Financial Valuation Flashcards
Name and describe the different valuation motives regarding changes in the ownership structure
- transactional: change in the ownership structure planned
- dominating: unilaterally
- non-dominating: non-unilaterally
- non-transactional: change in the ownership structure NOT planned
What is the basic principle underlying valuation purposes?
“purpose adequacy principle”: Vauation purposes according to economical doctrine/practise
Name the valuation purposes according to the a) economical doctrine, and b) economical practice.
a) - decision value
- fair market value/standard value (legally impressed value)
- arbitrium value
b) - subjective shareholder
- objective shareholder
- arbitrium value
Is there a a) subjective value?, b) objective value?, and c) objectified value?
a) subjective: yes, the value lies in the eye of the beholder
b) objective: no, there is no objective value
c) objectified: yes, fair market value
What is a “subjective” value?
the value lies in the eyes of the beholder
Arbitrium Value
intermediation between interests of contracting parties
fair
1. calculation of decision values
2. balancing between values
Explain the difference between value and price.
value is what you think it is worth, represents the level of usability
price is what you pay for something, represents the exchange relationship of goods
What is the economical consequence of a transaction exactly at the decision value?
it leaves the assets (economic situation) of the valuation subject unchanged
In what forms does the decision value come?
- upper price limit of the acquirer
- lower price limit of the vendor
in-between: transactional area
What are the main characteristics of the objectified (fair market) value?
- independent of subjective
- realistic future expectation
- valuation by the market
Define the “standard value”?
value primarily considering legal rules
Name and describe the valuation principles.
Principle of:
- decisiveness of the valuation purpose
- relevance of the future: future benefit
- overall valuation: combining effects
- individuality (subjectivity): specific valuation subject/object
- valuing the total assets: essential/non-essential assets
- considering a realistic payout: consistency in planning
- regarding the valuation date: only infos at valuation date
- conservatism
- equivalence
Name and describe the several forms of the principle of equivalence.
equivalence of:
- duration of the income stream
- risk
- income availability
- labor input
- value of money (real vs nominal income)
Principle of equivalence
- duration
- risk
- income availability
- labor input: same input of owners labor
- value of money: nominal vs real income
Who is standard setter in Austria? How is the Austrian valuation standard called?
KFS BW1
Institute for business economics, tax law and organization of the austrian chamber for chartered public accountants and tax consultants
Who is standard setter in Germany? How is the German valuation standard called?
IDW S 1
IDW: Institute of German Chartered Public Accountants
Who are standard setter in the USA? How are their valuation standards called?
SSVS 1 (Statement on standards for valuation services) by AICPA (American institute of certified public account)
USPAP (Uniform Stand. of Professional Appraisal Practice) by AF (Appraisal Foundation=
ASA Business Valuatin Standards (BSB) by ASA (American Society of Appraisers)
BAS by IBA
NAVCA Professional Standards (NPS) by NACVA (Notional accociation of certified Valuation analysts)
Who are international standard setter? How are their valuation standards called?
IACVA/EACVA Professional Standards (IPS/EPS) by International/European Association of Consultants, Valuers and Analysts
International Valuation Standards (IVS) by IVSC (… Council)
Give an overview of the different valuation approaches.
- Income approach
- DCF-Approach: Entity-based (WACC), Equity-based, APV-approach
- Market approach:
- Comparative Company approach
- Asset approach: asset/liquidation value
- Combined approach
Whats the fundamental difference between DCF-Approaches
“tax shield”: how the use of depth affects the tax benefit in value
consistent assumptions concerning planning depth and equity will result in the same shareholder value
Explain the difference between gross procedures and net procedures within the DCF-Approach.
gross procedures: shareholder value computed indirectly
- Entity-approach (WCAA)
- APV-approach
net procedures: shareholder value computed directly
- Equity-approach
Name the different DCF-Methods.
gross procedures: shareholder value computed indirectly
- Entity-approach (WACC)
- APV-approach
net procedures: shareholder value computed directly
- Equity-approach
Explain the Entity-Approach. Draw a diagram.
Free cashflow
Complete equity financing:
- income tax effects cause by debt financ. disregarded
- mixed discount rate
What is free cashflow?
distributable cashflow to both equity investors and debt capital providers
Explain the APV-Approach. Draw a diagram.
Adjusted Present Value Approach
free cash flow, complete equity financing same as in entity-approach
“tax shield”: income tax savings due to tax deductibility of interest on debt
Tax shield is added to the virtually unlevered (using zero debt) business market value
Explain the Equity-Approach. Draw a diagram.
Flows to Equity (FtE): cashflow only distributable among investors (includes impact of debt financing and tax effects)
FtE are discounted with the cost of equity of the levered business
Describe the two-stage planning model.
First stage:
detailed planning
3 to 5 years
Second stage:
forecast period
constant cash flow or growth trend is assumed
business in steady state
Describe the three-stage planning model.
First stage:
detailed planning
3 to 5 years
First stage:
convergence period
another 5 years
expected and unexpected changes in the market and company
Third stage:
forecast period
constant cash flow or growth trend is assumed
business in steady state
In what forms can the life expectancy of a company be assumed? Which is the standard
assumption?
- finite life expectancy: liquidation or selling
- infinite life expectancy: standard assumption
Explain the computation of the Free Cashflow.
EBIT
- Tax on EBIT
_______________
NOPLAT (net operating profit less adjusted taxes)
- …
What is the “WACC”?
weighted average cost of (equity and depth) capital
weighted cashflow to both equity investors and depth financiers
Describe the circular reference in computing the WACC. How is this problem often solved
in practice?
WACC depends on the cost of equity and vice versa
solved by assuming that the equity/debt ratio stays constant, so changes in the total capital are calculated back to the equity via debt
this is called a value-based (“breathing”) financing policy
State the “Textbook-Formula” to compute the WACC assuming validity of the hypothesis
of irrelevance of Modigliani and Miller.
cost of debt * (1 - corporate income tax rate) * mv debt cap / mv total cap
+ cost of equity * mv equity cap / mv total cap
mv. ..market value
cap. ..capital
Describe the assumptions underlying the hypothesis of irrelevance of the capital structure of the company.
- capital market is perfect
- debt capital is risk-free
- no difference in borrowing from private or business
- there are no bankrupcies
- no difference in tax treatment of equity and debt capital
Explain the computation of the shareholder value in the Entity-Approach.
Present value of FCF
+ market value of non-essential assets
———————————————–
= market value of total capital
- market value of interest bearing debt
———————————————–
market value of equity (shareholder value)
What components does the cost of equity consist of? State the formula.
risk free interest rate
plus a market risk premium
adjusted for a company-specific risk
What is the “risk-free interest rate”?
corresponds to the interest rate of a (virtually) risk-free investment
is disregarding correlation to other investments and the default-risk
considers:
- investor time preference
- interest rate over term
- rate of inflation
expressed by interest yield curve: the longer the maturity the longer the duration of the interest rate
How is the risk-free interest rate computed in case of
a) a finite life expectancy of the company?
b) an infinite life expectancy of the company?
a) risk-free securities with comparable maturity
b) Svensson-Method: approximation method
What are the input variables used in the Svensson-Method?
- maturity T
- beta, theta: constants
What are the different categories of risk concerning the investment in a company?
- strategic risk: corporate culture/governance, …
- operating risk: supply market, goods and services, sales market, …
- financial risk: investments, liquidity, …
- cross-functional risk: legal environment, data processing, …
In what components is the beta segregated in practice?
- Operating Beta: risk measure, operating business risk
- Financial Beta: risk measure, capital structure risk
Describe the Beta.
Derived by CAPM (capital asset pricing model)
- describes the risk of an investment
- describes to what extend the rate of return of a single stock reacts to the rate of return of a portfolio in the market
the higher the beta, the higher the risk single stock vs portfolio
computed by univariate regression analysis, it is the slope of the regression line
How can a market portfolio be represented?
National share index (ATX, DAX, FTSE100, …)
International share index (EuroStoxx50, …)
peer group-index
What is the Beta of the market (portfolio)?
the beta of the market portfolio is 1
What is the Beta of a risk-free investment?
The beta of a risk-free investment is 0
What denotes a Beta of
a) > 1
b) 1
c) <1
risk of company stock is
a) lower than, reacting disproportionally
b) same than, reacting proportionally
c) higher than, reacting disproportionally
portfolio
How can the Beta be adjusted according to the capital structure?
the beta increases in case of an increase in the debt/equity ratio
What does the Debt/Equity-Ratio denote?
the ratio between the market value of the debt vs the market value of the equity
Describe the different methods to compute Beta.
- listed company: via fluctuation of the stock-price
- unlisted company: industry-beta or peer group beta
What methods can be used to compute the MRP?
Which is used primarily in practice?
Market risk premium
- Historical -> used in practice
- expert opinion
- implicit
Cost of debt
common required rate of return to the debt financiers
determined by:
- creditworthiness of the debtor
- terms of credit
- market conditions
Capital Structure
- debt with interest rate
- equity:
listed companies: market capitalization
unlisted companies: hidden assets/reserves
What are “non-essential” assets?
How are they included in the computation of the shareholder value according to the different DCF-Methods?
assets that can be sold independently of the business (fixed assets, …)
valued by higher value of going concern value and liquidation value
used to calculate the total capital (additive to FCF) or the shareholder value (additive to FtE)
Give examples of non-essential assets.
undervalued financial assets/real estate
excess fixed assets/cash
Explain the fundamental characteristics of the APV-Approach
The total capital of the unlevered business is computed under the assumption of complete equity financing (FCF discounted with cost of equity, adding non-essential assets)
the tax shield (interest on debt, income tax rate) is discounted with the cost of depth
Explain the computation of the shareholder value in the APV-Approach.
present value of the Free Cash Flow
+ non-essential assets
——————————-
= total capital of unlevered business
+ present value of tax shield
——————————-
= total capital of levered business
- interest baring debt
——————————-
= shareholder value
Explain the fundamental characteristics of the Equity-Approach.
FtE: flows to equity, cash flows only distribute to equity investors, but considers effects of debt financing
FtE is discounted by the cost of equity of the levered business
Explain the computation of the Flow to Equity.
FtE considers the effects of debt financing (changes in debt, interest and tax effects)
solely distributable to equity investors
Explain the relationship between FCF and FtE.
FtE = FCF + FtD (flow to debt)
FtE considers the effects of debt financing (changes in debt, interest and tax effects), FCF does not
Explain the computation of the shareholder value in the Equity-Approach.
Present value of the FtE
+ non-essential assets
——————————————
shareholder value (value of equity)
Describe the computation of the Beta based on historical capital market data.
Covariance of the return of the stock
divided by
variance of the return of the portfolio
What circumstances does the choice of an appropriate market portfolio depend on?
- shareholders structure of the company
- regional origin of shareholders (taxes, …)
How many observations should the Beta-computation be based on?
50 - 60
What methods can the assessment of the reliability of the Beta be based on?
- means of liquidity
- trade volume
- sales volume
- bid-ask Spread (difference between sales and bid price)
- standard error
- t-test
- coefficient of determination (R2)
Describe the assessment of the reliability of the Beta based on the liquidity of the security.
- means of liquidity
- trade volume
- sales volume
- bid-ask Spread (difference between sales and bid price)
Describe the assessment of the reliability of the Beta based on the standard error.
measures the accuracy of the mean
the smaller the standard error, the better the unknown value can be estimated
Describe the assessment of the reliability of the Beta based on the T-Test.
calculates how statistically significant the deviation of the beta is from null hypothesis (beta = 0)
Describe the assessment of the reliability of the Beta based on the Coefficient of Determination.
R^2 = explained dispersion / total dispersion
the higher, the higher the explanatory value of the regression line
What does the Standard-Beta calculation assume?
The standard beta calculation assumes a perfectly diversified investor:
meaning that the investor can minimize the risk by investing in many different securities and maximizing the return at the same time
Explain the impact of the diversification effect on risk.
The diversification effect allows the investor to destroy part of the investment risk (unsystematic risk) while only having the remaining systematic risk
What does the Coefficient of Correlation measure in computing Beta?
in computing the standard beta, to Coefficient of Correlation is assumed 0 (investor is fully diversified)
in computing the total beta, to Coefficient of Correlation is assumed 1 (investor is NOT able to diversify his investment)
Explain the impact of the level of diversification on risk.
The higher the level of diversification, the lower the unsystematic risk
the level of diversification increases with portfolio size (which has a limit)
Explain the two extremes denoting complete lack of diversification and full diversification.
complete lack of diversification: standard beta
full diversification: total beta
Explain the computation of the Total Beta
total beta = std dev returns single stock / std dev returns on portfolio
or
beta_standard / coefficient of correlation
Explain the relationship between Total Beta and Standard Beta.
the total beta is always higher than the standard beta
total beta = standard beta / coefficient of correlation
Explain the relationship between total Beta, Standard Beta and the “real” Beta in view of the degree of diversification.
total beta: always larger than standard beta, degree of divers. is 1
standard beta: degree of divers. is 0
real beta: approximation is the arithmetic mean between total and standard beta, degree of divers. is between 0 and 1
