Financing - Valuation - Big Picture

Question 1

Explain what business valuation is

Answer 1

It is the process and set of procedures used to estimate the economic value of the business

• A common reason is for the sale of a business
  This often requires in following situation:
  1. Company receives takeover bid and offers price id different from market price
  2. A company wishes to go public, must set issue price
  3. Shares are being pledge as collateral for a loan
  4. A company needs to evaluate whether any impairment exist

It is a form of “art” not a science, professional judgement

Question 2

How is FMV used for determining business valuation?

Answer 2

Fair market value is used as the highest price available in open and unrestricted market
- Arms length transaction
- Determined under stand-alone basis, can be negotiated price as the price is different from notional market value

Components of this:
1. Highest price available
2. Open and unrestricted market
3. Informed and prudent parties - All vendors know the facts of importance to the valuation at hand
4. Acting at arm’s length
5. Under no compulsion to act
6. Expressed in terms of money or money worth

Question 3

Provide the three types of approaches to valuation

Answer 3

1. Asset-based valuation
   - Liquidation
   - Adjusted net asset
   - Replacement cost
2. Income-based valuation
   - Discounted cash flow
   - capitalized cash flow
   - Discounted earnings
   - Capitalized cash flow
3. Market based valuation
   - Asset with an active market
   - Comparable transaction

• Determining what valuation method to use is based on whether the company is a going concern. If not, use the liquidation approach.
• Need to determine the future operation fo the company

Question 4

What are the questions that need to be asked to determine the approach to use

Answer 4

1. Is reliable and comparable data available?
   Yes - Market-based approach (active market - Quoted market price, No active market - Comparable transaction approach)
   No - Second question
2. Does the asset generate cash flow?
   Yes - Income-based approach (Determine if to use earning or cash flow discounted or capitalized)
   No - Third approach
3. Use asset-based approach
   Use a replacement cost approach

Question 5

Explain the three approach for asset-based approach

Answer 5

1. Liquidation approach
   - If a company is not a going concern.
2. Orderly liquidation - owners generally have more time to seek out purchasers (NRV)
3. Forced liquidation - The owner is being forced to sell the asset (bank or creditor)
4. Adjusted asset approach
   - Company is a going concern but does not maintain active operation
   - Approach is used to calculate “floor value”
   - Can be appropriate if the entity has an active operation with no excess earning
5. Replacement cost approach
   - Rarely used as it lacks economic validity
   - Actual cost to replace the asset is considered. Asser values are adjusted to the current replacement value/ cost

Question 6

Explain the three types of income-based approach

Answer 6

• Cash flow or earnings are normalized - they are adjusted for items that are unusual or do not occur often in new takeover

1. Capitalized cash flow approach
   - Entity has active operation and excess earning
   - Consistent cash flow that is a reflection of future operation, use capitalization rate
2. Discounted cash flow approach
   - Entity is a start-up, cash flow may be negative
   - Not a reflection of potential cash flow in the future
   - Management can prepare a reliable projection of future cash flow
3. Capitalized earning approach
   - Is an income approach based on the historical earnings of the company, rather than cash flows
   - Earnings are multiplied by a multiplier or divided by the capitalization rate
4. Discounted earning approach
   - Is most often used in merger and acquisition valuation
   - Future earnings are expected to be volatile before leveling out.
   - Estimated future earnings from business for each forecasted period are determined

Question 7

Explain how market based approach is used

Answer 7

• it is used in a corroborative approach to other income-based approaches
• Used to determine valuation multiple, based on valuation multiples used to value companies
• Multiplied by entity’s EBITDA to obtain market-based value for the business
  -Intangible and tangible assets if there are similar assets that have been sold

Question 8

Provide the decision tree for valuing a business

Answer 8

1. Is the company a going concern
   No - Liquidation approach
   Yes - Second question
2. Is the company maintaining active operation
   No - Adjusted net asset approach
   Yes - Third questions
3. Does the company have excess earnings
   No - Adjusted net asset approach
   Yes - Fourth question
4. Is historical cash flow reflective of future operation
   No - Discounted cash flow approach
   Yes - Capitalized cash flow/ earnining approach
   Market- based approach - corroborative