Financial Valuation

Question 1

What are some of the factors that must be considered in assigning value?

Answer 1

The following factors must be considered in assigning value:

1. The specific item or items (asset, liability, equity, etc.) being valued;
2. The condition of the item(s);
3. The location of the item(s);
4. The time at which the valuation is occurring;
5. The economic environment in which the valuation is occurring

Question 2

Identify ways in which professional judgment must be used in carrying out a valuation.

Answer 2

Professional judgment is used in valuation to develop an understanding of the purpose and context of a valuation, the selection of appropriate quantitative techniques and data, and ultimately, the assignment of a value.

Question 3

How is “fair value” defined and determined for United States Generally Accepted Accounting Principles (GAAP) purposes?

Answer 3

Fair value for United States Generally Accepted Accounting Principles (GAAP) purposes is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

Question 4

Identify and briefly describe the three approaches to determining fair value as specified by United States Generally Accepted Accounting Principles (GAAP).

Answer 4

1. Market approach: Information generated by market transactions for identical or similar items.
2. Income approach: Converts future amounts of benefit or sacrifice to determine current value.
3. Cost approach: Determines the amount required to acquire or construct a comparable item.

Question 5

Identify and briefly describe the three component levels of the United States Generally Accepted Accounting Principles (GAAP) hierarchy of inputs used for determining fair value.

Answer 5

Level 1: Quoted prices in active markets for identical items.

Level 2: Quoted prices in inactive markets or for items similar (but not identical) to those being valued; observable inputs other than quoted prices relevant to the item being valued.

Level 3: Unobservable inputs relevant to valuing an item (e.g., assumptions, estimates, etc.).

Question 6

Briefly describe the nature of level 1 inputs identified in the United States GAAP fair-value framework.

Answer 6

Level 1 of the U.S. GAAP fair value framework consists of quoted market prices in active markets for identical assets or liabilities.

Question 7

Briefly describe the nature of level 2 inputs identified in the United States GAAP fair-value framework.

Answer 7

Level 2 of the U.S. GAAP fair value framework consists of inputs that are either directly or indirectly observable, including:

1. Quoted prices for similar items in active markets and in markets that are inactive;
2. Quoted prices for identical items in inactive markets;
3. Observable inputs other than quoted prices;
4. Inputs not directly observable but which are derived from or corroborated by observable market data.

Question 8

Briefly describe the nature of level 3 inputs identified in the United States Generally Accepted Accounting Principles (GAAP) fair-value framework.

Answer 8

Level 3 of the U.S. GAAP fair value framework consists of inputs that are not observable but are based on an entity’s assumptions and estimates.

Question 9

Define/describe the “capital asset pricing model (CAPM)”.

Answer 9

The capital asset pricing model (CAPM) is an economic model that determines the relationship between risk and expected return and uses that measure in assigning value to securities, portfolios, capital projects and other assets.

Question 10

Give the capital asset pricing model formula and describe its components.

Answer 10

RR = RFR + B(ERR - RFR)

Where:
RR 	= Required rate of return.
RFR 	= Risk-free rate of return.
B = Beta, a measure of volatility.
ERR 	= Expected rate of return for a benchmark for the entire class of the asset being valued.

Question 11

Define “Beta”.

Answer 11

Beta is a measure of the systematic risk associated with an investment as reflected by its volatility as compared with the volatility of the entire class of the investment. Shows relationship of asset return and benchmark return.

Question 12

Identify and describe the three (3) possible alternative values of beta.

Answer 12

Beta = 1: Asset has average systematic risk for the entire class

Beta > 1: Asset is more volatile than entire class

Beta < 1: Asset is less volatile than entire class

Question 13

What are the major assumptions and limitations of the capital asset pricing model (CAPM)?

Answer 13

1. All investors have equal access to all investments and are using a one period time horizon;
2. Asset risk is measured solely by its variance from the asset class benchmark;
3. There are no external cost - commissions, taxes, etc.;
4. There are no restrictions on borrowing or lending at the risk-free rate of return;
5. There is a market and market benchmark for all asset classes;
6. Uses historical data.

Question 14

What is the Black-Scholes option-pricing model?

Answer 14

A technique for valuing options on securities. A mathematical formula for valuing stock options, which are derivative instruments (and certain other instruments). The original model was developed to value European-style options, which permit exercise only at the expiration date of the option.

Question 15

What are some major limitations of the original Black-Scholes option pricing model?

Answer 15

1. Appropriate only for European call options, which permit exercise only at the expiration date;
2. Assumes options are for stocks that pay no dividends;
3. Assumes options are for stocks whose price increases in small increments;
4. Assumes the risk-free rate of return remains constant during life of the option;
5. Assumes there are no transaction costs or taxes associated with the options.

Question 16

What are some major advantages of the original Black-Scholes option pricing model?

Answer 16

1. Assigns probability factor to the likelihood that the price of the stock will pay off within the time to expiration;
2. Assigns probability factor to the likelihood that the option will be exercised;
3. Discounts the exercise price to present value.

Question 17

Briefly describe the methodology of the binomial option pricing model.

Answer 17

The binomial option-pricing model is a method that can be generalized for the valuation of options. It uses a tree or network diagram to represent points in time between the present (valuation date) and the expiration of the option and uses probabilities to work backwards in assigning value to each branch in the tree to derive a value at the present (valuation date).

Question 18

Identify the three basic approaches to valuing a business.

Answer 18

1. Market approach.
2. Income approach.
3. Asset approach.

Question 19

Describe the Market approach to valuing a business.

Answer 19

The market approach to valuing a business determines the value of a business by comparing it to other entities with highly similar characteristics for which a fair value can be more readily determined.

Question 20

Describe the Income approach to valuing a business.

Answer 20

The income approach to valuing a business determines the value of a business by calculating the present value of the expected benefit stream to be generated by the business. This approach may use discounted cash flows, capitalization of earnings, multiple of earnings or other similar approaches that develop a fair value based on income/earnings.

Question 21

Describe the Asset approach to valuing a business.

Answer 21

The asset approach to valuing a business determines the value of a business by adding (summing) the values of the individual asset that comprise the business. The sum of those asset values constitutes the value of the entire business. This approach is particularly appropriate when the business being valued has little or no cash flows and/or earnings, or when the business will not continue as a going concern.

Question 22

Identify and describe the two major classes of business forecasting methods.

Answer 22

1. Qualitative: methods that are subjective in nature and based on judgment and opinion.
2. Quantitative: methods that are objective in nature and based on mathematical calculations and determinations.

Question 23

Identify and describe three classes of qualitative business forecasting methods.

Answer 23

1. Executive opinion: The collective judgment and opinion of executives and managers are used to develop a forecast.
2. Market research: Surveys of customers and others are done to determine preferences and other factors as a basis for formulating a forecast.
3. Delphi method: Uses a consensus developed by a group of experts using a multi-stage process for converging on a forecast.

Question 24

Identify and describe the two major classes of quantitative business forecasting methods.

Answer 24

1. Time-series models: Use patterns from past data to predict a future value or values. These methods are not concerned with causes of patterns, just the patterns in the data.
2. Causal models: Use assumed relationships between the variable being forecasted and other variables to make projections based on those relationships.

Question 25

Identify the major forms of time-series models (mathematical methods) used for forecasting.

Answer 25

1. Naive;
2. Simple mean (average);
3. Simple moving average;
4. Weighted moving average;
5. Exponential smoothing;
6. Trend-adjusted exponential smoothing;
7. Seasonal indexes;
8. Linear trend line.

Question 26

Identify and briefly describe major time-series patterns.

Answer 26

1. Level - data are relatively constant or stable over time;
2. Seasonal - data reflect up and down swings over short or intermediate periods of time; each swing of about the same timing and level of change;
3. Cycles - data reflect up and down swings over a long period of time;
4. Trend - data reflect a steady and persistent up or down movement over a long period of time;
5. Random - data reflect unpredictable, erratic variations over time.

Question 27

Identify the major forms of causal models used for forecasting.

Answer 27

1. Regression models (linear or non-linear);
2. Input-Output models;
3. Economic models.

Question 28

Identify and briefly describe the major types of causal models used for forecasting.

Answer 28

1. Regression - uses an equation to relate a dependent variable to one or more independent variables to forecast the dependent variable.
2. Input-output models - describe the flow from one stage, sector, or other component to another in order to forecast values for either the predecessor or successor stage, sector or other component.
3. Economic models - specify a statistical relationship between various economic quantities to forecast the value of one using the value of another.