Chapter 4

Question 1

The income approach is the primary approach for what type of companies?

Answer 1

Operating companies

Question 2

What is the prevailing approach to using pre-tax or after-tax cash flows in the income approach?

Answer 2

After-tax to either equity or invested capital holders

Question 3

What is the principle of future benefits?

Answer 3

The value of a business or an interest in a business depends on the future economic benefits that will accrue to the owners, discounted back to the present at an appropriate risk-adjusted discount rate.

Question 4

What are the advantages of an income approach?

Answer 4

1) It values an enterprise based on its earnings or cash flow generating abilities. Therefore, there is a relationship between the value of the enterprise and the earnings/cash flows it produces.
2) It requires a simple mathematical application that is frequently performed more quickly relative to other approaches.
3) At times, it is the only approach that can be used to value intangible assets.
4) Financial markets frequently use the income approach in decision-making.

Question 5

What are disadvantages of an income approach?

Answer 5

1) Frequently difficult to determine the correct level of the sustainable benefits stream especially for smaller companies.
2) Extremely difficult to choose the correct cap or discount rates, requires judgment and can be difficult to defend on its own merits.

Question 6

Which is a principle underlying the income approach?

a. economic utility
b. future benefits
c. optimal benefits
d. non-efficient markets

Answer 6

Future benefits

Question 7

What are the two primary methods of the income approach?

Answer 7

DCF and CCF

Question 8

What is the definition of the DCF method?

Answer 8

Discounted cash flow:

1) a multiple period valuation model
2) that converts a future series of benefit streams into value by discounting them to present value at a rate of return that reflects the risk inherent in the benefit stream
3) used for erratic or unstable net cash flows
4) residual (terminal) value after stabilization
5) discounted by use of a required rate of return
- cost of equity capital when valuing equity
- WACC when valuing invested capital

Question 9

What is the definition of the CCF method?

Answer 9

Capitalized cash flow method:

1) a single period valuation model based on either prior historical periods or projected period which is representative of future performance
2) converts a benefit stream into value by dividing the benefit stream by a rate of return that is adjusted for growth
3) abridged version of DCF when the valuation analyst expects long-term, stable cash flows into perpetuity
4) used for stable net cash flows
5) discounted by use of a cap rate
- the capitalization rate is a derivative of the discount rate
- cap rate = discount rate - long-term growth rate

Question 10

Can the DCF method be used to value both direct equity and invested capital?

Answer 10

Yes

Question 11

Can the CCF method be used to value both direct equity and invested capital?

Answer 11

Yes

Question 12

Which earnings parameter is appropriate to use a WACC as a proxy for a discount rate in a DCF?

Answer 12

Cash flow to invested capital

Question 13

The DCF method is most often used when?

Answer 13

The company’s performance is not at a stabilized level.

Question 14

For which consideration is the use of the CCF and DCF methods not similar?

Answer 14

Number of periods used

Question 15

What are the two primary models for the income approach?

Answer 15

Direct equity valuation model and invested capital valuation model

Question 16

What is the direct equity valuation model?

Answer 16

• The net cash flow would be the amount available to common stockholders of the company
• Some experts regard this amount as the dividend paying capacity meaning the amount left over after the company reinvests in itself to continue operations while providing for growth

Question 17

What is the invested capital model?

Answer 17

• Valuing the enterprise on a debt-free basis so that the cash flow is to both the equity and interest-bearing debt holders. Adds back interest expenses, net of taxes, to the cash flow and does not consider changes in debt.
• Common equity value is obtained by subtracting the market value of interest bearing debt and preferred stock of the subject company

Question 18

What does the direct equity valuation model measure?

Answer 18

The value of common equity

Question 19

What does the invested capital model measure?

Answer 19

The value of common equity, preferred stock, and interest-bearing debt

Question 20

When is the direct equity valuation model used?

Answer 20

• Often used when valuing minority interests because a minority interest holder has no ability to influence capital structure
• Also used when valuing a controlling interest with an average amount of debt

Question 21

When is the invested capital model used?

Answer 21

• Often used when the capital structure is expected to change or when valuing control, especially when the enterprise has little to no debt, or too much debt, and an optimal amount of debt would enhance equity value

Question 22

What is the formula for direct equity for DCF?

Answer 22

Present Value = ∑(n) (net cash flow to equity for the period)/(1+discount rate for equity)

Question 23

What is the formula for invested capital for DCF?

Answer 23

Present Value = ∑(n) (net cash flow to invested capital for the period)/(1+WACC)

Question 24

What is the formula for direct equity for CCF?

Answer 24

Present Value = net cash flow to equity for the next period/(discount rate for equity - long-term expected sustainable growth rate of net cash flow into perpetuity)

Question 25

What is the formula for invested capital for CCF?

Answer 25

Present Value = net cash flow to invested capital for the next period/(WACC - long-term expected sustainable growth rate of net cash flow into perpetuity)

Question 26

If the subject company has preferred stock and the assignment is to value the common equity, what does the analyst do?

Answer 26

Subtract preferred stock dividends to obtain NCF available to debt and common equity holders
or
Consider an approach to directly subtract value of preferred equity similar to interest-bearing debt

Question 27

How long should the forecast period be?

Answer 27

At least a complete business cycle or a period until the long-term growth rate and the level of NCF are expected to stabilize

Question 28

What questions about net cash flow should be asked to determine potential adjustments?

Answer 28

1) Are the forecasts, profit margins, and growth rates similar to historical results? If not, explain.
2) Is the industry expected to perform in a similar manner?
3) How long are the economic cycles?
4) What was the subject company’s performance historically compared to the industry?
5) Any downturns or increases anticipated?
6) Are projected CAPEX and working capital in line with projected volume, revenue, and profits?
7) Have tax issues such as NOLs and AMT been addressed?
8) Has the net cash flow been adjusted for non-operating assets?
9) Have admin, financial, or managerial charges from related entities been reviewed? Does the forecast reflect expected charges?
10) Does forecasted depreciation and amortization expense reflect both historical and future CAPEX?

Question 29

How are interim period net cash flows treated?

Answer 29

Typically discrete. Discounted using either end-of-year or mid-year conventions.

Question 30

What are the three residual (terminal) value calculation methods?

Answer 30

1) Gordon growth model (capitalization of future net cash flows discounted based on risk-adjusted rate)
2) Exit multiples (price to earnings - P/E, invested capital to EBIT - MVIC/EBIT, others)
3) Liquidation or salvage value based on finite life

Question 31

What is the Gordon Growth Model formula for equity?

Answer 31

Direct equity DCF terminal value = (NCF to equity * (1+long-term growth rate))/(cost of equity - long-term growth rate)

Question 32

What is the Gordon Growth Model formula for invested capital?

Answer 32

Invested capital terminal value = (NCF to invested capital * (1+long-term growth rate)/(WACC - long-term growth rate)

Question 33

What discount factor period is used under the Gordon Growth Model?

Answer 33

The same discount factor period as the last period prior to the terminal period.

Question 34

Can the income approach be used to value controlling interests?

Answer 34

Yes, depending on the forecasted net cash flows used.

Question 35

Can the income approach be used to value minority interests?

Answer 35

Yes, depending on the forecasted net cash flows used.

Question 36

Where is lack of control or control embodied?

Answer 36

In net cash flows not the discount or cap rates

Question 37

What are four control adjustments to net cash flows?

Answer 37

1) Owner compensation
2) Perquisites
3) Capital structure
4) Fixed asset activity

Question 38

Are net cash flows that have been normalized for non-recurring expenses control or minority?

Answer 38

Either depending on whether adjustments for control prerogatives were made

Question 39

When conceived, what was the excess earnings method intended to value?

Answer 39

Only intangible assets

Question 40

What is the theory behind the excess earnings method?

Answer 40

Earnings in excess of the required (market) rate of return on the value of the net tangible assets is associated with the intangible assets of the business. A capitalization of the excess earnings method would result in the FMV of a company’s intangible assets.

Question 41

Why do some consider excess earnings method a hybrid method?

Answer 41

Because it incorporates a separate valuation of tangible assets and a capitalization of excess earnings.

Question 42

Under the excess earnings method, how many intangible assets are assumed?

Answer 42

One, no allocation to individual components.

Question 43

Where was the excess earnings method conceived?

Answer 43

Appeals and Review Memorandum 34 (ARM-34) from 1920 and updated in Revenue Ruling 68-609

Question 44

What are the steps in the excess earnings method?

Answer 44

1) Determine FMV of the net tangible assets
2) Develop normalized earnings or cash flows
3) Determine an appropriate return (WACC) for the net tangible assets
4) Determine the normalized earnings or cash flows attributable to the net tangible asset values
5) Subtract cash flows attributable to net tangible assets from total cash flows to arrive at excess earnings
6) Determine an appropriate rate of return for intangible assets
7) Determine the FMV of the intangible assets by capitalizing the earnings or cash flows by the appropriate rate of return for intangible assets
8) Add the FMV of the net tangible assets to the FMV of the intangible assets
9) Subtract any interest-bearing debt to arrive at a value conclusion for equity

Question 45

According to Revenue Ruling 68-609, when should the excess earnings method be used?

Answer 45

Only when no better method exists for the valuation of intangible assets which should be explained in the report

Question 46

When is the excess earnings method frequently used?

Answer 46

Smaller business enterprises such as professional practices and commonly used in many jurisdictions for divorce purposes

Question 47

When is the excess earnings method less appropriate?

Answer 47

Companies with small asset bases

Question 48

What revenue ruling deals with the calculation of the return on tangible assets and cap rates for intangibles under the excess earnings method?

Answer 48

Revenue Ruling 68-609

Question 49

What problems are associated with the excess earnings method?

Answer 49

1) Division of earnings between tangible and intangible (assumed to be easy)
2) Level of earnings (doesn’t indicate)
3) Standard and premise of value (doesn’t state whether FMV on a going concern premise or some other premise such as replacement cost new or replacement cost less allowance for depreciation or obsolescence)
4) Rate of return on tangible assets (no market observable rate, largely subjective)
5) Cap rate for excess earnings (no market observable rate, largely subjective)
6) Treatment of specific intangible assets (cannot be used to address value of a certain intangible assets)
7) Does not address liabilities associated with intangible assets

Question 50

What problems are associated with the excess earnings method?

Answer 50

1) Division of earnings between tangible and intangible (assumed to be easy)
2) Level of earnings (doesn’t indicate)
3) Standard and premise of value (doesn’t state whether FMV on a going concern premise or some other premise such as replacement cost new or replacement cost less allowance for depreciation or obsolescence)
4) Rate of return on tangible assets (no market observable rate, largely subjective)
5) Cap rate for excess earnings (no market observable rate, largely subjective)
6) Treatment of specific intangible assets (cannot be used to address value of a certain intangible assets)
7) Does not address liabilities associated with intangible assets

Question 51

If the excess earnings method is used to develop an indicated value for the enterprise, what value is reached?

Answer 51

Control marketable value, since it assumes the use of entire stream of earnings to determine the excess and the value is added to the entire net asset base

Question 52

Is the excess earnings method applicable to minority interests?

Answer 52

No, since the minority shareholder essentially holds a claim against the earnings of the business as opposed to the assets of the business

Question 53

Complete case study 4-1

Answer 53

1) c. 437,100 (does not include normalization of COO/CFO since that is an arms-length agreement and don’t forget to adjust taxes)
2) c. 497,860
3) b. 257,760 (no adjustments to projection, start with net income after taxes and take into account depreciation, debt in, principal payments, capex, and working capital)
4) a. 83,440 (net income after tax + tax affected interest (interest (1-tax rate)) + depreciation - working capital - capex)
5) b. 1,300,000 (don’t forget to grow cash flow by long-term growth rate)
6) a. 1,000,000 (round(1/((1+discount rate)^(number of years)),3)cash flow)

Question 54

Complete case study 4-2

Answer 54

1) d. CCF of CF to IC at the WACC less LT growth (because you are valuing control level and earnings are stabilized)
2) a. 2003-2005 (since future is supposed to similar to historical all three years should be considered)
3) d. 119,000 (officer compensation replaced with 150,000)
4) a. 40,000 (plus depreciation less capex less incremental working capital (10% of incremental revenues))
5) d. 1,373,333 (don’t forget to grow by one year)