Citibank: basic of corporate finance
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The future economic factors of the country are also important to
consider in an analysis. Inflation, investment regulations, and taxation
rules are factors that may affect the value of a company and should be
considered when making assumptions concerning the future prospects
of the company.
Industry Conditions
It is difficult to analyze a company without studying the industry in
which it competes. Most analysts have an understanding of industry
conditions and a company's competitors — issues that must be
thoroughly considered when making assumptions.
Example
For example, a company has had growth rates of about 25% per year
for the past five years. If the analyst knows that there will be several
new competitors in the industry and the potential number of buyers for
the product is limited, can the analyst reasonably expect similar growth
rates in the future? These are the types of questions that are asked and
answered by analysts when making assumptions concerning the future.
Synergies
Whole is
worth more
than sum of
parts
In conceptual terms, synergy refers to the phenomenon of the whole
being worth more than the sum of the parts. For example, two
companies combined into one may be worth more than both companies
as stand-alone entities. The combined company may be able to
eliminate some duplicate costs and operations or combine functions to
increase profitability.
These synergies are often discovered when undertaking a thorough
analysis of the operations of the companies. In a buyout scenario, one
company may be willing to pay more for a potential takeover target than
another bidding competitor because of these potential synergies.
However, synergies often are more perceived than realized, so care
should be taken when adding a premium to an investment opportunity
just because of potential synergies.
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UNIT SUMMARY
We began this unit with the concept of forecasting cash flows and
discounting them by using the cost of capital. You also saw how to
estimate the residual value of the firm after the forecast period.
Finally, you learned some other methods for estimating the value of a
company. These methods were compared to the discounted cash flow
method and their relative strengths and weaknesses were discussed. We
also discussed factors that may affect the value of the company. These
factors are considered when making assumptions about a company's
future prospects. They often are used to help assess whether
assumptions are reasonable and valid.
You have completed Unit Eight: Corporate Valuation – Estimating Corporate Value and
you have demonstrated your ability to complete the calculations presented in this unit.
Please complete Progress Check 8 to check your understanding of the concepts, then
continue to Unit Nine: Fixed Income Securities. If you answer any questions incorrectly,
please review the appropriate text.
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4PROGRESS CHECK 8
Directions: Select the correct answer for each question. Check your solution with the
Answer Key on the next page.
1. An estimate of future free cash flows:
_____a) indicates the amount of cash generated by a company's operations that is
available to debt and equity investors.
_____b) provides a summary of a company's positive and negative cash flows.
_____c) assumes a 0% growth in a company's operations.
_____d) provides a much more accurate estimate of future cash flows when
calculated by analysts outside the company.
2. A project that is completed at the end of the forecast period:
_____a) has residual value that is equal to the value of the project.
_____b) has a residual value of $0.00.
_____c) has a residual value equal to the sale price.
_____d) requires that the perpetuity method be used to calculate residual value.
3. The appropriate discount rate to use in the discounted cash flow method for estimating
corporate value is the:
_____a) risk-free market interest rate.
_____b) investors' required rate of return.
_____c) weighted average of the possible returns.
_____d) weighted average cost of capital.
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ANSWER KEY
1. An estimate of future free cash flows:
a) indicates the amount of cash generated by a company's operations
that is available to debt and equity investors.
2. A project that is completed at the end of the forecast period:
b) has a residual value of $0.00.
3. The appropriate discount rate to use in the discounted cash flow method for estimating
corporate value is the:
d) weighted average cost of capital.
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PROGRESS CHECK
(Continued)
4. The sum of the discounted projected cash flows equals the:
_____a) market value of the equity.
_____b) market value of current liabilities plus long-term debt.
_____c) corporate value.
_____d) value of preferred stock plus the value of equity.
5. An analyst has projected cash flows for ABC Corporation based on assumptions about
growth in sales and profit margin and increases in capital investments. The analyst
decides to change the assumption about sales growth and redo the projection. The
analyst is:
_____a) changing the company's strategy for future sales growth.
_____b) isolating the sensitivity of the corporation's value to the estimate of the
future growth rate.
_____c) estimating the probabilities of each scenario.
_____d) effecting an increase in the market price of the stock.
6. Select four factors a company cannot control that may affect the company's estimated
future value.
_____a) Market liquidity, synergies, industry conditions, management profile
_____b) Country conditions, market liquidity, pooling of resources, tax increases
_____c) Market liquidity, synergies, country conditions, industry conditions
_____d) Management profile, tax increases, market liquidity, synergies
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ANSWER KEY
4. The sum of the discounted projected cash flows equals the:
c) corporate value.
5. An analyst has projected cash flows for ABC Corporation based on assumptions about
growth in sales and profit margin and increases in capital investments. The analyst
decides to change the assumption about sales growth and redo the projection. The
analyst is:
b) isolating the sensitivity of the corporation's value to the estimate of
the future growth rate.
6. Select four factors a company cannot control that may affect the company's estimated
future value.
c) Market liquidity, synergies, country conditions, industry conditions
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PROGRESS CHECK
(Continued)
7. Match each of the valuation methodologies in Column A with its definition in Column
B.
Column A
____Dividend value
____Market / book ratio
____Price / earnings ratio
____Liquidation value
Column B
a) Amount investors are paying for each
dollar of income generated by the firm
b) Amount left for shareholders after assets
are sold and creditors are paid
c) Amount investors are paying relative to
value of the company according to
accounting methods
d) Value of equity based on value of
perpetuity
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ANSWER KEY
7. Match each of the valuation methodologies in Column A with its definition in Column
B.
Column A
d Dividend value
c Market / book ratio
a Price / earnings ratio
b Liquidation value
Column B
a) Amount investors are paying for each
dollar of income generated by the firm
b) Amount left for shareholders after assets
are sold and creditors are paid
c) Amount investors are paying relative to
value of the company according to
accounting methods
d) Value of equity based on value of
perpetuity
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Unit 9
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