Deck 10: Analysis and Valuation

Question 1

12 An analyst constructs a privately held firm's cost of equity using the "build-up" method. The 10-year Treasury bond rate is 4% and the historical equity risk premium for the S&P 500 stock index is 5.5%. The risk premium associated with firms of this size is 3.8% and for firms within this industry is 2.4%. Based on due diligence, the analyst estimates the risk premium specific to this firm to be 2.5%. What is the firm's cost of equity based on this information?

Answer 1

4.0% + 5.5% + 3.8% +2.4% +2.5% = 18.2%

Question 2

are some of the reasons a family-owned or privately-owned business may want to go public? What are
some of the reasons that discourage such firms from going public?

Answer 2

Private or family owned firms are more likely to go public when valuations are high or are increasing. Companies also are inclined to go public when they anticipate an inability to finance future investment opportunities or the outlook for the future profitability is unclear. In contrast, private firms are less likely to go public because of the increasing reporting requirements of Sarbanes-Oxley and the SEC, as well as concern about interference from public shareholders. Private firms also are less likely to go public when the special privileges that accrue to the controlling shareholders exceed the anticipated benefits from going public.

Question 3

14 Based on its growth prospects, a private investor values a local bakery at $750,000. She believes
that cost savings having a present value of $50,000 can be achieved by changing staffing levels and
store hours. Based on recent empirical studies, she believes the appropriate liquidity discount is 20
percent. A recent transaction in the same city required the buyer to pay a 5 percent premium to the
asking price to gain a controlling interest in a similar business. What is the most she should be
willing to pay for a 50.1 percent stake in the bakery?

Answer 3

The investor should not offer more than $336,672.
Maximum Offer Price (50.1%) = ($750,000+$50,000) x (1-.2)(1+.05) x .501 = $336,672

Question 4

are common reasons for a private firm to go public? What are the advantages and disadvantages or doing so? Be specific.

Question 5

11 It is usually appropriate to adjust the financials received from the target firm to reflect any changes that you
as the new owner would make in order to create an adjusted EBITDA. Using the Excel spreadsheet entitled
"Adjusting Target Firm's Financials" on the CDROM accompanying this book, make at least two
adjustments to the target's hypothetical financials to determine the impact on the adjusted EBITDA. (Note:
The adjustments should be made in the section on the spreadsheet entitled "Adjustments to Target Firm's
Financials.") Explain your rationale for each adjustment.

Question 6

2 What are the common ways of estimating the capitalization rate?

Question 7

10 Rank from the highest to the lowest the liquidity discount you would apply if you as a business appraiser had
been asked to value the following businesses: a) a local, profitable hardware store, b) a money losing
laundry, c) a large privately owned but marginally profitable firm with significant excess cash balances and
other liquid short-term investments, and d) a pool cleaning service whose primary tangible assets consist of
a 2-year old truck and miscellaneous equipment. Explain your ranking.

Question 8

7 Why might succession planning be more challenging for family owned firms?

Question 9

is it likely that shares trade at a discount from their value when issued if investors attempted to sell such shares within one year following closing of the reverse merger?

Question 10

4 Give examples of private company costs that might be understated and explain why.

Question 11

is the purpose of ultimately listing of a major stock exchange such as NASDAQ?

Question 12

were the options available to One Group LLC to raise capital to finance their expansion plans? Discuss
the pros and cons of each. Be specific.

Question 13

9 Why are family owned firms often attractive to private equity investors?

Question 14

are corporate shells, and how can they create value? Be specific.

Question 15

5 How can an analyst determine if the target firm's costs and revenues are understated or overstated?

Question 16

6 Why might shell corporations have value?

Question 17

1 What is the capitalization rate and how does it relate to the discount rate?

Question 18

Discuss the pros and cons of a reverse merger versus an IPO.

Question 19

3 What is the marketability discount and what are common ways of estimating this discount?

Question 20

13 An investor is interested in making a minority equity investment in a small privately held firm. Because of the nature of the business, she concludes that it would be difficult to sell her interest in the business quickly. Therefore, she believes that the discount for the lack of marketability to be 25%. She also estimates that if she were to acquire a controlling interest in the business, the control premium would be 15%. Based on this information, what should be the discount rate for making a minority investment in this firm? What should she pay for 20% of the business if she believes the value of the entire business to be $1 million.

Question 21

privately held firms, firm specific risk may include lack of product, industry, and geographic
diversification; limited management depth, volatile stock markets, and unionized workforces.

Question 22

public and private firms always attempt to maximize earnings growth.

Question 23

increase in the target firm's reserves for doubtful accounts increases taxable income, while a
decrease reduces the firm's taxable income.

Question 24

Private businesses may need to be valued to settle shareholder disputes, court cases, divorce, or the payment of gift or estate taxes.

Question 25

Managers and owners in public companies are likely to have the same emotional attachment to their
businesses as those in private firms.

Question 26

The availability and reliability of data for public companies tends to be much greater than for small private firms.

Question 27

The risk associated with an illiquid market for a specific stock is referred to as the liquidity or marketability risk.

Question 28

It is easier to obtain the fair market value of private companies than for public companies because of the
absence of volatile stock markets.

Question 29

Asset valuation includes specific business risks but ignores any adjustment for liquidity risk.

Question 30

Revenue may be inflated by booking as revenue products shipped to resellers without adequately
adjusting for probable returns.

Question 31

Empirical evidence suggests that discounts have declined in recent years.

Question 32

Private firms must file quarterly earnings reports with the Securities and Exchange Commission.

Question 33

purpose of adjusting the target's income statement is to provide an accurate estimate of the
current year's reported operating income or operating cash flow.

Question 34

Private firms are likely to understate revenue and understate costs in order to minimize their tax liabilities.

Question 35

Employee benefit levels in private firms are almost always mandated by state or federal law and
therefore cannot be changed.

Question 36

Because of data limitations, valuation of private firms often requires more subjective adjustments than for
public firms.

Question 37

Financial information for both public and private firms is equally reliable because their statements are audited by outside accounting firms to ensure that are developed in a manner consistent with GAAP.

Question 38

a buyer expects that the target firm's revenue has been overstated, the buyer can reconstruct revenue by examining usage levels of the key inputs required to produce the product or service.

Question 39

Shell corporations may have significant value to acquiring firms.

Question 40

Methodologies employed to value private firms are substantially different from those employed to value
public firms.

Question 41

Family owned businesses account for about 89% of all businesses in the U.S.

Question 42

All family owned businesses are small.

Question 43

Before selling a business, an owner may increase advertising expenses in order to inflate profits.

Question 44

Restricted stock is often issued to employees of privately held firms as a significant portion of their total
compensation. Such stock is similar to other types of common stock except that its sale on the open market is prohibited for a period of time.

Question 45

Very few closely held businesses are family owned.

Question 46

The market model of corporate governance is readily applicable to privately held, family owned firms.

Question 47

The primary purpose of the buyer adjusting the seller earnings is to provide an accurate estimate of the
current year's operating income or cash flow in the base year.

Question 48

The M&A market for employer firms tends to be concentrated among smaller firms, as firms in the United States with 99 or fewer employees account for 98% of all firms with employees.

Question 49

In many family owned firms, family influence is exercised by family members holding senior management positions, seats on the board of directors, and through holding super-voting stock (i.e., stock with multiple voting rights).

Question 50

Valuation of privately held businesses may involve substantial adjustment of the discount or capitalization
rate.

Question 51

Membership or subscription businesses, such as health clubs and magazine publishers, may inflate revenue by booking the full value of muliyear contracts in the first year of the contract.

Question 52

A private corporation is a firm whose securities are not registered with state or federal authorities.

Question 53

The term capitalization refers to the conversion of a future income stream into a present value, and it is a
term often used by business appraisers when future income or cash flows are not expected to grow or to grow at a constant rate.

Question 54

Succession issues tend to be easier for small family owned firms than for large publicly traded firms.

Question 55

Firms that are family owned but not managed by family members are often well managed, as family shareholders with large equity stakes carefully monitor those charged with managing the business.

Question 56

Privately owned businesses are often referred to as "closely held" since they are usually characterized by a small group of shareholders controlling operating and managerial policies of the firm.

Question 57

If the buyer believes that the seller has overstated revenue in a specific accounting period, the buyer can reconstruct revenue by examining usage levels, in the same accounting period, of the key inputs required to produce the product or service.

Question 58

In adjusting base year income, an appraiser must be aware of the implications of various accounting
methods for value. During periods of inflation, businesses frequently use the last-in, first out method to
value inventories. This approach results a reduction in the cost of sales and an increase in gross profits and taxable income.

Question 59

Intangible assets such as customer lists, intellectual property, licenses, distributorships agreements, leases,
regulatory approvals, and employment contracts may offer significant sources of value.

Question 60

Fair value is by necessity more subjective than the concept of fair market value, because it represents the
dollar value of a business based upon an appraisal of the tangible and intangible assets of the business.

Question 61

Private investment in public entities (PIPES) is a commonly used method of financing reverse mergers.

Question 62

It is generally easier to sell a minority interest than a majority interest in a business without loss of the value of the original investment.

Question 63

The fair value concept is applied when no strong market exists for a business or it is not possible to identify the value of substantially similar firms.

Question 64

A control premium is the additional premium a buyer is willing to pay for the right to direct the activities of a firm.

Question 65

A sudden improvement in operating profits in the year in which the business is being offered for sale may suggest that both revenue and expenses had been overstated during the historical period.

Question 66

If the cash flows of the firm are not expected to grow or are expected to grow at a constant rate indefinitely, the discount rate used by practitioners often is referred to as the capitalization rate.

Question 67

Shell corporations may be attractive for investors interested in capitalizing on the intangible value associated with the existing corporate shell. This could include name recognition; licenses, patents, and other forms of intellectual properties; and underutilized assets such as warehouse space and fully depreciated equipment with some economic life remaining.

Question 68

Private companies are generally not subject to the same level of rigorous controls and reporting systems as are public companies.

Question 69

Small firms may lack product, industry, and geographic diversification, which add to their specific business risk.

Question 70

Because of the need to satisfy both the demands of stockholders and regulatory agencies, public companies need to balance the desire to minimize taxes with the goal of achieving quarterly earnings levels consistent with investor expectations. Failure to do so frequently results in an immediate loss in the firm's market value.

Question 71

A family owned firm's board faces the sometimes daunting challenge of achieving the proper balance between monitoring and collaboration to minimize the emotionality and overlapping roles that often characterize such firms.

Question 72

Shell corporations rarely have any value.

Question 73

The control model of corporate governance may be more applicable where ownership tends to be highly diverse and the right to control the business is separate from ownership.

Question 74

It is rare that the owner or a family member is either an investor in or an owner of a vendor supplying products or services to the family owned firm.

Question 75

Owners of private businesses attempting to minimize taxes may overstate their contribution to the firm by giving themselves or family members unusually low salaries, bonuses, and benefits.

Question 76

In many countries, family owned firms have been successful because of their shared interests and because investors place a higher value on short-term performance than on the long-term health of the business.

Question 77

An investor in a small company generally has little difficulty in selling their shares because of the high demand for small businesses.

Question 78

EBITDA has become an increasingly popular measure of value for privately held firms in recent years.

Question 79

If the discount rate is assumed to be 8% and the current cash flow is $1.5 million and is expected to remain at that level in perpetuity, the implied valuation is $18.75 million.

Question 80

Despite the lack of public exchanges for privately held firms, Wall Street analysts have ample incentive to analyze such firms in search of emerging companies.