Copyright © 2011 Nelson Education Limited Finance for Non-Financial Managers, 6 th edition PowerPoint Slides to accompany Prepared by Pierre Bergeron, University of Ottawa

Copyright © 2011 Nelson Education Limited Finance for Non-Financial Managers, 6 th edition CHAPTER 12 BUSINESS VALUATION

Copyright © 2011 Nelson Education Limited 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 statement of income and the statement of financial position. 6.Present the various ways of price-tagging an on-going business. 7.Calculate the market value of publicly-traded companies. 8.Calculate investment return on capital projects from an investor’s (venture capitalist) perspective. Chapter Reference Chapter 12: Business Valuation

Copyright © 2011 Nelson Education Limited 1. Book Value Versus Market Value Statement of Financial Position (based on book value) Statement of Financial Position (based on market value) House Original cost $ 200,000 Accumulated depreciation (100,000) Book value $ 100,000 New mortgage$ 200,000 House Market value $ 400,000 New mortgage$ 200,000

Copyright © 2011 Nelson Education Limited 2. Valuation Models  Book value  Market value  Liquidation value  Industry multipliers  DCF method  Going concern value  Economic value  Replacement value  Assessed value

Copyright © 2011 Nelson Education Limited 3. Scanning the Environment This is a method used during the planning process to pin down planning assumptions or premises. General  Past  Present  Future  Statement of income  Statement of financial position 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

Copyright © 2011 Nelson Education Limited 4. Documenting Planning Assumptions Planning assumptions are used to prepare a company’s projected financial statements. The following are typical planning assumptions related to the statement of income.  Revenue: size of market, profile of key competitors, consumer preferences, selling price, existing products/services  Cost of sales: key suppliers, location of suppliers, cost of raw materials, labour rates, freight costs, distribution network, competencies or skills required in manufacturing  Distribution costs: 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 non-current assets, management fees  Other charges: interests, downsizing costs, fluctuation of Canadian dollar

Copyright © 2011 Nelson Education Limited Documenting Planning Assumptions (continued) The following are typical planning assumptions related to the statement of financial position.  Non-current assets: assets to be purchased, composition of non-current assets, amount to be invested in new assets, modernization, expansion, assets to be sold, depreciation and CCA rates for different non-current assets  Current assets: cash required in the bank to meet on-going activities, composition of the prepaid expenses, aging of the trade receivables, estimated bad debts, inventories in raw materials, work-in-process and finished goods, holding costs, ordering costs  Equity: number of shares outstanding, dividend policy  Long-term borrowings: amount outstanding, cost of debt, nature of agreements  Current liabilities: payment policies, terms required by suppliers, amount outstanding and interest rates, nature of accruals

Copyright © 2011 Nelson Education Limited 5. Restating Futurama’s Statement of Financial Position (slide 3.5) Non-current assets (at cost) Accumulated depreciation Non-current assets (net) Goodwill Current Assets Inventories Trade receivables Prepaid expenses Cash Total Current Assets Total Assets Common Shares Retained Earnings Equity Total Long-term borrowings Current Liabilities Trade and other payables Notes payable Accrued expenses Taxes payable Total current liabilities Total Liabilities Total equity and liabilities $ 3,000, , , , ,000 $ 1,340, ,000 1,200, , ,000 60,000 22, ,000 $ 1,800,000 $ 300, , , , , ,000 20,000 80, ,000 1,245,000 $ 1,800,000  Total $3,625,000    

Copyright © 2011 Nelson Education Limited Restating Futurama’s Income Statement (slide 3.6) Revenue $ 2,500,000 Cost of sales (1,900,000) Gross profit 600,000 Salaries (300,000) Rent (50,000) Depreciation (40,000) Other expenses (15,000) Total expenses 405,000 Profit before taxes 195,000 Income tax expense (97,500) Profit for the year 97,500 Add back depreciation 40,000 Total cash flow $ 137,000 $ 4,000,000 $ 369,000 $ 150,000 $ 519,000

Copyright © 2011 Nelson Education Limited 6. Book Value Method Futurama Ltd. (slide 3.5) Book Value Assets Non-current assets $ 1,200,000 Inventories 218,000 Trade receivables 300,000 Prepaid expenses 60,000 Cash 22,000 Total assets$ 1,800,000 Equity Liabilities Trade and other payables 195,000 Misc. loans 1,050,000 Total Liabilities 1,245,000 Total equity and _________ liabilities $ 1,800,000 Difference between assets and liabilities Book value $ 555,000

Copyright © 2011 Nelson Education Limited Liquidation Value Method Liquidation Value Assets Non-current assets$ 900,000 Inventories 150,000 Trade receivables 200,000 Prepaid expenses Cash 22,000 Total Assets$ 1,272,000 Equity Liabilities Trade and other payables 195,000 Misc. loans 1,050,000 Total Liabilities 1,245,000 Total equity and liabilities $ 1,272,000 Difference between assets and liabilities if sold individually on the open market. Liquidation value 27,000

Copyright © 2011 Nelson Education Limited Industry Multipliers Industry multipliers are standards used to determine the value or worth of a business. Examples of industry multipliers Multipliers Industries Travel agencies Retail businesses Fast food Restaurants Food distributors.05 to.1 x annual gross sales.75 to 1.5 x annual net profit + inventories + equipment.5 to.7 x monthly gross sales + inventories.3 to.5 x annual gross sales, or.4 x monthly gross sales + inventories 1 to 1.5 x annual net profit + inventories + equipment

Copyright © 2011 Nelson Education Limited 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 20% The offer price $ __________ $ _________ X ________ $ __________  - 3,625, , ,189, , ,175,907 6,000, ,313, ,060 6,000, ,877, ,033 IRR 17.2% $ __________ - 3,625,000  $ __________ 3,144,967 0 If you want to make a 20% IRR

Copyright © 2011 Nelson Education Limited 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

Copyright © 2011 Nelson Education Limited 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)

Copyright © 2011 Nelson Education Limited 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 tax b) After tax

Copyright © 2011 Nelson Education Limited Projects from an investor’s (venture capitalist) perspective Investors are looking for a Winning Combination! Products/ Services (%) (the horse) Management Team (The jockey)

Copyright © 2011 Nelson Education Limited The Rich-Gumpert Evaluation System 1/1 2/1 2/2 1/2 3/1 3/2 3/3 2/3 1/3 4/1 4/24/34/4 3/4 2/4 1/4 Level 1 A single would-be founder/ Entrepreneur. Management Status MOSTDESIRABLEMOSTDESIRABLE MOST DESIRABLE PRODUCT/SERVICESTATUSPRODUCT/SERVICESTATUS 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. Level 4 Product/service fully developed. Many satisfied users. Market established. Level 2 Product/service pilot operative. Not yet developed for production. Market assumed. Level 3 Product/service fully developed. Few or no users as yet. Market assumed. Level 1 Product/service idea and not yet operable. Market assumed. Source: Business Plans that Wins $$$, Stanley R. Rich and David E. Gumpert, Harpor & Row, 1986, p Ready for an IPO

Copyright © 2011 Nelson Education Limited 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

Copyright © 2011 Nelson Education Limited Cash flow from operations$ 519$ 800$ 900$1,200$1,450 Investment in non-current assets (1,200) (400) (400) (300) (300) Incremental working capital (200) (200) (200) (200) (200) Sub-total(1,400) (600) (600) (500) (500) Net cash flows (881) Discount 20% Present values ($ 734) $ 139 $ 174 $ 337 $ 382 Cash Flow Forecast (step 1) This method determines the net present value of the projected discretionary annual cash flows. NPV +$ 298

Copyright © 2011 Nelson Education Limited Residual Value of the Forecast Period (step 2) Forecast of residual value in 2014 Cash flow $ 1,450 Investments (500) Net cash flows (from transparency 12.14) 950 Capitalization 18% ($950,000 ÷ 18%)$ 5,278 x Present value 20% Present value of the residual value$ 2,121 This step determines the residual value of the company after the forecast period is over.

Copyright © 2011 Nelson Education Limited Estimated Market Value (step 3) Forecast of discretionary cash flow $ 298 (from transp ) Add: residual value 2,121 (from transp ) 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

Copyright © 2011 Nelson Education Limited A. Investment return before taxes Initial investment ($ 600) Cash distribution to investors (transparency 12.19) $ 950 Multiplier 8.0 Total value at exit 7,600 Investor’s required share (40%) ,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 investor38.34%

Copyright © 2011 Nelson Education Limited 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

Copyright © 2011 Nelson Education Limited 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 Calculation After-tax return to investor 28.78%