Financial management revision question and answer

CPA-Financial-Management-Section-3 Revision kit

Discuss the drawbacks of using the following approaches in estimating a security‟s value:

(i) Book value;
(ii) Replacement value;
(iii) Substitution value;
(iv) Intrinsic value.
ANSWER
Book value – historical or balance sheet value

Book value of an asset is determined using the net asset basis/liquidating method where, the value of a share i.e
The main weakness of the book value valuation is that the data used is historical.

Replacement Value:
Its based on the cost of replacing the existing assets. However, only the productive fixed assets can be replaced at ago since current assets are circulating working capital.

The problems with this value are:
(i) It is based on one portion of total assets.
(ii) Replacement value is subjectively determined.

Substitution value
This involves determining the value of a security looking at the value of a similar/substitute value of a share of a competitor company in the same industry.

The problems with this value are:-
(i) Firms do not have similar productive assets for the purpose of using one security as a substitute of the other.
(ii) There are no two firms which are identical or similar in their operating characteristics e.g firms in the same industry will have different accounting policies and management styles.

Intrinsic Value
It‟s the value determined using historical information and financial models
e.g the dividend yield model.

The problems with this value are:
(i) It is based on historical data.
(ii) The models may not be accurate in fact different models produce different intrinsic values.

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