3C - Financial Valuation Methods and Decision Models. Questions from review

A project has an initial investment of $100,000 and a project profitability index of 1.15. The firm's cost of capital is 12%. The net present value of the project is:

$15,000. Project profitability index = Present value of future inflows / Initial investment 1.15 = Present value of future inflows / $100,000 $100,000 x 1.15 = Present value of future inflows $115,000 = Present value of future inflows Net present value = Present value of future inflows - Initial investment = $115,000 - $100,000 = $15,000

Financial statements were being prepared for the ABC Company, and among its long-term investments were 1,000 shares of XYZ common stock, a publicly held company traded on a major market. At the close of the day related to the date of the financial statements, the XYZ stock had a quoted market price of $65 per share; however, at approximately 4:30 p.m., after the close of the market, it was announced that a major fire had destroyed the only production plant held by XYZ Company. As a result of this new information, the quoted market price for the XYZ common stock fell to $25 per share on the following day. When considering all of this information, ABC Company should value the investment of the XYZ common stock at:

- $25 per share due to the new information; however, the input level would be dropped to Level 2. As a general rule, if observable inputs such as quoted market prices for identical assets are available, the subject asset should be used in determining value, since this would represent a Level 1 input in the fair value hierarchy. However, if a company announces negative information that has a negative impact on the market price shortly after the close of the market, the fair value valuation should employ the use of the new information and list the value of the subject asset at the lower price. This would also drop the input level to Level 2.

Which of the following changes would result in the highest present value?

- A $100 decrease in taxes each year for four years Two general rules can be developed related to present value calculations: Increases in cash inflows (decreases in cash outflows) will result in higher present values, all else being equal. The earlier the cash inflows (the later the cash outflows) the higher the present value, all else being equal. Increases in cash flows can be the result of increased revenues, increases in other cash inflows, or decreases in cash outflows. Of the answer choices available, only one (a $100 decrease in taxes each year for four years) results in increased net cash inflows for each of four years, thus resulting in the highest present value.

World Foods (WF) imports a wide variety of consumer food items for sale in the United States. Due to the sporadic nature of this type of market, WF often deals with its suppliers on an infrequent and sometimes one-time basis. In order to facilitate and accelerate its purchase and receipt of these imported goods, WF most likely benefits from the use of:

- A letter of credit is an arrangement whereby a bank agrees to stand behind the obligation of the importer. The transaction is significantly accelerated because the exporter has virtual assurance of collection for the goods shipped to the customer (importer).

An agreement between a small firm and a bank that permits the firm to borrow varying amounts of funds as needed over a specified time period is called a:

- A line of credit is an agreement between a borrower and a bank or other financial source that permits the borrower to obtain credit up to a maximum specified amount over a designated time period. It permits funds to be borrowed as needed and typically interest is computed monthly on the average balance owed.

Which of the following covenants obliges the borrower to repay the bonds if a large quantity of common stock is held by a single investor and the bond rating is downgraded?

- A poison put clause is a covenant that obliges the borrower to repay the bonds if a large quantity of common stock is held by a single investor and the bond rating is downgraded. This type of bond covenant is used as a defensive strategy to prevent hostile takeovers.

Which of the following statements that relate to capital budgeting is true?

- Accelerated methods of tax depreciation that recognize more depreciation in the early years of a project generate tax savings that have greater present values than tax savings generated in the later years of a project. This is because saving money today is worth more than saving an equal amount of money in the future.

If income tax considerations are ignored, how is depreciation handled by the following capital budgeting techniques?

- Accounting rate of return is included; internal rate of return and payback are excluded. Internal rate of return is a capital budgeting method which attempts to determine the internal return from a proposed project (NPV inflows = NPV outflows). The internal rate of return is that rate which produces a zero net present value. With this in mind, depreciation is only relevant if it affects cash flows. So, if tax considerations are ignored, depreciation must be excluded in performing internal rate of return analysis. Accounting rate of return is calculated as follows: Accounting rate of return = Increase in accounting income/Cash invested in project Since depreciation is used in computing accounting income, it must be included. Payback, like internal rate of return, focuses on cash flows. Because of this, if tax considerations are ignored, there is no cash flow effect from depreciation so it is excluded from the calculation.

Which one of the following provide a spontaneous source of financing for a firm?

- Accounts Payable Because trade credit arises automatically from purchase transactions, it provides a spontaneous source of financing for the firm. Trade credit is represented on the balance sheet of the borrowing firm as Accounts Payable. Mortgage bonds are not spontaneous and require a formal debt agreement. Accounts receivable is the inverse of accounts payable and is not a form of financing for the recipient. Debentures are also not spontaneous and typically require a formal agreement.

Which one of the following statements concerning cash flow determination for capital budgeting purposes is incorrect?

- Book depreciation is relevant since it affects net income. Depreciation itself is not a cash outflow. Depreciation is relevant for capital budgeting purposes only because it affects the income upon which taxes must be assessed. Taxes are a cash outflow. Therefore, only tax depreciation is relevant. Book depreciation is not relevant despite its effect on net income. -Tax depreciation must be considered since it affects cash payments for taxes. - Sunk costs are not incremental flows and should not be included. - Net working capital changes should be included in cash flow forecasts.

Net present value as used in investment decision-making is stated in terms of which of the following options?

- Cash flow The net present value determines whether the present value of the estimated net future cash inflows at a desired rate of return will be greater or less than the cost of the proposed investment. Using this method, the present value of the net cash inflows is calculated and compared to the initial investment. An investment proposal is desirable if the net present value is positive.

What is the formula for calculating the profitability index of a project?

- Divide the present value of the annual after-tax cash flows by the original cash invested in the project The profitability index considers the size of the original investment and the value of the discounted cash flows. It is calculated by dividing the present values of the cash flows after the initial investment by that investment.

Which tool would most likely be used to determine the best course of action under conditions of uncertainty?

- Expected value (EV) applies estimated percentages of occurrence to estimated values such as sales or costs. For example, assume that in preparing next month's sales budget we think that there is a 60% chance that sales will be $200,000 and a 40% chance that sales will be $160,000. The expected value of sales is computed: Sales x Probability = Expected Value $200,000 x .60 = $120,000 $160,000 x .40 = 64,000 Total expected value for sales = $184,000 Expected value can be used to determine the best estimate or course of action under uncertainty. Cost-volume-profit (CVP) analysis uses sales price and cost numbers that are assumed to be known in the short run. Program evaluation and review technique (PERT) is used to plan and control the resources consumed in completing large and complex projects. PERT does use a probabilistic approach in identifying a "critical path," but it is not applicable in situations other than those involving critical path identification. The scattergraph approach is a graphical method for separating fixed and variable costs. Historical cost data is used as input in this process.

Which of the following is an accurate comparison of fair value and fair market value?

- Fair market value defines the seller as hypothetical, whereas fair value assumes a specific seller. The differences between fair market value and fair value are quite substantial: - Fair market value implies a willing buyer and seller, whereas the buyer and seller under fair value are not necessarily willing. - Fair market value defines the seller as hypothetical, whereas there is a specific seller when using fair value. - Fair market value takes advantage of an unrestricted market, whereas fair value uses the principal or most advantageous market.

An entity is examining potential investments and notes that 1-year maturity yields are higher than those for 10-year maturities. Which of the following explanations for this occurrence is best?

- Investors are expecting reduced inflation in the future as reflected in the lower long-term returns. Inflation drives interest rates up, so if investors are expecting reduced inflation in the future, interest rates and returns would also be lower.

A multiperiod project has a positive net present value. Which of the following statements is correct regarding its required rate of return?

- Less than the project's internal rate of return

Which of the following statements is correct when a corporation is earning excess profits?

- Participating preferred stock acts more like equity than cumulative preferred stock. Participating preferred stock acts more like equity than cumulative preferred stock when a corporation is earning excess profits because the stock does not receive a fixed percentage like debt. When excess profits are earned, the participating preferred stock receives additional dividends.

Which of the following inputs would be most beneficial to consider when management is developing the capital budget?

- Profit center equipment requests Capital budgeting involves management making decisions about spending money on long-term assets. In order to make these decisions, management must first know what each profit center's equipment needs are. Supply and demand for the company's products, current sales prices and costs, and wage trends would be helpful in order to determine future cash flows as they relate to implementing various capital projects, but these are not the best answers.

Which of the following methods should be used if capital rationing needs to be considered when comparing capital projects?

- Profitability index The profitability index is the present values of the cash flows after the initial investment divided by the amount of that investment. This allows the comparison of projects with differing investment amounts. It represents the percentage that a project's net present value exceeds the cost of the project. Since it is expressed as a percentage rather than a dollar amount of net present value, the profitability index allows comparisons of mutually exclusive projects. The project with the highest profitability index is selected. The other answer choices (net present value, internal rate of return, and return on investment) are incorrect because they calculate rates of return for a specific project, but do not facilitate a comparison of the capital investments required among separate projects, which is necessary if investment capital is limited.

Which of the following is correct?

- Short-term credit can generally be obtained quicker than long-term credit. - Generally short-term credit is more flexible than long-term credit. Short-term credit is generally less costly than long-term credit as shown by the yield curve. - Prepayment penalties are generally associated with long-term credit, but these penalties are not the basic reasons for a higher cost for long-term credit. - Short-term credit holds more risk than long-term credit due to the need to renew more often.

What is the calculation for the interest payment on a bond?

- Stated rate of interest × Par value The calculation for the interest payment on a bond is the Stated rate of interest × Par value. This is the calculation used by the corporation to establish the interest to be paid. Interest expense is found by multiplying the effective rate of interest by the carrying value of the bond. The other answer choices are not ways to determine interest expense or interest payments.

If a factory were to be replaced, which of the following cost approaches would be best for determining fair value?

- The cost approach determines fair value on what it would cost to replace the item. Examples include items that are functionally obsolete or in a state of physical deterioration.

Which of the following decision-making models equates the initial investment with the present value of the future cash inflows?

- The internal rate of return (IRR) can be referred to as the yield (return) expected over the life of a project. It is computed by equating the initial investment with the present value of the cash flows over the life of the project. IRR is the discount rate that results in the net present value of all cash flows to be zero.

A measure of project risk is provided by the capital budgeting technique of:

- The payback capital budgeting technique indicates how soon a project will recover its cost. The sooner the cost is recovered, the less risky the project—returns are less knowable the further in the future they are.

Market beliefs related to efficient markets take three forms. Which of the following is not a market belief?

- There is no active-form efficient market theory. Market beliefs related to efficient markets take three forms: weak-form efficiency suggests that information about past prices would not be of use in predicting future performance; semi-strong efficient markets suggest that all publicly available information is incorporated in market prices; and strong-form efficient markets suggest that all available information is incorporated in current market prices.

Which of the following observations regarding the valuation of bonds is correct?

- When the market rate of return is less than the stated coupon rate, the market value of the bond will be more than its face value, and the bond will be selling at a premium. The market value of bonds is based upon the present value of discounted future cash flows, comprised of an annuity plus a lump sum. The bond's market value fluctuates with changes in the market interest rates. When the face interest rate is the same as the market interest rate, the market value of the bond will be the same as the face (i.e., par) value. If the face interest rate is less than the market interest rate, the bond will sell at a discount; if it is greater, the bond will sell at a premium.

Under which one of the following conditions is the internal rate of return method less reliable than the net present value technique?

- When there are net cash inflows of sizable amounts early in the project The real issue here is the reinvestment assumption applied to "recovered funds." Net present value (NPV) assumes reinvestment at the cost of capital whereas internal rate of return (IRR) assumes reinvestment at the IRR. NPV makes the more realistic assumption about the rate of return that can be earned on cash flows from the project.

Joe CPA has just accepted a business valuation engagement for The Charter Company, a small business. Some of the facts related to this company are as follows: The company has been in existence for 25 years. For the last 3 years, the company has shown little, if any, profit. The owner has recently had some difficulty making expected loan principal repayments. The owner met with a credit counselor last month and is in the process of making some recommended changes. As a beginning step in the valuation process, Joe has determined the premise of value to be:

- a going concern As defined in the International Glossary of Business Valuation Terms, the premise of value is defined as "an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation." The premise of value will be one of two situations: a going concern or liquidation. Although The Charter Company has displayed poor performance in the past few years, the business does not appear to be in liquidation at this time. Companies can falter, regroup, and continue. It appears that The Charter Company is currently in the process of regrouping, as demonstrated by the owner's attempts to obtain and implement expert advice; therefore, this business valuation should use a "going concern" as the premise of value.

Of the following decisions, capital budgeting techniques would least likely be used in evaluating the:

- adoption of a new method of allocating non-traceable costs to product lines. Capital budgeting does not deal only with the acquisition of fixed assets as in "acquisition of new aircraft by a cargo company." Rather, it more broadly involves evaluating cash outlays and inflows and deciding whether the outlay can be justified, as in answer choices: design and implementation of a major advertising program and trade for a star quarterback by a football team. The evaluation of a new method for allocation of non-traceable costs to product lines relates to the allocation of expenditures, not a comparison of project inflows and outflows.

Everything else being equal, the internal rate of return (IRR) of an investment project will be lower if:

- cash inflows are received later in the life of the project. Later cash inflows have a lower present value than earlier cash inflows, since the present value of a dollar is higher the sooner it is received. Projects with later cash flows will have lower net present values, for any given discount rate, than will projects with earlier cash flows, everything else being equal. Hence, projects with later cash flows will have a lower internal rate of return (IRR). - The IRR is the discount rate that sets the net present value (NPV) of a project equal to zero. NPV is calculated as follows: NPV = Present value of cash inflows - Investment cost. If the discount rate is higher, the present value of the cash inflows is lower. If the investment cost is lower, then a higher discount rate will be required to set the net present value to zero. - The larger the cash inflows, the higher the IRR. - Projects with shorter payback periods have higher cash inflows early in the life of the project, which means a higher IRR.

If a project has differing required rates of return over its life, i.e., 8% in the first three years and 12% in the second three years, the analyst should:

- compute the project's net present value using both rates for the appropriate years and accept the project if the net present value is at least zero.

The capital budgeting model that is generally considered the best model for long-range decision making is the:

- discounted cash flow model. The capital budgeting model that is generally considered the best model for long-range decision making is the discounted cash flow model because the time value of money (present and future values) is considered. The payback model and accounting rate of return model are unadjusted rate of return models which do not consider the time value of money.

The payback reciprocal can be used to approximate a project's:

- internal rate of return if the cash flow pattern is relatively stable. Payback reciprocal = 1/Payback period Where: Payback = Net cash invested/Annual cash inflow If the cash flow pattern is relatively stable, the payback reciprocal number serves as a good approximation of a present value of an annuity table factor. Using the payback number and a PV of an Annuity table, it becomes a relatively simple matter to look up an interest rate corresponding to the appropriate number of years' life of a project. This interest rate will be a close approximation of the internal rate of return.

If the net present value of a capital budgeting project is positive, it would indicate that the:

- rate of return for this project is greater than the discount percentage rate used in the net present value computation. Net present value (NPV) is defined as the excess of present value of cash inflows from a project over the discounted net cash outflows. A positive net present value indicates that the project's rate of return is greater than the discount (bundle) rate of interest. Projects promising a positive NPV should be undertaken if funds are available.

Carol and Jane were sitting in the local coffee shop discussing Jane's possible strategies for constructing her investment portfolio. Carol suggested that Jane spend time reviewing the financial information for stocks she might consider purchasing and do some ratio analysis once she had obtained the information, but at the same time, it probably wouldn't be a good idea for Jane to attempt to predict the future movements of the markets. Jane said that she would think about these suggestions, but that she had come to believe the best approach would be for her to do her analysis using charts based on the historic market data using price and trading volume to predict the future movement of stock prices. Someone overhearing this conversation would believe that Jane wanted to use ________ and did not believe in the ________.

- technical analysis; weak form of the efficient market hypothesis Technical analysis involves analyzing past market data of price and volume movements to attempt to determine future price movements of individual securities. The weak form of the efficient market hypothesis suggests that information about past prices would not be of use in predicting future performance, and therefore technical analysis would not be a viable technique to use. Fundamental analysis uses factors specific to a firm, such as financial statements, ratio analysis, projected earnings growth, and dividend yield in an attempt to find undervalued securities.

In determining cash flows from a proposed investment, the amount of the investment's depreciation tax savings (shield) in a given year is equal to:

- the depreciation times the tax rate. Many items in capital budgeting have related tax effects. Items that do not affect cash flows such as depreciation must be taken into consideration when income taxes are relevant or the present value of the cash flows related to taxes is relevant. Noncash items are adjusted for the tax impact by multiplying by the tax rate; cash items (such as revenues) are adjusted by multiplying by (1 − tax rate).

Joan CPA has been engaged to do some estate planning for a client. As part of that estate planning, Joan is expected to do a valuation of the client's small business. In the process of performing this engagement, Joan will be determining the ________ of the small business.

- value The terms "price,""worth," and "value" are often used interchangeably when dealing with business-related topics. In actuality, however, these terms have quite different meanings. Price is the observed exchange price that occurs in the marketplace; therefore, it is not determined in the process of doing a business valuation, due to the fact that no actual transaction is taking place. Worth refers to the advantages of ownership based upon the perceived benefits at a particular point in time and for a particular use. Joan's client is probably concerned about worth, but worth is not the focus of a business valuation. Value is the determination of what would be received in an exchange between two willing parties in an arm's-length transaction in the marketplace where both parties had acted with knowledge, with prudence, and without compulsion. This is the focus of a business valuation. Cost is what was paid for an asset in the marketplace and is not the subject of a business valuation.

For capital budgeting purposes, management would select a high hurdle rate of return for certain projects because management:

- wants to factor risk into its consideration of projects. The hurdle rate of return (or discount rate) is the desired (or "internal") rate of return; that rate which the investment must return for the investor to "break even." This rate must reward the investor for the risk that is being assumed in the investment—the higher the risk the higher the required rate of return. Thus, for capital budgeting purposes, management would select a high hurdle rate of return for certain projects because management wants to factor risk of the project into its consideration. If management: believes too many proposals are being rejected, a lower hurdle rate would be used. believes bank loans are riskier than capital investments, the hurdle rate would be different for the different methods of financing, not for different projects. believes capital investment proposals involve average risk, the hurdle rate would be "average," not "high."

Which of the following characteristics represent(s) an advantage of the internal rate of return technique over the accounting rate of return technique in evaluating a project? I.Recognition of the project's salvage value II.Emphasis on cash flows III.Recognition of the time value of money

Accounting rate of return (ARR) is simply "accounting income" from a project divided by the investment cost of the project. Internal rate of return (IRR) considers the amount and timing of cash inflows and outflows in calculating a "true" (internal) rate of return on a project. Concerning the characteristics: Both ARR and IRR consider salvage value—ARR in computation of depreciation expense and IRR as a future cash flow. The primary emphasis in IRR is cash flows. Cash flows are not addressed in ARR. Time value of money lies at the heart of IRR analysis but is not considered in ARR. Thus, (2) and (3) are advantages of the IRR analysis.

Which of the following is an advantage of net present value modeling?

Advantages of using the net present value method for decision making include the following: The time value of money is considered (compounding of returns). Given a perfect market, correct decision advice will be obtained. A correct ranking will be obtained for mutually exclusive projects given similar lives and investments. An absolute value is obtained. Disadvantages of using the net present value method for decision making include the following: The discount rate is difficult to determine. Assumptions related to cash flows have to be made that may or may not be correct.

What type of covenant requires a corporation to maintain, at all times, some minimum level of working capital?

An affirmative covenant is a covenant that requires a corporation to maintain, at all times, some minimum level of working capital.

An accountant using the Black-Scholes model to value stock options has input the exercise price of the options, time to expiration for the options, and an interest rate. Which of the following variables also is required for the model?

Black-Scholes (also called Black-Scholes-Merton) is a price variation model of financial instruments that can be used to determine the price of a European call option by incorporating five input variables: the current stock price, the related stock option's strike price (also called the exercise price), the time to the option's expiration, the risk-free interest rate, and the volatility.

Which of the following methods is best suited for evaluating the performance of a firm's capital in any given year?

Economic value added (EVA) is the best measure for evaluating performance of a firm's capital relative to the other choices in the question. EVA is a measure of a company's financial performance; it is the "true" economic profit of a firm, consisting of all costs, including the cost of capital. Earning more than the cost of capital creates value for the stockholders. EVA is the incremental difference in the rate of return over a company's cost of capital; it is used to measure the value a company generates from funds invested into it.

A stock priced at $50 per share is expected to pay $5 in dividends and trade for $60 per share in one year. What is the expected return on this stock?

Expected total return is the full return of an investment over a given time period. It would include all capital gains and any dividends or interest paid if that information had been provided. To determine the expected return, divide the ending price plus dividends by the opening price, and then subtract 1: [($60 + $5) ÷ $50] - 1 = 0.30.

A small vacuum cleaner repair shop is located in a once-quiet, out-of-the way neighborhood. Recently, however, a large entertainment complex that will be used for concerts, basketball games, and other major events was just opened a block from this small business. When determining the fair value of this property, the fair value should be based upon:

FASB ASC 820 provides guidance when determining the fair value of an asset or business ownership. The fair value measurement assumes that the business (or item) being valued will be put to the highest and best use that is physically possible, legally permissible, and financially feasible. The result will be the maximization of value. It is important to realize that the highest and best use may not be the current use; therefore, the highest and best use is determined from the viewpoint of the purchaser and not the seller. In this scenario, the use of the facility as a vacuum cleaner repair shop is clearly not the highest and best use of the property. That service can be provided from a lower-cost area and would not be best served being next to an entertainment complex. Due to the need to have small restaurants and bars in the vicinity of a large entertainment complex, the highest and best use of the property would likely be an establishment such as a small restaurant serving light fare for the before-the-event crowd and desserts for the after-the-event group.

Theamatics, Inc., leased 400 acres of vacant land from Farmco, Inc., on January 1. Theamatics hopes to construct a hotel-shopping center complex on the land. The lease agreement states that title to the land will pass to Theamatics at the end of the lease term. The cost of the land to Farmco was $500,000. The fair value of the land and the present value of the lease payments is $625,000. The collectibility of the lease payments is reasonably predictable, and no important uncertainties surround the amount of unreimbursable costs yet to be incurred by Farmco on the lease. What type of lease is this for Farmco?

Farmco is the lessor and would account for the land lease as either a sales-type lease or an operating lease. A finance lease is a lease form from the perspective of the lessee, not the lessor. If any one of five criteria are met, Farmco will classify the lease as a sales-type lease. The five criteria are: Title (ownership) transfers to the lessee by the end of the lease term. The lease contains a purchase option that the lessee is reasonably certain to exercise. The lease term is for the major part of the remaining economic life of the underlying asset. This criterion shall not be used if the lease commencement date is near the end of the asset's economic life. The present value of the sum of the lease payments and any lessee guaranteed residual value not already in the lease payments equals or exceeds substantially all of the fair value of the underlying asset. The underlying asset is specialized and is not expected to have an alternative use to the lessor at the end of the lease term. The first criteria is met in that the land will transfer to Theamatics at completion of the lease. Therefore, Farmco will classify the lease as a sales-type lease with selling profit.

Which of the following types of bonds is most likely to maintain a constant market value?

Floating-rate bonds eliminate interest rate risk since the interest rate paid for a given payment period is based upon the prevailing rates in the current bond market; therefore, if interest rates rise, the interest payment will also increase. Since the market value of bonds is based upon the present value of future cash flows, the market value of floating-rate bonds will remain relatively constant.

Which of the following is not considered an assumption of valuation using the rules of thumb?

Hiring an industry expert to give a detailed, thorough report on valuation is ideal compared to using the rule of thumb, but rules of thumb have been used for many years in business valuations. They often use measurements such as square feet, number of rooms, and number of tables to calculate specifics related to specific businesses. Statement on Standards for Valuation Services 1 (SSVS 1) specifically states that a rule of thumb should not be used as the method to set value; however, it can be used as a reasonableness check for the results achieved using other methods. The use of a rule of thumb can show the valuator is knowledgeable about the subject company's industry; support valuation arrived at using another method with similar results; and/or support valuation arrived at using another method with different results along with why arguments as to why the subject company is not average within the industry.

When evaluating capital budgeting analysis techniques, the payback period emphasizes:

Payback period is the length of time in years required to recover the cash invested in a project. Payback is computed as net investment divided by average expected annual cash inflow. Payback focuses on rapid recovery of cash investment (i.e., liquidity).

Beyond the identification of the subject of a valuation, it is important to determine the premise of value before initiating any work on the engagement. Which of the following is the correct definition of premise of value?

The International Glossary of Business Valuation Terms defines the premise of value as "an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation." The actual observed exchange price that is used in the marketplace defines the term "price"; the advantages of ownership based upon the perceived benefits at a particular point in time and for a particular use define the term "worth", and the amount that would be received in exchange for an asset between willing parties in an arm's-length transaction is "value."

It was time for an investment advisor to meet with one of her major clients for the annual review of his portfolio. She knew that the investor would be very interested in the performance of his portfolio in the turbulent and volatile market that had existed for the past 12 months. She reviewed the client's file and saw that he had indicated that he expected his portfolio would provide him with a risk-adjusted return that provided a high portfolio return per unit of risk. She picked up the phone and called one of the firm's analysts and asked him to complete an analysis of the ________ for the portfolio.

The Treynor index is based on the premise that there are two components of risk: Risk produced by fluctuations in the market Risk produced by fluctuations of the individual stock The index measures the portfolio return per unit of risk using the following equation: (Portfolio return - Risk-free rate) ÷ Beta The Sharpe measure of portfolio risk provides information similar to that of the Treynor index, except that the risk measure is the standard deviation of the portfolio rather than beta. The Jensen measure of portfolio risk measures the absolute value of performance of a portfolio on a risk-adjusted basis.

All of the following are the rates used in net present value analysis except for the:

The accounting rate of return is a capital budgeting method or technique which disregards the time value of money. It is not a rate used in a net present value analysis. Each of the other terms—cost of capital, hurdle rate, and required rate of return—describes a rate used in net present value analysis. Note: Hurdle rate and required rate of return are synonyms.

An investment advisor is working with a client to be sure that he understands the client's needs and preferences as he develops recommendations for the client's portfolio. As he speaks with the client, he ascertains that the client is willing to accept a reasonable level of risk in her portfolio. He further determines that the client expects to be fairly compensated for the level of risk that is assumed by a commensurate increase in value to her portfolio. The investment advisor believes that his client is:

The definition of a risk-adverse investor is one who is willing to take risk but believes that they will be reasonably compensated for the level of risk being taken. The security market line is a theoretical construct that provides a graphic representation of the expected return of a particular security as a function of beta, i.e., nondiversifiable risk.

In capital budgeting, the excess present value index (profitability index) is best used to:

The excess present value index, or profitability index, is computed as the present value of future net cash inflows divided by the discounted initial investment. The result is an index number rather than a dollar amount. This allows for the evaluation of mutually exclusive projects with different (not the same) investment amounts.

If you were to see the formula (Portfolio return - Risk-free rate) ÷ Standard deviation, you would be dealing with:

The formula for the Sharpe measure for portfolio performance is (Portfolio return - Risk-free rate) ÷ Standard deviation. The formula for the Treynor index for portfolio performance is (Portfolio return - Risk-free rate) ÷ Beta. The formula for the Jensen measure of portfolio performance measure of return on portfolio is Risk-free rate + ((Return on market index - Risk-free rate) × Beta).

The discount rate used when preparing a business valuation when employing an income approach is critical. Which of the following statements about discount rates is true?

The higher the risk, the higher the discount rate, and the lower the present value of the subject company. The higher the perceived risk involved in a particular investment, the greater the return that an investor would demand on that investment; therefore, the higher the discount rate used, the lower the present value. IRS Revenue Ruling 68-609 states, "The 8 percent rate of return and the 15 percent rate of capitalization are applied to tangibles and intangibles, respectively, of businesses with a small risk factor and stable and regular earnings; the 10 percent rate of return and 20 percent rate of capitalization are applied to businesses in which the hazards of business are relatively high." However, even the IRS has denounced the use of the treasury method discussed in Revenue Ruling 68-609 as well as a blanket approach to determine discount and capitalization rates. There are a number of ways to determine the discount rate: CAPM (capital asset pricing model), build-up methods, and the weighted average cost of capital. Although CAPM is a frequently used tool in finance, it is generally not used in business valuations. Discount and capitalization rates are not the same. A company's capitalization rate is often derived by subtracting a company's expected long-term annual growth rate from its discount rate; therefore, a growing company's capitalization rate is usually lower than its discount rate.

IRS Revenue Ruling 68-608 provides guidance as to the form of the financial statement when used in a valuation process. This guidance can be summarized as which of the following?

The past earnings used in the valuation process should fairly reflect the probable future earnings. Revenue Ruling 68-608 does provide guidance for the business valuator as to the normalization process often required for the financial statements of the subject company being valued. Although 68-608 specifically discusses the use of the treasury method, the direction provided as to the form that financial statements should take is valid when using any valuation method or approach. Revenue Ruling 68-608 states: "The past earnings to which the formula is applied should fairly reflect the probable future earnings. Ordinarily, the period should not be less than five years, and abnormal years, whether above or below the average, should be eliminated. If the business is a sole proprietorship or partnership, there should be deducted from the earnings of a business a reasonable amount for services performed by the owner or partners engaged in the business."

Tam Co. is negotiating for the purchase of equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment were acquired. The equipment's estimated useful life is 10 years, with no residual value, and would be depreciated by the straight-line method. Tam's predetermined minimum desired rate of return is 12%. Present value of an annuity of 1 at 12% for 10 periods is 5.65. Present value of 1 due in 10 periods at 12% is .322. In estimating the internal rate of return, the factors in the table of present values of an annuity should be taken from the columns closest to:

The payback period serves as a fair approximation of the annuity factor value from the table of present values of an annuity. Using the data given: Payback = Investment / Annual saving= $100,000 / $20,000= 5.00 Thus, internal rate of return can be obtained as a percentage rate from an annuity table for 10 periods nearest the annuity factor of 5.00.

A company purchased property that it expects to sell for $14,000 next year. The net present value of the investment is $1,000. The company is guaranteed an interest rate of 12% by the bank. What amount did the company pay for the property?

The present value of $14,000 in one year discounted at 12% is 14,000 ÷ 1.12, or $12,500. The net present value of $1,000 is the difference between this $12,500 present value and the cost of the investment; therefore, the cost of the investment must be $11,500.

The recommended technique for evaluating projects when capital is rationed and there are no mutually exclusive projects from which to choose is to rank the projects by:

The profitability index is a ratio obtained by calculating the total present value of all future net cash inflows and dividing that by the total cash outflow. This ratio is also called the excess present value index. This method is considered superior to accounting rate of return, payback, and internal rate of return because it gives full weight to the time value of money and provides a ranking of project profitability. The profitability index is a more realistic ranking tool than internal rate of return because it assumes reinvestment at cost of capital rather than at the internal rate of return. This is particularly important when capital is rationed. error_outline

Capital budgeting methods are often divided into two classifications: project screening and project ranking. Which one of the following is considered a ranking method rather than a screening method?

The profitability index provides a means to rank capital projects with differing amounts of investment. It is computed as follows: PI = PV benefits/ Cost The other choices are all screening methods. Note that the payback method and the accounting rate of return do not consider the time value of money.

An accountant has been retained by a company as an investment advisor for its employees. Research of historical rates of return yields the following information:

The reward/risk ratio is the rate of return divided by a measure of risk (the standard deviation in this question). Computing this reward-to-risk ratio for U.S. Treasury bills gives 4%/3%, or 1.33, which exceeds the ratio for the other investment alternatives: Common stocks: 12%/20%, or 0.60 Long-term corporate bonds: 6%/8%, or 0.75 Intermediate-term government bonds: 5%/5%, or 1.00

The cost approach to valuation is appropriate to use when:

The use of a cost (asset-based) approach for valuation is appropriate when: - the company is in liquidation. - the company is worth more in liquidation than as a going concern. - the company's value is basically related to the assets held. - the company has had no income in recent years. - future benefit streams cannot be adequately predicted.

There are two types of valuation engagements described by the Statement on Standards for Valuation Services (SSVS 1), issued by the AICPA, that went into effect in 2008. Valid comparisons of these two types of engagements include which of the following?

There are two types of business valuation engagements outlined in the SSVS 1, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset: 1. In a valuation engagement, the valuation analyst is free to employ the use of any valuation approach or method that is professionally deemed appropriate under the circumstances. The results are expressed in terms of a conclusion of value and can either be a single number or a range. The premise of value can be either a going concern or liquidation. 2. In a calculation engagement, the valuation analyst and the client agree upon the valuation methods and approaches to be used; therefore, the analyst is not free to use any approach or method available. The results are expressed in terms of a calculated valued and can be either a single number or a range. The premise of value can be either a going concern or liquidation.

A company issued common stock and preferred stock. Projected growth rate of the common stock is 5%. The current quarterly dividend on preferred stock is $1.60. The current market price of the preferred stock is $80 and the current market price of the common stock is $95. What is the expected rate of return on the preferred stock?

To determine the expected rate of return on preferred stock, annualize the quarterly dividend, and then divide the expected dividend per share by the price per share; multiply by 100 to get the percentage rate of return: ($1.60 × 4) ÷ $80 = 8%

Which of the following events would decrease the internal rate of return of a proposed asset purchase?

Two general rules can be developed related to the internal rate of return (IRR) of a proposed asset purchase: Increases in cash inflows (decreases in cash outflows) will result in a higher internal rate of return. The earlier the cash inflows (the later the cash outflows) the higher the internal rate of return, all else being equal. Taxes in general will lower the IRR of a proposed asset purchase, as will decreases in the tax credits available when an asset is purchased.

The market approach to determining the fair value of a small company is based upon the theory that:

companies within the industry that have similar performance records and structure will have similar value.

In the definition of fair value as presented in FASB ASC 820, the principal market is considered to be a market where:

the holder of the asset or liability could find the greatest volume of asset sales or liability transfers of items similar to the one being valued.