Finance

Question 1

A mature company is looking to complete a tax reorganization and has asked you to estimate its value. The company has had stable operating cash flow after taxes for the last three years and expects similar results in the future with no growth. Which valuation approach would be most relevant to use in this circumstance?

a)

Adjusted net asset

b)

Capitalized cash flow

c)

Liquidation

d)

Discounted cash flow

Answer 1

B - The company has a track record of stable positive cash flows to capitalize, and future results are expected to be similar.

Question 2

A troubled company has growing liabilities and the owner does not believe it can continue to operate. You are asked to estimate the value of the company. Which valuation approach would be most relevant to use in this circumstance?

a)

Adjusted net asset

b)

Capitalized cash flow

c)

Liquidation

d)

Discounted cash flow

Answer 2

C - The company is not operating under the going-concern assumption, and there is indication from the owner that the business should be liquidated.

Question 3

The definition of fair market value for valuation purposes includes which of the following terms:

a)

Acting at arm’s length

b)

Closed and restricted market

c)

Lowest price available

d)

Under a compulsion to act

Answer 3

A - Acting at arm’s length is part of the definition of fair market value.

Question 4

A new startup company is looking to go public and has asked you to estimate what the price of its shares should be. The company has yet to achieve profitability and expects a high-growth period for the next five years. Which valuation approach would be most relevant to use in this circumstance?

a)

Capitalized earnings

b)

Capitalized cash flow

c)

Liquidation

d)

Discounted cash flow

Answer 4

D - By using the discounted cash flow approach, you can model the financial statements during the high-growth period and then calculate a terminal value when the business reaches maturity.

Question 5

You have been hired by a lawyer to prepare an independent valuation of a holding company in Bermuda in relation to a divorce case. The company has no active operations but is considered a going concern. Which valuation approach would be most relevant to use in this circumstance?

a)

Adjusted net asset

b)

Capitalized cash flow

c)

Liquidation

d)

Discounted cash flow

Answer 5

A - The company does not have active operations but is considered a going concern with investments that can be valued.

Question 6

The objective of business valuations is to determine the fair market value of the enterprise, and several different approaches can be used. Which of the following is correct with regard to business valuations?

a)

The only theoretically correct value of a going-concern enterprise is the discounted present value of its future cash flows.

b)

Fair market value is the highest price available in an open and unrestricted market.

c)

Income statements are normalized to adjust net earnings to the highest amount possible.

d)

The adjusted net asset approach is used to determine the multiple to be used for the market approach.

Answer 6

B - Fair market value is the highest price that an arm’s length purchaser would be willing to pay in order to complete the transaction in an open and unrestricted market.

Question 7

Which of the following statements concerning business valuations is true?

a)

The capitalized earnings approach uses earnings and a capitalization rate to determine value.

b)

The liquidation approach determines the value of a business by estimating the fair market value of the assets.

c)

The adjusted net asset approach uses the net book value of operating assets and liabilities to determine the value of a business.

d)

The market-based approach uses the entity’s current share price and number of shares outstanding to determine the value.

Answer 7

A - The liquidation approach uses the net realizable value of the assets less liabilities less taxes to determine the value of a business. Answer a) is correct. In the capitalized earnings approach, earnings are divided by a capitalization rate to determine value.

Question 8

You are discussing valuation concepts with Colin, another associate at your firm. Colin is confused over some of the concepts in business valuation and has made a series of statements. Which of the following statements is true?

a)

When you are using the capitalized earnings approach, past earnings are used with no adjustments.

b)

The adjusted net asset approach will calculate a “floor” selling price for the vendor.

c)

When you are using the capitalized earnings approach, higher risk gives rise to a higher capitalization multiple.

d)

Using a market-based approach, an appropriate multiple times the earnings before interest, tax, depreciation, and amortization (EBITDA) of a business will give a good approximation of its equity value.

Answer 8

B - The adjusted net asset approach usually determines the “floor” value of a business.

Question 9

You are discussing the valuation of business interests with Denise, another associate at your firm. You have made a number of general statements about valuation. Which of the following statements about business valuation is true?

a)

The adjusted net asset approach provides a maximum price for the assets of a business.

b)

If Company A is found to have a higher risk than Company B, then Company A will have the higher multiplier.

c)

Both the discounted cash flow and the capitalized earnings approaches should be adjusted for unusual items.

d)

A valuation approach based on a multiple of net earnings estimates the enterprise value of a business.

Answer 9

C - Both income-based approaches require cash flows or earnings to be normalized and adjusted for unusual items.

Question 10

You have been asked to value a business by an owner who intends to shut the business down due to lack of productivity. The owner still has control over the assets and is not being forced to sell them immediately. Which valuation approach should you use?

a)

Capitalized cash flow

b)

Adjusted net asset

c)

Orderly liquidation

d)

Forced liquidation

Answer 10

C - The company is not a going concern, but the owner is not being forced to sell the assets.

Question 11

You have been asked to value a company with ongoing operations that are expected to continue into the future. You have valued the company a number of different ways and arrived at the following values:

· capitalized cash flow approach: $300,000
· market approach: $305,000
· adjusted net asset approach: $250,000
· liquidation approach: $200,000

What is considered the “floor” value of the company?

a)

$200,000

b)

$250,000

c)

$300,000

d)

$305,000

Answer 11

B - When an operating company is a going concern, the adjusted net asset approach is often used to determine a “floor” value.

Question 12

You have been asked to value Moneky Inc. using an asset-based approach. Moneky’s primary business is the manufacturing of plastic bottles. Below are some of Moneky’s assets:

·         accounts receivable
·         inventories
·         marketable securities
·         prepaid expenses
·         goodwill

Which of the following represents a redundant asset?

a)

Goodwill

b)

Prepaid expenses

c)

Marketable securities

d)

Inventories

Answer 12

C - Answer a) is incorrect. Goodwill is not separable from the assets of the company and therefore does not represent a redundant asset. Answer c) is correct. Marketable securities are a redundant asset because they are not used in the normal operations. A redundant asset can be sold without impacting the operations of the company.

Question 13

You have been asked to value a company using the adjusted net asset approach. The company has:

· cash of $100,000
· accounts receivable of $50,000
· marketable securities with a book value of $30,000 (fair market value [FMV] of $60,000 and latent taxes and selling costs of $7,500)
· fixed assets with a book value of $100,000 (FMV of $150,000 and latent taxes and selling costs of $20,000)
· long-term debt of $75,000

What is the value of the company?

a)

$205,000

b)

$257,500

c)

$285,000

d)

$332,500

Answer 13

B - The value of the company under the adjusted net asset approach = cash ($100,000) + accounts receivable ($50,000) + FMV securities ($60,000) – latent taxes and selling costs ($7,500) + FMV fixed assets ($150,000) – latent taxes and selling costs ($20,000) – long-term debt ($75,000) = $257,500.

Question 14

You have been asked to value a holding company using the liquidation approach. The key assets and liabilities of the company are:

· $50,000 in cash
· $30,000 in accounts receivable
· a piece of land acquired for $100,000 with a FMV of $200,000
· short-term liabilities of $50,000

The company pays taxes at 20% on taxable capital gains. Selling costs of the land are estimated at 5%.

What is the amount distributable to shareholders?

a)

$161,000

b)

$211,000

c)

$220,000

d)

$230,000

Answer 14

B - Cash ($50,000) + accounts receivable
($30,000) + FMV land ($200,000) – selling costs on land ($200,000 × 0.05 = $10,000) – taxes on land ($200,000 – $10,000 = $190,000 – $100,000 = $90,000 / 2 × 20% = $9,000) – short-term liabilities ($50,000) = $211,000. Note: The sale of the land would be a capital disposition, so the gain is only taxable at 50%.

Question 15

You are valuing a company using a capitalized cash flow approach. You have determined that the company has the following:

· maintainable earnings before interest, tax, depreciation, and amortization (EBITDA) of $200,000
· sustaining capital reinvestment net of taxes of $50,000
· a tax rate of 30%
· a capitalization rate of 10%
· a present value (PV) of the undepreciated capital cost (UCC) tax shield on existing assets of $20,000
· interest-bearing debt of $130,000

What is the equity value of the company?

a)

$1,290,000

b)

$920,000

c)

$790,000

d)

$770,000

Answer 15

C - The equity value of the company = EBITDA after tax [$200,000 × (1 – 30%)] – sustaining capital reinvestment ($50,000) = $90,000 / capitalization rate (10%) = $900,000 + PV of UCC tax shield ($20,000) – interest-bearing debt ($130,000) = $790,000.

Question 16

You are calculating the value of a company using the capitalized cash flow approach. You have determined the following:

· The capitalized value of operations is $1,000,000.
· The current cash balance is $300,000 (management has informed you that it typically requires $100,000 to run the business).
· Other working capital is $200,000.
· Long-term debt is $300,000.

What is the equity value of the company?

a)

$700,000

b)

$900,000

c)

$1,000,000

d)

$1,100,000

Answer 16

B - The value of the company’s equity using the capitalized cash flow approach = capitalized value of operations ($1,000,000) + redundant cash ($300,000 – $100,000 = $200,000) – interest-bearing debt ($300,000) = $900,000.

Question 17

You are calculating the value of a company using the discounted cash flow (DCF) approach. You have determined the following:

· Cash flow from operations after taxes for the next three years will be $100,000, $120,000, and $150,000, and will then grow at a rate of 2% after that.
· Net capital investment net of the tax shield is expected to be flat at $40,000 per year.
· The company’s weighted average cost of capital (WACC) is 12%.
· The company has $100,000 in interest-bearing debt.

What is the equity value of the company (rounded)?

a)

$766,000

b)

$814,000

c)

$900,000

d)

$1,000,000

Answer 17

C - The value of the company’s equity using the discounted cash flow approach is calculated as follows:
Year 1 DCF = cash flow from operations ($100,000) – capital investment net of tax shield ($40,000) = $60,000 / 1.12 = $53,571
Year 2 DCF = cash flow from operations ($120,000) – capital investment net of tax shield ($40,000) = $80,000 / 1.122 = $63,776
Year 3 DCF = cash flow from operations ($150,000) – capital investment net of tax shield ($40,000) = $110,000 / 1.123 = $78,296
Terminal DCF = cash flow from operations in Year 3 ($150,000) × [1 + growth rate (2%)] = $153,000 – capital investment net of tax shield ($40,000) = $113,000 / capitalization rate (12% – 2% = 10%) = $1,130,000 / 1.123 = $804,312
Value of company = DCF Year 1 ($53,571) + DCF Year 2 ($63,776) + DCF Year 3 ($78,296) + terminal DCF ($804,312) – interest-bearing debt ($100,000) = $899,955, or $900,000 rounded

Question 18

You are calculating the value of a company using the discounted cash flow approach. You have determined that the company has the following:

· discretionary cash flows with a PV of $500,000
· redundant assets of $100,000
· redundant liabilities of $50,000
· interest-bearing debt of $200,000
· net working capital of $50,000
· an existing tax shield with a PV of $100,000

What is the value of the company?

a)

$350,000

b)

$400,000

c)

$450,000

d)

$500,000

Answer 18

C - The value of the company under the discounted cash flow approach = PV of discretionary cash flows ($500,000) + redundant assets ($100,000) – redundant liabilities ($50,000) – interest-bearing debt ($200,000) + PV of existing tax shield ($100,000) = $450,000.

Question 19

You recently assisted your client, Charles Letkey, by describing different approaches to business valuations when he was considering the purchase of Autoworld Inc.
Which of the following statements about the discounted cash flow approach for business valuations is correct?

a)

A lower risk results in a higher discount rate used to discount the cash flows.

b)

Depreciation and income taxes are added back to calculate discretionary cash flows.

c)

The appropriate discount rate to use for a discounted cash flow is the company’s cost of debt.

d)

A terminal value is determined when the business is assumed to exist in perpetuity.

Answer 19

D - The discounted cash flow includes a terminal or residual value when the company is assumed to exist in perpetuity.

Question 20

You are calculating a preliminary valuation for TQ Enterprises Inc. using the capitalization of earnings method. Which of the following types of expenses would be considered normalizing items that should be adjusted?

a)

Owner’s salary, which is an amount that is comparable to salaries in the market for the same position

b)

Costs for student employees who were hired under a one-time government program

c)

Ongoing new product development costs

d)

Annual vacation pay and bonuses paid to employees

Answer 20

B - As the one-time government program is now finished and a new owner would not incur these costs, this is a normalized item that would be adjusted.

Question 21

Lori, the sole shareholder of Zenlon Inc., has been approached to sell her business. She has come to you for some advice on the value of her company. Below is some information that she has gathered:

Sales	$4,900,000 
Operating expenses	(3,800,000)
Amortization	(200,000)
Operating income	900,000 
Interest expense	(150,000)
Income taxes	(190,000)
Net income	$560,000 

Sustaining capital investment $250,000
PV of tax shield on sustaining capital investment 24,000
PV of tax shield on existing UCC balances 65,000

Cost of capital for her business 25%
Terminal growth rate 2%
Income tax rate 25%

Using the discounted cash flow approach, what is the enterprise value for Zenlon Inc.?

a)

$2,017,200

b)

$2,461,000

c)

$2,604,300

d)

$2,669,300

Answer 21

D - Maintainable discretionary cash flow:
Operating cash flows after tax [($900,000 + $200,000) × (1 – 0.25)] $825,000
Less:
Sustaining capital investments ($250,000 – $24,000) $(226,000)
Annual discretionary cash flow $599,000
Capitalized at 25% less terminal growth rate of 2% 23%
Capitalized discretionary cash flows $2,604,348
Add:
Value of tax shield on existing UCC balances $65,000
Enterprise value of Zenlon $2,669,348

Question 22

The capitalized earnings method will be used to value the sale of Merrymen Musical Instruments. The business is a going concern, but there is increased competition in the area from a “big box” instrument supplier.

What could this mean to the cost of capital and the capitalization multiple used in the valuation?

a)

The cost of capital will be higher and the capitalization multiple will be lower.

b)

The cost of capital will be higher and the capitalization multiple will be higher.

c)

The cost of capital will not change but the capitalization multiple will be lower.

d)

The cost of capital will be higher but this will have no effect on the capitalization factor.

Answer 22

A - As the risk of the investment increases due to the big box competitor, the cost of capital (the discount rate) increases and the capitalization multiple (which is the inverse of the discount rate) decreases.

Question 23

You are valuing a highly customized piece of machinery and have decided to use the replacement cost approach. You have collected the following information:
· direct materials and labour: $3,400
· obsolescence: $600
· allocated overhead costs: $500
· indirect costs: $400
· contractor’s profit: $300
· tax benefit of deductible expenses: $450

What is the value of the machinery using the replacement cost method?

a)

$3,550

b)

$4,150

c)

$4,450

d)

$5,650

Answer 23

C - The correct calculation is as follows: direct materials and labour plus allocated overhead costs plus indirect costs plus contractor’s profit plus the tax benefit of deductible expenses less obsolescence = $3,400 + $500 + $400 + $300 + $450 – $600 = $4,450.

Question 24

You are calculating the value of a brand-name piece of equipment using the market-based approach. Which of the following is the most appropriate factor to consider when evaluating the comparability of recent sales transactions?

a)

Net operating income earned from using the asset

b)

Location, age, and operating condition

c)

The appropriate discount rate

d)

Obsolescence

Answer 24

B - Location, age, and operating condition are considered when assessing how similar or different comparable transactions are.

Question 25

You are valuing a highly customized processing plant that has a remaining useful life of 20 years. The plant generates income for the current owner. You have decided to use two methods to value this asset.

Which combination of two methods is most appropriate for this valuation?

a)

Replacement cost and discounted cash flow approaches

b)

Capitalization of net operating income and replacement cost approaches

c)

Replacement cost and market-based approaches

d)

Market-based and discounted cash flow approaches

Answer 25

A - Information on replacement costs should be available, and the discounted cash flow approach can be used by discounting the future cash flows for the next 20 years.

Question 26

You are valuing a warehouse using the capitalization of net operating income approach. You have determined the following:

· The warehouse earns annual rental income of $140,000.
· Costs to operate the warehouse include:
o repairs and maintenance: $20,000
o utilities: $25,000
o property taxes: $15,000
· The income tax rate is 25%.
· Annual depreciation on the warehouse is $30,000.

The appropriate capitalization rate to use for this rental property is 9%. What is the value of the warehouse (rounded to the nearest $10 increment)?

a)

$555,560

b)

$666,670

c)

$750,000

d)

$888,890

Answer 26

D -The value of the warehouse is calculated as follows: Rental income of $140,000 less maintenance of $20,000 less utilities of $25,000 less property taxes of $15,000 = $80,000 / 9% = $888,888, or $888,890 rounded.

Question 27

The replacement cost approach is one approach to valuing a tangible asset. The following information has been gathered with respect to a piece of machinery that is being valued using this approach.

Direct costs	$500
Indirect costs	100
Overhead costs	120
Contractor’s profit	50
Physical obsolescence	40
Technical obsolescence	50
Economic obsolescence	30
Tax shield	150

What is the value of the machinery using the replacement cost approach?

a)

$600

b)

$650

c)

$800

d)

$890

Answer 27

B - The amount is calculated as follows: $500 + $100 + $120 + $50 – $40 – $50 – $30 = $650.

Question 28

Triton Inc. is looking to value a warehouse using the replacement cost approach. You have been hired to prepare this valuation and have accumulated the following information related to this asset:

· The warehouse is 100,000 square feet.
· Current costs to construct a similar warehouse today as provided by an independent contractor are $125 per square foot.
· The current warehouse is eight years old and originally cost $108 per square foot. Due to excessive asset use, the value of the warehouse is estimated to have deteriorated by $1,400,000.
· The current warehouse is inefficiently designed compared to newer models, resulting in a reduction in value of $600,000.
· The company expects that the warehouse will last another 30 years.
· The present value of the warehouse’s tax shield is $95,000.

The income tax rate is 25%. Which of the following is the correct value of the warehouse, using the replacement cost approach?

a)

$10,595,000

b)

$10,500,000

c)

$8,800,000

d)

$7,375,000

Answer 28

B - The value of the warehouse is determined as follows: ($125/square foot × 100,000 square feet) – $1,400,000 – $600,000 = $10,500,000.

Question 29

You are valuing land and a building using the capitalization of net operating income approach. You have determined the following:

· Annual rental revenue for the building is $150,000.
· Annual costs to operate the building include:
o management fees: $10,000
o repairs and maintenance: $12,000
o utilities: $15,000
o property taxes: $11,000
· Vacancies and bad debts are expected to be 9% of gross rental revenue.
· The income tax rate is 25%.
· Annual depreciation on the building is $40,000.

The appropriate capitalization rate is 10%. What is the value of the land and building?

a)

$485,000

b)

$663,750

c)

$885,000

d)

$1,020,000

Answer 29

C - The value of the land and building is correctly calculated as follows: rental revenue ($150,000) less vacancies and bad debts ($150,000 × 9% = $13,500) less management fees ($10,000) less repairs and maintenance ($12,000) less utilities ($15,000) less property taxes ($11,000) = $88,500. This amount is then divided by the capitalization rate of 10% to arrive at the value of $885,000 ($88,500 / 0.10 = $885,000).