Finance 201 Brau Chapter 13 flashcards

Question 1

What is the core idea behind the Replacement Cost Method?

Accepted Answer

It estimates a firm's value by determining the current market price required to acquire or replicate all of its tangible components and capital structure, as if building it from scratch.

Question 2

What are tangible assets in the context of the Replacement Cost Method?

Accepted Answer

Tangible assets are the physical items a firm owns, such as property, plant, and equipment, which are valued at their current market prices.

Question 3

What is a key limitation of the Replacement Cost Method?

Accepted Answer

It fails to account for intangible assets like patents, brand recognition, or synergy, which often contribute significantly to a firm's true value but are difficult to quantify.

Question 4

What is the fundamental principle of the Discounted Cash Flow (DCF) method?

Accepted Answer

The DCF method asserts that an asset's worth is derived from the present value of all its expected future cash flows, adjusted for the time value of money.

Question 5

What does the DCF formula $V_a = \sum_{t=1}^{T} \frac{CF_t}{(1+k)^t}$ represent?

Accepted Answer

It represents the value of an asset ($V_a$) as the sum of its future cash flows ($CF_t$) discounted back to the present at a rate ($k$) that reflects the risk of those cash flows.

Question 6

Why is the choice of cash flow measure critical in DCF analysis?

Accepted Answer

The choice of cash flow measure (e.g., Dividends, FCFF, FCFE) determines whether you are valuing the entire firm or just its equity, and dictates the appropriate discount rate to use.

Question 7

What is Free Cash Flow to the Firm (FCFF)?

Accepted Answer

FCFF is the cash flow available to all capital providers (creditors and stockholders) after operating expenses and necessary investments, calculated as $FCFF = EBIT - 	ext{Cash Tax Payments} + 	ext{Depreciation} - 	ext{CAPEX} - 	ext{Increases in NWC}$.

Question 8

What discount rate should be used when valuing a firm using FCFF?

Accepted Answer

The Weighted Average Cost of Capital (WACC) should be used as the discount rate when valuing a firm using FCFF, as it represents the average cost of financing for the entire firm.

Question 9

What is Free Cash Flow to the Equity (FCFE)?

Accepted Answer

FCFE is the cash flow available only to equity holders after all expenses, debt payments, and investments have been made, calculated as $FCFE = NI + 	ext{Depreciation} - 	ext{CAPEX} - 	ext{Increases in NWC} + 	ext{Increases in Net Long-Term Debt}$.

Question 10

What discount rate is appropriate for FCFE?

Accepted Answer

The cost of equity ($k_e$) is the appropriate discount rate for FCFE, as these cash flows are available solely to equity holders.

Question 11

How can firm value be calculated if $V_{equity}$ is found using FCFE?

Accepted Answer

Firm value can be found by adding the market value of debt to the calculated equity value: $V_{firm} = V_{equity} + V_{debt}$.

Question 12

What is the first step in the five steps of DCF valuation?

Accepted Answer

The first step is to forecast the firm's financial performance for a reasonable future period, typically three to five years, by creating pro forma financial statements.

Question 13

What is the purpose of calculating Terminal Value (TV) in a DCF?

Accepted Answer

Terminal Value represents the estimated value of all cash flows beyond the explicit forecast horizon, allowing for a valuation of the firm's long-term existence.

Question 14

How is Terminal Value calculated using the Constant Growth Model?

Accepted Answer

It is calculated as $V_t = \frac{CF_t(1+g)}{k_{cf} - g}$, assuming cash flows grow at a constant rate ($g$) indefinitely beyond the forecast period.

Question 15

What is the assumption behind the No-Growth Model for Terminal Value?

Accepted Answer

The No-Growth Model assumes that cash flows will remain constant indefinitely beyond the forecast period, calculated as $V_t = \frac{CF_t}{k_{cf}}$.

Question 16

What is the fourth step in the DCF valuation process?

Accepted Answer

The fourth step is to compute the appropriate discount rate, which is either WACC for FCFF or the cost of equity ($k_e$) for FCFE, ensuring consistency with the cash flow measure.

Question 17

What is the Comparables Method of valuation?

Accepted Answer

It's a market-based approach that values a firm by comparing it to similar companies that are publicly traded or have been recently involved in M&A activities.

Question 18

What is a key advantage of the Comparables Method?

Accepted Answer

It is practical when detailed financial forecasts for a DCF model are difficult to obtain, relying instead on market data from similar firms.

Question 19

What is a limitation of the Comparables Method?

Accepted Answer

It may not be suitable for valuing unprofitable firms, as many common valuation multiples rely on earnings or profitability metrics.

Question 20

What does the Price-to-Earnings (P/E) ratio measure?

Accepted Answer

The P/E ratio indicates how many dollars investors are willing to pay for every dollar of a company's earnings, calculated as $\frac{	ext{Price per share}}{	ext{EPS}}$ or $\frac{	ext{Market value of equity}}{	ext{Net income}}$.

Question 21

How is a target firm's value estimated using the P/E ratio?

Accepted Answer

You multiply the comparable company's P/E ratio by the target company's earnings per share (or total earnings for market value).

Question 22

When is the Price-to-Sales (P/S) ratio most useful?

Accepted Answer

The P/S ratio is particularly useful for valuing companies where earnings are negative or non-existent, as it does not require profitability.

Question 23

What is a drawback of using the Price-to-Sales (P/S) ratio?

Accepted Answer

Sales alone do not always reflect a company's profitability or efficiency, making it a less comprehensive measure of value compared to earnings-based multiples.

Question 24

What does the Price/EBITDA ratio measure?

Accepted Answer

It measures a company's valuation relative to its earnings before interest, taxes, depreciation, and amortization, often used for early-stage companies to assess operational cash flow.

Question 25

What is the 'Unpaid Salary Issue' in private firm valuation?

Accepted Answer

It occurs when a private firm owner doesn't take a formal salary, understating operating expenses and overstating earnings; appraisers add a hypothetical salary expense to correct this.

Question 26

What is a 'Liquidity Discount' in private firm valuation?

Accepted Answer

It's a reduction in the valuation of private firm shares because they are harder to sell quickly compared to liquid public shares, typically resulting in a 40-50% lower valuation.

Question 27

What is a 'Control Premium' in private firm valuation?

Accepted Answer

It's an additional amount paid to acquire a majority stake in a company, compensating existing shareholders for relinquishing control, typically 30-35% above the per-share value.

Question 28

How does the Replacement Cost approach apply to real estate appraisal?

Accepted Answer

It estimates a property's value by calculating the current cost to construct an identical property, including the structure and additional features like landscaping.

Question 29

How is the Comparables Approach used in real estate appraisal?

Accepted Answer

It relies on market data from recently sold similar properties ('comps') in the same area to estimate the subject property's value.

Question 30

What are 'comps' in real estate appraisal?

Accepted Answer

'Comps' are comparable houses that have recently sold in the same area, used as benchmarks in the Comparables Approach to estimate market value.

Question 31

Why are adjustments made in the real estate Comparables Approach?

Accepted Answer

Adjustments are made to account for differences between the subject property and the comparable homes, such as variations in square footage, features, or condition.

Question 32

What is the primary goal of the Replacement Cost Method?

Accepted Answer

To estimate a firm's value by determining the cost to build an identical business from scratch using current market prices for its components.

Question 33

What is the core assumption of the DCF method regarding asset value?

Accepted Answer

An asset's worth is equal to the present value of all the cash it is expected to generate in the future.

Question 34

What is the relationship between FCFF and WACC in DCF valuation?

Accepted Answer

FCFF represents the cash flow available to all capital providers, and WACC is the appropriate discount rate to use when valuing the entire firm based on FCFF.

Question 35

What is the relationship between FCFE and $k_e$ in DCF valuation?

Accepted Answer

FCFE represents the cash flow available only to equity holders, and $k_e$ (the cost of equity) is the appropriate discount rate to use when valuing the equity portion of the firm.

Question 36

What is the purpose of forecasting pro forma financial statements in DCF?

Accepted Answer

Pro forma statements help project future revenues, expenses, and investments to accurately calculate future free cash flows for the DCF model.

Question 37

What is the main difference between FCFF and FCFE?

Accepted Answer

FCFF is available to all capital providers (debt and equity), while FCFE is available only to equity holders after debt obligations are met.

Question 38

What is the main advantage of the Comparables Method over DCF?

Accepted Answer

The Comparables Method is simpler and more practical when detailed financial forecasts required for a DCF are difficult to obtain.

Question 39

Why is the P/S ratio useful for certain companies?

Accepted Answer

It is useful for valuing companies with negative or no earnings because it relies on sales, a metric that is typically positive even for unprofitable firms.

Question 40

How does the 'Unpaid Salary Issue' affect a private firm's reported earnings?

Accepted Answer

It makes reported earnings appear higher than they truly are because the owner's compensation is not recorded as an operating expense.

Question 41

What is the typical range for a 'Liquidity Discount' on private firm shares?

Accepted Answer

Private firm shares typically face a liquidity discount of 40-50% compared to their publicly traded counterparts.

Question 42

What is the typical range for a 'Control Premium'?

Accepted Answer

A control premium, paid for a majority stake, is typically 30-35% above the per-share value.

Question 43

What is the main similarity between firm valuation and real estate appraisal using the Comparables Method?

Accepted Answer

Both methods rely on comparing the subject asset (firm or property) to similar assets that have recent market transaction data to estimate value.

Question 44

What is the core idea of 'intrinsic value' in finance?

Accepted Answer

Intrinsic value represents the true, underlying worth of an asset, calculated based on its expected future cash flows and risk, independent of current market price.

Question 45

What does EBITDA stand for and why is it used in valuation?

Accepted Answer

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization; it's used in valuation multiples to provide a measure of operational cash flow before certain non-cash expenses and financing costs.