Financial Valuation and Techniques Flashcards
Review definitions for valuation, financial valuation, and accounting fair value.
Valuation - Process of assigning worth or value to something
Financial Valuation - Process of estimating fair value (market value) of an asset, liability, equity, or business enterprise.
Accounting fair value - Price rec’d to sell an asset or paid to transfer a liability in an orderly transaction between market participants.
Most valuation has elements of ______ and ______?
- Science (Objective characteristics) - Valuation involves use of quantitative data
- Art (subjective) - Valuation involves use of qualitative dimension
Should location and condition be taken into account when assigning value to an item?
Yes both.
What are the three broad valuation approaches that can be used to develop a fair value?
- Market approach (also called Sales Comparison approach)
- Income approach
- Cost Approach
This valuation approach uses prices and other information generated by market transactions involving assets or liabilities that are identical or comparable to those being valued. What approach is this?
Market approach (Sales comparison approach)
This valuation approach is based on converting future amounts of economic benefits (or sacrifices of economic benefits) to determine what those future amounts are worth as of the valuation date. Converts futures amounts to current amounts. What approach is this?
Income approach
This valuation approach uses the amount required to acquire or construct a substitute item (e.g. replacement cost) as the basis for determining fair value. What approach is this?
Cost approach
Which GAAP approach for determining fair value will provide the best evidence of fair value?
Market approach.
With regards to inputs characteristics, GAAP provides a framework for prioritizing or ranking the quality of inputs used in fair value determination. How many levels are there.
Three.
Level 1 - Highest Level
Level 2 - Middle Level
Level 3 - Lowest level
Which level (input characteristics) is related to the factors related below?
- Inputs are observable
- Quoted prices in active market provide most reliable evidence of fair value
- Inputs in this level are unadjusted quoted prices.
Level 1 (Highest Level)
Which level (input characteristics) is related to the factors related below?
- Inputs are observable
- Quoted prices for similar assets/liabilities in active markets
- Quoted prices for similar assets/liabilities not in active markets
- Inputs may need to be adjusted for factors such as condition, location, and level of activity
- Inputs derived from observable market data
Level 2 (Middle Level)
Which level (input characteristics) is related to the factors related below?
- Inputs are not observable (unobservable)
- Can be used to determine fair value if observable inputs are not available
- Unobservable inputs used to reflect entity’s assumptions about what market participants would assume.
Level 3 (Lowest Level)
Which U.S. GAAP levels of inputs for valuation are based on observable inputs?
Levels 1 and 2
Which levels of US GAAP can include inputs not directly observable for the item being valued?
Levels 2 and 3
Level 2 - Observable and unobservable
Level 3 - Only unobservable
Are there any levels of in US GAAP hierarchy that are based exclusively on observable inputs?
Level 1
Can equity securities and debt securities that are traded on active market be valued using level 1 inputs?
Yes. Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Either equity securities or debt securities that are traded in an active market could be valued using the prices established in those markets.
Level 2 inputs can be used in determining fair value in which type of markets?
Active and inactive markets
Both New York Stock Exchange and Over-the-Counter market are both active markets. These are the basis for which level of inputs?
Level 1. Since these are active markets.
Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Why would level 1 be the most appropriate way for valuing agricultural commodities?
Agricultural commodities of identical nature are widely traded in active commodities markets. The prices from those transactions would be the best measure of the value of identical agricultural commodities.
The Capital Asset Pricing Model (CAPM) is an economic model that determines the relationship between risk and expected return and uses that measure in valuing securities, portfolios, capital projects and other assets. CAPM incorporates what two things?
- Time Value of Money (incorporated as risk-free rate of return)
- Element of risk called “beta”
What is the basic formula for CAPM?
RR = RFR + B (ERR-RFR) RR = Required rate of return RFR = Risk-free rate of return B = Beta ERR = Expected rate of return
What does beta measure in the capital pricing model?
Volatility of a stock relative to the market.
In general, beta measures volatility of an asset against the asset class of the asset being valued. For stock, the asset class would be the market in which the stock is traded.
Which category of risk does an investment’s beta measure?
Options: systematic risk, unsystematic risk, default risk, and interest rate risk
Systematic risk. It shows how the value of an investment changes with changes in the entire class of similar investments. Systematic risk is the uncertain inherent in the entire market; it cannot be avoided through diversification.
Define unsystematic risk, default risk, and interest rate risk.
Unsystematic risk - (also company-specific or diversifiable risk) can be avoided or mitigated by diversification.
Default risk - possibility that a borrower will not pay interest when due or repay principal when due, resulting in a loss to the lender.
Interest rate risk - possibility that the market rate of interest will increase, causing the value of existing fixed rate investments to decline.
