Explain the use of strategic option in valuation. Explain how strategic options are often abused in valuation.
Strategic options are utilized in the valuation of capital investment projects. They allow the managers of the firm to add value to their business by working to maximize the consistent cash flows and mitigate any potential loss. The option can be to wait and investigate the project before investing, abandon the investment or to make a follow up on the investment if the recent project of investment succeeds. The strategic options can be abused by the managers when they do not choose when to invest the projects well
Explain the APV approach and how it is used in enterprise valuation.
Adjusted Present Value (APV) is a method of valuing a firm without any debt. In this Approach, we use the net effect on the value of the firm by determining both the net benefits and the borrowing costs. We consider the assumption that the benefit of borrowing is a benefit of tax and that the borrowing costs is one potential risk of bankruptcy.
The value of the firm is estimated using the APV Approach in three steps. First, we determine the value of a firm without leverage. Secondly, we determine the interest tax savings present value that come from borrowing a certain money value. Lastly, we analyze and evaluate the net effect of borrowing the amount of money on the probability that the business can go into bankruptcy. We estimate the approximate expected cost of going into bankruptcy.
To determine the value of unleveraged firms using the APV approach, we first approximate the value of the unleveraged business by assuming the company did not have any debt. We discount the expected cash flows at the cost of equity. The business value can be determined using a fixed set of assumptions of the growth that is reasonable to the individual firm. We then calculate the approximated tax benefits from a constant debt level. The tax benefit is discounted at the company’s cost of debt so that it can reflect the cash flow riskiness. Finally, we determine the net effect of debt on the expected risk of the firm and the costs of bankruptcy. We then adjust for the probability of bankruptcy.
Explain how derivative securities are used to find certainty equivalent cash flows. How would you use these cash flows in valuation?
Valuation of cash flows is an important issue in finance. It is the present value that the cash flows the asset is expected to bring in a lifetime. The value depends on the riskiness of the cash flows and the period in the future. We can account for risk in the valuation of cash flows using three different methods. One method is first to adjust the cash flows that are risky to make them risk-free or certain cash flows that have equal value as the tricky ones. The certainty equivalent cash flows can be determined using two methods.
We can use the CAPM or the derivative securities, for example, options and futures. We then discount them back to the present value at the interest rate that is risk-free
Compare and contrast relative valuation techniques with discounted cash flow valuation.
Methods of valuation can be categorized into two that is the absolute valuation models and the relative valuation models. Absolute valuation techniques try to determine the intrinsic value of an asset through the use of fundamentals only such as dividends and the rate of growth of a single firm. The discounted cash flow technique is an example of the absolute valuation models.
On the other hand, Relative valuation techniques operate in an attempt to calculate the assessment through the comparison of the particular company being studied to other same enterprises in the industry. Relative valuation techniques involve the calculation of various ratios and multiples, for example, the multiple of price-to-earnings. We then compare them to the price to earnings multiples of other similar firms.
The relative valuation techniques are much easier and faster to calculate compared to the absolute valuation techniques. Because of these, most investors like beginning their business analysis using the relative methods.
Identify the issues that make private equity more difficult to value as compared to public firms.
Valuation of private equity can be expensive and challenging because of several factors. The size of the private equity can be an issue in the valuation of the firm. Most private investments are small in size. They are not attractive and mostly have a stagnated growth rate that affects the valuation ratios and multiples. They are also riskier than the public firms. Private equity firms lack the market liquidity.
The operating History makes the private equity difficult to value. The individual equities do not have a track of operating history, and this causes a larger discount of valuation. The market share and the concentration of the product determine the risk of the business, and this affects the discount cost.
The level of management control is another issue that makes it difficult to value the private equity. They have a small number of shareholders, and most of them act as the managers also. It limits the level of competency and talent in the management of the firm. There is no proper plan of succession that puts the business at a bigger risk in the manager dies or fails to do the work well. The risks lead to higher discount valuation. The private equity does not have a broad access to better financial sources. It is not able to select their capital sources to maximize the cost of capital. It majorly depends on the bank loans that are extremely expensive and weaken the internal cash flows
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