mouse123

Which of the following statements regarding closely held companies is NOT correct?

A) Closely held companies can be formed as corporations, partnerships, or sole proprietorships.

B) The valuation of closely held companies is straightforward because of the relatively small number of investors.

C) The equity shares of closely held companies are not publicly traded.

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Closely held companies can be structured as one of several legal forms. The shares of closely held companies by definition are not publicly traded and are highly illiquid. Although there may be a small number of investors, the valuation of closely held companies is difficult because shares are illiquid, and there is limited information available.

mouse123

Edward Cloever, CFA, is reviewing a colleague’s first draft of a research report on how the legal environment affects the valuation of closely held companies. Two statements in the report draw Cloever’s attention:
Statement 1: In situations that require a legal determination of a company’s value, market transactions provide a ready estimate for a publicly traded company, but no uniform definition exists for the value of a closely held company.
Statement 2: If two closely held companies are identical in their operations and profitability, but one is structured as a corporation and the other is structured as a partnership, the rational investor should be indifferent between the two companies.
Should Cloever agree or disagree with these two statements?

Statement 1

Statement 2

A) Agree Agree

B) Agree Disagree

C) Disagree Disagree

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Cloever should agree with Statement 1 but disagree with Statement 2. Because their equity shares do not trade in the open market, closely held companies do not have a readily available estimate of their value. Different legal jurisdictions have their own definitions of intrinsic value, fundamental value, and fair value that can become important if litigation arises. A closely held company’s legal structure as a corporation, partnership, or proprietorship affects the rights and responsibilities of the investors, and therefore affects the value of their investments. The investor must take the difference in legal structure into account when evaluating otherwise identical firms.

mouse123

Approaches commonly used in the valuation of closely held companies include all of the following EXCEPT the:

A) comparables approach.

B) fundamental value approach.

C) cost approach.

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The cost approach and the comparables approach are both used in the valuation of closely held companies. The fundamental value approach is a fictitious approach.

mouse123

Regarding closely held companies, the valuation adjustment, due to the lack of a public market for the shares, is called a:

A) marketability discount.

B) marketability premium.

C) minority discount.

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A minority discount would be applied to shares that represent a non-controlling minority interest in a company. Shares of closely held companies are not publicly traded, so the shares should be discounted an appropriate amount to reflect this lack of marketability.

mouse123

Which of the following is a disadvantage to using the comparables approach to valuing investments in closely held companies?

A) Cost to replace assets may not reflect current value.

B) It is difficult to determine the appropriate discount rate.

C) The benchmark value used may be mispriced or difficult to establish.

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A discount rate and an estimate of future income are both variables used in the income approach. The cost to replace a company’s asset is a factor when using the cost approach. The benchmark value used in the comparable may be mispriced or difficult to establish if no comparable companies have been sold recently.

mouse123

The securities of companies that are either close to bankruptcy or have already filed for bankruptcy protection are called:

A) inactively traded securities.

B) discount securities.

C) distressed securities.

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Inactively traded securities are infrequently traded, but the name “inactively traded” does not imply anything about the financial condition of the company. “Discount” is a description that may be applied to any of number of investment vehicles available. Distressed securities are the securities of companies in the midst of financial difficulties.

mouse123

Investing in distressed securities is most similar to investing in which of the following asset classes?

A) Venture capital.

B) Exchange-traded funds.

C) Hedge funds.

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Investing in distressed securities is similar to venture capital investing because both strategies seek an equity position in a company that is eventually successful. Both are illiquid investments with long time horizons.

mouse123

A typical distressed security investment strategy would involve purchasing:

A) the debt of a distressed company, allowing the company to utilize the infusion of capital to avoid bankruptcy.

B) the debt of a struggling company, with the goal of ending up with an equity position in the reorganized company.

C) a controlling equity position in a company experiencing financial difficulties and replacing management with a team of turnaround specialists.

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A typical strategy is to invest in the debt of a company, continue to hold the position throughout the bankruptcy negotiations, and ultimately end up with equity in the new, revitalized operation.

mouse123

Investing in distressed securities and venture capital investing are similar in all of the following ways EXCEPT:

A) illiquid investments.

B) heavy involvement by investors.

C) a large investment requirement.

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Only venture capital requires a large investment. Both remaining choices are true of both investing in distressed securities and investing in venture capital.

mouse123

In periods of rising inflation, commodities can act as a hedge to a portfolio of stocks and bonds because the:

A) commodities will typically appreciate in price while the prices of the stocks and bonds may decline.

B) commodities will not be affected by a rise in inflation.

C) commodities can provide current income to offset any price decreases in the stocks and bonds.

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In a period of rising inflation, the prices of commodities tend to go up, while the prices of stocks and bonds often tend to go down. Thus, the commodities position will act as an inflation hedge for the stock and bond portfolio.