invic

The capitalized cash flow method (CCM) used in private firm valuation is most appropriate when:

A) there are many intangible assets to value.

B) stable growth is expected.

C) earnings are growing quickly in an initial period.

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The CCM is a growing perpetuity model that assumes stable growth and is in effect a single-stage free cash flow model. It may be suitable when no comparables or projections are available and when stable growth is expected. The excess earnings method (EEM) is useful when there are intangible assets to value. The free cash flow method assumes high growth in an initial period followed by constant growth thereafter.

invic

Using the following figures, calculate the value of the equity using the capitalized cash flow method (CCM), assuming the firm will be acquired.

Normalized FCFE in current year	$3,000,000
Reported FCFE in current year	$2,400,000
Growth rate of FCFE	7.0%
Equity discount rate	16.0%
WACC	13.0%
Risk-free rate	3.5%
Cost of debt	10.5%
Market value of debt	$3,000,000

The value of the equity is:

A) $28,533,333.

B) $32,666,667.

C) $35,666,667.

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To arrive at the value of the equity using the CCM, it can be estimated using the free cash flows to equity and the required return on equity (r):

Note that we grow the FCFE at the growth rate because the current year FCFE is provided in the problem (not next year’s FCFE). We use normalized earnings, not reported earnings, given that normalized earnings are most relevant for the acquirers of the firm. The relevant required return for FCFE is the equity discount rate, not the WACC.
An alternative approach to calculate the value of the equity would be to subtract the market value of the firm’s debt from total firm value. However, the FCFF are not provided so a total firm value cannot be calculated.

invic

Using the following figures, calculate the value of the firm using the excess earnings method (EEM).

Working capital	$600,000
Fixed assets	$2,300,000
Normalized earnings	$340,000
Required return for working capital	5%
Required return for fixed assets	13%
Growth rate of residual income	4%
Discount rate for intangible assets	18%

A) $2,981,714.

B) $2,978,571.

C) $3,027,111.

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The answer is calculated using the following steps.
Step 1: Calculate the required return for working capital and fixed assets.
Given the required returns in percent, the monetary returns are:
Working Capital: $600,000 × 5% = $30,000.
Fixed Assets: $2,300,000 × 13% = $299,000.
Step 2: Calculate the residual income.
After the monetary returns to assets are calculated, the residual income is that which is left over in the normalized earnings:
Residual Income = $340,000 − $30,000 − $299,000 = $11,000.
Step 3: Value the intangible assets.
Using the formula for a growing perpetuity, the discount rate for intangible assets, and the growth rate for residual income:
Value of Intangible Assets = ($11,000 × 1.04) / (0.18 − 0.04) = $81,714.
Step 4: Sum the asset values to arrive at the total firm value.
Firm Value = $600,000 + $2,300,000 + $81,714 = $2,981,714.

invic

Which of the following best describes the use of size premiums when estimating the discount rate for private company valuations?

A) The treatment is similar to that for public firms.

B) When using data from comparable public firms, a distress premium may be inadvertently added in.

C) A size premium is subtracted when calculating the discount rate.

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For private company valuations, a size premium is often added in when calculating the discount rate. This is not typically done for public firms. To get the size premium, the appraiser may use data from the smallest cap segment of public equity. This however may include a distress premium that is not applicable to the private firm.

invic

Which of the following best describes the use of size premiums when estimating the discount rate for private company valuations?

A) The treatment is similar to that for public firms.

B) When using data from comparable public firms, a distress premium may be inadvertently added in.

C) A size premium is subtracted when calculating the discount rate.

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For private company valuations, a size premium is often added in when calculating the discount rate. This is not typically done for public firms. To get the size premium, the appraiser may use data from the smallest cap segment of public equity. This however may include a distress premium that is not applicable to the private firm.

invic

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

A) Management will always be overly optimistic to increase the acquisition price.

B) Projection risk results in higher discount rates.

C) If the availability of information from private firms is poor, the uncertainty of projected cash flows may increase.

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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 overestimate future prospects. The discount rate would then be decreased or increased accordingly. So management is not always overly optimistic and projection risk does not always result in higher discount rates.

invic

Using the following information, calculate the required return on equity using the expanded CAPM.

Income return on bonds	6.0%
Capital return on bonds	2.0%
Long-term Treasury yield	3.5%
Beta	1.4
Equity risk premium	6.0%
Small stock premium	4.0%
Company-specific risk premium	3.0%
Industry risk-premium	2.0%
Pretax cost of debt	11.0%
Optimal Debt/Total Cap	16%
Current Debt/Total	7%
Debt/Total Cap for public firms in industry	33%
Tax Rate	30%

A) 15.9%.

B) 18.9%.

C) 11.9%.

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The required return on equity using the CAPM is: 3.5% + 1.4(6%) = 11.9%.
Note that the risk-free rate is the Treasury yield, not the returns for bonds in general.
Using the expanded CAPM, a small stock premium and company-specific risk premium are added: 11.9% + 4% + 3% = 18.9%.

invic

Using the following information, calculate the WACC using the build-up method, assuming the firm is being acquired.

Income return on bonds	6.0%
Capital return on bonds	2.0%
Long-term Treasury yield	3.5%
Beta	1.4
Equity risk premium	6.0%
Small stock premium	4.0%
Company-specific risk premium	3.0%
Industry risk-premium	2.0%
Pretax cost of debt	11.0%
Optimal Debt/Total Cap	20%
Current Debt/Total	7%
Debt/Total Cap for public firms in industry	33%
Tax Rate	30%

A) 17.7%.

B) 18.5%.

C) 16.3%.

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Using the build-up method: the risk-free rate, the equity risk premium, the small stock premium, a company-specific risk premium, and an industry risk premium are added together: 3.5% + 6.0% + 4.0% + 3.0% + 2.0% = 18.5%. Note that the risk-free rate is the Treasury yield, not the returns for bonds in general.
Because the firm is being acquired, we assume the new owners will utilize an optimal capital structure and weights in the WACC calculation. The capital structure for public firms should not be used because public firms have better access to debt financing.
The WACC using the optimal capital structure factors in the debt to total cap, the cost of debt, the tax rate, and the given cost of equity:
[20% × 11% × (1-30%)] + [(1-20%) × 18.5%] = 16.3%.

invic

Which of the following statements related to the models used to estimate the required rate of return to private company equity is most accurate:

A) The CAPM model uses betas estimated from firm returns of other private firms.  

B) The expanded CAPM model adds premiums for size and firm-specific risk.

C) The build-up method begins with betas for comparable public firms and adds risk premiums.





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Expanded CAPM adds premiums for size and firm-specific risk. CAPM may not be appropriate for private firms because beta is usually estimated from public firm returns. The build-up method adds an industry risk and other risk premiums to market rate of return; it is used when betas for comparable public firms are not available. (Study Session 12, LOS 43.h)

invic

A private pharmaceutical firm is under consideration for acquisition where the financial buyer will pay with equity. Part of the payment to the sellers is based on FDA approval of the firm’s drug. If the analyst uses a market approach and comparable data from public firms, which of the following would most likely result in a price-multiple that is too high? The comparable data is:

A) from transactions where the buyer used cash.

B) for strategic buyers.

C) for transactions where the consideration was non-contingent.

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In market approaches, the analyst values the subject private firm using price multiples from previous public and private transactions. A strategic buyer is one who will have synergies with the target whereas a financial buyer does not. A financial transaction typically has a smaller price premium. So in this case, the comparable price-multiple will be too high.
If the acquisition involves the acquirer’s stock, the acquirer may be using overvalued shares to buy their target. Using comparables where cash is the consideration would result in lower price multiples.
Contingent consideration is payment to the sellers based on the achievement of specific goals such as FDA approval. Contingent consideration increases the risk to the seller and ceteris paribus, they would demand a higher price. Using comparables where the consideration was non-contingent would result in lower price multiples.