Do you agree that there really are many situations in which closely held companies need to be valued because of a desired or required sale of some portion of the ownership? Explain.

Saint Thomas University

Module 6 Assignment

Professor:

Chapter 17

2. Do you agree that there really are many situations in which closely held companies need to be

valued because of a desired or required sale of some portion of the ownership? Explain.

Yes. The future is unpredictable, and situations where a partner died, retired, or became disabled

or divorce can trigger the necessity of the business valuation. Unfortunately, not many businesses

considered the importance of the future and how it can affect the management and control of the

company. Some cases are resolved friendly, and some other instances specified the partnership

value or methodology to estimate beforehand in the cooperation agreement. "Sometimes, in a

partnership, there are differences of opinion about the amount that should be paid for the

business interest that is being sold. Such disputes are often litigated in a legal forum in "forensic"

fashion. Additionally, many business sales or dissolutions are fraught with conflict from the start.

Family business dissolutions that result from divorce are often contentious. Typically, divorces

involve significant conflict already, and when the issue of valuing large commonly owned assets

such as a business is involved, there are major disagreements" (Crumbley, Smith, & Heitger,

2017). Like any other sale, the seller and buyer have distinct benefits from the sale. The higher

the price, the better for the seller and the worst for the buyer and vice versa. "To resolve such

differences, business valuators are asked to provide an impartial valuation that is developed in a

professional and systematic manner" (Crumbley, Smith, & Heitger, 2017).

References

Crumbley, D. L., Fenton, J. E. D., Smith, G. S., & Heitger, L. E. (2017). Forensic and

investigative accounting (8th ed.). Chicago, IL: Wolters Kluwer

The Buy-Sell Agreement: What it is and why it is important? (n.d.). Retrieved April 16, 2020,

from https://www.buchananlaw.com/the-buysell-agreement

5. Describe some situations giving rise to the need for valuations.

Identifying how much a company worth should be an essential part of an ongoing

business plan. Business valuation is a sophisticated financial method that should be conducted by

a qualified valuation expert with the proper certification. Some of the reason why a business

valuation is demanded are list as follow:

-Exit Strategy Planning: When planning to sell a business, having a baseline value can help to

improve profitability to increase the worth as an exit strategy.

-Buy/Sell Agreements: An arrangement between principals can help to avoid future disputes.

Valuation allows firms to prepare a buy/sell agreement between all parties.

-Shareholder or Partnership Disputes: If an owner determines they want out of the

organization, an impartial business valuation is required to reach a fair settlement of ownership

interest.

-Mergers and Acquisitions: Valuation of the business help to determine if the price asked to pay

is a fair one when merging with another business or purchasing a company.

-Marital Dissolution: A reasonable market value of the business interests must be established

for an equal division of assets

-Tax purposes: Avoid problems with the IRS by having an accurate, defensible, and documented

value.

Valuation is also needed for Lost business value, Minority shareholder distributions, Bankruptcy,

Recapitalizations, Insurance disputes, and Damages disputes, etc.

References

Crumbley, D. L., Fenton, J. E. D., Smith, G. S., & Heitger, L. E. (2017). Forensic and

investigative accounting (8th ed.). Chicago, IL: Wolters Kluwer

Feilteau, R. P. (2017, February 9). Top 10 Reasons for a Business Valuation. Retrieved April 16,

2020, from https://www.gggcpas.com/Top-10-Reasons-for-a-Business-Valuation

7. Group these valuation approaches into asset-based, income approach, and market

approach types:

a. Adjusted book value method- Asset Based

b. Capitalization of earnings method-Income approach

c. Discounted future earnings method-Income approach

d. Guideline public company method-Market approach

e. Merger and acquisition method-Market approach

f. Rules of thumb approach-Market approach

8. Define these terms:

a. Historical cost:

 The www.merriam-webster.com/dictionary defines it as:

o The value at which a capital asset is recorded on the books representing the outlay of

money or its equivalent given in exchange at the time of acquisition.

o The value at which a capital asset is recorded on the books representing the outlay of

money or its equivalent given in exchange at the time of acquisition

o The original cost of a property in a public utility

b. Replacement cost:

 The www.merriam-webster.com/dictionary defines it as the cost of replacing property

with property of like kind and equal quality or effectiveness

c. Intrinsic value

 “Intrinsic value is the value to a particular individual. Intrinsic value often arises in a

divorce situation where the sale of a business may not be possible, however, the court still

finds that the business has value to its owner or owners” (Crumbley, Smith, & Heitger,

2017).

d. Fair market value

 The www.merriam-webster.com/dictionary defines it as a price at which buyers and

sellers with a reasonable knowledge of pertinent facts and not acting under any

compulsion are willing to do business.

 Fair value can be explained in at least three separate approaches:

1. “Minority shareholder’s pro-rata share of the 100-percent controlling interest value:

Fair market value of the minority shareholder’s specific shares, discounted for

minority interest status only, without discounts for lack of marketability” (Crumbley,

Smith, & Heitger, 2017).

2. “Fair market value of the minority shareholder’s specific shares, discounted for

minority interest status only, without discounts for lack of marketability. This

approach is a compromise view that attempts to give some value to the shares of the

dissenting minority shareholder without unfairly penalizing the business and its

remaining shareholder” (Crumbley, Smith, & Heitger, 2017).

3. “Fair market value of the minority shareholder’s specific shares, ordinarily discounted

for minority interest status and lack of marketability. This view of fair value tends to

favor the company at the expense of the minority shareholder, because it does not

give the minority shareholder anything more than he or she already has” (Crumbly,

Smith, & Heitger, 2017).

e. Discounted future earnings method:

 “Discounted future earnings is a method of valuation used to estimate a firm's worth. The

discounted future earnings method uses forecasts for the earnings of a firm and the firm's

estimated terminal value at a future date, and discounts these back to the present using an

appropriate discount rate. The sum of the discounted future earnings and discounted

terminal value equals the estimated value of the firm” (Kenton, 2020).

f. Capitalization of earnings method:

 “All capitalization methods estimate value by converting a company’s estimated future

income stream into a value. This conversion involves the application of an appropriate

capitalization rate, which incorporates both an investor’s required rate of return for risk

and a factor for future growth in income. The resulting value is ultimately based on the

present worth, today, of anticipated benefits the buyer will receive in the future (in the

form of income, cash flow, or dividends)” (Crumbly, Smith, & Heitger, 2017).

g. Capital asset pricing model (CAPM):

 “The Capital Asset Pricing Model (CAPM) describes the relationship between systematic

risk and expected return for assets, particularly stocks. CAPM is widely used throughout

finance for pricing risky securities and generating expected returns for assets given the

risk of those assets and cost of capital” (Kenton, 2020).

References

Crumbley, D. L., Fenton, J. E. D., Smith, G. S., & Heitger, L. E. (2017). Forensic and

investigative accounting (8th ed.). Chicago, IL: Wolters Kluwer

Historical Cost. (n.d.). Retrieved April 16, 2020, from https://www.merriam-

webster.com/dictionary

Kenton, W. (2020, January 29). Capital Asset Pricing Model (CAPM). Retrieved April 16, 2020,

from https://www.investopedia.com/terms/c/capm.asp

Kenton, W. (2020, January 29). Introduction to Discounted Future Earnings. Retrieved April 16,

2020, from https://www.investopedia.com/terms/d/discounted-future-earnings.asp

18. Refer to the information in Exercise 17-17 but use the average income approach to find the

base valuation rather than the weighted average method. Determine the value of the 12 percent

interest of the retiring employee.

Year Earnings (000) 1 $ 700 .00

2 750 .00 3 400 .00 4 800 .00 5 950 .00

Average Annual Earnings $ 720 .00

Price Earnings Ratio to capitalize = 9

Average Annual Earnings (000) * Price Earnings Ratio to capitalize =$720.00*9 = $6,480.00

Estimated Value of the Business (000): = $6,480.00

The 12% owned by the retiring employee before applying discounts (000)

=$6,480.00*12% = $777.60

Minority Interest Discount (30%):

=$777.60* (1-30%) = $544.32

Loss of a Key Person Discount (10%):

=$777.60* (10%) = $77.76

Then to calculate the 12% interest of the retiring employee is:

=$544.32-$77.76= $466.56*1000

The estimated value is = $466,560.00

21. E&K Company has a net book value of $250,000. The company has a 10 percent cost of

capital. The firm expects to have profits of $45,000, $40,000, and $55,000 respectively for the

next three years. The company pays no dividends and depreciation is five percent per year of

book value.

a. Using the excess earnings model, should the firm be valued at more or less than its book

value?

The Capitalization of Excess Earnings Method is a combination of the cost and income approach

and involves using the following steps:

1) “Multiply the net tangible assets of the company by the rate of return such assets might

reasonably be required to earn” (Crumbly, Smith, & Heitger, 2017).

2) “Deduct this estimate of earnings from the total earnings to derive that portion of the

earnings that might be attributed to the intangible assets” (Crumbly, Smith, & Heitger,

2017).

3) “Divide the earnings attributed to intangibles by a capitalization rate for intangibles to

estimate the total value attributed to the intangibles” (Crumbly, Smith, & Heitger, 2017).

4) “Sum the value attributed to intangibles and the market value of the net tangible assets of

the firm to estimate an overall fair market value” (Crumbly, Smith, & Heitger, 2017).

There is not enough information to complete all of these steps, but we can consider that the firm

should be valued at more than the book value because the earnings are over the cost of capital.

b. What, if anything, are the company’s abnormal earnings for the next three years?

“Abnormal earnings are: AEt= Actual earning t-Required or "normal" earnings t

Which may be expressed as Aet= NOPAT t- (r x BVt-1)

Where NOPAT is the firm's net operating profit after taxes, r is the cost of equity capital and BV

t-1”( https://brainmass.com, retrieved 2020).

The following tables show calculations:

c. What is your best estimate of the firm’s value using the excess earnings model?

Capitalized Value = (Cost of Capital + Average excess earning)/ cost of capital factor

Earnings Cost of Capital Depreciation Total Year 1 45,000 25,000 12,500 7,500 Year 2 40,000 25,000 12,500 2,500 Year 3 55,000 25,000 12,500 17,500

Average excess earning 9,167

= (25000+9167)/0.1

= $341,667

References:

Calculating abnormal earnings and analyzing investment options. (n.d.). Retrieved April 18,

2020, from https://brainmass.com/business/accounting/calculating-abnormal-earnings-analyzing-

investment-options-77725

Crumbley, D. L., Fenton, J. E. D., Smith, G. S., & Heitger, L. E. (2017). Forensic and

investigative accounting (8th ed.). Chicago, IL: Wolters Kluwer

Earnings Cost of Capital Total

Year 1 45,

000 25,

000 20,0

00

Year 2 40,

000 25,

000 15,0

00

Year 3 55,

000 25,

000 30,0

00

65,000

Assets-Liabilities $250,000 Cost of Capital 10% 25,000 Depreciation 5% 12,500

23. Discounted cash flows valuation model. Smooth-tone Products manufactures sound systems.

The company’s weighted average cost of capital is 12 percent. The company forecasted the

following free cash flows for the next 20 years.

Year Free Cash Flows

1 $10,000,000

2 15,000,000

3 20,000,000

4 23,000,000

5 25,000,000

6–10 20,000,000 per year

11–20 17,000,000 per year

Use the discounted cash flow approach to value the Smooth-tone Products Company.

“The discounted cash flow method is designed to establish the present value of a series of future

cash flows. Present value information is useful for investors, under the concept that the value of

an asset right now is worth more than the value of that same asset that is only available at a later

date. An investor will use the discounted cash flow method to derive the present value of several

competing investments, and usually picks the one that has the highest present value” (Bragg,

2018).

“Palepu, Healy, and Bernard, the authors of Business Analysis & Valuation Using Financial

Statements, suggest these three steps in calculating discounted cash flow methods:

1. Forecast the free cash flows available over a finite period (e.g., 5–10 years),

2. Forecast the cash flows beyond the terminal period using some simplifying assumption,

3. Discount the free cash flows” (Crumbly, Smith, & Heitger, 2017).

The following tables show calculations for:

Estimated Free Cash

Flows PV factor PV of Free Cash Flow

PV Factor Calculation @ 12% Year A B A*B

1.0000 =1+0.12 1.12 0.8929 1 10,000,000 0.8929 8,928,571

0.8929 =1+0.12 1.12 0.7972 2 15,000,000 0.7972 11,957,908

0.7972 =1+0.12 1.12 0.7118 3 20,000,000 0.7118 14,235,605

0.7118 =1+0.12 1.12 0.6355 4 23,000,000 0.6355 14,616,916

0.6355 =1+0.12 1.12 0.5674 5 25,000,000 0.5674 14,185,671

0.5674 =1+0.12 1.12 0.5066 6 20,000,000 0.5066 10,132,622

0.5066 =1+0.12 1.12 0.4523 7 20,000,000 0.4523 9,046,984

0.4523 =1+0.12 1.12 0.4039 8 20,000,000 0.4039 8,077,665

0.4039 =1+0.12 1.12 0.3606 9 20,000,000 0.3606 7,212,200

0.3606 =1+0.12 1.12 0.3220 10 20,000,000 0.3220 6,439,465

0.3220 =1+0.12 1.12 0.2875 11 15,000,000 0.2875 4,312,142

0.2875 =1+0.12 1.12 0.2567 12 15,000,000 0.2567 3,850,126

0.2567 =1+0.12 1.12 0.2292 13 15,000,000 0.2292 3,437,613

0.2292 =1+0.12 1.12 0.2046 14 15,000,000 0.2046 3,069,297

0.2046 =1+0.12 1.12 0.1827 15 15,000,000 0.1827 2,740,444

0.1827 =1+0.12 1.12 0.1631 16 15,000,000 0.1631 2,446,825

0.1631 =1+0.12 1.12 0.1456 17 15,000,000 0.1456 2,184,665

0.1456 =1+0.12 1.12 0.1300 18 15,000,000 0.1300 1,950,594

0.1300 =1+0.12 1.12 0.1161 19 15,000,000 0.1161 1,741,602

0.1161 =1+0.12 1.12 0.1037 20 15,000,000 0.1037 1,555,001

Present value using discounted free cash flows $132,121,917

References:

Bragg, S. (2018, May 3). The discounted cash flow method. Retrieved April 18, 2020, from

https://www.accountingtools.com/articles/the-discounted-cash-flow-method.html

Calculating abnormal earnings and analyzing investment options. (n.d.). Retrieved April 18,

2020, from https://brainmass.com/business/accounting/calculating-abnormal-earnings-analyzing-

investment-options-77725

Crumbley, D. L., Fenton, J. E. D., Smith, G. S., & Heitger, L. E. (2017). Forensic and

investigative accounting (8th ed.). Chicago, IL: Wolters Kluwer

Feilteau, R. P. (2017, February 9). Top 10 Reasons for a Business Valuation. Retrieved April 16,

2020, from https://www.gggcpas.com/Top-10-Reasons-for-a-Business-Valuation

Historical Cost. (n.d.). Retrieved April 16, 2020, from https://www.merriam-

webster.com/dictionary

Kenton, W. (2020, January 29). Capital Asset Pricing Model (CAPM). Retrieved April 16, 2020,

from https://www.investopedia.com/terms/c/capm.asp

Kenton, W. (2020, January 29). Introduction to Discounted Future Earnings. Retrieved April 16,

2020, from https://www.investopedia.com/terms/d/discounted-future-earnings.asp

The Buy-Sell Agreement: What it is and why it is important? (n.d.). Retrieved April 16, 2020,

from https://www.buchananlaw.com/the-buysell-agreement