Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

exam 7 > Goldfarb > Flashcards

Goldfarb Flashcards

1
Q

how does the Dividend Discount Model (DDM) define the equity value of a firm?

(Goldfarb)

A

present value of all future dividends

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

what are two ways to apply the Dividend Discount Model? (DDM)

(Goldfarb)

A
  • dividends are forecasted for all future periods, then discounted using a risk-adjusted rate
  • dividends are forecasted over a finite horizon, terminal value is used to reflect the value of the remaining dividends beyond the horizon
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

what is free cash flow?

Goldfarb

A
  • all cash that could be paid as a dividend

- net of any amounts that need to be reinvested in the firm for required operations and growth

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

what are the approaches to the Discounted Cash Flow model?

Goldfarb

A
  • Free Cash Flow to the Firm (FCFF)

- Free Cash Flow to Equity (FCFE)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

what does the Free Cash Flow to the Firm approach focus on?

Goldfarb

A

free cash flow to the entire firm, prior to accounting for debt payments or taxes associated with debt payments

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

what does discounting the FCFF result in?

Goldfarb

A

total firm value

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

how is equity value of the firm found under the FCFF?

Goldfarb

A

by subtracting the market value of the debt from the total firm value

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

what does Free Cash Flow to Equity approach focus on?

Goldfarb

A

cash flows to equity holders only

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

how does the FCFE approach determine free cash flow to equity?

(Goldfarb)

A

subtract debt payments, net of associated tax consequences, from the free cash flow to the firm

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

what does discounting the resulting free cash flows to equity result in?

(Goldfarb)

A

equity value

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

what is an important distinction between FCFF and FCFE methods?

(Goldfarb)

A
  • FCFF uses discount rate that reflects overall risk to both debtholders and equity holders
  • FCFE uses a discount rate that reflects risk to equity holders only
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

what is a weighted average cost of capital?

Goldfarb

A

discount rate that reflects overall risk to both debtholders and equity holders

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

what does the Abnormal Earnings method do?

Goldfarb

A

separates the book value of the firm from the value of future earnings

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

what is book value?

Goldfarb

A

value of the firm’s equity assuming that the firm earns only the investors’ required return in all future periods

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

what are abnormal earnings?

Goldfarb

A

earnings excess of the investors’ required earnings

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

how does Abnormal Earnings (AE) calculate the equity value of the firm?

(Goldfarb)

A

by discounting abnormal earnings and adding them to the current book value

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

what is an important distinction between the AE and DDM/DCF methods?

(Goldfarb)

A

-DDM and DCF adjust the accounting-based net income measure into a cash flow measure

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

what does it mean for the DDM and DCF to adjust the accounting-based net income into a cash flow measure?

(Goldfarb)

A

removes distortions introduced by accounting rules that are designed to defer recognition of revenues and expenses

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

why is adjusting accounting-based net income measure into a cash flow measure not necessarily the best thing to do?

(Goldfarb)

A

unadjusted accounting values may provide a more accurate valuation over a finite horizon

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

what is another important distinction between the AE and DDM/DCF methods?

(Goldfarb)

A
  • AE focuses on the source of value creation: firm’s ability to earn a return on equity in excess of investors’ required return
  • DCF and DDM focus on effect of value creation: firm’s ability to pay cash flows to its owner
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

how does relative valuation using multiples determine equity value?

(Goldfarb)

A

uses a multiple applied to a selected financial measure to determine equity value

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q

what does a “multiple” in relative valuation using multiples represent?

(Goldfarb)

A

all assumptions needed for the other methods (AE, DCF, DDM, etc.), including revenues, expenses, growth rates, etc.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

how can the multiple (in relative valuation using multiples) serve as a reasonability check?

(Goldfarb)

A

indicates whether the assumptions driving the DDM, DCF or AE approaches make sense and whether they differ from comparable firms

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
24
Q

how does the option pricing theory view equity value of a firm?

(Goldfarb)

A
  • as a call option on the assets of the firm, with a strike price equal to the undiscounted value of the liabilities
  • conceptually: equity owners have sold the assets of the firm to debtholders but they have the right to buy them back by repaying the face value of the debt
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
25
Q

why is the option pricing theory difficult to implement?

Goldfarb

A
  • practical limitations associated with determining which inputs to model
  • difficult to accurately reflect firms’ capital structures (e.g.: multiple classes of debt)
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
26
Q

what are examples of “real options” that option pricing theory is useful for?

(Goldfarb)

A
  • options to expand current operations
  • options to make follow-on investments
  • options to abandon projects
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
27
Q

what is a value of a share of stock?

Goldfarb

A

discounted present value of the expected future dividends

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
28
Q

when do we incorporate a terminal value term?

Goldfarb

A

when dividends are projected over a finite horizon and then assumed to grow at a constant rate beyond that horizon

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
29
Q

what does the “multiple” applied to the current dividend amount as of the terminal date represent?

(Goldfarb)

A

net effect of assumptions:

  • dividends will grow at constant rate forever
  • growth rate is g
  • discount rate is k
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
30
Q

what are three assumptions needed to implement the DDM?

Goldfarb

A
  • expected dividends during forecast horizon
  • dividend growth rates beyond forecast horizon
  • appropriate risk-adjusted discount rate
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
31
Q

what are drawbacks of estimating expected dividends during the forecast horizon?

(Goldfarb)

A
  • extremely complex to forecast future dividends

- involves forecasts of revenues, expenses, investment needs, cash flows, etc.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
32
Q

what is a simple approach to estimate dividend growth rates beyond the forecast horizon?

(Goldfarb)

A

use growth rates during the forecast horizon to extrapolate the future growth rates

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
33
Q

what is another approach to base dividend growth rates on?

Goldfarb

A

base on:

  • dividend payout ratio
  • return on equity
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
34
Q

what is the dividend payout ratio?

Goldfarb

A

portion of earnings paid as dividends

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
35
Q

what is return on equity (ROE)?

Goldfarb

A

-profit per dollar of reinvested earnings

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
36
Q

what is the plowback ratio?

Goldfarb

A

portion of earnings retained and reinvested

1 - div. payout ratio

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
37
Q

why doesn’t a high growth rate necessarily mean that firm value will increase?

(Goldfarb)

A
  • only the case if everything is held constant

- in reality, growth rates, div. payout ratios, and risk-adjusted rate are not independent

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
38
Q

what are two examples of dependence between dividends and growth rates?

(Goldfarb)

A
  • high growth rates and high dividends are not sustainable (at the same time) -> high growth rates will likely be offset by lower dividends
  • firms with high growth rates tend to be riskier -> drives up the risk-adjusted rate and drives down the present value of dividend amounts
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
39
Q

what are two ways to reflect the risk in the value being calculated, when valuing risk cash flows?

(Goldfarb)

A
  • use a risk-adjusted rate higher than the risk-free rate -> lowers value of cash flows
  • adjust cash flows for risk directly, then discount using risk-free rate
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
40
Q

what is does private valuation assume?

Goldfarb

A
  • individual investors have their own views of “risk”
  • potential investments are assessed relative to investors’ existing portfolios -> same investment has different value to different investors
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
41
Q

what does equilibrium market valuation assume?

Goldfarb

A
  • all investors hold the same portfolio and assess “risk” in identical fashions
  • investments will have the same value for all investors
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
42
Q

in the Capital Asset Pricing Model (CAPM), how is risk defined?

(Goldfarb)

A

in terms of the investment’s beta -> measure of systematic risk that cannot be diversified away

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
43
Q

what are two methods for determining beta?

Goldfarb

A
  • firm beta

- industry beta

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
44
Q

what is a firm beta?

Goldfarb

A

linear regression of the company’s returns against the market returns using historical stock price data

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
45
Q

what is an industry beta?

Goldfarb

A

uses an industrywide mean or median value

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
46
Q

what factors might an industry beta be adjusted to reflect?

Goldfarb

A
  • mix of business

- financial leverage

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
47
Q

how might an industry beta be adjusted to reflect mix of business?

(Goldfarb)

A

-only use firms with comparable mixes of business

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
48
Q

what is a drawback to adjusting an industry beta to reflect mix of business?

(Goldfarb)

A

-drops number of firms significantly -> reduces reliability of result

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
49
Q

what is financial leverage and what is its impact on firm risk?

(Goldfarb)

A

using debt to raise capital -> increases risk to equity holders

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
50
Q

how can the beta be adjusted due to different levels of financial leverage?

(Goldfarb)

A

-beta can be defined to reflect solely business risk, and NOT effect of debt leverage -> “all-equity beta”

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
51
Q

what might it be best not to adjust the beta for financial leverage?

(Goldfarb)

A
  • policyholder liabilities also result in leverage effects (not fully accounted for when adjusting solely for debt leverage)
  • assume TOTAL leverage of all firms in industry are similar
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
52
Q

what should the risk-free rate be based on?

Goldfarb

A

current yields on risk-free securities

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
53
Q

what are three options of risk-free securities to base the risk-free rate on?

(Goldfarb)

A
  • 90-day T-Bills
  • Maturity Matched T-Notes
  • T-Bonds
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
54
Q

what are 90-Day T-Bills free of?

Goldfarb

A

both credit and reinvestment risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
55
Q

what is the term of Maturity-Matched T-Notes?

Goldfarb

A

term matches average maturity of the cash flows

56
Q

when are T-Bonds the best estimate?

Goldfarb

A

for the long run average SHORT-TERM yields

57
Q

what should be noted about T-Bonds?

Goldfarb

A

when estimating the risk-free rate, we need to subtract the liquidity premium from the T-Bond yield to put it on par with other risk-free investments

58
Q

what is a liquidity premium?

Goldfarb

A

premium added to long-term investments to make up for the fact that the investment is less liquid

59
Q

what are key considerations in determining the appropriate equity risk premium?

(Goldfarb)

A
  • risk-free rate shows up twice in CAPM: need to be consistent in what we use
  • for single period forecasts, arithmetic averages are preferred
  • for multiple period forecasts, geometric averages are preferred
60
Q

what are two limitations of the DDM?

Goldfarb

A
  • actual dividend payments are discretionary and can be difficult to forecast
  • may need to redefine “dividend” due to increased use of stock buybacks as a vehicle for returning funds to shareholders
61
Q

why is the FCFF difficult to apply to PC companies?

Goldfarb

A
  • difficult to determine what should be treated as policyholder liabilities and debt
  • hard to define weighted average cost of capital
  • hard to define all-equity discount rate needed for adjusted present value method
62
Q

according to Goldfarb, what is the difference between policyholder liabilities and debt?

(Goldfarb)

A

arbitrary - no reason to treat differently

63
Q

what is the weighted average cost of capital (WACC) used for in the FCFF method?

(Goldfarb)

A

to discount cash flows that include both equity and debt sources of capital

64
Q

what does the adjusted present value (APV) method do?

Goldfarb

A

uses all-equity discount rate to derive the value of the firm without considering debtholders’ claims, tax consequences of debt, or the impact of debt on the riskiness of the equity holders’ claims

65
Q

in words, how is FCFE calculated?

Goldfarb

A

Net Income + Non-Cash Charges (Excluding Changes in Reserves) - Net Working Capital Investment - Increase in Required Capital + Net Borrowing

66
Q

what are non-cash charges as defined in FCFE?

Goldfarb

A

expenses that are deducted under GAAP accounting but do not represent actual cash expenditures

67
Q

why are changes in loss and expense reserves excluded from non-cash changed in FCFE method?

(Goldfarb)

A
  • also considered a capital expenditure

- capital expenditures are subtracted from net income, so the two effects cancel each other out

68
Q

what does net working capital investment reflect in the FCFE?

(Goldfarb)

A

net short term assets held to maintain operations, such as inventory or accounts receivable

69
Q

what does “increased in required capital” in the FCFE method reflect?

(Goldfarb)

A
  • regulatory and rating agency capital requirements

- management’s assessment of the capital needed to take on risk without negatively impacting growth goals

70
Q

if given more than one “required capital” constraint in the FCFE method, which should be used?

(Goldfarb)

A

most binding (largest) one

71
Q

what are two differences between DDM and FCFE?

Goldfarb

A
  • growth rates

- discount rates

72
Q

how are growth rates different between FCFE and DDM?

Goldfarb

A
  • in DDM, if not paid out as dividend, it’s reinvested

- in FCFE, all free cash flow is paid to shareholders - difficult to define reinvestment

73
Q

how do we calculate growth rates in FCFE method?

Goldfarb

A
  • use increase in required capital to determine reinvestment

- combine with ROE to estimate growth rate beyond forecast horizon

74
Q

why can the FCFE use increase in required capital to determine reinvestment?

(Goldfarb)

A

capital base of the firm determines the max growth that can be achieved given regulatory and rating agency constraints

75
Q

in theory, why should the DDM and FCFE models use different discount rates?

(Goldfarb)

A

due to the riskiness of the cash flows paid to shareholders:

  • DDM - assumed dividends are paid to shareholders, remaining income reinvested in marketable securities
  • FCFE - pays out all free cash flow to shareholders
76
Q

how is DDM’s measure of risk impacted by the difference in cash flows paid to shareholders?

(Goldfarb)

A

-larger proportion of the risk comes from marketable securities than from U/W risk

77
Q

in practice, how do discount rates compare between DDM and FCFE?

(Goldfarb)

A

assume same discount rates can be used due to challenge involved in quantifying the difference in risk

78
Q

what are three weaknesses of the DCF method?

Goldfarb

A
  • must forecast financial statements according to a specific set of accounting standards
  • variety of adjustments must be made to forecasts of net income to estimate free cash flows
  • resulting free cash flows may not be very similar to those using internally for planning purposes
79
Q

what does the Abnormal Earnings (AE) method rely on instead of cash flows?

(Goldfarb)

A

directly on accounting measures (reported book value instead of forecasted net income)

80
Q

when should the market value of the firm’s equity equal its book value, under the AE method?

(Goldfarb)

A

if the firm can earn a return exactly equal to the return demanded by its shareholders

81
Q

is the AE terminal value calculation different from the DDM and FCFE approaches?

(Goldfarb)

A
  • AE method doesn’t assume a constant growth rate in perpetuity
  • decline to zero as new competition enters the market to capture some AE
82
Q

why is the decline in AE to zero an appealing quality?

Goldfarb

A

forces analysts to explicitly consider the limits of growth from a value perspective (growth in earnings does not drive growth in value; we only grow in value if we exceed expected returns)

83
Q

in the AE method, how are we able to use unadjusted earnings for valuation purposes when they’re based on arbitrary accounting rules?

(Goldfarb)

A

-accounting rules that distort estimates of earnings will also distort the estimates of book value -> will eventually self-correct

84
Q

what are possible adjustments to book value when applying the AE method?

(Goldfarb)

A
  • eliminate systematic bias in reported asset and liability values (may involve restating reported loss reserves)
  • adjust reported book value to reflect tangible book value
85
Q

how does tangible book value differ from reported book value?

(Goldfarb)

A

removes the impact of intangible assets such as goodwill (e.g. brand, reputation, etc.)

86
Q

what should be noted about discounting loss reserves in the AE method?

(Goldfarb)

A
  • not necessary, better reflects economic reality
  • causes corresponding adjustment to ROE, since capital base is larger
  • requires us to pick a rate to discount the reserves
87
Q

what are two benefits of the AE approach?

Goldfarb

A
  • uses assumptions that are more directly tied to value creation (abnormal profits) instead of those that are consequences of value creation (dividends and free cash flows)
  • deemphasizes terminal value, and reflects more of firm value within the forecast horizon
88
Q

what are three problems with DDM, DCF, and AE methods?

Goldfarb

A
  • investor may not have access to data in sufficient detail to parameterize the model (i.e. determine financial statement variables)
  • growth and rate adequacy estimates are difficult to obtain without market knowledge and planning data
  • horizon used may stretch the limits of our forecasting ability
89
Q

what does the P-E ratio summarize in a single number?

Goldfarb

A

combined effect of the dividend payout ratio, the growth rate, and the discount rate

90
Q

what are the two types of P-E ratios?

Goldfarb

A
  • forward (leading): uses expected future earnings

- trailing: uses prior period’s earnings

91
Q

what can distort trailing P-E ratios?

Goldfarb

A

unusually positive or negative earnings in the past year

92
Q

how do analysts avoid distorted P-E ratios?

Goldfarb

A
  • smooth effects of unusual events

- use forward P-E ratios that reflect estimates of prospective earnings

93
Q

how can prospective earnings for a forward P-E ratio be found?

(Goldfarb)

A

found by multiplying current book value by an expected ROE

94
Q

what are three alternative uses for P-E (or P-BV) ratios?

Goldfarb

A
  • validation of assumptions
  • shortcut to valuation
  • terminal value
95
Q

how can P-E ratios be used to validate assumptions?

Goldfarb

A

may need to revisit assumptions if differences in P-E ratios with comparable growth rates, dividend payout ratios, etc., cannot be explained by those key variables

96
Q

how can P-E ratios be used as a shortcut to valuation?

Goldfarb

A

when industry average performance is expected, can select a group of peer companies and use their mean or median P-E ratio

97
Q

how can P-E ratios used for terminal value?

Goldfarb

A

rely on peer P-E ratios to guide terminal value calculation

98
Q

when might current P-E ratios overstate the appropriate P-E ratio at the forecast horizon?

(Goldfarb)

A

if industry is expected to experience excessive short-term growth followed by a low growth state

99
Q

what is a P-E ratio?

Goldfarb

A

Price-Earnings ratio = price of equity per share / earnings per share

100
Q

what is a P-BV ratio?

Goldfarb

A

Price to Book Value ratio

101
Q

when is the P-BV ratio preferred over the P-E ratio?

Goldfarb

A

when valuing banks, insurance companies, and other financial services firms with large holdings in marketable securities

102
Q

is it preferred to use firm or equity multiples for P-E and P-BV ratios?

(Goldfarb)

A

best to avoid firmwide valuation multiples - use per share equity measures in denominator

103
Q

what are P-E and P-BV ratios based on?

Goldfarb

A

market price of the companies’ shares and most recent financial statement values

104
Q

why might it be better to focus on transaction multiples or consider market multiples over multiple periods?

(Goldfarb)

A

market value and financial statement values fluctuate greatly

105
Q

what are transaction multiples based on?

Goldfarb

A

merger and acquisition (M&A) prices or initial public offerings (IPO)

106
Q

what is an advantage of using transaction multiples?

Goldfarb

A

price is based on a complex negotiation with sophisticated parties on both sides, resulting in multiples that are more meaningful than ones based on current market prices

107
Q

what are five reasons to be cautious when using transaction multiples?

(Goldfarb)

A
  • control premiums
  • overpricing in M&A transactions
  • underpricing in IPO transactions
  • reported financial variables
  • underlying economic assumptions
108
Q

what are control premiums?

Goldfarb

A

buyer in an acquisition may pay more than the company is worth in order to gain control of its operations

109
Q

why is overpricing in M&A transactions a reason to be causing when using transaction multiples?

(Goldfarb)

A

M&A transactions tend to increase shareholder value more for the target firm’s shareholders, implying that the acquiring firms are overpaying

110
Q

why should we be cautious about using reported financial variables when using transaction multiples?

(Goldfarb)

A

reported multiples may not be accurate if they do not reflect the buyer’s underlying assumptions about growth rates, ROE, and discount rates

111
Q

what should we be cautious about the underlying economic assumptions when using transaction multiples?

(Goldfarb)-

A

multiples come from past transactions that were carried out in a different economic environment (interest rates, growth rates, etc.)

112
Q

what are two approaches to valuing multi-line firms with multiples?

(Goldfarb)

A
  • use segment-specific financial measures and multiples based on firms that operate only in that space
  • use peer companies with comparably diverse operations along with firmwide financial measures
113
Q

what are six steps for valuing a firm with diverse operations using multiples?

(Goldfarb)

A
  1. collect financial data by segment
  2. select peer companies
  3. choose multiples
  4. apply multiples for segment valuation
  5. calculate the total firm value
  6. validate against other diversified insurers
114
Q

what should be included when collecting financial data by segment to value a firm with diverse operations using multiples?

(Goldfarb)

A
  • growth rate
  • profitability
  • risk level
115
Q

how should peer companies be selected, and why? (when valuing a firm with diverse operations using multiples)

(Goldfarb)

A
  • peer company for each segment should only operate in that segment (“pure play” firms)
  • ensures that underlying financial characteristics of each business are reflected
  • should have comparable growth rates, ROE, etc.
116
Q

how should multiples be chosen when valuing a firm with diverse operations?

(Goldfarb)

A

several valuation multiples should be chosen to avoid reliance on a single multiple

117
Q

how can equity be viewed as a call option on the company’s assets?

(Goldfarb)

A
  • when equity holders issue debt, they no longer own all of the value of the firm
  • equity can be viewed as call option with strike price, D, equal to face value of debt
  • by borrowing PV of D, equity holders give all the assets of the firm to the debtholders
  • equity holders have the right to buy back the assets of the firm by paying D at time T
118
Q

what is a limitation of valuing equity as a call option?

Goldfarb

A

the notion of “debt” for an insurance company is not well-defined:
-policyholder liabilities are indistinguishable from other debt

119
Q

what are five “real options” that can be used for valuation?

Goldfarb

A
  • abandonment option
  • expansion option
  • contraction option
  • option to defer
  • option to extend
120
Q

what is an abandonment option?

Goldfarb

A

-American put option on the value of the project, with strike price equal to net liquidation proceeds

121
Q

what scenario does an expansion option apply to?

Goldfarb

A

-scope of successful project is expanded to capture more profits

122
Q

what scenario does an abandonment option apply to?

Goldfarb

A

project is terminated early and investment sold for its liquidation value less closing-down costs

123
Q

what is an expansion option?

Goldfarb

A

American call option on the gross value of the additional capacity, with a strike price equal to the cost of creating the capacity

124
Q

what is a contraction option?

Goldfarb

A

American put option on the gross value of the lost capacity, with a strike price equal to the cost savings

125
Q

what scenario does a contraction option apply to?

Goldfarb

A

opposite of expansion option scenario - scope of unsuccessful project is contracted

126
Q

what does an option to defer measure?

Goldfarb

A

value of holding off on a project until more info is known

127
Q

what is an option to defer?

Goldfarb

A

American call option on the value of the project

128
Q

how does an option to extend operate?

Goldfarb

A

extends the life of a project by paying a fixed amount

129
Q

what is an option to extend?

Goldfarb

A

European call option on the asset’s future value

130
Q

what are practical difficulties when valuing managerial flexibility using options?

(Goldfarb)

A
  • difficult to identify new businesses for which some real option value may exist
  • difficult to assess the current value of these businesses
  • difficult to determine whether the firm has the ability to enter these businesses at a fixed price or at a price that differs from market value
131
Q

what are four key valuation considerations when using options?

(Goldfarb)

A
  • valuing the underlying business cash flows
  • time to option maturity
  • exercise type
  • appropriate valuation formula
132
Q

what should be considered when valuing the underlying business cash flows when using options to value a firm/managerial flexibility?

(Goldfarb)

A

if using AE method to determine gross value of cash flows, after each period passes where the option is not exercised, we must adjust the value
(since AE are assumed to decline over time)

133
Q

why should time to option maturity be considered when using options to value a firm/managerial flexibility?

(Goldfarb)

A

real options tend to have uncertain maturities

134
Q

what should be considered about exercise type when using real options to value managerial flexibility?

(Goldfarb)

A

real options tend to be American options that can be exercised at any time until maturity

135
Q

why should the valuation formula be considered when using real options to value managerial flexibility?

(Goldfarb)

A

Black-Scholes formula may not be appropriate

136
Q

what are three characteristics that would make real options more valuable?

(Goldfarb)

A
  • new info is discovered prior to expiration date -> more informed decision
  • expansion options are only valuable if there’s an exclusive right to exercise them
  • in order for the option to have value, exercise price must be fixed

exam 7 (21 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2024 Bold Learning Solutions. Terms and Conditions