Presentation on theme: "Fundamentals of Corporate Finance, 2/e"— Presentation transcript:
1 Fundamentals of Corporate Finance, 2/e ROBERT PARRINO, PH.D.DAVID S. KIDWELL, PH.D.THOMAS W. BATES, PH.D.
2 Chapter 18: Business Formation, Growth, and Valuation
3 Learning ObjectivesEXPLAIN WHY THE CHOICE OF ORGANIZATIONAL FORM IS IMPORTANT, AND DESCRIBE TWO FINANCIAL CONSIDERATIONS THAT ARE ESPECIALLY IMPORTANT IN STARTING A BUSINESS.DESCRIBE THE KEY COMPONENTS OF A BUSINESS PLAN AND EXPLAIN WHAT A BUSINESS PLAN IS USED FOR.EXPLAIN THE THREE GENERAL APPROACHES TO VALUATION AND VALUE A BUSINESS USING COMMON BUSINESS VALUATION APPROACHES.
4 Learning ObjectivesEXPLAIN HOW VALUATIONS CAN DIFFER BETWEEN PUBLIC AND PRIVATE COMPANIES AND BETWEEN YOUNG AND MATURE COMPANIES, AND DISCUSS THE IMPORTANCE OF CONTROL AND KEY PERSON CONSIDERATIONS IN VALUATION.
5 Starting a Business STARTUP CONSIDERATIONS Individuals go into business for a variety of reasons.Irrespective of their motivation, the first decision they must make is whether they want to found a business or acquire an existing business.Starting a business is inherently more risky than buying and growing a business that someone else has already established.
6 Starting a Business STARTUP CONSIDERATIONS The founder of a company must start from scratch and make several critical decisions including:Choosing the product(s) to sell.Choosing the markets to sell them in.Choosing the best strategy for selling them.Raising the money needed to develop the product(s).Acquiring the necessary assets.Hiring the right people.
7 Starting a Business MAKING THE DECISION TO PROCEED Businesses fail for many reasons including:Lack of acceptance of the products by customers.Poorly thought-out strategy.Poor management skills to properly execute a good strategy.Underestimating how much money it will take to get their businesses up and running.
8 Starting a Business MAKING THE DECISION TO PROCEED Chances of success in a business can improve if oneDoesn’t jump into a business without careful thought.Doesn’t overanalyze opportunities to the point where you are just convincing yourself not to proceed.Takes on calculated risks.Doesn’t think that failure will ruin your chances of ultimately achieving business success.
9 Starting a Business CHOOSING THE RIGHT ORGANIZATIONAL FORM In addition to the organizational forms discussed in Chapter 1–sole proprietorship, partnerships, and corporations–two other forms of organizations are discussed here. They are the limited liability companies (LLC) and the S-Corporations.
10 Starting a Business CHOOSING THE RIGHT ORGANIZATIONAL FORM The LLC Is a hybrid of a limited partnership and a corporation.It was first developed in Wyoming in 1977.Like a corporation, an LLC provides limited liability for the people who make the business decisions in the firm while enabling all investors to retain the tax advantages of a limited partnership.
11 Starting a Business CHOOSING THE RIGHT ORGANIZATIONAL FORM The LLC Limited partnerships are more costly to form than sole proprietorships because the partners must hire an attorney to draw up and maintain the partnership agreement.The lives of partnerships and LLCs are flexible.Partnerships can turn to all of the partners for additional capital.Limited partnerships and LLCs are less constrained than general partnerships because they can raise money from limited partners or “members”.
12 Starting a Business CHOOSING THE RIGHT ORGANIZATIONAL FORM The S‑corporationAn S‑corporation is a variation of the C‑corporation form that is used by public corporations.With approval from the IRS, any C‑corporation can become an S‑corporation.This change allows the stockholders to avoid double taxation but places limits on the ownership of the firm’s stock.
13 Starting a Business CHOOSING THE RIGHT ORGANIZATIONAL FORM The S‑corporationAll profits of an S‑corporation pass directly to the stockholders as they would pass to the partners in a partnership.Currently, an S‑corporation can haveNo more than 100 stockholders.Only one class of common stock.Can only have individuals who are U.S. citizens or residents as stockholders (no corporations or partnerships can own shares).
14 Starting a Business CHOOSING THE RIGHT ORGANIZATIONAL FORM Choosing an Organizational FormA sole proprietorship is the least expensive type of business to start.The life of a sole proprietorship is limited to the life of the proprietor.Sole proprietorships must rely on equity contributions from the proprietor and debt or lease financing.
15 Starting a Business CHOOSING THE RIGHT ORGANIZATIONAL FORM Choosing an Organizational FormForming a corporation also requires hiring an attorney to draft a document that spells out things such as how many shares can be issued, the voting right that the stockholders will have, the names of the board members, and so on.Corporations, which are “legal persons” under state law, automatically have an indefinite life.
16 Starting a Business CHOOSING THE RIGHT ORGANIZATIONAL FORM Choosing an Organizational FormC‑corporations can have an unlimited number of stockholders.Exhibit 18.1 provides a comparison of these common forms of business organization on a number of different dimensions.
17 Exhibit 18.1: Characteristics of Different Forms of Business Organization
18 Starting a Business FINANCIAL CONSIDERATIONS Cash Flow (EBITDA) Break-EvenTwo tools are particularly useful in understanding the cash requirements of a business and in estimating how much financing a new business will require–cash flow break-even analysis and the cash budget.It is important for an entrepreneur to understand the concept of cash flow (EBITDA) break-even and how to calculate this point for each product a business produces.
19 Starting a Business FINANCIAL CONSIDERATIONS Cash Flow (EBITDA) Break-EvenThis calculation focuses the entrepreneur’s attention on the importance of maximizing a product’s per-unit contribution and minimizing its associated overhead costs.It also provides a means of estimating how long it will take for a product to reach the break-even point, and therefore, how much money will be needed to launch a new product or business.
20 Starting a Business FINANCIAL CONSIDERATIONS Cash Inflows and Outflows The cash budget is also a very useful planning tool for entrepreneurs.It summarizes the cash flows into and out of a firm over a period of time.Cash budgets often present the inflows and outflows on a monthly basis but can be prepared for any period, including daily or weekly.
21 Starting a Business FINANCIAL CONSIDERATIONS Cash Inflows and Outflows Preparing a cash budget helps an entrepreneur better understand where money is coming from, where it is going, and how much external financing is likely to be needed and when.Knowing how much external financing is likely to be needed and when helps the entrepreneur plan fund-raising efforts before it is too late.
23 The Role of the Business Plan WHY BUSINESS PLANS ARE IMPORTANTA business plan is like a road map for a business. It presents the results from a strategic planning process that focuses on how the business will be developed over time.The entrepreneur must convince potential investors that purchasing debt or equity in the firm will yield attractive returns.To overcome the scepticism of outside investors, many entrepreneurs prepare a business plan.
24 The Role of the Business Plan WHY BUSINESS PLANS ARE IMPORTANTA well-prepared business plan makes it easier for an entrepreneur to communicate to potential investors precisely what he or she expects the business to look like in the future, how he or she expects to get it to that point, and what returns an investor might expect to receive.
25 The Role of the Business Plan WHY BUSINESS PLANS ARE IMPORTANTA business plan is a tool thatCan help raise capital.Can help an entrepreneur set the goals and objectives for the company.Serve as a benchmark for evaluating and controlling the company’s performance.Communicate the entrepreneur’s ideas to managers, outside directors, customers, suppliers, and others.
26 The Role of the Business Plan THE KEY ELEMENTS OF A BUSINESS PLANAn executive summary, which summarizes the key issues presented in the report.A company overview, which describes what the company does and what its comparative advantages are.A detailed description of the product(s) and services the company will sell, its current state of development or market penetration, competitive advantages, product life cycle, and any patents or legal protections that might provide a competitive advantage.
27 The Role of the Business Plan THE KEY ELEMENTS OF A BUSINESS PLANA market analysis, which discusses the industry and highlights the important characteristics of the industry as they relate to the company.A detailed discussion of the marketing and sales activities that will enable the business to achieve the sales and margin levels reflected in the financial forecasts.A detailed discussion of the operations of the business.
28 The Role of the Business Plan THE KEY ELEMENTS OF A BUSINESS PLANDetailed information on the management team and ownership structure of the business.A detailed discussion of capital requirements and uses.A business plan also presents historical financial results when they are available and financial forecasts.The end of a business plan often includes appendixes, which contain information providing detailed support for the analyses that are presented in the report.
29 Valuing a BusinessThe value of a business is determined by the magnitude of the cash flows that it is expected to produce, the timing of those cash flows, and the likelihood that the cash flows will be realized.
30 Valuing a Business FUNDAMENTAL BUSINESS VALUATION PRINCIPLES There are two important valuation principlesThe first principle is that the value of a business changes over time.The second valuation principle is that there is no such thing as the value for a business.
31 Valuing a Business FUNDAMENTAL BUSINESS VALUATION PRINCIPLES The value of a business changes over time becauseChanges in general economic conditions, industry conditions, and decisions that are made by the managers all affect the value of the cash flows that a business is expected to generate in the future.Actions by competitors also affect the value of a business.The investment, operating, and financing decisions made by managers also affect the value of a business.
32 Valuing a Business FUNDAMENTAL BUSINESS VALUATION PRINCIPLES The value of a business can be different to different investors.A strategic investor is one who has an interest in acquiring the business.The investment value of the firm to a strategic investor will take into consideration the benefits that can accrue from the acquisition and hence is likely to carry a higher value.
33 Valuing a Business FUNDAMENTAL BUSINESS VALUATION PRINCIPLES A financial investor, on the other hand, is only interested in financial performance of the firm and not in acquiring the business. Their valuation, known as the fair market value, will be lower than that of the strategic investor.
34 Valuing a Business BUSINESS VALUATION APPROACHES Can be classified into one of three general categories:Cost approachesMarket approachesIncome approaches
35 Valuing a Business BUSINESS VALUATION APPROACHES Cost Approaches Replacement costAdjusted book value
36 Valuing a Business BUSINESS VALUATION APPROACHES Cost Approaches - Replacement CostThe replacement cost of a business is the cost of duplicating the assets of the business in their present form as of the valuation date.The replacement cost valuation approach is generally used to value individual assets within a business when they are being insured.When using the replacement cost approach in a buy-versus-build analysis, you must include the cost of all tangible assets and all intangible assets.
37 Valuing a Business BUSINESS VALUATION APPROACHES Cost Approaches - Replacement CostYou must also include the cost of hiring the people necessary to run the business and the time that it would take to build the business.The timing of the cash flows is very important and must be taken into consideration as, generally, acquired businesses lead to quicker cash flows.
38 Valuing a Business BUSINESS VALUATION APPROACHES Cost Approaches - Adjusted Book ValueThe adjusted book value approach involves restating the value of the individual assets in a business to reflect their fair market values.The fair market value of each individual asset is estimated separately and the total value of the business is then obtained by summing the fair market values of the individual assets.An adjusted book value analysis should include all tangible and intangible assets.
39 Valuing a Business BUSINESS VALUATION APPROACHES Cost Approaches - Adjusted Book ValueThe adjusted book value approach is useful in valuing holding companies whose main assets are publicly traded or other investment securities but is generally less applicable for operating businesses.
40 Valuing a Business BUSINESS VALUATION APPROACHES Cost Approaches - Adjusted Book ValueThe value of an operating business is usually greater than the sum of its individual assets, and the excess value is called the “going-concern” value.The going-concern value of an asset reflects the value associated with additional future cash flows the business produces because of the way in which the individual assets are managed together.
41 Valuing a Business BUSINESS VALUATION APPROACHES Cost Approaches - Adjusted Book ValueThe adjusted book value approach is useful in estimating a floor value for a business under certain circumstances.It is especially difficult to forecast the cash flows that a business is likely to produce.You suspect that the going-concern value of the business is negative.Liquidation is being explicitly considered.
42 Valuing a Business BUSINESS VALUATION APPROACHES Market Approaches Multiples analysisTransactions analysis
43 Valuing a Business BUSINESS VALUATION APPROACHES Market Approaches - Multiples analysisMultiples analysis uses stock price or other value multiples that are observed for public companies to estimate the value of a company’s stock or an entire business.Identifying publicly traded companies engaged in business activities that are similar to those of the company being analyzed.Using the prices at which shares of those comparables are trading, along with accounting data, to estimate the value of the company of interest.This approach is often used to help price a company’s shares for an IPO, or when all of its shares are being sold privately to investors.
44 Valuing a Business BUSINESS VALUATION APPROACHES Market Approaches - Multiples analysisPrice/earnings (P/E) and price/revenue multiples (ratios) are commonly used to directly estimate the value of the stock in a company.The P/E multiple can be stated as:
45 Valuing a Business BUSINESS VALUATION APPROACHES Market Approaches - Multiples analysisBy focusing on the variables that drive the P/E multiple in this framework, we can see the importance of identifying comparable companies that are as similar to the company of interest as possible.Analysts either use the average multiple from other publicly held peers, or a multiple from a single comparable company to estimate the value of the company of interest.
46 Valuing a Business BUSINESS VALUATION APPROACHES Market Approaches - Multiples analysisWhile doing a multiples analysis, one needs to be aware of certain issues.When using multiples of publicly held firms to value one that is not, one should be aware of the presence of a marketability discount that can be sizable.Identifying one or more comparable firms is not an easy task.When using the multiple of a comparable firm, one needs to be aware of differences in the capital structures of the firms being compared.You are estimating a fair market value, not the investment value.
47 Valuing a Business BUSINESS VALUATION APPROACHES Market Approaches - Multiples analysisWhile doing a multiples analysis, one needs to be aware of certain issues.It is important to make sure that the numerator and the denominator of the ratio you are using are consistent with each other.The data used to compute the multiple for the comparable company should include the stock price as of the valuation date and accounting data from the same period for which you have accounting data for the company of interest.
48 Valuing a Business BUSINESS VALUATION APPROACHES Market Approaches – Transactions analysisIn the transaction approach analysts use the information on what someone has paid for a comparable company in a merger or acquisition to estimate the value for the firm.This transaction information is used to compute the same types of multiples that are used in a multiples analysis, and these multiples are used in the same way to value the company of interest.
49 Valuing a Business BUSINESS VALUATION APPROACHES Market Approaches – Transactions analysisSince transaction data reflects the price that a particular investor paid for an entire company, it provides an estimate of the investment value to that investor.Transaction information is obtained from the financial statements of public companies that have acquired other companies or from services that collect and sell this type of information.
50 Valuing a Business BUSINESS VALUATION APPROACHES Market Approaches – Transactions analysisIt is difficult to use this approach in practice for several reasons.Transactions data are not typically as reliable as the data available for multiples analysis, especially when they are associated with a private firm.Transactions involving the purchase or sale of an entire business in an industry tend to occur relatively infrequently, and hence the data is not very timely.The terms of the transactions can be difficult to assess.
51 Valuing a Business BUSINESS VALUATION APPROACHES Income Approaches The most direct approaches for estimating the value of the cash flows a business is expected to produce are the income approaches, which, like NPV analysis, directly estimate the value of those cash flows.These approaches provide the intrinsic value for the firm, which can be different from the market value. While market value reflects what people are willing to pay for the firm, the intrinsic value reflects what the firm is truly worth.
52 Valuing a Business BUSINESS VALUATION APPROACHES Income Approaches There are a couple of things to consider when using the income approach.First, unlike with projects, it is difficult to estimate the life of a business.Second, businesses often have cash or other assets that are not necessary for operations, which can complicate the valuation. These assets will be identified as non operating assets.
53 Valuing a Business BUSINESS VALUATION APPROACHES Income Approaches The following equation shows how these factors are taken into consideration when valuing the firm using an income approach.VF = PV(FCFT) + PV(TVT) + NOA (18.2)where VF is the value of the firm, PV(FCFT) is the present value of free cash flows that the business is expected to produce over the next T years, PV(TVT) is the present value of all free cash flows after year T, and NOA is the value of all of the non-operating assets of the firm.
54 Valuing a Business BUSINESS VALUATION APPROACHES Income Approaches: Free Cash Flow from the Firm ApproachIn the free cash flow from the firm (FCFF) approach, an analyst values the free cash flows that the assets of the firm are expected to produce in the future.The present value of these cash flows equals the total value of the firm, or its enterprise value.We do not include the cash necessary to pay short-term liabilities that do not have interest charges associated with them, such as accounts payable and accrued expenses.
55 Valuing a Business BUSINESS VALUATION APPROACHES Income Approaches: Free Cash Flow from the Firm ApproachThe costs associated with these non-interest-bearing current liabilities, which are included in the firm’s cost of sales and other operating expenses, are subtracted in the calculation of FCFF.Exhibit 18.3 shows how to determine the value of FCFF.
56 Exhibit 18.3: The Finance Balance Sheet and Firm Value
58 Valuing a Business BUSINESS VALUATION APPROACHES Income Approaches: Free Cash Flow from the Firm ApproachIn this approach the total value of the firm, VF, is computed as the present value of the FCFF, discounted by the firm’s WACC.When analysts use the WACC approach to value a business, they must make an assumption about how the firm’s operations will be financed in the future.
59 Exhibit 18.5: FCFF Calculation for Bell Mountain Mfg. Company
60 Valuing a Business BUSINESS VALUATION APPROACHES Income Approaches: Free Cash Flow to Equity ApproachThe free cash flow to equity (FCFE) approach uses only the portion of the cash flows that are available for distribution to stockholders.Stripping out the cash flows to or from the lenders leaves the cash flows available to stockholders.Three specific cash flows associated with lenders are not included–the interest expense on existing debt, the repayment of debt principal, and the proceeds from new debt issues.
61 Valuing a Business BUSINESS VALUATION APPROACHES Income Approaches: Free Cash Flow to Equity ApproachIn using the FCFE valuation approach, the cost of equity, kE, is used to discount the residual cash flows.Exhibit 18.6 shows how FCFE is calculated.
63 Valuing a Business BUSINESS VALUATION APPROACHES Income Approaches: Dividend Discount Model ApproachThe dividend discount model (DDM) approach estimates the value of equity directly by discounting cash flows to stockholders.In contrast to the FCFE approach which values cash flows that are available for distribution to stockholders, the DDM approach values the stream of cash flows that stockholders expect to receive through dividend payments. Recognize that the firm may or may not be expected to distribute all available cash flows in any particular year.
64 Valuing a Business BUSINESS VALUATION APPROACHES Income Approaches: Dividend Discount Model ApproachThe constant-growth dividend model, Equation 9.4 in chapter 9, is an example of a DDM.However, only some firms have a constant growth. More often, use of the DDM approach involves discounting dividends that either do not begin until some point in the future or that are currently growing at a high rate that is not sustainable in the long run.
65 Important Issues in Valuation PUBLIC VERSUS PRIVATE COMPANIESFinancial StatementsIncomplete and unreliable financial statements can complicate the process of valuing a private business, making it more difficult to accurately assess its value.Some private companies have complete, audited financial statements, while others have incomplete financial statements that are not prepared in accordance with the GAAP. All public companies are required to file audited financial statements with the SEC.
66 Important Issues in Valuation PUBLIC VERSUS PRIVATE COMPANIESFinancial StatementsIn contrast to the financial statements of publicly held firms, private company financials often include personal expenses of the owner and excess compensation expenses.
67 Important Issues in Valuation PUBLIC VERSUS PRIVATE COMPANIESMarketabilityThe shareholder of a private firm may have to spend considerable resources (both money and time) to sell his or her shares.The shareholders of publicly held firms find it much easier to liquidate their holdings.
68 Important Issues in Valuation PUBLIC VERSUS PRIVATE COMPANIESMarketabilityThe higher transaction costs associated with the stock at the private firm will result in a lower price for that investment.This must be taken into account in the form of a marketability discount when estimating the value of any claim to the cash flows of a firm.
69 Important Issues in Valuation YOUNG (RAPIDLY GROWING) VERSUS MATURE COMPANIESYoung, rapidly growing companies tend to be more difficult to value than mature, stable companies.One factor that makes it more difficult to value a young company is that less-reliable historical information is available.
70 Important Issues in Valuation YOUNG (RAPIDLY GROWING) VERSUS MATURE COMPANIESAnother factor is that the future of a young, rapidly growing company is often less certain than that of a mature company because much of the young company’s future growth depends on investment, operating, and financing decisions that have not yet been made.Without profits, it is difficult to use earnings multiples to value the business, leaving price/revenue or enterprise value/revenue multiples as the only viable alternatives for a multiples analysis.
71 Important Issues in Valuation YOUNG (RAPIDLY GROWING) VERSUS MATURE COMPANIESIn order to grow, many young companies have to invest a considerable amount of money.The cash flows will be negative until the business becomes profitable and its investment expenditures are less than those profits. This means that the positive cash flows, which represent the value of the business, are further into the future and are therefore less certain.
72 Important Issues in Valuation CONTROLLING INTEREST VERSUS MINORITY INTERESTAnother important issue that must be considered when valuing a business is whether a controlling ownership interest or a minority interest is being valued.The amount of stock that is required for an investor to exercise control can vary depending on the ownership structure of the company.Whether a controlling ownership interest is being sold has important implications for a valuation analysis.
73 Important Issues in Valuation CONTROLLING INTEREST VERSUS MINORITY INTERESTAn adjustment must be made to reflect the benefits of control if one used multiples based on public stock market prices to estimate the value of a controlling interest.Similarly, when you use an income approach to value a business, the cash flow forecasts and discount rate assumptions will differ depending on whether you are valuing a minority or a controlling ownership interest.
74 Important Issues in Valuation CONTROLLING INTEREST VERSUS MINORITY INTERESTA discount rate based on CAPM might be too high for a valuation that involves a controlling position. To adjust for the effects of an incorrect discount rate and for any possible cash flows that are not reflected in a valuation based on an income approach, analysts add a control premium.
75 Important Issues in Valuation KEY PEOPLEAnalysts must also consider whether it is appropriate to adjust the estimated value of the business for the likelihood that these “key people” may not remain with the firm as long as expected.If an analyst believes that those customers may go to another firm if the CEO departs, then a key person discount may be appropriate.