CVA Sample Questions & Answers

When there is a significant difference in financial leverage, the financial risk profile of the companies differs. The standard procedure is to remove the effect of leverage from the public companies' betas (unlevering), calculate an average or median unlevered beta, and then apply the private company's specific leverage to this unlevered beta (relevering). This adjusts the systematic risk measure for the subject company's unique capital structure, allowing for a more accurate cost of capital calculation.

For an early-stage company with negative current earnings but significant future potential, the Multi-Period DCF Method is most appropriate. This method allows the analyst to project cash flows through different stages of development (R&D, clinical trials, commercialization) and capture the expected future profitability. The Capitalization of Earnings method is unsuitable due to the lack of stable earnings. The Asset Approach would likely undervalue the company by ignoring the potential of its intangible intellectual property.

Normalization adjustments aim to present a company's financial performance as if non-recurring events had not occurred. A one-time gain from selling a subsidiary is not part of ongoing operations and inflates reported earnings. Therefore, the after-tax impact of this gain must be removed (subtracted) from net income to arrive at a normalized earnings figure that represents sustainable profitability.

The Adjusted Net Asset Method is most appropriate for companies whose value is primarily derived from the assets they hold, rather than the earnings they generate. An investment holding company fits this description perfectly, as its value is the sum of the fair market values of its underlying investments (securities, real estate, etc.), less liabilities. Service-based and technology companies' values are typically driven by intangible assets and future earnings, making income or market approaches more suitable.

Restricted stock studies compare the prices of publicly traded shares of a company that are freely tradable with those that are identical but restricted from sale for a period (e.g., under SEC Rule 144). This price difference is a direct measure of the lack of marketability. For a stable, dividend-paying company, these studies provide a strong benchmark, as the underlying asset is identical, isolating the marketability feature. Pre-IPO studies are more relevant for high-growth companies expecting a liquidity event.

The valuation starts from a value indication that is often on a control, marketable basis (or is adjusted to one). To value a 20% interest, two levels of discounts are needed. First, a Discount for Lack of Control (DLOC) is applied to reflect the owner's inability to direct company policy. Second, a Discount for Lack of Marketability (DLOM) is applied because the shares are not publicly traded and cannot be easily converted to cash. Applying a control premium would be incorrect as this is a minority interest.

A one-time, failed R&D project is a non-recurring expense. To normalize earnings and reflect the ongoing profitability of the business, the after-tax amount of this unusual expense should be added back to the reported net income.

In the Gordon Growth Model (Terminal Value = FCF * (1+g) / (WACC-g)), the terminal value is extremely sensitive to the perpetual growth rate (g). A small change in 'g' can lead to a very large change in the terminal value because it directly affects both the numerator and the denominator. While the final year's cash flow and WACC are also important, the perpetual growth rate assumption often has the most leverage on the outcome.

The Department of Labor (DOL) and the Employee Retirement Income Security Act (ERISA) govern ESOPs. These regulations mandate that an ESOP cannot pay more than 'adequate consideration' for the employer's stock, which is defined as Fair Market Value. This is the price at which the 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.

Geographic concentration and unreliable financial reporting are unsystematic risks specific to the company, justifying a CSRP. Industry cyclicality is a systematic risk, typically captured in beta or an industry risk premium. Being smaller than the smallest decile for size premium data is addressed by the size premium itself, not CSRP, although some practitioners might add a small premium for this.