In: Accounting
Georgia Isaacson and her son Rubin have been thinking about buying a business. After talking to seven entrepreneurs, all of whom have expressed an interest in selling their operations, the Isaacsons have decided to make an offer for a retail clothing store. The store is very well located, and its earnings over the past five years have been excellent. The current owner has told the Isaacsons he will sell for $500,000. The owner arrived at this value by projecting the earnings of the operation for the next seven years and then using a discount factor of 15 percent.
The Isaacsons are not sure the retail store is worth $500,000, but they do understand the method the owner used for arriving at this figure. Georgia feels that since the owner has been in business for only seven years, it is unrealistic to discount seven years of future earnings. A five-year estimate would be more realistic, in her opinion. Rubin feels that the discount factor is too low. He believes that 20 to 22 percent would be more realistic.
In addition to these concerns, the Isaacsons feel they would like to make an evaluation of the business using other methods. In particular, they would like to see what the value of the company would be when the adjusted tangible book value method is employed. They also would like to look at the replacement value and liquidation value methods.
“We know what the owner feels his business is worth,” Georgia noted to her son. “However, we have to decide for ourselves what we think the operation is worth. From there, we can negotiate a final price. For the moment, I think we have to look at this valuation process from a number of different angles.”
QUESTIONS
1. If the owner reduces the earnings estimates from seven to five years, what effect will this have on the final valuation? If he increases the discount factor from 15 percent to 20 to 22 percent, what effect will this have on the final valuation?
2. How do the replacement value and liquidation value methods work? Why would the Isaacsons want to examine these methods?
3. If the Isaacsons conclude that the business is worth $410,000, what will be the final selling price, assuming a sale is made? Defend your answer.
ANSWER :
WORKING NOTES ;
1. Offer Price for the retail cloth store by the Owner = $5,00,000
2. Price arrived by projecting the earnings for the nex 7 yrs with a discount factor of 15 %
3. Price to be arrived by projecting the earning factor for next 5 yrs
4. Price to be arrived with 7 yr projection and discounting factor of 20 % to 22 %
5. Other valuation methods to be tried :
1. Adjusted Tangible Book Value Method
2. Replacement Value Method
3. Liquidation value Method.
Part 1.
Net Present Value of future cash flow is arrived by the formula :
NPV = F/ (1 + i) ^ n = F = Future Cash flow : i = discounting rate ; n = number of years cash flow
The valuation of $5,00,000 is arrived by assuming the future Cash flow for 7 years at a discount factor of 15 %. So the cash flow figure can be arrived by :
5,00,000 = CF/ (1 + .15)^ 7 . CF = 5,00,000 * ( 1.15 )^7 = 13,30,000.
If the owner agrees to reduce the earning estimate from 7 years to 5 years , then the average cash folw for 5 years are arrived and the discount rate is assumed to be at 15 % only
So average Cash flow for 5 Yrs = 13,30,000 * 5/7 = 9,50,000.
So the new valuation is : NPV = 9,50,000/(1+.15)^5 = 9,50,000 / 2.011357 = 4,72,318
If he owner agrees to increase the discounting factor only from 15 to 20 and to 22 , assuming that the cash flow for 7 yrs are considersd then the two valuations will be ;
1. NPV = 13,30,000/ (1+.20)^7 = 13,30,000/ 3.5831 = 3,71,187
2. NPV = 13,30,000/(1+.22)^7 = 13,30,000/4.0227 = 3,30,624.
ANSWER - Part 2
1. Adjusted Tangible Book Value Method of Valuation :
Adjusted Book Value is the measure of a company's valuation after liabilities - including off-balance sheet liabilities -and assets adjusted to reflect the TRUE FAIR market value.
Tangible Book Value is calculated by subtracting intangible assets ( Intellectual Property rights,patents,Goodwill etc ) from the company's book value. That is Price to Tangible Book Value represents the amount of money that share holders would receive for each share owned if the Company were to liquidate its operations.
2. Replacement value Method of Valuation :
This takes into account " the amount required to replace the existing Company " as the valuation of the Company. That is if one is to create a similar Company ,in the same industry , all costs required to do so will form part of the value of the company.
3. Liquidation value method :
Liquidation Value is the Total worth of a Company's physical assets if it were to go out of business and the Assets are sold. The Liquidation value is the value of the Company real estate , fixtures,equipments and Inventory . Intangible assets are excluded from the Valuation.
In the Replacement Value Method of valuation the assumption is that ,the Business continues to operate as against Shut Down. Whereas Liquidation value method assumes that the business will be Shutting down and the hence the valuation is for Salvage Value.
Isaacson wanted to do both these valuations to understand the amount of investments , they have to make if they want to establish a New Retail Cloth Store as the one offered for sale and the Value of that if they go for purchasing it.
Part 3. If Isaacson arrives the value of the business at $4,10,000 and the sale is through - I think one more factor is needed to arrive the final sale price, ? Otherwise my answer ids $4,10,000.