© 2008 by Nelson, a division of Thomson Canada Limited Transparency 12.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron University of Ottawa

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 12.2 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

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

© 2008 by Nelson, a division of Thomson Canada Limited Transparency Valuation Models  Book value  Market value  Liquidation value  Industry multipliers  DCF method  Going concern value  Economic value  Replacement value  Assessed value

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

© 2008 by Nelson, a division of Thomson Canada Limited Transparency Documenting Planning Assumptions Planning 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

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 12.7 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  Shareholder’s equity: number of shares outstanding, dividend policy

© 2008 by Nelson, a division of Thomson Canada Limited Transparency Restating Futurama’s 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 60,000 $ 502,000 3,000, ,000, ,000 3,902,000 $ 195, ,000 20,000 80, ,000 2,000,000 2,445,000 1,457, ,457,000 $ 3,902,000      Total $3,625,000 $300, ,000 1,200, ,000

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 12.9 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

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

© 2008 by Nelson, a division of Thomson Canada Limited Transparency Liquidation Value Method 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 Difference between assets and liabilities if sold individually on the open market. Liquidation value 27,000

© 2008 by Nelson, a division of Thomson Canada Limited Transparency Industry Multipliers Industry multipliers are standards used to determine the value or worth of a business. Examples of industry multipliers Multiplier Industry 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

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

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

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

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

© 2008 by Nelson, a division of Thomson Canada Limited Transparency Projects from an investor’s (venture capitalist) perspective Investors are looking for a Winning Combination! Products/ Services (%) (the horse) Management Team (The jockey)

© 2008 by Nelson, a division of Thomson Canada Limited Transparency The Rich-Gumpert Evaluation System 4/1 4/24/34/4 3/1 3/2 3/3 3/4 2/1 2/2 2/3 2/4 1/1 1/21/3 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 hat Wins $$$, Stanley R. Rich and David E. Gumpert, Harpor & Row, 1986, p. 169.

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

© 2008 by Nelson, a division of Thomson Canada Limited Transparency Cash flow from operations$ 519$ 800$ 900$1,200$1,450 Capital investments-1, Incremental working capital Sub-total-1, NCF Discount 20% Present value -$ 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

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

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

© 2008 by Nelson, a division of Thomson Canada Limited Transparency A. Investment return before taxes Initial investment -$ Cash distribution to investors (transparency 12.18) $ 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%

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

© 2008 by Nelson, a division of Thomson Canada Limited Transparency Initial investment - $ 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%