CHAPTER 18 Business Formation, Growth, and Valuation Learning Objectives 1. Explain why the choice of organizational form is important, and describe two financial considerations that are especially important in starting a business. 2. Describe the key components of a business plan, and explain what a business plan is used for. 3. Explain the three general approaches to valuation, and be able to value a business with commonly used business valuation approaches. 4. Explain how valuations can differ between public and private companies and between young and mature companies, and discuss the importance of control and key person considerations in valuation. I. Chapter Outline 1
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CHAPTER 18
Business Formation, Growth, and Valuation
Learning Objectives
1. Explain why the choice of organizational form is important, and describe two
financial considerations that are especially important in starting a business.
2. Describe the key components of a business plan, and explain what a business plan is
used for.
3. Explain the three general approaches to valuation, and be able to value a business
with commonly used business valuation approaches.
4. Explain how valuations can differ between public and private companies and
between young and mature companies, and discuss the importance of control and
key person considerations in valuation.
I. Chapter Outline
18.1 Starting 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.
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The founder of a company must start from scratch and make several critical
decisions including,
Choosing the product(s) to sell
Choosing the markets to sell them in
Choosing the best strategy for selling them
Raising the money necessary to develop the product(s)
Acquiring the necessary assets
Hiring the right people
As the business is being built, the founder must also manage the day-to-day
operations to ensure that his or her overall plan is being implemented.
A. Making the Decision to Proceed
According to the SBA, over 671,800 businesses were started in 2005 in the
United States, but less than 50 percent of them will still be in business by
2009.
Businesses fail for a number of different reasons including:
Lack of acceptance of the products by customers.
Poorly thought-out strategy
Poor management skills to properly execute a good strategy.
Underestimating how much money it will take to get their businesses up and
running.
Chances of succeeding in a business can improve if one
Does not jump into a business without careful thought.
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Doesn’t overanalyze opportunities to the point where you are just
convincing yourself not to proceed.
Takes on calculated risks.
Doesn’t think that failure will ruin your chances of ultimately achieving
business success.
B. Choosing the Right Organizational Form
In addition to the organizational forms discussed in Chapter 1—sole
proprietorship, partnerships, and corporations—two other forms of
organizations are discussed here. They are the limited liability companies
(LLC) and the S-corporation.
An LLC is a hybrid of a limited partnership and a corporation.
It was first developed in Wyoming in 1977.
Like a corporation, an LLC provides limited liability for the people who
make the business decisions in the firm while enabling all investors to
retain the tax advantages of a limited partnership.
Limited partnerships are more costly to form than sole proprietorships
because the partners must hire an attorney to draw up and maintain the
partnership agreement.
The lives of partnerships and LLCs are flexible.
Limited partners and LLCs are less constrained than general
partnerships because they can raise money from limited partners or
“members,” General partnerships can turn to all of the partners for
additional capital.
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An S-corporation is a variation of the C-corporation form that is used by
public corporations.
With approval from the IRS, any C-corporation can become an
S-corporation.
This change allows the stockholders to avoid double taxation but places
limits on the ownership of the firm’s stock.
All profits of an S-corporation pass directly to the stockholders as they
would pass to the partners in a partnership.
Currently, an S-corporation can have
o no more than100 stockholders
o only one class of common stock
o individuals who are U.S. citizens or residents as stockholders (no
corporations or partnerships can own shares).
A sole proprietorship is the least expensive type of business to start.
The life of a sole proprietorship is limited to the life of the proprietor.
Sole proprietorships must rely on equity contributions from the
proprietor and debt or lease financing.
Forming a corporation also requires hiring an attorney to draft a document that
spells 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.
Corporations, which are “legal persons” under state law, automatically
have an indefinite life.
C-corporations can have an unlimited number of stockholders.
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Exhibit 18.1 provides a comparison of these common forms of business
organization on a number of different dimensions.
C. Financial Considerations
Two tools are particularly useful in understanding the cash requirements of a
business and in estimating how much financing a new business will require—
cash flow break-even analysis and the cash budget.
It is important for an entrepreneur to understand the concept of cash flow break-
even and how to calculate this point for each product a business produces.
This calculation focuses the entrepreneur’s attention on the importance
of maximizing a product’s per unit contribution and minimizing its
associated overhead costs.
It also provides a means of estimating how long it will take for a product
to reach the break-even point and, therefore, how much money will be
needed to launch a new product or business.
The cash budget is also a very useful planning tool for entrepreneurs. It
summarizes the cash flows into and out of a firm over a period of time.
Cash budgets often present the inflows and outflows on a monthly
basis but can be prepared for any period, including daily or weekly.
Preparing a cash budget helps an entrepreneur better understand where
money is coming from, where it is going, and how much external
financing is likely to be needed and when.
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Knowing how much external financing is likely to be needed and
when helps the entrepreneur plan fund-raising efforts before it is too
late.
18.2 The Role of the Business Plan
A. The Business Plan
The entrepreneur must convince potential investors that purchasing debt or
equity in the firm will yield attractive returns.
To overcome the skepticism of outside investors, many entrepreneurs prepare
a business plan.
A business plan is like a road map for a business in that it presents results
from a strategic planning process that focuses on how the business will be
developed over time.
A well-prepared business plan makes it easier for an entrepreneur to
communicate to potential investors precisely what he or she expects the
business to look like in the future, how he or she expects to get it to that point,
and what returns an investor might expect to receive.
A business plan is a tool that
can help raise capital
can help an entrepreneur set the goals and objectives for the company,
serve as a benchmark for evaluating and controlling the company’s
performance, and
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communicate the entrepreneur’s ideas to managers, outside directors,
customers, suppliers, and others.
B. The Key Elements of a Business Plan
A well-developed business plan includes the following:
An executive summary, which summarizes the key issues presented in the
report.
A market analysis, which discusses the industry and highlights the
important characteristics of the industry as they relate to the company.
A company overview, which describes what the company does and what
its comparative advantages are.
A detailed description or the product(s) and services the company will
sell, its current state of development or market penetration, competitive
advantages, product life cycle, and any patents or legal protections that
might provide a competitive advantage.
A 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.
A detailed discussion of the operations of the business.
Detailed information on the management team and ownership of the
business.
A detailed discussion of capital requirements and uses.
A business plan also presents historical financial results when they are
available and financial forecasts.
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The end of a business plan often includes appendixes, which contain
information providing detailed support for the analyses that are presented
earlier in the report.
18.3 Valuing a Business
The value of a business is determined by the magnitude of the cash flows that it
is expected to produce, the timing of those cash flows, and the likelihood that
the cash flows will be realized.
A. Fundamental Business Valuation Principles
There are two important valuation principles.
The first principle is that the value of a business changes over time.
The second valuation principle is that there is no such thing as the
value for a business.
The value of a business changes over time because
Changes 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 expected to generate in the future.
Actions by competitors also affect the value of a business.
The investment, operating, and financing decisions made by managers
also affect the value of a business.
The value of a business can be different to different investors.
A strategic investor is one who has an interest in acquiring the business.
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o The investment value 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.
A financial investor, on the other hand, is only interested in financial
performance of the firm and not in acquiring the business.
o Their valuation, known as the fair market value, will be lower
than that of the strategic investor.
B. Business Valuation Approaches
Business valuation methods can be classified into one of three general
categories: (1) cost approaches, (2) market approaches, and (3) income
approaches.
C. Cost Approaches
Two cost approaches that are commonly used are replacement cost and
adjusted book value.
The replacement cost of a business is the cost of duplicating the assets of
the business in their present form as of the valuation date.
The replacement cost valuation approach is generally used to value
individual assets within a business when they are being insured.
When using the replacement cost approach in a buy-versus-build
analysis, you must include the cost of all tangible assets and all
intangible assets.
You must also include the cost of hiring the people necessary to run the
business and the time that it would take to build the business.
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The timing of the cash flows is very important and must be taken into
consideration because, generally, acquired businesses lead to quicker
cash flows.
The adjusted book value approach 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 separately,
and the total value of the business is then obtained by summing the fair
market values of the individual assets.
An adjusted book value analysis should include all tangible and
intangible assets.
The adjusted book value approach is useful in valuing holding companies
whose main assets are publicly traded or other investment securities but is
generally less applicable for operating businesses.
The value of an operating business is usually greater than the sum of its
individual assets, and the excess value is called the “going concern”
value.
The going-concern value of an asset reflects the value associated
with additional future cash flows the business produces because
of the way in which the individual assets are managed together.
The adjusted book value approach is useful in estimating a floor value
for a business under certain circumstances: (1) it is especially difficult
to forecast the cash flows that a business is likely to produce, (2) you
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suspect that the going-concern value of the business is negative, and
(3) liquidation is being explicitly considered.
D. Market Approaches
Two market approaches that are commonly used are multiples analysis and transactions
analysis.
Multiples analysis uses stock price or other value multiples that are
observed for public companies to estimate the value of a company’s stock
or an entire business.
The process calls for:
identifying publicly traded companies engaged in business activities
that are similar to those of the company being analyzed, and
using the prices at which shares of those comparables are trading,
along with accounting data, to estimate the value of the company of
interest.
This approach is often used to help price a company’s shares for an IPO,
or when all of its shares are being sold privately to investors.
Price/earnings (P/E) and price/revenue multiples (ratios) are commonly
used to directly estimate the value of the stock in a company.
Analysts either use the average multiple from other publicly held peers, or
a multiple from a single comparable company to estimate the value of the
company of interest.
While doing a multiples analysis, one needs to be aware of certain issues.
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When using multiples of publicly held firms to value one that is not,
one should be aware of the presence of a marketability discount that
can be sizable.
Identifying one or more comparable firms is not an easy task.
When using the multiple of a comparable firm, one needs to be aware
of differences in the capital structures of the firms being compared.
You are estimating a fair market value, not the investment value.
It is important to make sure that the numerator and the denominator of
the ratio you are using are consistent with each other.
The data used to compute the multiple for the comparable company
should include the stock price as of the valuation date and accounting
data from the same period for which you have accounting data for the
company of interest.
In the transaction approach, analysts use the information on what
someone has paid for a comparable company in a merger or an acquisition
to estimate a value for the firm.
This transaction information is used to compute the same types of
multiples that are used in a multiples analysis, and these multiples are used
in the same way to value the company of interest.
Since transaction data reflects the price that a particular investor paid for
an entire company, it provides an estimate of the investment value to that
investor.
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Transaction information is obtained from the financial statements of
public companies that have acquired other companies or from services that
collect and sell this type of information.
It is difficult to use this approach in practice for several reasons.
Transactions data are not typically as reliable as the data available for
multiples analysis, especially when they are associated with a private firm.
Transactions involving the purchase 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.
E. Income Approaches
The most direct approaches for estimating the value of the cash flows a
business is expected to produce are the income approaches, which, like NPV
analysis, directly estimate the value of those cash flows.
These approaches provide the intrinsic value for the firm, which can be
different from the market value.
While market value reflects what people are willing to pay for the
firm, the intrinsic value reflects what the firm is truly worth.
There are a couple of things to consider when using the income approach
First, unlike the case with projects, it is difficult to estimate the life of
a business.
Second, businesses often have cash or other assets that are not necessary
for operations that can complicate the valuation.
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These assets will be identified as nonoperating assets; Equation
18.2 shows how these factors are taken into consideration when
valuing the firm using an income approach.
In the free cash flow from the firm (FCFF) approach, an analyst values the
free cash flows that the assets of the firm are expected to produce in the
future.
The present value of these cash flows equals the total value of the firm, or
its enterprise value.
We do not include the cash necessary to pay short-term liabilities that
do not have interest charges associated with them, such as accounts
payable and accrued expenses.
The costs associated with these non-interest-bearing current
liabilities, which are included in the firm’s cost of sales and
other operating expenses, are subtracted in the calculation of
FCFF.
Exhibit 18.3 shows how to determine the value of FCFF.
In this approach the total value of the firm, VF, is computed as the
present value of the FCFF, discounted by the firm’s WACC.
When analysts use the WACC approach to value a business, they must
make an assumption about how the firm’s operations will be financed
in the future.
The free cash flow to equity (FCFE) approach uses only the portion of the
cash flows that are available for distribution to stockholders.
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Stripping out the cash flows to or from the lenders leaves the cash flows
available to stockholders.
Three specific cash flows associated with lenders are not included: the
interest expense on existing debt, the repayment of debt principal, and
the proceeds from new debt issues.
Exhibit 18.6 shows how FCFE is calculated.
In using the FCFE valuation approach, the cost of equity, kE, is used to
discount the residual cash flows as shown in Equation 18.4.
The dividend discount model (DDM) approach estimates the value of
equity directly by discounting cash flows to stockholders.
In contrast to the FCFE approach which values cash flows that are
available for distribution to stockholders, the DDM approach values
the stream of cash flows that stockholders expect to receive through
dividend payments.
Recognize that the firm may or may not be expected to
distribute all available cash flows in any particular year.
The constant-growth dividend model, Equation 9.4, is an example of a
DDM.
However, only some firms have a constant growth.
More often, use of the DDM approach involves discounting
dividends that either do not begin until some point in the
future or that are currently growing at a high rate that is not
sustainable in the long run.
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18.4 Important Issues in Valuation -Public versus Private Companies
A. Financial Statements
Incomplete and unreliable financial statements can complicate the process
of valuing a private business, making it more difficult to accurately assess
its value.
Some private companies have complete, audited financial statements, while
others have incomplete financial statements that are not prepared in
accordance with the GAAP.
All public companies are required to file audited financial statements
with the SEC.
In contrast to the financial statements of publicly held firms, private
company financials often include personal expenses of the owner and
excess compensation expenses.
B. Marketability
The shareholder of a private firm may have to spend considerable resources
(both money and time) to sell his or her shares.
The shareholders of publicly held firms find it much easier to liquidate their
holdings.
The higher transaction costs associated with the stock at the private firm
will result in a lower price for that investment.
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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. Young versus Mature Companies
Young, rapidly growing companies tend to be more difficult to value than
mature, stable companies.
One factor that makes it more difficult to value a young company is that
less reliable historical information is available.
Another factor is that the future of a young, rapidly growing company is
often less certain than that of a mature company because much of the
young company’s future growth depends on investment, operating, and
financing decisions that have not yet been made.
Without profits, it is difficult to use earnings multiples to value the
business, leaving price/revenue or enterprise value/revenue multiples as
the only viable alternatives for a multiples analysis.
In order to grow, many young companies have to invest a considerable
amount of money.
The cash flows will be negative until the business becomes profitable and
its investment expenditures are less than those profits.
This means that the positive cash flows, which represent the value of
the business, are further into the future and are, therefore, less certain.
D. Control
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Another important issue that must be considered when valuing a business is
whether a controlling ownership interest or a minority interest is being
valued.
The amount of stock that is required for an investor to exercise control can
vary depending on the ownership structure of the company.
Whether a controlling ownership interest is being sold has important
implications for a valuation analysis.
An adjustment must be made to reflect the benefits of control if one used
multiples based on public stock market prices to estimate the value of a
controlling interest.
Similarly, when you use an income approach to value a business, the cash
flow forecasts and discount rate assumptions will differ depending on
whether you are valuing a minority or a controlling ownership interest.
A discount rate based on CAPM might be too high for a valuation that
involves a controlling position.
To adjust for the effects of an incorrect discount rate and for any
possible cash flows that are not reflected in a valuation based on an
income approach, analysts add a control premium.
E. Key People
Analysts must also consider whether it is appropriate to adjust the
estimated value of the business for the likelihood that these “key people”
may not remain with the firm as long as expected.
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If an analyst believes that those customers may go to another firm if the
CEO departs, then a key person discount may be appropriate.
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II. Suggested and Alternative Approaches to the Material
The earlier chapters discussed how businesses are organized and how financial managers make
long-term investment decisions, manage working capital requirements, and finance the
investments and activities of their businesses. In this chapter these concepts are reexamined in
the context of a discussion of business formation, growth, and valuation. This chapter provides
an integrated perspective on how financial managers’ decisions affect firm value.
The authors begin by considering the decision by an entrepreneur to start a business and
how the business should be organized. They then discuss financial considerations that must be of
concern to managers of young, rapidly growing firms.
Next, they focus on the role that a carefully prepared business plan plays in raising capital
for a young, rapidly growing business and in providing a road map of where the business is
going for use in managerial decision making. The last two sections of this chapter address business
valuation concepts. The discussions in these sections provide a broad overview of the business valuation
approaches that financial managers use and how differences in the characteristics of public and private
companies and of young, rapidly growing, and mature companies affect valuation analyses. The impact
of control considerations and key people on business valuations is also considered.
This chapter is an ideal way to complete a semester’s discussion on the principles of finance and
how they apply in a corporate context. The instructor is encouraged to use the end–of-chapter material to
help convey the information to the students because the material is consistent with the approach in
previous chapters in providing a variety of questions, yet allowing for repetition to benefit the
students.
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III. Summary of Learning Objectives
1. Explain why the choice of organizational form is important, and describe two
financial considerations that are especially important in starting a business.
The choice of organizational form is important because it affects the returns from a
business in a number of ways. For example, it affects the cost of getting started, the life
of the business, management’s ability to raise capital and grow the business, the control
of the business, the ability to attract and retain good managers, the exposure of the
investors to liabilities, and the taxes that are paid on the earnings of the business.
Two especially important financial considerations are the cash flow break-even
point for the business and its overall cash inflows and outflows. The cash flow break-
even point is important because it represents the level of unit sales that must be achieved
in order for the business to break even on a cash flow basis. Entrepreneurs 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 helps with this understanding.
2. Describe the key components of a business plan, and explain what a business plan is
used for.
The key components of a business plan include the executive summary, a company
overview (a description of the company’s products and services), a market analysis, a
discussion of marketing and sales activities, a discussion of the businesses operations, a
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discussion of the management team, the ownership structure of the firm, capital
requirements and uses, and financial forecasts. (AU: Changes made per text p. 616, ok?)
A business plan helps an entrepreneur set the goals and objectives for a company,
serves as a benchmark for evaluating and controlling the company’s performance, and
helps communicate the entrepreneur’s ideas to managers and others (including investors)
outside the firm.
3. Explain the three general approaches to valuation, and be able to value a business
with using commonly used business valuation approaches.
The three general valuation approaches are (1) cost approaches, (2) market approaches,
and (3) income approaches. Cost approaches commonly used in business valuation are
the replacement cost and adjusted book value approaches. The market approaches are
multiples analysis and transactions analysis. Three key income approaches are the free
cash flow from the firm, free cash flow to equity, and dividend discount approaches. The
application of these approaches is discussed in Section 18.3.
4. Explain how valuations can differ between public and private companies and between
young and mature companies as well as the importance of marketability, control,
and key person considerations in valuation.
Valuations differ between public and private companies for a number of reasons. Two
reasons discussed in this section are that the quality of the financial statements and the
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marketability of the securities being valued can differ considerably. Marketability is
important because it affects the price that investors are willing to pay for a security. The
less marketable a security is, the lower the price investors will be willing to pay.
Young, rapidly growing companies tend to be more difficult to value than mature
companies because there is less reliable historical information on young companies and
their futures tend to be less certain.
Control is an important consideration in business valuation because having
control of a business provides an investor with more flexibility with regard to how he or
she will manage the business. Investors value this flexibility and will, therefore, pay more
for a controlling interest in a company.
If the cash flows that a business is expected to generate depend heavily on certain
employees, those employees are key people. When valuing a business, an analyst must
account for the possibility that the key people will unexpectedly leave the company and
must consider the associated impact on the company’s cash flows.
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IV. Summary of Key Equations
Equation Description Formula
18.1 Price/earnings multiple based on constant-growth model
18.2 Implementing the income approach to business valuation
VF = PV(FCFT) + PV(TVT) + NOA
18.3 FCFF approach
18.4 FCFE approach
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V. Before You Go On Questions and Answers
Section 18.1
1. What are three general reasons that new businesses fail?
Businesses fail for a variety of reasons. In some cases, a firm’s product(s) may find no
demand among consumers. For 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 operate the business and are unable to raise more.
2. How do financing considerations affect the choice of organizational form?
Of all the different forms of organizations, the sole proprietor takes the least amount of
money to set up and is only dependent on the founder’s money. Forming a partnership is
more involved and costs more. Setting up as a corporation is the most expensive and calls
for a more active role by attorneys to set up the organization.
3. How does a cash budget help an entrepreneur?
The cash budget is also a very useful planning tool for entrepreneurs. It summarizes the
cash flows into and out of a firm over a period of time. Cash budgets often present the
inflows and outflows on a monthly basis but can be prepared for any period, including
daily or weekly. Preparing a cash budget helps an entrepreneur better understand where
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money is coming from, where it is going, and how much external financing is likely to be
needed and when. Understanding where the money is coming from and where it is going
helps an entrepreneur maintain control of the company’s finances. Knowing how much
external financing is likely to be needed and when helps the entrepreneur plan fund-
raising efforts before it is too late.
Section 18.2
1. Why is a business plan important in raising capital for a young company?
A well-prepared business plan makes it easier for an entrepreneur to communicate to
potential investors precisely what he or she expects the business to look like in the future,
how he or she expects to get it to that point, and what returns an investor might expect to
receive. This allows potential investors to get a feel for the strategic plan of the firm and
also allows them to gauge the management ability of the entrepreneur.
2. What else can a business plan be used for?
A business plan is a tool that
can help raise capital
can help an entrepreneur set the goals and objectives for the company,
serve as a benchmark for evaluating and controlling the company’s
performance, and
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communicate the entrepreneur’s ideas to managers, outside directors,
customers, suppliers, and others.
3. Why is it important to discuss the qualifications of the management team in a business
plan.
The discussion of the qualification of the management team is especially important when
it comes to raising capital. Investors in young businesses invest in the key people as much
as in the business idea itself.
Section 18.3
1. Why is it important to specify a valuation date when you value a business?
One of the most important principles 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 managers—all affect the value of
the cash flows that a business is expected to generate in the future. Actions by
competitors also affect the value of a business. The investment, operating, and financing
decisions made by managers also affect the value of a business. Given this, it is important
to specify a valuation date when valuing a business. This is the date as of which the value
estimate is current.
2. What is the difference between investment value and fair market value?
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A strategic investor is one who has an interest in acquiring the business. The investment
value 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 fair market value is the valuation arrived by an investor who is
only interested in the financial performance of the firm and not in acquiring the business.
The fair market value will be lower than that of the strategic investor.
3. What are the two market approaches that can be used to value a business, and how do
they differ?
Two market approaches that are commonly used are multiples analysis and transactions
analysis. Multiples analysis uses stock price or other value multiples that are observed
for public companies to estimate the value of a company’s stock or an entire business.
In the transaction approach analysts use the information on what someone has paid for
a comparable company in a merger or an acquisition to estimate a value for the firm.
4. What is a nonoperating asset, and how are such assets accounted for in business
valuation?
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Nonoperating assets (NOA) are assets like cash or other assets that are not essential for
operations. As Equation 18.3 shows, when valuing a business, the net operating assets are
included in the cash flows that are discounted to arrive at the present value of a firm.
5. What are three income approaches used to value a business?
The three income approaches to valuing a business are free cash flow from the firm (FCFF),
free cash flow to equity (FCFE), and dividend discount model (DDM). In the free cash
flow from the firm (FCFF) approach, an analyst values the free cash flows that the assets
of the firm are expected to produce in the future. The free cash flow to equity (FCFE)
approach uses only the portion of the cash flows that are available for distribution to
stockholders. The dividend discount model (DDM) approach estimates the value of
equity directly by discounting cash flows to stockholders.
6. What is the difference between FCFE and dividends?
The FCFE is an estimate of all cash flows available for distribution to shareholders of the
firm. Recognize that not all of this will be distributed to stockholders as dividends. Thus,
FCFE includes both dividends and retained earnings, the portion not distributed to
shareholders but reinvested in the firm.
Section 18.4
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1. How might financial statements for private companies differ from those for public
companies?
Some private companies have complete, audited financial statements, while others have
incomplete financial statements that are not prepared in accordance with the GAAP. All
public companies are required to file audited financial statements with the SEC.
In contrast to the financial statements of publicly help firms, private company financials
often include personal expenses of the owner and excess compensation expenses.
2. Why is marketability an important issue in business valuation?
The shareholders of a publicly held company 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 simple call to a broker will take care of it. In contrast, the shareholders of a
privately held firm will have to spend 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.
3. What is a key person?
If the cash flows that a business is expected to generate depend heavily on the retention
of a particular individual or group of individuals, then that individual or group can be
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referred to as key people. The survival of the firm is dependent on the continued
employment of this individual or group.
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VI. Self-Study Problems
18.1 Your sister wants to open a store that sells antique-style jewelry and accessories. She has
$15,000 of savings to invest, but opening the store will require an initial investment of
$20,000. Net cash inflows will be −$2,000, −$1,000, and $0 in the first three months. As
the store becomes better known, net cash inflows will become +$500 in the fourth month
and grow at a constant rate of 5 percent in the following months. You want to help your
sister by providing the additional money that she needs. How much money do you have
to invest each month to start and to keep the store operating with a minimum cash balance
of $1,000?
Solution:
You will have to invest in $5,000 initially for her business to start (the difference between
$20,000 and $15,000). You will then need to invest an additional $3,000 in the first
month to cover the cash flow of -$2,000 and to establish a cash balance of $1,000.
Another $1,000 will be required in the second month to cover the negative cash flow that
month. Since cash flows will be positive beginning in the third month, you will not have
to invest any additional funds after the second month.
18.2 You have the following information for a company you are valuing and for a comparable
company:
Comparable company: Company you are valuing:
Stock price = $23.45 Value of debt = 3.68 million
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Number of shares outstanding = 6.23 million Est. EBITDA next year = $4.4 million
Value of debt = $18.45 million Est. income next year = $1.5 million
Est. EBITDA next year = $17.0 million
Est. income next year = $5.3 million
Estimate the enterprise value of the company you are evaluating using the P/E and
enterprise value/EBITDA multiples.
Solution:
The P/E and enterprise value/EBITDA multiples for the comparable company are:
P/EComparable = Stock price/Earnings per share = $23.45/($5.3/6.23 shares)