Question

1. Why is identification of the ownership interest to be valued important?

2. What is the significance of industry risk premium and specific company risk premium?

3. Excluding valuation discounts allows for a more equitable determination of fair value. Substantiate.

4. What is the purpose of the Statement on Standards for Valuation Services (SSVS) No. 1 introduced by the AICPA?

Answer 1

Q1. iWhy iis iidentification iof ithe iownership iinterest ito ibe ivalued iimportant?

As ithe isize iand icomplexity iof ia ifirm igrows, ithe iability ito iidentify iwhat imoney i(i.e. icash) icame iand iwent iduring ia iperiod ibecomes imore idaunting.

i i i i i i i i i i i i i i iWhat imoney icame iinto iand iwent iout iof ithe ibusiness?” iOne imight iask ithis iquestion ito iunderstand inot ijust iwhat ihappened ito icash, ibut iwhether ia ibusiness iis ivaluable iby ivirtue iof iits iability ito igenerate ipositive icash iflows ior iwhether ithe ienterprise ican imeet iits iobligations.

Generally iaccepted iaccounting iprinciples itell ius i“the iprimary iobjective iof ia istatement iof icash iflows iis ito iprovide irelevant iinformation iabout ithe icash ireceipts iand icash ipayments iof ian ientity iduring ia iperiod.” i

As ithe isize iand icomplexity iof ia ifirm igrows, ithe iability ito iidentify iwhat imoney i(i.e. icash) icame iand iwent iduring ia iperiod ibecomes imore idaunting. iSimply igoing ithrough ithe ibank ideposits iand iwithdrawals ibecomes iless ifeasible ias isize iand icomplexity iof ioperations iincrease.

i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i iFortunately, ias isize iand icomplexity iincrease, iso idoes ithe ilikelihood ithe ifirm iwill iprepare ia istatement iof icash iflows iinternally iand iin iturn iits iauditor iwill iopine iupon ithis iparticular ifinancial istatement iwithin ithe iaudit.

The istatement iof icash iflows iperforms ithe itasks iof iorganizing ithe icash ireceipts iand idisbursement iand idemonstrating ithose icash iflows ipresented irepresent ithe ichange ito ithe ibank iaccounts i(i.e. ithe ichange iin icash) iduring ithe iperiod icovered iby ithe istatement.

To iaccomplish ithis ihelpful iorganization, ithe istatement iuses ithree icategories iof icash iflows: ioperating, ifinancing iand iinvesting.

i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i iOperating icash iflows ibegin iwith inet iincome icoming idirectly ifrom ithe iGAAP iincome istatement. iBecause iGAAP iaccounting iuses ithe iaccrual imethod, irecognizing iincome iwhen iearned iand iexpenses iwhen iincurred, iadjustments iare ineeded ito iarrive iat ithe icash ibasis iincome. iIn iother iwords, ithe ioperating icash iflows irepresent ithe inet icash iprovided iduring ithe iperiod ifrom ioperating iactivities.

i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i iThe ispecific iadjustments ishown ion ithe istatement iof icash iflows ito iarrive iat ioperating icash iflow iadd iback iexpenses ithat iwere iincurred ibut inot ipaid, iwith icorresponding ideductions ifor iincome iearned ibut inot ireceived. i

i i i i i i i i i i i i i i i i i i i i i i i i i i iInvesting icash iflows iinform ithe ireader ias ito ithe icash ieffect iof itransactions inot icaptured ion ithe iincome istatement

i i i i i i i i i i i i i i i i i i i i i i i i i i i i i iFinancing icash iflows, ias ione iexpects, itell ithe ireader iwhat ithe ifirm ihas itransacted iin icash iwith iits idebt iand iequity ifinancing isources. iPositive iamounts icome ifrom iborrowings iof idebt ior iissuances iof iequity iwhile inegative iamounts irelate ito icorresponding irepayments, iincluding idividends.

The isum iof ithe icash iflows ifrom ithe ithree icategories, ioperating, ifinancing iand iinvesting, iequals ithe ichange iin ithe icash iof ithe ifirm’s ibank iaccounts iduring ithe iperiod icovered, itypically ithe icalendar ior ifiscal iyear. iThis iis iproved iby ia ireconciliation iat ithe ibottom iof ithe istatement iof icash iflows ireflecting ithe ibeginning icash ibalances iwith ithe isum iof ioperating, ifinancing iand iinvesting icash iflows iadded iwith ithat isum ishown ito iequal ithe iending icash ibalances. iThe ireader iof ithe icash iflow istatement ibenefits ifrom iits ioverview iof iwhat i“money” ior icash icame iinto iand iout iof ithe ifirm iduring ithe iperiod

Q2. iWhat iis ithe isignificance iof iindustry irisk ipremium iand ispecific icompany irisk ipremium?

To ian iinvestor, ispecific irisk iis ia ihazard ithat iapplies ionly ito ia iparticular icompany, iindustry, ior isector. iIt iis ithe iopposite iof ioverall imarket irisk ior isystematic irisk. iThere iare isystemic irisks ithat iaffect ithe ieconomy ias ia iwhole iand imost iof ithe iindustries iand icompanies iin iit. iSpecific irisks iare ipeculiar ito ione istock, isector, ior iindustry. iA ipharmaceutical icompany imay ihave ia inew idrug irejected iby ithe iFood iand iDrug iAdministration i(FDA) ior ian iold ione iremoved ifrom ithe imarket.

Company-Specific iRisks

Two ifactors icause icompany-specific irisks:

1. Business iRisk: iInternal ior iexternal iissues imay icause ibusiness irisk. iInternal irisk irelates ito ithe ioperational iefficiency iof ithe ibusiness. iManagement ifailing ito iprotect ia inew iproduct iwith ia ipatent iwould ibe ian iinternal irisk, iresulting iin ia iloss iof icompetitive iadvantage. iThe iFDA ibanning ia ispecific iproduct ithat ia icompany isells iis ian iexample iof iexternal ibusiness irisk.

2. Financial iRisk: iThis irelates ito ithe icapital istructure iof ia icompany. iA icompany ineeds ito ihave ian ioptimal ilevel iof idebt iand iequity ito icontinue ito igrow iand imeet iits ifinancial iobligations. iA iweak icapital istructure imay ilead ito iinconsistent iearnings iand icash iflow.

Investors ican ireduce ispecific irisk iby idiversifying itheir iportfolios. iEconomist iHarry iMarkowitz ifound ithat ispecific irisk idecreases isignificantly iif ia iportfolio iholds iapproximately i30 isecurities. iThe isecurities ishould ibe iin ivarious isectors iso ithat istock- ior iindustry-specific inews ican iaffect ionly ia iminority iof ithe iassets iin ithe iportfolio.

i i i i iAccording ito icapital iasset ipricing imodel i(CAPM), ithe ireturn irate iof ian iasset ican ibe idivided iinto irisk-free irate iof ireturn i(RF) iand ireturn irate iproduced iby irisk ifactors. iThis ipaper iadopts iindustry irisk ipremium i(IRP) irejecting irisk-free irate iof ireturn ito ianalyze iindustry irisk. iThe iadvantage iis ionly iconsidering ireturn irate iproduced iby irisk ifactors, iand iin icontrast ito ireturn irate icomputed iby istock iprice, iit ican imeasure ilevels iand ivolatility iranges iof iindustry irisk imore iaccurately. i i i i i i i i i i i i i i i i i i i i i i i

i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i iIt iis ivery iimportant ito iidentify ideviation imechanism iof iprice ivolatility iof ian iindustry iasset iand ithe iaffecting ifactors, iand iit iis iimportant ito igive ithe ireasonable iexplanation iand imeasurement ito ithe iabnormality iof iprice ivolatility iof ithe iindustry iasset. iInvestors ican iuse iindustry ianalysis ifor iindustry irisk. iInvestors ican iidentify iseparately ithe iaffecting iextent ito ievery iindustry’s irisk ifor imacroeconomic idimension, iindustry ivalue idimension iand inoise iinvestor iirrational isentiment idimension, iand igive icomparison iand ianalysis iamong imulti iindustries ifor ifurther iinvestment idecision. iAn iinvestor ican iselect iindustries iwith isuitable irisk ilevels iand irisk iaffecting ifactors iaccording ito ihis/her iown ipreferred iinvestment iprinciple.

Q3. iWhat iis ithe ipurpose iof ithe iStatement ion iStandards ifor iValuation iServices i(SSVS) iNo. i1 iintroduced iby ithe iAICPA?

i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i iThe ipurpose iof iSSVS i1 iis ito iimprove ithe iconsistency iand iquality iof ipractice iamong iAICPA imembers iproviding ivaluation iservices. iSpecifically, ithe istandard iprovides iguidance ito iCPAs iwhen ithey iperform iengagements ito iestimate ivalue ithat iculminate iin ithe iexpression iof ia iconclusion iof ivalue ior ia icalculated ivalue. iThe istandards icontained iin iSSVS i1 iapply ito iall iAICPA imembers iwho iperform ian iengagement ithat iestimates ithe ivalue iof ia ibusiness, ibusiness iinterest, isecurity, ior iintangible iasset ifor ipurposes isuch ias isales itransactions, ifinancing, itaxation, ifinancial ireporting, imergers iand iacquisitions, imanagement, ifinancial iplanning, iand ilitigation. iBecause iof ithe iincreasing inumber iof iCPAs iproviding ibusiness ivaluation iservices, iand ithe ifact ithat iSSVS i1 iprovides iprofessional iguidance ias ito igenerally iaccept ibest ipractices iwithin ithe ivaluation iand ibusiness icommunities, iit iis iimperative ithat iCPA ivaluation ianalysts ibecome ifamiliar iwith iSSVS i1’s irequirements.

SSVS i1 iprovides iguidance ifor ithe ipractitioner iin idetermining iwhen ian iengagement iis ideemed ito ibe ia ivaluation iengagement. iIt ialso iidentifies ipreviously iissued iAICPA istandards ithat iall iCPAs iwho iprovide ivaluation iservices ishould iobserve.

i i i i i i i i i i i i i i i i i i i i i i i i i i i i iBusiness ivaluations iare irequired ifor ia ivariety iof ipurposes. iSSVS i1 iindicates ithat iin iinstances iwhere ia iCPA iis irequired ito iapply ivaluation iapproaches iand imethods, iand iuse iprofessional ijudgment iin iapplying ithose iapproaches iand imethods, ithe iCPA iis isubject ito ithe iAICPA’s ispecial ivaluation istandards icontained iin iSSVS i1. iFurthermore, ithe ivaluation istandards iapply ieven iwhen iestimating ivalue iis ionly ia ipart iof ia ilarger iengagement. iFor iexample, iCPAs iare ifrequently irequired ito iprovide iestimated ivalue ifor icertain iassets iinvolved iin itax, ilitigation, ior iacquisition-related iengagements.

i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i iSSVS i1 iestablishes ithat iany iCPA iinvolved iin ian iengagement ito iestimate ivalue iis iidentified ias ia ivaluation ianalyst. iSuch iindividuals iare iexpected ito ipossess ispecial iskills iand iknowledge ispecifically ifor ivaluation iengagements. iThe iSSVS irecommends ithat ia iCPA ianalyst ihave ia ifundamental iawareness iof ithe iprofessional istandards icontained iin ithe iAICPA iCode iof iProfessional iConduct iand ithe iStatement ion iStandards ifor iConsulting iServices i(SSCS) i1, iConsulting iServices: iDefinitions iand iStandards. iThe iCPA imust iunderstand ithe iextent ito iwhich isuch iprofessional istandards iapply ito ivaluation iengagements. iThe iCPA ishould ialso ibe iaware iof iother iAICPA istandards ithat, idepending ion ithe icircumstances, imay ior imay inot ibe iapplicable ito ia ivaluation iengagement, ibut ithat ithe iCPA ineeds ito iconsider iwhen iproviding ivaluation iservices.