Finance 01 Basics

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Questions and Answers

What is the primary basis for valuing an asset in intrinsic valuation?

Current macroeconomic forecasts and financial news.

Historical cost and accounting records.

Market sentiment and comparable asset prices.

Its fundamental characteristics and expected cash flows. (correct)

According to the principles of intrinsic valuation, which factor directly impacts the value of cash flow generating assets?

The current political climate and regulatory environment

The historical volatility of the market

The magnitude of expected cash flows and the certainty of receiving them (correct)

The current level of interest rates and tax laws

In discounted cash flow (DCF) valuation, how is risk typically taken into account?

By adjusting either the discount rate or the expected cash flows (correct)

By adjusting the historical cashflow amounts.

By increasing the value of assets that have proven to be low risk.

By discounting the certainty equivalent cashflows at a risk-adjusted rate.

What is the key distinguishing feature of the 'certainty equivalent' approach in DCF valuation with respect to expected cashflows?

It replaces expected cashflows with guaranteed equivalents. (D) Signup and view all the answers

According to the 'IT' proposition of risk-adjusted value, under what circumstance can 'IT' not affect value?

When 'IT' does not affect either expected cash flows or riskiness. (C) Signup and view all the answers

What does the 'DON'T BE A WUSS' proposition state about valuation?

Valuation requires making estimates, even with uncertainty. (B) Signup and view all the answers

According to the 'DUH' proposition, what is a necessary condition for an asset to have value?

The expected cash flows must be positive at some point. (B) Signup and view all the answers

What does the 'DON'T FREAK OUT' proposition suggest about assets with early vs. later cash flows?

Assets with earlier cash flows will be worth more, all else being equal. (A) Signup and view all the answers

When moving from firm value to equity value, which of the following adjustments is necessary?

Subtract the value of all debt. (B) Signup and view all the answers

How does the equity value derived from firm valuation compare to that from a direct equity valuation?

It will be equal. (B) Signup and view all the answers

A company's cost of debt is given as 10% pre-tax, and its tax rate is 50%. What is the after-tax cost of debt?

5% (A) Signup and view all the answers

What is the primary risk associated with mixing cash flows and discount rates in valuation?

It can produce severely misleading results. (D) Signup and view all the answers

A company has a cost of equity of 13.625%, and the market value of its equity is $1073. The value of debt outstanding is $800. If the after-tax cost of debt is 5%, what is the company's cost of capital?

9.94% (B) Signup and view all the answers

What is the difference between valuing equity directly and indirectly through firm valuation?

They are just different ways of arriving at the same equity value if done correctly. (C) Signup and view all the answers

Given a firm valuation, if the firm value is $1873 and the market value of debt is $800, what is the value of equity?

$1073 (C) Signup and view all the answers

If a company has consistent cash flows of $40 for the next five years, and a cost of equity of 13.625%, which method can be used to calculate the value of equity?

Discount the cash flows to equity at the cost of equity. (C) Signup and view all the answers

What is the result of discounting cash flows to equity using the weighted average cost of capital (WACC)?

An upwardly biased estimate of the value of equity. (B) Signup and view all the answers

If you discount pre-debt cashflows at the cost of equity, what kind of bias will this create in the valuation of the firm?

A downward bias (A) Signup and view all the answers

In one of the errors, the present value of equity is calculated to be $1248 when it should be $1073. What type of error was committed to get this result?

Discounting cash flows to equity at the cost of capital. (C) Signup and view all the answers

If the present value of a company is $1613 and the value of the debt is $800, and the correct value of equity is $1073, what type of error would lead to an equity value of $813?

Discounting cash flows of the firm at the cost of equity, and then correctly subtracting debt. (B) Signup and view all the answers

What is the result of discounting cash flows to the firm at the cost of equity, and then forgetting to subtract debt?

An overstated estimate of the equity value. (C) Signup and view all the answers

What type of cash flow is used in the Free Cash Flow to Equity (FCFE) model?

Potential dividends, or cash flows after taxes and reinvestment. (A) Signup and view all the answers

Which of the following is an accurate description of Free Cash Flow to the Firm (FCFF)?

Cash flows before debt payments, but after reinvestment needs and taxes. (D) Signup and view all the answers

Which of these is NOT used in a typical Discounted Cash Flow model?

Share repurchases. (C) Signup and view all the answers

When valuing a company using the Free Cash Flow to Equity (FCFE) model, which item is directly deducted to arrive at cash flows?

Changes in non-cash working capital. (B) Signup and view all the answers

What discount rate is typically used when employing the Free Cash Flow to the Firm (FCFF) model?

The weighted average cost of capital. (A) Signup and view all the answers

Which of the following best describes the condition for a steady state in a Free Cash Flow to Equity (FCFE) valuation model?

When FCFE grows at a constant rate. (A) Signup and view all the answers

In the valuation process outlined, what is the primary purpose of reviewing a company's past performance and cross-sectional data?

To gather clues about future performance. (D) Signup and view all the answers

What is the first step in valuing a company?

Get a handle on the past and cross-section. (A) Signup and view all the answers

Which of the following is NOT a component required to compute Free Cash Flow to Firm (FCFF)?

Dividends Paid. (A) Signup and view all the answers

What role does risk play in financial valuation, according to the text?

It has a notable impact on the calculation of the discount rate. (D) Signup and view all the answers

Which of these has to be considered to determine the value per share after calculating the total value of the business?

All of these (D) Signup and view all the answers

Study Notes

Valuation Basics

Valuation involves assessing an asset's worth based on fundamental characteristics.
Intrinsic value of a cash flow-generating asset depends on the size and certainty of future cash flows.
Discounted Cash Flow (DCF) valuation discounts future cash flows to their present value, adjusting for risk.

Essence of Intrinsic Value

Intrinsic value is determined by an asset's fundamentals.
Cash flow-generating assets are valued based on the expected magnitude of cash flows over their lifespan, considering uncertainty in receiving them.
DCF valuation is a tool used to estimate intrinsic value.
Intrinsic valuation models preceded modern DCF models; investors have consistently incorporated expected cash flows into valuations.

Two Faces of DCF Valuation

A risky asset's value is calculated by discounting expected future cash flows at a risk-adjusted rate.
Alternatively, expected cash flows can be replaced with their certainty equivalents and discounted at the risk-free rate.

Risk-Adjusted Value: Two Basic Propositions

Asset value equals the risk-adjusted present value of its cash flows.
"IT" proposition: Risk or non-cash flow impacts don't affect a company's value if they do not impact the expected cash flows.
"DON'T BE A WUSS" proposition: Estimating future cash flows is crucial for valuation; uncertainty isn't an excuse for not making estimates.
"DUH" proposition: For an asset to have value, it must generate positive cash flows at some point.
"DON'T FREAK OUT" proposition: Early cash flows are more valuable than those further into the future, though later cash flows can have higher growth potential for compensation.

DCF Choices: Equity Versus Firm Valuation

Firm valuation: Values the entire business. Assets include existing investments, assets in place, and growth assets. Liabilities include debt.
Equity valuation: Values just the equity claim within the business.

Equity Valuation

Cash flows are considered after debt payments and reinvestment needs.
Discount rate only considers equity financing costs.

Firm or Business Valuation

Cash flows are considered before debt payments but after reinvestments.
Discount rate includes both debt and equity financing costs in proportion to use.

Firm Value and Equity Value

To derive equity value from firm value, subtract the value of all liabilities in the firm.
Resulting equity value will be higher than a stand-alone equity valuation due to factors like debt.

Cash Flows and Discount Rates

Example data demonstrates cash flow (to equity, to the firm) for five years, terminal value, cost of equity, cost of debt, tax rate, current equity market value, and outstanding debt value.

Equity Versus Firm Valuation

Method 1: Calculating equity value by discounting cash flows to equity at the cost of equity.
Method 2: Calculating firm value by discounting cash flows to the firm at the cost of capital to derive equity value from the value of the firm less the market value of the debt.

First Principle of Valuation

Discounting Consistency Principle: Never mismatch cash flows and discount rates.
The Mismatch Effect: Mismatching cash flows and discount rates leads to problematic valuation estimates.

The Effects of Mismatching Cash Flows and Discount Rates

Errors occur when mismatching either cash flows to the firm or to equity and using different discount rates.
Errors can overstate or understate equity value.

DCF: First Steps

A brief introductory statement about DCF's processes.

Generic DCF Valuation Model

Presentation of a generic DCF valuation model demonstrating the key input factors such as Cash Flows, Expected Growth, Discount Rate, and Terminal Value calculations.

Same Ingredients, Different Approaches

Detailed explanation of the Dividend Discount Model, FCFE, and FCFF valuation approaches to show the differences in accounting treatments of cash flows and discount rates.

Start Easy: The Dividend Discount Model

A detailed summary of the Dividend Discount Model, considering net income, payout ratio, expected growth (in net income), cost of equity, and stable growth to define the model's limitations.

Moving on Up: The “Potential Dividends” or FCFE Model

A detailed explanation of the Free Cash Flow to Equity (FCFE) Model, outlining considerations such as non-cash net income, changes in non-cash working capital, and debt financing to derive equity value.

To Valuing the Entire Business: The FCFF Model

A detailed explanation of the Free Cash Flow to the Firm (FCFF) Model, outlining the difference in terms of accounting treatment and cash flow and discount rate, showing considerations for operating income, capital expenditures, change in noncash working capital, reinvestment, and cost of capital.

DCF: The Process

A presentation of the DCF valuation process, explaining the steps from estimating past and current financial data, forecasting future cash flows, calculating the cost of capital for discounting future value, and applying the appropriate closure for valuation.

The Sequence

Explains the five-step sequence in the valuation procedure, emphasizing the importance of considering past data, risk assessment, forecasting, and closure to reach a comprehensive valuation.

Studying That Suits You

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Description

Test your knowledge on the principles of intrinsic valuation, particularly in the context of discounted cash flow (DCF) valuation. This quiz covers various concepts including risk adjustments, cash flow generation, and the key propositions surrounding asset valuation. Dive into the fundamental theories that underpin the valuation of financial assets.