Finance Flashcards
Valuations - FMV
Highest price available in an open and unrestricted market between informed and prudent parties, acting at arms length and under no compulsion to act, expressed in terms of money or money’s worth
Valuations - Notional Market
Hypothetical transaction, whereas the open market is where the real transaction occurs
Valuations - FMV - Highest Price Available
Valuator determines highest price that an arms length purchaser would be willing to pay
Valuations - FMV - Open and Unrestricted Market
In this notional market, there are no potential purchasers excluded from participating in the potential transaction.
No statutory, contractual or other restrictions affecting marketability
Valuations - FMV - Informed and Prudent Parties
Both the vendor and the purchase know all the facts that would be of importance to the valuation at hand
Valuations - FMV - Acting at arms length
Opposing parties will have an economic interest in the outcome of the transaction
Valuations - FMV - Under no compulsion to act
Neither of the parties involved is under any obligation and can walk away at any point
Valuations - FMV - Expressed in terms of moneys worth
Open-market transaction could occur by exchanging non-cash, the FMV is expressed in cash-equivalent
3 Valuation Approaches
- Asset Based
- Income Based
- Market Based
Asset- Based Valuations
- Liquidation
- Adjusted Net Assets
- Replacement Cost
Income-Based Valuations
- Capitalized Cash Flows
- Discounted Cash Flows
- Capitalized Earnings
- Discounted Earnings
Market-Based Valuations
- Assets with an Active Market
2. Comparable Transactions
Liquidation Approach
Asset-Based Valuation
- Not considered a going concern
a) Orderly - assets sold at NRV
b) forced - assets are sold quickly and for lower proceeds
Adjusted Net Assets Approach
Asset-Based Valuation
- Going Concern
- Does not have active operations or does not have excess earnings (no inherent GW)
- Holding companies
- Calculate a “floor” value - lowest value that would be accepted
- All assets are valued at FMV’s net of disposition costs
Replacement Cost Approach
Asset-Based Valuation
- Rarely used because it lacks economic validity
- Used for insurance purposes or valuing intangible assets
Income Based Approaches
CF’s or earnings are normalized - adjusted for unusual items or items that may not occur when the new owner takes over
Capitalized CF report
Income-Based Approach
- Entity has active operations and excess earnings
- Historical CF’s relative to future earnings
Determine CF’s and apply capitalization rate
Discounted CF Approach
Income-Based Approach
- Startups
- Historical CF are negative
CF’s for a given number of years are calculated and individually discounted
- Lack of regularly prepared forecast and unreliability of the information
Capitalized Earnings Approach
Income-Based Approach
- Based on historical earnings
- Earnings are multiplied by a multiplier or divided by capitalization rate
Discounted Earnings Approach
Income-Based Approach
- Merger & Acquisition
- Future earnings are expected to be volatile and are separated out from earnings in steady-state years
- Estimates are discounted at the appropriate discount rate
Market Based Approach
- Going Concern
- Information required is publicly available and reasonably comparable
- Corroborative
- Valuation multiple is applied to entity’s net earnings
Latent Taxes
Those that would arise from selling the assets, such as taxes on capital gains and/ or recapture
Foregone tax shield
FMV of assets are greater than current tax values for those assets
Replacement Cost Approach
Higher than BV because depreciation is not taken into account
Redundant Assets
Tangible or Intangible asses that can be sold without impacting the normal operations of the business
- Marketable securities
Calculating Equity Value (Capitalized CF Approach)
- Maintainable Operating CF
- Deduct Income Taxes
- Deduct Sustaining Capital Investment
= Estimated Maintainable Free CF Balance - Divide Capitalization Rate
= Capitalized CF - Add PV of existing tax pools
- Deduct Redundant NA
- Deduce Outstanding-Interest Bearing Debt
= Equity Value
Calculating Equity Value (DCF Approach)
- PV of free cash flows
- Plus PC of residual/ Terminal Value
- Plus PV of tax shield
= Enterprise Value - Plus NRV of redundant assets and liabilities
- Less Outstanding interest-bearing debt
= Equity Value
Financial Risks
Unexpected changes in interest rates, exchange rates and commodity prices
Derivative Financial Instrument
Contracts that are linked to changes in value of underlying variable
Two types of Derivatives
- Privately traded - Over the Counter - OTC
- Exchange Traded - ETD
- ETDs are regulated
Forward Contract
Delivery of a specified good/item on a specified future date at a specified price
- Non standardized, written by parties involved
- Must be fulfilled at an agreed upon date
- No upfront cost
- Counterparty Risk
Counterparty Risk
Risk that one of the parties will not be able to perform as required under the contract
Future Contract
Standardized contract to buy/ sell an asset on or before a future date at a specified price
- written by a clearing house
- Used to manage price risk or foreign currency risk
- Requirement to maintain a margin account as deposit
- Net balance of daily profit or loss is kept in the margin account
- If you buy back a future you can sell at any time
Options
Give the owner the right to buy (call) or sell (put) an asset at the strike price or exercise price
Call Option Terminology
In the money - Strike Price is below current market price
Out of the money - Strike Price is above current market price
Intrinsic Value - Equal to the spot price less the exercise price time the specified quantity
Option Premium
Upfront amount to be paid to buy the option and is in current no matter if the option is exercised or not.
- depends on options length of time to maturity
- strike price
- current value of underlying asset
- prevailing risk-free rate
Implications to FV - Call Option
Underlying Item Price
- Higher price, the higher the FV
Exercise Price
- Lower EP, higher the value
Volatility
- Higher volatility, higher FV
Risk-Free Interest Rate
- Higher Rate, Higher FV
Time
- Longer Period, Higher FV
Implications on FV - Put Option
Underlying Item Price
- Lower price, the higher the FV
Exercise Price
- Higher EP, higher the value
Volatility
- Higher volatility, higher FV
Risk-Free Interest Rate
- Lower Rate, Higher FV
Time
- Longer Period, Higher FV
