Financial Valuation Methods Pt. 2 Flashcards
What is an option?
a contract that entitles the owner (holder) to buy (call option) or sell (put option) a stock (or some other asset) at a given price within a stated period of time
American-style options can be exercised at any time prior to their expiration while European-style options can be exercised only at the expiration or maturity date of the option
The Black-Scholes Model
inputs include: the current price of the underlying stock, the option exercise price, the risk-free interest rate, the time until expiration, and a measure of risk tied to the underlying stock
one of the underlying assumptions is that there are no transaction costs for buying or selling the stock or option
a distinguishing feature is that it requires European-style options (only exercisable at maturity)
The Binomial Model (aka Cox-Ross-Rubinstein Model)
it is a variation of the Black-Scholes Model with two primary differences: it uses American-style options (can be exercised any time before maturity) and it can be used for stocks that pay periodic dividends without modifying the model
T/F: the value of a bond is equal to the present value of its future cash flows
True; bonds paying a fixed coupon rate equal to the market rate for comparable bonds are issued at par/face value; if a bond’s coupon rate at issuance is less (more) than the market rate, the bond will be issued at a discount (premium)
ex. if a $1,000 bond that matures in 3 years pays annual interest of 4% while the market rate at issuance is 5%, then you would calculate it like this:
yr1: 40/1.05 = 38.10
yr2: 40/1.05^2 = 36.28
yr3: (40 + 1000) /1.05^3 = 898.39
total value: 38.10 + 36.28 + 898.39 = 972.77
Fact: fixed assets represent PP&E held by a company to provide the infrastructure needed to support operations
GAAP dictates how PP&E (tangible assets) is reported on the BS; the actual value of these assets can be determined using the following methods:
cost method - the value of the assets is based on the original cost paid to acquire the asset; adjustments may be made for depreciation in order to reduce the value of the asset to reflect current utility
market value method - requires similar assets be available in the marketplace in order to find a comparable value; two iterations of the market value method are replacement cost method and the net realizable value method (what it could be sold for in the marketplace less any costs associated with selling the asset)
appraisal method - a professional appraiser determines the value of the asset
liquidation value - the amount a company would get if the asset were to be sold today assuming there is an active market
Methods used to value intangible assets
market approach - requires that actual arm’s-length transactions (sales, transfers licenses) in similar markets be used as a reference for the asset to be valued
income approach - future expected cash flows over the estimated useful life of the intangible asset are discounted to present value using discount rates, reflecting the level of risk associated with the income stream
cost approach - used when there are no similar assets or transactions involving similar assets, and no reasonable estimates of future income; iterations of the cost approach include replacement cost and reproduction cost; costs incorporated will include materials, labor, overhead, legal and other fees, development costs, production costs, and opportunity costs (no G&A allocated costs as these are period expenses)
When preparing accounting estimates, management must consider the following data and factors:
historical information, market information, expected usage, and estimates from experts
accounting estimates should be supported by documentation that shows the assumptions and calculations upon which the estimates are based; management should regularly review the support for material accounting estimates and should approve each estimate when reviewed
