Fuel Cell Enterprises is in a new and rapidly-evolving industry, and is being evaluated as an acquisition candidate by Auto Giant, Inc. There are about 10 firms that broadly resemble Fuel Cell, but none of its competitors have been taken over up to this point. Because of the nature of the firm’s technology, the level of risk is difficult to estimate and may change rapidly as the technology matures. Which type of analysis is likely to be most appropriate in the valuation of Fuel Cell? A) Discounted cash flow analysis. B) Comparable transaction analysis. C) Comparable company analysis.
Damil, I dare say C. With risk level difficult to estimate, you cannot estimate expected cashflow nor discount it appropriately. With no previous (similar) transaction history B is eliminated.
I will agree with Oal29 and go with C too.
With comparable company analysis, and no takeovers in the near past - where are you going to get the takeover premium from? also both comparable company, and comparable transaction do not allow you to modify them according to level of risk present in the deal. So I am inclined to go with A) Discounted cash flow…
^Makes good sense. Can I change to A now :))) This is where it gets difficult 
This was a tough one. I would choose C as it allows me to change according to risk. Edit: A, not C, thanks cp
Comparable company? does not allow to change according to risk…
I’m going with C The question says none of its competitors have been taken over - not that there weren’t any transactions in the market at all. I don’t think that in order to find the transaction premium the co that was taken over needs to be a comparable co. since you are just finding a %age premium for the transaction. You would just use the comparable company for the base valuation and any co. for the premium. What the correct answer?
I would go with “A” as the level of risk is difficult to estimate.
C
Correct answer = C. See Oal29’s comment for reasoning.
I have serious doubts on the validity of the question. 1. Is the big risk in the project being captured because you are taking into account the comparable companies? 2. No transactions available - so Comparable transaction is definitely out. 3. What happened to a takeover premium? Where is that coming from? 4. What happened to “specific” risk that the firm faces? All in all, I think Schweser has just provided a bad question… too many open ends here. The book specifically seems to mention “inability to account for firm specific risk, which can be built into the discounted cash flow model” as one of the disadvantages of both the “comparable” company/transaction methods. So I am not sure what to go with here.
I agree with CP, sometimes Sch really does a bad job at writing questions
My reasoning for A is: There are 2 components in determining Value of a business. 1) Cash Flows 2) Discount Rate Discount Rate captures the risk of that business. Higher the risk, higher the discount rate, lower the value of that business. But, if somehow risk of the business is not feasable to measure exactly, it is better to modify cash flows by making them much more conservative. That is reduce cash flows and discount them by general risk level (discount rate) to get reduced business value. As a crude example, say we have a cashflow of 100. There are 70% chances of getting cashflow as 100, and 30% chances of getting it as 0. So, instead of reflecting this Risk in the discount rate, I could also reflect this risk by reducing our cashflow to 70. That is why I thought A made more sense here.
B is out because there are no comparable transactions. A is out because the question says that the risk is difficult to measure and may change rapidly (i.e, the discount rate cannot be applied with any certainty here). This leaves C, which makes sense because there are 10 firms that broadly resemble the subject. Pretty simple question in my opinion.
^^ I agree with thommo’s reasoning here, the question clearly states that “the level of risk is difficult to estimate and may change rapidly” so for me that throws away A and the only feasible answer left is C
Dear all, I have warned on a previous thread, let us only answer the question asked, and not “support” or substitute question with our own assumptions. some of my friends here talked about “take over premium” I wonder where that was mentioned in this question! or whether it is even relevant to the question!
oal29, Comparable transaction analysis - includes the takeover premium internally. since you are using the transactions information to build up your takeover estimate. comparable company analysis - excludes takeover premium. It is only comparing the companies - and making an estimate for how much the target company would be worth. That’s where the takeover premium came from - from the methods themselves. The question seems to be differentiating between determining how much the target company would be worth [which is what the comparable company analysis gives], vs. how much someone would pay to acquire it…
cp, now I understand where you are coming from. Now, look at the question again. Fuel Cell is the target, who is concerned with “take over premium”? target or acquirer? That apart, you were told any acquisition of this type had never happened before, this fact eliminated of option B. Now, lets go to the curriculum to kill option A. DCF rest on the available of expected cashflow and discount rate, if you read valuation in emerging market, it hinted 2 methods to account for risk in the application of the DCF. You either adjust for this risk in the expected Cashflow(recommended approach) or adjust for risk in the discount rate you will use. Now, this question tell you (for free) that you cannot even estimate this risk. (you are laughing now…) common let’s rock level 2. -:0)