608 Making Key Strategic Decisions arrive at a proper value of ACME. This methodology determines the earn- ings of ACME without regard to its debt service. Thus, net income on a debt- free basis will be higher than the company’s net income, which typically includes interest expense. The resulting higher value using the debt-free methodology is not only for equity holders but also debt holders. This com- bined value of equity and debt is known as the market value of invested capital (MVIC). Once the value of ACME’s MVIC is determined, then the value of debt capital is subtracted resulting in the value of ACME’s equity. Victoria summarizes this concept for Bob. The debt-free methodology results initially in the combined value of equity and debt (total invested capital) of the busi- ness. Interest bearing debt is then subtracted to determine the value of the company’s equity. This methodology is more complicated but it is frequently necessary to obtain a correct valuation when the business’s debt and equity blend is not optimal. ADJUSTMENTS TO EARNINGS FOR VALUATION PURPOSES As previously mentioned, financial statements of private companies sometimes do not reflect the true profitability. Victoria tells Bob that valuation adjust- ments to the financial statements are sometimes necessary. These adjustments fall into two categories. The first type of adjustment is the elimination of unusual or nonrecurring items. These adjustments eliminate the effect of past events that are not expected to occur again in the future, such as a profit center that has been eliminated, legal expenses that were in- curred to defend an extraordinary lawsuit, or a nonrecurring capital gain from the sale of an asset. A buyer of the business does not expect these items to recur in the future and, therefore, they are eliminated. The second type of ad- justment are the economic adjustments. These include adjustments to expenses that are not reflected at their market values, such as the officers’ compensa- tion being paid at an above-market amount, the company’s rent expense being paid on a shareholder-owned building at an amount different than market rent, or the shareholder’s extra perquisites being expensed by the business. In addi- tion, some closely held businesses fail to report all of their revenues and these amounts should be considered in the adjustments. Any expenses related to non- operating assets (e.g., a ski condominium) would also be eliminated. After the valuator identifies the adjustments, the reported earnings of the company are modified to reflect the economic earnings of the business on an ongoing basis. In the case of ACME, Victoria determines that officers’ compensation ac- tually being paid is in excess of the amount the business would need to pay by re- placing the family members. Thus, officers’ compensation expense is reduced to the market level and earnings increased accordingly. In addition, Bob owns some of the factory locations personally. Victoria also determines that ACME is not Business Valuation 609 paying market rents to Bob, and she makes the corresponding adjustment to rent expense. As reflected in Exhibit 18.2, ACME has elected to be treated as an S corporation for income tax purposes. Thus, ACME does not pay income taxes since the income is reported on Bob’s personal income tax return. Bob pays the income taxes instead of the corporation. Victoria determines that the most likely buyer of ACME would be a large corporation that would not be able to maintain ACME’s S corporation tax status. (The most likely buyer is a C corporation that pays its own taxes.) Therefore, Victoria makes an economic adjustment to ACME’s pro forma income statement to include income tax expense. The after- tax income is what a typical buyer expects to earn from purchasing this business. After these adjustments are made on a pro forma income statement, the result indicates ACME’s true profitability to a typical buyer of the business. Once Victoria determines ACME’s actual earnings base, she continues her appraisal by applying the most appropriate valuation methodologies for the business. INCOME APPROACH: DISCOUNTED CASH FLOW METHOD As previously discussed, the income approach is based on the concept that the value of an asset today represents its perceived future benefits discounted to present value. Victoria uses the discounted cash flow (DCF) methodology in her valuation. This method forecasts ACME’s cash flows into the future and discounts them to their present value. In addition, this method assumes that ACME will be sold at some point in the future and the owner will receive the sales proceeds at that time. The estimated future sales price, also know as the residual value (or terminal value), is also discounted back to present value. The sum of the present values of future cash flows and the residual value are added together to determine the value of ACME. This concept is summarized here: This methodology can be applied to different forms of earnings—net in- come, cash flow to equity holders, or debt-free cash flow. Many business valu- ators prefer to use cash flows as the earnings base rather than net income because it is cash flow that is available for shareholder distributions. As previ- ously discussed, cash flows may be determined after the inclusion of debt costs (referred to as equity net cash flow) or on a debt-free basis (referred to as in- vested capital net cash flow). The formulas for these types of cash flows are presented below. The use of either type of cash flow is valid when the appro- priate discount rate is applied in the DCF model. Discounted Cash Flow Valuation Method (simplified) Annual future cash flows, discounted to present value Future residual value of the company, discounted to present value Value (today) + = 610 Making Key Strategic Decisions A common error in the income approach to valuation is improperly match- ing the income stream and discount rate. The equity net cash flow represents the return on investment to the equity holders. Thus, the appropriate discount rate in the DCF model is the company’s cost of equity. The invested capital net cash flow is the rate of return to all holders of invested capital and, therefore, the company’s weighted average cost of capital should be used. Projected Financial Statements Management of ACME prepared a financial projection and discusses it and the underlying assumptions with Victoria. Management’s financial projections are presented in Exhibits 18.5, 18.6, and 18.7. Key assumptions incorporated into the projections include: • Sales would grow 12% in 2001 and 2002, 11% in 2003 and 2004, and 10% in 2005. • Costs of goods sold are 69% of sales. • Operating expenses (exclusive of officers’ salaries) are 12% of sales. • Officers’ salaries (at market) are 3.1% of sales. • The 2001 capital expenditures are $2.8 million and increase thereafter 5% per year. • The company needs a minimum cash balance of $200,000. Invested Capital Net Cash Flow After-tax net income + Depreciation and amortication (noncash) expenses − Capital expenditures − Increases (or + decreases) in working capital requirements + Interest expense × (1 minus tax rate) = Net cash flow to holders of total invested capital (debt and equity) Equity Net Cash Flow After-tax net income + Depreciation and amortization (noncash) expenses − Capital expenditures − Increases (or + decreases) in working capital requirements + Increases (or − decreases) in long-term debt = Net cash flow to equity holders Application of DCF Model Type of Type of Income Stream Discount Rate Equity net cash flow Cost of equity Invested capital net cash flow Weighted average cost of capital Business Valuation 611 • The dividend payout ratio (the amount of cash flows actually distributed to shareholders; the remainder is reinvested in the company) ranges from 55% to 65% per year. Residual Value The DCF valuation methodology assumes the company will be sold at some point in the future and the business owner will receive the proceeds. Victoria assumes ACME will be sold five years in the future, on December 31, 2005. (Five years is common among analysts for established businesses. Start-up businesses may require financial projections for a longer period such as 10 years until the company’s earnings become stable.) The value of a company at the end of the financial forecast is the residual value. The residual value of EXHIBIT 18.5 ACME Manufacturing Inc.: Projected income statements 2001–2005. ($million) Pro Forma 2001 2002 2003 2004 2005 Revenue $50.29 $56.32 $63.08 $70.02 $77.72 $85.50 Cost of goods sold 34.58 38.86 43.53 48.32 53.63 58.99 Gross profit 15.70 17.46 19.56 21.71 24.09 26.50 Operating expenses 5.95 6.76 7.57 8.40 9.33 10.26 Officers’ salary 1.54 1.75 1.96 2.17 2.41 2.65 Depreciation & amortization 1.00 0.88 1.01 1.14 1.28 1.43 Interest expense 0.84 1.04 1.10 1.14 1.21 1.28 Operating profit 6.37 7.03 7.92 8.85 9.87 10.88 Other expenses/(income) (0.30) (0.21) (0.21) (0.21) (0.21) (0.21) Income before taxes 6.66 7.24 8.13 9.06 10.08 11.09 Income taxes 2.67 2.90 3.25 3.63 4.03 4.44 Adjusted net income $4.00 $4.34 $4.88 $5.44 $6.05 $6.65 Common Size Pro Forma 2001 2002 2003 2004 2005 Revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Cost of goods sold 68.8 69.0 69.0 69.0 69.0 69.0 Gross profit 31.2 31.0 31.0 31.0 31.0 31.0 Operating expenses 11.8 12.0 12.0 12.0 12.0 12.0 Officers’ salary 3.1 3.1 3.1 3.1 3.1 3.1 Depreciation & amortization 2.0 1.6 1.6 1.6 1.6 1.7 Interest expense 1.7 1.8 1.7 1.6 1.6 1.5 Operating profit 12.7 12.5 12.6 12.6 12.7 12.7 Other expenses/(income) −0.6 −0.4 −0.3 −0.3 −0.3 −0.2 Income before taxes 13.2 12.9 12.9 12.9 13.0 13.0 Income taxes 5.3 5.1 5.2 5.2 5.2 5.2 Adjusted net income 8.0% 7.7% 7.7% 7.8% 7.8% 7.8% 612 Making Key Strategic Decisions ACME is estimated based on the net cash flows in 2005 and then increasing them by the estimated sustainable (long-term) earnings growth rate. For the projection’s final year, items such as interest expense and depreciation need to be stated at their stabilized ongoing amounts since the hypothetical new buyer at December 31, 2005, is expecting to receive a stabilized annual net cash flow using this residual value methodology. The result of this portion of the DCF analysis is the estimated net cash flows someone would expect ACME to earn in 2006. The presumption is that the company will be sold at the end of 2005, its earnings have stabilized, and a new owner can expect to receive the 2006 cash flows. A multiple is applied to ACME’s estimated 2006 net cash flow in order to determine the residual value at the end of 2005. The multiple is based on the inverse of the company’s weighted average cost of capital less the estimated sustainable long-term earnings growth rate. This is called a capitalization rate (or capitalization factor) and is illustrated: Capitalization rate Discount rate Sustainable long-term earnings growth rate Price-earnings (P/E) multiple Capitalization rate =− = 1 EXHIBIT 18.6 ACME Manufacturing Inc.: Projected invested capital net cash f lows 2001–2005. ($million) 2001 2002 2003 2004 2005 Projected after-tax income $4.35 $4.88 $5.44 $6.05 $6.65 Projected interest expense 1.04 1.10 1.14 1.21 1.28 Tax shield of interest expense (0.42) (0.44) (0.45) (0.48) (0.51) Common stock dividend adjustment (0.30) (0.26) — — — Projected depreciation/amortization 0.88 1.01 1.14 1.29 1.43 After-tax gross cash flow to invested capital 5.55 6.28 7.26 8.06 8.86 ± Increase/decrease in working capital (excluding interest-bearing ST debt) (0.54) (0.63) (0.65) (0.72) (0.73) ± Increase/decrease in investments (2.80) (2.94) (3.09) (3.24) (3.40) ± Increase/decrease in other assets (0.13) (0.15) (0.16) (0.18) (0.20) ± Increase/decrease in other liabilities ————— Cash available for financing 2.08 2.57 3.37 3.92 4.53 − Preferred stock dividends ————— Net cash flow 2.08 2.57 3.37 3.92 4.53 + Beginning cash balance 0.04 0.20 0.20 0.20 0.20 Preliminary cash available 2.12 2.77 3.57 4.12 4.73 − Minimum required cash balance (0.20) (0.20) (0.20) (0.20) (0.20) Available for dividend to invested capital, net free cash flow $1.92 $2.57 $3.37 $3.92 $4.53 Business Valuation 613 Required Discount Rate (Rate of Return) As previously discussed, since ACME is being analyzed on a debt-free basis, Victoria uses the weighted average cost of capital (WACC) as the discount rate. The WACC incorporates the cost of debt and the cost of equity using market evidence and weights them based on capital structure. Each element of the weighted average cost of capital as it applies to ACME is discussed in the fol- lowing sections. Cost of Equity As discussed earlier in this chapter, an investor has many places to invest his or her funds. A rational investor expects a higher rate of return when an invest- ment carries more risks. In developing ACME’s rate of return on equity capi- tal, Victoria uses the modified capital asset pricing model (CAPM) that is defined as: Equity rate of return Risk-free rate Equity risk premium Beta) Size risk premium Specific company risk premium =+ × ++ ( EXHIBIT 18.7 ACME Manufacturing Inc.: Projected balance sheets 2001–2005. Adjusted ($million) 2000 2001 2002 2003 2004 2005 Cash $ 0.04 $ 0.20 $ 0.20 $ 0.23 $ 0.24 $ 0.40 Accounts receivable 6.87 7.69 8.61 9.55 10.61 11.67 Inventory 4.45 4.98 5.58 6.19 6.88 7.56 Other current assets 0.34 0.38 0.42 0.47 0.52 0.57 Total current assets 11.69 13.24 14.81 16.44 18.24 20.20 Fixed assets 14.34 17.14 20.08 23.16 26.40 29.80 Accumulated depreciation (2.94) (3.82) (4.83) (5.97) (7.26) (8.69) Net fixed assets 11.40 13.32 15.25 17.19 19.15 21.12 Other assets 1.33 1.47 1.61 1.77 1.95 2.15 Total assets $24.42 $28.03 $31.67 $35.41 $39.34 $43.46 Accounts payable $ 4.55 $ 5.12 $ 5.74 $ 6.37 $ 7.07 $ 7.77 Notes payable — 0.30 0.26 — — — Current portion LTD 4.58 3.28 3.45 3.63 3.85 4.07 Other current liabilities 2.37 2.66 2.97 3.30 3.66 4.03 Total current liabilities 11.50 11.35 12.42 13.29 14.58 15.87 Long-term debt 5.83 7.65 8.04 8.46 8.98 9.49 Total liabilities 17.33 19.00 20.46 21.75 23.57 25.36 Equity 7.09 9.03 11.21 13.66 15.77 18.10 Total liabilities & equity $24.42 $28.03 $31.67 $35.41 $39.34 $43.46 614 Making Key Strategic Decisions Investments in closely held businesses are widely considered to be long- term rather than short-term investments. Accordingly, the risk-free rate, the first element in the modified CAPM, is based on the 20-year U.S. Treasury bond yield as of the valuation date. U.S. Treasuries are considered risk-free in- vestments and the 20-year bond is considered a long-term investment bench- mark for purposes of valuing closely held businesses. At the valuation date, the risk-free rate is 6.4%. Victoria explains that the second element of the modified CAPM is the equity risk premium. The equity risk premium is the additional rate of return investors in stocks require above a risk-free rate of return because of the higher risks of investing in equities. Ibbotson Associates of Chicago, Illinois, has performed annual empirical studies of the equity risk premium that in- vestors have received dating back to 1926. As of ACME’s valuation date, the historic equity risk premium since 1926 has been 8.1% above the risk-free rate. Again, since investments in closely held businesses are considered long term, the equity risk premium is also measured on a long-term basis. The CAPM uses the sensitivity of a company (investment) as compared to swings in the overall investment market. The risk that is common to all invest- ment securities that cannot be eliminated through diversification is called sys- tematic risk. When using CAPM, the systematic risk of a particular investment is measured by beta. Beta is a measure of the relationship between the returns on an individual investment and the returns of the overall market as typically measured by an index such as the Standard & Poor’s 500. For example, the market prices of some investments have a tendency to rise and fall faster than the overall market. The base measure of beta is 1.0. When an investment’s beta is greater than 1.0, its returns have tended to be more than the market re- turns. Also, the investment’s losses have tended to be greater than the market’s losses. An investment with a beta of less than 1.0 has had returns that tend to be less than the market returns. In summary, beta measures an investment’s return volatility as compared to the overall market. If an investment has a beta greater than 1.0, its returns are more volatile and carry more risk than the market. If beta is less than 1.0, its returns are less volatile and carry less risk than the market. One way to estimate the beta of a closely held company is to use the aver- age beta of guideline publicly traded companies. Beta is a coefficient used by financial analysts that adjusts the general equity risk premium to a specific in- vestment in the CAPM. A complete discussion of beta is beyond the scope of this chapter but it is widely available in finance literature. The beta of publicly traded companies is generally available from investment publications and from empirical studies such as the one conducted by Ibbotson Associates. Victoria’s research analysis indicates the average beta of publicly traded companies in ACME’s industry is 0.99 as of the valuation date. She concludes that this average is a reasonable estimate of ACME’s beta for use in the CAPM. Therefore, the equity risk premium for ACME is 8.0% (the general equity risk premium of 8.1% multiplied by the beta of 0.99). Business Valuation 615 Victoria tells Bob that the capital asset pricing model is widely used by analysts for investment management where a specific investment’s risks can be eliminated through portfolio diversification. Business valuation theory uses CAPM but modifies it to consider a specific company’s unsystematic risks in addition to the systematic risks. Unsystematic risk represents those risks uniquely associated with an investment that cannot be avoided through port- folio diversification. ACME’s unsystematic risks are discussed next. Studies have shown that investments in small companies typically have more risk than those in large companies. Generally, small company earnings and stock prices are more volatile than those of larger companies. Over the long term, investors in smaller companies have received higher rates of return than investors in the larger Standard & Poor’s (S&P) 500 companies. Empirical data from Ibbotson Associates shows that the smallest 20% of public com- panies have yielded an extra 2.2% rate of return above the returns of S&P 500 companies since 1926. Therefore, Victoria adds a premium of 2.2% to ACME’s required rate of return for the risks associated with its size as compared to S&P 500 companies. Finally, the differences between ACME and small publicly traded com- panies are considered. Victoria previously identified the quantitative and qual- itative attributes of ACME that are considered negative and positive risk factors for the company. These were presented earlier in the chapter. After re- viewing her quantitative and qualitative analyses, she determines that ACME is somewhat more risky than small public companies. In Victoria’s judgment, she adds a 2% specific company risk premium as an additional required rate of return for an investor in ACME. In summary, Victoria determines ACME’s cost of equity using the modi- fied CAPM as shown Exhibit 18.8. Cost of Debt Victoria analyzes ACME’s audited financial statements, including the foot- notes, and interviews management to determine the company’s interest rate on long-term financing was 9%. This was comparable to market interest rates. Since interest paid by the company is tax deductible, the after-tax effective EXHIBIT 18.8 ACME Manufacturing Inc.: Cost of equity. Risk-free rate 6.4% Overall equity risk premium 8.1% Multiply by Beta 0.99 ACME’s equity risk premium 8.0% Small company risk premium 2.2% Specific company risk premium 2.0% ACME’s cost of equity 18.6% 616 Making Key Strategic Decisions interest rate is less than 9%. Victoria determines that ACME is in the 40% in- come tax bracket. Therefore, ACME’s after-tax cost of debt is 5.4% as pre- sented in Exhibit 18.9. Weighted Average Cost of Capital Victoria estimates the optimal capital structure for ACME as 40% debt and 60% equity based on her analysis of the average capital structures of publicly traded companies and then considering that ACME does not have the same ac- cess to capital sources as public companies. Based on this weighting between debt and equity, ACME’s weighted av- erage cost of capital is 13.3%. The calculation is presented in Exhibit 18.10. Discounted Cash-Flow Calculation As previously discussed, ACME’s forecasted invested capital net cash flows for 2001 to 2005 are discounted to present value as of the December 31, 2000, val- uation date. The discount rate is ACME’s weighted average cost of capital— 13.3%. In addition, the residual value of ACME in 2005 is discounted to present value using the same rate. Victoria prepares Exhibit 18.11 that presents the resulting value from dis- counting the cash flows for the five-year period and also discounting the resid- ual value. It assumes that the annual cash flows are earned equally throughout each year. Therefore, the present value calculation for the annual cash flows uses the middle of each year (June 30) to determine the length of time for the present value calculation. This is called the mid-year convention. For example, EXHIBIT 18.9 ACME Manufacturing Inc.: Cost of debt. ACME’s borrowing rate 9.0% Multiply by the tax effect (1 − Tax rate of 40%) 60% ACME’s cost of debt 5.4% EXHIBIT 18.10 ACME Manufacturing Inc.: Weighted average cost of capital. Cost of equity (above) 18.6% Equity weighting 60% 11.1% Cost of debt (above) 5.4% Debt weighting 40% 2.2% ACME's weighted average cost of capital 13.3% Business Valuation 617 the first forecasted year (2001) is discounted one-half year, rather than one complete year, to the valuation date of December 31, 2000. The residual value is based on the expected invested capital net cash flow in the last year of the projection (2005) of $4.533 million. Victoria estimates ACME’s long-term sustainable earnings growth rate at 5% annually. Accord- ingly, the cash flow for 2006 is estimated at $4.760 million ($4.533 million × 1.05). The multiple Victoria applies for the residual year is 12. The calculation for the multiple is presented in Exhibit 18.11. ACME’s residual value at De- cember 31, 2005, is estimated as $57.1 million. The present values of the five years of cash flows are added together plus the present value of the residual value. These items represent the antici- pated future benefits to all capital holders at December 31, 2000. The sum of the present values represents the market value of the total invested capital (MVIC) of $42.1 million. ACME’s interest bearing debt of $10.4 million is subtracted resulting in $31.7 million for the value of ACME’s common stock EXHIBIT 18.11 ACME Manufacturing Inc.: DCF method of valuation as of December 31, 2000. (Exhibit 18.6) Forecast Projected Present Year Cash Flows WACC Value 2001 $1,921,000 13.3% $ 1,804,731 2002 2,565,000 13.3% 2,126,878 2003 3,367,000 13.3% 2,464,157 2004 3,917,000 13.3% 2,530,165 2005 4,533,000 13.3% 2,584,349 Residual value (see below) 13.3% 30,591,919 Value of invested capital 42,102,198 Less: debt capital (10,411,554) Value of equity $31,690,644 Value of equity (rounded) $31,700,000 Residual Value at December 31, 2005 2005 Projected cash flow $4,533,000 Estimated sustainable growth rate 1.05 2006 Projected cash flow 4,759,650 Price multiple WACC (discount rate) 13.3% Less: Sustainable growth rate −5.0% Capitalization rate 8.3% Multiple (inverse of capitalization rate) 12 Residual value at December 31, 2005 $57,115,800 Present value of residual value $30,591,919 . statements 2001–2005. ($million) Pro Forma 2001 2002 2003 2004 2005 Revenue $50.29 $56.32 $63. 08 $70.02 $77.72 $85.50 Cost of goods sold 34.58 38.86 43.53 48.32 53 .63 58.99 Gross profit 15.70 17.46 19.56 21.71 24.09 26.50. (0.21) (0.21) Income before taxes 6.66 7.24 8.13 9.06 10.08 11.09 Income taxes 2.67 2.90 3.25 3 .63 4.03 4.44 Adjusted net income $4.00 $4.34 $4.88 $5.44 $6.05 $6.65 Common Size Pro Forma 2001. 8.06 8.86 ± Increase/decrease in working capital (excluding interest-bearing ST debt) (0.54) (0 .63) (0.65) (0.72) (0.73) ± Increase/decrease in investments (2.80) (2.94) (3.09) (3.24) (3.40) ± Increase/decrease in