Finance for Non-Financial Managers Fifth Edition

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 12.1

Finance for Non-Financial ManagersFifth Edition

Slides prepared by

Pierre G. BergeronUniversity of Ottawa


Business Valuation

Chapter Objectives

1. Differentiate between market value and book value.

2. Discuss the various valuation models.

3. Comment on the meaning of scanning the environment.

4. Explain how to go about documenting planning assumptions.

5. Show how to restate the income statement and the balance sheet.

6. Present the various ways of price-tagging an ongoing business.

7. Calculate the market value of publicly traded companies.

8. Determine investment return on capital projects from an investor’s (venture capitalist) perspective.

Chapter Reference

Chapter 12: Business Valuation


1. Book Value Versus Market Value

Balance Sheet (based on book value)

Balance Sheet (based on market value)

House

Original cost $ 200,000

Accumulated

amortization 100,000

Book value $ 100,000 New mortgage $ 200,000

House

Market value $ 400,000 New mortgage $ 200,000


2. Valuation Models

Book value

Market value

Liquidation value

Industry multipliers

DCF method

Going concern value

Economic value Replacement value

Assessed value


3. Scanning the Environment

This is a method used during the planning process to pin down planning

assumptions or premises.

General Past

Present

Future

Income

statement

Balance

sheet

Scanning the environment

(SWOT analysis)

Documenting the planning assumptions

Restating the financial

statements

Industry

Examples of planning assumptions: GNP, labour rates, market demand, supply capability, unemployment, interest rate, price for raw materials, competitive climate, consumer profile, etc.

Price-tagging the business


4. Documenting Planning AssumptionsPlanning assumptions are used to prepare a company’s pro-forma financial statements. The following are typical planning assumptions related to the income statement.

Sales revenue: size of market, profile of key competitors, consumer preferences, selling price, existing products/services

Cost of goods sold: key suppliers, location of suppliers, cost of raw materials, labour rates, freight costs, distribution network, competencies or skills required in manufacturing

Selling expenses: profile of typical sales representative, compensation package, competencies or skills needed, advertising costs, promotional programs, training and development, management fees, insurance premiums

Administrative expenses: number of people and composition of people working in overhead units, compensation package, leasing costs, composition of capital assets, management fees

Other charges: interests, downsizing costs, fluctuation of Canadian dollar


Documenting Planning Assumptions (continued)

The following are typical planning assumptions related to the balance sheet.

Current assets: cash required in the bank to meet on-going activities, composition of the prepaid expenses, aging of the accounts receivable, estimated bad debts, inventory in raw materials, work-in-process and finished goods, holding costs, ordering costs

Capital assets: assets to be purchased, composition of capital assets, amount to be invested in new assets, modernization, expansion, assets to be sold, amortization and CCA rates for different capital assets

Current liabilities: payment policies, terms required by suppliers, amount outstanding and interest rates, nature of accruals

Long-term debts: amount outstanding, cost of debt, nature of agreements

Shareholder’s equity: number of shares outstanding, dividend policy


5. Restating Futurama’s Balance Sheet (transparency 3.6)

Current Assets Cash Accounts Receivable Inventory Prepaid ExpensesTotal Current Assets

Capital Assets (at cost)Accumulated amortizationCapital Assets (net)GoodwillTotal Assets

Current Liabilities

Accounts Payable

Notes Payable Accrued Expenses Taxes PayableTotal Current LiabilitiesTotal Long-term debts

Total LiabilitiesCommon Shares

Retained Earnings

Shareholders Equity

Total Liabilities & shareholders’ equity

$ 22,000

250,000 170,000 60,000 $ 502,000

3,000,000

- - - - - 3,000,000 400,000 3,902,000

$ 195,000 150,000 20,000 80,000 445,000

2,000,000

2,445,000

1,457,00

- - - - - -

1,457,000

$ 3,902,000

Total $3,625,000

$300,000218,000

1,200,000000

195,000


Restating Futurama’s Income Statement (transparency 3.7)

Sales revenue $ 4,000,000

Cost of sales 2,400,000

Gross profit 1,600,000

Operating expenses

Selling expenses $330,000

Administrative 370,000

Total operating expenses $ 700,000

Operating income 900,000

Other income/expenses 162,000

Income before taxes 738,000

Income taxes 369,000

Net income 369,000

amortization 150,000

Total cash flow $ 519,000

$ 2,500,000

$ 97,500


6. Book Value Method Futurama Ltd. (transparency 3.6)

Book Value

Assets

Cash $ 22,000

Accounts Receivable 300,000

Inventory 218,000

Prepaid expenses 60,000

Capital Assets 1,200,000

Total Assets $ 1,800,000

Liabilities

Accounts Payable 195,000

Misc. loans 1,050,000

Total Liabilities 1,245,000

Shareholders’ equity

Total liabilities and _________

shareholders’ equity $ 1,800,000

Difference between assets and liabilities

Book value

555,000


Liquidation Value Method

Liquidation ValueAssets Cash $ 22,000 Accounts Receivable 200,000 Inventory 150,000 Prepaid expenses ------- Capital Assets 900,000Total Assets $ 1,272,000

Liabilities

Accounts Payable 195,000

Misc. loans 1,050,000

Total Liabilities 1,245,000

Shareholders’ equity __________

Total liabilities and

shareholders’ equity $ 1,272,000

Difference between assets and liabilities if sold individually on the open market.

Liquidation value

27,000


Industry Multipliers

Industry multipliers are standards used to determine the value or worth of a business.

Examples of industry multipliers

MultiplierIndustry

Travel agencies

Retail businesses

Fast food

Restaurants

Food distributors

.05 to .1 x annual gross sales

.75 to 1.5 x annual net profit + inventory +

equipment

.5 to .7 x monthly gross sales + inventory

.3 to .5 x annual gross sales, or .4 x monthly

gross sales + inventory

1 to 1.5 x annual net profit + inventory +

equipment


Discounted Cash Flow Method (10 year life span)

Discount rates Cost of capital

10%

Purchase price (outflow)

Cash inflows

Cost of capital

Hurdle rate

Net present value

Sale of the business (inflow)

Cost of capital

Hurdle rate

Hurdle rate

20%

The offer

price

$ __________

$ __________

$ __________

$ __________

$ __________

$ __________

$ __________

$ _________ X ________

$ _________ X ________

$ _________ X ________

$ _________ X ________

$ __________

- 3,625,000

519,000 6.1446 + 3,189,047

519,000 4.1926 + 2,175,907

6,000,000 .38554 +2,313,240

+ 969,0606,000,000 .16151

+ 1,877,287 - 480,033

IRR 17.2%

$ __________

- 3,625,000 $ __________3,144,967

0

If you want to make a

20% IRR


Going Concern Value (using the capitalization rate)

Capitalization Value

Cash flow from operations $ 519,000

(from transparency 12.8)

Divided by capitalization rate* ÷ 20%

Going concern value (present value) $2,595,000

*Capitalization rate represents the required rate of return for the company which is based on a number of subjective factors and conditions at the time of the valuation.

Company will be sold as a viable business generating a cash flow of say $519,000/year forever.

Going concern value


7. Market Value of Publicly-Traded Companies

Number of shares outstanding: 50,000

Company’s net worth: $2,000,000

Book value of each share: $40.00 ($2,000,000 / 50,000)

Shares are trading at: $50.00

Market value of the company: $2,500,000 ($50.00 x 50,000)


8. Projects From an Investor’s Perspective

Step 1: Cash flow forecast

Step 2: Residual value of the forecast period

Step 3: Estimated market value

Step 4: Investor’s return (40% investment in the business)a) Before taxb) After tax


Projects from an investor’s (venture capitalist) perspective

Investors are looking for a Winning Combination!

Products/Services (%)(the horse)

Management Team

(The jockey)


The Rich-Gumpert Evaluation System

4/1 4/2 4/3 4/4

3/1 3/2 3/3 3/4

2/1 2/2 2/3 2/4

1/1 1/2 1/3 1/4

Level 1A single would-be

founder/Entrepreneur.

Management Status

MOST

DESIRABLE

MOST DESIRABLE

PRODUCT/SERVICE

STATUS

Level 2Two founders, additional slots

but personnel not identified.

Level 3Partly staffed team, absent members

but will join when firm is funded.

Level 4Fully staffed by

experienced management

team.

Level 4Product/servicefully developed.

Many satisfied users.Market established.

Level 2Product/service

pilot operative. Notyet developed for

production.Market assumed.

Level 3Product/servicefully developed.

Few or no users as yet.Market assumed.

Level 1Product/service

idea and notyet operable.

Market assumed.

Source: Business Plans hat Wins $$$, Stanley R. Rich and David E. Gumpert, Harpor & Row, 1986, p. 169.


Steps When Approaching Venture Capitalists

Demonstrate investment

potential

Demonstrate management

team capabilities

Identify potential

needs

Write investment proposal

Meet potential investors

Negotiate the deal

Close the deal

Identify potential investors

Step 1 Step 6 Step 7Step 5Step 4

Step 3

Step 2

Step 8


2007 2008 2009 2010 2011

Cash flow from operations $ 519 $ 800 $ 900 $1,200 $1,450

Capital investments -1,200 -400 -400 -300 -300Incremental working capital -200 -200 -200 -200 -200

Sub-total -1,400 -600 -600 -500 -500

NCF -881 +200 +300 +700 +950

Discount factor @ 20% .83333 .69444 .57870 .48225 .40188Present value -$ 734 +$ 139 +$ 174 +$ 337 +$ 382

Cash Flow Forecast (step 1)This method determines the net present value of the projected

discretionary annual cash flow.

NPV +$ 298


Residual Value of the Forecast Period (step 2)

Forecast of residual value in 2011

Cash flow $ 1,450

Investments -500

Net cash flow 950

Capitalization rate @ 18% ($950,000 ÷ 18%) $ 5,278

x

Present value factor @ 20% .40188

Present value of the residual value $ 2,121

This step determines the residual value of the company after the forecast period is over.


Estimated Market Value (step 3)

Forecast of discretionary cash flow $ 298 (from transp. 12.20)

Add: residual value 2,121 (from transp. 12.21)

Estimated fair market $ 2,419

value of the shares

This step determines the residual value of the company after the forecast period is over.

Estimated fair market

value


2006 2007 2008 2009 2010 2011

A. Investment return before taxes --- --- --- ---

Initial investment -$ 600 --- --- --- ---

Cash distribution to investors (transparency 12.18) $ 950 Multiplier 8.0 Total value at exit 7,600

Investor’s required share (40%) --- --- --- 3,040 Initial investment -$ 600 Total discounted cash inflow +$ 600 $ 3,040

Investor’s Return - Before Tax (step 4)This method takes into account the discounted value of the future cash flows to calculate the investor’s return.

Before-tax return to investor 38.34%


B. After-tax return Proceeds received on exit $3,040 Initial investment -600 Capital gain on investment 2,440

Taxable portion (75%) 1,830 Investor’s tax payable (50%) 915

Gross proceeds received on exit 3,040 Investor’s tax payable 915

Net after-tax proceeds to investor $ 2,125

Investor’s Return - After Tax


2006 2007 2008 2009 2010 2011

Initial investment - $ 600 --- --- --- --- ---

Total value at exit

Net after-tax proceeds to investor --- --- --- --- --- $ 2,125

Total cash flowsInitial investment - $ 600Total cash flows + $ 600 $ 2,125

After-Tax Return Calculation

After-tax return to investor 28.78%

Finance for Non-Financial Managers Fifth Edition

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