PTA3 Flashcards

1
Q
Number of Workers	Units Produced	Revenue Generated
1	1,000	$ 200,000
2	2,500	 500,000
3	4,500	 900,000
4	6,400	1,280,000
5	7,400	1,332,000
  1. At what level of worker employment does the law of diminishing returns per unit of labor become evident?
A

The law of diminishing returns recognizes that in the short run, in which you have one or more fixed inputs, as additional units of a variable input are added (in this case, workers), the output per unit of the variable input eventually will begin to decrease as a result of the variable input overwhelming the fix input(s). For NoCo this occurs when the fourth worker is added. Up to 3 workers the marginal units per worker increases. At three workers, the marginal units per worker is 2,000 units (4,500 units – 2,500 units), but when the fourth worker is added, the marginal units is only 1,900 (6,400 units – 4,500 units). The output per unit of worker begins to decline with the addition of the fourth worker; the law of diminishing returns has come into play.

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2
Q

Valuation Circumstance GAAP Input Hierarchy Level
2 1. Using a price-earnings multiple to value a business
Level ?
3 2. Using Nasdaq quotes to value a block of common stock traded on the Nasdaq Exchange
Level ?
4 3. Using market interest rates and risk premiums to value an interest rate swap contract
Level ?
5 4. Using a firm’s estimates of future net cash flows to value the recoveRable cost of an impaired asset
Level ?
6 5. Using the CAPM (model) to value a stock
Level?

A
2
1
2
3
2
Using a price-earnings multiple to value a business is a Level 2 input in the GAAP hierarchy. Inputs in this level of the hierarchy are observable values, other than quoted prices in active markets for assets or liabilities identical to those being valued. The price-earnings multiple approach uses the observable inputs of market price and earnings per share to compute value.
Using Nasdaq (National Association of Securities Dealers Automated Quotations exchange) quotes is a Level 1 input in the GAAP hierarchy. Inputs in this level of the hierarchy are quoted market prices in active markets for identical assets or liabilities. Nasdaq is a major, active stock exchange that permits traders to buy and sell stocks on a computerized and transparent system.
Using market interest rates and market-based risk premiums to value an interest rate swap contract is a Level 2 input in the GAAP hierarchy. Inputs in this level of the hierarchy are observable values, other than quoted prices in active markets for assets or liabilities identical to those being valued. Market interest rates and market-based risk premiums are observable market data that can be used to value a swap contract.
Using a firm's estimates of future net cash flows to value the recoverable cost of an impaired asset is a Level 3 input in the GAAP hierarchy. Inputs in this level of the hierarchy are unobservable in the market and are based primarily on an entity's assumptions and estimates, not on external, market-based inputs. A firm's estimates of future net cash flow are Level 3 inputs.
Using the CAPM (model) to value a stock is a Level 2 input in the GAAP hierarchy. Inputs in this level of the hierarchy are observable values, other than quoted prices in active markets for assets or liabilities identical to those being valued. CAPM uses observable values, other than quoted prices in active markets, including the risk-free rate of return, asset and asset class statistical values, and asset class returns, to determine the value of a specific asset in the class.
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3
Q
  1. A client firm is considering issuing 10-year bonds each with a face value of $100 and an 8% coupon rate paid annually. The yield to maturity of comparable bonds in the market is 6%. The client has asked for an estimated selling price.

What would be the expected issue price of each bond?

A

PV of annual interest payments = ($100×.08)×PVannuity
(n=10;6%)
=$8.00×7.360
=$58.88

PV of face maturity value
=$100×PV(n=10;6%)
=$100×0.558=55.80

Total PV=$114.68
=$115rounded

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4
Q

. A client firm is considering investing in the common stock of Joco, Inc., as a short-term investment. Joco is not publicly traded and is currently paying $3.00 per share, an amount that is expected to continue for the foreseeable future. The client requires a 15% return on equity investments and asks that your firm determine the maximum amount it should be willing to pay for the stock.

What is the maximum amount the client should be willing to pay for each share of stock?

A
The maximum amount the client should be willing to pay for each share of stock is $20.00. Since Joco's dividend amount is not expected to grow in the foreseeable future, the determination is straightforward and can be expressed as “What amount of investment earning 15% would be expected to return $3.00?” Expressed mathematically that would be:
.15X=$3.00
Where X is the(maximum)investment amount
 Rearranged, the formula is:
X=$3.00/.15
Solved:
X=$20.00,the maximum amount the client should pay per share of Joco
.
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5
Q

A client has asked that your firm determine the value of its closely held firm. The firm has a number of competitors that are publicly traded with comparable risk, dividend rate, and growth rate. Information about those firms shows that their average share price is $6.00 and their average earnings is $0.50 per share, with very little variation between those firms. Your client’s firm has 10,000 shares outstanding and has consistently earned $0.45 per share.***Using the price-earnings ratio, what is the estimated value of your client’s firm?

A

Using the price-earnings ratio, the estimated value of your client’s firm is $54,000. The value of a closely held (nonpublic) firm can be determined by multiplying its current earnings per share by the price-earnings (P/E) ratio of comparable publicly traded firms for which information is available. From the facts given, the P/E ratio for the comparable firms can be determined as follows:

P/E ratio=price $6.00/ earnings$0.50=12.0 P/E ratio

By multiplying the client firm’s earnings per share (EPS) by the P/E ratio for the comparable group of firms, we can determine a value for a share of the client firm’s stock. That calculation is:
Per share value=EPS$.45×P/Eratio of comparable firms
12.0=$5.40per share value

With 10,000 shares outstanding, the client firm’s value would be:
10,000shares×$5.40per share=$54,000 total value

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6
Q

A client firm is considering investing in the common stock of a publicly traded firm and has asked that your firm determine the required rate of return that the investee firm must earn in order to be considered an acceptable investment. The risk-free rate on U.S. Treasury securities is 3%. The beta for the investee firm has been determined to be 1.20, and the benchmark rate for the entire market in which the investee operates is 12%.

Using the capital asset pricing model (CAPM), what is the required rate of return that the firm must earn in order to be considered an acceptable investment? Show your answer as a rounded percentage without decimals or the percentage sign (e.g., 12.34% or 0.1234 should be entered as 12).

A

Using the capital asset pricing model (CAPM), the required rate of return that the firm must earn in order to be considered an acceptable investment is 13.8%, rounded to 14% for grading purposes. The formula for the capital asset pricing model (CAPM) is:
Required (minimum)rate=RFR+[B(ERR−RFR)]

where:

RFR = Risk-free rate (3%)
B = Beta (1.20)
ERR = Expected rate of return for benchmark (entire asset class) (12%)

Using the values provided in the facts, the calculation is:
Required(minimum)rate=.03+[1.20(.12−03)]

Required(minimum)rate=.03+[1.20(.09)]

Required(minimum)rate=.03+.108=.138

The 1.20 beta indicates that the firm under consideration has a greater volatility (risk) than that of the entire asset class of which it is a part. As a consequence, the return required by that firm in order to compensate for the higher risk (13.8%) is greater than the return of the entire asset class (12%).

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