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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 1

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Page 1: ch18

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)

= 27.6

Enterprise value/EBITDAComparable = (VD + VE)/EBITDA

= [$18.45 + ($23.45 × 6.23 shares)]/$17.0

= 9.68

Using the P/E multiple, we can calculate the value of the equity as:

VE = P/EComparable × Net incomeCompany being valued = 27.6 × $1.5 = $41.4 million

Using Equation 18.2, suggests an enterprise value of:

VF = VE + VD = $41.4 million + $3.68 million = $45.08 million

Using the enterprise/EBITDA multiple, we obtain:

VF = Enterprise value/EBITDAComparable × EBITDACompany being valued

= 9.68 × $4.4 million = $42.59 million

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18.3 How do the cash flows that are discounted when the WACC approach is used to value a

business differ from those that are discounted when the free cash flow to equity (FCFE)

approach is used to value the equity in a business?

Solution:

The cash flows that are discounted when the WACC approach is used to value a business

are calculated in the same way that the cash flows are calculated for a project analysis.

These cash flows represent the total cash flows that the business is expected to generate

from operations. The cash flows that are discounted when the FCFE approach is used are

the portion 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

expected 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 principal payments that the firm makes less any

proceeds for the sale of new debt.

18.4 You are valuing a company using the WACC approach and have estimated that the free

cash flows from the firm (FCFF) in the next five years will be $36.7, $42.6, $45.1, $46.3,

and $46.6 million, respectively. Beginning in year 6, you expect the cash flows to

decrease at a rate of 3 percent per year for the indefinite future. You estimate that the

appropriate WACC to use in discounting these cash flows is 10 percent. What is the value

of this company?

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Solution:

The present value of the cash flows expected over the next five years is:

The terminal value is:

and the present value of the terminal value is:

Therefore, if there are no nonoperating assets, the value of the firm is:

VF = $163.01 million + $215.90 million = $378.91 million

18.5 You want to estimate the value of a local advertising firm. The earnings of the firm are

expected to be $2 million next year. Based on expected earnings next year, the average

price-to-earnings ratio of similar firms in the same industry is 48. Therefore, you estimate

the firm’s value to be $96 million.

Further investigation shows that a large portion of the firm’s business is obtained

through connections that John Smith, a senior partner of the firm, has with various advertising

executives at customer firms. Mr. Smith only recently started working with his junior partners

to establish similar relationships with these customers.

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Mr. Smith is approaching 65 years of age and might announce his retirement at

the next board meeting. If he does retire, revenues will drop significantly and earnings are

estimated to shrink by 30 percent. You estimate that the probability that Mr. Smith will

retire this year is 50 percent. If he does not retire this year, you expect that Mr. Smith will

have sufficient time to work with his junior partners so his departure will not affect

earnings when he departs. How does this information affect your estimate of the value of

the firm?

Solution:

Mr. Smith is a key person in this firm. An adjustment should be made to the valuation to

account for his potential departure this year.

Taking into account the possibility that Mr. Smith will retire, the expected

earnings next year will be:

2,000,000 × 50% + 2,000,000 × (1 − 30%) × 50% = $1,700,000

Therefore the adjusted value for the firm is: $1,700,000 × 48= $81.6 million. We can see

that this implies a 15 percent key person discount from the original estimate of $96

million.

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VII. Critical Thinking Questions

18.1 Given that many new businesses fail in the first four years, how should an entrepreneur

think about the risk of failure associated with a new business? From what you have

learned in this chapter, what can an entrepreneur do to increase the chance of success?

First of all, it is important for an entrepreneur to understand why many new businesses

fail. Common reasons include poor products, poor business strategy, poor management

skills, and wrong financing decisions. However, the risk of failure should not stop the

start of a new business if the entrepreneur believes that he or she has a great business idea

and is capable of implementing the idea. The entrepreneur should be careful and realistic

in assessing the opportunities and taking risks into consideration.

From what we have learned in this chapter, the entrepreneur should consult an

attorney and choose the right organizational form according to the business’s operating

and financing needs. In addition, he or she should carefully prepare a business plan that

incorporates the main aspects of the business and facilitates the raising of external capital.

The entrepreneur can use several tools to assess the financing needs of the new business:

cash flow break-even analysis and cash budget. To value the new business, the

entrepreneur can use one or more of the following methods: cost approach, market

approach, or income approach.

18.2 Explain how the taxation of a C-corporation differs from the taxation of the other forms

of business organization discussed in this chapter.

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With the exception of C-corporations, all profits flow through to the owners in proportion

to their ownership interests. These owners pay taxes on the business profits only when

they file their personal tax returns. In contrast, profits earned in C-corporations are taxed

at the corporate tax rate, and the after-tax profits are taxed a second time when they are

distributed to stockholders in the form of dividends. On the bright side, because profits

are taxed in the corporation, certain benefits like health insurances that are paid to

stockholders who work in a C-corporation are tax deductible. These benefits are not

generally deductible with the other forms of organization.

18.3 What is a business plan? Explain how a business plan can help an entrepreneur succeed

in building a business.

A business plan is a document that describes the details of how a business will be

developed over time. A well-prepared business plan helps an entrepreneur raise external

capital. It 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. In

addition, a business plan is a tool that 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 communicate the entrepreneur’s ideas to managers and

stakeholders.

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18.4 You are entering negotiations to purchase a business and are trying to formulate a

negotiating strategy. You want to determine the minimum price you should offer and the

maximum you should be willing to pay. Explain how the concepts of fair market value

and investment value can help you do this.

An estimate of the fair market value of a business would provide you with an idea of the

price that the seller could probably 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 price you should offer. The investment value of the business to you represents

the maximum price that you should pay. If you pay more than the investment value, the

acquisition will be a negative NPV project.

18.5 You have just received a business valuation report that is dated six months ago. Describe

the factors that might have changed during the past six months and, therefore, caused the

value of the business today to be different from the value six months ago. Which of these

changes affect the expected cash flows, and which affect the discount rate that you would

use in a discounted cash flow valuation of this company?

A lot might have changed in the last six months. For example, there might have been

changes in general economic conditions, capital market conditions, the competitive

environment in the industries in which the company competes, and in company

characteristics such as the products it sells, the geographic markets it competes in, and

management quality. Changes in all of these areas can affect expected cash flows through

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their impact on demand for the company’s products, the prices of these products,

production costs, and investment requirements. Changes in capital market conditions can

affect the company’s cost of capital and therefore the discount rate.

18.6 Is the replacement cost of a business generally related to the value of the cash flows that

the business is expected to produce in the future? Why or why not? Illustrate your answer

with an example.

The replacement cost of a business is an estimate of what it would cost to replace the

tangible and intangible assets of an on-going business rather than a reflection of the value

of the expected future cash flows of the business. Let us say that you are planning to start

up a new coffee shop. You have a choice of either buying an existing coffee shop or

starting up one entirely from scratch. The replacement cost of the coffee shop business

should include the cost of all tangible assets, such as property, plant, and equipment, and

all intangible assets, such as brand names, customer lists, and the cost of hiring the people

necessary to run the business and the time that it would take to build the business. This

provides you a fair value of what you would pay for an existing business. If you can start

up a business from start at a lower cost than that estimated value, then you should not buy

up the existing business. It does not reflect the cash flows that the existing coffee shop will

produce in the future, but only what it is worth now.

18.7 You want to estimate the value of a company that has three very different lines of

business. It manufactures aircraft, is in the data-processing business, and manufactures

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automobiles. How could you use an income approach to value a company such as this—

one with three very distinct businesses that will have different revenue growth rates,

profit margins, investment requirements, discount rates, and so forth

In using an income approach like the free cash flow from the firm (FCFF) to value an

entire firm, one would first estimate the expected 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 up the cash flows across all the different lines of businesses and discount

them using the firm’s WACC (as shown in Equation 18.3) to estimate the value of the

firm. If, however, the three distinct businesses have been financed differently, then each

of the business’s value should be estimated independently and then finally added up to

determine the value of the firm.

18.8 Your boss has asked you to estimate the intrinsic value of the equity for Google, which

does not currently pay any dividends. You are going to use an income approach and are

trying to choose between the free cash flow to equity (FCFE) approach and the dividend

discount model (DDM) approach. Which would be more appropriate in this instance?

Why? What concerns would you have in applying either of these valuation approaches to

a company such as this?

Google is a fast growing, young firm that is unlikely to pay dividends in the near future.

The dividend discount model (DDM) approach typically uses the constant-growth model

to determine the intrinsic value of the firm’s equity. This model will not be applicable to

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firms like Google until it has settled down to a steady growth pattern at some point in the

future. In contrast, the FCFE approach values cash flows that are available for

distribution to stockholders. It allows for the firm to not distribute all available cash

flows as dividends in any particular year. Hence, it would be more appropriate to use the

FCFE approach to determine the intrinsic value of Google’s equity.

18.9 Explain how the financial statements of a private company might differ from those of a

public company. What does this imply for valuing a private company?

Financial statements of many private companies are not as complete and reliable as those

of public companies. One needs to take caution in valuing a private business based on its

financial statements. For example, private company financials often include personal

expenses of the owner and extremely high compensation expenses. Excess

compensations for the owners benefit them by voiding double taxation. To value a private

firm more precisely, adjustments for excess expenses and compensations should be made.

18.10 Explain why it is difficult to value a young, rapidly growing company.

It is difficult to value a young, rapidly growing company for several reasons. First, such a

company has less reliable historical information available; second, the future of such a

company is often less certain than a matured company; third, such a company is usually

not yet profitable, and therefore it is difficult to apply earnings multiples; and finally,

such a company usually invests

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VIII. Questions and Problems

BASIC

18.1 Organizational form: List some common forms of business organization, and discuss

how access to capital differs across these forms of organization.

Solution:

The forms of organizations discussed in this chapter include: sole proprietorship,

partnership (general partnership and limited partnership), limited liability company

(LLC), and corporations (S-corporation and C-corporation).

The closer the type of organization is to the end of the list above, the better is its

access to capital. Sole proprietorships rely on equity contribution from the proprietor and

debt or lease financing. In contrast, partnerships can turn to all of the partners for

additional capital, and corporations can sell shares to outsiders. Limited partners and

LLCs are less constrained than general partnerships because they can raise money from

limited partners or “members,” as outside investors in LLCs are called, who are not

directly involved in running the business. C-corporations can have an unlimited number

of stockholders.

18.2 Starting a business: What are some of the things that the founder of a company must do

to launch a new business?

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Solution:

The founder of a company needs to decide on its products, market, and business strategy.

Then, he or she needs to estimate the company’s financing needs and raise the money to

develop the products, acquire assets, and hire employees. As the business is being built,

the founder must also manage the day-to-day operations.

18.3 Organizational form: Explain how financial liabilities differ among different forms of

business organization.

Solution:

Sole proprietorships, general partnerships, and limited partnerships all are at a

disadvantage. Sole proprietors and general partners face the possibility that their personal

assets can be taken from them to satisfy claims on their businesses. In contrast, the

liabilities of investors in limited partnerships, LLCs, and corporations are limited to the

money that they have invested in the business.

18.4 Cash requirements: List two useful tools to help an entrepreneur to understand the cash

requirements of a business and to estimate the financing needs of his or her business.

Solution:

An entrepreneur 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 compute the level of unit sales that is necessary to break even on

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operations from a pretax operating cash flow perspective. The cash budget presents the

cash inflows and outflows as well as additional financing needs, usually on a monthly

basis.

18.5 Cash requirements: You believe you have a great business idea and want to start your

own company. However, you do not have enough savings to finance it. Where can you

get the additional funds you need?

Solution:

You can try to raise additional equity financing from your friends and family, from

venture capitalists, or from other potential investors that you know. Debt financing might

be obtained through bank loans, cash advances on credit cards, or loans from other local

individual investors or other businesses. Of course, if a company is large enough ,equity

and debt financing can be obtained in the public markets.

18.6 Raising capital: Why is it especially difficult for an entrepreneur with a new business to

raise capital? What is a tool that can help him or her to raise external capital?

Solution:

To raise external capital, an entrepreneur must convince potential investors that

purchasing debt or equity from the firm will yield attractive returns given the risks they

will bear. It is especially difficult for an entrepreneur with a new business to do this,

because the business does not have a well-established record and its future is typically

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very uncertain. A well-written business plan can be very helpful in convincing potential

investors to put their money in the business.

18.7 Replacement cost: What is the replacement cost of a business?

Solution:

The replacement cost is the cost of duplicating the assets of a business in their present

form, consisting of tangible and intangible assets.

18.8 Multiples analysis: It is April 4, 2007, and your company is considering the possibility

of purchasing the Chrysler automobile manufacturing business from the German car

manufacturer DaimlerChrysler. DaimlerChrysler has hinted that it might be interested in

selling Chrysler. Since Chrysler does not have publicly traded shares of its own, you have

decided to use Ford Motor Company as a comparable company to help you determine the

market value of Chrysler.

This morning Ford’s common stock was trading at $8.15 per share, and the

company had 1.89 billion shares outstanding. You estimated that the market value of all

of the company’s other outstanding securities (excluding the common stock but including

special shares owned by the Ford family) is $100 billion and that its revenues from auto

sales were $143.3 billion last year. Chrysler’s revenue in 2006 was $62.2 billion. Based

on the enterprise value/revenue ratio, what is the total value of Chrysler that is implied by

the Ford market values?

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Solution:

The enterprise value of Ford is:

VF = VE + VOther Securities = ($8.15 × 1.89 billion) + $100 billion = $115.4 billion

and the enterprise value/revenue ratio is:

$115.4/$143.3 billion = 0.805

This suggests that the value of the Chrysler business is 0.805 × $62.2 billion = $50.1

billion. (Note that in this example we used the enterprise value/revenue ratio because

EDITDA was virtually zero for Ford and was unclear for Chrysler.)

18.9 Nonoperating assets: Why is excess cash a nonoperating asset (NOA)? Why does it

make sense to add the value of excess cash to the value of the discounted cash flows

when we use the WACC or FCFE approach to value a business?

Solution:

Excess cash is a nonoperating asset because, by definition, this cash can be distributed to

stockholders without affecting the operations of the business and therefore the value of

the expected future cash flows. It makes sense to add back the value of excess cash

because it represents value over and above that which the business is expected to

produce.

18.10 Dividend discount approach: You want to estimate the total intrinsic value of a large

gas and electric utility company. This company has publicly traded stock and has been

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paying a regular dividend for many years. You decide that, due to the predictability of the

dividend that this company pays, you can use the dividend discount valuation approach.

The company is expected to pay a dividend of $1.25 per share next year, and the dividend

is expected to grow at a rate of 3 percent per year thereafter. You estimate that the

appropriate rate for discounting future dividends is 12 percent. In addition, you know that

the company has 46 million shares outstanding and that the market value of its debt is

$350 million. What is the total value of the company?

Solution:

The value of a share of stock can be calculated using the constant-growth dividend model

as:

Multiplying the price per share by the number of shares outstanding gives us the value of

the equity:

VE = $13.89 × 46 million = $638.94 million

Therefore, the total value of the firm is:

VF = VE + VD = $638.94 + $350 = $988.94 million

18.11 Public versus private company valuation: You are considering investing in a private

company that is owned by a friend of yours. You have read through the company’s

financial statements and believe that they are reliable. Multiples of similar publicly traded

companies in the same industry suggest that the value of a share of stock in your friend’s

company is $12. Should you be willing to pay $12 per share?

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Solution:

Shareholders in a private company may have to spend considerable resources in money

and time to sell their shares. This additional transaction cost will make value derived

from similar publicly traded company an overestimated figure. Therefore, you will most

likely not be willing to pay for $12 a share. You can apply an appropriate marketability

discount to this price as a fair price for this private equity.

18.12 Control: Does the expected rate of return that is calculated using CAPM, with a beta

estimated from stock returns in the public market, reflect a minority or a controlling

ownership position? How is it likely to differ between a minority and a controlling

position?

Solution:

The estimates we obtain using public market data with CAPM 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 implied by CAPM (this generates a higher value and

therefore a premium price for control).

INTERMEDIATE

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18.13 Organizational form: Compare an LLC to a partnership and a corporation.

Solution:

An LLC is a hybrid of a limited partnership and a corporation. 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.

18.14 Organizational form: Discuss the pros and cons of an S-corporation compared to a

C-corporation.

Solution:

An S-corporation is a variation of the C-corporation. The advantage of an S-corporation

compared to a C-corporation is that all of its profits are passed directly to the

stockholders, and therefore double taxation is avoided while it still offers the protection

of limited liability for shareholders. The disadvantage of an S-corporation is the

limitation on stock ownership. Currently, an S-corporation can have no more than 100

stockholders and have only one class of common stock, and all stockholders must be

individuals who are U.S. citizens or residents. As a result, access to capital is more

limited, and cost to transfer ownership is much higher for an S-corporation than for a C-

corporation.

18.15 Break-even: You have started a business that sells a home gardening system that

allows people to grow vegetables on the countertop in their kitchens. You are

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considering two options for marketing your product. The first is to advertise on local

TV. The second is to distribute flyers in the local community. The TV option, which

costs $50,000 annually, will promote the product more effectively and create a

demand for 1,200 hundred units per year. The flyer advertisement costs only $6,000

annually but will create a demand for only 250 units per year. The price per unit of

the indoor gardening system is $100, and the variable cost is $60 per unit. Assume

that the production capacity is not limited and that the marketing cost is the only fixed

cost involved in your business. What are the break-even points for both marketing

options? Which one should you choose?

Solution:

The break-even point for TV advertisement = $50,000/$40 = 1,250 units. However, the

demand is only 1,200 units with TV advertisement. Therefore you cannot break even.

The break-even point for flyers = $6,000/$40 = 150 units. With a market demand of 250,

you will make a profit. Therefore you should choose the flyer option.

18.16 Going-concern value: Aggie Motors is a chain of used car dealerships that has

publicly traded stock. Using the adjusted book value approach, you have estimated the

value of Aggie Motors to be $45,646,000. The company has $40.5 million of debt

outstanding. Its stock price is $5.5 per share, and there are 1,378,000 shares

outstanding. What is the going concern value of Aggie Motors?

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Solution:

The going-concern value equals the difference between the market value of the business

and its adjusted book value. The market value of the business can be calculated as:

VF = VD + VE = $40,500,000 + ($5.5 × 1,378,000) = $48,079,000

Therefore, the going concern value is $48,079,000 – $45,646,000 = $2,433,000

Use the following information concerning Johnson Machine Tool Company in Problems

18.17, 18.18, and 18.19.

Johnson’s income statement from the fiscal year that ended this past December is:

Revenue $995

Cost of goods sold 652

Gross profit $343

Selling, general, & administrative expenses 135

Operating profit (EBIT) $208

Interest expense 48

Earnings before taxes $160

Taxes 64

Net income $ 96

All dollar values are in millions. Depreciation and amortization expenses last year were

$42 million, and the company has $533 million of debt outstanding.

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18.17 Multiples analysis: You are an analyst at a firm that buys private companies, improves

their operating performance, and sells them for a profit. Your boss has asked you to

estimate the fair market value of the Johnson Machine Tool Company. You have

identified a public company with business operations that are virtually identical to those

at Johnson. The income statement for this company, Billy’s Tools, for the fiscal year that

ended this past December is as follows:

Revenue $1,764

Cost of goods sold 1,168

Gross profit $ 596

Selling, general, & administrative expenses 211

Operating profit (EBIT) $ 385

Interest expense 12

Earnings before taxes $ 373

Taxes 147

Net income $ 226

All dollar values are in millions. Billy’s had depreciation and amortization expenses of $71

million last year and 200 million shares and $600 million of debt outstanding as of the end of

the year. Its stock is currently trading at $12.25 per share.

Using the P/E multiple, what is the value of Johnson’s stock? What is the total

value of Johnson Machine Tool Company?

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Solution:

The P/E multiple for Billy’s Tools is:

P/E = ($12.25 × 200 million shares)/$226 = 10.84

which implies a value of 10.84 × $96 = $1,040.64 million for the equity of Johnson

Machine Tools Company. Therefore, the implied total value of Johnson is:

VF = VE + VD = $1,040.64 + $533.00 = $1,573.64 million

18.18 Multiples analysis: Using the enterprise value/EBITDA multiple, what is the total value of

Johnson Machine Tool Company? What is the value of Johnson’s stock?

Solution:

The enterprise value/EBITDA multiple for Billy’s is:

EV/EBITDA = (($12.25 × 200 million shares) + $600 million debt)/($385

million EBIT+ $71 million D&A)

= 6.69

Therefore, the implied total value of Johnson is:

VF = 6.69 × ($208 million EBIT + $42 million D&A) = $1,672.50

And the value of its stock is:

VE = VF – VD = $1,672.50 million - $533.00 million = $1,139.50 million

18.19 Multiples analysis: Which of the above multiple analyses do you believe is more

appropriate?

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Solution:

While the value estimates in the previous questions are reasonably similar, the enterprise

value/EBITDA multiple is more appropriate for this analysis. The reason is that the

capital structures of Johnson and Billy’s differ considerably and the enterprise

value/EBITDA multiple is less sensitive to differences in leverage.

The debt/total capital ratio for Billy’s is

$600 million /(($12.25 × 200 million shares) + $600 million debt) = 0.196

The debt/total capital ratio for Johnson is:

$533 million / $1,672.50 million = 0.319

18.20 Income approaches: You are using the FCFF approach to value a business. You have

estimated that the FCFF for next year will be $123.65 million and that it will increase at a

rate of 8 percent for each of the following four years. After that point, the FCFF will

increase at a rate of 3 percent forever. If the WACC for this firm is 10 percent, what is it

worth?

Solution:

You can value the FCFF for the first five years using the growing annuity formula from

Chapter 6 (Equation 6.5).

The present value of the terminal value is

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and the value of the firm is therefore:

VF = $541.98 million + $1,659.93 million = $2,201.91 million

18.21 Valuing a private business: You want to estimate the value of a privately owned

restaurant that is financed entirely with equity. Its most recent income statement is as

follows:

Revenue $3,000,000

Cost of goods sold 600,000

Gross profit $2,400,000

Salaries and wages 1,400,000

Selling expenses 100,000

Operating profit (EBIT) $ 900,000

Taxes 315,000

Net income $ 585,000

You note that the profitability of this restaurant is significantly lower than that of

comparable restaurants, primarily due to high salary and wage expenses. Further

investigation reveals that the annual salaries for the owner and his wife, the firm’s

accountant, are $900,000 and $300,000, respectively. These salaries are much higher than

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the industry median salaries for these two positions of $100,000 and $50,000, respectively.

Compensation for other employees ($200,000 in total) appears to be consistent with the

market rates. The median P/E ratio of comparable restaurants with no debt is 10. What is

the total value of this restaurant?

Solution:

The owner is paying himself and his wife salaries that are above normal for this industry,

probably to avoid double taxation (assuming that the restaurant is organized as a C

corporation). You should adjust the income statement to reflect the market rates of

compensation for these positions. The adjusted income statement is as follows:

Revenue $3,000,000

Cost of goods sold 600,000

Gross profit $2,400,000

Salaries and wages 350,000

Selling expenses 100,000

Operating profit (EBIT) $1,950,000

Taxes 682,500

Net income $1,267,500

Therefore you estimate the company’s value to be: $1,267,500 * 30 = $12,675,000. The

value of the company will be underestimated if no adjustment for excess compensation is

made.

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18.22 Valuing a private business: A few years ago, a friend of yours started a small business

that develops gaming software. The company is doing well and is valued at $1.5 million

based on multiples for comparable public companies after adjustments for their lack of

marketability. With 300,000 shares outstanding, each share is estimated to be worth $5.

Your friend, who has been serving as CEO and CTO (chief technology officer), has

decided that he lacks sufficient managerial skills to continue to build the company. He

wants to sell his 160,000 shares and invest the money in an MBA education. You believe

you have the appropriate managerial skills to run the company. Would you pay $5 each

for these shares? What are some of the factors you should consider in making this

decision?

Solution:

You should consider at least two additional factors in valuing these equity shares. First,

note that since the company has a total 300,000 shares of equity outstanding, you will be

purchasing a majority of the shares and will gain control of the company. 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 person, you must consider the impact of his departure on the

development and sales of the company’s products. Your valuation of the equity could be

higher or lower than $5 per share, based on adjustments for both potential control

premium and key person discount.

ADVANCED

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18.23 You plan to start a business that sells waterproof sun block with a unique formula that

reduces the damage of UVA radiation 30 percent more effectively than similar products

on the market.

You expect to invest $50,000 in plant and equipment to begin the business. The

targeted price of the sun block is $15 per bottle. You forecast that unit sales will total

1,500 bottles in the first month and will increase by 20 percent in each of the following

months during the first year. You expect the cost of raw materials to be $3 per bottle. In

addition, monthly gross wages and payroll are expected to be $13,000, rent is expected to

be $3,000, and other expenses are expected to total $1,000. Advertising costs are

estimated to be $35,000 in the first month but to remain constant at $5,000 per month

during the following 11 months.

You have decided to finance the entire business at one time using your own

savings. Is an initial investment of $75,000 adequate to avoid a negative cash balance in

any given month? If not, how much more do you need to invest up front? How much do

you need to invest up front to keep a minimum cash balance of $5,000? What is the

break-even point of the business?

Solution:

The monthly cash budget is as follows:

Monthly Cash Budget

Month 1 2 3 4

Beginning cash balance $ 75,000 $ (9,000) $ (9,400) $ (5,480)

Cash receipts

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Cash sales 22,500 27,000 32,400 38,880

Total cash available $ 97,500 $ 18,000 $ 23,000 $ 33,400

Operations

Raw material 4,500 5,400 6,480 7,776

Gross wages and payroll 13,000 13,000 13,000 13,000

Advertising 35,000 5,000 5,000 5,000

Rent 3,000 3,000 3,000 3,000

Other expenses 1,000 1,000 1,000 1,000

Operations total $ 56,500 $ 27,400 $ 28,480 $ 29,776

Financing and investments

Capital expenditures 50,000 --- --- ---

Total cash payments $106,500 $ 27,400 $ 28,480 $ 29,776

Ending cash balance $ (9,000) $ (9,400) $ (5,480) $ 3,624

With $75,000 of capital invested in the initial period, the company will have

negative cash balances during each of the first three months and positive cash balances in

the following months. Additional capital investment totaling $9,400 will be needed to

avoid negative cash balances in month 2. In other words, you will have to invest $84,400

of capital in total at the beginning of the business just to avoid negative cash balances. To

maintain a minimum cash balance of $5,000, you will need to make an initial capital

investment of $89,400 ($84,000 + $5,000).

Break-even: Fixed costs in the initial month will equal:

$13,000 + $35,000 + $3,000 + $1,000 = $52,000

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Fixed monthly costs in the following months will be:

$13,000 + $5,000 + $3,000 + $1,000 = $22,000.

Since variable costs per bottle are $3, the monthly break-even points for the firm are:

$52,000 / ($15 – $3) = 4,333.3 bottles in the initial month and $22,000 / ($15 – $3)

=1,833.3 bottles in the following months.

The sales of the company are 1,500, 1,800, 2,160, and 2,592 bottles in the first four

months. Therefore, the firm will start to make a profit in the third month. This can be

seen from the cash budget analysis above. Month 3 is the first month the firm’s cash

balance is increasing (becoming less negative).

18.24 For the previous question, assume that you do not have sufficient savings to cover the

entire amount required to start your sun block business. You are going to have to get

external financing. A local banker that you know has offered you a six-month loan of

$20,000 at an APR of 12 percent. You will pay interest each month and repay the entire

principal at the end of six months.

Assume that instead of making a single up-front investment, you are going to

finance the business by making monthly investments as cash is needed in the business.

Assuming the proceeds from the loan go directly into the business on the first day and are

therefore available to pay for some of the capital expenditures, how much money do you

need to pull out of your savings account every month to run the business and keep the

cash balances positive?

Solution:

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The monthly payment of the loan is $20,000*1% = $2,000. The cash budget without your

investment is as follows:

Monthly Cash Budget

Month 1 2 3 4 5 6

Beginning cash balance $ 20,000 $(66,000) $(68,400) $(66,480) $(59,376) $(46,051)

Cash receipts

Investments by owner

Cash sales 22,500 27,000 32,400 38,880 46,656 55,987

Total cash available $ 42,500 $(39,000) $(36,000) $(27,600) $(12,720) $ 9,936

Cash payments

Operations

Raw material 4,500 5,400 6,480 7,776 9,331 11,197

Gross wages and payroll 13,000 13,000 13,000 13,000 13,000 13,000

Advertising 35,000 3,000 3,000 3,000 3,000 3,000

Rent 3,000 3,000 3,000 3,000 3,000 3,000

Other expenses 1,000 1,000 1,000 1,000 1,000 1,000

Operations total $ 56,500 $ 27,400 $ 28,480 $ 29,776 $ 31,331 $ 33,197

Financing and investments

Capital expenditures 50,000 --- --- --- --- ---

Debt/interest payment 2,000 2,000 2,000 2,000 2,000 22,000

Total cash payments $108,500 $ 29,400 $30,480 $ 31,776 $ 33,331 $ 55,197

Ending cash balance $(66,000) $(68,400) $(66,480) $(59,376) $(46,051) $(45,261)

Therefore, you need to put in $66,000 initially, and $2,400 ($68,400–66,000) in the next

month. You don’t need to invest in more money afterward, because the cash balance is

increasing afterward.

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18.25 Your friend is starting a new company. He wants to write a business plan to clarify the

company’s business outlook and raise venture capital. Knowing that you have taken this

course, he has asked you, as a favor, to help him prepare a template for a business plan.

Prepare a template that includes the key elements of a business plan.

Solution:

Business varies and so does a business plan. Here is a template for an intermediate-level

business plan, which could be tailored to specific industry and company situations:

1. Executive Summary

1.1 Objectives

1.2 Mission

1.3 Keys to Success

2. Market Analysis

2.1 Market Segmentation

2.2 Target Market Segment Strategy

2.3 Market Needs

2.4 Competitions and Buying Patterns

3. Company Overview

4. Product Description

5. Marketing and Sales

5.1 Competitive Edge

5.2 Sales Strategy

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6. Operations

6.1 Production

6.2 Distribution

6.3 Supply

7. Management and Ownership

7.1 Organizational Structure

7.2 Management Team

7.3 Ownership

8. Financial Plan

8.1 Break-even Analysis

8.2 Projected Profit and Loss

8.3 Projected Cash Flow

9. Appendices: Tables and charts

18.26 A friend of yours is trying to value the equity of a company and, knowing that you have

read this book, has asked for your help. So far she has tried to use the FCFE approach.

She estimated the cash flows to equity to be as follows:

Sales $800.0

− CGS −450.0

− Depreciation −80.0

− Interest − 24.0

Earnings before taxes (EBT) $246.0

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− Taxes (0.35 × EBT) − 86.1

= Cash flow to equity $159.9

She also computed the cost of equity using CAPM as follows:

kE = kF + E(Risk premium) = 0.06 + (1.25 × 0.084) = 0.164 or 16.4%

where, the beta is estimated for a comparable publicly traded company.

Using this cost of equity, she estimates the discount rate as

WACC = xDebtkDebt pretax(1 − t) + xcs kcs

= 0.20 × 0.06 × (1 − 0.35) + 0.80 × 0.165 = 0.14, or 14%

Based on this analysis, she concludes that the value of equity is $159.9 million/0.14 =

$1,142 million.

Assuming that the numbers used in this analysis are all correct, what advice would you

give your friend regarding her analysis?

Solution:

There are a number of potential problems with your friend’s analysis. First, she has

calculated FCFF incorrectly. She is assuming that net income equals FCFE. Once she

obtains net income she should add back depreciation, subtract capital expenditures and

additions to working capital, and subtract any net repayment of debt principal. Second,

she is using the incorrect discount rate. She should be using the cost of equity to discount

the FCFE. Finally, since your friend is using the perpetuity formula, she is assuming that

the expected future FCFE will be constant forever. You should inquire whether this is

really what she expects.

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18.27 Forever Youth Technology is a biochemical company that is two years old. Its main

product, an antioxidant drink that is supposed to energize the consumer and delay aging,

is still under development. The company’s equity consists of $5 million invested by its

founders and $5 million from a venture capitalist. The company has spent $3 million in

each of the past two years, mostly on lab equipment and R&D costs. The company has

had no sales so far. What are the challenges associated with valuing such a young and

uncertain company?

Solution:

As discussed in the chapter, it is very difficult to value such a young firm with many

uncertainties. The company has a short history, high investments, no sales, and highly

uncertain cash flows in the future. The cost approach is not valid for such a young

biochemical company. It is hard to value the company using multiples because of the lack

of sales and negativity of earnings, and because of lack of comparable companies of the

same business. The transaction approach is also hard to apply.

Despite the many uncertainties, we should try to estimate the future cash flows

and risks associated with these cash flows. First of all, we need to estimate the probability

and time length to achieve success in developing the product. In addition, we need to find

out what happens in case the firm’s capital is used up before the product is developed.

We need to decide whether, based on the company’s future prospects, it is possible to

raise additional external capital at that point 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

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shares as well as target price of the product, in case it is developed successfully. We also

need to estimate the short-term and long-term growth rate of the company based on

market, industry, and firm-specific conditions.

18.28 Mad Rock, Inc., is a company that sells mp3 music online. It is expected to generate

earnings of $1 per share this year after its Web site is upgraded and online marketing is

stepped up. Given the popularity of iPod and other mp3 players, the stock price of Mad

Rock has rocketed from $8 to $95 per share in the past 12 months. The cost of capital for

the company is 18 percent.

Of course, the future of a young Internet company such as Mad Rock is highly

uncertain. Nevertheless, using the very limited information provided in this problem, do

you think $95 per share could be a fair price for its stock? Support your argument with a

simple analysis.

Solution:

Assume that the earnings of $1 will be realized. To simplify the problem, assume that all

earnings will be paid out as dividends. Using the dividend growth model, $95 = $1/(0.18

– g), which implies that g = 16.9%. We know that it is not possible for a firm to grow at

this rate forever because G is a growth rate that must be sustainable in perpetuity. No

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 Mad Rock’s stock is

overpriced.

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On the other hand, it is possible that Mad Rock could grow very rapidly for a few

years and then grow at a sustainable rate that justifies the $95 price. For example, if we

assume that a sustainable rate is 6 percent, we can solve for the earnings per share that

would be required to justify a $95 stock price. This value is $95 = D/(0.18 – 0.06) which

implies D = $11.4. Therefore, if the earnings per share increased rapidly to a value above

$11.4, it is possible that a price of $95 could be justified. How much above $11.4 it

would have to be would depend on how quickly it increased.

One other consideration here is that as the business matures, its cost of capital is

likely to decrease because its risk will decline. This will tend to increase the value of

the equity.

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Sample Test Problems

18.1 You own a business that specializes in designing and producing roofs for houses in

central Texas. Your annual costs include office rent of $14,400, salaries for four

designing engineers of $240,000, design software costs of $12,000, and other overhead

costs of $3,000. An average roof in this region is priced at $3,500. It costs $1,200 in raw

material, $1,100 in labor, and $100 in other expenses (for example, purchasing building

permits). What is the minimum number of roofs you need to sell to earn a profit? What

can you do to reduce the break-even level of sales?

Solution:

Fixed costs = 14,400+240,000+12,000+3,000 = $269,400

Unit variable costs = 1,200 + 1,100 + 100 = $2,400

Therefore, the break-even point = FC / (Price-Unit VC)

= $269,400/ ($3,500 – $2,400)

= 244.9, or 245 roofs every year

To increase the profitability of the business, you can either reduce the fixed costs of the

business or increase the unit contribution of each roof. For example, to minimize the

fixed costs, you could rent a less expensive office, or reduce the number of roof designers

(instead, use better software to design the roofs more efficiently); to maximize the unit

contribution, you can try to increase the price based on the quality of your roof, or get

cheaper material or work labor given acceptable output standards.

18.2 Explain why the replacement cost approach is rarely used to value an entire business.

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Solution:

The replacement cost approach is rarely used because investors in businesses are

concerned with the value of the cash flows the business can be expected to generate in the

future. The replacement cost approach does not generally reflect the value of these cash

flows.

18.3 Why is the rate used to discount FCFF different from the rate used to discount FCFE?

Solution:

The discount rates are different because the riskiness of the FCFF and FCFE cash flow

streams are different. The FCFF, which are the total cash flows that the business is

expected to produce, are discounted using the WACC. The WACC represents the rate of

return that the market requires for cash flows having the risk of the FCFF. The FCFE are

the cash flows that remain for stockholders after the debt holders have been paid. Since

the FCFE are residual cash flows, they are riskier than the FCFF and are therefore

discounted at a higher rate—the cost of equity.

18.4 You are valuing the equity of a company using the FCFE approach and have estimated

that the FCFE in the next five years will be $6.05, $6.76, $7.36, $7.85, and $8.15 million,

respectively. Beginning in year 6, you expect the cash flows to increase at a rate of 2

percent per year for the indefinite future. You estimate that the cost of equity is 12

percent. What is the value of equity in this company?

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Solution:

The present value of the cash flows expected over the next five years is

The terminal value is

Present value of the terminal value is:

Therefore, if there are no nonoperating assets, the value of the equity is

VF = $25.64 + $47.17 = $72.81

18.5 You are interested in investing in a private company. Based on earnings multiples of

similar publicly traded firms, you estimate the value of the private company’s stock to be

$11 per share. You plan to acquire a majority of the shares in the company. The expected

control premium is 10 percent. You estimate the marketability discount for such a firm to

be 20 percent. The discount for the key person, one of the founders who may leave the

firm upon your control of the firm, is 15 percent. What price should you be willing to pay

for these shares?

Solution:

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Value per share = Share value × [(1 + Control premium)×(1 – Marketability discount) ×

(1 – Key person discount)

= $11×(1+10%)×(1-20%)×(1-15%)

= $8.228

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