Calculate Capitalized Earnings Approach
Calculate Capitalized Discounted Cashflow Approach
Calculate Capitalized Discounted Earnings Approach
Calculation
iii. Capitalized cash flow approach (time horizon) /Capitalized earnings approach (indefinite)
1. Consistent cash flows that are reflective of the future operations
Step 1: Determine Normalized EBITDA
EBIT
+/- Normalizing entries (these can include ((1) Add: Actual vs Deduct: Expected adjustments, (2) Add: Actual vs Deduct:FMV Expenses, (3) One-time expenses)
= Normalized EBIT
Normalized EBIT - Interest Income \+ Interest Expense \+ Depreciation = Normalized EBITDA
Step 2: Determine a range Low/High (Year T-5 to Year T-3 & Year T-2 to Year T-1)
Step 3: Deduct Taxes
Normalized EBITDA
- Tax -> (Normalized EBITDA * Tax Rate)
= Normalized Cash Flow after taxes
Step 4: Deduct Sustaining Capital Reinvestment
Normalized Cash Flow after taxes
- Sustaining Capital reinvestment
= Normalized Discretionery Cash Flow
Step 5: Apply Capitalizatin Rate
Normalized Discretionery Cash Flow * (1 / WACC)
= Capitalized Discretionary Cash Flows
Step 6: Add PV of UCC Tax Shield
Capitalized Discretionary Cash Flows
+ PV of UCC Tax Shield
= Capitalized value of operations (Enterprise value)
Step 7: Add Redundant Assets and deduct interest-bearing liabilties
Capitalized value of operations (Enterprise value)
+ Redundant Assets (Available cash / unused land / interest bearning assets)
- Interest bearing liabilties (Long-term debt)
= Equity value
iv. Discounted Cashflow approach (time horizon) /Discounted earnings approach (Indefinite)
1. Start-up, historical cash flow may be negative, which would not be reflective of the potential cash flow that the entity
could generate on a go-forward basis
2. Past cashflow is not representive of future cashflows of a company and future projections are provided.
Step 1: Determine Normalized EBITDA Projected EBT \+ Depreciation \+ Interest = Projected EBITDA
Step 2: DEDUCT Taxes
Projected EBITDA
- Tax -> (Normalized EBITDA * Tax Rate)
= Projected Cash Flow after taxes
Step 3: DEDUCT Sustaining Capital Reinvestment & Working Capital Adjustment Projected Cash Flow after taxes - Sustaining Capital reinvestment - Working Capital Adjustment = Projected Discretionery Cash Flow
Step 4: Apply Capitalizatin Rate to determine Terminal Value
TERMINAL Projected Discretionery Cash Flow * (1 / (WACC - Longterm Growth Rate)
Step 5: Determine PV of Discretionery Cashflows Discount Cashflows (n-1) and Terminal Value at WACC and Aggregrate
Step 6: ADD PV of Existing Tax Shield
PV of Discretionery Cashflows
+ PV of existing Tax Shield
= Projected Capitalized value of operations (Enterprise value)
Step 6: ADD Redundant Assets, DEDUCT Interest bearing Debt
Projected Capitalized value of operations (Enterprise value)
+ Redundant Assets
- Interest bearning Assets
= Equity value
Chapter 3 - Cost of Capital
- How to calculate cost of equity - common
- How to calculate cost of equity - preferred
- How to calculate cost of debt
- Calculate WACC
- How to calculate cost of equity - common
Cost of Equity = Rf + Beta (Market Risk Premium)
Market risk premium = Expected return - Rf - How to calculate cost of equity - preferred
Cost of Equity - Preferred = Dividend per P/S / Price per P/S - How to calculate cost of debt
Cost of Debt = Yield * (1 - Tax) - Calculate WACC
Weighted average cost of capital (WACC) = D/V(Rd)(1 – T) + P/V(Rp) + E/V(Re) where:
D is the market value of debt
V is the total of market value of debt + market value of preferred shares + market value of equity
Rd is the current cost of debt
T is the marginal tax rate
P is the market value of preferred shares outstanding
Rp is the current cost of preferred shares
E is the market value of common shares outstanding
Re is the current cost of equity
Calculate Return on Equity Unlevered
Re = Ru + D/E(Ru – Rd)(1 – T)
where
Re is the cost of equity
Ru is the cost of equity when the entity is unlevered (no debt)
Rd is the entity’s cost of debt
D/E is the existing debt-to-equity ratio for the company based on market values, not book values.
