FM3
UNIT IBusiness Valuation Q1) Explain the different concepts of valuationsA1) The following concepts of valuation are generally used to help the finance manager arrive at a more accurate valuation, reducing the element of subjectivity to the maximum possible extent.Book value - Book value is the accounting record value of assets that is shown in the balance sheet. It is usually the purchase cost of an asset less the accumulated depreciation on it. It may not reflect the sale value or the fair value of the asset. This valuation is based on the going concern principle of accounting. It is the total book value of all the assets that are valuable excluding the fictitious assets, minus the external liabilities. It is otherwise known as the net worth. Market value - Market value is the value at which an asset or a security of a company can be sold in the market. Market value can be applied to tangible assets only because intangible assets cannot be sold generally. The total market value of all the outstanding equity shares as quoted in the stock market can be referred as the market value of a business. Market value can be ascertained for listed corporates only. Intrinsic/Economic value - The present value of all the incremental future cash flows can be termed as the intrinsic value. The present value is arrived by discounting the incremental cash flows at an appropriate discount rate. The maximum price at which a business can be acquired is the economic value. Liquidation value - This represents the price at which each individual asset can be sold in the event of liquidation of business. It is valued after subtracting all the external liabilities. The liquidation value would generally be the least. Replacement value - It is the cost of purchasing or replacing a new asset which is of equal utility to the business. It is generally applied to tangible assets like equipment, plant etc. Salvage value - Salvage value, also called as the scrap or residual value is the sale value of an old asset after its usage. Valuation of goodwill - Valuation of goodwill is one of the toughest as goodwill is non-monetary. A business is said to have a real goodwill if it can earn a higher rate of return on an investment when compared with its competitor having the same risk. When the firm earns super profits, goodwill results. It can be valued as the present value of all the future expected super profits for ‘n’ number of years. It is very useful in merger and acquisition decisions. Fair value - fair value is based on all of the valuations explained above. Particularly, it is the average of the market value, book value and the intrinsic value. Q2) What are the ways to evaluate the worth? A2) Approaches of ValuationWhen determining the value of a company, there are three ways to evaluate worth: Asset-based approaches Earning value approaches Market value approaches Each approach has its considerations, and if you own a sole proprietorship there are further factors to consider. Asset-Based ApproachesEssentially, an asset-based business valuation will total up all the investments in the company. Asset-based business valuations can be done in one of two ways: A going concern asset-based approach takes a look at the company's balance sheet, lists the business's total assets, and subtracts its total liabilities. This is also called book value. A liquidation asset-based approach determines the liquidation value, or the net cash that would be received if all assets were sold and liabilities paid off. Asset-based Valuations of Sole ProprietorshipsUsing the asset-based approach to value a sole proprietorship is more difficult. In a corporation, all assets are owned by the company and would normally be included in the sale of the business. Assets in a sole proprietorship, on the other hand, exist in the name of the owner, and separating business assets from personal ones can be difficult.For instance, a sole proprietor in a lawn care business may own various pieces of lawn care equipment for both business and personal use. A potential purchaser of the business would need to sort out which assets the owner intends to sell as part of the business. Earning Value ApproachesAn earning value approach is based on the idea that a business's value lies in its ability to produce wealth in the future. Capitalizing Past Earning determines an expected level of cash flow for the company using a company's record of past earnings, normalizes them for unusual revenue or expenses, and multiplies the expected normalized cash flows by a capitalization factor. The capitalization factor is a reflection of what rate of return a reasonable purchaser would expect on the investment, as well as a measure of the risk that the expected earnings will not be achieved. Discounted Future Earnings is another earning value approach to business valuation where instead of an average of past earnings, an average of the trend of predicted future earnings is used and divided by the capitalization factor. Earning-Based Valuations of Sole ProprietorshipsValuation of a sole proprietorship in terms of past earnings can be tricky, as customer loyalty is directly tied to the identity of the business owner. Whether the business involves plumbing or management consulting, the question is: Will existing customers automatically expect that a new owner will deliver the same degree of service and professionalism?Any valuation of a service-oriented sole proprietorship needs to involve an estimate of the percentage of business that might be lost under a change of ownership. INCOME APPROACH Revenue Ruling 59-60 clearly requires that an income approach be used when it lists “the earning capacity of the company,” as a factor to be considered. The income approach is defined in the International Glossary of Business Valuation Terms as, “A general way of determining a value indication of a business, business ownership interest, security, or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount.” Q3) Write a note on Market Value ApproachA3) Market value approaches to business valuation attempt to establish the value of your business by comparing your company to similar ones that have recently sold. The idea is similar to using real estate comps, or comparable, to value a house. This method only works well if there are a sufficient number of similar businesses to compare. Market-Based Valuations of Sole ProprietorshipsAssigning a value to a sole proprietorship based on market value is particularly difficult. By definition,sole proprietorships are individually owned, so attempting to find public information on prior sales of similar businesses is not an easy task. Non-Competition ClausesNon-competition clauses are frequently included in agreements for the sale of a business, particularly in cases where goodwill forms a significant part of the valuation. No one wants to purchase a business on the assumption that current customers will continue to patronize the business only to have the previous owner immediately join a competitor or even open a similar business in the same area. Non-competition clauses typically contain restrictions such as:Forbidding the seller from opening up a competing business in the same geographical area Placing a time limit restricting the seller from direct competition—say, for five years NOPAT = Net operating profit after taxes Invested capital = Debt + capital leases + shareholders' equity WACC = Weighted average cost of capital The equation for EVA shows that there are three key components to a company's EVA—NOPAT, the amount of capital invested, and the WACC. NOPAT can be calculated manually but is normally listed in a public company's financials. Capital invested is the amount of money used to fund a company or a specific project. WACC is the average rate of return a company expects to pay its investors; the weights are derived as a fraction of each financial source in a company's capital structure. WACC can also be calculated but is normally provided. The equation used for invested capital in EVA is usually total assets minus current liabilities—two figures easily found on a firm's balance sheet. In this case, the modified formula for EVA is NOPAT - (total assets - current liabilities) * WACC. The goal of EVA is to quantify the cost of investing capital into a certain project or firm and then assess whether it generates enough cash to be considered a good investment. A positive EVA shows a project is generating returns in excess of the required minimum return. As noted by Stern Value Management, "In 1983 we developed the Economic Value-Added metric to measure value that companies generate." EVA assesses the performance of a company and its management through the idea that a business is only profitable when it creates wealth and returns for shareholders, thus requiring performance above a company's cost of capital. EVA as a performance indicator is very useful. The calculation shows how and where a company created wealth, through the inclusion of balance sheet items. This forces managers to be aware of assets and expenses when making managerial decisions. However, the EVA calculation relies heavily on the amount of invested capital and is best used for asset-rich companies that are stable or mature. Companies with intangible assets, such as technology businesses, may not be good candidates for an EVA evaluation. Q5) Write a note on Capitalization of earningsA5) The Capitalization of Earnings Method is an income-oriented approach. This method is used to value a business based on the future estimated benefits, normally using some measure of earnings or cash flows to be generated by the company. These estimated future benefits are then capitalized using an appropriate capitalization rate. This method assumes all of the assets, both tangible and intangible, are indistinguishable parts of the business and does not attempt to separate their values. In other words, the critical component to the value of the business is its ability to generate future earnings/cash flows. This method expresses a relationship between the following: Estimated future benefits (earnings or cash flows) Yield (required rate of return) on either equity or total invested capital (capitalization rate) Estimated value of the business It is important that any income or expense items generated from non-operating assets and liabilities be removed from estimated future benefits prior to applying this method. The fair market value of net non-operating assets and liabilities is then added to the value of the business derived from the capitalization of earnings. This method is more theoretically sound in valuing a profitable business Although the Earning Value Approach is the most popular business valuation method, for most businesses, some combination of business valuation methods will be the fairest way to set a selling price. The first step is to hire a professional Business Valuator; she will be able to advise you on the best method or methods to use to set your price so you can successfully sell your business. Having the Valuation Done ProfessionallyBusiness owners should not do their own business valuation; they won't have the necessary distance to be objective.To ensure that you set—and get—the best price when selling a business, have it performed by a professional. A Chartered Business Valuator (CBV) can be found through the American Society of Appraisers (ASA) in the U.S.; in Canada, you can find them through the Canadian CBV Institute.Where the investor's intent is to provide for a return on investment over and above a reasonable amount of compensation and future benefit streams or earnings are likely to be level or growing at a steady rate.
Non-competition agreements can be a thorny legal issue and are often the subject of court cases between buyers and sellers after a business is sold.
From a legal standpoint, to enforce the restrictions placed in a non-competition clause, they must be clearly defined and 'reasonable'. Non-competition covenants can be nullified by the courts if it is determined that enforcement places overly broad and/or unreasonable restrictions on the seller's ability to continue his trade and earn a living.Non-competition clauses should be reviewed by the legal representatives of both buyer and seller prior to the sale of the business. Q4) Elaborate Economic Value-Added measureA4) Economic value added (EVA) is a measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, as it attempts to capture the true economic profit of a company. This measure was devised by management consulting firm Stern Value Management, originally incorporated as Stern Stewart & Co. EVA is the incremental difference in the rate of return (RoR) over a company's cost of capital. Essentially, it is used to measure the value a company generates from funds invested in it. If a company's EVA is negative, it means the company is not generating value from the funds invested into the business. Conversely, a positive EVA shows a company is producing value from the funds invested in it.The formula for calculating EVA is: EVA = NOPAT - (Invested Capital * WACC)Where:
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