Valuation II et 1 private equity Course Objectives

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Questions and Answers

What is the first step in using the Venture Capital Method to value a start-up?

Compute the final value using a multiple of future sales or earnings. (correct)

Determine the required final percent ownership based on the investment amount and discounted final value.

Discount the final value back to the present using a target rate of return.

Account for future dilution to compute the required current percent ownership.

Which of the following factors does NOT affect the value of a call option in the Black-Scholes model?

Stock price

Risk-free interest rate

Exercise price

Dividend yield (correct)

Why might accounting-based comparables be less suitable for valuing certain companies?

Because of unstable markets

Because of high profitability

Because of rapid growth or unprofitability (correct)

Because of complex financial structures

What is the formula for computing cash flows in the DCF method?

CFt = EBITt - Corporate Taxes t + DEPRt - CAPEXt - ΔNWCt Signup and view all the answers

Why is depreciation added back to compute cash flows in the DCF method?

Because it is a non-cash expense Signup and view all the answers

How is the terminal value (TV) calculated in the DCF method?

TVt = [CFt * (1 + g)] / (r - g) Signup and view all the answers

What is the Weighted Average Cost of Capital (WACC) formula?

r = (D/V) * rd * (1 - τ) + (E/V) * re Signup and view all the answers

What is a limitation of using option pricing to value investment opportunities?

Estimating volatility is difficult Signup and view all the answers

What is a typical valuation ratio used in public markets?

All of the above Signup and view all the answers

What is the main learning objective of the 'Valuation I' course?

To use comparables to value projects and recognize the caveats of the method regarding start-ups Signup and view all the answers

What are the key learning objectives of the 'Valuation II' course?

Use comparables to value projects, compute the DCF, use option pricing theory, and use the venture capital method. Signup and view all the answers

What is a limitation of the DCF method in valuing projects?

It often fails to account for multiple rounds of financing, which can be seen as options to make follow-on investments. Signup and view all the answers

What is a call option in the context of option pricing theory?

A call option is the right to buy an asset at a specified exercise price on or before the exercise date. Signup and view all the answers

What components are needed to compute the value of a call option using the Black-Scholes model?

Underlying stock price, exercise price, volatility of the stock returns, time to option expiration, and risk-free rate. Signup and view all the answers

What is the main difference between financial options and real options?

Financial options involve assets such as stocks, while real options are related to a firm's operational decisions. Signup and view all the answers

What is the purpose of calculating the option value of a project?

To capture the value of managerial flexibility in investment decisions, such as the option to expand, defer, or abandon a project. Signup and view all the answers

How can negative NPV projects become positive when considering real options?

By incorporating the option to expand, defer, or abandon the project based on initial outcomes, which can mitigate risks and enhance potential returns. Signup and view all the answers

What are real options in the context of valuation?

Options related to a firm's operational decisions, such as the option to expand, defer, or abandon a project. Signup and view all the answers

Study Notes

Valuation II

Key learning objectives: using comparables, computing DCF, using option pricing theory, and using the venture capital method.

Limitations of DCF Method

Does not account for flexibility in projects, such as increasing or decreasing production rates, deferring development, or abandoning the project.
Often fails to account for multiple rounds of financing, which can be seen as options to make follow-on investments.

Option Pricing Theory

A call option: the right to buy an asset at a specified exercise price on or before the exercise date, representing a right, not an obligation.

Black-Scholes Model

Required components: underlying stock price, exercise price, volatility of stock returns, time to option expiration, and risk-free rate.

Financial Options vs. Real Options

Financial options: involve assets like stocks, while real options relate to a firm's operational decisions, such as exercising the option to expand, defer, or abandon a project.

Option Value of a Project

Captures the value of managerial flexibility in investment decisions, such as the option to expand, defer, or abandon a project.

Negative NPV Projects

Can become positive when considering real options, as it mitigates risks and enhances potential returns.

Venture Capital Method

Steps: compute final value using a multiple of future sales or earnings, discount the final value, determine required final percent ownership, and account for future dilution.

Factors Affecting Option Value

Stock price, exercise price, volatility of stock returns, time to expiration, and risk-free interest rate.

Weaknesses of Option Pricing

Estimating volatility is difficult, real-world opportunities are complex, and the Black-Scholes formula may not suit nested call options.

Valuation I

Key learning objectives: using comparables, computing DCF, and recognizing caveats for start-ups.

Using Comparables

Steps: identify firms with similar characteristics, identify relevant valuation ratios, and multiply ratios to obtain an implied market value.

Accounting-Based Comparables

May be less suitable for valuing unprofitable or rapidly growing companies, where non-financial, industry-specific measures might be more appropriate.

Valuation Ratios

Typical ratios used in public markets: Price-Earnings Ratio (P/E), Market-to-Book Ratio, and Market Value to Total Revenue Ratio.

Discounted Cash Flow (DCF) Method

Calculates the value of a project by discounting its future cash flows to the present value using a discount rate.

Computing Cash Flows

Formula: CFt = EBITt - Corporate Taxes t + DEPRt - CAPEXt - ΔNWCt + other t

Depreciation

Added back to compute cash flows because it's a non-cash expense, reflecting the actual cash flow generated by the business.

Terminal Value (TV)

Formula: TVt = [CFt * (1 + g)] / (r - g), where g is the growth rate in perpetuity and r is the discount rate.

Weighted Average Cost of Capital (WACC)

The average rate of return a company is expected to pay to all its security holders, calculated as r = (D/V) * rd * (1 - τ) + (E/V) * re.

DCF Method Limitations for Start-ups

Lack of comparable companies to find current beta and estimate target capital structure, high sensitivity of terminal value to assumptions, and questionable appropriateness of beta as a measure of firm risk.

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Description

Learn about the key learning objectives and limitations of the DCF method in the Valuation II course, covering topics such as comparables, option pricing, and venture capital methods.