Income Based Approach

Question 1

Methods/Approaches

Answer 1

• capitalized cash flow
• discounted cash flow
• market based
• capitalized earnings
• discounted earnings

Question 2

Capitalized cash flow

Answer 2

• used when: going concern with active operations, historical results reflective of expected future results, and does not have reliable financial projections prepared
• most commonly income based approach used

Question 3

Capitalized cash flow steps

Answer 3

1) maintainable operating cash flows estimated (EBITDA)
2) deduct income taxes
3) deduct NPV of tax shield
4) divide by WACC
5) = capitalized cash flows
6) add PV of existing tax shield
7) less redundant assets (net of liabilities)
8) deduct outstanding debt
9) = equity value

Question 4

Capitalized cash flow step 1: estimate maintainable operating cash flows (EBITDA)

Answer 4

• normalized revenues and expenses
• normalized income is then adjusted for: add back interest, ammortization added back, tax added back
• valuators will then value a high and low EBITDA

Question 5

Capitalized cash flow step 2: deduct income taxes

Answer 5

• determine tax based on EBITDA and deduct from EBITDA

Question 6

Capitalized cash flow step 3: deduct PV of CCA tax sheild

Answer 6

• there is a tax savings (CCA) from purchasing assets so the assets are counted net of tax sheild (usually given)

Question 7

Capitalized cash flow step 4: divide by WACC to = Step 5: capitalized cash flow

Answer 7

• WACC or capitalization rate - based on risk and growth rate
• if there is a high and low range of EBITDA there will also be high and low range for WACC - use higher WACC for higher EBITDA and vice-versa

Question 8

Capitalized cash flow step 6: add PV of tax pools existing

Answer 8

• the purchaser will be able to use the tax pools and therefore should be added into the value

Question 9

Capitalized cash flow step 7: add redundant assets and substract redundant liabilities

Answer 9

• assets and liabilities not required to generate cash flows
• NRV added / deducted
• review income accounts relating to redundant assets (interest on redundant investment) is normalized in step 1

Question 10

Capitalized cash flow step 8: deduct debt and 9: equity value

Answer 10

• deduct interest bearing debt to = equity value

Question 11

Discounted cash flow approach

Answer 11

• preferred approach due to analysis of forecast
• however, not always possible due to lack of info
• chosen if: going concern with active operations, historical results not reflective of expected future results, and reliable financial projections can/have been prepared

Question 12

Discounted cash flow approach steps

Answer 12

1) PV free of cash flows
2) plus PV of RV (or terminal value)
3) plus PV of existing tax shield
4) = Enterprise value
5) Plus NRV of redundant assets/liabilities
6) Less outstanding interest bearing debt
7) = Equity value

Question 13

Discounted cash flow approach step 1: PV of free cash flows

Answer 13

• this is step 1 + 2 + 3 if capitalized cash flow approach
• 1) normalize NI (based on EBITDA) 2) deduct income tax 3) adjust for interest expense (+), amortization expense (+), capital expenditures (-), working capital investments (-)
• take free cash flows calclauted and discount to PV using WACC

Question 14

Discounted cash flow approach step 2: add PV of RV (terminal value)

Answer 14

• terminal value: existing into perpetuity
• RV: disposal assumed
• discount to PV using WACC

Question 15

Discounted cash flow approach step 3: PV of existing tax shield and 4: = enterprise value

Answer 15

• add back PV of tax shield to = enterprise value

Question 16

Discounted cash flow approach step 5: plus NRV pf redundant assets and 6: less outstanding debt and 7: = equity value

Answer 16

• calculate to = equity value

Question 17

Market based approach

Answer 17

• if public and reasonable, MB approach is the best estimate to be used to FMV (usually used as secondary test)
• normally shown as range of values because of the use of professional judgment
• When selecting comparable companies, consider: size, region, industry, management, operating risks, financials, dividend payouts

Question 18

Capitalization of earnings

Answer 18

1) determine type of earnings being capitalized (EBITDA, NP, NI)
2) normalize income
3) choose capitalization rate to divide by or multiplier rate
4) calculate investment value

Question 19

Discounted earning approach

Answer 19

• used for mergers and acquisitions where earnings in the next few years are volitile before expecting to level out