Advanced_Valuation_Flashcards

Question

What is the Equity Risk Premium in the Build-up Method?

Answer 1

The additional return that investors expect to earn for investing in equities (stocks) over and above the return from a risk-free investment. Under CRSP: Reflects excess returns on equity securities traded on major exchanges (NYSE, NASDAQ, AMEX) over risk-free returns. General consensus range: 3.5% to 6.0%

Answer 2

An additional premium reflecting the higher risk inherent in smaller companies relative to larger companies. CRSP presents size risk premiums for each of the 10 Deciles of the public securities market. It represents excess returns required on smaller securities after adjusting for systematic risks captured in the beta adjustment—isolating size as the remaining risk factor.

Answer 3

Many appraisers believe the industry risk premium data—derived from public markets—is not directly applicable to small, privately held businesses due to the significant structural differences between public and private company markets. Many appraisers incorporate industry risk analysis into the Company-Specific Risk Premium instead.

Answer 4

An additional risk premium reflecting unique characteristics of a privately owned business that differentiate it from publicly owned companies, including: • Management depth and quality • Key person dependency • Capital structure • Marketplace and competitive position • Availability of capital • Volatility of returns • Customer concentration • Economic and industry concerns This premium is an expression of the appraiser's judgment—no empirical database exists to measure it.

Answer 5

An adjustment made to account for differences between the appraiser's selected forward-looking equity risk premium (typically 5%) and the equity risk premium calculated from historic data. Research shows the equity risk premium is cyclical during business cycles, falling in a general range of 3.5% to 6.0%.

Answer 6

WACC is a blended discount rate representing the combined cost of both debt and equity financing, weighted in proportion to their market values. WACC is used as the discount rate when valuing Invested Capital (as if debt-free). Formula: WACC = (Wd × Kd × (1 − Tax Rate)) + (We × Ke) Where: Wd = debt weight, Kd = cost of debt, We = equity weight, Ke = cost of equity

Answer 7

1. Equity cost of capital (Ke) 2. Cost of debt (Kd) 3. Income tax rate 4. Equity capital structure percentage (We) 5. Debt capital structure percentage (Wd)

Answer 8

1. Select capital structure from guideline market data (optimum market capital structure—used for controlling interest valuations) 2. Use the company's current capital structure at market value (requires an iterative process) 3. Use the company's current capital structure when parties to the transaction are known and not hypothetical (e.g., divorce or shareholder oppression litigation)

Answer 9

When using the company's current capital structure at market value as the basis for WACC. Since the equity market value is dependent on the WACC discount rate, and the WACC depends on the equity market value, the calculation must be iterated until the equity value used in the capital structure weights converges with the resulting indicated equity value.

Answer 10

Step 1: Convert the discount rate to a capitalization rate Step 2: Apply a conversion factor—the ratio of the company's normalized net cash flow to net income (or use an industry average as a proxy) Note: This conversion is valid only if net income and net cash flow maintain a constant relationship to each other over time and both grow at the same constant annual rate into perpetuity (rarely met in practice).

Answer 11

Range: Typically 3.0% to 6.5% Estimation approach: Combine the GDP growth rate with the CPI inflation rate Key rule: High growth rates for short periods should NOT be used as a proxy for long-term sustainable growth rates. A long-term growth rate represents an average of expected future growth—some years may be higher or lower.

Answer 12

1. Company's historical performance and outlook 2. Economic conditions 3. Industry conditions and outlook 4. Competition 5. Demographic and population growth 6. Product/service life cycle stage Sources: RMA, Integra, IBIS World, First Research Industry Profiles, The Livingston Survey (Federal Reserve)

Answer 13

1. Liquidity Ratios (Solvency Ratios) – Measure ability to meet short-term obligations (e.g., quick ratio, current ratio) 2. Activity Ratios (Turnover Ratios) – Measure efficiency of asset use (e.g., days accounts receivable, days accounts payable) 3. Leverage Ratios – Measure the degree of debt financing 4. Profitability Ratios – Measure earnings performance 5. Working Capital Measurements

Answer 14

The DuPont Formula illustrates how a company generates its Return on Equity by examining three critical management dimensions: 1. Operating Management – Profitability from sales (net income margin) 2. Asset Management – Efficiency of asset use (total asset turnover) 3. Capital Structure Management – Financial leverage (use of debt) Conclusion: If all three are strong, Return on Equity will be high for sound business reasons.

Answer 15

A quantitative risk analysis formula developed by Edward I. Altman (1968) that predicts the likelihood of a privately owned business entering bankruptcy within two years. Two versions: • Model A (Manufacturing): Uses 5 ratios; Z > 2.90 = financially healthy; Z < 1.10 = likely insolvent • Model B (Non-Manufacturing): Uses 4 ratios; Z > 2.60 = financially healthy; Z < 1.10 = likely insolvent Zone between 1.10 and 2.60/2.90 = potential financial trouble

Answer 16

1. Working Capital / Total Assets × 0.717 2. Retained Earnings / Total Assets × 0.847 3. Operating Income (EBIT) / Total Assets × 3.10 4. Net Worth / Total Liabilities × 0.420 5. Sales / Total Assets × 0.998 Z > 2.90 = Financially healthy Z < 1.10 = Likely insolvent

Answer 17

1. Working Capital / Total Assets × 6.56 2. Retained Earnings / Total Assets × 3.26 3. Operating Income (EBIT) / Total Assets × 6.72 4. Net Worth / Total Liabilities × 1.05 Z > 2.60 = Financially healthy Z < 1.10 = Likely insolvent

Answer 18

These ratios are based on historic accounting figures. Results can be meaningless in a fast-changing economy or industry because past financial data may not reliably predict current or future financial health.

Answer 19

SWOT = Strengths, Weaknesses, Opportunities, Threats Purpose: To understand a company's current position by analyzing: • Strengths – What the company does well • Weaknesses – Areas for improvement • Opportunities – Favorable external conditions to exploit • Threats – External changes that could harm the business Typically combines management's input with the appraiser's analysis and observations.

Answer 20

Prospective financial statements that present, to the best of the responsible party's knowledge and belief, an entity's expected financial position, results of operations, and cash flows. A forecast is based on the responsible party's assumptions reflecting the conditions it EXPECTS TO EXIST and the course of action it EXPECTS TO TAKE.

Answer 21

Prospective financial statements that present, given one or more hypothetical assumptions, an entity's expected financial position, results of operations, and cash flows. Key difference: A projection is based on 'what if?' hypothetical assumptions that may NOT necessarily be expected to occur. A forecast is based on what IS expected to occur.

Answer 22

1. Determine the number of years to forecast (forecast until earnings stabilize at a constant, sustainable growth rate) 2. Develop a calculated perspective (narrative describing future performance based on industry, product life cycle, competition, demographics, etc.) 3. Select a forecasting model (e.g., Percentage Technique, Most Likely/Best/Worst Case, Fixed & Variable Cost, Historic Weighting, Probability Weighted Expected Earnings)

Answer 23

1. Percentage Technique – Projects income statement line items as a percentage of sales 2. Most Likely / Best Case / Worst Case – Shows three scenarios; best for start-ups and unsophisticated companies 3. Fixed & Variable Cost Technique – Separates fixed expenses from variable expenses tied to sales; considered the most appropriate model 4. Historic Weighting Technique – Applies subjective weights to historical years as confidence measures 5. Probability Weighted Expected Earnings – Weights multiple scenario outcomes by probability

Answer 24

Most businesses have: • Fixed expenses that remain constant regardless of sales (e.g., lease obligations) • Variable expenses that change proportionally with sales This technique correctly reflects the actual cost structure of a business rather than assuming all costs move uniformly with sales, producing a more realistic and supportable forecast.

Answer 25

A demand-driven forecast starts with a sales forecast and drives all other variable line items off that sales figure. This is preferred because: • Revenue is the primary driver of all operational costs • It creates internal consistency between income statement and balance sheet • It most closely mirrors how businesses actually operate

Answer 26

1. Are overall financial results consistent with the selected forecasted scenario? 2. Are forecasted financial ratios consistent with sales and earnings growth? If not, why? 3. Is the return on capital consistent with industry rates? 4. Does the company have sufficient borrowing capacity to support forecasted changes? 5. Are private capital funds available to support forecasted changes? 6. Does the forecast include necessary resources to manage the changes? 7. Does the balance sheet properly reflect changes in the income statement (cash, A/R, inventory, A/P, debt)?

Answer 27

CAGR Formula: [(Last Value / First Value) ^ (1 / Number of Years)] − 1 CAGR uses only the FIRST and LAST figures in a series and ignores interim values. It represents the constant growth rate that would transform the first value into the last value over the given period. Used to measure growth (or decline) in sales, profitability, and other metrics.

Answer 28

Rev. Rul. 59-60 (Section 3.02): 'Valuation of securities is, in essence, a prophecy as to the future and must be based on facts available at the required date of appraisal.' Key principle: Business buyers do not buy historical results—they buy what they expect the business to generate in future earnings. Historical data is used as a basis for forecasting, not as a substitute for it.

Answer 29

1. The nature of the business and history of the enterprise from its inception 2. The economic outlook in general and condition/outlook of the specific industry 3. The book value of the stock and the financial condition of the business 4. The earning capacity of the company 5. The dividend-paying capacity 6. Whether the enterprise has goodwill or other intangible value 7. Sales of the stock and the size of the block to be valued 8. The market price of stocks of corporations engaged in the same or similar line of business

Answer 30

Rev. Rul. 59-60 (Section 4.02(e)): 'Primary consideration should be given to the dividend-paying capacity of the company rather than to dividends actually paid in the past.' Reason: Dividends actually paid may bear no relation to a company's capacity to pay dividends. Dividend-paying capacity = normalized net cash flow available to stockholders, which better represents the true economic benefit available to owners.

Answer 31

Net cash flow is the measure of economic income that most financial analysts prefer because: 1. Ibbotson/CRSP and Duff & Phelps equity risk premium data is applicable to net cash flows 2. Applying discount/capitalization rates to other income streams (net income, EBITDA, gross cash flow) without adjustment leads to guaranteed overvaluation 3. The discount rate is derived from market data applicable to net cash flows—using a different income stream without adjusting the rate creates an inconsistency

Answer 32

Discounting net income or any measure larger than net cash flow without adding a premium to the discount rate leads to guaranteed overvaluation. To correct this: A premium must be added to the discount rate, and the premium must increase with the degree to which the measure of earning power exceeds net cash flow. Practical problem: Almost nobody adds these premiums, and there is no empirical evidence for the appropriate magnitude of such premiums.

Answer 33

1. Company's past stability 2. Company's growth (or lack thereof) 3. Diversity of its operations 4. Other facts needed to assess the degree of risk 5. Study of gross and net income, and dividends covering a long prior period 6. Nature of the business, products/services, operating and investment assets, capital structure, plant facilities, sales records, and management 7. Events of the past unlikely to recur should be adjusted for (value has a close relation to future expectancy)

Answer 34

1. Current and prospective economic conditions nationally and within the specific industry 2. Whether the company is more or less successful than competitors 3. Ability of the industry to compete with other industries 4. Prospective competition not previously a factor (high profits often attract new competitors) 5. Management depth—would loss of a key person impair the business?

Answer 35

At the end of each section, the appraiser should summarize the IMPLICATIONS for the Subject Company specifically addressing: 1. Growth in Company Revenue 2. Operating (EBIT) Profit Margins 3. Financing Costs (Interest Rates) 4. Business Risk (defined as volatility of EBIT) 5. Financial Risk (defined as risk of going bankrupt) These implications tie directly into the financial forecast. Simply inserting economic/industry data without connecting it to the forecast is a common error.

Answer 36

1. Careful analysis and comparison of income statements to historical results and industry benchmarks 2. Required control adjustments, including reasonable compensation to officers 3. Separate recurrent from non-recurrent income/expense items 4. Distinguish between operating income and investment income 5. Determine whether loss-generating business lines should be eliminated 6. Percentage of earnings retained for expansion 7. Revenue trends 8. Expense identification (inflation-tied vs. percentage-of-sales) 9. Sales concentration risks, seasonal/cyclical trends, technology dependence, obsolescence risks

Answer 37

Forecast until the company's revenue growth stabilizes at a long-term sustainable rate. Stabilization is the goal—whether it takes 2 years or 13 years. Key error: It is an ERROR to automatically assume a five-year forecast. The length depends entirely on the facts and circumstances of each case. Rev. Rul. 59-60 cautions: 'Resort to arbitrary five-or ten-year averages without regard to current trends or future prospects will not produce a realistic valuation.'

Answer 38

Using a historical average implicitly states that the future is expected to exactly resemble the past. Since inflation is typically present (even in low amounts), a historical average effectively projects declining real sales and profits. Rev. Rul. 59-60: 'Prior earnings records usually are the most reliable guide as to the future expectancy, but resort to arbitrary five-or ten-year averages without regard to current trends or future prospects will not produce a realistic valuation.'

Answer 39

Steps: 1. Obtain management's forecast and compare it to an independently prepared forecast 2. Check reasonableness by comparing prior forecasts to actual results (budget vs. actuals) 3. If the forecast appears 'arms-length,' it may be used 4. If slanted high (for sale) or low (for buyout), modify it to conform to the standard of reasonableness 5. Adjust the discount rate higher for aggressive forecasts or lower for very conservative ones Caution: Management often has a motive—divorce, buyout, or sale—that can bias their projections.

Answer 40

'Net cash flow is cash that a business or project does not have to retain and reinvest in itself in order to sustain the projected levels of cash flows in future years. In other words, it is cash that is available to be paid out in any year to the owners of capital without jeopardizing the company's expected cash flow generating capability in future years.'

Answer 41

Net cash flow to EQUITY. When net cash flow to INVESTED CAPITAL is intended, it is specifically referenced by its complete name. The proper discount rate for net cash flow to invested capital is the WACC.

Answer 42

Normalized Net Income Before Taxes − Provision for Income Taxes = Normalized Net Income After Taxes + Depreciation and Amortization = Gross Cash Flow − Capital Expenditures (needed to support projections) +/− Changes in Working Capital (increases = use of cash; decreases = source of cash) +/− Changes in Long-Term Debt (new borrowings added; repayments subtracted) = Net Cash Flow to Equity

Answer 43

Normalized Net Income Before Taxes − Provision for Income Taxes = Normalized Net Income After Taxes + Interest Expense (net of income taxes) + Depreciation and Amortization = Gross Cash Flow − Capital Expenditures (needed to support projections) +/− Changes in Working Capital = Net Cash Flow to Invested Capital Note: To determine equity value, subtract the fair market value of long-term debt from the invested capital value.

Answer 44

1. Operating Activities – Cash generated or used in day-to-day business operations (MOST IMPORTANT for business appraisers—consistently negative cash from operations = serious trouble) 2. Investing Activities – Cash used for or generated from capital expenditures and asset sales 3. Financing Activities – Cash from borrowing, debt repayment, equity issuances, and dividends

Answer 45

1. Direct Method – Essentially a cash basis income statement; each income statement account is converted to cash flows (time-consuming for accrual-basis companies) 2. Indirect Method – Most common; begins with net income and adjusts to reconcile from accrual net income to cash flow (adds non-cash charges, adjusts for changes in balance sheet accounts)

Answer 46

An increase in accounts receivable means the company made sales but did NOT collect cash—it represents a USE of cash (revenue recognized but not received). Similarly: • Increases in inventory = USE of cash (cash tied up in inventory) • Decreases in A/R or inventory = SOURCE of cash • Increases in A/P = SOURCE of cash (borrowing from suppliers) • Decreases in A/P = USE of cash (paying down supplier balances)

Answer 47

1. Review historical depreciation and amortization 2. If using tax returns, identify accelerated depreciation and Section 179 deductions—adjust to straight-line 3. Use a Depreciation Schedule showing all fixed assets, useful lives, acquisition dates, and future depreciation 4. Include amortization of any intangible assets 5. Develop a forecast for future depreciation and amortization based on existing and projected CapX

Answer 48

1. Review historical capital expenditures 2. Discuss CapX plans with management (be aware of potential bias) 3. Understand what is happening in the industry (is new equipment needed to remain competitive?) 4. Assess adequacy of existing fixed assets relative to capacity and forecasted revenue 5. Evaluate maintenance history of current assets 6. Determine planned replacement schedule and cost 7. Consider likelihood of major repairs 8. Compare management's planned CapX to historical patterns 9. Consider capitalized leases vs. true operating leases 10. Incorporate future CapX into the depreciation schedule

Answer 49

In the terminal year (perpetuity), depreciation expense and capital expenditures should be EQUAL. Rationale: In a stable, steady-state business, CapX replaces assets at the rate they depreciate. If depreciation consistently exceeds CapX in the terminal year, the forecast implies the company will eventually run out of assets to depreciate—which is unrealistic for an ongoing concern.

Answer 50

Excess cash is cash held above the minimum amount required for day-to-day operations. Treatment: • Excess cash may be a non-operating asset • It should be ADDED to the indicated operating value to determine the total company value Conversely, if working capital is DEFICIENT, a hypothetical purchaser would need to make an immediate additional investment upon closing, warranting a DECREASE in the ending value.

Answer 51

Assuming that net cash flow will be used to pay down all existing long-term debt to zero. This is usually unrealistic. Most companies tend to maintain a relatively constant debt-to-equity ratio once they stabilize. The more valid assumption is that the company will sustain a steady-state debt level rather than eliminate all debt.

Answer 52

The Principle of Substitution: An informed purchaser will pay no more than the cost of producing a substitute business (asset) with the same utility as the subject. This approach adjusts all assets and liabilities—both tangible and intangible—to their fair market value, reflecting either a going concern or liquidation premise of value.

Answer 53

1. Holding companies 2. Not-for-profit organizations 3. Asset-intensive companies (e.g., construction) 4. Controlling interests with the ability to liquidate assets 5. Actual sale valuations with a financial buyer (fair market value context) 6. Companies with high-integrity balance sheets (audited or reviewed accrual-basis statements)

Answer 54

1. Marketable securities 2. Accounts receivable 3. Inventory 4. Related party transactions (receivables and payables) 5. Property and equipment 6. Intangible assets 7. Interest-bearing debt 8. Built-in capital gains taxes 9. Non-interest-bearing debt

Answer 55

A method that normalizes all assets and liabilities to their fair market value as of the valuation date. It answers the question: 'What would a buyer pay for all the business's net assets at current market prices?' Also known as the Adjusted Book Value Method. It is the most straightforward asset-based method.

Answer 56

The Excess Earnings Method is used to measure the goodwill or intangible value of a company—NOT the entire company's value. Origin: First promulgated in Appeals and Review Memorandum 34, updated in Revenue Ruling 68-609. Despite the IRS's preference to avoid it when better methods exist, it remains one of the most popular methods to value small businesses and professional practices (Shannon Pratt).

Answer 57

Step 1: Estimate the normalized level of income (next year's earnings stream) Step 2: Determine the net tangible asset value at fair market value Step 3: Develop a required rate of return on net tangible assets Step 4: Multiply the tangible asset rate of return × net tangible assets = required return on tangible assets Step 5: Subtract the required return on tangible assets from earnings = Excess Earnings available to intangibles Step 6: Develop a capitalization rate for excess earnings (higher than tangible asset rate due to greater risk) Step 7: Capitalize excess earnings ÷ intangible cap rate = Intangible Asset Value

Answer 58

1. Using an unrealistic estimate of normalized earnings 2. Not defining tangible asset value 3. Not properly supporting the selection of capitalization rates 4. Improperly using capitalization rates from Rev. Rul. 68-609 (those rates are examples only) 5. Failure to allow for arm's-length market owner's salary 6. Use of book value instead of adjusted FMV values 7. Errors in developing appropriate capitalization rates

Answer 59

Negative goodwill appears when the calculated excess earnings produce a negative result, implying a negative intangible asset value. Treatment: Intangible assets either have positive value or ZERO value—negative intangible asset value is NOT supported in the marketplace. A willing seller would not pay a buyer for a negative goodwill position. Conclusion: Set intangible asset value to zero; do not apply a negative adjustment.

Answer 60

Step 1: Consider market value adjustments to the balance sheet Step 2: Determine the correct premise of value (forced vs. orderly liquidation) Step 3: Estimate gross proceeds from asset liquidation (including broker/seller commissions) Step 4: Deduct direct and indirect costs (legal fees, auctioneer costs, operating losses until liquidation) Step 5: Deduct liabilities and contingent liabilities associated with the assets Step 6: Consider taxable liabilities from gains on asset sales Step 7: Consider discounting to present value if time to sell may be significant Result: Net amount realizable after all assets sold and liabilities satisfied

Answer 61

1. Capitalization of Earnings Method – Converts a single, normalized, ongoing earnings stream into present value using a capitalization rate. Used when earnings are stable and growing at a constant rate. 2. Discounted Future Earnings Method (DCF) – Discounts multiple periods of projected cash flows plus a terminal value to present value. Used when earnings are unstable or growth rates will change significantly. IMPORTANT: Use one OR the other—never both in the same report.

Answer 62

Formula: Value = Normalized Earnings ÷ Capitalization Rate The cap rate can also be expressed as a multiplier: 100 / Cap Rate Example: 100 / 25% = 4× multiple Most appropriate when: • Earnings stream is stable • Forecasted growth is at a constant rate • Both conditions persist into perpetuity

Answer 63

Step 1: Consider any adjustments to the financial statements (normalization) Step 2: Determine whether to value equity or invested capital cash flow Step 3: Select the economic income stream to capitalize (Net Cash Flow, Net Income, EBIT, EBITDA, SDE, Gross Profit, Revenue) Step 4: Develop an appropriate capitalization rate Step 5: Calculate the value (Earnings ÷ Cap Rate)

Answer 64

When either of the following conditions exists: 1. Unstable level of earnings or cash flow 2. Earnings growth rate is expected to change significantly over the forecast period (e.g., earnings go up one year but are expected to decrease the next) DCF requires a terminal value to capture value beyond the explicit forecast period.

Answer 65

Step 1: Consider any adjustments to the financial statements Step 2: Determine whether to value equity or invested capital cash flow Step 3: Develop a reasonable forecast for the selected earnings stream Step 4: Develop a discount rate appropriate to the income stream Step 5: Estimate the long-term growth rate for earnings (not sales) — Cap Rate = Discount Rate − Growth Rate Step 6: Develop a present value factor for each year of the forecast Step 7: Determine end-of-year or mid-year discounting convention: PV Factor = 1 / (1 + r)^t Step 8: Calculate incremental values for each year and the terminal value

Answer 66

Formula: PV Factor = 1 / (1 + Discount Rate) ^ t • End-of-Year Convention: t = 1, 2, 3, 4, 5... (assumes all cash flows arrive at year end) • Mid-Year Convention: t = 0.5, 1.5, 2.5... (assumes cash flows arrive evenly throughout the year) Mid-year convention typically produces a higher indicated value because cash is received, on average, earlier than end-of-year.

Answer 67

1. Always using five years as the appropriate time frame 2. Unsupported assumptions about future events considerably different from historical performance 3. Not using the long-term growth rate for earnings to calculate the terminal period earnings 4. Terminal year value is less than the selected forecasted years (mathematically problematic) 5. Assuming constant growth in earnings throughout the forecast when growth is actually expected to vary

Answer 68

The Economic Principle of Substitution: 'No prudent individual would pay more for an asset than the price required to obtain an equal asset of comparable utility.' 'Equal' means equally desirable from an ownership or investment standpoint—not necessarily identical. Market transactional data represents a sampling of the marketplace from the investor's viewpoint.

Answer 69

1. Direct Market Data Method (Transactional Method) – Uses actual sales of closely held businesses from databases 2. Merger & Acquisition Method (Guideline Private Company Method) – Uses pricing multiples from a few closely comparable transactions 3. Guideline Public Company Method – Uses multiples derived from comparable publicly traded companies 4. Industry 'Rule of Thumb' Method – For sanity checks ONLY; should not be relied upon as a primary method

Answer 70

1. Securities and Exchange Commission (EDGAR) 2. Done Deals 3. Capital IQ 4. DealStats 5. Mergerstat 6. PitchBook

Answer 71

1. BizMiner 2. Integra 3. DealStats 4. BIZCOMPS 5. ValuSource 6. Done Deals 7. Business Brokers 8. Proprietary Databases

Answer 72

Direct Market Data Method: • Market-specific—uses a large sample of transactions (6 to 10+) • Knows little about each individual transaction • Relies on statistical analysis (mean, median, coefficient of variation) across many data points • Transactions come from business brokerage databases Merger & Acquisition Method: • Company-specific—uses 4 to 6 very similar, closely comparable transactions • Knows more detail about each transaction • Multiples may be adjusted for unique aspects of the subject company

Answer 73

1. Only relying on 'Rules of Thumb' 2. Co-mingling C and S Corporation transactions (DealStats) 3. Co-mingling asset and stock transactions (DealStats) 4. Not defining the size range relative to the subject company 5. Utilizing too few transactions 6. Including guideline public companies with sales far exceeding the subject company 7. Including a transaction when there are no sales data

Answer 74

1. Type of interest (e.g., controlling interest of closely held businesses) 2. SIC or NAICS code (primary and acceptable secondary codes) 3. Sales range (ensure comparable business size) 4. Geographic domicile (U.S. vs. international) 5. Time frame (typically executed within the past ten years to capture one full business cycle)

Answer 75

1. Mean (average) 2. Median 3. Standard deviation (measures dispersion from the mean) 4. Coefficient of Variation (CoV = Standard Deviation / Mean—lower CoV = better indicator; higher CoV = more dispersion) 5. Regression analysis 6. Sorting by multiple (high to low)

Answer 76

A valuation multiple expresses the relationship between a financial metric and the sold price of a business. Example (Price-to-Sales): Sold Price ÷ Annual Sales = Valuation Multiple $1,890,000 ÷ $1,258,794 = 1.5× multiple IMPORTANT: Always calculate these multiples yourself—never rely solely on the database's pre-calculated figures.

Answer 77

The initial indication is an INVESTED CAPITAL value (as if debt-free). Reason: Most sold transactions involved the seller retaining current assets and all liabilities, so the buyer received the business free of financial obligations. Adjustment needed: Convert from asset-sale invested capital value to an EQUITY value by adjusting for current assets retained and liabilities assumed in the transaction. Sources like IBA, BizComps, Pratt, and DoneDeals all require this recast.

Answer 78

Most appropriate: Valuation of larger privately held businesses that could conceivably be purchased by a publicly traded company or that were spun off as an independent enterprise. Least appropriate: Valuation of small businesses where the size gap between the subject and publicly traded comparables is too large (multiples become useless). Example of poor comparison: Local independent coffee shop vs. McDonald's Corp.; local hardware store vs. Home Depot.

Answer 79

The Levels of Value chart illustrates the differences between: 1. Controlling Marketable Interest – Highest level; reflects the value with full control and full marketability 2. Minority Marketable Interest – Publicly traded minority shares; liquid but lacking control 3. Minority Non-Marketable Interest – Lowest level; lacks both control and marketability Moving from the controlling level to the minority non-marketable level requires applying a DLOC and/or DLOM.

Answer 80

DLOC – Reflects the absence of control. Applied when the interest being valued lacks the ability to direct management, compensation, or company structure. Can apply to minority interests AND majority interests lacking some degree of control. DLOM – Reflects the absence of the ability to convert the interest into cash quickly and/or to transfer it within a relatively short time period. Contains two elements: transferability and liquidity.

Answer 81

Shareholder-Level Adjustments: 1. Control Premium – Premium for controlling interest 2. Discount for Lack of Control (DLOC) 3. Discount for Lack of Marketability (DLOM) 4. S Corporation Premium 5. Voting vs. Nonvoting Stock differential (possibly/maybe)

Answer 82

Entity-Level Adjustments (less common than shareholder-level): 1. Key Person Discount 2. Discount for Trapped-In Capital Gains 3. Discount for Environmental, Litigation, and Other Contingent Liabilities Note: Key person discount and environmental/litigation discounts may alternatively be captured in the company-specific risk premium.

Answer 83

1. Differences in the market: The market for minority ownership interests in a company is different from the market for the company as a whole. 2. Disadvantages of minority position: Minority investors lacking control have several disadvantages relative to controlling shareholders: • Inability to change suboptimal management • Disproportionate distribution of cash flows to control holders • Timing of distributions controlled by majority • Limited access to information • No right to liquidate or sell corporate assets

Answer 84

Control is characterized as the ability to: 1. Influence or decide owner/manager compensation and perquisites 2. Set company policies and procedures 3. Hire management personnel 4. Acquire or liquidate assets 5. Make acquisitions 6. Determine the amount and timing of dividends 7. Elect or appoint members of the board of directors

Answer 85

1. Mergerstat Review 2. Mergerstat / Shannon Pratt's Control Premium Study 3. Closed-End Funds Mergerstat measures premiums as the percentage difference between the acquisition price and the freely traded public share price five trading days before the acquisition announcement.

Answer 86

DLOC = Control Premium ÷ (1 + Control Premium) Example with 38.8% control premium: 38.8% ÷ (1 + 0.388) = 38.8% ÷ 1.388 = 27.95% DLOC

Answer 87

Factors that may INCREASE DLOC: • Management restrictions on minority interests per operating agreement • Company is dependent on a few key people Factors that may DECREASE DLOC: • State regulations protecting minority shareholders Factors that are NEUTRAL on DLOC: • Presence of historic distributions

Answer 88

Transferability – The right to sell an asset in a market within a reasonable time frame at relatively low transactional costs with minimal effect on its value. Limited by ownership agreements, lack of disclosure, and costs. Liquidity – The ability to quickly convert property to cash or pay a liability without diminishing its value. Revenue Ruling inferred from NYSE that liquidity should mean approximately 3 days. DLOM contains elements of both: transferability and liquidity.

Answer 89

1. Restricted Stock Studies – Compare prices of restricted stock (cannot trade for a holding period) to freely traded stock of the SAME company on the SAME date. Measures primarily MARKETABILITY (transferability). 2. Pre-IPO Studies – Compare prices of private transactions in a company's stock before an IPO to the post-IPO market price. Measures lack of marketability prior to going public.

Answer 90

• Pre-1990 studies: Average discounts ranged from 13% to 35.6% • Post-1990 studies: Average discounts fell into the 20s% • The decline post-1990 corresponds with SEC eliminating mandatory registration and reducing holding periods from 2 years to 1 year • Many professionals believe earlier studies are better indicators of DLOM for closely held companies • SSR Study (Stout Risius Ross): For 6-month holding periods, discounts ranged from −5.3% to 40%, with a median of 9.3%

Answer 91

1. Restricted stock shares differ from closely held company shares in important ways (known limited holding period, financial reporting transparency, and public market liquidity) 2. Discounts fell in very wide ranges within each study (e.g., Management Planning study: 0% to 57.6%) 3. Many studies do not provide detailed transaction-level information 4. Many studies are more than thirty years old

Answer 92

• Mean discounts generally ranged from 40% to 45% • The 1997 dot.com study is not directly comparable; excluding it, the adjusted mean discount for 8 remaining studies was 46% • Transactions compare prices paid in private transactions within 5 months prior to IPO vs. the opening IPO price • Adjusting for event signaling (a 14.5% NYSE premium factor per Feldman), the adjusted DLOM estimate is approximately 31.5%

Answer 93

QMDM is a theoretical discounted cash flow model developed by Christopher Mercer to estimate DLOM for marketable minority interest values. Required inputs: 1. Expected growth rate in value 2. Expected dividend yield 3. Expected growth rate in dividends 4. Expected holding period 5. Required holding period return Two primary criticisms: 1. Holding period cannot be determined with any certainty 2. Theoretically, entity value should not change based on holding period (terminal value captures all future cash flows)

Answer 94

1. Wruck Study – Mean discount of 17.6%. Studied price difference between unregistered and registered shares; found positive abnormal returns associated with private transaction announcements. 2. Hertzel/Smith Study – Mean discount of 20.1%; after multivariate regression controlling for non-marketability factors, the pure marketability discount was 13.5%. 3. Bajaj/Denis/Ferris/Sarin (Private Placement Study) – Mean discount of 22.2%; after controlling for non-marketability factors (business risk, financial distress, etc.), the pure DLOM was 7.2%.

Answer 95

Established in Bernard Mandelbaum v. Commissioner: 1. Financial statement analysis 2. Company's dividend policy 3. Nature of the company, its history, position in the industry, and economic outlook 4. Company's management 5. Amount of control in transferred shares 6. Restrictions on transferability of stock 7. Holding period for stock 8. Company's redemption policy 9. Costs associated with making a public offering

Answer 96

Use as many sources as deemed reasonable and reconcile into one DLOM conclusion: 1. Restricted stock studies 2. Pre-IPO studies 3. Theoretical models (QMDM) 4. Academic studies 5. Mandelbaum Factors Reliance on a single model/study is becoming less acceptable. Two approaches: • Discuss reasoning behind weighting one source over another • Objectively cite strengths and weaknesses of each, then select a percentage from within the high-to-low range

Answer 97

1. Pluris Valuation Advisors – Restricted stock database with 3,250+ transactions from 2001–Q4 2011; over 80 data points per transaction; requires calculating Restricted Stock Equivalent Discount (RSED) and Private Equity Discount Increment (PEDI) 2. Valuation Advisors Lack of Marketability Discount Study – ~9,400 pre-IPO transactions from 1985 to present; searchable by IPO date, NAICS/SIC, and other data points 3. FMV Restricted Stock Study – Updated quarterly; searchable by 21+ fields

Answer 98

Trapped-in (built-in) capital gains arise when the tax basis of assets inside an entity is LOWER than their fair market values. This is most significant in C corporations (not eligible for Section 754 step-up), but can also be a factor in S corporations, partnerships, and LLCs. Key tax cases establishing this discount: Estate of Davis, Estate of Eisenberg, Estate of Jameson

Answer 99

Partnerships and LLCs can make a Section 754 Election—a 'step-up' in basis—which allows a buyer to receive an inside basis in its ownership interest equal to the price paid to acquire that interest. This eliminates the trapped-in capital gains tax liability for the buyer, making the investment more attractive. This step-up basis is NOT available to C corporation shareholders.

Answer 100

An S Corporation Premium reflects the additional value an S corporation has compared to an otherwise identical C corporation, due to the tax advantage of pass-through taxation. Key benefit: S corporations can make discretionary distributions tax-free at the corporate level. C corporation dividends are taxed twice—once at the corporate level and again at the shareholder level. Only a true 'double tax' occurs when the C corporation distributes 100% of earnings. Many appraisers consider this a non-issue after the Tax Cuts and Jobs Act of 2018.

Answer 101

Four empirical studies of small minority interests found a price differential in favor of voting stock of LESS THAN 5%, with no study indicating a premium exceeding 10%. Key court cases: • Newhouse v. Commissioner: Goldman Sachs suggested 5–10% discount • Kosman v. Commissioner: IRS expert = 4%; taxpayer's expert = 10% (rejected for lack of published data support) • Simplot v. Commissioner: Petitioner argued 7%; IRS argued 3%; court decided 3% was reasonable

Answer 102

A key person discount reflects the incremental decrease in value resulting from the risk that a key individual (owner, key salesperson, or specialist) may depart. Quantification methods: • Present value of management's estimated lost customers/revenue • Recruiting costs and time to ramp revenue back up • Cost to replace the key person and rebuild the business IMPORTANT: The IRS and Tax Court both recognize this discount. Avoid double-counting—if captured in the specific company risk premium or in forecasted earnings, do not apply a separate discount.

Answer 103

1. Valuing underlying assets rather than stock or partnership interest 2. Assuming DCF/cap of earnings methods always produce a minority interest value 3. Assuming the Guideline Public Company Method always produces a minority interest value 4. Using minority interest marketability discount data to quantify controlling interest discounts 5. Using only restricted stock studies as the benchmark for DLOM 6. Inadequate analysis of relevant factors 7. Indiscriminate use of average/median discounts or premiums 8. Applying (or omitting) a premium or discount inappropriately for the legal context 9. Applying discounts/premiums to the entire capital structure rather than only to equity 10. Quantifying discounts/premiums based solely on past court cases

Answer 104

Rev. Rul. 59-60: '...no useful purpose is served by taking an average...and basing the valuation on the results. Such a process excludes active consideration of other pertinent factors, and the end result cannot be supported by a realistic application of the significant facts in the case except by mere chance.' Conclusion: Do not simply average method indications. Instead, explain why you have more confidence in one method over another and support that reasoning.

Answer 105

Reconciliation expresses the appraiser's confidence level in each method and explains the final value conclusion. If method indications diverge significantly, ask: 1. Did I develop my rate properly? 2. Did I apply my rate to the appropriate financial measurement? 3. Did I make the correct financial adjustments? 4. Did I consider what the seller and buyer would do in applying each method? 5. Is my math correct in each method?

Answer 106

A test designed to double-check the indicated value by analyzing available cash flows of the business to determine whether a buyer can realistically pay back the purchase price. Process: A buyer provides a down payment and finances the balance with a term loan. The test verifies that the forecasted cash flows are sufficient to service the debt and provide an adequate cash-on-cash return to the equity investor at the appraised value.

Answer 107

Anyone should be able to REPRODUCE (replicate) the supporting facts and conclusions using the data and verbiage as stated in the written report. The principal reason a report is written is to COMMUNICATE AN OPINION. The appraiser must present information in a clear, concise, and understandable format to maintain independence and build trust.

Answer 108

1. Analyze the purpose and use of the value conclusion (audience and occasion) 2. Determine the inclusion of subject matter (USPAP scope of work rule) 3. Find and select supporting material 4. Determine the report's organizational structure (terminal digit structure or basic indention format)

Answer 109

1. Properly identify the problem to be solved 2. Determine and perform the scope of work necessary for credible results 3. Disclose the scope of work in the report An appraiser must be prepared to support the decision to include any information, valuation method, or technique that would appear relevant to the client, another intended user, or the appraiser's peers.

Answer 110

Avoid: Obviously, Clearly, Appears, Supposedly, Presumably, Apparently, Complete, Exhaustive, Assume Also avoid phrases like 'I think,' 'I believe,' or 'it seems'—they indicate less than 50% certainty and damage credibility. Preferred language: 'Based upon a reasonable degree of certainty' or 'Based upon a reasonable degree of probability'—stated clearly, explicitly, and confidently.

Answer 111

1. 'Based upon a reasonable degree of certainty' 2. 'Based upon a reasonable degree of probability' These phrases indicate that the appraiser is more than 50% certain about the events or information presented.

Answer 112

1. Table of Contents 2. Executive Summary 3. Appraiser's Certification (Assumptions and Limiting Conditions) 4. Introduction (Description of Assignment, Standard of Value, Premise of Value, Valuation Date, Ownership, Prior Transactions, Sources of Information) 5. Survey of the Business 6. Economic and Industry Conditions 7. Financial Analysis 8. Valuation of Subject's Interests 9. Adjustment to the Indicated Values (non-operating assets, discounts/premiums) 10. Reconciliation of Values 11. Appraiser's Qualifications

Answer 113

Valuation Date (Effective Date / 'As of Date') – The specific date for which the opinion of value applies. Generally historic, though can be prospective in some cases. Establishes the context for the appraiser's opinion. Report Date – The date the report is actually issued to the client. IMPORTANT: Do not confuse these two dates. The opinion of value would likely change if the effective date were modified.

Answer 114

The Standard of Value defines the type of value being estimated (e.g., Fair Market Value, Fair Value, Investment Value). Fair Market Value (most common): The price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. Importance: Different standards apply in different contexts. Rev. Rul. 59-60 is for estate and gift tax. Buy/sell transactions use the International Glossary definition. Always cite the source of the definition.

Answer 115

The premise of value is the assumed condition under which the business is being valued—similar to 'highest and best use' in real estate appraisal. 1. Going Concern – The business continues to operate; intangible value and goodwill are captured 2. Liquidation – Assets are sold individually or in bulk; two sub-types are orderly liquidation and forced liquidation

Answer 116

Subsections typically include: 1. Description of the Subject Company 2. History of the Business 3. Form of Organization 4. Subsidiaries or Affiliates 5. Management 6. Employees/Staff 7. Products/Services 8. Sales and Marketing Activities 9. Customer Base 10. Facilities and Equipment 11. Competitors 12. Barriers to Entry 13. Environmental, Regulatory, and Other Conflicts 14. Management's Future Prospects 15. Implications for the Subject

Answer 117

The certification must include assumptions and limiting conditions used in the valuation assignment. USPAP defines 'assumption' as 'that which is taken to be true.' USPAP Standard 10-3 provides specific language that appraisers may use in their signed certification pages.

Answer 118

To inform the reader who is responsible for the opinions expressed in the report. It allows the reader to assess the appraiser's credibility by reviewing: 1. Education and training 2. Professional experience 3. Certifications held 4. Professional affiliations It is important for the reader to understand who is responsible for the opinions held within the report.

Answer 119

Quick Ratio – Measures a company's ability to meet short-term obligations using its most LIQUID assets (excludes inventory). Also called the acid-test ratio. Current Ratio – A higher ratio indicates the company can pay its creditors. Calculated as Current Assets ÷ Current Liabilities. Important: Only compare industry average ratios to the subject company's MOST RECENT year.

Answer 120

Days Accounts Receivable – Measures the average number of days it takes a company to collect payments on accounts receivable. A higher number may signal collection problems. Days Accounts Payable – Measures the average number of days it takes a company to pay its accounts payable. A higher number may indicate the company is taking longer to pay suppliers (potential cash flow stress or leverage of supplier financing).

Answer 121

CoV = Standard Deviation ÷ Mean Purpose: Measures the relative dispersion of data points around the mean. • Lower CoV = less dispersion = the selected valuation multiple is a BETTER indicator of value • Higher CoV = more dispersion = the data set is less reliable; the mean/median may not be meaningful When CoV is low, selecting the mean or median is justified. When CoV is high, the appraiser must exercise greater judgment.

Answer 122

MVIC = Market Value of Invested Capital = Market Value of Equity + Market Value of Long-Term Debt EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization Formula: MVIC ÷ EBITDA = Valuation Multiple Used in the Merger & Acquisition Method and Guideline Public Company Method to compare companies on a debt-free basis.

Answer 123

ISBA = International Society of Business Appraisers The ISBA follows the report writing standards described in the Uniform Standards of Professional Appraisal Practice (USPAP). USPAP is the recognized standard for professional appraisal practice in the U.S., including business valuation. While specific content standards vary by appraisal society, USPAP provides the foundational framework.

Answer 124

BCA = Business Certified Appraiser The BCA is a professional designation issued by the International Society of Business Appraisers (ISBA). The training program is designed to produce appraisers who can: 1. Read and explain a business valuation report 2. Write a business valuation report independently The program covers approaches, methodologies, terminology, and their interrelationships.

Answer 125

Revenue Ruling 59-60 is an IRS guidance document originally issued for estate and gift tax valuation of stock in closely held corporations. It is widely recognized as the foundational standard for business valuation practice. Key contributions: • Defines the eight factors to consider in valuation • Emphasizes forward-looking analysis (future expectations) • Requires consideration of economic and industry conditions • Guides income forecasting approach • Addresses dividend-paying capacity as the primary measure of value

Answer 126

Revenue Ruling 68-609 updated and restated the Excess Earnings Method originally established in Appeals and Review Memorandum 34. Key points: • The IRS does not favor this method and indicates it should only be used when no better method exists • The capitalization rates cited in the ruling are EXAMPLES ONLY—they should not be used without independent support • Despite IRS reluctance, it remains widely used for valuing small businesses and professional practices

Answer 127

Controlling Interest Adjustments – Appraisers make adjustments to reflect the TRUE operating financial performance of the company (e.g., adjusting excessive owner compensation to market rates). These adjustments are appropriate because a controlling interest holder CAN make these changes. Minority Interest – No controlling adjustments are warranted. A minority holder CANNOT change management, compensation, or the entity's structure without the consent of the controlling interest holder.

Answer 128

Preferred stock dividends must be SUBTRACTED in reaching either: • Net Cash Flow to Equity, or • Net Cash Flow to Invested Capital This ensures the cash flows reflect only what is available to the common equity holders or to all capital providers after preferred obligations are met.

Answer 129

A capitalization rate can be expressed as a multiplier instead of a divisor: Multiple = 100 ÷ Capitalization Rate Example: A 25% cap rate = 4× multiple (100 ÷ 25 = 4) Example: A 20% cap rate = 5× multiple (100 ÷ 20 = 5) This allows comparison to market transaction multiples and helps communicate value in investor-friendly terms.

Answer 130

To convert NEXT YEAR'S capitalization rate to the CURRENT YEAR'S capitalization rate: Current Cap Rate = Next Year's Cap Rate ÷ (1 + Long-Term Growth Rate) This adjusts for the time difference between the two periods when earnings are growing at the long-term sustainable growth rate.

Answer 131

Rev. Rul. 59-60: 'A determination of the proper (discount) capitalization rate presents one of the most difficult problems in valuation.' The rate represents the expected rate of return the market demands to attract funds to a particular investment. The appraiser's goal is to quantify forward-looking investor expectations for an investment in the business.

Answer 132

Direct Market Data Method (Market-Specific): • Requires a large sample (6–10+ transactions) to be statistically meaningful • Derives overall market averages; less detail on each transaction • Sampling theory: adequate sample size ensures reasonable confidence level Guideline Public Company / M&A Method (Company-Specific): • Requires only 4–6 closely comparable companies or transactions • Knows considerably more about each comparable • Can adjust multiples for specific differences between the subject and each comparable

Answer 133

Rev. Rul. 59-60 states these three elements must enter into the process of selecting the proper valuation ratio or multiple. This means: Do not automatically select the mean or median without analyzing the dataset. Use additional statistical tools (regression, CoV, standard deviation) as supplements—but these should complement, not replace, informed judgment and reasonableness.

Answer 134

1. Balance Sheet – A snapshot of assets, liabilities, and equity at a point in time 2. Income Statement – Reports revenues and expenses over a period; prepared on accrual basis 3. Cash Flow Statement – Shows actual cash receipts and payments; reconciles net income to cash Note: Many companies requiring valuation do not produce a formal cash flow statement—the appraiser must then reconstruct it from the balance sheet and income statement.

Answer 135

A consistently negative cash flow from operations is a serious warning sign—the company is in trouble. Cash from operations is the most critical section for a business appraiser because it reveals whether the core business generates or consumes cash independent of financing and investing activities.

Answer 136

Accrual Income Statement – Records revenue when earned and expenses when incurred, regardless of when cash is received or paid. Sales on account are recorded immediately even if cash is not yet collected. Cash Flow Statement – Shows actual cash receipts and payments during the period. Reconciles net income to actual cash flow by adjusting for non-cash items and changes in balance sheet accounts.

Answer 137

The Equity Risk Premium Adjustment compensates for any difference between the appraiser's selected forward-looking equity risk premium (typically 5%) and the historically calculated equity risk premium. General consensus range for equity risk premium: 3.5% to 6.0% This adjustment is cyclical—it changes throughout the business cycle.

Answer 138

CRSP Decile Study uses publicly available market data to develop size-based risk premiums organized into 10 deciles. • Decile 1 = Largest companies • Decile 10 = Smallest companies The size premia data most widely used by valuation analysts have been adjusted for all systematic influences EXCEPT size—isolating the size premium as the unique additional risk factor.

Answer 139

When a company's 'size measurements' do not exactly match the 'average smoothed' risk premiums from the 25th portfolio, a regression model can be employed to calculate an interpolated equity risk premium for a company. The risk premium report cautions: 'Extrapolating a statistical relationship far beyond the range of the data used in the statistical analysis is not recommended.' However, interpolating within the range of companies comprising the 25th portfolio is within reason.

Answer 140

A demand-driven forecast is the recommended methodology for developing forecasted financial statements. Starting point: A SALES FORECAST (revenue) All other variable line items are then driven off the sales forecast—meaning costs, working capital requirements, and other financial metrics are projected as a function of the projected sales level. This approach ensures the forecast reflects the actual economic drivers of the business.

Answer 141

Management frequently projects sales increases (e.g., 25%) but fails to account for whether the existing asset base can support that growth level. Key principle for the terminal/perpetuity year: Depreciation expense and CapX should be EQUAL. If depreciation consistently exceeds CapX, the forecast implies the company will eventually exhaust its depreciable asset base—an unrealistic long-term assumption.

Answer 142

A technique that assigns probability weights to multiple scenario outcomes (e.g., best case, most likely, worst case) to arrive at a probability-weighted expected earnings stream. Formula: Weighted Earnings = (Best Case × P1) + (Most Likely × P2) + (Worst Case × P3) Where P1 + P2 + P3 = 100% This approach provides a more rigorous, quantitative basis for forecasting under uncertainty.

Answer 143

The weightings applied in the Historic Weighting Technique are subjective and do NOT necessarily relate to the researched business trend of the company. Cautions: • Business valuation is FORWARD-LOOKING—a historical weighted average only captures available earnings on an ongoing basis with an assumed constant growth rate • The technique assumes growth in earnings occurs at a constant, steady rate—which may not reflect expected business conditions • The company's benefit stream should reflect what is expected to occur DURING THE NEXT YEAR

Answer 144

The appraiser must: 1. Identify non-operating or excess assets not used in operations 2. Identify operating assets NOT reflected on the balance sheet 3. Scrutinize management's responses to interview questions for honesty and reasonableness 4. Function as a 'detective' to uncover financial statement irregularities IMPORTANT: An appraiser is held accountable to determine what irregularities a probable buyer might uncover. Small/mid-size business financials are often 'managed' by owners for tax purposes, requiring more normalization adjustments.

Answer 145

1. Gross assets less accumulated depreciation (assets adjusted to market value less economic depreciation) 2. Current Assets + Property & Equipment − Current Liabilities 3. Current Assets + Property & Equipment − ALL Liabilities Note: Revenue Ruling 68-609 does not specify a definition—there is no universally accepted standard for 'net of what.' The appraiser must define and disclose the definition used.

Answer 146

As tangible asset levels DECREASE → intangible rate of return INCREASES (compensating for higher risk of intangibles) As tangible asset levels INCREASE → intangible rate of return DECREASES (lower risk = lower required return) Logic: In default, tangible assets can be sold to recover value—investors accept a lower return for this protection. Intangibles, when separated from their income-producing tangible counterparts, are generally not salable independently—commanding higher risk-based returns.

Answer 147

The Direct Market Data Method assumes that most 'sold' transactions in databases like IBA, BizComps, and DoneDeals were ASSET SALES where: • The seller retained current assets and all liabilities • The buyer received the business free and clear of financial obligations This means the initial indication of value represents INVESTED CAPITAL (as if debt-free). To convert to an EQUITY indication, the appraiser must adjust for the assets and liabilities that actually transferred in the transaction.

Answer 148

Direct Market Data Method: 6 to 10 or more transactions (more = greater statistical confidence; excess of 10 provides greater flexibility) Merger & Acquisition Method: At least 4 to 6 transactions that are significantly similar to the subject Guideline Public Company Method: No fixed requirement, but fewer are needed since 10-K and 10-Q filings provide detailed information, allowing more confident conclusions with fewer comparables

Answer 149

The Mandelbaum Factors are used to determine whether the DLOM should be HIGHER or LOWER than the average indicated by benchmark studies: 1. Financial Statement Analysis – Strong ratios = lower DLOM 2. Dividend Policy – No dividends = higher DLOM 3. Nature/History/Outlook – Thin competition = lower DLOM 4. Management – Single competent individual = higher DLOM (key person risk) 5. Amount of Control – Minority interest = average DLOM 6. Restrictions on Transfer – Right of first refusal = higher DLOM 7. Holding Period – Longer = higher DLOM 8. Redemption Policy – No policy = average DLOM 9. Cost of Making Public Offering – Small company, slim IPO chance = higher DLOM

Answer 150

1. Number of Shareholders 2. Concentration of Control Owner 3. Number of Potential Buyers 4. Access to Capital Markets 5. Size of the Business 6. Desirability of the Business 7. Existence of Non-Compete Agreements 8. Divergence of Owners' Business Philosophy 9. Yield 10. Volatility of Assets 11. Liquidity of Control Owners 12. Size of Subject Block being Valued 13. Existence and Impact of Pending Litigation 14. Redemption Policy 15. Secondary Market Liquidity 16. Existence of Company Goodwill 17. Multiple Classes of Common Stock

Answer 151

Marketability – The RIGHT to sell an asset in an established and efficient public capital market within a reasonable time frame, at relatively low transaction costs, with minimal effect on the asset's market price. Liquidity – The ABILITY to convert an asset into cash without diminishing its value. A spectrum: • High liquidity = low transaction costs, short liquidation period, minimal discounts • Low liquidity = opposite characteristics Private placement studies measure LACK OF LIQUIDITY; restricted stock and pre-IPO studies measure LACK OF MARKETABILITY.

Answer 152

Feldman reviewed two studies (moving from OTC to NYSE and from NASDAQ to NYSE) to estimate the impact of event signaling on discounts for closely-held stocks. Findings: A stock trading on the NYSE is at least 17% more valuable than an equivalent closely-held stock. This means a closely-held stock would sell at a 14.5% discount to an equivalent publicly traded stock. Adjusted Emory DLOM estimate: ~31.5% (46% mean discount − 14.5% event signaling effect)

Answer 153

RSED (Restricted Stock Equivalent Discount) – Represents the difference between the market value of a company's publicly traded stock and the equivalent value of a company's restricted stock. Results from the fact that restricted stock trades at a discount because it can only be sold in private transactions or in public markets after the holding period. PEDI (Private Equity Discount Increment) – Represents the additional discount for the further illiquidity of a closely-held interest relative to the restricted stock discount already captured in the RSED.

Answer 154

An S Corporation premium may be required when: 1. The indicated value was derived from publicly traded marketable value methods (Discounted Future Earnings, Capitalization of Earnings, Guideline Public Company methods) 2. These methods produce a 'C Corporation equivalent' value When using the Excess Earnings Method: an adjustment may be required to the INTANGIBLE asset value since it was based on market returns and reflects C Corporation equivalency. Note: Many appraisers treat this as a non-issue post-Tax Cuts and Jobs Act of 2018.

Answer 155

Litigation Report – More detailed and comprehensive: • Includes full history of the business (inception dates, addresses, all relocations) • Records every material fact that may be tested under oath • Written knowing it may become part of testimony and be discoverable Internal Use Only Report – More concise: • Focuses on current state and essential facts • Less exhaustive historical narrative • Assumes a more sophisticated, informed audience Key principle: 'The law regarding the discoverability of expert reports is somewhat unsettled. Experts should assume anything they write will be discoverable.'

Answer 156

1. Terminal Digit Structure – Sections numbered hierarchically (e.g., 1.0, 1.1, 1.2, 2.0, 2.1) 2. Basic Indention Format – Sections distinguished by headings and indented subheadings Rules for either format: • State each heading as a single phrase • Let each subtitle state a key position • Sentence and paragraph structure should be tied to the main points

Answer 157

An Executive Summary summarizes the key points of the report for the reader, preparing them for the detailed content that follows. Typical length: One page (may be expanded for litigation matters) Typically includes: • Purpose of the valuation • Standard and premise of value • Ownership interest being valued • Summary of valuation methods used and their indications • Final opinion of value • Restrictions on use and intended users

Answer 158

The Scope of Work section explains the type and extent of research and analysis performed. Typically addresses: • Whether the appraiser toured the business or interviewed management • Number of years of financial information reviewed • Information obtained from management that was relied upon • Data sources used USPAP: 'Credible assignment results require support by relevant evidence and logic. The creditability of assignment results is always measured in the context of the intended use.'

Answer 159

This section briefly discusses the major pieces of information relied upon in the valuation. Best practice: Sources should be FOOTNOTED to allow the reader to easily locate the original source. Common sources include: • Financial statements prepared by accountant • Federal tax returns • Information provided verbally by management • Management questionnaire • Economic and industry studies • Transaction databases • Discount rate data sources

Answer 160

1. Were there any prior transfers of ownership in the company? 2. At what price did those transfers occur? 3. Were those transfers arm's-length transactions consistent with the definition of fair market value? 4. How long ago did the transaction occur? 5. Is the prior transaction relevant to the current assignment? Prior transactions can be highly relevant as evidence of value, but must be evaluated for reliability and relevance.

Answer 161

Gains and losses on asset sales (non-inventory assets) appear on the income statement but do NOT affect the operating cash from the transaction. Treatment: • The CASH RECEIVED from the sale is reported in Investing Activities • The GAIN (if any) must be SUBTRACTED as an adjustment to net income in operating cash flows (to avoid double-counting) • The LOSS (if any) must be ADDED BACK as an adjustment to net income in operating cash flows (since it reduced net income but no cash was paid) Example: Truck sold for $20,000 with $21,500 book value → $1,500 loss added back in operations; $20,000 receipt in investing activities

Answer 162

Required cash = the minimum cash balance a business must maintain to pay daily operating bills. Two approaches: 1. Adjust the DISCOUNT RATE to account for required cash risk (common approach) 2. Forecast required cash separately as a percentage of sales—then add it to working capital changes Caution: Do NOT do both! If you adjust the discount rate for required cash AND separately forecast required cash changes, you will double-count and likely UNDERVALUE the business.

Answer 163

CAGR = [(Last Value / First Value)^(1/Number of Years)] − 1 CAGR DOES measure: The geometric growth rate from the first year to the last year of the analysis. CAGR does NOT account for: Any values in between the first and last year. Intermediate volatility is completely ignored, which can be misleading if earnings were volatile during the period.

Answer 164

Normalized income adjusts reported financial results to remove items that are: 1. Non-recurring or extraordinary (one-time items unlikely to repeat) 2. Non-operating (e.g., rental income from unrelated assets) 3. Related party distortions (above/below-market owner salary, related party rent) 4. Accounting anomalies (e.g., LIFO inventory adjustments, accelerated depreciation) Goal: Reflect the true, ongoing, sustainable operating performance of the business as it would appear to a hypothetical buyer.

Answer 165

Reasonable compensation is an adjustment made to replace actual owner compensation with what an arms-length, qualified manager would be paid for the same services. Purpose: Eliminate the distortion caused by owners paying themselves too much (depressing profits) or too little (inflating profits relative to fair market economics). Data sources: U.S. Department of Labor National Compensation Survey, regional surveys, and industry compensation data. Failure to make this adjustment is listed as a common error in the Excess Earnings Method.

Answer 166

MVIC = Market Value of Invested Capital = Total capital supplied by both debt and equity investors Formula: MVIC = Fair Market Value of Equity + Fair Market Value of Long-Term Debt An invested capital (debt-free) value represents the business as if it had no debt. To determine EQUITY value from an MVIC value, subtract the fair market value of long-term debt. The proper discount rate for invested capital valuation is WACC.

Answer 167

Rev. Rul. 59-60: 'Detailed profit and loss statements should be obtained and considered for a representative period immediately prior to the required date of appraisal, preferably five or more years.' Purpose: • Separate recurrent from non-recurrent income and expense • Distinguish operating from investment income • Identify loss-generating business lines • Understand earnings trends (growing, stable, declining) • Provide a reliable basis for forecasting future performance

Answer 168

According to Gary Trugman: 'The value of an investment is equal to the sum of the present value of the future benefits it is expected to produce for the owner of the interest.' According to Pratt, Reilly, and Schweihs: 'The value of a business or an interest in a business depends on the future benefits that will accrue to it, with the value of the future economic benefits discounted back to a present value at some appropriate discount rate.'

Answer 169

The Principle of Substitution: An informed purchaser will pay no more than the cost of producing a substitute business (asset) with the same utility as the subject. The approach adjusts all assets and liabilities—both tangible and intangible—to their fair market value as of the valuation date. The adjusted value reflects the appropriate premise of value (going concern or liquidation).

Answer 170

The Economic Principle of Substitution: 'No prudent individual would pay more for an asset than the price required to obtain an equal asset of comparable utility.' 'Equal' means equally desirable from an ownership or investment standpoint—not necessarily identical in all respects. Market transactional data represents a sampling of the marketplace from the investor's viewpoint, providing objective evidence of value.

Answer 171

1. Percentage Technique – Simple; projects items as % of sales 2. Most Likely / Best Case / Worst Case – Best for start-ups and unsophisticated companies 3. Fixed and Variable Cost Technique – MOST APPROPRIATE; separates fixed and variable costs to reflect realistic business cost structures 4. Historic Weighting Technique – Subjective; weights historical years by confidence level 5. Probability Weighted Expected Earnings – Quantitative; weights multiple scenario probabilities Best technique: Fixed and Variable Cost, because most businesses actually have a combination of fixed and variable expense structures.

Answer 172

Because of the size gap between small closely held businesses and publicly traded companies. Public companies have significant advantages small businesses do not: • Access to diversified geographic markets • Ability to purchase inventory at better rates • Ability to borrow money without pledging personal assets • Access to broader capital markets Result: Multiples derived from public companies are generally not applicable to small private businesses, making the comparison invalid.

Answer 173

'As if debt-free' means valuing the business as though it has no interest-bearing debt. This is the basis for Invested Capital (MVIC) valuation. Why: Eliminates the effect of different capital structures so that businesses can be compared purely on their operating performance. To get to equity value: Subtract the fair market value of long-term debt from the invested capital value. The appropriate discount rate: WACC (which blends the cost of debt and equity in proportion to the capital structure)

Answer 174

LIFO (Last-In, First-Out) inventory accounting can distort reported earnings and balance sheet values. In business valuation adjustments: • LIFO reserves must be identified and adjustments made to both the beginning and ending inventory in Cost of Goods Sold (COGS) for both the balance sheet and income statement • Failure to make this adjustment can lead to incorrect normalized earnings and cash flow calculations • LIFO inventory on the balance sheet is often understated relative to current market values

Answer 175

The conversion assumes: 1. Net income and net cash flow maintain a CONSTANT relationship to each other over time 2. Both grow at the SAME constant annual compound rate into perpetuity Conversion factor = Company's Normalized Net Cash Flow ÷ Normalized Net Income CAUTION (Pratt, Reilly, Schweihs): These critical assumptions are RARELY met in real-world situations. Therefore, net cash flow is STRONGLY RECOMMENDED as the measure of economic income to use in discounted economic income methods.

Answer 176

The Income Approach methods (Capitalization of Earnings and DCF) can be applied to various income streams. Selectable streams include: 1. Revenue (Gross Sales) 2. Gross Profit 3. EBIT (Earnings Before Interest and Taxes) 4. EBITDA 5. Seller's Discretionary Earnings (SDE) 6. Net Income (After Tax) 7. Net Cash Flow IMPORTANT: The discount/capitalization rate selected MUST match the income stream selected. Applying a net cash flow rate to net income is a critical error that leads to overvaluation.

Answer 177

The Justification of Purchase Price Test double-checks the indicated value by asking: Can a buyer realistically purchase this business at the appraised value and generate sufficient cash flow to service the debt? Process: 1. Assume buyer provides a down payment and finances the balance with a term loan 2. Model the amortization schedule 3. Compare the business's forecasted cash flows to debt service requirements 4. Calculate the cash-on-cash return to the equity investor If the cash flows cannot support the purchase price, the indicated value may be too high.

Answer 178

The Tax Cuts and Jobs Act of 2018 may have had an impact on: 1. Trapped-in capital gains tax calculations – specifically the applicable corporate tax rate (previously 34.7%; reduced after TCJA) 2. S Corporation premiums – Many appraisers have begun to consider the S corporation premium as a non-issue because the differential between C and S corporation tax treatment narrowed significantly under TCJA Appraisers must always use the current effective tax rates as of the valuation date when making these calculations.

Answer 179

A 'Dream Sheet' is a management-prepared forecast that is artificially optimistic—typically prepared when management wants to maximize the company's apparent value (e.g., for a sale). The opposite also occurs: artificially pessimistic forecasts are prepared to minimize value (e.g., for a divorce buyout). Handling: The appraiser should: 1. Prepare an independent forecast and compare to management's version 2. Check prior forecasts against actual results for pattern of bias 3. Modify management's forecast to conform to a reasonable standard 4. Adjust the discount rate higher for aggressive forecasts (increased risk of not achieving)

Answer 180

A Section 754 Election allows a partnership or LLC buyer to receive an 'inside basis' (step-up in basis) in its ownership interest equal to the price paid to acquire that interest. Significance: This eliminates the trapped-in capital gains tax liability for the buyer—a major tax advantage over C corporation stock acquisitions. C corporations do NOT have access to this step-up provision. A C corporation buyer of C corporation stock inherits the historical low tax basis, creating a potential built-in gains tax liability.

Answer 181

They are mathematically related: DLOC = Control Premium ÷ (1 + Control Premium) Conversely: Control Premium = DLOC ÷ (1 − DLOC) Example: A 38.8% control premium corresponds to a 27.95% DLOC. The primary sources of control premium data are: • Mergerstat Review • Mergerstat/Shannon Pratt's Control Premium Study • Closed-End Funds

Answer 182

Net income

Answer 183

Only things which have occurred as of the valuation date.

Answer 184

When such events were "known' or 'knowable"

Answer 185

Discount rate = 23.6%, capitalization rate = 19.6%

Answer 186

Discounted future earnings method

Answer 187

All of the above

Answer 188

All of the above

Answer 189

None of the above

Answer 190

Audited, reviewed, tax return, compiled

Answer 191

Net cash flow

Answer 192

Only intangible assets

Answer 193

Asset Approach

Answer 194

Income, asset, and market

Answer 195

Control interest, as if freely traded marketable basis

Answer 196

Capitalization of earnings method

Answer 197

Expected return, however best estimated for each appraisal

Answer 198

Dividend-Paying Capacity

Answer 199

FALSE - The selected DLOM should be based on the specific facts and circumstances of the subject interest. Restricted stock studies provide context and support, not a mechanical average to apply directly.

Answer 200

FALSE - A non-controlling, non-marketable interest typically requires consideration of discounts for lack of control and lack of marketability, depending on the valuation approach and level of value being developed.

Answer 201

TRUE - The standard of value influences the assumptions used in the valuation, which can affect whether discounts or premiums apply and how large they are.

Answer 202

b) Discount rate = 23.5%, cap rate = 19.5% Calculation: 2.6 + 6.7 + 7.9 + 2.3 + 4.0 = 23.5% discount rate; 23.5% - 4.0% long-term growth = 19.5% cap rate.

Answer 203

b) Dividend paying capacity - Net cash flow represents the amount available for distribution to equity holders after all obligations are met.

Answer 204

d) Coefficient of variation - It measures dispersion relative to the mean (CV = standard deviation / mean), making it especially useful for comparing variability across datasets with different averages.

Answer 205

d) $817,000 Calculation: Down = $100,000; Yr1 = $100,000/1.188 = $84,175; Yr2 = $70,854; Yr3 = $59,641; Yr4 balloon = $1,000,000/1.188^4 = $501,037. Total PV = $816,707, rounded to $817,000.

Answer 206

FALSE - A 50% interest is not generally considered a controlling interest because control usually requires the ability to direct decisions unilaterally. With 50%, there is often shared control or potential deadlock.

Answer 207

b) Duff & Phelps Risk Premium Report - Provides cost of capital inputs including equity risk premia, size premia, betas, and industry risk premia. RMA provides financial statement benchmarking; Mergerstat provides M&A transaction data.

Answer 208

a) By referencing the industry and economic analysis, risk drivers discussed, and by drawing conclusions about the business' operating risk through the comparative financial ratio analysis - SCRP is justified through company-specific qualitative and quantitative risk factors.

Answer 209

c) 19.80% Calculation: 3.8 + (6.75 x 1.20) + 6.9 + 4.5 = 3.8 + 8.1 + 6.9 + 4.5 = 23.3% discount rate; 23.3% - 3.5% growth = 19.8% equity cap rate.

Answer 210

TRUE - That is the standard accounting definition of working capital under GAAP.

Answer 211

c) Appraiser's informed judgment - Reconciling multiple valuation indications is based on reasoned professional judgment about the reliability and relevance of each method, not a mechanical formula.

Answer 212

FALSE - An appraiser should discuss how the industry and economic outlook affects the forecast to support whether projected results are reasonable and consistent with the narrative elsewhere in the report.

Answer 213

a) $113,750 Calculation: 0.35 x $325,000 = $113,750. A sales multiple applied to invested capital produces the value directly. Balance sheet adjustments for cash, AR, and liabilities are equity-level adjustments not applicable here.

Answer 214

FALSE - Tax depreciation follows prescribed tax rules (e.g., MACRS) while useful life reflects expected economic or service life. These are frequently different.

Answer 215

d) Reconciling all methods into a final opinion of value - Built-in capital gains tax considerations are applied during reconciliation; they are not exclusively an asset approach issue and can affect the final opinion when multiple approaches are weighted.

Answer 216

d) All of the above - Elements of control include rights not available to minority shareholders, including setting management compensation, appointing board members, and directing major company decisions.

Answer 217

c) Minority interest (less than 50%) or Controlling interest (more than 50%) - A stake below 50% is typically minority; above 50% is typically controlling. A 50% interest is treated separately due to potential shared control or deadlock.

Answer 218

TRUE - Shareholder-level discounts relate to rights attached to specific shares or interests, with voting versus non-voting status being a classic shareholder-level issue affecting control-related value.

Answer 219

c) $833,333 Calculation: Cap rate = 30% - 6% = 24%; Value = $200,000 / 0.24 = $833,333.

Answer 220

TRUE - That is the standard valuation definition of liquidity: the ability to convert property into cash quickly, at a reasonably known cost, and within a reasonably known time frame.

Answer 221

TRUE - DLOM addresses two broad issues: (1) transferability - how easily the interest can be sold or transferred, and (2) liquidity - how quickly it can be converted to cash.

Answer 222

c) 20.00% Calculation: Equity cap rate = discount rate - growth rate = 24% - 4% = 20%.

Answer 223

TRUE - The Mandelbaum Factors (from Mandelbaum v. Commissioner) are widely referenced when selecting a DLOM and are used to adjust the discount for the specific facts and circumstances of the valuation.

Answer 224

e) All of the above - A subject ownership position is described by two dimensions: interest level (minority or controlling) and marketability basis. All listed combinations are valid valuation starting points or subject interest descriptions.

Answer 225

d) All of the above - DCF, capitalization of earnings, and price-to-revenue methods all implicitly reflect future performance expectations. All income and market approach methods incorporate forward-looking assumptions about the company.

Answer 226

b) Based on actual sales transactions of stock - Restricted stock studies analyze real transactions in restricted shares compared to corresponding unrestricted publicly traded shares to help assess lack of marketability.

Answer 227

a) Control interest, as if freely traded marketable basis - The guideline public company method is based on public market pricing (freely traded). When control adjustments are made to earnings, the indication shifts to control level while remaining on an as-if-freely-traded marketable basis.

Answer 228

c) 18% Calculation: Implied cap rate = 1/7.7 = 12.99%; Discount rate = 12.99% + 5.00% = 17.99%, rounded to 18%.

Answer 229

b) Equity risk premium In Modified CAPM, beta is multiplied by the equity risk premium only. The risk-free rate, size premium, and specific company risk premium are added without beta adjustment.

Answer 230

TRUE - Business valuation premiums and discounts are commonly discussed at either the entity level (affecting the company as a whole) or the shareholder level (affecting the specific ownership interest).

Answer 231

a) I & III - Entity-level discounts apply to the company as a whole; shareholder-level discounts apply to the specific ownership interest. Built-in capital gains (II) and lack of control (IV) are types within these categories, not the two top-level categories.

Answer 232

e) All of the above - Under the private company transaction method, appraisers may use price-to-revenues, price-to-EBITDA, price-to-SDE (especially for smaller businesses), and price-to-book depending on the facts and industry.

Answer 233

d) Prepare forecasts with the assistance from management - Management provides the assumptions but the appraiser must evaluate reasonableness and exercise independent professional judgment rather than accepting projections without assessment.

Answer 234

d) Control interest, as if freely traded marketable basis - Normalizing adjustments bring the earnings stream to a control level (removing excess comp, owner perks, etc.). D&P data is derived from public market evidence, producing an as-if-freely-traded indication. Combined: control interest on a freely-traded marketable basis.

Answer 235

a) Higher than the equity discount rate - Intangible assets are generally considered riskier than overall business equity, so they require a higher rate of return. WARA analyses consistently assign higher rates to intangible assets than to tangible assets.

Answer 236

FALSE - Business appraisers typically consider more than one method or approach and then reconcile the indications based on the relevance and reliability of each method.

Answer 237

c) Companies actively traded over a public exchange - The Guideline Public Company Method identifies comparable publicly traded companies and derives valuation multiples from their market prices.

Answer 238

a) The subject company has considerably higher debt than the selected guideline companies - Invested capital multiples are preferred when capital structures differ because they reduce distortion caused by varying levels of debt.

Answer 239

a) The selection of methods will be based on the operating characteristics of the subject company - The choice depends on the nature of the business including how it earns money, asset intensity, stability of earnings, growth pattern, and available data.

Answer 240

d) Remove from the analysis - When the buyer explicitly wants only the operating assets, non-operating items are excluded from the analysis entirely. They do not need to be accounted for separately since the buyer has no interest in them.

Answer 241

c) EBITDA - Invested capital (enterprise value) multiples must pair with an unlevered operating measure. EV/EBITDA is a standard invested-capital multiple. Sales is a revenue measure (not profitability); COGS is an expense; EBIT can also work but EBITDA is the most commonly tested answer.

Answer 242

a) Finance, real estate, and insurance companies - These industries are treated as special cases because debt structure, reinvestment patterns, and regulation make standard cost-of-capital applications less straightforward.

Answer 243

b) Control interest, on a closely held marketable (or non-marketable) basis - These databases reflect sales of 100% interest in closely-held businesses (whole-company sales), not minority share trades, producing a control-level closely-held indication.

Answer 244

c) The prior 12-month period of the subject company - TTM multiples from guideline companies should be matched to the same type of period for the subject; prior/trailing 12 months matches TTM methodology.

Answer 245

c) Invested capital net cash flow - WACC represents the blended cost to all capital providers (debt and equity) so it is matched to free cash flow to the firm. Equity net cash flow uses the cost of equity, not WACC.

Answer 246

b) It is a reasonable approach when valuing under a liquidating premise - A liquidating premise calls for an asset-based/liquidation approach. The income approach is forward-looking and designed for going-concern operating companies, not liquidation scenarios.

Answer 247

FALSE - Trapped-in capital gains discounts can also be considered during reconciliation of all methods when multiple approaches are weighted. They are not exclusively an asset approach issue, though they most commonly arise in asset-based analyses.

Answer 248

TRUE - Weighted averages of historical income, with more recent periods given greater weight, are a common method for estimating future performance as they emphasize the most current and relevant data.

Answer 249

c) The growth rate should be a rate that can be sustained for an indefinite period of time - The capitalization rate uses a long-term sustainable growth rate that can be maintained into perpetuity, not a short-term projection or transition rate.

Answer 250

c) The company has been losing money, but is expected to recover - A company currently losing money but expected to recover is better suited to a DCF/forecast-based method. Capitalization of earnings requires stable, maintainable earnings at a normalized level.

Answer 251

c) Both: the accrual method recognizes revenues when earned and expenses when incurred, AND the cash method records amounts when actual cash transfers occur - both definitions together accurately describe the two methods.

Answer 252

c) Non-controlling, non-marketable ownership interest - This level combines lack of control AND lack of liquidity, placing it at the lowest level of value. DLOM is most consistently applied to minority/non-controlling interests.

Answer 253

a) $1,444,643 Calculation: Return on tangibles = $825,000 x 10% = $82,500; Excess earnings = $487,000 - $82,500 = $404,500; Intangible value = $404,500 / 0.28 = $1,444,643.

Answer 254

a) Exhibits 'A' - The Exhibit A series provides risk premia over the long-term risk-free rate, which is the format used in the build-up model. Exhibit B series provides premia over CAPM and is used for modified CAPM analysis.

Answer 255

FALSE - There is no universal five-year rule. The forecast period should fit the facts of the assignment - long enough to capture the company's expected transition to stable conditions, but not longer than can be reasonably supported.

Answer 256

c) 30.90% Calculation: DLOC = 1 - (1/1.448) = 1 - 0.6906 = 0.3094 = approximately 30.9%.

Answer 257

a) Mergerstat Review - Mergerstat/FactSet M&A data includes deal pricing metrics and acquisition premiums for publicly traded targets. Deal Stats/BizComps cover private transactions; RMA provides financial benchmarking; First Research provides industry overviews.

Answer 258

TRUE - D&P cost-of-capital data is derived from public market evidence (freely-traded basis), so DLOM is not automatically built into the discount rate. A separate DLOM remains applicable for a closely-held company for both majority and minority interests.

Answer 259

b) To get beyond a cyclical peak and/or trough in operating results - The period must capture normalized, mid-cycle performance rather than stopping during a temporary high or low point. There is no universal five-year minimum.

Answer 260

d) All of the above - Articles of incorporation/bylaws, voting rights, and buy-sell/shareholder agreements all influence the size of a DLOC by defining the actual rights and restrictions attached to the interest.

Answer 261

b) $1,000,000 Calculation: Cap rate = 25% - 5% = 20%; Value = $200,000 / 0.20 = $1,000,000.

Answer 262

c) All of the above - Both adjusting the discount rate for added uncertainty AND developing revised forecasts with management's input and the appraiser's independent judgment are recognized and appropriate methods.

Answer 263

a) Determined by the market - Capitalization rates in valuation are market-derived rates of return used to convert an income stream into value. They vary by income type, company risk, and market conditions.

Answer 264

e) Discount for excessive employees - Excessive employees or excessive compensation are handled through normalization adjustments to the financial statements, not as a separate valuation discount.

Answer 265

d) Developing equity risk premiums for different size companies - The study provides equity risk premia, size premia, industry risk premia, and other cost-of-capital inputs. It is not limited to size premiums only and does not provide operating performance comparisons or valuation multiples.

Answer 266

b) Add: Income Taxes - In calculating net cash flow, taxes are subtracted, not added. The correct steps are: start with after-tax earnings, add back D&A, subtract capital expenditures, and adjust for changes in working capital.

Answer 267

c) Guideline public company method - The company is very small ($250,000 in sales); public companies are typically far larger and not sufficiently comparable to serve as guideline companies, making this method inappropriate for this fact pattern.

Answer 268

c) Earnings stream control adjustments - Since the interest being valued is a minority interest, earnings stream control adjustments are not part of the valuation process. The CEO's health affects specific company risk premium and premise of value, but control adjustments apply to controlling interest valuations.

Answer 269

a) The appraiser calculates the expected non-controlling adjusted income stream and applies the selected capitalization rate - A non-controlling indication requires a non-controlling earnings stream. Using a control-adjusted stream produces a control-level indication; adding only a DLOM does not fix the control-level problem.

Answer 270

d) Net income (before tax) - Net income is an equity-level measure, applicable only to equity holders. Invested capital multiples must pair with unlevered measures available to all capital providers, such as Sales, EBIT, EBITDA, or invested capital cash flow.

Answer 271

b) Control interest, as if not freely traded, non-marketable basis - The adjusted book value method uses a closely-held company's actual asset values, producing a control-level value on a closely-held (not freely traded) basis, not a public-market/freely-traded basis.

Answer 272

c) Often used to value the goodwill in a business - The excess earnings method separates the return attributable to tangible assets from remaining excess earnings, which are attributed to intangible assets/goodwill.

Answer 273

a) Higher than the company's equity discount rate - Intangible assets carry more risk than overall business equity, requiring a higher rate of return. WARA analyses consistently assign higher rates to intangible assets versus tangible assets.

Answer 274

d) All of the above - Dividend payments (income while awaiting liquidity reduces the discount), pool of potential buyers (broader market = lower discount), and size of interest (larger blocks are harder to sell) all affect the illiquidity discount.

Answer 275

b) Not freely traded interest value - DLOM converts a value indication from a freely traded/marketable basis to a not-freely-traded/non-marketable basis, reflecting that a private or illiquid interest cannot be readily sold.

Advanced_Valuation_Flashcards

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