Introduction to Cost of Capital Applications: Valuation and Project Selection
www.investment-guild.com
Menu
This article is part of eBook. Please use the link at bottom to jump to the rest of the eBook...
Section Two: Answers
Multiple Choice Questions
1. d
2. d. A very common error is to use the acquiring company's cost of capital to evaluate a potential acquisition that is riskier than the acquirer. This adds to the risk of the acquirer, resulting in a reduction of its stock price.
3. c
4. d
5. b
6. c
7. c
8. d
9. a
True or Faise Questions
10. True
11. True
12. False, The excess earnings method is based on required returns to categories of assets rather than on required returns to categories of capital.
13. False. It is a common error for analysts to set capital expenditures equal to depreciation in the terminal year. But if a company is expected to grow, capital expenditures should be expected to exceed depreciation. This error leads to an overstatement of expected cash flows and, therefore, an overvaluation of the company.
14. False. The capital structure components should be weighted on the basis of their respective market values, not their book values,
15. True
Multiple Choice Questions
1. c
2. a
3. a
True or False Questions
4. False. The U.S. Tax Court has accepied Lhe small stock preiiiium in many cases in which the expert gave evidence that the size of the company warranted such a premium.
5. False. The U.S. Tax Court has addressed the issue of beta in several cases.
6. False. The bankruptcy court interest rate awards have tended to be at lhe rate that the creditor would charge on loans with similar characteristics.
7. False. Bankruptcy courts frequently have accepted the discounted cash flow method for valuing a company.
8. true
9. True
10. Tine
11. True. Where experts convince the court that the financial commimitv would value the company by the discounted cash flow method, judges have accepted that method.
12. False, Courts have included the cost of capital in damages awards.
Multiple Choice Questions
1. b
2. b
True or Faise Questions
3. True
4. False. The EVA bonus plan ties bonuses to improvements in EVA.
Fill-in-the-Blank Questions
5. a. Increase (he return from existing assets.
b. Invest additional capital so long as the return earned exceeds the cost of the new capiliil.
c. Release capital from activities that earn less than their cost of capital.
6. a. A cash bonus plan that simulates ownership,
b. A leveraged stock option (LSO) that makes ownership real.
Exercise
7. 0.20 XS100 million = $20 million
0.12 x S100 million = -$12 million
Economic Value Added $8 million
1. a
2. b
3. d
FtH-in-the-BSank Questions
4. The Standard & Poor's Corporate Value Consulting (S&P CVC) Risk Premium Report is available online at Ihhotson's Cost of Capital Center,
5. blectronic Data, Gathering Analysis Retrieval. bDGAR is the electronic database of SBC-filings: 10-Ks, 10-Qs, 8-Ks, and other public company information.
6. Jbbotson Associates' Slocks, Bonds, Bills, and Inflation®, cither Classic Edition or Valuation Edition Yearbooks,
7. Ibbotsoms Associates1 Cost of Capital Yearbook
8. a. CompuServe
b. Ihhotson Associates1 Beta Book
c. Ibbotson Associates' Cost of Capital Center
d. Merrill Lynch Capital Markets
c. Standard & Poor's COMPUSTAT
f. Standard & Poor's Slock Reports
g. Tradeline
h. Value Line Investment Survey
9. a. Value line investment Survey
b. Thompson Financial's First Call and l/B/F/S
c. Standard and Poor's ACb (Analysts' Consensus Bstimates)
d. Zack's Earnings Forecaster
10. The Partnership Spectrum (published by Partnership Profiles, Inc.)
The second edition of the International Glossary of Business Valuation Terms is now out. It contains definitions of '38 additional lerms (not in the original edition and denoted here by an asterisk). Definitions of only two terms are changes from the original edition, and the changes are only to clarify the wording, not changing the meaning. The glossary is a joint effort of the American Institute of Certified Public Accountants, the American Society of Appraisers, the Canadian Institute of Chartered Business Valuators, the National Association of Certified Valuation Analysts, and the Institute of Business Appraisers.
- -Shannon Pratt
To enhance and sustain the quality of business valuations for Hie benefit of the profession
and its clientele, the below idcnUfied societies and organizations have adopted the definitions for the terms included in this glossary.
The performance of business valuation services requires a high degree of skill and imposes upon the valuation professional a duty to communicate the valuation process and conclusion, in a manner that is clear and not misleading. This duty is advanced throughtheuseof terms whose meanings are clearly established and consistently applied throughout the profession.
If, in the opinion of the business valuation professional, one or more of these terms needs to be used in a manner that materially departs from the enclosed definitions, it is recommended that the term be defined as used within that valuation engagement.
This glossary has been developed to provide guidance to business valuation practitioners by further memorializing the body of knowledge that constitutes the competent and careful determination of value and, more particularly, the communication of how that value was determined.
Departure from this glossary is not intended to provide a basis for civil liability and should not be presumed to create evidence that any duty has been breached.
* Adjusted Book Value Method A method within the asset approach wiiereby all assets and liabilities (including off-balance sheet, intangible, and contingent) are adjusted to their fair market values [NOTE: In Canada on a going concern basis, *Adjlisted Net Asset Method See Adjusted Book Value Method.
Appraisal See Valuation.
Appraisal Approach See Valuation Approach.
Appraisal Date See Valuation Date.
Appraisa! Method See Valuation Method.
Appraisal Procedure See Valuation Procedure.
* Arbitrage Pricing Theory A multivariate model for estimating the cost of equity capital, which incorporates several systematic risk factors.
Asset (Asset-Based) Approach A general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on (he value of the assets net of liabilities.
This article is part of eBook. To read the rest of the eBook (full version) please look at: capital investment
Section Two: Answers
Part 1 Cost of Capital Basses
Introduction to Cost of Capital Applications: Valuation and Project Selection
1. a. Some use net income, but Ibbotson rate of return data are sped fically matched to net cash flow.
2. c
3. b. If return to equily is being discounted, the rate would be the equity discount rate, if return to the overall capital structure is being discounted, the rate would be the weighted average cost of capital.
4. True
5. True
6. Free cas
7. Capitalization rate
8. PV =
Interest at end of year 1
$70 (1 + 0.10) $70 (U0) $63.64 $907.00
Interest at end of year 2
$70 (1 + 0.10)' $70 (L21) $57.85
Interest at end of year 3
$70 (1 + 0.10)3 $70 033) $52.63
Interest at end of year 4
$1070 (1 + 0.10)4 $1070 (1-46) $732.88
Alternatively, this may be computed by factors times dollars to be received:
Factor for year 1:1/1.10 = 1A909 = 0.909 Factor for year 2: 1/(1.10)2 = 1/1-21 = 0.826 Factor for year 3: 1/(1.1.0)3 = 1/133 = 0.752 Factor for year 4: 1/(1.10)4 = 1/1.46 = 0.685
Year 1: 0.909 x $70 = $63.63 Year 2: 0.826 x $70 = 57.82 Year 3: 0.752 x $70 = 52.64 Year 4: 0.685 x $1070 = $732.95 $907.04 (Differences are due to rounding.)
9. The company's embedded cost of capital for this bond is 7%. That is what they actually will pay over the life of the bond.
10. The company's market cost of capital for tills bond is 10%. That is what they would have to pay if they were to issue comparable bonds at the valuation date.
ANSWERSMultiple Choice Questions
1. d
2. d. A very common error is to use the acquiring company's cost of capital to evaluate a potential acquisition that is riskier than the acquirer. This adds to the risk of the acquirer, resulting in a reduction of its stock price.
3. c
4. d
5. b
6. c
7. c
8. d
9. a
True or Faise Questions
10. True
11. True
12. False, The excess earnings method is based on required returns to categories of assets rather than on required returns to categories of capital.
13. False. It is a common error for analysts to set capital expenditures equal to depreciation in the terminal year. But if a company is expected to grow, capital expenditures should be expected to exceed depreciation. This error leads to an overstatement of expected cash flows and, therefore, an overvaluation of the company.
14. False. The capital structure components should be weighted on the basis of their respective market values, not their book values,
15. True
Multiple Choice Questions
1. c
2. a
3. a
True or False Questions
4. False. The U.S. Tax Court has accepied Lhe small stock preiiiium in many cases in which the expert gave evidence that the size of the company warranted such a premium.
5. False. The U.S. Tax Court has addressed the issue of beta in several cases.
6. False. The bankruptcy court interest rate awards have tended to be at lhe rate that the creditor would charge on loans with similar characteristics.
7. False. Bankruptcy courts frequently have accepted the discounted cash flow method for valuing a company.
8. true
9. True
10. Tine
11. True. Where experts convince the court that the financial commimitv would value the company by the discounted cash flow method, judges have accepted that method.
12. False, Courts have included the cost of capital in damages awards.
Multiple Choice Questions
1. b
2. b
True or Faise Questions
3. True
4. False. The EVA bonus plan ties bonuses to improvements in EVA.
Fill-in-the-Blank Questions
5. a. Increase (he return from existing assets.
b. Invest additional capital so long as the return earned exceeds the cost of the new capiliil.
c. Release capital from activities that earn less than their cost of capital.
6. a. A cash bonus plan that simulates ownership,
b. A leveraged stock option (LSO) that makes ownership real.
Exercise
7. 0.20 XS100 million = $20 million
0.12 x S100 million = -$12 million
Economic Value Added $8 million
1. a
2. b
3. d
FtH-in-the-BSank Questions
4. The Standard & Poor's Corporate Value Consulting (S&P CVC) Risk Premium Report is available online at Ihhotson's Cost of Capital Center,
5. blectronic Data, Gathering Analysis Retrieval. bDGAR is the electronic database of SBC-filings: 10-Ks, 10-Qs, 8-Ks, and other public company information.
6. Jbbotson Associates' Slocks, Bonds, Bills, and Inflation®, cither Classic Edition or Valuation Edition Yearbooks,
7. Ibbotsoms Associates1 Cost of Capital Yearbook
8. a. CompuServe
b. Ihhotson Associates1 Beta Book
c. Ibbotson Associates' Cost of Capital Center
d. Merrill Lynch Capital Markets
c. Standard & Poor's COMPUSTAT
f. Standard & Poor's Slock Reports
g. Tradeline
h. Value Line Investment Survey
9. a. Value line investment Survey
b. Thompson Financial's First Call and l/B/F/S
c. Standard and Poor's ACb (Analysts' Consensus Bstimates)
d. Zack's Earnings Forecaster
10. The Partnership Spectrum (published by Partnership Profiles, Inc.)
The second edition of the International Glossary of Business Valuation Terms is now out. It contains definitions of '38 additional lerms (not in the original edition and denoted here by an asterisk). Definitions of only two terms are changes from the original edition, and the changes are only to clarify the wording, not changing the meaning. The glossary is a joint effort of the American Institute of Certified Public Accountants, the American Society of Appraisers, the Canadian Institute of Chartered Business Valuators, the National Association of Certified Valuation Analysts, and the Institute of Business Appraisers.
- -Shannon Pratt
To enhance and sustain the quality of business valuations for Hie benefit of the profession
and its clientele, the below idcnUfied societies and organizations have adopted the definitions for the terms included in this glossary.
The performance of business valuation services requires a high degree of skill and imposes upon the valuation professional a duty to communicate the valuation process and conclusion, in a manner that is clear and not misleading. This duty is advanced throughtheuseof terms whose meanings are clearly established and consistently applied throughout the profession.
If, in the opinion of the business valuation professional, one or more of these terms needs to be used in a manner that materially departs from the enclosed definitions, it is recommended that the term be defined as used within that valuation engagement.
This glossary has been developed to provide guidance to business valuation practitioners by further memorializing the body of knowledge that constitutes the competent and careful determination of value and, more particularly, the communication of how that value was determined.
Departure from this glossary is not intended to provide a basis for civil liability and should not be presumed to create evidence that any duty has been breached.
* Adjusted Book Value Method A method within the asset approach wiiereby all assets and liabilities (including off-balance sheet, intangible, and contingent) are adjusted to their fair market values [NOTE: In Canada on a going concern basis, *Adjlisted Net Asset Method See Adjusted Book Value Method.
Appraisal See Valuation.
Appraisal Approach See Valuation Approach.
Appraisal Date See Valuation Date.
Appraisa! Method See Valuation Method.
Appraisal Procedure See Valuation Procedure.
* Arbitrage Pricing Theory A multivariate model for estimating the cost of equity capital, which incorporates several systematic risk factors.
Asset (Asset-Based) Approach A general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on (he value of the assets net of liabilities.
This article is part of eBook. To read the rest of the eBook (full version) please look at: capital investment
Financial Links
News
Introduction to Cost of Capital Applications: Valuation and Project Selection