CHAPTER 18

Business Formation, Growth, and Valuation

Learning !"e#ti$es
1% E&'lain wh( the #hoi#e o) organi*ational )orm is im'ortant, and des#ri!e two
)inan#ial #onsiderations that are es'e#iall( im'ortant in starting a !usiness%
+% ,es#ri!e the -e( #om'onents o) a !usiness 'lan, and e&'lain what a !usiness 'lan is
used )or%
.% E&'lain the three general a''roa#hes to $aluation, and !e a!le to $alue a !usiness
with #ommonl( used !usiness $aluation a''roa#hes%
/% E&'lain how $aluations #an di))er !etween 'u!li# and 'ri$ate #om'anies and
!etween (oung and mature #om'anies, and dis#uss the im'ortan#e o) #ontrol and
-e( 'erson #onsiderations in $aluation%
0% Cha'ter utline
18%1 1tarting a Business
Individuals go into business for a variety of reasons.
Regardless 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.
1
The founder of a comany must start from scratch and make several critical
decisions including,
!hoosing the roduct"s# to sell
!hoosing the markets to sell them in
!hoosing the best strategy for selling them
Raising the money necessary to develo the roduct"s#
$cquiring the necessary assets
%iring the right eole
$s the business is being built, the founder must also manage the day&to&day
oerations to ensure that his or her overall lan is being imlemented.
A. Making the Decision to Proceed
$ccording to the S'$, over ()1,*++ businesses were started in ,++-
in the .nited States, but less than -+ ercent of them will still be in
business by ,++/.
'usinesses fail for a number of different reasons including0
1ack of accetance of the roducts by customers.
2oorly thought&out strategy
2oor management skills to roerly execute a good strategy.
.nderestimating how much money it will take to get their
businesses u and running.
!hances of succeeding in a business can imrove if one
3oes not 4um into a business without careful thought.
,
3oesn5t overanaly6e oortunities to the oint where you are 4ust
convincing yourself not to roceed.
Takes on calculated risks.
3oesn5t think that failure will ruin your chances of ultimately
achieving business success.
B. Choosing the Right Organizational Form
In addition to the organi6ational forms discussed in !hater 17sole
rorietorshi, artnershis, and cororations7two other forms of
organi6ations are discussed here. They are the limited liability
companies (C! and the "#corporation.
$n 11! is a hybrid of a limited artnershi and a cororation.
It was first develoed in 8yoming in 1/)).
1ike a cororation, an 11! rovides limited liability for the eole
who make the business decisions in the firm while enabling all
investors to retain the tax advantages of a limited artnershi.
1imited artnershis are more costly to form than sole
rorietorshis because the artners must hire an attorney to draw
u and maintain the partnership agreement.
The lives of artnershis and 11!s are flexible.
1imited artners and 11!s are less constrained than general
artnershis because they can raise money from limited
artners or 9members,: ;eneral artnershis can turn to all of
the artners for additional caital.
<
$n S-corporation is a variation of the C- corporation form that is used
by ublic cororations.
8ith aroval from the IRS, any !&cororation can become an
S&cororation.
This change allows the stockholders to avoid double taxation but
laces limits on the ownershi of the firm5s stock.
$ll rofits of an S&cororation ass directly to the stockholders as
they would ass to the artners in a artnershi.
!urrently, an S&cororation can have
o no more than1++ stockholders
o only one class of common stock
o individuals who are ..S. citi6ens or residents as stockholders
"no cororations or artnershis can own shares#.
$ sole rorietorshi is the least exensive tye of business to start.
The life of a sole rorietorshi is limited to the life of the
rorietor.
Sole rorietorshis must rely on equity contributions from the
rorietor and debt or lease financing.
=orming a cororation also requires hiring an attorney to draft a
document that sells 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.
!ororations, which are 9legal ersons: under state law,
>
automatically have an indefinite life.
!&cororations can have an unlimited number of stockholders.
?xhibit 1*.1 rovides a comarison of these common forms of
business organi6ation on a number of different dimensions.
C. Financial Considerations
Two tools are articularly useful in understanding the cash
requirements of a business and in estimating how much financing a
new business will require7#ash )low !rea-2e$en anal(sis and the
#ash !udget.
It is imortant for an entrereneur to understand the concet of cash
flow break&even and how to calculate this oint for each roduct a
business roduces.
This calculation focuses the entrereneur5s attention on the
imortance of maximi6ing a roduct5s er unit contribution and
minimi6ing its associated overhead costs.
It also rovides a means of estimating how long it will take for a roduct
to reach the break&even oint and, therefore, how much money will be
needed to launch a new roduct or business.
The cash budget is also a very useful lanning tool for entrereneurs.
It summari6es the cash flows into and out of a firm over a eriod of
time.
-
!ash budgets often resent the inflows and outflows on a
monthly basis but can be reared for any eriod, including
daily or weekly.
2rearing a cash budget hels an entrereneur better
understand where money is coming from, where it is going,
and how much external financing is likely to be needed and
when.
@nowing how much external financing is likely to be needed
and when hels the entrereneur lan fund&raising efforts
before it is too late.
18%+ The Role o) the Business Plan
A. $he B%siness Plan
The entrereneur must convince otential investors that urchasing
debt or equity in the firm will yield attractive returns.
To overcome the sketicism of outside investors, many entrereneurs reare
a business lan.
$ !usiness 'lan is like a road ma for a business in that it resents
results from a strategic lanning rocess that focuses on how the
business will be develoed over time.
$ well&reared business lan makes it easier for an entrereneur to
communicate to otential investors recisely what he or she exects
(
the business to look like in the future, how he or she exects to get it to
that oint, and what returns an investor might exect to receive.
$ business lan is a tool that
can hel raise caital
can hel an entrereneur set the goals and ob4ectives for the
comany,
serve as a benchmark for evaluating and controlling the comany5s
erformance, and
communicate the entrereneur5s ideas to managers, outside
directors, customers, suliers, and others.
B. $he &ey 'lements o( a B%siness Plan
$ well&develoed business lan includes the following0
$n executive summary, which summari6es the key issues resented
in the reort.
$ market analysis, which discusses the industry and highlights the
imortant characteristics of the industry as they relate to the
comany.
$ company overview, which describes what the comany does and
what its comarative advantages are.
$ detailed descrition or the product(s) and services the comany
will sell, its current state of develoment or market enetration,
cometitive advantages, roduct life cycle, and any atents or legal
rotections that might rovide a cometitive advantage.
)
$ 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.
$ detailed discussion of the operations of the business.
3etailed information on the management team and ownership of
the business.
$ detailed discussion of capital requirements and uses.
$ business lan also resents historical financial results when they
are available and financial forecasts.
The end of a business lan often includes appendixes, which
contain information roviding detailed suort for the analyses that
are resented earlier in the reort.
18%. Valuing a Business
The value of a business is determined by the magnit%de of the cash
flows that it is exected to roduce, the timing of those cash flows, and
the likelihood that the cash flows will be reali6ed.
A. F%ndamental B%siness )al%ation Principles
There are two imortant valuation rinciles.
The first rincile is that the value of a business changes over time.
The second valuation rincile is that there is no such thing as
the value for a business.
The value of a business changes over time because
*
!hanges 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 exected to generate in the future.
$ctions by cometitors also affect the value of a business.
The investment, oerating, and financing decisions made by
managers also affect the value of a business.
The value of a business can be different to different investors.
$ strategic investor is one who has an interest in acquiring the
business.
o The in$estment $alue 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.
$ financial investor, on the other hand, is only interested in
financial erformance of the firm and not in acquiring the business.
o Their valuation, known as the )air mar-et $alue, will be
lower than that of the strategic investor.
B. B%siness )al%ation Approaches
'usiness valuation methods can be classified into one of three
general categories0 "1# cost aroaches, ",# market aroaches, and
"<# income aroaches.
C. Cost Approaches
/
Two cost aroaches that are commonly used are relacement cost
and ad4usted book value.
The re'la#ement #ost of a business is the cost of dulicating the
assets of the business in their resent form as of the valuation date.
The relacement cost valuation aroach is generally used to
value individual assets within a business when they are being
insured.
8hen using the relacement cost aroach in a buy&versus&build
analysis, you must include the cost of all tangible assets and all
intangible assets.
Aou must also include the cost of hiring the eole necessary to
run the business and the time that it would take to build the
business.
The timing of the cash flows is very imortant and must be
taken into consideration because, generally, acquired businesses
lead to quicker cash flows.
The ad"usted !oo- $alue aroach 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
searately, and the total value of the business is then obtained by
summing the fair market values of the individual assets.
$n ad4usted book value analysis should include all tangible and
intangible assets.
1+
The ad4usted book value aroach is useful in valuing holding
comanies whose main assets are ublicly traded or other
investment securities but is generally less alicable for oerating
businesses.
The value of an oerating business is usually greater than the sum
of its individual assets, and the excess value is called the 9going
concern: value.
The going&concern value of an asset reflects the value
associated with additional future cash flows the business
roduces because of the way in which the individual
assets are managed together.
The ad4usted book value aroach is useful in estimating a
floor value for a business under certain circumstances0 "1# it is
esecially difficult to forecast the cash flows that a business is
likely to roduce, ",# you susect that the going&concern value
of the business is negative, and "<# liquidation is being
exlicitly considered.
D. Market Approaches
Two market aroaches that are commonly used are multiles analysis and transactions
analysis.
3ulti'les anal(sis uses stock rice or other value multiles that
are observed for ublic comanies to estimate the value of a
comany5s stock or an entire business.
11
The rocess calls for0
identifying ublicly traded comanies engaged in business
activities that are similar to those of the comany being
analy6ed, and
using the rices at which shares of those comparales are
trading, along with accounting data, to estimate the value of the
comany of interest.
This aroach is often used to hel rice a comany5s shares for an
I2B, or when all of its shares are being sold rivately to investors.
2riceCearnings "2C?# and riceCrevenue multiles "ratios# are
commonly used to directly estimate the value of the stock in a
comany.
$nalysts either use the average multile from other ublicly held eers, or
a multile from a single comarable comany to estimate the value of the
comany of interest.
8hile doing a multiles analysis, one needs to be aware of certain
issues.
8hen using multiles of ublicly held firms to value one that
is not, one should be aware of the resence of a marketability
discount that can be si6able.
Identifying one or more comarable firms is not an easy task.
1,
8hen using the multile of a comarable firm, one needs to be
aware of differences in the caital structures of the firms being
comared.
Aou are estimating a fair market value, not the investment
value.
It is imortant to make sure that the numerator and the
denominator of the ratio you are using are consistent with each
other.
The data used to comute the multile for the comarable
comany should include the stock rice as of the valuation date
and accounting data from the same eriod for which you have
accounting data for the comany of interest.
In the transa#tion a''roa#h, analysts use the information on what
someone has aid for a comarable comany in a merger or an acquisition
to estimate a value for the firm.
This transaction information is used to comute the same tyes of
multiles that are used in a multiles analysis, and these multiles are used
in the same way to value the comany of interest.
Since transaction data reflects the rice that a articular investor aid for
an entire comany, it rovides an estimate of the investment value to that
investor.
1<
Transaction information is obtained from the financial statements of
ublic comanies that have acquired other comanies or from services that
collect and sell this tye of information.
It is difficult to use this aroach in ractice for several reasons.
Transactions data are not tyically as reliable as the data available for
multiles analysis, esecially when they are associated with a rivate firm.
Transactions involving the urchase 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.
'. *ncome Approaches
The most direct aroaches for estimating the value of the cash flows a
business is exected to roduce are the income aroaches, which, like D2E
analysis, directly estimate the value of those cash flows.
These aroaches rovide the intrinsic value for the firm, which can be
different from the market value.
8hile market value reflects what eole are willing to ay for
the firm, the intrinsic value reflects what the firm is truly
worth.
There are a coule of things to consider when using the income aroach
=irst, unlike the case with ro4ects, it is difficult to estimate the
life of a business.
1>
Second, businesses often have cash or other assets that are not
necessary for oerations that can comlicate the valuation.
These assets will be identified as nono'erating assets4
E5uation 18%+ shows how these factors are taken into
consideration when valuing the firm using an income
aroach.
In the )ree #ash )low )rom the )irm 6FCFF7 a''roa#h, an analyst values the
free cash flows that the assets of the firm are exected to roduce in the
future.
The resent value of these cash flows equals the total value of the
firm, or its enterrise value.
8e do not include the cash necessary to ay short&term
liabilities that do not have interest charges associated with
them, such as accounts ayable and accrued exenses.
The costs associated with these non&interest&bearing
current liabilities, which are included in the firm5s cost
of sales and other oerating exenses, are subtracted in
the calculation of =!==.
?xhibit 1*.< shows how to determine the value of =!==.
In this aroach the total value of the firm, E
=
, is comuted as
the resent value of the =!==, discounted by the firm5s
8$!!.
1-
8hen analysts use the 8$!! aroach to value a business,
they must make an assumtion about how the firm5s oerations
will be financed in the future.
The )ree #ash )low to e5uit( 6FCFE7 a''roa#h uses only the ortion of the
cash flows that are available for distribution to stockholders.
Striing out the cash flows to or from the lenders leaves the cash
flows available to stockholders.
Three secific cash flows associated with lenders are not
included0 the interest exense on existing debt, the reayment
of debt rincial, and the roceeds from new debt issues.
?xhibit 1*.( shows how =!=? is calculated.
In using the =!=? valuation aroach, the cost of equity, k
?
, is
used to discount the resid%al cash flows as shown in ?quation
1*.>.
The di$idend dis#ount model 6,,37 a''roa#h estimates the value of
equity directly by discounting cash flows to stockholders.
In contrast to the =!=? aroach which values cash flows that
are availale for distriution to stockholders, the 33F
aroach values the stream of cash flows that stockholders
expect to receive through dividend ayments.
Recogni6e that the firm may or may not be exected to
distribute all available cash flows in any articular year.
1(
The constant&growth dividend model, ?quation /.>, is an
examle of a 33F.
%owever, only some firms have a constant growth.
Fore often, use of the 33F aroach involves
discounting dividends that either do not begin until
some oint in the future or that are currently
growing at a high rate that is not sustainable in the
long run.
18%/ 0m'ortant 0ssues in Valuation 2Pu!li# $ersus Pri$ate Com'anies
A. Financial "tatements
Incomlete and unreliable financial statements can comlicate the rocess
of valuing a rivate business, making it more difficult to accurately assess
its value.
Some rivate comanies have comlete, audited financial statements, while
others have incomlete financial statements that are not reared in
accordance with the ;$$2.
$ll ublic comanies are required to file audited financial
statements with the S?!.
1)
In contrast to the financial statements of ublicly held firms, rivate
comany financials often include ersonal exenses of the owner and
excess comensation exenses.
B. Marketability
The shareholder of a rivate firm may have to send considerable resources
"both money and time# to sell his or her shares.
The shareholders of ublicly held firms find it much easier to liquidate their
holdings.
The higher transaction costs associated with the stock at the rivate firm
will result in a lower rice 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.
C. +o%ng ,ers%s Mat%re Companies
Aoung, raidly growing comanies tend to be more difficult to value than
mature, stable comanies.
Bne factor that makes it more difficult to value a young comany is that
less reliable historical information is available.
$nother factor is that the future of a young, raidly growing comany is
often less certain than that of a mature comany because much of the
young comany5s future growth deends on investment, oerating, and
financing decisions that have not yet been made.
1*
8ithout rofits, it is difficult to use earnings multiles to value the
business, leaving riceCrevenue or enterrise valueCrevenue multiles as
the only viable alternatives for a multiles analysis.
In order to grow, many young comanies have to invest a considerable
amount of money.
The cash flows will be negative until the business becomes rofitable and
its investment exenditures are less than those rofits.
This means that the ositive cash flows, which reresent the
value of the business, are further into the future and are,
therefore, less certain.
D. Control
$nother imortant issue that must be considered when valuing a business is
whether a controlling ownershi interest or a minority interest is being
valued.
The amount of stock that is required for an investor to exercise control can
vary deending on the ownershi structure of the comany.
8hether a controlling ownershi interest is being sold has
imortant imlications for a valuation analysis.
$n ad4ustment must be made to reflect the benefits of control if one used
multiles based on ublic stock market rices to estimate the value of a
controlling interest.
Similarly, when you use an income aroach to value a business, the cash
flow forecasts and discount rate assumtions will differ deending on
1/
whether you are valuing a minority or a controlling ownershi interest.
$ discount rate based on !$2F might be too high for a valuation that
involves a controlling osition.
To ad4ust for the effects of an incorrect discount rate and for any
ossible cash flows that are not reflected in a valuation based on
an income aroach, analysts add a #ontrol 'remium%
'. &ey People
$nalysts must also consider whether it is aroriate to ad4ust the
estimated value of the business for the likelihood that these 9key eole:
may not remain with the firm as long as exected.
If an analyst believes that those customers may go to another firm if the
!?B dearts, then a -e( 'erson dis#ount may be aroriate.
,+
00% 1uggested and Alternati$e A''roa#hes to the 3aterial
The earlier chaters discussed how businesses are organi6ed and how financial managers make
long&term investment decisions, manage working caital requirements, and finance the
investments and activities of their businesses. In this chater these concets are reexamined in
the context of a discussion of business formation, growth, and valuation. This chater rovides
an integrated ersective on how financial managers5 decisions affect firm value.
The authors begin by considering the decision by an entrereneur to start a business and
how the business should be organi6ed. They then discuss financial considerations that must be of
concern to managers of young, raidly growing firms.
Dext, they focus on the role that a carefully reared business lan lays in raising caital
for a young, raidly growing business and in roviding a road ma of where the business is
going for use in managerial decision making. The last two sections of this chater address business
valuation concets. The discussions in these sections rovide a broad overview of the business valuation
aroaches that financial managers use and how differences in the characteristics of ublic and rivate
comanies and of young, raidly growing, and mature comanies affect valuation analyses. The imact
of control considerations and key eole on business valuations is also considered.
This chater is an ideal way to comlete a semester5s discussion on the rinciles of finance and
how they aly in a cororate context. The instructor is encouraged to use the endGof&chater material to
hel convey the information to the students because the material is consistent with the aroach in
revious chaters in roviding a variety of questions, yet allowing for reetition to benefit the
students.
,1
000% 1ummar( o) Learning !"e#ti$es
1. E&'lain wh( the #hoi#e o) organi*ational )orm is im'ortant, and des#ri!e two
)inan#ial #onsiderations that are es'e#iall( im'ortant in starting a !usiness%
The choice of organi6ational form is imortant because it affects the returns from a
business in a number of ways. =or examle, it affects the cost of getting started, the life
of the business, management5s ability to raise caital and grow the business, the control
of the business, the ability to attract and retain good managers, the exosure of the
investors to liabilities, and the taxes that are aid on the earnings of the business.
Two esecially imortant financial considerations are the cash flow break&even
oint for the business and its overall cash inflows and outflows. The cash flow break&
even oint is imortant because it reresents the level of unit sales that must be achieved
in order for the business to break even on a cash flow basis. ?ntrereneurs must also
understand where money is coming from, where it is going, and how much external
financing is likely to be needed and when. The cash budget hels with this understanding.
,. ,es#ri!e the -e( #om'onents o) a !usiness 'lan, and e&'lain what a !usiness 'lan is
used )or%
The key comonents of a business lan include the executive summary, a comany
overview "a descrition of the comany5s roducts and services#, a market analysis, a
discussion of marketing and sales activities, a discussion of the businesses oerations, a
,,
discussion of the management team, the ownershi structure of the firm, caital
requirements and uses, and financial forecasts. (A-. Changes made per te/t p. 0102 ok3!
$ business lan hels an entrereneur set the goals and ob4ectives for a comany,
serves as a benchmark for evaluating and controlling the comany5s erformance, and
hels communicate the entrereneur5s ideas to managers and others "including investors#
outside the firm.
<. E&'lain the three general a''roa#hes to $aluation, and !e a!le to $alue a !usiness
with using #ommonl( used !usiness $aluation a''roa#hes%
The three general valuation aroaches are "1# cost aroaches, ",# market aroaches,
and "<# income aroaches. !ost aroaches commonly used in business valuation are
the relacement cost and ad4usted book value aroaches. The market aroaches are
multiles analysis and transactions analysis. Three key income aroaches are the free
cash flow from the firm, free cash flow to equity, and dividend discount aroaches. The
alication of these aroaches is discussed in Section 1*.<.
/% E&'lain how $aluations #an di))er !etween 'u!li# and 'ri$ate #om'anies and !etween
(oung and mature #om'anies as well as the im'ortan#e o) mar-eta!ilit(, #ontrol,
and -e( 'erson #onsiderations in $aluation%
Ealuations differ between ublic and rivate comanies for a number of reasons. Two
reasons discussed in this section are that the quality of the financial statements and the
,<
marketability of the securities being valued can differ considerably. Farketability is
imortant because it affects the rice that investors are willing to ay for a security. The
less marketable a security is, the lower the rice investors will be willing to ay.
Aoung, raidly growing comanies tend to be more difficult to value than mature
comanies because there is less reliable historical information on young comanies and
their futures tend to be less certain.
!ontrol is an imortant consideration in business valuation because having
control of a business rovides an investor with more flexibility with regard to how he or
she will manage the business. Investors value this flexibility and will, therefore, ay more
for a controlling interest in a comany.
If the cash flows that a business is exected to generate deend heavily on certain
emloyees, those emloyees are key eole. 8hen valuing a business, an analyst must
account for the ossibility that the key eole will unexectedly leave the comany and
must consider the associated imact on the comany5s cash flows.
,>
0V% 1ummar( o) 8e( E5uations
E5uation ,es#ri'tion Formula
18%1
2riceCearnings multile based on
constant&growth model
+
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cs
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18%+
Imlementing the income
aroach to business valuation
E
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# I DB$
18%. =!== aroach
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=!==
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18%/ =!=? aroach

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V% Be)ore 9ou Go n :uestions and Answers
1e#tion 18%1
1. 8hat are three general reasons that new businesses failJ
'usinesses fail for a variety of reasons. In some cases, a firm5s roduct"s# may find no
demand among consumers. =or others, the founding management may lack a clearly
thought out strategy or lack the skills to move the firm forward. In addition, a lot of firms
fail because they run out of money to oerate the business and are unable to raise more.
,. %ow do financing considerations affect the choice of organi6ational formJ
Bf all the different forms of organi6ations, the sole rorietor takes the least amount of
money to set u and is only deendent on the founder5s money. =orming a artnershi is
more involved and costs more. Setting u as a cororation is the most exensive and calls
for a more active role by attorneys to set u the organi6ation.
<. %ow does a cash budget hel an entrereneurJ
The cash budget is also a very useful lanning tool for entrereneurs. It summari6es the
cash flows into and out of a firm over a eriod of time. !ash budgets often resent the
inflows and outflows on a monthly basis but can be reared for any eriod, including
daily or weekly. 2rearing a cash budget hels an entrereneur better understand where
,(
money is coming from, where it is going, and how much external financing is likely to be
needed and when. .nderstanding where the money is coming from and where it is going
hels an entrereneur maintain control of the comany5s finances. @nowing how much
external financing is likely to be needed and when hels the entrereneur lan fund&
raising efforts before it is too late.
1e#tion 18%+
1. 8hy is a business lan imortant in raising caital for a young comanyJ
$ well&reared business lan makes it easier for an entrereneur to communicate to
otential investors recisely what he or she exects the business to look like in the future,
how he or she exects to get it to that oint, and what returns an investor might exect to
receive. This allows otential investors to get a feel for the strategic lan of the firm and
also allows them to gauge the management ability of the entrereneur.
,. 8hat else can a business lan be used forJ
$ business lan is a tool that
can hel raise caital
can hel an entrereneur set the goals and ob4ectives for the
comany,
serve as a benchmark for evaluating and controlling the comany5s
erformance, and
,)
communicate the entrereneur5s ideas to managers, outside directors,
customers, suliers, and others.
<. 8hy is it imortant to discuss the qualifications of the management team in a business
lan.
The discussion of the qualification of the management team is esecially imortant when
it comes to raising caital. Investors in young businesses invest in the key eole as much
as in the business idea itself.
1e#tion 18%.
1. 8hy is it imortant to secify a valuation date when you value a businessJ
Bne of the most imortant rinciles in valuing a business is that the value of a business
changes over time. This can be caused by changes in general economic conditions,
industry conditions, and decisions that are made by the managers7all affect the value of
the cash flows that a business is exected to generate in the future. $ctions by
cometitors also affect the value of a business. The investment, oerating, and financing
decisions made by managers also affect the value of a business. ;iven this, it is imortant
to secify a valuation date when valuing a business. This is the date as of which the value
estimate is current.
,. 8hat is the difference between investment value and fair market valueJ
,*
$ strategic investor is one who has an interest in acquiring the business. The in$estment
$alue 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.
In contrast, the )air mar-et $alue is the valuation arrived by an investor who is
only interested in the financial erformance of the firm and not in acquiring the business.
The fair market value will be lower than that of the strategic investor.

<. 8hat are the two market aroaches that can be used to value a business, and how do
they differJ
Two market aroaches that are commonly used are multiles analysis and transactions
analysis. 3ulti'les anal(sis uses stock rice or other value multiles that are observed
for ublic comanies to estimate the value of a comany5s stock or an entire business.
In the transa#tion a''roa#h analysts use the information on what someone has aid for
a comarable comany in a merger or an acquisition to estimate a value for the firm.
>. 8hat is a nonoerating asset, and how are such assets accounted for in business
valuationJ
,/
;ono'erating assets 6;A7 are assets like cash or other assets that are not essential for
oerations. $s ?quation 1*.< shows, when valuing a business, the net oerating assets are
included in the cash flows that are discounted to arrive at the resent value of a firm.
-. 8hat are three income aroaches used to value a businessJ
The three income aroaches to valuing a business are free cash flow from the firm "=!==#,
free cash flow to equity "=!=?#, and dividend discount model "33F#% In the )ree #ash
)low )rom the )irm 6FCFF7 a''roa#h, an analyst values the free cash flows that the assets
of the firm are exected to roduce in the future. The )ree #ash )low to e5uit( 6FCFE7
a''roa#h uses only the ortion of the cash flows that are available for distribution to
stockholders. The di$idend dis#ount model 6,,37 a''roa#h estimates the value of
equity directly by discounting cash flows to stockholders.
(. 8hat is the difference between =!=? and dividendsJ
The =!=? is an estimate of all cash flows available for distribution to shareholders of the
firm. Recogni6e that not all of this will be distributed to stockholders as dividends. Thus,
=!=? includes both dividends and retained earnings, the ortion not distributed to
shareholders but reinvested in the firm.
1e#tion 18%/
<+
1. %ow might financial statements for rivate comanies differ from those for ublic
comaniesJ
Some rivate comanies have comlete, audited financial statements, while
others have incomlete financial statements that are not reared in accordance
with the ;$$2. $ll ublic comanies are required to file audited financial
statements with the S?!.
In contrast to the financial statements of ublicly hel firms, rivate comany
financials often include ersonal exenses of the owner and excess
comensation exenses.
,. 8hy is marketability an imortant issue in business valuationJ
The shareholders of a ublicly held comany have an easier time of liquidating their
holdings if they so desire. Since a market and a value for their holdings is already
established, a simle call to a broker will take care of it. In contrast, the shareholders of a
rivately held firm will have to send a lot more time and money to liquidate their shares.
This additional time and effort is a reflection of a lower level of marketability of such
firms and will result in a discount in the value of the firm.
<. 8hat is a key ersonJ
<1
If the cash flows that a business is exected to generate deend heavily on the retention
of a articular individual or grou of individuals, then that individual or grou can be
referred to as key eole. The survival of the firm is deendent on the continued
emloyment of this individual or grou.
<,
V0% 1el)21tud( Pro!lems
18%1 Aour sister wants to oen a store that sells antique&style 4ewelry and accessories. She has
K1-,+++ of savings to invest, but oening the store will require an initial investment of
K,+,+++. Det cash inflows will be LK,,+++, LK1,+++, and K+ in the first three months. $s
the store becomes better known, net cash inflows will become IK-++ in the fourth month
and grow at a constant rate of - ercent in the following months. Aou want to hel your
sister by roviding the additional money that she needs. %ow much money do you have
to invest each month to start and to kee the store oerating with a minimum cash balance
of K1,+++J
1olution<
Aou will have to invest in K-,+++ initially for her business to start "the difference between
K,+,+++ and K1-,+++#. Aou will then need to invest an additional K<,+++ in the first
month to cover the cash flow of &K,,+++ and to establish a cash balance of K1,+++.
$nother K1,+++ will be required in the second month to cover the negative cash flow that
month. Since cash flows will be ositive beginning in the third month, you will not have
to invest any additional funds after the second month.
18%+ Aou have the following information for a comany you are valuing and for a comarable
comany0
Com'ara!le #om'an(< Com'an( (ou are $aluing<
Stock rice H K,<.>- Ealue of debt H <.(* million
<<
Dumber of shares outstanding H (.,< million ?st. ?'IT3$ next year H K>.> million
Ealue of debt H K1*.>- million ?st. income next year H K1.- million
?st. ?'IT3$ next year H K1).+ million
?st. income next year H K-.< million
?stimate the enterrise value of the comany you are evaluating using the 2C? and
enterrise valueC?'IT3$ multiles.
1olution<
The 2C? and enterrise valueC?'IT3$ multiles for the comarable comany are0
2C?
!omarable
H Stock riceC?arnings er share H K,<.>-C"K-.<C(.,< shares#
H ,).(
?nterrise valueC?'IT3$
!omarable
H "E
3
I E
?
#C?'IT3$
H MK1*.>- I "K,<.>- N (.,< shares#OCK1).+
H /.(*
.sing the 2C? multile, we can calculate the value of the equity as0
E
?
H 2C?
!omarable
N Det income
!omany being valued
H ,).( N K1.- H K>1.> million
.sing ?quation 1*.,, suggests an enterrise value of0
E
=
H E
?
I E
3
H K>1.> million I K<.(* million H K>-.+* million
.sing the enterriseC?'IT3$ multile, we obtain0
E
=
H ?nterrise valueC?'IT3$
!omarable
N ?'IT3$
!omany being valued
H /.(* N K>.> million H =/+%>? million
<>
18%. %ow do the cash flows that are discounted when the 8$!! aroach is used to value a
business differ from those that are discounted when the free cash flow to equity "=!=?#
aroach is used to value the equity in a businessJ
1olution<
The cash flows that are discounted when the 8$!! aroach is used to value a business
are calculated in the same way that the cash flows are calculated for a ro4ect analysis.
These cash flows reresent the total cash flows that the business is exected to generate
from oerations. The cash flows that are discounted when the =!=? aroach is used are
the ortion of the total cash flows from the business that are available for distribution to
the stockholders. In other words, they equal the total cash flows that the business is
exected to generate less the net cash flows to the debt holders. The net cash flows to the
debt holders is equal to the interest and rincial ayments that the firm makes less any
roceeds for the sale of new debt.
18%/ Aou are valuing a comany using the 8$!! aroach and have estimated that the free
cash flows from the firm "=!==# in the next five years will be K<(.), K>,.(, K>-.1, K>(.<,
and K>(.( million, resectively. 'eginning in year (, you exect the cash flows to
decrease at a rate of < ercent er year for the indefinite future. Aou estimate that the
aroriate 8$!! to use in discounting these cash flows is 1+ ercent. 8hat is the value
of this comanyJ
<-
1olution<
The resent value of the cash flows exected over the next five years is0
( )
( ) ( ) ( ) ( )
- , < > -
K<(.) K>,.( K>-.1 K>(.< K>(.(
2E"=!== # H I I I I
1I+.1
1I+.1 1I+.1 1I+.1 1I+.1
H K1(<.+1million.
The terminal value is0
( ) ( )
-
-
=!== N 1I K>(.(N 1& +.+<
TE H H H K<>).)1million
8$!!& +.1I+.+<
g
g
and the resent value of the terminal value is0
( ) ( )
-
- - -
TE K<>).)1
2E"TE # H H H K,1-./+million.
1I 8$!! 1I+.1
Therefore, if there are no nonoerating assets, the value of the firm is0
E
=
H K1(<.+1 million I K,1-./+ million H =.@8%?1 million
18%> Aou want to estimate the value of a local advertising firm. The earnings of the firm are
exected to be K, million next year. 'ased on exected earnings next year, the average
rice&to&earnings ratio of similar firms in the same industry is >*. Therefore, you estimate
the firm5s value to be K/( million.
=urther investigation shows that a large ortion of the firm5s business is obtained
through connections that Pohn Smith, a senior artner of the firm, has with various advertising
executives at customer firms. Fr. Smith only recently started working with his 4unior artners
to establish similar relationshis with these customers.
<(
Fr. Smith is aroaching (- years of age and might announce his retirement at
the next board meeting. If he does retire, revenues will dro significantly and earnings are
estimated to shrink by <+ ercent. Aou estimate that the robability that Fr. Smith will
retire this year is -+ ercent. If he does not retire this year, you exect that Fr. Smith will
have sufficient time to work with his 4unior artners so his dearture will not affect
earnings when he dearts. %ow does this information affect your estimate of the value of
the firmJ
1olution<
Fr. Smith is a key person in this firm. $n ad4ustment should be made to the valuation to
account for his otential dearture this year.
Taking into account the ossibility that Fr. Smith will retire, the exected
earnings next year will be0
,,+++,+++ N -+Q I ,,+++,+++ N "1 L <+Q# N -+Q H K1,)++,+++
Therefore the ad4usted value for the firm is0 K1,)++,+++ N >*H =81%A million% 8e can see
that this imlies a 1- ercent key erson discount from the original estimate of K/(
million.
<)
V00% Criti#al Thin-ing :uestions
18%1 ;iven that many new businesses fail in the first four years, how should an entrereneur
think about the risk of failure associated with a new businessJ =rom what you have
learned in this chater, what can an entrereneur do to increase the chance of successJ
=irst of all, it is imortant for an entrereneur to understand why many new businesses
fail. !ommon reasons include oor roducts, oor business strategy, oor management
skills, and wrong financing decisions. %owever, the risk of failure should not sto the
start of a new business if the entrereneur believes that he or she has a great business idea
and is caable of imlementing the idea. The entrereneur should be careful and realistic
in assessing the oortunities and taking risks into consideration.
=rom what we have learned in this chater, the entrereneur should consult an
attorney and choose the right organi6ational form according to the business5s oerating
and financing needs. In addition, he or she should carefully reare a business lan that
incororates the main asects of the business and facilitates the raising of external caital.
The entrereneur can use several tools to assess the financing needs of the new business0
cash flow break&even analysis and cash budget. To value the new business, the
entrereneur can use one or more of the following methods0 cost aroach, market
aroach, or income aroach.
18%+ ?xlain how the taxation of a !&cororation differs from the taxation of the other forms
of business organi6ation discussed in this chater.
<*
8ith the excetion of !&cororations, all rofits flow through to the owners in roortion
to their ownershi interests. These owners ay taxes on the business rofits only when
they file their ersonal tax returns. In contrast, rofits earned in !&cororations are taxed
at the cororate tax rate, and the after&tax rofits are taxed a second time when they are
distributed to stockholders in the form of dividends. Bn the bright side, because rofits
are taxed in the cororation, certain benefits like health insurances that are aid to
stockholders who work in a !&cororation are tax deductible. These benefits are not
generally deductible with the other forms of organi6ation.
18%. 8hat is a business lanJ ?xlain how a business lan can hel an entrereneur succeed
in building a business.
$ business lan is a document that describes the details of how a business will be
develoed over time. $ well&reared business lan hels an entrereneur raise external
caital. It makes it easier for an entrereneur to communicate to otential investors
recisely what he or she exects the business to look like in the future, how he or she
exects to get it to that oint, and what returns an investor might exect to receive. In
addition, a business lan is a tool that can hel an entrereneur set the goals and
ob4ectives for the comany, serve as a benchmark for evaluating and controlling the
comanyRs erformance, and communicate the entrereneur5s ideas to managers and
stakeholders.
</
18%/ Aou are entering negotiations to urchase a business and are trying to formulate a
negotiating strategy. Aou want to determine the minimum rice you should offer and the
maximum you should be willing to ay. ?xlain how the concets of fair market value
and investment value can hel you do this.
$n estimate of the fair market value of a business would rovide you with an idea of the
rice that the seller could robably get from someone else. Since this is an indication of
the alternatives available to the seller, it is a useful benchmark for determining the
minimum rice you should offer. The investment value of the business to you reresents
the maximum rice that you should ay. If you ay more than the investment value, the
acquisition will be a negative D2E ro4ect.
18%> Aou have 4ust received a business valuation reort that is dated six months ago. 3escribe
the factors that might have changed during the ast six months and, therefore, caused the
value of the business today to be different from the value six months ago. 8hich of these
changes affect the exected cash flows, and which affect the discount rate that you would
use in a discounted cash flow valuation of this comanyJ
$ lot might have changed in the last six months. =or examle, there might have been
changes in general economic conditions, caital market conditions, the cometitive
environment in the industries in which the comany cometes, and in comany
characteristics such as the roducts it sells, the geograhic markets it cometes in, and
management quality. !hanges in all of these areas can affect exected cash flows through
>+
their imact on demand for the comany5s roducts, the rices of these roducts,
roduction costs, and investment requirements. !hanges in caital market conditions can
affect the comany5s cost of caital and therefore the discount rate.
18%A Is the relacement cost of a business generally related to the value of the cash flows that
the business is exected to roduce in the futureJ 8hy or why notJ Illustrate your answer
with an examle.
The relacement cost of a business is an estimate of what it would cost to relace the
tangible and intangible assets of an on&going business rather than a reflection of the value
of the exected future cash flows of the business. 1et us say that you are lanning to start
u a new coffee sho. Aou have a choice of either buying an existing coffee sho or
starting u one entirely from scratch. The relacement cost of the coffee sho business
should include the cost of all tangible assets, such as roerty, lant, and equiment, and
all intangible assets, such as brand names, customer lists, and the cost of hiring the eole
necessary to run the business and the time that it would take to build the business. This
rovides you a fair value of what you would ay for an existing business. If you can start
u a business from start at a lower cost than that estimated value, then you should not buy
u the existing business. It does not reflect the cash flows that the existing coffee sho will
roduce in the future, but only what it is worth now.
18%@ Aou want to estimate the value of a comany that has three very different lines of
business. It manufactures aircraft, is in the data&rocessing business, and manufactures
>1
automobiles. %ow could you use an income aroach to value a comany such as this7
one with three very distinct businesses that will have different revenue growth rates,
rofit margins, investment requirements, discount rates, and so forth
In using an income aroach like the )ree #ash )low )rom the )irm 6FCFF7 to value an
entire firm, one would first estimate the exected future cash flows from each of the three
distinct lines of business. If all three lines of businesses are financed the same way, then
one would add u the cash flows across all the different lines of businesses and discount
them using the firm5s 8$!! "as shown in ?quation 1*.<# to estimate the value of the
firm. If, however, the three distinct businesses have been financed differently, then each
of the business5s value should be estimated indeendently and then finally added u to
determine the value of the firm.
18%8 Aour boss has asked you to estimate the intrinsic value of the equity for ;oogle, which
does not currently ay any dividends. Aou are going to use an income aroach and are
trying to choose between the free cash flow to equity "=!=?# aroach and the dividend
discount model "33F# aroach. 8hich would be more aroriate in this instanceJ
8hyJ 8hat concerns would you have in alying either of these valuation aroaches to
a comany such as thisJ
;oogle is a fast growing, young firm that is unlikely to ay dividends in the near future.
The dividend discount model "33F# aroach tyically uses the constant&growth model
to determine the intrinsic value of the firm5s equity. This model will not be alicable to
>,
firms like ;oogle until it has settled down to a steady growth attern at some oint in the
future. In contrast, the =!=? aroach values cash flows that are availale for
distriution to stockholders. It allows for the firm to not distribute all available cash
flows as dividends in any articular year. %ence, it would be more aroriate to use the
=!=? aroach to determine the intrinsic value of ;oogle5s equity.

18%? ?xlain how the financial statements of a rivate comany might differ from those of a
ublic comany. 8hat does this imly for valuing a rivate comanyJ
=inancial statements of many rivate comanies are not as comlete and reliable as those
of ublic comanies. Bne needs to take caution in valuing a rivate business based on its
financial statements. =or examle, rivate comany financials often include ersonal
exenses of the owner and extremely high comensation exenses. ?xcess
comensations for the owners benefit them by voiding double taxation. To value a rivate
firm more recisely, ad4ustments for excess exenses and comensations should be made.
18%1B ?xlain why it is difficult to value a young, raidly growing comany.
It is difficult to value a young, raidly growing comany for several reasons. =irst, such a
comany has less reliable historical information availableS second, the future of such a
comany is often less certain than a matured comanyS third, such a comany is usually
not yet rofitable, and therefore it is difficult to aly earnings multilesS and finally,
such a comany usually invests
><
V000% :uestions and Pro!lems
BA10C
18%1 rgani*ational )orm< 1ist some common forms of business organi6ation, and discuss
how access to caital differs across these forms of organi6ation.
1olution<
The forms of organi6ations discussed in this chater include0 sole rorietorshi,
artnershi "general artnershi and limited artnershi#, limited liability comany
"11!#, and cororations "S&cororation and !&cororation#.
The closer the tye of organi6ation is to the end of the list above, the better is its
access to caital. Sole rorietorshis rely on equity contribution from the rorietor and
debt or lease financing. In contrast, artnershis can turn to all of the artners for
additional caital, and cororations can sell shares to outsiders. 1imited artners and
11!s are less constrained than general artnershis because they can raise money from
limited artners or 9members,: as outside investors in 11!s are called, who are not
directly involved in running the business. !&cororations can have an unlimited number
of stockholders.
18%+ 1tarting a !usiness< 8hat are some of the things that the founder of a comany must do
to launch a new businessJ
1olution<
>>
The founder of a comany needs to decide on its roducts, market, and business strategy.
Then, he or she needs to estimate the comany5s financing needs and raise the money to
develo the roducts, acquire assets, and hire emloyees. $s the business is being built,
the founder must also manage the day&to&day oerations.
18%. rgani*ational )orm< ?xlain how financial liabilities differ among different forms of
business organi6ation.
1olution<
Sole rorietorshis, general artnershis, and limited artnershis all are at a
disadvantage. Sole rorietors and general artners face the ossibility that their ersonal
assets can be taken from them to satisfy claims on their businesses. In contrast, the
liabilities of investors in limited artnershis, 11!s, and cororations are limited to the
money that they have invested in the business.
18%/ Cash re5uirements< 1ist two useful tools to hel an entrereneur to understand the cash
requirements of a business and to estimate the financing needs of his or her business.
1olution<
$n entrereneur can use cash flow break&even analysis and cash budget to estimate the
cash requirement and financing needs of his or her business. The cash flow break&even
analysis is used to comute the level of unit sales that is necessary to break even on
oerations from a retax oerating cash flow ersective. The cash budget resents the
>-
cash inflows and outflows as well as additional financing needs, usually on a monthly
basis.
18%> Cash re5uirements< Aou believe you have a great business idea and want to start your
own comany. %owever, you do not have enough savings to finance it. 8here can you
get the additional funds you needJ
1olution<
Aou can try to raise additional equity financing from your friends and family, from
venture caitalists, or from other otential investors that you know. 3ebt financing might
be obtained through bank loans, cash advances on credit cards, or loans from other local
individual investors or other businesses. Bf course, if a comany is large enough ,equity
and debt financing can be obtained in the ublic markets.
18%A Raising #a'ital< 8hy is it esecially difficult for an entrereneur with a new business to
raise caitalJ 8hat is a tool that can hel him or her to raise external caitalJ
1olution<
To raise external caital, an entrereneur must convince otential investors that
urchasing debt or equity from the firm will yield attractive returns given the risks they
will bear. It is esecially difficult for an entrereneur with a new business to do this,
because the business does not have a well&established record and its future is tyically
>(
very uncertain. $ well&written business lan can be very helful in convincing otential
investors to ut their money in the business.
18%@ Re'la#ement #ost< 8hat is the relacement cost of a businessJ
1olution<
The relacement cost is the cost of dulicating the assets of a business in their resent
form, consisting of tangible and intangible assets.
18%8 3ulti'les anal(sis< It is $ril >, ,++), and your comany is considering the ossibility
of urchasing the !hrysler automobile manufacturing business from the ;erman car
manufacturer 3aimler!hrysler. 3aimler!hrysler has hinted that it might be interested in
selling !hrysler. Since !hrysler does not have ublicly traded shares of its own, you have
decided to use =ord Fotor !omany as a comarable comany to hel you determine the
market value of !hrysler.
This morning =ord5s common stock was trading at K*.1- er share, and the
comany had 1.*/ billion shares outstanding. Aou estimated that the market value of all
of the comany5s other outstanding securities "excluding the common stock but including
secial shares owned by the =ord family# is K1++ billion and that its revenues from auto
sales were K1><.< billion last year. !hrysler5s revenue in ,++( was K(,., billion. 'ased
on the enterrise valueCrevenue ratio, what is the total value of !hrysler that is imlied by
the =ord market valuesJ
>)
1olution<
The enterrise value of =ord is0
E
=
H E
?
I E
Bther Securities
H "K*.1- N 1.*/ billion# I K1++ billion H K11-.> billion
and the enterrise valueCrevenue ratio is0
K11-.>CK1><.< billion H +.*+-
This suggests that the value of the !hrysler business is +.*+- N K(,., billion H =>B%1
!illion. "Dote that in this examle we used the enterrise valueCrevenue ratio because
?3IT3$ was virtually 6ero for =ord and was unclear for !hrysler.#
18%? ;ono'erating assets< 8hy is excess cash a nonoerating asset "DB$#J 8hy does it
make sense to add the value of excess cash to the value of the discounted cash flows
when we use the 8$!! or =!=? aroach to value a businessJ
1olution<
?xcess cash is a nonoerating asset because, by definition, this cash can be distributed to
stockholders without affecting the oerations of the business and therefore the value of
the exected future cash flows. It makes sense to add back the value of excess cash
because it reresents value over and above that which the business is exected to
roduce.
18%1B ,i$idend dis#ount a''roa#h< Aou want to estimate the total intrinsic value of a large
gas and electric utility comany. This comany has ublicly traded stock and has been
>*
aying a regular dividend for many years. Aou decide that, due to the redictability of the
dividend that this comany ays, you can use the dividend discount valuation aroach.
The comany is exected to ay a dividend of K1.,- er share next year, and the dividend
is exected to grow at a rate of < ercent er year thereafter. Aou estimate that the
aroriate rate for discounting future dividends is 1, ercent. In addition, you know that
the comany has >( million shares outstanding and that the market value of its debt is
K<-+ million. 8hat is the total value of the comanyJ
1olution<
The value of a share of stock can be calculated using the constant&growth dividend model
as0
1
+
cs
3 K1.,-
2 H K1<.*/.
& +.1, +.+< k g

Fultilying the rice er share by the number of shares outstanding gives us the value of
the equity0
E
?
H K1<.*/ N >( million H K(<*./> million
Therefore, the total value of the firm is0
E
=
H E
?
I E
3
H K(<*./> I K<-+ H =?88%?/ million
18%11 Pu!li# $ersus 'ri$ate #om'an( $aluation< Aou are considering investing in a rivate
comany that is owned by a friend of yours. Aou have read through the comany5s
financial statements and believe that they are reliable. Fultiles of similar ublicly traded
comanies in the same industry suggest that the value of a share of stock in your friend5s
comany is K1,. Should you be willing to ay K1, er shareJ
>/
1olution<
Shareholders in a rivate comany may have to send considerable resources in money
and time to sell their shares. This additional transaction cost will make value derived
from similar ublicly traded comany an overestimated figure. Therefore, you will most
likely not be willing to ay for K1, a share. Aou can aly an aroriate marketability
discount to this rice as a fair rice for this rivate equity.
18%1+ Control< 3oes the exected rate of return that is calculated using !$2F, with a beta
estimated from stock returns in the ublic market, reflect a minority or a controlling
ownershi ositionJ %ow is it likely to differ between a minority and a controlling
ositionJ
1olution<
The estimates we obtain using ublic market data with !$2F are based on small stock
transactions. To the extent that having control would enable an investor to better manage
the systematic risk associated with a business, a discount rate for a controlling transaction
is likely to be lower than that imlied by !$2F "this generates a higher value and
therefore a remium rice for control#.
0;TER3E,0ATE
-+
18%1. rgani*ational )orm< !omare an 11! to a artnershi and a cororation.
1olution<
$n 11! is a hybrid of a limited artnershi and a cororation. 1ike a cororation, an
11! rovides limited liability for the eole who make the business decisions in the firm
while enabling all investors to retain the tax advantages of a limited artnershi.
18%1/ rgani*ational )orm< 3iscuss the ros and cons of an S&cororation comared to a
!&cororation.
1olution<
$n S&cororation is a variation of the !&cororation. The advantage of an S&cororation
comared to a !&cororation is that all of its rofits are assed directly to the
stockholders, and therefore double taxation is avoided while it still offers the rotection
of limited liability for shareholders. The disadvantage of an S&cororation is the
limitation on stock ownershi. !urrently, an S&cororation can have no more than 1++
stockholders and have only one class of common stock, and all stockholders must be
individuals who are ..S. citi6ens or residents. $s a result, access to caital is more
limited, and cost to transfer ownershi is much higher for an S&cororation than for a !&
cororation.
18%1> Brea-2e$en< Aou have started a business that sells a home gardening system that
allows eole to grow vegetables on the counterto in their kitchens. Aou are
-1
considering two otions for marketing your roduct. The first is to advertise on local
TE. The second is to distribute flyers in the local community. The TE otion, which
costs K-+,+++ annually, will romote the roduct more effectively and create a
demand for 1,,++ hundred units er year. The flyer advertisement costs only K(,+++
annually but will create a demand for only ,-+ units er year. The rice er unit of
the indoor gardening system is K1++, and the variable cost is K(+ er unit. $ssume
that the roduction caacity is not limited and that the marketing cost is the only fixed
cost involved in your business. 8hat are the break&even oints for both marketing
otionsJ 8hich one should you chooseJ
1olution<
The break&even oint for TE advertisement H K-+,+++CK>+ H 1,,-+ units. %owever, the
demand is only 1,,++ units with TE advertisement. Therefore you cannot break even.
The break&even oint for flyers H K(,+++CK>+ H 1-+ units. 8ith a market demand of ,-+,
you will make a rofit. Therefore you should choose the flyer otion.
18%1A Going2#on#ern $alue< $ggie Fotors is a chain of used car dealershis that has
ublicly traded stock. .sing the ad4usted book value aroach, you have estimated the
value of $ggie Fotors to be K>-,(>(,+++. The comany has K>+.- million of debt
outstanding. Its stock rice is K-.- er share, and there are 1,<)*,+++ shares
outstanding. 8hat is the going concern value of $ggie FotorsJ
-,
1olution<
The going&concern value equals the difference between the market value of the business
and its ad4usted book value. The market value of the business can be calculated as0
E
=
H E
3
I E
?
H K>+,-++,+++ I "K-.- N 1,<)*,+++# H K>*,+)/,+++
Therefore, the going concern value is K>*,+)/,+++ G K>-,(>(,+++ H =+,/..,BBB
Cse the )ollowing in)ormation #on#erning Dohnson 3a#hine Tool Com'an( in Pro!lems
18%1@, 18%18, and 18%1?.
Pohnson5s income statement from the fiscal year that ended this ast 3ecember is0
Revenue K//-
!ost of goods sold (-,
;ross rofit K<><
Selling, general, T administrative exenses 1<-
Berating rofit "?'IT# K,+*
Interest exense >*
?arnings before taxes K1(+
Taxes (>
Det income K /(
$ll dollar values are in millions. 3ereciation and amorti6ation exenses last year were
K>, million, and the comany has K-<< million of debt outstanding.
-<
18%1@ 3ulti'les anal(sis< Aou are an analyst at a firm that buys rivate comanies, imroves
their oerating erformance, and sells them for a rofit. Aour boss has asked you to
estimate the fair market value of the Pohnson Fachine Tool !omany. Aou have
identified a ublic comany with business oerations that are virtually identical to those
at Pohnson. The income statement for this comany, 'illy5s Tools, for the fiscal year that
ended this ast 3ecember is as follows0
Revenue K1,)(>
!ost of goods sold 1,1(*
;ross rofit K -/(
Selling, general, T administrative exenses ,11
Berating rofit "?'IT# K <*-
Interest exense 1,
?arnings before taxes K <)<
Taxes 1>)
Det income K ,,(
$ll dollar values are in millions. 'illy5s had dereciation and amorti6ation exenses of K)1
million last year and ,++ million shares and K(++ million of debt outstanding as of the end of
the year. Its stock is currently trading at K1,.,- er share.
.sing the 2C? multile, what is the value of Pohnson5s stockJ 8hat is the total
value of Pohnson Fachine Tool !omanyJ
->
1olution<
The 2C? multile for 'illy5s Tools is0
2C? H "K1,.,- N ,++ million shares#CK,,( H 1+.*>
which imlies a value of 1+.*> N K/( H K1,+>+.(> million for the equity of Pohnson
Fachine Tools !omany. Therefore, the imlied total value of Pohnson is0
E
=
H E
?
I E
3
H K1,+>+.(> I K-<<.++ H =1,>@.%A/ million
18%18 3ulti'les anal(sis< .sing the enterrise valueC?'IT3$ multile, what is the total value of
Pohnson Fachine Tool !omanyJ 8hat is the value of Pohnson5s stockJ
1olution<
The enterrise valueC?'IT3$ multile for 'illy5s is0
?EC?'IT3$ H ""K1,.,- N ,++ million shares# I K(++ million debt#C"K<*-
million ?'ITI K)1 million 3T$#
H (.(/
Therefore, the imlied total value of Pohnson is0
E
=
H (.(/ N "K,+* million ?'IT I K>, million 3T$# H K1,(),.-+
$nd the value of its stock is0
E
?
H E
=
G E
3
H K1,(),.-+ million & K-<<.++ million H =1,1.?%>B million
18%1? 3ulti'les anal(sis< 8hich of the above multile analyses do you believe is more
aroriateJ
--
1olution<
8hile the value estimates in the revious questions are reasonably similar, the enterrise
valueC?'IT3$ multile is more aroriate for this analysis. The reason is that the
caital structures of Pohnson and 'illy5s differ considerably and the enterrise
valueC?'IT3$ multile is less sensitive to differences in leverage.
The debtCtotal caital ratio for 'illy5s is
K(++ million C""K1,.,- N ,++ million shares# I K(++ million debt# H B%1?A
The debtCtotal caital ratio for Pohnson is0
K-<< million C K1,(),.-+ million H B%.1?
18%+B 0n#ome a''roa#hes< Aou are using the =!== aroach to value a business. Aou have
estimated that the =!== for next year will be K1,<.(- million and that it will increase at a
rate of * ercent for each of the following four years. $fter that oint, the =!== will
increase at a rate of < ercent forever. If the 8$!! for this firm is 1+ ercent, what is it
worthJ
1olution<
Aou can value the =!== for the first five years using the growing annuity formula from
!hater ( "?quation (.-#.
n -
1
!= 1I K1,<.(- 1.+*
2E$ H N 1& H N 1&
"8$!!& # 1I 8$!! +.1+& +.+* 1.1
HK->1./* million
1 1
_ _
1 1

, ,
1 1
] ]
n
g
g
The resent value of the terminal value is
-(
( )
( )
( )
-
>
1 1 ,
,
- - -
K1,<.(-N 1I+.+* N"1I+.+<#
=!== N"1I # N 1I
+.1& +.+<
8$!!&
2E"TE # H H
"1I+.1#
1I8$!!
H K1, (-/./< million
1
1
1
1
1
] ]
g g
g
and the ,al%e o( the (irm is therefore0
E
=
H K->1./* million I K1,(-/./< million H =+,+B1%?1 million
18%+1 Valuing a 'ri$ate !usiness< Aou want to estimate the value of a rivately owned
restaurant that is financed entirely with equity. Its most recent income statement is as
follows0
Revenue K<,+++,+++
!ost of goods sold (++,+++
;ross rofit K,,>++,+++
Salaries and wages 1,>++,+++
Selling exenses 1++,+++
Berating rofit "?'IT# K /++,+++
Taxes <1-,+++
Det income K -*-,+++
Aou note that the rofitability of this restaurant is significantly lower than that of
comarable restaurants, rimarily due to high salary and wage exenses. =urther
investigation reveals that the annual salaries for the owner and his wife, the firm5s
accountant, are K/++,+++ and K<++,+++, resectively. These salaries are much higher than
-)
the industry median salaries for these two ositions of K1++,+++ and K-+,+++, resectively.
!omensation for other emloyees "K,++,+++ in total# aears to be consistent with the
market rates. The median 2C? ratio of comarable restaurants with no debt is 1+. 8hat is
the total value of this restaurantJ
1olution<
The owner is aying himself and his wife salaries that are above normal for this industry,
robably to avoid double taxation "assuming that the restaurant is organi6ed as a !
cororation#. Aou should ad4ust the income statement to reflect the market rates of
comensation for these ositions. The ad4usted income statement is as follows0
Revenue K<,+++,+++
!ost of goods sold (++,+++
;ross rofit K,,>++,+++
Salaries and wages <-+,+++
Selling exenses 1++,+++
Berating rofit "?'IT# K1,/-+,+++
Taxes (*,,-++
Det income K1,,(),-++
Therefore you estimate the comany5s value to be0 K1,,(),-++ U <+ H =1+,A@>,BBB. The
value of the comany will be underestimated if no ad4ustment for excess comensation is
made.
-*
18%++ Valuing a 'ri$ate !usiness< $ few years ago, a friend of yours started a small business
that develos gaming software. The comany is doing well and is valued at K1.- million
based on multiles for comarable ublic comanies after ad4ustments for their lack of
marketability. 8ith <++,+++ shares outstanding, each share is estimated to be worth K-.
Aour friend, who has been serving as !?B and !TB "chief technology officer#, has
decided that he lacks sufficient managerial skills to continue to build the comany. %e
wants to sell his 1(+,+++ shares and invest the money in an F'$ education. Aou believe
you have the aroriate managerial skills to run the comany. 8ould you ay K- each
for these sharesJ 8hat are some of the factors you should consider in making this
decisionJ
1olution<
Aou should consider at least two additional factors in valuing these equity shares. =irst,
note that since the comany has a total <++,+++ shares of equity outstanding, you will be
urchasing a ma4ority of the shares and will gain control of the comany. Second, while
you might be able to use your excellent managerial skills to create new value for the firm,
if your friend is a key erson, you must consider the imact of his dearture on the
develoment and sales of the comany5s roducts. Aour valuation of the equity could be
higher or lower than K- er share, based on ad4ustments for both otential control
remium and key erson discount.
A,VA;CE,
-/
18%+. Aou lan to start a business that sells waterroof sun block with a unique formula that
reduces the damage of .E$ radiation <+ ercent more effectively than similar roducts
on the market.
Aou exect to invest K-+,+++ in lant and equiment to begin the business. The
targeted rice of the sun block is K1- er bottle. Aou forecast that unit sales will total
1,-++ bottles in the first month and will increase by ,+ ercent in each of the following
months during the first year. Aou exect the cost of raw materials to be K< er bottle. In
addition, monthly gross wages and ayroll are exected to be K1<,+++, rent is exected to
be K<,+++, and other exenses are exected to total K1,+++. $dvertising costs are
estimated to be K<-,+++ in the first month but to remain constant at K-,+++ er month
during the following 11 months.
Aou have decided to finance the entire business at one time using your own
savings. Is an initial investment of K)-,+++ adequate to avoid a negative cash balance in
any given monthJ If not, how much more do you need to invest u frontJ %ow much do
you need to invest u front to kee a minimum cash balance of K-,+++J 8hat is the
break&even oint of the businessJ
1olution<
The monthly cash budget is as follows0
3onthl( Cash Budget
3onth 1 + . /
'eginning cash balance K )-,+++ K "/,+++# K "/,>++# K "-,>*+#
Cash re#ei'ts
!ash sales ,,,-++ ,),+++ <,,>++ <*,**+
Total #ash a$aila!le K /),-++ K 1*,+++ K ,<,+++ K <<,>++
'erations
Raw material >,-++ -,>++ (,>*+ ),))(
(+
;ross wages and ayroll 1<,+++ 1<,+++ 1<,+++ 1<,+++
$dvertising <-,+++ -,+++ -,+++ -,+++
Rent <,+++ <,+++ <,+++ <,+++
Bther exenses 1,+++ 1,+++ 1,+++ 1,+++
'erations total K -(,-++ K ,),>++ K ,*,>*+ K ,/,))(
Finan#ing and in$estments
!aital exenditures -+,+++ &&& &&& &&&
Total #ash 'a(ments K1+(,-++ K ,),>++ K ,*,>*+ K ,/,))(
Ending #ash !alan#e = 6?,BBB7 = 6?,/BB7 = 6>,/8B7 = .,A+/
8ith K)-,+++ of caital invested in the initial eriod, the comany will have
negative cash balances during each of the first three months and ositive cash balances in
the following months. $dditional caital investment totaling K/,>++ will be needed to
avoid negative cash balances in month ,. In other words, you will have to invest K*>,>++
of caital in total at the beginning of the business 4ust to avoid negative cash balances. To
maintain a minimum cash balance of K-,+++, you will need to make an initial caital
investment of K*/,>++ "K*>,+++ I K-,+++#.
'reak&even0 =ixed costs in the initial month will equal0
K1<,+++ I K<-,+++ I K<,+++ I K1,+++ H K-,,+++
=ixed monthly costs in the following months will be0
K1<,+++ I K-,+++ I K<,+++ I K1,+++ H K,,,+++.
Since variable costs er bottle are K<, the monthly break&even oints for the firm are0
K-,,+++ C "K1- G K<# H >,<<<.< bottles in the initial month and K,,,+++ C "K1- G K<#
H1,*<<.< bottles in the following months.
The sales of the comany are 1,-++, 1,*++, ,,1(+, and ,,-/, bottles in the first four
months. Therefore, the firm will start to make a rofit in the third month. This can be
seen from the cash budget analysis above. Fonth < is the first month the firm5s cash
balance is increasing "becoming less negative#.
(1
18%+/ =or the revious question, assume that you do not have sufficient savings to cover the
entire amount required to start your sun block business. Aou are going to have to get
external financing. $ local banker that you know has offered you a six&month loan of
K,+,+++ at an $2R of 1, ercent. Aou will ay interest each month and reay the entire
rincial at the end of six months.
$ssume that instead of making a single u&front investment, you are going to
finance the business by making monthly investments as cash is needed in the business.
$ssuming the roceeds from the loan go directly into the business on the first day and are
therefore available to ay for some of the caital exenditures, how much money do you
need to ull out of your savings account every month to run the business and kee the
cash balances ositiveJ
1olution<
The monthly ayment of the loan is K,+,+++U1Q H K,,+++. The cash budget without your
investment is as follows0
3onthl( Cash Budget
3onth 1 + . / > A
'eginning cash balance K ,+,+++ K"((,+++# K"(*,>++# K"((,>*+# K"-/,<)(# K">(,+-1#
Cash re#ei'ts
Investments by owner
!ash sales ,,,-++ ,),+++ <,,>++ <*,**+ >(,(-( --,/*)
Total #ash a$aila!le K >,,-++ K"</,+++# K"<(,+++# K",),(++# K"1,,),+# K /,/<(
Cash 'a(ments
'erations
Raw material >,-++ -,>++ (,>*+ ),))( /,<<1 11,1/)
;ross wages and ayroll 1<,+++ 1<,+++ 1<,+++ 1<,+++ 1<,+++ 1<,+++
$dvertising <-,+++ <,+++ <,+++ <,+++ <,+++ <,+++
Rent <,+++ <,+++ <,+++ <,+++ <,+++ <,+++
Bther exenses 1,+++ 1,+++ 1,+++ 1,+++ 1,+++ 1,+++
'erations total K -(,-++ K ,),>++ K ,*,>*+ K ,/,))( K <1,<<1 K <<,1/)
Finan#ing and in$estments
!aital exenditures -+,+++ &&& &&& &&& &&& &&&
(,
3ebtCinterest ayment ,,+++ ,,+++ ,,+++ ,,+++ ,,+++ ,,,+++
Total #ash 'a(ments K1+*,-++ K ,/,>++ K<+,>*+ K <1,))( K <<,<<1 K --,1/)
Ending #ash !alan#e =6AA,BBB7 =6A8,/BB7 =6AA,/8B7 =6>?,.@A7 =6/A,B>17 =6/>,+A17
Therefore, you need to ut in K((,+++ initially, and K,,>++ "K(*,>++G((,+++# in the next
month. Aou don5t need to invest in more money afterward, because the cash balance is
increasing afterward.
18%+> Aour friend is starting a new comany. %e wants to write a business lan to clarify the
comany5s business outlook and raise venture caital. @nowing that you have taken this
course, he has asked you, as a favor, to hel him reare a temlate for a business lan.
2reare a temlate that includes the key elements of a business lan.
1olution<
'usiness varies and so does a business lan. %ere is a temlate for an intermediate&level
business lan, which could be tailored to secific industry and comany situations0
1. ?xecutive Summary
1.1 Bb4ectives
1., Fission
1.< @eys to Success
,. Farket $nalysis
,.1 Farket Segmentation
,., Target Farket Segment Strategy
,.< Farket Deeds
,.> !ometitions and 'uying 2atterns
(<
<. !omany Bverview
>. 2roduct 3escrition
-. Farketing and Sales
-.1 !ometitive ?dge
-., Sales Strategy
(. Berations
(.1 2roduction
(., 3istribution
(.< Suly
). Fanagement and Bwnershi
).1 Brgani6ational Structure
)., Fanagement Team
).< Bwnershi
*. =inancial 2lan
*.1 'reak&even $nalysis
*., 2ro4ected 2rofit and 1oss
*.< 2ro4ected !ash =low
/. $endices0 Tables and charts
18%+A $ friend of yours is trying to value the equity of a comany and, knowing that
you have read this book, has asked for your hel. So far she has tried to use the =!=?
aroach. She estimated the cash flows to equity to be as follows0
(>
Sales K*++.+
L !;S L>-+.+
L 3ereciation L*+.+
L Interest L ,>.+
?arnings before taxes "?'T# K,>(.+
L Taxes "+.<- N ?'T# L *(.1
H !ash flow to equity K1-/./
She also comuted the cost of equity using !$2F as follows0
k
?
H k
=
I
?
"Risk remium# H +.+( I "1.,- N +.+*># H +.1(> or 1(.>Q
where, the beta is estimated for a comarable ublicly traded comany.
.sing this cost of equity, she estimates the discount rate as
8$!! H x
3ebt
k
3ebt retax
"1 L t# I x
cs
k
cs
H +.,+ N +.+( N "1 L +.<-# I +.*+ N +.1(- H +.1>, or 1>Q
'ased on this analysis, she concludes that the value of equity is K1-/./ millionC+.1> H
K1,1>, million.
$ssuming that the numbers used in this analysis are all correct, what advice would you
give your friend regarding her analysisJ
1olution<
There are a number of otential roblems with your friend5s analysis. =irst, she has
calculated =!== incorrectly. She is assuming that net income equals =!=?. Bnce she
obtains net income she should add back dereciation, subtract caital exenditures and
(-
additions to working caital, and subtract any net reayment of debt rincial. Second,
she is using the incorrect discount rate. She should be using the cost of equity to discount
the =!=?. =inally, since your friend is using the eretuity formula, she is assuming that
the exected future =!=? will be constant forever. Aou should inquire whether this is
really what she exects.
18%+@ =orever Aouth Technology is a biochemical comany that is two years old. Its main
roduct, an antioxidant drink that is suosed to energi6e the consumer and delay aging,
is still under develoment. The comany5s equity consists of K- million invested by its
founders and K- million from a venture caitalist. The comany has sent K< million in
each of the ast two years, mostly on lab equiment and RT3 costs. The comany has
had no sales so far. 8hat are the challenges associated with valuing such a young and
uncertain comanyJ
1olution<
$s discussed in the chater, it is very difficult to value such a young firm with many
uncertainties. The comany has a short history, high investments, no sales, and highly
uncertain cash flows in the future. The cost aroach is not valid for such a young
biochemical comany. It is hard to value the comany using multiles because of the lack
of sales and negativity of earnings, and because of lack of comarable comanies of the
same business. The transaction aroach is also hard to aly.
3esite the many uncertainties, we should try to estimate the future cash flows
and risks associated with these cash flows. =irst of all, we need to estimate the robability
((
and time length to achieve success in develoing the roduct. In addition, we need to find
out what haens in case the firm5s caital is used u before the roduct is develoed.
8e need to decide whether, based on the comany5s future rosects, it is ossible to
raise additional external caital at that oint of time, and if not we need to decide whether
the business has any liquidation value. Then we need to estimate the market demand and
shares as well as target rice of the roduct, in case it is develoed successfully. 8e also
need to estimate the short&term and long&term growth rate of the comany based on
market, industry, and firm&secific conditions.
18%+8 Fad Rock, Inc., is a comany that sells m< music online. It is exected to generate
earnings of K1 er share this year after its 8eb site is ugraded and online marketing is
steed u. ;iven the oularity of i2od and other m< layers, the stock rice of Fad
Rock has rocketed from K* to K/- er share in the ast 1, months. The cost of caital for
the comany is 1* ercent.
Bf course, the future of a young Internet comany such as Fad Rock is highly
uncertain. Devertheless, using the very limited information rovided in this roblem, do
you think K/- er share could be a fair rice for its stockJ Suort your argument with a
simle analysis.
1olution<
$ssume that the earnings of K1 will be reali6ed. To simlify the roblem, assume that all
earnings will be aid out as dividends. .sing the dividend growth model, K/- H K1C"+.1*
G g#, which imlies that g H 1(./Q. 8e know that it is not ossible for a firm to grow at
()
this rate forever because ; is a growth rate that must be sustainale in perpetuity. Do
firm can grow indefinitely at such a high rate, which is many times the average growth
rate of the world economy. Therefore, this analysis suggests that Fad Rock5s stock is
overriced.
Bn the other hand, it is ossible that Fad Rock could grow very raidly for a few
years and then grow at a sustainable rate that 4ustifies the K/- rice. =or examle, if we
assume that a sustainable rate is ( ercent, we can solve for the earnings er share that
would be required to 4ustify a K/- stock rice. This value is K/- H 3C"+.1* G +.+(# which
imlies 3 H K11.>. Therefore, if the earnings er share increased raidly to a value above
K11.>, it is ossible that a rice of K/- could be 4ustified. %ow much above K11.> it
would have to be would deend on how quickly it increased.
Bne other consideration here is that as the business matures, its #ost o) #a'ital is
li-el( to de#rease !e#ause its ris- will de#line% This will tend to in#rease the $alue o)
the e5uit(%
(*
1am'le Test Pro!lems
18%1 Aou own a business that seciali6es in designing and roducing roofs for houses in
central Texas. Aour annual costs include office rent of K1>,>++, salaries for four
designing engineers of K,>+,+++, design software costs of K1,,+++, and other overhead
costs of K<,+++. $n average roof in this region is riced at K<,-++. It costs K1,,++ in raw
material, K1,1++ in labor, and K1++ in other exenses "for examle, urchasing building
ermits#. 8hat is the minimum number of roofs you need to sell to earn a rofitJ 8hat
can you do to reduce the break&even level of salesJ
1olution<
=ixed costs H 1>,>++I,>+,+++I1,,+++I<,+++ H K,(/,>++
.nit variable costs H 1,,++ I 1,1++ I 1++ H K,,>++
Therefore, the break&even oint H =! C "2rice&.nit E!#
H K,(/,>++C "K<,-++ G K,,>++#
H ,>>./, or +/> roo)s e$er( (ear
To increase the rofitability of the business, you can either reduce the fixed costs of the
business or increase the unit contribution of each roof. =or examle, to minimi6e the
fixed costs, you could rent a less exensive office, or reduce the number of roof designers
"instead, use better software to design the roofs more efficiently#S to maximi6e the unit
contribution, you can try to increase the rice based on the quality of your roof, or get
cheaer material or work labor given accetable outut standards.
18%+ ?xlain why the relacement cost aroach is rarely used to value an entire business.
(/
1olution<
The relacement cost aroach is rarely used because investors in businesses are
concerned with the value of the cash flows the business can be exected to generate in the
future. The relacement cost aroach does not generally reflect the value of these cash
flows.
18%. 8hy is the rate used to discount =!== different from the rate used to discount =!=?J
1olution<
The discount rates are different because the riskiness of the =!== and =!=? cash flow
streams are different. The =!==, which are the total cash flows that the business is
exected to roduce, are discounted using the 8$!!. The 8$!! reresents the rate of
return that the market requires for cash flows having the risk of the =!==. The =!=? are
the cash flows that remain for stockholders after the debt holders have been aid. Since
the =!=? are residual cash flows, they are riskier than the =!== and are therefore
discounted at a higher rate7the cost of equity.
18%/ Aou are valuing the equity of a comany using the =!=? aroach and have estimated
that the =!=? in the next five years will be K(.+-, K(.)(, K).<(, K).*-, and K*.1- million,
resectively. 'eginning in year (, you exect the cash flows to increase at a rate of ,
ercent er year for the indefinite future. Aou estimate that the cost of equity is 1,
ercent. 8hat is the value of equity in this comanyJ
)+
1olution<
The resent value of the cash flows exected over the next five years is
( )
( ) ( ) ( ) ( )
- , < > -
K(.+- K(.)( K).<( K).*- K*.1-
2E"=!== # H I I I I
1I+.1,
1I+.1, 1I+.1, 1I+.1, 1I+.1,
H K,-.(> million.
The terminal value is
( ) ( )
-
-
?
=!=? N 1I K*.1-N 1I+.+,
TE H H H K*<.1< million
& +.1,& +.+,
g
k g
2resent value of the terminal value is0
( ) ( )
-
- - -
?
TE K*<.1<
2E"TE # H H H K>).1) million.
1I 1I+.1, k
Therefore, if there are no nonoerating assets, the value of the equity is
E
=
H K,-.(> I K>).1) H =@+%81
18%> Aou are interested in investing in a rivate comany. 'ased on earnings multiles of
similar ublicly traded firms, you estimate the value of the rivate comany5s stock to be
K11 er share. Aou lan to acquire a ma4ority of the shares in the comany. The exected
control remium is 1+ ercent. Aou estimate the marketability discount for such a firm to
be ,+ ercent. The discount for the key erson, one of the founders who may leave the
firm uon your control of the firm, is 1- ercent. 8hat rice should you be willing to ay
for these sharesJ
1olution<
)1
Ealue er share H Share value N M"1 I !ontrol remium#N"1 G Farketability discount# N
"1 G @ey erson discount#
H K11N"1I1+Q#N"1&,+Q#N"1&1-Q#
H =8%++8
),