CFA 2018 Quest bank 07 Private Company Valuation

Test ID: 7441484

Private Company Valuation

Question #1 of 50

Question ID: 463533

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Question #2 of 50

Question ID: 463552

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Question #3 of 50

Question ID: 463549

Which of the following is least likely an example of a litigation-related valuation for a private company?

Lost profits claims. Bankruptcy proceeding.

Divorce settlements.

Explanation

Litigation-related valuations may be required for shareholder suits, damage claims, lost profits claims, or divorce settlements.

A bankruptcy proceeding is an example of a transaction-related valuation for a private company.

Which of the following best describes projection risk in the estimation of the discount rate for private company valuations?

Management will always be overly optimistic to increase the acquisition price. Projection risk results in higher discount rates.

If the availability of information from private firms is poor, the uncertainty of projected

cash flows may increase.

Explanation

Projection risk refers to the risk of misestimating future cash flows. Given the lower availability of information from private firms,

the uncertainty of projected cash flows may increase.

However, management may not be experienced with projections and may underestimate or overestimatefutureprospects. The discount rate would then be decreased orincreased accordingly. So managementisnotalways overly optimistic and projection risk doesnotalways resultin higher discount rates.

Using thefollowing figures, calculatethevalue oftheequityusing the capitalized cash flow method (CCM), assuming thefirm will beacquired.

Normalized FCFE incurrentyear $3,000,000 Reported FCFEincurrentyear $2,400,000

Growthrateof FCFE 7.0%

Equitydiscountrate 16.0%

WACC 13.0%

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Question #4 of 50

Question ID: 463577

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Question #5 of 50

Question ID: 463528

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Costofdebt 10.5%

Marketvalueofdebt $3,000,000

Thevalue oftheequityis:

$28,533,333. $32,666,667. $35,666,667.

Explanation

To arriveatthevalue oftheequityusing theCCM, it can beestimated using thefree cash flowsto equityand the required return onequity (r):

Notethat we grow theFCFE atthe growth rate becausethecurrentyear FCFE isprovided intheproblem (notnextyear"s FCFE). Weusenormalized earnings, not reported earnings, giventhatnormalized earningsaremost relevantfor the acquirers ofthefirm.The relevant required returnfor FCFE istheequity discount rate, notthe WACC.

Analternativeapproach to calculatethevalue oftheequity would beto subtractthemarketvalue ofthefirm"s debtfromtotal firmvalue. However, theFCFFarenotprovided so atotalfirmvalue cannot be calculated.

Which ofthefollowing best describestheimplementation ofprivate companyvaluationstandards?

The federal government mandates compliance. Complianceisusuallyatthe discretion oftheappraiser. Industry groupsmandate compliance.

Explanation

One ofthe challengesinvolved with theimplementation ofappraisalstandardsisthat complianceisusuallyatthe discretion of theappraiser becausemost buyersarestillunaware oftheir existence.

Ananalystisexamining three companies. Giventheinformation below, which ofthemis mostlikelyto beaprivatefirm?

Firm Numberof Yearsin

Operation

Market

Capitalization

Required ReturnforCommon Stock

A 12years $1,324.8million 14.8%

B 4years $1,313.9 million 18.3%

C 19 years $2,231.0million 16.4%

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Question ID: 463578

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Question ID: 463560

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Question #8 of 50

Question ID: 463532

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FirmC.

FirmB.

Explanation

Thefirmmostlikelyto beaprivatefirmisFirmB.Compared to public firms, privatefirmsarelessmature (4yearsfor FirmB), smaller (market cap ofBis $1,313.9 million), and have higher required returns (required returnfor Bis18.3%).

Which ofthefollowing best describesthe guidance ontheuse ofprivate companyvaluationstandardsprovided byappraisal organizations?

Technical guidance on the use of standards is widespread, as it is provided by both industry and consumer groups.

Guidance ontheuse ofstandardsisnotprovided.

Guidance ontheuse ofstandardsisnecessarilylimited dueto the heterogeneity of valuations.

Explanation

One ofthe challengesinvolved with theimplementation ofappraisalstandardsisthatalthough the organizationsprovide technical guidance ontheuse oftheir standards, itisnecessarilylimited dueto the heterogeneity ofvaluations.

Ananalystvaluesaprivatefirm byusing pricemultiplesfromthesale of whole companies, with adjustmentsfor risk differences. Which ofthefollowing best describesthevaluationmethod thattheanalystisusing?

The prior transaction method. The guidelinepublic companymethod. The guidelinetransactionsmethod.

Explanation

The guidelinetransactionsmethod (GTM) generatesavalueestimate based onpricing multiplesassociated with the acquisition of control ofentire companies.The guidelinepublic companymethod (GPCM) generatesanestimate ofvalue based onthemultiplesfromtrading activityintheshares ofpublic companiesthataresimilar to theprivate companyin question.Theprior transactionmethod (PTM)usesactualtransactionsinthestock ofthesubjectprivate company.

Which ofthefollowing isleastlikelyanexample ofatransaction-related valuationfor aprivate company?

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Question #

9

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Question ID: 472547

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Financial reporting.

Explanation

Venture capitalfinancing, initialpublic offering (IPO), bankruptcyproceeding, performance-based managerial compensation, and saleinanacquisitionareallexamples oftransaction-related valuationsfor aprivate company.

Using thefollowing figures, calculatethevalue ofthefirmusing theexcessearningsmethod (EEM).

Workingcapital $600,000

Fixedassets $2,300,000

Normalizedearnings $340,000

Requiredreturnforworkingcapital 5%

Requiredreturnforfixedassets 13%

Growthrateofresidualincome 4%

Discountrateforintangibleassets 18%

$3,073,199. $2,981,714. $3,027,111.

Explanation

Theanswer is calculated using thefollowing steps.

Step1:Calculatetherequiredreturnforworkingcapitalandfixedassets. Giventhe required returnsinpercent, themonetary returnsare:

Working Capital: $600,000 × 5% = $30,000. Fixed Assets: $2,300,000 × 13% = $299,000. Step2:Calculatetheresidualincome.

After themonetary returnsto assetsare calculated, the residualincomeisthat which isleft over inthenormalized earnings: ResidualIncome = $340,000 − $30,000 − $299,000 = $11,000.

Step3:Valuetheintangibleassets.

Using theformulafor a growing perpetuity, the discount ratefor intangibleassets, and the growth ratefor residualincome: Value ofIntangibleAssets = ($11,000 × 1.04) / (0.18 − 0.04) = $81,714.

Question #10 of 50

Question ID: 463548

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Question #11 of 50

Question ID: 463538

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Question #12 of 50

Question ID: 463559

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The capitalized cash flow method (CCM)used inprivatefirmvaluationis mostappropriate when:

stable growth is expected.

therearemanyintangibleassetsto value. earningsare growing quicklyinaninitialperiod.

Explanation

TheCCMisa growing perpetuitymodelthatassumesstable growth and isineffectasingle-stagefree cash flow model.Itmay besuitable whenno comparables or projectionsareavailableand whenstable growth isexpected.Theexcessearnings method (EEM)isuseful whenthereareintangibleassetsto value.Thefree cash flow method assumes high growth inaninitial period followed by constant growth thereafter.

Ananalystusesinvestmentanalysisinanattemptto determinethe "true" value ofasecurity, independent ofanyshort-term mispricing.Thisestimate ofassetvalueisbest defined as:

Intrinsic value Investmentvalue

Fair marketvalue

Explanation

Intrinsic valueisthe "true" value derived frominvestmentanalysis.Fair marketvalueisused for tax purposesinthe United Statesand based onanarm'slength transaction.Investmentvalue, in contrastto theprevious definitionsthat weremarket based, isthevalueto aparticular buyer. (Study Session10, LOS 30.a)

Ananalystisvaluing aprivatefirm onthe behalf ofastrategic buyer and deflatestheaveragepublic companymultiple by15% to accountfor the higher risk oftheprivatefirm. Giventhefollowing figures, calculatethevalue offirmequityusing the

guidelinepublic companymethod (GPCM).

Marketvalueofdebt $4,100,000

NormalizedEBITDA $42,800,000

AverageMVIC/EBITDA multiple 8.5

Controlpremium from pasttransaction 25% Thevalue ofthefirm'sequityisclosestto:

$304,060,000. $382,438,000. $381,412,500.

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Question ID: 463544

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Question #15 of 50

Question ID: 463529

Theadjustmentto theMVIC/EBITDAmultiplefor the higher risk oftheprivatefirmis:8.5 × (1 − 0.15) = 7.225. Giventhatthe buyer isastrategic buyer, a controlpremiumadjustmentshould bemade onthevalue ofequity.

MVIC = 7.225 × $42,800,000 = $309,230,000.

Subtracting outthe debt resultsintheequityvalue (before controlpremium): $309,230,000 − $4,100,000 = $305,130,000. Equityvalueafter applying controlpremium = 305,130,000(1.25) = 381,412,500

Assumethatapropertythatyouareevaluating hasa grossannualincomeequalto $230,000, and that comparableproperties areselling for 10.5times grossincome.The grossincomemultiplier approach providesamarketvaluefor thispropertythatis closestto:

$2,587,500. $2,190,476. $2,415,000.

Explanation

Grossincomemultiplier technique:MV = grossincome × incomemultiplier. MV = $230,000 × 10.5 = $2,415,000

Ananalystisvaluing asmallprivatefirmthatisstill developing and hasyetto generateanyearnings. Which ofthefollowing best describestheapproach thatshould beused?

Nonoperating assets are not crucial to the firm and should be excluded in any valuation.

Amarketapproach based onpublic comparables would beutilized. Anasset-based approach would beused.

Explanation

Thevaluationapproach used will depend onthefirm's operationsand itslifecyclestage. Earlyinitslife, afirm'sfuture cash flowsmay beso uncertainthatanasset-based approach would beselected.Thepricemultiplesfromlargepublic firmsshould not beused for asmallprivatefirm whenusing themarketapproach.Although afirm'snonoperating assetsarenot crucialto thefirm, theyshould beincluded inanyvaluation.

Ananalystisexamining thestock ofthree companies. Giventheinformation below, which ofthemis mostlikelyto bethestock ofaprivatefirm?

Question #17 of 50

Question ID: 463576

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Question #18 of 50

Question ID: 463553

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Question #1

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Question ID: 463547

ofequity:

[20% × 11% × (1-30%)] + [(1-20%) × 18.5%] = 16.3%.

Which ofthefollowing best describestheimplementation ofprivate companyvaluationstandards?

Because most valuation reports are private, it is very difficult for appraisal organizations to ensure compliance to standards.

Appraisersare required to periodicallysubmittheir reportsfor review bythelocal appraisal board.

Appraisersvoluntarilyand periodicallysubmittheir reportsfor review bythelocal appraisal board.

Explanation

One ofthe challengesinvolved with theimplementation ofappraisalstandardsisthat becausemostvaluation reportsare private, itisvery difficultfor the organizationsto ensure complianceto thestandards.

Which ofthefollowing best describes how debtisincorporated into theestimation ofthe discount ratefor private company valuations, relativeto thatfor public firms? In general, the cost of debt:

is higher for private firms and debt capacity is the same for both private and public firms.

is higher for privatefirmsand debt capacityislower for privatefirms. and debt capacityisthesamefor both privateand public firms.

Explanation

Aprivatefirmmaynot beableto obtainasmuch debtfinancing asapublic firm.Thesmallsize ofprivatefirmsmay resultin higher operating riskand a higher cost of debt.

Giventhefollowing figures, calculatetheFCFF.Assumetheearningsand expensesarenormalized and that capital expenditures will cover depreciationplus 3 percent ofthefirm'sincremental revenues.

Current Revenues $30,000,000

Revenuegrowth 6%

Grossprofitmargin 20%

Depreciationexpenseasapercentofsales 1%

Workingcapitalasapercentofsales 15%

Question #20 of 50

Question ID: 463565

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Question #21 of 50

Question ID: 463558

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FCFF Operating incomenetoftheadjustmentsabove

Ananalyst calculatesa controlpremium of15% and discountfor lack ofmarketability (DLOM) of20%. Which ofthefollowing is closestto thetotal discountfor valuing minorityequityinterestsintheprivatefirm?

35.7%. 30.4%. 35.0%.

Explanation

The discountfor lack of control (DLOC) can be backed out ofthe controlpremium.

Thetotal discountalso usestheDLOM. TotalDiscount = 1 − [(1 − DLOC)(1 − DLOM)] TotalDiscount = 1 − [(1 − 0.1304)(1 − 0.20)] = 30.4%

Aprivatepharmaceuticalfirmisunder considerationfor acquisition wherethefinancial buyer willpay with equity.Part ofthe paymentto thesellersis based onFDAapproval ofthefirm's drug.Iftheanalystusesamarketapproach and comparable datafrompublic firms, which ofthefollowing would mostlikely resultinaprice-multiplethatistoo high? The comparable data is:

from transactions where the buyer used cash.

for transactions wherethe consideration wasnon-contingent. for strategic buyers.

Explanation

Inmarketapproaches, theanalystvaluesthesubjectprivatefirmusing pricemultiplesfrompreviouspublic and private transactions.Astrategic buyer is one who will havesynergies with thetarget whereasafinancial buyer doesnot.Afinancial transactiontypically hasasmaller pricepremium. So inthis case, the comparableprice-multiple will betoo high.

Iftheacquisitioninvolvestheacquirer'sstock, theacquirer may beusing overvalued sharesto buytheir target. Using comparables where cash isthe consideration would resultinlower pricemultiples.

Question #22 of 50

Question ID: 463539

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Question #24 of 50

Question ID: 463566

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Anappraiser must determinethevalue ofanassetfor tax purposes. Which ofthefollowing isthe mostlikelystandard ofvalue theappraiser willuse?

Fair value for financial reporting. Marketvalue.

Fair marketvalue.

Explanation

Fair marketvalueisused for tax purposesinthe U.S.and based onanarm'slength transaction.Though similar to fair market value, fair valuefor financial reporting isused for financialnottax reporting.Marketvalueisused in realestateand other real assetappraisals.

Ananalystvaluesaprivate companyusing apricemultiple based on recentsales of comparableassets.Thisapproach to private companyvaluationisbest described asthe:

market approach asset-based approach incomeapproach

Explanation

Under themarketapproach, afirmisvalued using pricemultiples based on recentsales of comparableassets. Under the incomeapproach, afirmisvalued according to thepresentvalue ofitsexpected futureincome. Under theasset-based approach, thevalue ofafirmis calculated asthefirm'sassetsminusitsliabilities. (Study Session12, LOS 43.d)

Which ofthefollowing best describestheestimation of discountsfor lack ofmarketability (DLOM)inprivate company valuations? Theprimaryadvantage ofusing putpricesto estimatetheDLOM over the other two methodsis:

exchange traded put prices are readily available.

theBlack-Scholesmodel has beenshownto bevalid for privatefirms. thevolatility ofthefirm can beincorporated into theanalysis.

Explanation

Question #28 of 50

Question ID: 463564

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Question ID: 463563

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The guidelinepublic companymethod (GPCM)approach to private companyvaluationusespricemultiplesfromtraded public companies with adjustmentsfor risk differences.The guidelinetransactionsmethod (GTM)usesthepricemultiplesfromthe sale of wholepublic and private companies, again with adjustmentsfor risk differences.Theprior transactionmethod (PTM) uses historicalstocksales ofthesubject company; it works best whenusing recent, arm's-length data ofthesamemotivation. (Study Session12, LOS 43.i)

When would theasset-based approach resultina higher valuationthanits going concernvalue, inthe case ofprivate companyvaluation?

If the firm has minimal profits and poor prospects. Whenvaluing pharmaceuticalfirms.

Whenvaluing biotech firms.

Explanation

Ifafirm hasminimalprofitsand little hopefor better prospects; itmight bevalued more highlyfor itsliquidationvaluethanasa going concernifanother firm canputtheassetsto better use.Becausetheasset-based approach valuesfirmequityasthe fair value ofitsassetsminusthefair value ofitsliabilities, it would capturethisliquidationvalue.

Pharmaceuticaland biotech firms havea high degree ofintangibleassets.Inthese cases, the going concernvalueislikelyto be higher thanthevaluefromtheasset-based approach.

Which ofthefollowing approachesto private companyvaluationuses discounted cash flow analysis?

The income approach. Themarketapproach. Theasset-based approach.

Explanation

Theincomeapproach valuesafirmasthepresentvalue ofitsfutureincome.Theasset-based approach valuesafirmasits assetsminusliabilities.Themarketapproach valuesafirmusing theprice-multiplesfromthesales of comparableassets.

Theasset-based approach valuesafirm based on:

fair values. investmentvalues.

bookvalues.

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Question ID: 463551

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Question ID: 463567

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Question ID: 463546

Theasset-based approach valuesfirmequityasthefair value ofitsassetsminusthefair value ofitsliabilities.

Which ofthefollowing best describestheuse ofsizepremiums whenestimating the discount ratefor private company valuations?

A size premium is subtracted when calculating the discount rate. Thetreatmentissimilar to thatfor public firms.

Whenusing datafrom comparablepublic firms, a distresspremiummay be inadvertentlyadded in.

Explanation

For private companyvaluations, asizepremiumis oftenadded in when calculating the discount rate.Thisisnottypically done for public firms.To getthesizepremium, theappraiser mayuse datafromthesmallest capsegment ofpublic equity.This however mayincludea distresspremiumthatisnotapplicableto theprivatefirm.

Assumeaminorityshareholder holds10% ofaprivatefirm'sequity, with theCEO holding the other 90%. Using normalized earnings, thevalue ofthefirm'sequityisestimated at $20million.TheCEO refusesto sellthefirmand theminority

shareholder cannotselltheir interesteasily.A discountfor lack ofmarketability (DLOM) of15% will beapplied.A discountfor lack of control (DLOC) willalso beestimated. Using reported earningsinstead ofnormalized earningsprovidesanestimated firmequityvalue of $19 million. Which ofthefollowing isclosestto thevalue oftheminorityshareholder'sequityinterest?

$1,900,000. $1,700,000. $1,615,000.

Explanation

Giventhesefigures, thevalue oftheminorityshareholder'sequityinterestis:

Firm'sequityvalue $19,000,000 Minorityinterest 10%

Valueofminorityinterestwithoutdiscounts $1,900,000

minusDLOCof0% 0

Valueofinterestifmarketable $1,900,000

minusDLOMof15% $285,000

Valueofminorityinterest $1,615,000

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Question ID: 463531

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Question ID: 463545

ReportedEBITDA $4,500,000

CurrentExecutiveCompensation $700,000

Market-BasedExecutiveCompensation $620,000

CurrentSG&Aexpenses $6,300,000

SG&Aexpensesaftersynergisticsavings $5,600,000

CurrentLease Rate $300,000

Market-BasedLease Rate $390,000

Thenormalized EBITDAfor each type of buyer is: FinancialBuyerStrategic Buyer

$4,190,000 $4,890,000 $4,490,000 $5,190,000 $4,670,000 $5,370,000

Explanation

Both strategic and financial buyers willattemptto reduceexecutive compensationto marketlevels by $80,000 ($700,000 − $620,000).They willalso haveto paya higher lease rate of $90,000 ($390,000 − $300,000). So theadjustmentfor both buyersto generatenormalized EBITDAis $4,500,000 + $80,000 − $90,000 = $4,490,000.

However, onlyastrategic buyer will beableto realizesynergistic savings of $700,000 ($6,300,000 − $5,600,000). So normalized EBITDAfor astrategic buyer is $5,190,000and for afinancial buyer itis $4,490,000.

Aprivate businessis being valued for thepurpose of determining theappropriatelevel ofperformance-based managerial compensation.Thisprivate companyvaluation would bebest described asa:

Litigation-related valuation Compliance-related valuation Transaction-related valuation

Explanation

Transaction-related valuationsmay beperformed for reasons related to venture capitalfinancing, anIPO, asale ofthefirm, bankruptcy, or performance-based managerial compensation.Compliance-related valuationsareperformed for financial reporting and tax purposes.Litigation-related valuationsmay be required for shareholder suits, damage claims, lostprofits, or divorces. (Study Session12, LOS 43.b)

ᅞ A) adhere to government-authorized valuation standards.

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Question ID: 463554

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Question #40 of 50

Question ID: 463569

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Which ofthefollowing definitions ofvalue refersto thevalue ofanasset givena hypothetically completeunderstanding ofthe asset'sinvestment characteristics?

Fair value. Intrinsic value. Investmentvalue.

Explanation

Intrinsic valueis derived frominvestmentanalysisand isthe "true" valueindependent ofshort-termmispricing thatmay occur. Fair valueisa conceptused infinancial reporting or litigationmatters.Investmentvalueisthevalueto aparticular buyer.

Which ofthefollowing statements related to themodelsused to estimatethe required rate of returnto private companyequity is mostaccurate:

The build-up method begins withbetas for comparable public firms and adds risk premiums.

Theexpanded CAPMmodeladdspremiumsfor sizeand firm-specific risk. TheCAPMmodeluses betasestimated fromfirm returns of other privatefirms.

Explanation

Expanded CAPMaddspremiumsfor sizeand firm-specific risk.CAPMmaynot beappropriatefor privatefirms because beta isusuallyestimated frompublic firm returns.The build-upmethod addsanindustry riskand other riskpremiumsto market rate of return; itisused when betasfor comparablepublic firmsarenotavailable. (Study Session12, LOS 43.h)

Paul Smith isananalystperforming valuationsfor Lumber Limited. Smith has been givenaprojectto valueTimber Industries, afirmthatLumber Limited is considering acquiring. Smith isawarethatanumber of characteristics distinguish privateand public companies, and thatthese characteristicsmust be considered during hisprocess ofvaluing Timber Industries.A number ofissues complicate Smith'svaluation:Timber IndustriespaysitsCEO well below amarket-based compensation figure, leasesa warehouseatanabove-market rate, and ownsavacant office building thatisnotneeded for core operations. Smith isalso awarethat discountsand premiums based on controland marketabilitymust be considered in hisvaluation of Timber Industries.

Compared to apublic company, itis mostlikelythatasaprivate companyTimber Industries will have greater: focus on the short-term.

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Question ID: 463557

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Question ID: 463542

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Question #48 of 50

Question ID: 463534

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Which ofthefollowing best describesthe build-upmethod used for theestimation ofthe discount rateinprivate company valuations?

It is useful when there are no comparable public firms.

Anindustry riskpremiumisnotincluded becauseitis captured intheequity risk premium.

Becauseitisnotused inthe calculation, betaisassumed to be zero.

Explanation

Ifitisnotpossibleto find comparablepublic firms with which to estimate beta by, the build-upmethod can beused for a privatefirm.Itissimilar to theexpanded CAPMexceptthat betaisnotused.Implicitly, betaisassumed to be one.Both industry riskpremiumsand equity riskpremiumsareused.The risk-free rate, theequity riskpremium, thesmallstock premium, a company-specific riskpremium, and anindustry riskpremiumareadded together inthe build-upmethod.

Ananalystisvaluing afirm'sequityusing theprice-to-book-value ratio ofsimilar firms. Which ofthefollowing isthe mostlikely valuationapproach theanalyst willuse?

The income approach. Themarketapproach. Theasset-based approach.

Explanation

Themarketapproach valuesafirmusing theprice-multiplessuch astheprice-to-book-value ratio and price-earnings ratio of comparableassets.Theincomeapproach valuesafirmasthepresentvalue ofitsfutureincome.Theasset-based approach valuesafirmasitsassetsminusliabilities.

Which ofthefollowing isleastlikelyanexample ofa compliance-related valuationfor aprivate company?

Bankruptcy proceeding. Tax purposes.

Financial reporting.

Explanation

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Question ID: 463535

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Question #50 of 50

Question ID: 463555

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Assumethataproperty hasa grossannualincomeequalto $150,000, and that comparableproperties havea grossincome multiplier equalto 11.25.The grossincomemultiplier approach providesamarketvaluefor thispropertythatisclosestto:

$1,687,500. $1,333,333. $1,625,000.

Explanation

Grossincomemultiplier technique:MV = grossincome × incomemultiplier. MV = $150,000 × 11.25 = $1,687,500

Using thefollowing information, calculatethe required return onequityusing theexpanded CAPM.

Incomereturnonbonds 6.0%

Capitalreturnonbonds 2.0%

Long-term Treasuryyield 3.5%

Beta 1.4

Equityrisk premium 6.0%

Smallstock premium 4.0%

Company-specificrisk premium 3.0% Industryrisk-premium 2.0%

Pretaxcostofdebt 11.0%

OptimalDebt/TotalCap 16%

CurrentDebt/Total 7%

Debt/TotalCapforpublicfirmsinindustry 33%

Tax Rate 30%

15.9%. 18.9%. 11.9%.

Explanation

The required return onequityusing theCAPMis: 3.5% + 1.4(6%) = 11.9%.

Notethatthe risk-free rateistheTreasuryyield, notthe returnsfor bondsin general.