Finance for NonFinancial Managers Fifth Edition

1
Finance for Non-Financial ManagersFifth Edition

• Slides prepared by
• Pierre G. Bergeron
• University of Ottawa

2
Business Valuation

• Chapter Objectives
• Differentiate between market value and book
  value.
• Discuss the various valuation models.
• Comment on the meaning of scanning the
  environment.
• Explain how to go about documenting planning
  assumptions.
• Show how to restate the income statement and the
  balance sheet.
• Present the various ways of price-tagging an
  ongoing business.
• Calculate the market value of publicly traded
  companies.
• Determine investment return on capital projects
  from an investors (venture capitalist)
  perspective.

Chapter Reference Chapter 12 Business Valuation
3
1. Book Value Versus Market Value
Balance Sheet (based on book value)
House Original cost 200,000 Accumulated
amortization 100,000 Book value 100,000
New mortgage 200,000
Balance Sheet (based on market value)
House Market value 400,000
New mortgage 200,000
4
2. Valuation Models

• Book value
• Market value
• Liquidation value
• Industry multipliers
• DCF method
• Going concern value
• Economic value

• Replacement value
• Assessed value

5
3. Scanning the Environment
This is a method used during the planning process
to pin down planning assumptions or premises.
Scanning the environment (SWOT analysis)
Documenting the planning assumptions
Restating the financial statements

• Income
• statement
• Balance
• sheet

• Past
• Present
• Future

General
Price-tagging the business
Industry
6
4. Documenting Planning Assumptions
Planning assumptions are used to prepare a
companys 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

7
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
• Shareholders equity number of shares
  outstanding, dividend policy

8
5. Restating Futuramas Balance Sheet
(transparency 3.6)
Current Assets Cash Accounts Receivable
Inventory Prepaid Expenses Total Current
Assets Capital Assets (at cost) Accumulated
amortization Capital Assets (net) Goodwill Total
Assets Current Liabilities Accounts Payable
Notes Payable Accrued Expenses Taxes
Payable Total Current Liabilities Total Long-term
debts Total Liabilities Common 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
9
Restating Futuramas 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
10
6. Book Value Method Futurama Ltd. (transparency
3.6)

• Difference between assets and liabilities

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
11
Liquidation Value Method

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

Liquidation Value Assets Cash
22,000 Accounts Receivable 200,000
Inventory 150,000 Prepaid expenses
------- Capital Assets
900,000 Total 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
12
Industry Multipliers
Industry multipliers are standards used to
determine the value or worth of a business.
Examples of industry multipliers
Industry
Multiplier
.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
inventory1 to 1.5 x annual net profit
inventory equipment
Travel agenciesRetail businessesFast food
RestaurantsFood distributors
13
Discounted Cash Flow Method (10 year life span)
The offer price
Cost of capital 10
Hurdle rate 20

• Discount rates

__________
__________
__________
Purchase price (outflow)
Cash inflows Cost of capital Hurdle rate
_________ X ________
__________
__________
_________ X ________
Sale of the business (inflow) Cost of
capital Hurdle rate
IRR 17.2
_________ X ________
__________
_________ X ________
__________
1,877,287
Net present value
- 480,033
__________
__________
__________
14
Going Concern Value (using the capitalization
rate)

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

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.
15
7. Market Value of Publicly-Traded Companies

• Number of shares outstanding 50,000
• Companys 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)

16
8. Projects From an Investors Perspective

• Step 1 Cash flow forecast

Step 2 Residual value of the forecast period
Step 3 Estimated market value

• Step 4 Investors return (40 investment in the
  business)
• a) Before tax
• b) After tax

17
Projects from an investors (venture capitalist)
perspective

• Investors are looking for a
• Winning Combination!

Products/ Services () (the horse)
Management Team (The jockey)
18
The Rich-Gumpert Evaluation System
MOST DESIRABLE
Level 4 Product/service fully developed. Many
satisfied users. Market established.
P R O D U C T / S E R V I C E S T A T U S
M O S T D E S I R A B L E
Level 3 Product/service fully developed. Few or
no users as yet. Market assumed.
Level 2 Product/service pilot operative. Not yet
developed for production. Market assumed.
Level 1 Product/service idea and not yet
operable. Market assumed.
Source Business Plans hat Wins , Stanley R.
Rich and David E. Gumpert, Harpor Row, 1986, p.
169.

• Level 1
• A single would-be
• founder/
• Entrepreneur.

Level 2 Two founders, additional slots but
personnel not identified.
Level 3 Partly staffed team, absent members
but will join when firm is funded.
Level 4 Fully staffed by experienced
management team.
Management Status
19
Steps When Approaching Venture Capitalists
Step 2
Demonstrate investment potential
Step 1
Step 6
Step 7
Step 5
Step 4
Step 8
Identify potential needs
Write investment proposal
Meet potential investors
Identify potential investors
Negotiate the deal
Close the deal
Step 3
Demonstrate management team capabilities
20
Cash Flow Forecast (step 1)

• This method determines the net present value of
  the projected discretionary annual cash flow.

2007 2008 2009 2010 2011 Cash flow from
operations 519 800 900 1,200 1,450 Capit
al investments -1,200 -400 -400 -300
-300 Incremental working capital -200 -200
-200 -200 -200 Sub-total -1,400 -600
-600 -500 -500 NCF -881 200 300
700 950 Discount factor _at_
20 .83333 .69444 .57870 .48225 .40188 Present
value - 734 139 174
337 382
21
Residual Value of the Forecast Period (step 2)

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

Forecast of residual value in 2011 Cash flow
1,450 Investments -500 Net
cash flow 950 Capitalization rate _at_
18 (950,000 18) 5,278
x Present value factor _at_ 20 .40188 Present
value of the residual value 2,121
22
Estimated Market Value (step 3)

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

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
23
Investors Return - Before Tax (step 4)

• This method takes into account the discounted
  value of the future cash flows to calculate the
  investors return.

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 Investors required share (40)
--- --- --- 3,040 Initial
investment - 600 Total discounted
cash inflow 600
3,040
Before-tax return to investor 38.34
24
Investors Return - After Tax
B. After-tax return Proceeds
received on exit 3,040 Initial
investment -600 Capital gain on
investment 2,440 Taxable portion
(75) 1,830 Investors tax payable
(50) 915 Gross proceeds received on
exit 3,040 Investors tax payable
915 Net after-tax proceeds to investor
2,125
25
After-Tax Return Calculation
2006 2007 2008 2009 2010 2011 Initial
investment - 600 --- ---
--- --- --- Total value at
exit Net after-tax proceeds to investor ---
--- --- --- ---
2,125 Total cash flows Initial investment -
600 Total cash flows 600
2,125
After-tax return to investor 28.78