You are the potential buyer of a business, a shoe store.

You are the potential buyer of a business, a shoe store. You are negotiating with the seller: The seller is offering a selling price of $500,000. The seller calculated the NVP (business value) of $500,000, by forecasting future cash flows and applying a discount rate of 12%. In your negotiations, you agree with the future cash flow projections, but you want to pay a lower price.

What different discount rate will you suggest be used?
Are you sure about that discount rate? Try doing a quick NPV model (using your existing template) and see what happens!
The seller applied a 12% discount rate. With what logical reasoning will you try to convince the seller of a different discount rate?
Which Principle of Finance does your logical reasoning rest on?

Expert Solution

The value of the business is arrived based on various valuation techniques, and in the current scenario the business is valued based on the Net Present Value ('NPV') of future cash inflows and outflows. Thus, in simple terms, 100$ received today has a greater value than received after 5 years. Though the numerical value of money remains the same, the time value of money makes them different.

Thus, discount rates are used to determine the value of cashflows at any point in time during a particular investment.

There are straight jacket formulas to arrive at dicount rates (among the many includes weighted average cost of capital).

In the given question, the discount rate used to discount the cashflows to arrive at the value of business is '12%'.

From the perspetive of the buyer, since the potential investment is in a shoe store, there are various risks which include inflation, business risks , market risks etc. Thus, the buyer could suggest a 'risk adjusted discount rate model' wherein the discount rate will be the risk free rate + risk premium.

The average industry beta for apparels or in specific the shoe industry could be used to arrive at the risk premium for the business and market risks.

Thus, a risk adjusted discount rate would be higher than the discount rate suggested by the seller. A higher discount rate would lower the value of business by less than $5,00,000, thus making it a profitable investment for the buyer.

jeff jeffy answered 2 years ago

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