Copyright © 2014 Nelson Education Ltd. 12–1 PowerPoint Presentations for Finance for Non-Financial Managers: Seventh Edition Prepared by Pierre Bergeron University of Ottawa

Copyright © 2014 Nelson Education Ltd. 12–2 CHAPTER 12 Business Valuation

Copyright © 2014 Nelson Education Ltd. 12–3 1.Differentiate between market value and book value. 2.Discuss valuation models. 3.Comment on what it means to scan the environment. 4.Explain how to document planning assumptions. 5.Show how to restate the statement of income and the statement of financial position. 6.Present ways to price an ongoing business. 7.Calculate the market value of publicly traded companies. 8.Determine the investment return on capital projects from an investor’s perspective. Learning Objectives

Copyright © 2014 Nelson Education Ltd. 12–4 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 LO 1

Copyright © 2014 Nelson Education Ltd. 12–5 Valuation Models  Book value  Market value  Liquidation value  Industry multipliers  DCF method  Going-concern value  Economic value  Replacement value  Assessed value LO 2

Copyright © 2014 Nelson Education Ltd. 12–6 Scanning the Environment 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 LO 3

Copyright © 2014 Nelson Education Ltd. 12–7 Documenting Planning Assumptions Planning assumptions are used to prepare a company’s projected financial statements LO 4

Copyright © 2014 Nelson Education Ltd. 12–8 Documenting Planning Assumptions 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 in bank to meet on-going activities, composition of prepaid expenses, aging of trade receivables, estimated bad debts, inventories in raw materials, work-in-process and finished goods, holding costs, ordering costs Continued… LO 4

Copyright © 2014 Nelson Education Ltd. 12–9 Documenting Planning Assumptions (concluded) –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 LO 4

Copyright © 2014 Nelson Education Ltd. 12–10 Restating Futurama’s Statement of Financial Position (Slide 3-7) 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     LO 5

Copyright © 2014 Nelson Education Ltd. 12–11 Restating Futurama’s Income Statement (Slide 3-8) 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 LO 5

Copyright © 2014 Nelson Education Ltd. 12–12 Book Value Method—Futurama Ltd. (Slide 3-7) 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 LO 6

Copyright © 2014 Nelson Education Ltd. 12–13 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 LO 6

Copyright © 2014 Nelson Education Ltd. 12–14 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 × annual gross sales.75 to 1.5 × annual net profit + inventories + equipment.5 to.7 × monthly gross sales + inventories.3 to.5 × annual gross sales, or.4 × monthly gross sales + inventories 1 to 1.5 × annual net profit + inventories + equipment LO 6

Copyright © 2014 Nelson Education Ltd. 12–15 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 ________ $ _______ X ________ $ _________ 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 LO 6

Copyright © 2014 Nelson Education Ltd. 12–16 Going-Concern Value (using the capitalization rate) Capitalization Value Cash flow from operations$ 519,000 (from Slide 12-11) 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 LO 6

Copyright © 2014 Nelson Education Ltd. 12–17 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 × 50,000) LO 7

Copyright © 2014 Nelson Education Ltd. 12–18 Project Return: 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 LO 8

Copyright © 2014 Nelson Education Ltd. 12–19 Projects: Investor’s (Venture Capitalist) Perspective Investors are looking for a Winning Combination! Products/ Services (%) (the horse) Management Team (the jockey) LO 8

Copyright © 2014 Nelson Education Ltd. 12– 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 © 2014 Nelson Education Ltd. 12–21 Residual Value of the Forecast Period (Step 2) Forecast of residual value in 2014 Cash flow $ 1,450 Investments (500) Net cash flows (from Slide 12-20) 950 Capitalization 18% ($950,000 ÷ 18%)$ 5,278 × 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 © 2014 Nelson Education Ltd. 12–22 Estimated Market Value (Step 3) Forecast of discretionary cash flow $ 298 (Slide 12-20) Add: residual value 2,121 (Slide 12-21) 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 © 2014 Nelson Education Ltd. 12– A. Investment return before taxes Initial investment ($ 600) Cash distribution to investors (Slide 12-20) $ 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 © 2014 Nelson Education Ltd. 12–24 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 (Step 4)

Copyright © 2014 Nelson Education Ltd. 12– 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%