Business Structure Advice

the advantages and disadvantages of each, and possible tax consequences for each scenario?

use Parrino, Fundamentals of Corporate Finance, 2e as a reference.

Write a 350 to 700 word response to the following e-mail:

Dear Consultant,

starting a business and developing my business plan. some advice on how to start forming my business. I am not sure exactly how it will be financed and whether or not I want to take on partners. I am interested and willing to learn the intricacies of my options to determine how to best proceed with my plan.

Please advise on what my options are, the advantages and disadvantages of each, and possible tax consequences for each scenario?

Discuss the different forms of business organization and review the exhibit in 18.1 and share some of the advantages and disadvantages of the forms of organization.
18.1 Starting A Business

LEARNING OBJECTIVE 1
Explain why the choice of organizational form is important, and describe two financial considerations that are especially important in starting a business.
People start their own business for a wide variety of reasons. Some have an idea for a new product or service that they think will revolutionize an industry and make them rich. Others live in an area where there are no attractive employment opportunities for them, and starting a business is the only way to earn a living. Others simply want to be their own boss.

To learn more about starting a business, see the Business Owner’s Toolkit page on the CCH Web site at http://www.toolkit.cch.com.

Regardless of their motives, all of these people face the decision of whether to start their own business or purchase an already established business. Starting your own business can provide greater potential rewards but is inherently more risky than buying and growing a business that someone else has already built. The founder of a company must start from scratch by choosing the products to sell, the markets to sell them in, and the best strategy for selling them. He or she must then raise the money necessary to develop the products, acquire the necessary assets, and hire the right people. Of course, 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 as well as possible.
In this section, we discuss factors that entrepreneurs consider when deciding to launch a new business, factors that affect the form of organization that they choose, and financial considerations associated with starting a business.
Making the Decision to Proceed
Hundreds of thousands of new businesses are started in the United States each year, but many do not succeed. The Small Business Administration estimates that 627,200 new firms were formed in 2008. However, statistical analyses of earlier business formations suggest that only about 44 percent of these firms will still be in business in 2012. Among those that do survive, only a few will provide high returns to their founders.
Businesses fail for many reasons. Some fail because consumers do not accept their products. Others fail because the founder pursues a poorly thought-out strategy or does not have the management skills to properly execute a good strategy. Another common reason for new business failures is that founders underestimate how much money it will take to get their businesses up and running. For example, they underestimate the amount of money that will be needed to cover cash outflows until cash inflows from sales are large enough to do so. These founders fail to ensure that they have enough money to give the business a fighting chance.
The fact that many new businesses fail does not mean that you should not start a business if you believe that you have a good idea. It simply means that you should carefully think through your new business idea before you make the decision to proceed. Not thinking carefully about your idea can lead you to pursue a poor strategy, fail to realize that you might need help in executing your strategy, or underestimate how much money you will need.
It is beyond the scope of this book to tell you how to properly evaluate a business idea, a strategy for pursuing it, or your management abilities. Fortunately, a lot has been written on these topics by others. For example, you can find useful readings on these topics on the “Business Owner’s Toolkit” page on the CCH Web site (see the earlier margin reference).
The only advice that we can give you in these areas is to be careful and realistic in assessing your opportunities. On the one hand, don’t jump into a business without careful thought. On the other hand, don’t overanalyze opportunities to the point where you are just convincing yourself not to proceed. Taking calculated risks is part of business. The important thing to remember is that the risks you take should be “calculated.” Also, don’t think that failure will ruin your chances of ultimately achieving business success. Many successful entrepreneurs and executives have failed more than once in their careers. Successful people learn from both their failures and their successes.
Choosing the Right Organizational Form
Once you have made the decision to start a business, you must decide what form of organization will work best. Chapter 1 discussed some of the more common basic forms of business organization—sole proprietorships, partnerships, and corporations—and some of their advantages and disadvantages. In that discussion, you saw that there are variations in the basic forms of business organization. For example, Chapter 1 describes general, limited, and limited liability partnerships. There are also a number of different types of corporations, as well as hybrids between partnerships and corporations. The reason that so many different forms of organization exist is that the needs of businesses vary considerably. The wide range of choices has made the decision of how to organize a business so complex that many people don’t even try to make this decision without the advice of an attorney.
In this section, we extend the discussion begun in Chapter 1 by focusing, from a financial perspective, on factors that affect the choice of the appropriate organizational form for a new business. We highlight some of the most common forms of organization and identify important characteristics of these alternatives that should be considered when choosing the form of organization for a business.
Exhibit 18.1 compares the common forms of business organization on a number of different dimensions. You will note that there are two forms of organization in this table that are not discussed in detail in Chapter 1: limited liability companies (LLCs) and S-corporations. We first briefly describe LLCs and add to the brief discussion of S-corporations in Chapter 1. We then focus on the differences between the various forms of organization shown in the exhibit.

EXHIBIT 18.1 Characteristics of Different Forms of Business Organization
Choosing the appropriate form of business organization is an important step in starting a business. This exhibit compares key characteristics of the most popular forms of business organization in the United States.

LLCs and S-Corporations
Since it was first developed in Wyoming in 1977, the LLC form of organization has benefited founders of many businesses that would otherwise have been organized as limited partnerships. 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.
An S-corporation is a variation on a C-corporation, which is the corporate form used by public corporations listed on major exchanges. In contrast to C-corporations, all profits of an S-corporation pass directly to the stockholders as they would pass to the partners in a partnership. This means that no taxes are paid at the corporate level. However, since the firm is incorporated, the investors have limited liability. The downside of an S-corporation is that there are restrictions on how many stockholders the firm can have and who they are. Currently, an S-corporation can have no more than one hundred stockholders and only one class of common stock, and all stockholders must be individuals (no corporations or partnerships can own shares) who are U.S. citizens or residents, among other restrictions.
Choosing an Organizational Form
As you can see in Exhibit 18.1, a sole proprietorship is the least expensive type of business to start. To start a sole proprietorship, all you have to do is to obtain the business licenses required by your local and state governments. Limited partnerships are more costly to form because the partners must hire an attorney to draw up and maintain the partnership agreement, which specifies the nature of the relationship between the partners. Forming a corporation also requires hiring an attorney to draft a document that spells out things such as how many shares can be issued, what voting rights the stockholders will have, and who the board members are. Over the life of a successful business, these out-of-pocket costs are not very important. However, to a cash-strapped entrepreneur, they can seem substantial.
Because the life of a sole proprietorship is limited to the life of the proprietor, it ceases to exist when the proprietor gets out of the business. In contrast, the lives of all other forms of organization can be made independent of the life of the founder. Partnership agreements, including the related agreement in an LLC, can be amended to allow for the business to continue when the founder leaves. Corporations, which are legal persons under state law, automatically have an indefinite life. You will notice that Exhibit 18.1 indicates that the lives of partnerships and LLCs are flexible. This is because, while partnership and LLC agreements can be written so that their lives are indefinite, they can also be written with a fixed life in mind. For example, private equity and venture capital limited partnerships and LLCs are typically structured so that they last only 10 years.
The ability to make the life of a business independent of that of the founder increases the liquidity of the ownership interests, making it easier for the business to raise capital or for investors to sell their interests at an attractive price. Since a sole proprietorship has no ownership interest that can be sold directly, the proprietor can sell only the assets of the business. There is no way to sell a partial ownership interest.
Even with partnerships and corporations, it can be quite expensive to raise capital for the business or for an investor to sell an ownership interest. Common restrictions in partnership and LLC agreements and the need to amend the partnership and LLC documents to reflect a change in ownership can make transferring ownership time consuming and costly. Selling shares in a corporation can be costly if that corporation is not publicly traded.
Making sure that a new business has access to enough capital is always an important concern for an entrepreneur. By their nature, sole proprietorships must rely on equity contributions 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 both insiders and outsiders. Limited partnerships and LLCs are less constrained than general partnerships because they can raise money from limited partners or from “members,” as outside investors in LLCs are called, who are not directly involved in running the business. C-corporations can have a virtually unlimited number of potential stockholders.
The downside of being able to raise equity capital from other people is the need to share control. An entrepreneur who chooses a form of organization other than a sole proprietorship, and who does not retain 100 percent ownership, must give up some control. Of course, the entrepreneur may have little choice in this trade-off if the business requires more equity capital than he or she can personally provide.
It is important to recognize that certain investors who are especially important sources of capital for young, rapidly growing firms will only invest in C-corporations. For example, since venture capitalists do not typically want to become full operating partners in the businesses in which they invest and because the cost of transferring ownership interests can be much lower for C-corporations, they will generally invest only in businesses that are organized this way.
Chapter 1 discussed the concept of separation of ownership and control and how it is related to agency problems. This separation has benefits as well as costs. While it is true that agency problems can arise when owners delegate decision-making authority to professional managers, these costs might be smaller than the benefits. Specifically, the ability to separate ownership from management control enables a firm to raise capital from investors who have no interest in being directly involved in the business. This can greatly increase the number of potential investors. Another benefit is that an entrepreneur can turn over day-to-day control of a business to a more capable manager, become less involved in the business, and yet continue to benefit from its successes as an investor.
Another key concern of all entrepreneurs is being able to attract and retain high-quality employees. Being able to offer a current or potential employee an ownership interest in the business or the prospect of becoming a partner can help greatly in retention and recruiting. The inability to offer ownership interests is a major disadvantage of sole proprietorships.
Financial liabilities associated with a business are also an important consideration when choosing the form for a business. On this dimension, sole proprietorships, general partnerships, and limited partnerships 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 LLCs and corporations are limited to the money that they have invested in the business.
The choice of organizational form also affects how the business’s operating profits will be taxed. More taxes mean that the owners get less. In each of the organizational forms in Exhibit 18.1, with the exception of C-corporations, all profits flow through to the owners in proportion to their ownership interests.1 These owners pay taxes on the business profits when they file their personal tax returns. 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, such as health insurance, 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.
Financial Considerations
The most important financial concern of any entrepreneur is making sure that the business has access to enough money to be successful. Unlike a successful mature company, which can rely on cash flows from sales of other products to fund new product introductions, an entrepreneur must obtain funding from outside the firm. This makes it especially important for the entrepreneur to understand the cash requirements of the business.
The margin for error is small. If the entrepreneur miscalculates how much money is necessary, it may be too late to raise more money by the time this error is recognized. Raising external capital can be a time-consuming process and becomes increasingly difficult as a firm becomes more and more cash constrained. Outside investors are especially careful about investing in businesses that have run short of cash. The fact that the business has gotten into such a position can suggest that the business idea might not be viable or that the entrepreneur may not be the right person to build it, or both.
Two tools are particularly useful in understanding the cash requirements of a business and in estimating how much financing a new business will require: (1) the cash flow break-even analysis discussed in Chapter 12 and (2) the cash budget.
Cash Flow Break-Even
Recall that pretax operating cash flow (EBITDA) break-even analysis is used to compute the level of unit sales that is necessary to break even on operations from a pretax operating cash flow perspective. It is calculated using Equation 12.4:

where is the fixed costs associated with the business and is the per-unit contribution.
It is important for an entrepreneur to understand the concept of EBITDA 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 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.
Although it might seem obvious that an entrepreneur should want to maximize the per-unit contribution of each product and minimize total fixed costs, entrepreneurs often lose sight of these objectives. An entrepreneur can get so caught up in developing the best possible product that he or she does not adequately consider how much customers are willing to pay for that product. For example, adding another feature to a word-processing program can be expensive, and consumers might not be willing to pay the additional cost if they are unlikely to use that feature. Of course, being too sensitive to the possibility of overinvesting in new product development can harm a business by causing it to lose its competitive advantage. An entrepreneur should always be looking for ways to maximize the per-unit contribution of the firm’s products while maintaining the firm’s competitive position.
Many entrepreneurs also lose sight of the importance of controlling fixed costs. For example, several firms with virtually no sales have spent well over a million dollars each for short advertisements during Super Bowl football games. Many of these companies also spend a great deal of money on extravagant fringe benefits or things like team-building activities in which they take their entire product development staffs on week-long trips to vacation resorts. Although expenses such as these might help to increase employee productivity or encourage more creativity and hard work among the development staff, they also increase the number of units that a business must sell to break even. Unfortunately, some companies run out of money before they ever break even.
Cash Inflows and Outflows

The Cash Flow Template, Excel spreadsheet #60 on the Web site maintained by Matt H. Evans, is an example of a comprehensive Excel model for forecasting monthly cash flows. See the spreadsheet at http://www.exinfm.com/free_spreadsheets.html.

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, how much external financing is likely to be needed, and when the need is likely to arise. 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.
To better understand how a cash budget can help an entrepreneur, let’s consider an example. Suppose that it is March 1, 2012, and that you are planning to open a new restaurant called the Pizza Palace. You have saved $25,000, which you intend to invest in the business, and you have obtained a five-year loan for $50,000 at an APR of . The loan principal will be repaid in five equal installments of $10,000 at the end of each of the next five years. Exhibit 18.2 presents a monthly cash budget for your restaurant investment.

EXHIBIT 18.2 Pizza Palace Monthly Cash Budget for the Period March 2012 through February 2013aA monthly cash budget summarizes the cash that management expects to flow into and out of a business each month. At a minimum, it presents the cash inflows and outflows for each of the next 12 months and for the entire 12-month period. Monthly cash budgets can extend beyond 12 months.

The initial cash balance in row 1 of the March column of your budget equals the $75,000 that you have raised to finance the project. You estimate that it will take two weeks to actually open the restaurant and, knowing that you will have to build a customer base from scratch, you expect to have only $3,000 in sales during the first month. You do not anticipate providing any credit to your customers, so all of the proceeds from the sales will be received in cash. As shown in rows 8 through 25 of Exhibit 18.2, you expect cash operating expenses to total $20,770 and interest expense, capital expenditures, and start-up costs to be $333, $50,000, and $800, respectively, during March. With only $3,000 in cash inflows, these expenditures will reduce the cash balance by the end of March to only:

While the restaurant is expected to have a positive cash balance at the end of March, the cash balance will be negative by the end of April if no additional financing is obtained. You can see this by noting that the beginning cash balance of $6,097 plus the cash sales of $12,000 would provide a total of only $18,097 with which to pay $22,220 in operating expenses and $333 of interest. This would result in an ending cash balance of:2

Since a restaurant cannot operate without at least some cash for the cash register, you will have to invest more than $4,457 in the business during the month of April. For example, if you decide that you want to maintain a cash balance of at least $5,000, you will have to invest an additional . This investment is shown in row 5 of the April column in Exhibit 18.2. In this example, the investment is treated as an equity investment by the owner rather than as additional debt. You can tell this by the fact that there is no change in the interest payments in row 20. However, we could easily have treated this amount as a loan instead.
Notice that the cash budget tells you that if the cash forecasts in your budget are correct, you will have to raise a total of:

by the end of August to ensure that your restaurant’s cash balance does not fall below $5,000. Knowing this at the beginning of March can be very helpful in planning your fund-raising activities for the year.
You might also note that the cash budget indicates that $353 will have to be invested in February 2013. This is because the first principal payment on the debt is due at the end of that month. If you plan to maintain total debt of $50,000 in this business, you could cover this requirement by obtaining a new $10,000 loan, which you would use to make the debt principal payment.
We can also calculate the cash flow break-even for the Pizza Palace restaurant. If, for simplicity, we assume that the average customer spends $10 for pizza and a drink and that the only unit variable costs are those associated with the food, then we can calculate that the unit contribution will be $6 per customer when the business is up and running in September 2012. We know that the unit contribution is $6 because food purchases represent of cash sales. This leaves 60 percent of cash sales, or $6 per customer, to cover fixed costs. Knowing the unit contribution and assuming all costs other than those associated with food purchases are fixed, we can calculate the cash flow break-even as follows:

In other words, your restaurant will have to serve at least 3,195 customers per month (approximately 107 per day) in order to break even on a cash flow basis once it is up and running.
We have simplified our example by assuming that the restaurant does not provide credit to customers or hold any material inventories of food, supplies, and so forth. However, we could have incorporated these characteristics into our cash budget using the working capital management concepts discussed in Chapter 14.
DECISION MAKING EXAMPLE 18.1

Using a Cash Budget
SITUATION: It is January 1, and you have prepared the following cash budget for the next four months for your new business venture:
Monthly Cash Budget
Jan. Feb. Mar. Apr. Total
Beginning cash balance $ ? 0? ($18,510) ($25,270) ($28,530)
Cash receipts
Cash sales 2,500? 5,000? 12,000? 20,000? $39,500
Investments by owner –? –? –? –? –
Total cash receipts $ 2,500? $ 5,000? $12,000? $20,000? $39,500
Total cash available $ 2,500? ($13,510) ($13,270) ($ 8,530)
Cash payments
Operations
Merchandise purchases $ 1,250? $ 2,500? $ 6,000? $10,000? $19,750
Gross wages and payroll 5,760? 5,760? 5,760? 5,760? 23,040
Advertising 1,000? 1,000? 1,000? 1,000? 4,000
Rent 1,500? 1,500? 1,500? 1,500? 6,000
Other expenses 1,000? 1,000? 1,000? 1,000? 4,000
Operations total $10,510? $11,760? $15,260? $19,260? $56,790
Financing and investments
Capital expenditures $10,000? –? –? –? $10,000
Start-up costs 500? –? –? –? 500
Withdrawals by owner –? –? –? –? –
Total cash payments $21,010? $11,760? $15,260? $19,260? $67,290
Ending cash balance ($18,510) ($25,270) ($28,530) ($27,790)
If you plan to finance the business entirely with equity, how much money should you invest now to ensure that there is at least $1,000 still in the business at the end of April? How much will you have to invest each month after April to maintain a $1,000 cash balance if the cash inflows and outflows in the following months look like those for April?
DECISION:
Assuming that your cash forecast is correct, you should invest $28,790 today. This will cover the $27,790 cash shortfall reflected in the ending cash balance for April while leaving $1,000 in the business. The ending cash balance for April reflects the cumulative cash shortfall over the four-month period because the beginning cash balance for January has been set to zero. You will not have to invest any money after April because the cash inflows exceed the cash outflows in April, and this is not expected to change in the following months.

In our discussion of the cash budget, we assumed that any cash required by the business would come from the owner or from a loan. Unfortunately, financing a business is not always so simple. An important tool in financing a young, rapidly growing business—as well as in managing it—is the business plan.
Why Business Plans Are Important
Recall from Chapter 15 that the equity capital used by entrepreneurs includes their own money, investments from friends and family, investments by venture capitalists, equity raised by selling shares in the stock market, and so on. Debt financing can also come from a wide variety of sources, including the entrepreneur, a bank, a local individual investor, another business, and the sale of debt in the public debt markets, among others.
Ensuring that a young, rapidly growing business has enough cash is a simple matter if the money comes from the entrepreneur. The entrepreneur only has to decide to make the investment. Things are more complicated when the money comes from elsewhere. The entrepreneur must convince potential investors that purchasing debt or equity in the firm will yield attractive returns. In other words, they must be persuaded that they will be adequately compensated for the risks they bear.
Convincing outsiders to invest in a company can be difficult enough if the business has a well-established track record. Raising money from outsiders can be immensely difficult for a young company. The entrepreneur often begins the process with little more than an idea of where the business is headed and some limited operating results in the form of unaudited and often incomplete financial statements. To overcome the skepticism of outside investors, many entrepreneurs prepare a business plan.
A business plan is like a road map for a business. It presents the results from a strategic planning process that focuses on how the business will be developed over time. It describes where the company is going and what steps the company will follow to get there. 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. The fact that an entrepreneur has prepared such a document also demonstrates to investors that the entrepreneur has carefully thought through the business idea. This is especially important when the business is in a very early stage of development and the entrepreneur must convince investors that he or she is capable of building it.
In addition to its usefulness in raising capital, a business plan 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, outside directors, customers, suppliers, and others. A thoroughly thought-out plan can help a business owner avoid problems and better deal with those that arise. In short, business planning is extremely important to the survival of a small and growing company.
The Key Elements of a Business Plan
The depth and scope of business plans vary widely, but most well-developed business plans include the following:

• An executive summary, which summarizes the key points made in the plan.
• A company overview, which describes what the company does and what its comparative advantages are.
• A detailed description of the products and services the company sells or plans to sell, their 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 market analysis, which discusses the markets for the firm’s products and highlights the important characteristics of these markets as they relate to the company.
• A discussion of the marketing and sales activities that will enable the company to achieve the sales and profits reflected in the financial forecasts.
• A discussion of the operations of the business—how the product is (will be) produced and distributed, who the suppliers are, and any competitive advantages the business has in this area.
• A discussion of the management team, which includes the company’s organizational structure and describes the talents and skills of the managers. The discussion of the managers should explain why they are especially well qualified to manage and grow this particular business. This is an especially important part of the business plan when it comes to raising capital. Investors in young businesses invest in the key people as much as in the business idea itself.
• A description of the ownership structure, including the types of securities the firm has issued and who owns them. Potential investors use this information when they value the securities they are considering purchasing and to help them understand the incentives that managers and other owners have to make the business a success.
• A discussion of capital requirements and uses. This section covers the current capital requirements of the business as well as capital requirements over the next five years and provides a detailed account of how the money will be used.
• Historical financial results, when they are available, along with financial forecasts. If sufficient historical results are available, this section will also include an analysis of those results using the financial statement analysis tools discussed in Chapter 4. The forecasts include a month-by-month cash budget for the next two or three years as well as yearly forecasts of operating results. The cash budget helps the reader understand what the cash inflows and outflows will be and their timing. The yearly results provide an indication of what types of returns might be expected from the business.

Valuing A Business

LEARNING OBJECTIVE 3
Explain the three general approaches to valuation and value a business using common business valuation approaches.
Successful decision makers in both small and large firms must understand what determines the value of a business. It is not possible to consistently make investment and operating decisions that create value without knowing how to identify positive NPV projects or how operating decisions affect the value of a firm. This knowledge is also crucial when making financing decisions. In Chapters 16 and 17, we also saw how a firm’s value is affected by capital structure and payout policies. Decision makers must understand business valuation concepts in order to be able to identify the optimal capital structure and payout policy.
In this section, we discuss fundamental business valuation concepts. You will see that financial analysts apply many of the concepts that have already been discussed in this book when they value a business. The reason is that a business is really just a bundle of related projects, and the value of the business equals the total value of this bundle. In other words, 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.
Fundamental Business Valuation Principles
Before we discuss the specific ways in which businesses are valued, you should be aware of two important valuation principles.
The First Valuation Principle: The first valuation principle is that the value of a business changes over time. Changes in general economic and industry conditions, and decisions made by the managers, all affect the value of the cash flows that a business is expected to generate in the future. For example, changes in interest rates affect the firm’s cost of capital and, therefore, the present value of future cash flows. A change in interest rates can also affect the demand for a firm’s products if customers typically finance the purchases of those products with loans, as they often do for big-ticket items such as automobiles and houses. Similarly, competitors enter and exit industries, introduce new products, change prices, and so forth. These actions also affect the value of a business by altering its cash flows or risk. Finally, the value of a business is affected by managers’ investment, operating, and financing decisions.
Because the value of a business changes over time, it is important to specify a valuation date when valuing a business. Normally, this date is the date on which you do the analysis, but it can be an earlier date in some situations. For example, when companies are sued or when stockholders are involved in a dispute with the Internal Revenue Service, the value of the business or its stock as of some date in the past must often be estimated. A stockholder may claim that managers sold stock for less than it was worth at some time in the past, or the IRS may claim that the value of shares passed to an heir was greater than claimed when the taxes were filed by the estate of a deceased stockholder. By specifying the valuation date, the person who values a business makes it clear to anyone who uses the value estimate precisely what economic, industry, and firm conditions are reflected in that estimate.

BUILDING INTUITION

THE VALUE OF A BUSINESS IS SPECIFIC TO A POINT IN TIME
The value of a business is affected by general economic and industry conditions as well as the decisions made by managers. All of these factors affect the cash flows that a business is expected to produce in the future and the rate at which those cash flows should be discounted. Since all of these factors change over time, so will the value of the business.
The Second Valuation Principle: A second very important valuation principle is that there is no such thing as the value for a business. The value of a business can be different to different investors. To understand why, consider two different investors who are interested in purchasing a business that is for sale. Suppose that one investor is a competitor of the business that is for sale and the other is an individual who just wants to invest some money and plans to let the same management continue to operate the business independently. The competitor, who is what we call a strategic investor, might be willing to pay a higher price for the business than the other investor, who is what we call a financial investor, because the strategic investor might be able to combine the business with his or her current business in a way that reduces costs or increases revenues. The financial investor does not have the potential to benefit from these synergies.
The key implication of the idea that the value of a business can differ among investors is that the purpose of a valuation affects the way we do the analysis. If a valuation is being performed to determine what price a particular investor would be willing to pay for a business, the analysis must consider how that investor will operate the business. In the business valuation terminology, we would refer to this as an estimate of the investment value of the business to that investor.
If, instead of estimating the value of a business to a particular investor, an analyst is trying to estimate the price that a typical investor would pay for a business, he or she would be estimating the fair market value of the business. The fair market value of a business is the value of that business to a hypothetical person who is knowledgeable about the business. It does not include the value of synergies or the effects of any investor-specific management style. For this reason, the fair market value can differ considerably from the investment value of a business.

BUILDING INTUITION

THE VALUE OF A BUSINESS IS NOT THE SAME TO ALL INVESTORS
The value of a business is not the same to all investors because different investors will obtain different cash flows from owning a business. For example, the cash flows to passive investors will differ from the cash flows to investors who are active in the management of the business. Cash flows will also differ among active investors because they will have different skill levels, operating preferences, and abilities to benefit from synergies.
Business Valuation Approaches
There are a wide variety of business valuation methods, but most can be classified into one of three general categories: (1) cost approaches, (2) market approaches, and (3) income approaches. Cost, market, and income valuation approaches can be used to value a wide range of assets. They do not apply only to business valuation.
For example, the house or apartment building you live in has at some point been valued using a cost, market, or income approach—possibly even all three. When the building was insured, the insurance company probably used a cost approach to estimate its replacement cost. The appraiser for the local taxing authority is likely to have used a market approach, in which the estimated value was based on recent prices paid for similar properties in the local real estate market. Finally, if your house or apartment building was ever evaluated as a potential rental property by an investor, the investor probably used an income approach. In this analysis, the investor estimated the present value of the cash flows that the property would produce if it were rented.
While the ways in which the cost, market, and income approaches are used to value a business differ from the ways they are used to value real estate, the basic principles are the same. We next describe how these approaches are used to value businesses.
Cost Approaches
Two cost approaches that are commonly used to value businesses or their individual assets are the replacement cost and adjusted book value approaches.
Replacement Cost.
The replacement cost of a business is the cost of duplicating the business’s assets in their present form as of the valuation date. It thus reflects both the nature and condition of the assets. For example, the replacement cost of a 15-year-old electric wood saw that is in relatively good condition equals what it would cost to purchase an identical used saw in the same good condition.
The replacement cost valuation approach is generally used to value individual assets within a business when they are being insured, but it is rarely used to value an entire business. Since investors are concerned with the value of the cash flows that the business can be expected to generate in the future, they use valuation approaches that reflect the value of these cash flows when deciding how much to pay for firms.
Although the replacement cost approach tends to be more useful for insurance purposes, it can be helpful in conducting a buy-versus-build analysis when managers are thinking about making a business acquisition. Before purchasing a business, it usually makes sense to ask if you could build the same business in a way that would result in a greater NPV—in other words, whether it is cheaper to build the business yourself or to buy one that already exists. Answering this question can serve as a useful sanity check on whether you might be paying too much for the business.
When using the replacement cost approach in a buy-versus-build analysis, you must be sure to include the cost of all tangible assets, such as property, plant, and equipment, and all intangible assets, such as brand names and customer lists. You must also include the cost of hiring the people necessary to run the business and account for the cash flows that you would not receive during the time that it would take to build the business. It can take a long time to build a business, and until the business is up and running it will produce smaller cash flows than a business you might acquire.
Adjusted Book Value.
The adjusted book value approach involves estimating the market values of the individual assets in a business and adding them up. When this approach is used, the fair market value of each asset is estimated separately and the values are summed to arrive at the total value of the business. As with the replacement cost approach, an adjusted book value analysis should include all tangible and intangible assets, whether they are actually included on the accounting balance sheet or not.
The adjusted book value approach is useful in valuing holding companies whose main assets are publicly traded or other investment securities, but it is generally less applicable to operating businesses. The value of an operating business is usually greater than the sum of the values of its individual assets because the present value of the cash flows expected from the company is greater. The difference between the value of the expected cash flows and that of the assets is referred to as going-concern value.
Going-concern value reflects the value associated with additional cash flows the business is expected to produce because of the way in which the individual assets are managed together. A lot of different factors determine the going-concern value of a business. For example, one business can have a larger going-concern value than another business because it has a stronger management team that is able to invest in and utilize the business’s assets more efficiently. The going-concern value might also be larger because the employees of the company are more skilled or work better together or because the government provides some special benefit to a particular business.
To see how going-concern value might be created, suppose that you just obtained the exclusive right to produce and sell a patented type of specialty brick in the United States that has been very popular among homebuilders in Europe. Also suppose that you expect to be able to satisfy demand for this brick with a single manufacturing plant. No matter where you build this plant, its adjusted book value will be the same, assuming that the assets in the plant, such as kilns, forklifts, conveyer belts, and so forth, are commonly available and used all over the country. However, the actual value of the plant (business) will depend in part on where you decide to build it if transportation costs are an important component of the overall costs (bricks are heavy and cost a lot to transport). If you build the plant in Oklahoma (the middle of the country), it will be worth more than if you build it in one corner of the country, such as in Miami, because average transportation costs will be lower from Oklahoma. As a result, the going concern value will be greater if you build it in Oklahoma.
Although the adjusted book value approach does not capture the going-concern value associated with a business, it is useful under certain circumstances. We might use this approach (1) when it is especially difficult to forecast a business’s likely cash flows; (2) when we suspect that the going-concern value of the business is negative—in other words, the owners of the business would be better off if the business were simply shut down and its assets were sold off; or (3) if we are explicitly considering liquidation. The adjusted book value approach might also be used as a “sanity check” when using one of the other valuation approaches. If your value estimate is lower than the adjusted book value when you use another approach, it might indicate that there is an error in your analysis. Of course, if you find no errors, this might also be an indication that you would be better off shutting down the business and liquidating it.
When using the adjusted book value approach to estimate the liquidation value of a business, we must make sure to subtract liquidation-related expenses such as sales commissions, legal and accounting fees, and the cost of dismantling and hauling away the assets. To see how the adjusted book value approach might be used to estimate the liquidation value of a business, consider the following situation. Last year you started a business that prints custom logos on T-shirts for business clients. Unfortunately, the economy went into a recession shortly after you started your business, and it never got off the ground. You have virtually run out of cash and have decided to shut down the business rather than invest any more money. The current balance sheet of this business is as follows:

What is the liquidation value of your ownership interest in this business?
The first step in estimating the liquidation value of the business is to estimate how much value will be realized from the individual assets after accounting for liquidation costs. Let’s begin with the cash. Since the objective of the liquidation process is to convert all assets into cash, the liquidation value of any cash on the balance sheet, $78 in this example, simply equals its face value. Assuming that your customers are reputable businesspeople, you expect to collect all of the receivables with little effort. However, since you will incur some expenses in the collection process, you estimate that you will actually receive a net amount that equals 95 percent of the face value of the receivables. A call to your T-shirt supplier reveals that you can return unused inventory to the supplier and receive an 80 percent refund. You do not believe that anyone else will pay you more for the T-shirts. Finally, a supplier of T-shirt printing equipment has offered to pay you $600, or 75 percent of the book value, for your printing press.
With this information, you estimate the liquidation value of the assets is $4,208:

Therefore, after paying your accounts payable and the loan, your equity ownership interest has a liquidation value of .
LEARNING BY DOING APPLICATION 18.1

Using the Adjusted Book Valuation Approach
PROBLEM: You are considering purchasing a company that manufactures specialized components for recreational vehicles. These components are sold to the companies that manufacture the vehicles. As part of your analysis of this opportunity, you decide to estimate the liquidation value of the company. Management has provided you with the following information about its assets. All values are in thousands of dollars.
Cash $ ?444
Accounts receivable 739
Inventory 1,436
Net PP&E 8,463
Total assets $11,082
Management has also told you that you can reasonably expect to collect 93 percent of the receivables (accounting for collection expenses), that the inventory can be sold to realize 85 percent of its book value, and that sale of the property, plant, and equipment would yield $6,100. What is the liquidation value of this company?
APPROACH: Calculate the value that will be realized for each of the individual types assets and sum those values to obtain the liquidation value of the company.
SOLUTION:
The liquidation value is:
Cash $ ?444
100%
$ ?444
Accounts receivable $ ?739
93%
$ ?687
Inventory $ 1,436
85%
$1,221
Net PP&E $ 8,463 $6,100
Total assets $11,082 $8,452
You can expect to realize $8,452 from the liquidation of this company if there are no liquidation expenses that are not accounted for in these numbers.

Market Approaches
Two market approaches are commonly used in business valuation. The first approach, which is often called multiples analysis, uses stock price or other value multiples that are observed for similar public companies to estimate the value of a company or its equity. The second approach, often called transactions analysis, uses information from transactions involving the sale of similar companies to estimate the value of a company or its stock.
Market approaches reflect prices that have actually been paid for a company’s stock or for the entire company. While it is not always obvious why people pay a particular price, the information on what they pay can yield useful insights into how those people view the prospects for similar businesses. Market approaches can also provide useful benchmarks against which valuations based on other methodologies can be compared.
Multiples Analysis.
Multiples analysis is widely used in business valuation. This approach involves: (1) identifying publicly traded companies engaged in business activities that are similar to those of the company being analyzed and (2) using the prices at which shares of those comparables are trading, along with accounting data, to estimate the value of the equity of a company of interest or its entire value. Multiples analysis can be especially useful in estimating the price at which the stock of a private company can be sold. For example, this approach is often used to help identify the price at which shares can be sold when a company does its initial public offering (IPO) or when some or 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. These ratios divide a measure of stock price by an accounting measure of profits and revenue, respectively. Analysts typically estimate one of these multiples using data from comparable public companies, and then they use an average or, if one comparable is clearly better than the others, a multiple from a single comparable company to estimate the value of the company of interest.
Suppose, for example, that we want to estimate the value of the equity of a private department store chain that we are considering purchasing. The chain earned net income of $3.65 million last year. We have identified a publicly traded company that is very similar to the company we are valuing and notice in the Wall Street Journal that the P/E ratio for its common stock is 17.63. From this information, we can estimate that the market value of the equity (VE) of the company that we are considering purchasing is:

It is important to recognize that because the stock of the comparable companies is publicly traded and shares that are bought and sold in public markets are more liquid than shares that are not publicly traded, we must be careful when using multiples analysis to value a private company. The prices paid for shares that are not publicly traded can be considerably less than the prices paid for public shares. While the size of this marketability discount depends on many factors, such as the fraction of the total shares being bought or sold, it can amount to well more than 30 percent in some instances.3
A multiples analysis is conceptually straightforward but can be difficult in a real situation. One complicating factor is that truly comparable public companies are difficult to find. The ideal comparable company would match the company being valued on many dimensions. It would sell the same products, compete in the same markets, be of similar size, have similar revenue growth prospects, have similar profit margins, and have similar management quality, among other characteristics. In addition, if an equity ratio (such as price/earnings or price/revenue) is being used, the comparable should have a similar capital structure because, all else being equal, capital structure can have a dramatic impact on those ratios.
The importance of identifying comparable companies that are similar to the company being analyzed can be illustrated by considering the characteristics that determine a company’s price/earnings multiple. Recall from Chapters 9 and 13 that the constant-growth dividend model, Equation 9.4, can be used to estimate the value of a share of stock. Using the notation from Chapter 13, this model can be written as:

where is the current stock price, is the dividend that is expected next year, is the required return on common stock, and is the expected growth rate in dividends. If we recognize that dividends equal the fraction of earnings distributed to the stockholders times the earnings of the firm, we can rewrite Equation 9.4 as:

where is the earnings per share expected next year and is the fraction of the firm’s earnings that is paid out as dividends. is known as the dividend payout ratio, which is discussed in Chapter 19. Finally, we can rearrange this equation to obtain the price/earnings multiple:
(18.1)
This equation tells us that the P/E multiple can be thought of as equal to the dividend payout ratio over minus .4

You can learn more about business valuation and find a wide range of Excel templates that can be used to value businesses and their securities on the Web site maintained by Aswath Damodaran at http://pages.stern.nyu.edu/~adamodar.

By focusing on the variables that drive the P/E multiple in this simple framework, we can see the importance of identifying comparable companies that are as similar to the company of interest as possible. For example, consider what company characteristics determine . The Capital Asset Pricing Model (CAPM) tells us that depends on beta, which is a measure of the systematic risk associated with a company’s stock price. Since this systematic risk is closely related to the volatility of the earnings of the company, our discussion of total risk in Chapter 16 (see the discussion of Exhibit 16.3) suggests that the cost of equity depends on both business and financial risk. In other words, it depends on things such as the products the company sells, the markets it sells them in, its profit margins, and its operating and financial leverage. The growth rate of dividends, , is determined by the same factors that affect . This means that if we cannot identify a comparable company that is similar to the company of interest in both its business and financial characteristics, the P/E multiple we obtain for the comparable company will not be a good measure for our analysis.
Because P/E ratios are sensitive to leverage, many analysts use ratios that divide the total value of a company’s equity plus its debt by an accounting measure of cash flows available to all providers of capital (debt and equity). These ratios provide a direct measure of the total value of a company’s equity plus its debt, which is known as its enterprise value.5 The total value of the firm was written in Equation 16.1 as . In the interest of brevity, we will write it in this chapter as:

where is the value of the firm, is the value of the debt, and is the value of the equity. Multiples that are based on the total value of the firm are known as enterprise multiples. Examples include enterprise value/revenue and enterprise value/EBITDA.
To see how an enterprise multiple can be used to estimate the total value of a firm, let’s return to the example in which we were valuing the department store chain. Assume that, in addition to the P/E ratio analysis, we want to estimate the enterprise value of the business using an enterprise value/EBITDA ratio. We have estimated that EBITDA last year was $8.67 million for the department store chain we are valuing. In the Wall Street Journal, we find that the current price of the comparable company’s stock is $31.25, and, from the balance sheet in the annual report, we observe that the comparable company has 3.67 million shares outstanding. We also estimate that the value of the comparable company’s outstanding debt is $19.46 million, and we note that EBITDA for this company was $14.35 million last year. Using this information, we can calculate the enterprise value/EBITDA ratio for the comparable company as follows:

and we can estimate the enterprise value for the company we are valuing as:

LEARNING BY DOING APPLICATION 18.2
Using Multiples Analysis
PROBLEM: In addition to performing the liquidation analysis in Learning by Doing Application 18.1, you have decided to estimate the enterprise value of the company that manufactures specialized components for recreational vehicles. You have collected the following information for a comparable company and for the company you are valuing:
Comparable company: Company you are valuing:

Estimate the enterprise value of the company you are valuing using the P/E and enterprise value/EBITDA multiples.
APPROACH: First, calculate the P/E and enterprise value/EBITDA multiples for the comparable company. Next, use these multiples to estimate the value of the company you are valuing. Multiply the P/E multiple for the comparable company by the net income of the company you are valuing to estimate the equity value. Add this equity value to the value of the outstanding debt to obtain an estimate of the enterprise value. Multiply the enterprise value/EBITDA multiple for the comparable company by the EBITDA for the company you are valuing to obtain a direct estimate of the enterprise value.
SOLUTION:
The P/E and enterprise value/EBITDA multiples for the comparable company are:

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

which suggests an enterprise value of:

Using the enterprise/EBITDA multiple, we estimate the enterprise value to be:
Whenever we use multiples analysis, we must remember that we are estimating the fair market value of a company’s equity or its enterprise value and that this value is based on transactions involving small ownership interests. The transaction prices that we observe in the stock market are typically based on trades that involve unknown investors buying small numbers of shares that do not give them the ability to control the business. In other words, a multiples analysis does not provide an estimate of investment value because the identities of the buyers are not known. This means that value estimates based on a multiples analysis do not reflect the synergies that might be realized by combining the company with another business. These estimates also do not include the value associated with being able to control a business, an important consideration that we discuss in more detail later.
When performing a multiples analysis, it is also important to make sure that the numerator and the denominator of the ratio we are using are consistent with each other. In other words, if stock price is in the numerator, some measure of cash flow to equity must be in the denominator. If enterprise value is in the numerator, a measure of total cash flows from the entire business must be in the denominator.
The exception to this rule is the price/revenue ratio. This ratio can be useful in valuing the stock of a relatively young company that is not yet generating profits. Shares in very young companies are often bought and sold based on multiples of their revenue. Implicit in those multiples are expectations about future margins, as well as growth in revenue. By using price to revenue, the analyst is effectively assuming that the company being analyzed will, over time, have profit margins similar to those that are anticipated by the market in pricing the publicly traded comparables.
Another important point to keep in mind when doing multiples analysis is that the data used to compute the multiple for the comparable company should include the stock price as of the valuation date and that accounting data for the two companies should be from the same period. Since any value estimate is specific to a particular date, we must be sure to use multiples for the appropriate point in time. Furthermore, if we use accounting data from the past 12 months to estimate the ratio for a comparable company, we must use accounting data from the same 12-month period to calculate the value of the company of interest.
Transactions Analysis.
The information used in a transactions analysis is typically obtained from Securities and Exchange Commission (SEC) filings of public companies that have acquired other companies or from commercial services that collect and sell this information. This 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 a company. Transaction data reflect the price that a particular investor paid for an entire company. For this reason, it provides an estimate of the investment value to that investor.
Like multiples analysis, transactions analysis can be difficult to use in practice, although the reasons for the difficulty are different. One problem is that transactions data are not typically as reliable as the data available for multiples analysis, especially when the transactions involve private companies. For example, the available data on transactions might include revenues of the private company but not data on its profitability. The data might include the net income but not enough information to estimate EBITDA. This can make it difficult to compute some multiples.
In addition, unlike stock market transactions, transactions involving the purchase or sale of an entire business occur relatively infrequently. This means that the data available for a transactions analysis often include only transactions that occurred months or even years earlier. Since the value of a business is specific to a particular point in time, the price that was paid for a business becomes less useful an indicator of what the business is worth as time passes after the sale.
Finally, the terms of the transactions can be difficult to assess. While the P/E multiple for a publicly traded company is an indication of the price that might be obtained in a cash transaction, transactions involving the sale of an entire company often involve some combination of cash, debt, or equity payments. A whole package of such securities, some of which can be difficult to value, could be included in the reported transaction price, and this may not be apparent to the analyst. The value estimates for those securities and claims can also be distorted if the buyer or seller has a reason to prefer reporting a higher or lower price.
Income Approaches
At the beginning of this section, we said that 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. The cost and market approaches are useful for estimating this value in certain situations—such as in doing a buy-versus-build analysis, estimating the liquidation value of a firm, or when good comparable firms or transactions are available. The most direct approaches for estimating the value of the cash flows a business is expected to produce, however, are the income approaches. Like NPV analysis, these approaches directly estimate the value of those cash flows.
Before we discuss specific income valuation approaches, we should note that the market and income approaches differ in one very important way. Because the market approaches rely on prices that have been paid for companies or their securities, the value estimates that they yield are estimates of what people are willing to pay. In contrast, the income approaches provide estimates of the intrinsic, or true, value of a company or its securities.
While the market value can equal the intrinsic value, the two values are not necessarily the same. For example, if you are valuing the company you work for, you might have better information about its prospects than do stock market investors. By using an income approach, you would be able to incorporate your superior information directly into the valuation analysis in a way that you would not be able to do with a market approach.
Using Income Approaches.
The life of a business is not usually known when it is valued. Whereas a project might be expected to last a specific number of years, a business can have an indefinite life. This makes it more difficult to use an income approach to value a business than a project. It is difficult enough to forecast cash flows for a relatively short period, such as three or five years, let alone for the indefinite future.
Another complication in business valuation is that businesses often have cash or other assets that are not necessary for operations. These can include cash that was earned in the past but has not been distributed to stockholders and assets that are left over from old projects. We call these nonoperating assets (NOA). When we estimate the value of an individual project, we do not have to worry about NOA because there are none. However, when we value a business, NOA are an additional source of value. NOA can be distributed directly to stockholders or sold and the proceeds distributed to stockholders without affecting the cash flows that the operations of the business are expected to generate.
In practice, we account for the indefinite life associated with a business and the possibility that it has NOA by estimating the value of the business as the sum of three numbers. This calculation can be represented as follows:
(18.2)
where is the value of the firm, is the present value of the free cash flows that the business is expected to produce over the next years, is the present value of all free cash flows after year , and NOA is the value of all of the nonoperating assets in the firm. Note that the present value of all free cash flows after year is generally known as the terminal value. Note also that if we only want to calculate the value of the equity, we can do this by first calculating the value of the firm using Equation 18.2 and then subtracting the value of the debt.
Free Cash Flow from the Firm Approach.
When using 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 free cash flows equals the total value of the firm, or its enterprise value.
The free cash flows used in a FCFF analysis are almost identical to the free cash flows from the left-hand side of the finance balance sheet that was illustrated in Exhibit 13.1. The only difference is that when we value a business, we do not include cash flows 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 noninterest-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 precisely what we are referring to when we refer to the value of FCFF.

EXHIBIT 18.3 The Finance Balance Sheet and Firm Value
The value of a firm (enterprise value) equals the present value of the future free cash flows from the firm (FCFF). Since the owners of the interest-bearing debt and other long-term liabilities and the stockholders, collectively, have the right to receive all of the FCFF, the total value of those claims equals the value of the firm.

The most common FCFF approach involves using the weighted-average cost of capital (WACC), which we discussed in Chapter 13, to discount the FCFF. This is often referred to as the WACC valuation method. In this approach, the total value of the firm is computed as the present value of the FCFF, discounted by the firm’s WACC:
(18.3)
In this equation, equals the period when the cash flow is produced.
We compute the FCFF using the same calculation that we used for the free cash flows for a project in Chapter 11. The only differences are: (1) that since business valuation involves valuing all of the projects in the firm, we compute the total cash flows the firm’s assets are expected to produce rather than the incremental cash flows from a project and (2) we use the average tax rate instead of the marginal tax rate. The FCFF calculation is shown in Exhibit 18.4. Notice that this calculation is just like the calculation in Exhibit 11.1.
Analysts typically estimate future FCFF by forecasting each of the individual components and then performing the calculation shown in Exhibit 18.4. Next, the resulting FCFF values are discounted back to the present using the WACC, as already mentioned. Recall that the WACC is calculated using Equation 13.7:

where and where , , and are the pretax cost of debt and the after-tax costs of preferred stock and common stock, respectively. Also, is the tax rate that applies to interest deductions, and , , are the proportions of the value of the firm that are represented by debt, preferred stock, and common stock.

EXHIBIT 18.4 The FCFF Calculation
Free cash flows from the firm (FCFF) are calculated in the same way as the incremental after-tax free cash flows (FCF) that are expected from a project. The only differences between the FCFF calculation and the FCF calculation, which is illustrated in Exhibit 11.1, are that in the FCFF calculation (1) we use total cash flows rather than incremental cash flows, and (2) we use the average tax rate instead of the marginal tax rate when we are valuing a company that is operating independent of any other company.

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. For example, the financing might be 80 percent equity and 20 percent debt. Or it might be 30 percent equity and 70 percent debt. These are very important assumptions because, as we saw in Chapter 16 (see Exhibit 16.8), the capital structure choice affects the value of the firm. The FCFF calculation is not affected by the firm’s capital structure, but from Equation 18.3 we know that capital structure affects firm value by affecting the discount rate—the WACC. In fact, as we discussed in Chapter 16, the optimal capital structure for a business is the one that minimizes the WACC.
To see how the FCFF approach is used to value a business, consider an example involving Bell Mountain Manufacturing Company. Assume that we have forecast Bell Mountain’s FCFF in each of the next five years to be as shown in Exhibit 18.5. Also assume that we have estimated that the WACC for Bell Mountain to be 11 percent and that the cash flows after year 5 will grow at an annual rate of 3 percent. Finally, we observe that Bell Mountain has excess cash of $14.68 million but no other NOA.

EXHIBIT 18.5 FCFF Forecasts for Bell Mountain Manufacturing Company ($ millions)
This exhibit presents forecasts of free cash flow from the firm (FCFF) for Bell Mountain Manufacturing Company for each of the next five years.

With this information, we can calculate the enterprise value of Bell Mountain Manufacturing Company using Equation 18.2:

We begin by calculating the present value of the forecasted free cash flows in Exhibit 18.5. The present value of these cash flows is

In this example, we prepared cash flow forecasts for five years. The length of the period for which detailed projections are produced depends on the level of uncertainty surrounding the future of the business. In general, we want to forecast the cash flows out to a point in time where we expect the business to reach a steady-state growth rate. We can then estimate the cash flows for the remainder of the business’s life (the terminal value) by (1) calculating the present value of all cash flows after the final year of the detailed forecast using the formula for a growing perpetuity and (2) discounting this value to the present. For Bell Mountain, these calculations are as follows:

and:

Finally, we can use Equation 18.2 to calculate the total value of Bell Mountain Manufacturing Company:

Free Cash Flow to Equity Approach.
The free cash flow to equity (FCFE) approach is very similar to the FCFF approach. However, instead of valuing the total cash flows the assets of the business are expected to generate, we value only the portion of the cash flows that are available for distribution to stockholders. To see how the FCFF and FCFE approaches are related, ask yourself the following question: If you wanted to value only the equity claims, how would you adjust the cash flows that are used in the FCFF approach? The answer is that you would simply strip out the cash flows to or from the people who lend money to the firm. Since the value of the firm equals the value of the debt plus the value of the equity, stripping out the cash flows to or from the lenders leaves the cash flows available to stockholders.
LEARNING BY DOING APPLICATION 18.3
Using the FCFF Income Approach
PROBLEM: You have decided to use the FCFF income approach to estimate the intrinsic value of the company that manufactures components for recreational vehicles. You expect cash flows to grow very rapidly during the next five years and to level off after that. Based on this, you forecast the cash flows for each of the next five years to be:
Year
1 2 3 4 5
FCFF ($ millions)
$0.108 $0.998 $2.110 $2.857
You expect cash flows to be constant after year 5. There are no NOA in this firm. If the appropriate WACC is 9 percent, what is the enterprise value of this business? What is the value of the equity if the value of the company’s debt equals $1.25 million?
APPROACH: First calculate the total present value of the individual FCFF that you have forecast by discounting them to year 0 using the WACC and summing them up. Next, calculate the terminal value, assuming no growth in the cash flows after year 5, and discount this value to year 0. The enterprise value equals the present value of the individual cash flows plus the present value of the terminal value. The value of the equity can then be calculated by subtracting the value of the debt.
SOLUTION:
The present value of the cash flows in the first five years is:

The present value of the terminal value is:

Therefore, the total enterprise value is:

and the value of the equity equals .
Exhibit 18.6 shows how FCFE is calculated. Notice that this calculation includes three cash flows that are not in the FCFF calculation. One is the interest expense, which is a cash flow to the lenders. The others are the cash flows associated with the repayment of debt principal and the proceeds from new debt issues. As mentioned, then, this approach takes the total cash flows from the business and removes any cash flows to or from lenders, leaving cash flows available to the stockholders.

EXHIBIT 18.6 The FCFE Calculation
Free cash flow to equity (FCFE) equals free cash flow from the firm (FCFF) less any net cash outflows to debt holders. In the FCFE calculation, we subtract the interest and principal payments to the debt holders and add any proceeds from the sale of new debt.

Because cash flows available to stockholders are residual cash flows, they are riskier than the total cash flows from the firm (assuming the firm has some debt). Consequently, in using the FCFE valuation approach, the cost of equity is used to discount the cash flows:
(18.4)
Note that equals if the firm has no preferred stock outstanding. Otherwise is a weighted average of and . Other than the difference in the way that the cash flows are calculated, the procedure for estimating the value of a firm’s equity using the FCFE approach is the same as that used to estimate the total value of the firm using the FCFF approach.
Dividend Discount Model Approach.
The dividend discount model (DDM) approach is very similar to the FCFE approach. In this approach, we estimate the value of equity directly by discounting cash flows to stockholders. However, there is a subtle difference. The DDM approach values the stream of cash flows that stockholders expect to receive through dividend payments. In contrast, the FCFE approach values cash flows that are available for distribution to stockholders. 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:

Notice that in this model the price of a share of common stock is computed by discounting future dividends.
DECISION MAKING EXAMPLE 18.2

Choosing an Appropriate Valuation Approach
SITUATION: You have decided to make an offer for the recreational vehicle manufacturing business that you evaluated in Learning by Doing Applications 18.1, 18.2, and 18.3. Your analysis yielded the following enterprise value estimates:
Liquidation value $ 8.45 million
Value from multiples analysis
P/E multiple $18.35 million
Enterprise/EBITDA multiple $24.70 million
FCFF value $24.58 million
The seller of the company is asking for $18 million. Is this price reasonable?
DECISION:
The price appears to be reasonable. It is almost $10 million greater than the liquidation value, but this value does not include the going-concern value associated with the business. The other three estimates, which all reflect the company’s going-concern value, suggest that the fair market value of the business is greater than the seller’s asking price.

Since the constant-growth model assumes that the firm currently pays dividends and that these dividends will increase at a constant rate forever, this approach is really useful for only a limited number of mature firms that pay dividends. More often, use of the DDM approach involves discounting dividends that either will 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. In these cases, an approach such as that illustrated for the FCFF approach above must be used. The expected dividends must be individually discounted for some period, and then a terminal value must be estimated once the growth rate in dividends stabilizes at some level that is sustainable over the long run. This is the mixed (supernormal) growth dividend model from Chapter 9.
Important Issues in Valuation

LEARNING OBJECTIVE 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.
We conclude the chapter by discussing some important issues in valuing businesses. Whether a business is public or private, whether it is young or old, and whether a minority interest or a controlling interest is involved can make a difference in valuation. In addition, we may have to take account of the role of key employees.
Public versus Private Companies
The same valuation approaches are used to value both public and private companies. However, there are some important differences, which we consider next.
Financial Statements
While financial statements of public companies must be audited and filed with the Securities and Exchange Commission, there is no requirement that the financial statements of private companies be audited. As a result, the completeness and reliability of financial statements for private companies vary considerably. Some private companies have complete, audited financial statements, whereas others have incomplete financial statements that are not prepared in accordance with the generally accepted accounting principles (GAAP) discussed in Chapter 3. Incomplete and unreliable financial statements can complicate the process of valuing a private business, making it more difficult to accurately assess its value.
Financial statements of private companies also differ from those of public companies in some of the expense accounts. Owners of private businesses have incentives to pass some of their personal expenses through the business because this enables them to deduct the expenses on their taxes. Examples might include the owner’s car, “business” trips to Hawaii or Europe, the company condominium in New York, or the sky box at the local football stadium. While there may be legitimate reasons for a business to incur expenses such as these—for example, entertaining important customers in the sky box—there are often more such expenses in private companies.
Owners of private companies can also have incentives to pay themselves more than it would cost to hire someone to do their job. If the income from the company is taxed before it is distributed to the owners (such as in a C-corporation), this excess compensation reduces the taxes that the company must pay. Compensation payments are deductible for the corporation and are therefore only taxed as income to the owner. If instead of paying themselves excess compensation, owners distributed the money as dividends, it would be taxed twice—once as income to the corporation and a second time as income to the owner. In addition to having incentives to pay themselves excess compensation, owners of private companies often put family members on the payroll at wages that are above what would ordinarily be paid for the services they provide. When valuing a private company, analysts typically adjust for excess compensation to the owner and family members by estimating what it would cost to hire other people to perform the services and, using this, change the actual expense reported in the income statement accordingly.
Marketability
In the discussion of multiples analysis, we mentioned that the prices paid for shares in a company whose stock is not publicly traded can be considerably less than the prices paid for publicly traded shares of a similar company. One reason is that stockholders of a public firm can generally sell their shares by simply going online or calling a broker and paying a small fee. In contrast, a stockholder in a private firm may have to spend considerable resources (both money and time) to sell his or her shares. An investor who is offered the opportunity to buy identical equity claims to the cash flows of a public and a private firm (that is, the cash flows have the same size, timing, and risk) will require different rates of return for the two investments. Because of the higher transaction costs associated with the stock of the private firm, the investor will not be willing to pay as much for that stock (and will therefore expect a higher return) as for the publicly traded shares. This must be taken into account in estimating the value of any claim to the cash flows of a firm. As we mentioned earlier, differences in marketability can result in discounts of 30 percent or more for shares of private companies. Where analysts are able to estimate the appropriate size of such a discount, they deduct the discount directly from the final value estimate that is obtained using the methods described in the preceding section.
Young (Rapidly Growing) versus Mature Companies
Another important issue that arises in business valuation concerns the fact that young, rapidly growing companies tend to be more difficult to value than mature, stable companies. Both entrepreneurs and investors in new businesses, such as venture capitalists, must deal with these difficulties when young companies seek financing. One factor that makes it more difficult to value a young company is that less reliable historical information is available. A company may have only two or three years of historical financial records, and those records may reflect the company at a different stage in its development.
In addition, 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. This makes it much more complicated to identify appropriate comparable companies for a multiples or transactions analysis and more difficult to estimate expected cash flows for an income analysis.
Furthermore, many young, rapidly growing companies are not yet profitable. With no 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. When analysts use these multiples, they are implicitly assuming that the business they are valuing will become as profitable (specifically, have the same profit margins) as the public companies that were used to estimate the multiples and that the risks of the business will also be similar. These can be very heroic assumptions when the company being valued is only a couple of years old.
Finally, many young companies invest a considerable amount of money in order to grow. This can make it very difficult to use an income valuation approach. The cash flows will be negative until the business becomes profitable and its profits exceed its investment expenditures. Since it can take several years for this to happen, expected cash flows are typically negative for several years. This means that positive cash flows, which represent the value that the business is expected to produce for its owners, are further in the future and are therefore less certain. The bottom line is that this increases the overall level of uncertainty associated with an income-based valuation.
Controlling Interest versus Minority Interest
Another important issue that we must consider when we value a business is whether we are valuing a controlling ownership interest or a minority interest. The amount of stock required for an investor to exercise control varies depending on the ownership structure of the company. For example, a stockholder with just 20 percent, or possibly even less, of the total votes in a public company can effectively control that company if there are no other large stockholders. Even if there are other large stockholders, that investor can control the public company if friendly stockholders provide enough additional votes. In private companies, which tend to have relatively few stockholders, a stockholder must generally control 50 percent of the shares, either directly or indirectly through friendly stockholders, to control the firm. A stockholder who has such control can run the business as he or she wants. He or she can select the board of directors, choose the business strategy, hire and fire managers, and approve or disapprove any investment, operating, or financing decisions.
Whether a controlling ownership interest is being valued has important implications for a valuation analysis. Recall that in the discussion of multiples analysis we noted that a multiples analysis does not reflect the value associated with being able to control a business. Thus, when we are using multiples computed using public stock market prices to estimate the value of a controlling interest, we must make adjustments to reflect the benefits of control. Similarly, when we use an income approach to value a business, the cash flow forecasts and discount rate assumptions we use will differ depending on whether we are valuing a minority or a controlling ownership interest.
Let’s consider an example of how these differences arise when the income approach is used. Suppose we are valuing 100 shares of Hewlett-Packard (HP) stock. Since owning 100 shares of HP stock will not enable us to exercise any control, the expected cash flows that we should discount simply reflect the cash flows that we can expect HP to generate under its current management (assuming we know of no imminent management change). In contrast, if we are valuing a controlling interest in HP stock for a potential buyer, we would discount the cash flows that HP would be expected to generate if it were under the control of that buyer.
It is also important to note that the market rates of return that we use to calculate the cost of equity with the Capital Asset Pricing Model (CAPM) discussed in Chapter 7 are based on small stock transactions. If having control would enable an investor to better manage the systematic risk associated with a business, a discount rate based on small transactions would be higher than a discount rate estimated from a transaction that involves a controlling position. Therefore, a discount rate estimated using public stock market information and CAPM might be too high for a valuation that involves a controlling position.
Unfortunately, while the discount rate we estimate using CAPM might be too high when we value a controlling interest, the CAPM theory provides us with no insights concerning how we might adjust that rate. As a result, analysts typically adjust for the effects of an incorrect discount rate (as well as for any possible cash flows that are not reflected in an income-based valuation) by adding a control premium. For instance, if the value of a firm’s equity is estimated to be $100 million using an income approach, a 20 percent premium might be added to arrive at a final value of $120 million. Of course, the magnitude of the adjustment depends on the situation.

Write a 350 to 700 word response to the following e-mail:

Dear Consultant,

starting a business and developing my business plan. some advice on how to start forming my business. I am not sure exactly how it will be financed and whether or not I want to take on partners. I am interested and willing to learn the intricacies of my options to determine how to best proceed with my plan.

Please advise on what my options are, the advantages and disadvantages of each, and possible tax consequences for each scenario?

Discuss the different forms of business organization and review the exhibit in 18.1 and share some of the advantages and disadvantages of the forms of organization.
18.1 Starting A Business

LEARNING OBJECTIVE 1
Explain why the choice of organizational form is important, and describe two financial considerations that are especially important in starting a business.
People start their own business for a wide variety of reasons. Some have an idea for a new product or service that they think will revolutionize an industry and make them rich. Others live in an area where there are no attractive employment opportunities for them, and starting a business is the only way to earn a living. Others simply want to be their own boss.

To learn more about starting a business, see the Business Owner’s Toolkit page on the CCH Web site at http://www.toolkit.cch.com.

Regardless of their motives, all of these people face the decision of whether to start their own business or purchase an already established business. Starting your own business can provide greater potential rewards but is inherently more risky than buying and growing a business that someone else has already built. The founder of a company must start from scratch by choosing the products to sell, the markets to sell them in, and the best strategy for selling them. He or she must then raise the money necessary to develop the products, acquire the necessary assets, and hire the right people. Of course, 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 as well as possible.
In this section, we discuss factors that entrepreneurs consider when deciding to launch a new business, factors that affect the form of organization that they choose, and financial considerations associated with starting a business.
Making the Decision to Proceed
Hundreds of thousands of new businesses are started in the United States each year, but many do not succeed. The Small Business Administration estimates that 627,200 new firms were formed in 2008. However, statistical analyses of earlier business formations suggest that only about 44 percent of these firms will still be in business in 2012. Among those that do survive, only a few will provide high returns to their founders.
Businesses fail for many reasons. Some fail because consumers do not accept their products. Others fail because the founder pursues a poorly thought-out strategy or does not have the management skills to properly execute a good strategy. Another common reason for new business failures is that founders underestimate how much money it will take to get their businesses up and running. For example, they underestimate the amount of money that will be needed to cover cash outflows until cash inflows from sales are large enough to do so. These founders fail to ensure that they have enough money to give the business a fighting chance.
The fact that many new businesses fail does not mean that you should not start a business if you believe that you have a good idea. It simply means that you should carefully think through your new business idea before you make the decision to proceed. Not thinking carefully about your idea can lead you to pursue a poor strategy, fail to realize that you might need help in executing your strategy, or underestimate how much money you will need.
It is beyond the scope of this book to tell you how to properly evaluate a business idea, a strategy for pursuing it, or your management abilities. Fortunately, a lot has been written on these topics by others. For example, you can find useful readings on these topics on the “Business Owner’s Toolkit” page on the CCH Web site (see the earlier margin reference).
The only advice that we can give you in these areas is to be careful and realistic in assessing your opportunities. On the one hand, don’t jump into a business without careful thought. On the other hand, don’t overanalyze opportunities to the point where you are just convincing yourself not to proceed. Taking calculated risks is part of business. The important thing to remember is that the risks you take should be “calculated.” Also, don’t think that failure will ruin your chances of ultimately achieving business success. Many successful entrepreneurs and executives have failed more than once in their careers. Successful people learn from both their failures and their successes.
Choosing the Right Organizational Form
Once you have made the decision to start a business, you must decide what form of organization will work best. Chapter 1 discussed some of the more common basic forms of business organization—sole proprietorships, partnerships, and corporations—and some of their advantages and disadvantages. In that discussion, you saw that there are variations in the basic forms of business organization. For example, Chapter 1 describes general, limited, and limited liability partnerships. There are also a number of different types of corporations, as well as hybrids between partnerships and corporations. The reason that so many different forms of organization exist is that the needs of businesses vary considerably. The wide range of choices has made the decision of how to organize a business so complex that many people don’t even try to make this decision without the advice of an attorney.
In this section, we extend the discussion begun in Chapter 1 by focusing, from a financial perspective, on factors that affect the choice of the appropriate organizational form for a new business. We highlight some of the most common forms of organization and identify important characteristics of these alternatives that should be considered when choosing the form of organization for a business.
Exhibit 18.1 compares the common forms of business organization on a number of different dimensions. You will note that there are two forms of organization in this table that are not discussed in detail in Chapter 1: limited liability companies (LLCs) and S-corporations. We first briefly describe LLCs and add to the brief discussion of S-corporations in Chapter 1. We then focus on the differences between the various forms of organization shown in the exhibit.

EXHIBIT 18.1 Characteristics of Different Forms of Business Organization
Choosing the appropriate form of business organization is an important step in starting a business. This exhibit compares key characteristics of the most popular forms of business organization in the United States.

LLCs and S-Corporations
Since it was first developed in Wyoming in 1977, the LLC form of organization has benefited founders of many businesses that would otherwise have been organized as limited partnerships. 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.
An S-corporation is a variation on a C-corporation, which is the corporate form used by public corporations listed on major exchanges. In contrast to C-corporations, all profits of an S-corporation pass directly to the stockholders as they would pass to the partners in a partnership. This means that no taxes are paid at the corporate level. However, since the firm is incorporated, the investors have limited liability. The downside of an S-corporation is that there are restrictions on how many stockholders the firm can have and who they are. Currently, an S-corporation can have no more than one hundred stockholders and only one class of common stock, and all stockholders must be individuals (no corporations or partnerships can own shares) who are U.S. citizens or residents, among other restrictions.
Choosing an Organizational Form
As you can see in Exhibit 18.1, a sole proprietorship is the least expensive type of business to start. To start a sole proprietorship, all you have to do is to obtain the business licenses required by your local and state governments. Limited partnerships are more costly to form because the partners must hire an attorney to draw up and maintain the partnership agreement, which specifies the nature of the relationship between the partners. Forming a corporation also requires hiring an attorney to draft a document that spells out things such as how many shares can be issued, what voting rights the stockholders will have, and who the board members are. Over the life of a successful business, these out-of-pocket costs are not very important. However, to a cash-strapped entrepreneur, they can seem substantial.
Because the life of a sole proprietorship is limited to the life of the proprietor, it ceases to exist when the proprietor gets out of the business. In contrast, the lives of all other forms of organization can be made independent of the life of the founder. Partnership agreements, including the related agreement in an LLC, can be amended to allow for the business to continue when the founder leaves. Corporations, which are legal persons under state law, automatically have an indefinite life. You will notice that Exhibit 18.1 indicates that the lives of partnerships and LLCs are flexible. This is because, while partnership and LLC agreements can be written so that their lives are indefinite, they can also be written with a fixed life in mind. For example, private equity and venture capital limited partnerships and LLCs are typically structured so that they last only 10 years.
The ability to make the life of a business independent of that of the founder increases the liquidity of the ownership interests, making it easier for the business to raise capital or for investors to sell their interests at an attractive price. Since a sole proprietorship has no ownership interest that can be sold directly, the proprietor can sell only the assets of the business. There is no way to sell a partial ownership interest.
Even with partnerships and corporations, it can be quite expensive to raise capital for the business or for an investor to sell an ownership interest. Common restrictions in partnership and LLC agreements and the need to amend the partnership and LLC documents to reflect a change in ownership can make transferring ownership time consuming and costly. Selling shares in a corporation can be costly if that corporation is not publicly traded.
Making sure that a new business has access to enough capital is always an important concern for an entrepreneur. By their nature, sole proprietorships must rely on equity contributions 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 both insiders and outsiders. Limited partnerships and LLCs are less constrained than general partnerships because they can raise money from limited partners or from “members,” as outside investors in LLCs are called, who are not directly involved in running the business. C-corporations can have a virtually unlimited number of potential stockholders.
The downside of being able to raise equity capital from other people is the need to share control. An entrepreneur who chooses a form of organization other than a sole proprietorship, and who does not retain 100 percent ownership, must give up some control. Of course, the entrepreneur may have little choice in this trade-off if the business requires more equity capital than he or she can personally provide.
It is important to recognize that certain investors who are especially important sources of capital for young, rapidly growing firms will only invest in C-corporations. For example, since venture capitalists do not typically want to become full operating partners in the businesses in which they invest and because the cost of transferring ownership interests can be much lower for C-corporations, they will generally invest only in businesses that are organized this way.
Chapter 1 discussed the concept of separation of ownership and control and how it is related to agency problems. This separation has benefits as well as costs. While it is true that agency problems can arise when owners delegate decision-making authority to professional managers, these costs might be smaller than the benefits. Specifically, the ability to separate ownership from management control enables a firm to raise capital from investors who have no interest in being directly involved in the business. This can greatly increase the number of potential investors. Another benefit is that an entrepreneur can turn over day-to-day control of a business to a more capable manager, become less involved in the business, and yet continue to benefit from its successes as an investor.
Another key concern of all entrepreneurs is being able to attract and retain high-quality employees. Being able to offer a current or potential employee an ownership interest in the business or the prospect of becoming a partner can help greatly in retention and recruiting. The inability to offer ownership interests is a major disadvantage of sole proprietorships.
Financial liabilities associated with a business are also an important consideration when choosing the form for a business. On this dimension, sole proprietorships, general partnerships, and limited partnerships 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 LLCs and corporations are limited to the money that they have invested in the business.
The choice of organizational form also affects how the business’s operating profits will be taxed. More taxes mean that the owners get less. In each of the organizational forms in Exhibit 18.1, with the exception of C-corporations, all profits flow through to the owners in proportion to their ownership interests.1 These owners pay taxes on the business profits when they file their personal tax returns. 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, such as health insurance, 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.
Financial Considerations
The most important financial concern of any entrepreneur is making sure that the business has access to enough money to be successful. Unlike a successful mature company, which can rely on cash flows from sales of other products to fund new product introductions, an entrepreneur must obtain funding from outside the firm. This makes it especially important for the entrepreneur to understand the cash requirements of the business.
The margin for error is small. If the entrepreneur miscalculates how much money is necessary, it may be too late to raise more money by the time this error is recognized. Raising external capital can be a time-consuming process and becomes increasingly difficult as a firm becomes more and more cash constrained. Outside investors are especially careful about investing in businesses that have run short of cash. The fact that the business has gotten into such a position can suggest that the business idea might not be viable or that the entrepreneur may not be the right person to build it, or both.
Two tools are particularly useful in understanding the cash requirements of a business and in estimating how much financing a new business will require: (1) the cash flow break-even analysis discussed in Chapter 12 and (2) the cash budget.
Cash Flow Break-Even
Recall that pretax operating cash flow (EBITDA) break-even analysis is used to compute the level of unit sales that is necessary to break even on operations from a pretax operating cash flow perspective. It is calculated using Equation 12.4:

where is the fixed costs associated with the business and is the per-unit contribution.
It is important for an entrepreneur to understand the concept of EBITDA 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 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.
Although it might seem obvious that an entrepreneur should want to maximize the per-unit contribution of each product and minimize total fixed costs, entrepreneurs often lose sight of these objectives. An entrepreneur can get so caught up in developing the best possible product that he or she does not adequately consider how much customers are willing to pay for that product. For example, adding another feature to a word-processing program can be expensive, and consumers might not be willing to pay the additional cost if they are unlikely to use that feature. Of course, being too sensitive to the possibility of overinvesting in new product development can harm a business by causing it to lose its competitive advantage. An entrepreneur should always be looking for ways to maximize the per-unit contribution of the firm’s products while maintaining the firm’s competitive position.
Many entrepreneurs also lose sight of the importance of controlling fixed costs. For example, several firms with virtually no sales have spent well over a million dollars each for short advertisements during Super Bowl football games. Many of these companies also spend a great deal of money on extravagant fringe benefits or things like team-building activities in which they take their entire product development staffs on week-long trips to vacation resorts. Although expenses such as these might help to increase employee productivity or encourage more creativity and hard work among the development staff, they also increase the number of units that a business must sell to break even. Unfortunately, some companies run out of money before they ever break even.
Cash Inflows and Outflows

The Cash Flow Template, Excel spreadsheet #60 on the Web site maintained by Matt H. Evans, is an example of a comprehensive Excel model for forecasting monthly cash flows. See the spreadsheet at http://www.exinfm.com/free_spreadsheets.html.

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, how much external financing is likely to be needed, and when the need is likely to arise. 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.
To better understand how a cash budget can help an entrepreneur, let’s consider an example. Suppose that it is March 1, 2012, and that you are planning to open a new restaurant called the Pizza Palace. You have saved $25,000, which you intend to invest in the business, and you have obtained a five-year loan for $50,000 at an APR of . The loan principal will be repaid in five equal installments of $10,000 at the end of each of the next five years. Exhibit 18.2 presents a monthly cash budget for your restaurant investment.

EXHIBIT 18.2 Pizza Palace Monthly Cash Budget for the Period March 2012 through February 2013aA monthly cash budget summarizes the cash that management expects to flow into and out of a business each month. At a minimum, it presents the cash inflows and outflows for each of the next 12 months and for the entire 12-month period. Monthly cash budgets can extend beyond 12 months.

The initial cash balance in row 1 of the March column of your budget equals the $75,000 that you have raised to finance the project. You estimate that it will take two weeks to actually open the restaurant and, knowing that you will have to build a customer base from scratch, you expect to have only $3,000 in sales during the first month. You do not anticipate providing any credit to your customers, so all of the proceeds from the sales will be received in cash. As shown in rows 8 through 25 of Exhibit 18.2, you expect cash operating expenses to total $20,770 and interest expense, capital expenditures, and start-up costs to be $333, $50,000, and $800, respectively, during March. With only $3,000 in cash inflows, these expenditures will reduce the cash balance by the end of March to only:

While the restaurant is expected to have a positive cash balance at the end of March, the cash balance will be negative by the end of April if no additional financing is obtained. You can see this by noting that the beginning cash balance of $6,097 plus the cash sales of $12,000 would provide a total of only $18,097 with which to pay $22,220 in operating expenses and $333 of interest. This would result in an ending cash balance of:2

Since a restaurant cannot operate without at least some cash for the cash register, you will have to invest more than $4,457 in the business during the month of April. For example, if you decide that you want to maintain a cash balance of at least $5,000, you will have to invest an additional . This investment is shown in row 5 of the April column in Exhibit 18.2. In this example, the investment is treated as an equity investment by the owner rather than as additional debt. You can tell this by the fact that there is no change in the interest payments in row 20. However, we could easily have treated this amount as a loan instead.
Notice that the cash budget tells you that if the cash forecasts in your budget are correct, you will have to raise a total of:

by the end of August to ensure that your restaurant’s cash balance does not fall below $5,000. Knowing this at the beginning of March can be very helpful in planning your fund-raising activities for the year.
You might also note that the cash budget indicates that $353 will have to be invested in February 2013. This is because the first principal payment on the debt is due at the end of that month. If you plan to maintain total debt of $50,000 in this business, you could cover this requirement by obtaining a new $10,000 loan, which you would use to make the debt principal payment.
We can also calculate the cash flow break-even for the Pizza Palace restaurant. If, for simplicity, we assume that the average customer spends $10 for pizza and a drink and that the only unit variable costs are those associated with the food, then we can calculate that the unit contribution will be $6 per customer when the business is up and running in September 2012. We know that the unit contribution is $6 because food purchases represent of cash sales. This leaves 60 percent of cash sales, or $6 per customer, to cover fixed costs. Knowing the unit contribution and assuming all costs other than those associated with food purchases are fixed, we can calculate the cash flow break-even as follows:

In other words, your restaurant will have to serve at least 3,195 customers per month (approximately 107 per day) in order to break even on a cash flow basis once it is up and running.
We have simplified our example by assuming that the restaurant does not provide credit to customers or hold any material inventories of food, supplies, and so forth. However, we could have incorporated these characteristics into our cash budget using the working capital management concepts discussed in Chapter 14.
DECISION MAKING EXAMPLE 18.1

Using a Cash Budget
SITUATION: It is January 1, and you have prepared the following cash budget for the next four months for your new business venture:
Monthly Cash Budget
Jan. Feb. Mar. Apr. Total
Beginning cash balance $ ? 0? ($18,510) ($25,270) ($28,530)
Cash receipts
Cash sales 2,500? 5,000? 12,000? 20,000? $39,500
Investments by owner –? –? –? –? –
Total cash receipts $ 2,500? $ 5,000? $12,000? $20,000? $39,500
Total cash available $ 2,500? ($13,510) ($13,270) ($ 8,530)
Cash payments
Operations
Merchandise purchases $ 1,250? $ 2,500? $ 6,000? $10,000? $19,750
Gross wages and payroll 5,760? 5,760? 5,760? 5,760? 23,040
Advertising 1,000? 1,000? 1,000? 1,000? 4,000
Rent 1,500? 1,500? 1,500? 1,500? 6,000
Other expenses 1,000? 1,000? 1,000? 1,000? 4,000
Operations total $10,510? $11,760? $15,260? $19,260? $56,790
Financing and investments
Capital expenditures $10,000? –? –? –? $10,000
Start-up costs 500? –? –? –? 500
Withdrawals by owner –? –? –? –? –
Total cash payments $21,010? $11,760? $15,260? $19,260? $67,290
Ending cash balance ($18,510) ($25,270) ($28,530) ($27,790)
If you plan to finance the business entirely with equity, how much money should you invest now to ensure that there is at least $1,000 still in the business at the end of April? How much will you have to invest each month after April to maintain a $1,000 cash balance if the cash inflows and outflows in the following months look like those for April?
DECISION:
Assuming that your cash forecast is correct, you should invest $28,790 today. This will cover the $27,790 cash shortfall reflected in the ending cash balance for April while leaving $1,000 in the business. The ending cash balance for April reflects the cumulative cash shortfall over the four-month period because the beginning cash balance for January has been set to zero. You will not have to invest any money after April because the cash inflows exceed the cash outflows in April, and this is not expected to change in the following months.

In our discussion of the cash budget, we assumed that any cash required by the business would come from the owner or from a loan. Unfortunately, financing a business is not always so simple. An important tool in financing a young, rapidly growing business—as well as in managing it—is the business plan.
Why Business Plans Are Important
Recall from Chapter 15 that the equity capital used by entrepreneurs includes their own money, investments from friends and family, investments by venture capitalists, equity raised by selling shares in the stock market, and so on. Debt financing can also come from a wide variety of sources, including the entrepreneur, a bank, a local individual investor, another business, and the sale of debt in the public debt markets, among others.
Ensuring that a young, rapidly growing business has enough cash is a simple matter if the money comes from the entrepreneur. The entrepreneur only has to decide to make the investment. Things are more complicated when the money comes from elsewhere. The entrepreneur must convince potential investors that purchasing debt or equity in the firm will yield attractive returns. In other words, they must be persuaded that they will be adequately compensated for the risks they bear.
Convincing outsiders to invest in a company can be difficult enough if the business has a well-established track record. Raising money from outsiders can be immensely difficult for a young company. The entrepreneur often begins the process with little more than an idea of where the business is headed and some limited operating results in the form of unaudited and often incomplete financial statements. To overcome the skepticism of outside investors, many entrepreneurs prepare a business plan.
A business plan is like a road map for a business. It presents the results from a strategic planning process that focuses on how the business will be developed over time. It describes where the company is going and what steps the company will follow to get there. 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. The fact that an entrepreneur has prepared such a document also demonstrates to investors that the entrepreneur has carefully thought through the business idea. This is especially important when the business is in a very early stage of development and the entrepreneur must convince investors that he or she is capable of building it.
In addition to its usefulness in raising capital, a business plan 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, outside directors, customers, suppliers, and others. A thoroughly thought-out plan can help a business owner avoid problems and better deal with those that arise. In short, business planning is extremely important to the survival of a small and growing company.
The Key Elements of a Business Plan
The depth and scope of business plans vary widely, but most well-developed business plans include the following:

• An executive summary, which summarizes the key points made in the plan.
• A company overview, which describes what the company does and what its comparative advantages are.
• A detailed description of the products and services the company sells or plans to sell, their 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 market analysis, which discusses the markets for the firm’s products and highlights the important characteristics of these markets as they relate to the company.
• A discussion of the marketing and sales activities that will enable the company to achieve the sales and profits reflected in the financial forecasts.
• A discussion of the operations of the business—how the product is (will be) produced and distributed, who the suppliers are, and any competitive advantages the business has in this area.
• A discussion of the management team, which includes the company’s organizational structure and describes the talents and skills of the managers. The discussion of the managers should explain why they are especially well qualified to manage and grow this particular business. This is an especially important part of the business plan when it comes to raising capital. Investors in young businesses invest in the key people as much as in the business idea itself.
• A description of the ownership structure, including the types of securities the firm has issued and who owns them. Potential investors use this information when they value the securities they are considering purchasing and to help them understand the incentives that managers and other owners have to make the business a success.
• A discussion of capital requirements and uses. This section covers the current capital requirements of the business as well as capital requirements over the next five years and provides a detailed account of how the money will be used.
• Historical financial results, when they are available, along with financial forecasts. If sufficient historical results are available, this section will also include an analysis of those results using the financial statement analysis tools discussed in Chapter 4. The forecasts include a month-by-month cash budget for the next two or three years as well as yearly forecasts of operating results. The cash budget helps the reader understand what the cash inflows and outflows will be and their timing. The yearly results provide an indication of what types of returns might be expected from the business.

Valuing A Business

LEARNING OBJECTIVE 3
Explain the three general approaches to valuation and value a business using common business valuation approaches.
Successful decision makers in both small and large firms must understand what determines the value of a business. It is not possible to consistently make investment and operating decisions that create value without knowing how to identify positive NPV projects or how operating decisions affect the value of a firm. This knowledge is also crucial when making financing decisions. In Chapters 16 and 17, we also saw how a firm’s value is affected by capital structure and payout policies. Decision makers must understand business valuation concepts in order to be able to identify the optimal capital structure and payout policy.
In this section, we discuss fundamental business valuation concepts. You will see that financial analysts apply many of the concepts that have already been discussed in this book when they value a business. The reason is that a business is really just a bundle of related projects, and the value of the business equals the total value of this bundle. In other words, 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.
Fundamental Business Valuation Principles
Before we discuss the specific ways in which businesses are valued, you should be aware of two important valuation principles.
The First Valuation Principle: The first valuation principle is that the value of a business changes over time. Changes in general economic and industry conditions, and decisions made by the managers, all affect the value of the cash flows that a business is expected to generate in the future. For example, changes in interest rates affect the firm’s cost of capital and, therefore, the present value of future cash flows. A change in interest rates can also affect the demand for a firm’s products if customers typically finance the purchases of those products with loans, as they often do for big-ticket items such as automobiles and houses. Similarly, competitors enter and exit industries, introduce new products, change prices, and so forth. These actions also affect the value of a business by altering its cash flows or risk. Finally, the value of a business is affected by managers’ investment, operating, and financing decisions.
Because the value of a business changes over time, it is important to specify a valuation date when valuing a business. Normally, this date is the date on which you do the analysis, but it can be an earlier date in some situations. For example, when companies are sued or when stockholders are involved in a dispute with the Internal Revenue Service, the value of the business or its stock as of some date in the past must often be estimated. A stockholder may claim that managers sold stock for less than it was worth at some time in the past, or the IRS may claim that the value of shares passed to an heir was greater than claimed when the taxes were filed by the estate of a deceased stockholder. By specifying the valuation date, the person who values a business makes it clear to anyone who uses the value estimate precisely what economic, industry, and firm conditions are reflected in that estimate.

BUILDING INTUITION

THE VALUE OF A BUSINESS IS SPECIFIC TO A POINT IN TIME
The value of a business is affected by general economic and industry conditions as well as the decisions made by managers. All of these factors affect the cash flows that a business is expected to produce in the future and the rate at which those cash flows should be discounted. Since all of these factors change over time, so will the value of the business.
The Second Valuation Principle: A second very important valuation principle is that there is no such thing as the value for a business. The value of a business can be different to different investors. To understand why, consider two different investors who are interested in purchasing a business that is for sale. Suppose that one investor is a competitor of the business that is for sale and the other is an individual who just wants to invest some money and plans to let the same management continue to operate the business independently. The competitor, who is what we call a strategic investor, might be willing to pay a higher price for the business than the other investor, who is what we call a financial investor, because the strategic investor might be able to combine the business with his or her current business in a way that reduces costs or increases revenues. The financial investor does not have the potential to benefit from these synergies.
The key implication of the idea that the value of a business can differ among investors is that the purpose of a valuation affects the way we do the analysis. If a valuation is being performed to determine what price a particular investor would be willing to pay for a business, the analysis must consider how that investor will operate the business. In the business valuation terminology, we would refer to this as an estimate of the investment value of the business to that investor.
If, instead of estimating the value of a business to a particular investor, an analyst is trying to estimate the price that a typical investor would pay for a business, he or she would be estimating the fair market value of the business. The fair market value of a business is the value of that business to a hypothetical person who is knowledgeable about the business. It does not include the value of synergies or the effects of any investor-specific management style. For this reason, the fair market value can differ considerably from the investment value of a business.

BUILDING INTUITION

THE VALUE OF A BUSINESS IS NOT THE SAME TO ALL INVESTORS
The value of a business is not the same to all investors because different investors will obtain different cash flows from owning a business. For example, the cash flows to passive investors will differ from the cash flows to investors who are active in the management of the business. Cash flows will also differ among active investors because they will have different skill levels, operating preferences, and abilities to benefit from synergies.
Business Valuation Approaches
There are a wide variety of business valuation methods, but most can be classified into one of three general categories: (1) cost approaches, (2) market approaches, and (3) income approaches. Cost, market, and income valuation approaches can be used to value a wide range of assets. They do not apply only to business valuation.
For example, the house or apartment building you live in has at some point been valued using a cost, market, or income approach—possibly even all three. When the building was insured, the insurance company probably used a cost approach to estimate its replacement cost. The appraiser for the local taxing authority is likely to have used a market approach, in which the estimated value was based on recent prices paid for similar properties in the local real estate market. Finally, if your house or apartment building was ever evaluated as a potential rental property by an investor, the investor probably used an income approach. In this analysis, the investor estimated the present value of the cash flows that the property would produce if it were rented.
While the ways in which the cost, market, and income approaches are used to value a business differ from the ways they are used to value real estate, the basic principles are the same. We next describe how these approaches are used to value businesses.
Cost Approaches
Two cost approaches that are commonly used to value businesses or their individual assets are the replacement cost and adjusted book value approaches.
Replacement Cost.
The replacement cost of a business is the cost of duplicating the business’s assets in their present form as of the valuation date. It thus reflects both the nature and condition of the assets. For example, the replacement cost of a 15-year-old electric wood saw that is in relatively good condition equals what it would cost to purchase an identical used saw in the same good condition.
The replacement cost valuation approach is generally used to value individual assets within a business when they are being insured, but it is rarely used to value an entire business. Since investors are concerned with the value of the cash flows that the business can be expected to generate in the future, they use valuation approaches that reflect the value of these cash flows when deciding how much to pay for firms.
Although the replacement cost approach tends to be more useful for insurance purposes, it can be helpful in conducting a buy-versus-build analysis when managers are thinking about making a business acquisition. Before purchasing a business, it usually makes sense to ask if you could build the same business in a way that would result in a greater NPV—in other words, whether it is cheaper to build the business yourself or to buy one that already exists. Answering this question can serve as a useful sanity check on whether you might be paying too much for the business.
When using the replacement cost approach in a buy-versus-build analysis, you must be sure to include the cost of all tangible assets, such as property, plant, and equipment, and all intangible assets, such as brand names and customer lists. You must also include the cost of hiring the people necessary to run the business and account for the cash flows that you would not receive during the time that it would take to build the business. It can take a long time to build a business, and until the business is up and running it will produce smaller cash flows than a business you might acquire.
Adjusted Book Value.
The adjusted book value approach involves estimating the market values of the individual assets in a business and adding them up. When this approach is used, the fair market value of each asset is estimated separately and the values are summed to arrive at the total value of the business. As with the replacement cost approach, an adjusted book value analysis should include all tangible and intangible assets, whether they are actually included on the accounting balance sheet or not.
The adjusted book value approach is useful in valuing holding companies whose main assets are publicly traded or other investment securities, but it is generally less applicable to operating businesses. The value of an operating business is usually greater than the sum of the values of its individual assets because the present value of the cash flows expected from the company is greater. The difference between the value of the expected cash flows and that of the assets is referred to as going-concern value.
Going-concern value reflects the value associated with additional cash flows the business is expected to produce because of the way in which the individual assets are managed together. A lot of different factors determine the going-concern value of a business. For example, one business can have a larger going-concern value than another business because it has a stronger management team that is able to invest in and utilize the business’s assets more efficiently. The going-concern value might also be larger because the employees of the company are more skilled or work better together or because the government provides some special benefit to a particular business.
To see how going-concern value might be created, suppose that you just obtained the exclusive right to produce and sell a patented type of specialty brick in the United States that has been very popular among homebuilders in Europe. Also suppose that you expect to be able to satisfy demand for this brick with a single manufacturing plant. No matter where you build this plant, its adjusted book value will be the same, assuming that the assets in the plant, such as kilns, forklifts, conveyer belts, and so forth, are commonly available and used all over the country. However, the actual value of the plant (business) will depend in part on where you decide to build it if transportation costs are an important component of the overall costs (bricks are heavy and cost a lot to transport). If you build the plant in Oklahoma (the middle of the country), it will be worth more than if you build it in one corner of the country, such as in Miami, because average transportation costs will be lower from Oklahoma. As a result, the going concern value will be greater if you build it in Oklahoma.
Although the adjusted book value approach does not capture the going-concern value associated with a business, it is useful under certain circumstances. We might use this approach (1) when it is especially difficult to forecast a business’s likely cash flows; (2) when we suspect that the going-concern value of the business is negative—in other words, the owners of the business would be better off if the business were simply shut down and its assets were sold off; or (3) if we are explicitly considering liquidation. The adjusted book value approach might also be used as a “sanity check” when using one of the other valuation approaches. If your value estimate is lower than the adjusted book value when you use another approach, it might indicate that there is an error in your analysis. Of course, if you find no errors, this might also be an indication that you would be better off shutting down the business and liquidating it.
When using the adjusted book value approach to estimate the liquidation value of a business, we must make sure to subtract liquidation-related expenses such as sales commissions, legal and accounting fees, and the cost of dismantling and hauling away the assets. To see how the adjusted book value approach might be used to estimate the liquidation value of a business, consider the following situation. Last year you started a business that prints custom logos on T-shirts for business clients. Unfortunately, the economy went into a recession shortly after you started your business, and it never got off the ground. You have virtually run out of cash and have decided to shut down the business rather than invest any more money. The current balance sheet of this business is as follows:

What is the liquidation value of your ownership interest in this business?
The first step in estimating the liquidation value of the business is to estimate how much value will be realized from the individual assets after accounting for liquidation costs. Let’s begin with the cash. Since the objective of the liquidation process is to convert all assets into cash, the liquidation value of any cash on the balance sheet, $78 in this example, simply equals its face value. Assuming that your customers are reputable businesspeople, you expect to collect all of the receivables with little effort. However, since you will incur some expenses in the collection process, you estimate that you will actually receive a net amount that equals 95 percent of the face value of the receivables. A call to your T-shirt supplier reveals that you can return unused inventory to the supplier and receive an 80 percent refund. You do not believe that anyone else will pay you more for the T-shirts. Finally, a supplier of T-shirt printing equipment has offered to pay you $600, or 75 percent of the book value, for your printing press.
With this information, you estimate the liquidation value of the assets is $4,208:

Therefore, after paying your accounts payable and the loan, your equity ownership interest has a liquidation value of .
LEARNING BY DOING APPLICATION 18.1

Using the Adjusted Book Valuation Approach
PROBLEM: You are considering purchasing a company that manufactures specialized components for recreational vehicles. These components are sold to the companies that manufacture the vehicles. As part of your analysis of this opportunity, you decide to estimate the liquidation value of the company. Management has provided you with the following information about its assets. All values are in thousands of dollars.
Cash $ ?444
Accounts receivable 739
Inventory 1,436
Net PP&E 8,463
Total assets $11,082
Management has also told you that you can reasonably expect to collect 93 percent of the receivables (accounting for collection expenses), that the inventory can be sold to realize 85 percent of its book value, and that sale of the property, plant, and equipment would yield $6,100. What is the liquidation value of this company?
APPROACH: Calculate the value that will be realized for each of the individual types assets and sum those values to obtain the liquidation value of the company.
SOLUTION:
The liquidation value is:
Cash $ ?444
100%
$ ?444
Accounts receivable $ ?739
93%
$ ?687
Inventory $ 1,436
85%
$1,221
Net PP&E $ 8,463 $6,100
Total assets $11,082 $8,452
You can expect to realize $8,452 from the liquidation of this company if there are no liquidation expenses that are not accounted for in these numbers.

Market Approaches
Two market approaches are commonly used in business valuation. The first approach, which is often called multiples analysis, uses stock price or other value multiples that are observed for similar public companies to estimate the value of a company or its equity. The second approach, often called transactions analysis, uses information from transactions involving the sale of similar companies to estimate the value of a company or its stock.
Market approaches reflect prices that have actually been paid for a company’s stock or for the entire company. While it is not always obvious why people pay a particular price, the information on what they pay can yield useful insights into how those people view the prospects for similar businesses. Market approaches can also provide useful benchmarks against which valuations based on other methodologies can be compared.
Multiples Analysis.
Multiples analysis is widely used in business valuation. This approach involves: (1) identifying publicly traded companies engaged in business activities that are similar to those of the company being analyzed and (2) using the prices at which shares of those comparables are trading, along with accounting data, to estimate the value of the equity of a company of interest or its entire value. Multiples analysis can be especially useful in estimating the price at which the stock of a private company can be sold. For example, this approach is often used to help identify the price at which shares can be sold when a company does its initial public offering (IPO) or when some or 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. These ratios divide a measure of stock price by an accounting measure of profits and revenue, respectively. Analysts typically estimate one of these multiples using data from comparable public companies, and then they use an average or, if one comparable is clearly better than the others, a multiple from a single comparable company to estimate the value of the company of interest.
Suppose, for example, that we want to estimate the value of the equity of a private department store chain that we are considering purchasing. The chain earned net income of $3.65 million last year. We have identified a publicly traded company that is very similar to the company we are valuing and notice in the Wall Street Journal that the P/E ratio for its common stock is 17.63. From this information, we can estimate that the market value of the equity (VE) of the company that we are considering purchasing is:

It is important to recognize that because the stock of the comparable companies is publicly traded and shares that are bought and sold in public markets are more liquid than shares that are not publicly traded, we must be careful when using multiples analysis to value a private company. The prices paid for shares that are not publicly traded can be considerably less than the prices paid for public shares. While the size of this marketability discount depends on many factors, such as the fraction of the total shares being bought or sold, it can amount to well more than 30 percent in some instances.3
A multiples analysis is conceptually straightforward but can be difficult in a real situation. One complicating factor is that truly comparable public companies are difficult to find. The ideal comparable company would match the company being valued on many dimensions. It would sell the same products, compete in the same markets, be of similar size, have similar revenue growth prospects, have similar profit margins, and have similar management quality, among other characteristics. In addition, if an equity ratio (such as price/earnings or price/revenue) is being used, the comparable should have a similar capital structure because, all else being equal, capital structure can have a dramatic impact on those ratios.
The importance of identifying comparable companies that are similar to the company being analyzed can be illustrated by considering the characteristics that determine a company’s price/earnings multiple. Recall from Chapters 9 and 13 that the constant-growth dividend model, Equation 9.4, can be used to estimate the value of a share of stock. Using the notation from Chapter 13, this model can be written as:

where is the current stock price, is the dividend that is expected next year, is the required return on common stock, and is the expected growth rate in dividends. If we recognize that dividends equal the fraction of earnings distributed to the stockholders times the earnings of the firm, we can rewrite Equation 9.4 as:

where is the earnings per share expected next year and is the fraction of the firm’s earnings that is paid out as dividends. is known as the dividend payout ratio, which is discussed in Chapter 19. Finally, we can rearrange this equation to obtain the price/earnings multiple:
(18.1)
This equation tells us that the P/E multiple can be thought of as equal to the dividend payout ratio over minus .4

You can learn more about business valuation and find a wide range of Excel templates that can be used to value businesses and their securities on the Web site maintained by Aswath Damodaran at http://pages.stern.nyu.edu/~adamodar.

By focusing on the variables that drive the P/E multiple in this simple framework, we can see the importance of identifying comparable companies that are as similar to the company of interest as possible. For example, consider what company characteristics determine . The Capital Asset Pricing Model (CAPM) tells us that depends on beta, which is a measure of the systematic risk associated with a company’s stock price. Since this systematic risk is closely related to the volatility of the earnings of the company, our discussion of total risk in Chapter 16 (see the discussion of Exhibit 16.3) suggests that the cost of equity depends on both business and financial risk. In other words, it depends on things such as the products the company sells, the markets it sells them in, its profit margins, and its operating and financial leverage. The growth rate of dividends, , is determined by the same factors that affect . This means that if we cannot identify a comparable company that is similar to the company of interest in both its business and financial characteristics, the P/E multiple we obtain for the comparable company will not be a good measure for our analysis.
Because P/E ratios are sensitive to leverage, many analysts use ratios that divide the total value of a company’s equity plus its debt by an accounting measure of cash flows available to all providers of capital (debt and equity). These ratios provide a direct measure of the total value of a company’s equity plus its debt, which is known as its enterprise value.5 The total value of the firm was written in Equation 16.1 as . In the interest of brevity, we will write it in this chapter as:

where is the value of the firm, is the value of the debt, and is the value of the equity. Multiples that are based on the total value of the firm are known as enterprise multiples. Examples include enterprise value/revenue and enterprise value/EBITDA.
To see how an enterprise multiple can be used to estimate the total value of a firm, let’s return to the example in which we were valuing the department store chain. Assume that, in addition to the P/E ratio analysis, we want to estimate the enterprise value of the business using an enterprise value/EBITDA ratio. We have estimated that EBITDA last year was $8.67 million for the department store chain we are valuing. In the Wall Street Journal, we find that the current price of the comparable company’s stock is $31.25, and, from the balance sheet in the annual report, we observe that the comparable company has 3.67 million shares outstanding. We also estimate that the value of the comparable company’s outstanding debt is $19.46 million, and we note that EBITDA for this company was $14.35 million last year. Using this information, we can calculate the enterprise value/EBITDA ratio for the comparable company as follows:

and we can estimate the enterprise value for the company we are valuing as:

LEARNING BY DOING APPLICATION 18.2
Using Multiples Analysis
PROBLEM: In addition to performing the liquidation analysis in Learning by Doing Application 18.1, you have decided to estimate the enterprise value of the company that manufactures specialized components for recreational vehicles. You have collected the following information for a comparable company and for the company you are valuing:
Comparable company: Company you are valuing:

Estimate the enterprise value of the company you are valuing using the P/E and enterprise value/EBITDA multiples.
APPROACH: First, calculate the P/E and enterprise value/EBITDA multiples for the comparable company. Next, use these multiples to estimate the value of the company you are valuing. Multiply the P/E multiple for the comparable company by the net income of the company you are valuing to estimate the equity value. Add this equity value to the value of the outstanding debt to obtain an estimate of the enterprise value. Multiply the enterprise value/EBITDA multiple for the comparable company by the EBITDA for the company you are valuing to obtain a direct estimate of the enterprise value.
SOLUTION:
The P/E and enterprise value/EBITDA multiples for the comparable company are:

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

which suggests an enterprise value of:

Using the enterprise/EBITDA multiple, we estimate the enterprise value to be:
Whenever we use multiples analysis, we must remember that we are estimating the fair market value of a company’s equity or its enterprise value and that this value is based on transactions involving small ownership interests. The transaction prices that we observe in the stock market are typically based on trades that involve unknown investors buying small numbers of shares that do not give them the ability to control the business. In other words, a multiples analysis does not provide an estimate of investment value because the identities of the buyers are not known. This means that value estimates based on a multiples analysis do not reflect the synergies that might be realized by combining the company with another business. These estimates also do not include the value associated with being able to control a business, an important consideration that we discuss in more detail later.
When performing a multiples analysis, it is also important to make sure that the numerator and the denominator of the ratio we are using are consistent with each other. In other words, if stock price is in the numerator, some measure of cash flow to equity must be in the denominator. If enterprise value is in the numerator, a measure of total cash flows from the entire business must be in the denominator.
The exception to this rule is the price/revenue ratio. This ratio can be useful in valuing the stock of a relatively young company that is not yet generating profits. Shares in very young companies are often bought and sold based on multiples of their revenue. Implicit in those multiples are expectations about future margins, as well as growth in revenue. By using price to revenue, the analyst is effectively assuming that the company being analyzed will, over time, have profit margins similar to those that are anticipated by the market in pricing the publicly traded comparables.
Another important point to keep in mind when doing multiples analysis is that the data used to compute the multiple for the comparable company should include the stock price as of the valuation date and that accounting data for the two companies should be from the same period. Since any value estimate is specific to a particular date, we must be sure to use multiples for the appropriate point in time. Furthermore, if we use accounting data from the past 12 months to estimate the ratio for a comparable company, we must use accounting data from the same 12-month period to calculate the value of the company of interest.
Transactions Analysis.
The information used in a transactions analysis is typically obtained from Securities and Exchange Commission (SEC) filings of public companies that have acquired other companies or from commercial services that collect and sell this information. This 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 a company. Transaction data reflect the price that a particular investor paid for an entire company. For this reason, it provides an estimate of the investment value to that investor.
Like multiples analysis, transactions analysis can be difficult to use in practice, although the reasons for the difficulty are different. One problem is that transactions data are not typically as reliable as the data available for multiples analysis, especially when the transactions involve private companies. For example, the available data on transactions might include revenues of the private company but not data on its profitability. The data might include the net income but not enough information to estimate EBITDA. This can make it difficult to compute some multiples.
In addition, unlike stock market transactions, transactions involving the purchase or sale of an entire business occur relatively infrequently. This means that the data available for a transactions analysis often include only transactions that occurred months or even years earlier. Since the value of a business is specific to a particular point in time, the price that was paid for a business becomes less useful an indicator of what the business is worth as time passes after the sale.
Finally, the terms of the transactions can be difficult to assess. While the P/E multiple for a publicly traded company is an indication of the price that might be obtained in a cash transaction, transactions involving the sale of an entire company often involve some combination of cash, debt, or equity payments. A whole package of such securities, some of which can be difficult to value, could be included in the reported transaction price, and this may not be apparent to the analyst. The value estimates for those securities and claims can also be distorted if the buyer or seller has a reason to prefer reporting a higher or lower price.
Income Approaches
At the beginning of this section, we said that 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. The cost and market approaches are useful for estimating this value in certain situations—such as in doing a buy-versus-build analysis, estimating the liquidation value of a firm, or when good comparable firms or transactions are available. The most direct approaches for estimating the value of the cash flows a business is expected to produce, however, are the income approaches. Like NPV analysis, these approaches directly estimate the value of those cash flows.
Before we discuss specific income valuation approaches, we should note that the market and income approaches differ in one very important way. Because the market approaches rely on prices that have been paid for companies or their securities, the value estimates that they yield are estimates of what people are willing to pay. In contrast, the income approaches provide estimates of the intrinsic, or true, value of a company or its securities.
While the market value can equal the intrinsic value, the two values are not necessarily the same. For example, if you are valuing the company you work for, you might have better information about its prospects than do stock market investors. By using an income approach, you would be able to incorporate your superior information directly into the valuation analysis in a way that you would not be able to do with a market approach.
Using Income Approaches.
The life of a business is not usually known when it is valued. Whereas a project might be expected to last a specific number of years, a business can have an indefinite life. This makes it more difficult to use an income approach to value a business than a project. It is difficult enough to forecast cash flows for a relatively short period, such as three or five years, let alone for the indefinite future.
Another complication in business valuation is that businesses often have cash or other assets that are not necessary for operations. These can include cash that was earned in the past but has not been distributed to stockholders and assets that are left over from old projects. We call these nonoperating assets (NOA). When we estimate the value of an individual project, we do not have to worry about NOA because there are none. However, when we value a business, NOA are an additional source of value. NOA can be distributed directly to stockholders or sold and the proceeds distributed to stockholders without affecting the cash flows that the operations of the business are expected to generate.
In practice, we account for the indefinite life associated with a business and the possibility that it has NOA by estimating the value of the business as the sum of three numbers. This calculation can be represented as follows:
(18.2)
where is the value of the firm, is the present value of the free cash flows that the business is expected to produce over the next years, is the present value of all free cash flows after year , and NOA is the value of all of the nonoperating assets in the firm. Note that the present value of all free cash flows after year is generally known as the terminal value. Note also that if we only want to calculate the value of the equity, we can do this by first calculating the value of the firm using Equation 18.2 and then subtracting the value of the debt.
Free Cash Flow from the Firm Approach.
When using 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 free cash flows equals the total value of the firm, or its enterprise value.
The free cash flows used in a FCFF analysis are almost identical to the free cash flows from the left-hand side of the finance balance sheet that was illustrated in Exhibit 13.1. The only difference is that when we value a business, we do not include cash flows 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 noninterest-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 precisely what we are referring to when we refer to the value of FCFF.

EXHIBIT 18.3 The Finance Balance Sheet and Firm Value
The value of a firm (enterprise value) equals the present value of the future free cash flows from the firm (FCFF). Since the owners of the interest-bearing debt and other long-term liabilities and the stockholders, collectively, have the right to receive all of the FCFF, the total value of those claims equals the value of the firm.

The most common FCFF approach involves using the weighted-average cost of capital (WACC), which we discussed in Chapter 13, to discount the FCFF. This is often referred to as the WACC valuation method. In this approach, the total value of the firm is computed as the present value of the FCFF, discounted by the firm’s WACC:
(18.3)
In this equation, equals the period when the cash flow is produced.
We compute the FCFF using the same calculation that we used for the free cash flows for a project in Chapter 11. The only differences are: (1) that since business valuation involves valuing all of the projects in the firm, we compute the total cash flows the firm’s assets are expected to produce rather than the incremental cash flows from a project and (2) we use the average tax rate instead of the marginal tax rate. The FCFF calculation is shown in Exhibit 18.4. Notice that this calculation is just like the calculation in Exhibit 11.1.
Analysts typically estimate future FCFF by forecasting each of the individual components and then performing the calculation shown in Exhibit 18.4. Next, the resulting FCFF values are discounted back to the present using the WACC, as already mentioned. Recall that the WACC is calculated using Equation 13.7:

where and where , , and are the pretax cost of debt and the after-tax costs of preferred stock and common stock, respectively. Also, is the tax rate that applies to interest deductions, and , , are the proportions of the value of the firm that are represented by debt, preferred stock, and common stock.

EXHIBIT 18.4 The FCFF Calculation
Free cash flows from the firm (FCFF) are calculated in the same way as the incremental after-tax free cash flows (FCF) that are expected from a project. The only differences between the FCFF calculation and the FCF calculation, which is illustrated in Exhibit 11.1, are that in the FCFF calculation (1) we use total cash flows rather than incremental cash flows, and (2) we use the average tax rate instead of the marginal tax rate when we are valuing a company that is operating independent of any other company.

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. For example, the financing might be 80 percent equity and 20 percent debt. Or it might be 30 percent equity and 70 percent debt. These are very important assumptions because, as we saw in Chapter 16 (see Exhibit 16.8), the capital structure choice affects the value of the firm. The FCFF calculation is not affected by the firm’s capital structure, but from Equation 18.3 we know that capital structure affects firm value by affecting the discount rate—the WACC. In fact, as we discussed in Chapter 16, the optimal capital structure for a business is the one that minimizes the WACC.
To see how the FCFF approach is used to value a business, consider an example involving Bell Mountain Manufacturing Company. Assume that we have forecast Bell Mountain’s FCFF in each of the next five years to be as shown in Exhibit 18.5. Also assume that we have estimated that the WACC for Bell Mountain to be 11 percent and that the cash flows after year 5 will grow at an annual rate of 3 percent. Finally, we observe that Bell Mountain has excess cash of $14.68 million but no other NOA.

EXHIBIT 18.5 FCFF Forecasts for Bell Mountain Manufacturing Company ($ millions)
This exhibit presents forecasts of free cash flow from the firm (FCFF) for Bell Mountain Manufacturing Company for each of the next five years.

With this information, we can calculate the enterprise value of Bell Mountain Manufacturing Company using Equation 18.2:

We begin by calculating the present value of the forecasted free cash flows in Exhibit 18.5. The present value of these cash flows is

In this example, we prepared cash flow forecasts for five years. The length of the period for which detailed projections are produced depends on the level of uncertainty surrounding the future of the business. In general, we want to forecast the cash flows out to a point in time where we expect the business to reach a steady-state growth rate. We can then estimate the cash flows for the remainder of the business’s life (the terminal value) by (1) calculating the present value of all cash flows after the final year of the detailed forecast using the formula for a growing perpetuity and (2) discounting this value to the present. For Bell Mountain, these calculations are as follows:

and:

Finally, we can use Equation 18.2 to calculate the total value of Bell Mountain Manufacturing Company:

Free Cash Flow to Equity Approach.
The free cash flow to equity (FCFE) approach is very similar to the FCFF approach. However, instead of valuing the total cash flows the assets of the business are expected to generate, we value only the portion of the cash flows that are available for distribution to stockholders. To see how the FCFF and FCFE approaches are related, ask yourself the following question: If you wanted to value only the equity claims, how would you adjust the cash flows that are used in the FCFF approach? The answer is that you would simply strip out the cash flows to or from the people who lend money to the firm. Since the value of the firm equals the value of the debt plus the value of the equity, stripping out the cash flows to or from the lenders leaves the cash flows available to stockholders.
LEARNING BY DOING APPLICATION 18.3
Using the FCFF Income Approach
PROBLEM: You have decided to use the FCFF income approach to estimate the intrinsic value of the company that manufactures components for recreational vehicles. You expect cash flows to grow very rapidly during the next five years and to level off after that. Based on this, you forecast the cash flows for each of the next five years to be:
Year
1 2 3 4 5
FCFF ($ millions)
$0.108 $0.998 $2.110 $2.857
You expect cash flows to be constant after year 5. There are no NOA in this firm. If the appropriate WACC is 9 percent, what is the enterprise value of this business? What is the value of the equity if the value of the company’s debt equals $1.25 million?
APPROACH: First calculate the total present value of the individual FCFF that you have forecast by discounting them to year 0 using the WACC and summing them up. Next, calculate the terminal value, assuming no growth in the cash flows after year 5, and discount this value to year 0. The enterprise value equals the present value of the individual cash flows plus the present value of the terminal value. The value of the equity can then be calculated by subtracting the value of the debt.
SOLUTION:
The present value of the cash flows in the first five years is:

The present value of the terminal value is:

Therefore, the total enterprise value is:

and the value of the equity equals .
Exhibit 18.6 shows how FCFE is calculated. Notice that this calculation includes three cash flows that are not in the FCFF calculation. One is the interest expense, which is a cash flow to the lenders. The others are the cash flows associated with the repayment of debt principal and the proceeds from new debt issues. As mentioned, then, this approach takes the total cash flows from the business and removes any cash flows to or from lenders, leaving cash flows available to the stockholders.

EXHIBIT 18.6 The FCFE Calculation
Free cash flow to equity (FCFE) equals free cash flow from the firm (FCFF) less any net cash outflows to debt holders. In the FCFE calculation, we subtract the interest and principal payments to the debt holders and add any proceeds from the sale of new debt.

Because cash flows available to stockholders are residual cash flows, they are riskier than the total cash flows from the firm (assuming the firm has some debt). Consequently, in using the FCFE valuation approach, the cost of equity is used to discount the cash flows:
(18.4)
Note that equals if the firm has no preferred stock outstanding. Otherwise is a weighted average of and . Other than the difference in the way that the cash flows are calculated, the procedure for estimating the value of a firm’s equity using the FCFE approach is the same as that used to estimate the total value of the firm using the FCFF approach.
Dividend Discount Model Approach.
The dividend discount model (DDM) approach is very similar to the FCFE approach. In this approach, we estimate the value of equity directly by discounting cash flows to stockholders. However, there is a subtle difference. The DDM approach values the stream of cash flows that stockholders expect to receive through dividend payments. In contrast, the FCFE approach values cash flows that are available for distribution to stockholders. 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:

Notice that in this model the price of a share of common stock is computed by discounting future dividends.
DECISION MAKING EXAMPLE 18.2

Choosing an Appropriate Valuation Approach
SITUATION: You have decided to make an offer for the recreational vehicle manufacturing business that you evaluated in Learning by Doing Applications 18.1, 18.2, and 18.3. Your analysis yielded the following enterprise value estimates:
Liquidation value $ 8.45 million
Value from multiples analysis
P/E multiple $18.35 million
Enterprise/EBITDA multiple $24.70 million
FCFF value $24.58 million
The seller of the company is asking for $18 million. Is this price reasonable?
DECISION:
The price appears to be reasonable. It is almost $10 million greater than the liquidation value, but this value does not include the going-concern value associated with the business. The other three estimates, which all reflect the company’s going-concern value, suggest that the fair market value of the business is greater than the seller’s asking price.

Since the constant-growth model assumes that the firm currently pays dividends and that these dividends will increase at a constant rate forever, this approach is really useful for only a limited number of mature firms that pay dividends. More often, use of the DDM approach involves discounting dividends that either will 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. In these cases, an approach such as that illustrated for the FCFF approach above must be used. The expected dividends must be individually discounted for some period, and then a terminal value must be estimated once the growth rate in dividends stabilizes at some level that is sustainable over the long run. This is the mixed (supernormal) growth dividend model from Chapter 9.
Important Issues in Valuation

LEARNING OBJECTIVE 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.
We conclude the chapter by discussing some important issues in valuing businesses. Whether a business is public or private, whether it is young or old, and whether a minority interest or a controlling interest is involved can make a difference in valuation. In addition, we may have to take account of the role of key employees.
Public versus Private Companies
The same valuation approaches are used to value both public and private companies. However, there are some important differences, which we consider next.
Financial Statements
While financial statements of public companies must be audited and filed with the Securities and Exchange Commission, there is no requirement that the financial statements of private companies be audited. As a result, the completeness and reliability of financial statements for private companies vary considerably. Some private companies have complete, audited financial statements, whereas others have incomplete financial statements that are not prepared in accordance with the generally accepted accounting principles (GAAP) discussed in Chapter 3. Incomplete and unreliable financial statements can complicate the process of valuing a private business, making it more difficult to accurately assess its value.
Financial statements of private companies also differ from those of public companies in some of the expense accounts. Owners of private businesses have incentives to pass some of their personal expenses through the business because this enables them to deduct the expenses on their taxes. Examples might include the owner’s car, “business” trips to Hawaii or Europe, the company condominium in New York, or the sky box at the local football stadium. While there may be legitimate reasons for a business to incur expenses such as these—for example, entertaining important customers in the sky box—there are often more such expenses in private companies.
Owners of private companies can also have incentives to pay themselves more than it would cost to hire someone to do their job. If the income from the company is taxed before it is distributed to the owners (such as in a C-corporation), this excess compensation reduces the taxes that the company must pay. Compensation payments are deductible for the corporation and are therefore only taxed as income to the owner. If instead of paying themselves excess compensation, owners distributed the money as dividends, it would be taxed twice—once as income to the corporation and a second time as income to the owner. In addition to having incentives to pay themselves excess compensation, owners of private companies often put family members on the payroll at wages that are above what would ordinarily be paid for the services they provide. When valuing a private company, analysts typically adjust for excess compensation to the owner and family members by estimating what it would cost to hire other people to perform the services and, using this, change the actual expense reported in the income statement accordingly.
Marketability
In the discussion of multiples analysis, we mentioned that the prices paid for shares in a company whose stock is not publicly traded can be considerably less than the prices paid for publicly traded shares of a similar company. One reason is that stockholders of a public firm can generally sell their shares by simply going online or calling a broker and paying a small fee. In contrast, a stockholder in a private firm may have to spend considerable resources (both money and time) to sell his or her shares. An investor who is offered the opportunity to buy identical equity claims to the cash flows of a public and a private firm (that is, the cash flows have the same size, timing, and risk) will require different rates of return for the two investments. Because of the higher transaction costs associated with the stock of the private firm, the investor will not be willing to pay as much for that stock (and will therefore expect a higher return) as for the publicly traded shares. This must be taken into account in estimating the value of any claim to the cash flows of a firm. As we mentioned earlier, differences in marketability can result in discounts of 30 percent or more for shares of private companies. Where analysts are able to estimate the appropriate size of such a discount, they deduct the discount directly from the final value estimate that is obtained using the methods described in the preceding section.
Young (Rapidly Growing) versus Mature Companies
Another important issue that arises in business valuation concerns the fact that young, rapidly growing companies tend to be more difficult to value than mature, stable companies. Both entrepreneurs and investors in new businesses, such as venture capitalists, must deal with these difficulties when young companies seek financing. One factor that makes it more difficult to value a young company is that less reliable historical information is available. A company may have only two or three years of historical financial records, and those records may reflect the company at a different stage in its development.
In addition, 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. This makes it much more complicated to identify appropriate comparable companies for a multiples or transactions analysis and more difficult to estimate expected cash flows for an income analysis.
Furthermore, many young, rapidly growing companies are not yet profitable. With no 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. When analysts use these multiples, they are implicitly assuming that the business they are valuing will become as profitable (specifically, have the same profit margins) as the public companies that were used to estimate the multiples and that the risks of the business will also be similar. These can be very heroic assumptions when the company being valued is only a couple of years old.
Finally, many young companies invest a considerable amount of money in order to grow. This can make it very difficult to use an income valuation approach. The cash flows will be negative until the business becomes profitable and its profits exceed its investment expenditures. Since it can take several years for this to happen, expected cash flows are typically negative for several years. This means that positive cash flows, which represent the value that the business is expected to produce for its owners, are further in the future and are therefore less certain. The bottom line is that this increases the overall level of uncertainty associated with an income-based valuation.
Controlling Interest versus Minority Interest
Another important issue that we must consider when we value a business is whether we are valuing a controlling ownership interest or a minority interest. The amount of stock required for an investor to exercise control varies depending on the ownership structure of the company. For example, a stockholder with just 20 percent, or possibly even less, of the total votes in a public company can effectively control that company if there are no other large stockholders. Even if there are other large stockholders, that investor can control the public company if friendly stockholders provide enough additional votes. In private companies, which tend to have relatively few stockholders, a stockholder must generally control 50 percent of the shares, either directly or indirectly through friendly stockholders, to control the firm. A stockholder who has such control can run the business as he or she wants. He or she can select the board of directors, choose the business strategy, hire and fire managers, and approve or disapprove any investment, operating, or financing decisions.
Whether a controlling ownership interest is being valued has important implications for a valuation analysis. Recall that in the discussion of multiples analysis we noted that a multiples analysis does not reflect the value associated with being able to control a business. Thus, when we are using multiples computed using public stock market prices to estimate the value of a controlling interest, we must make adjustments to reflect the benefits of control. Similarly, when we use an income approach to value a business, the cash flow forecasts and discount rate assumptions we use will differ depending on whether we are valuing a minority or a controlling ownership interest.
Let’s consider an example of how these differences arise when the income approach is used. Suppose we are valuing 100 shares of Hewlett-Packard (HP) stock. Since owning 100 shares of HP stock will not enable us to exercise any control, the expected cash flows that we should discount simply reflect the cash flows that we can expect HP to generate under its current management (assuming we know of no imminent management change). In contrast, if we are valuing a controlling interest in HP stock for a potential buyer, we would discount the cash flows that HP would be expected to generate if it were under the control of that buyer.
It is also important to note that the market rates of return that we use to calculate the cost of equity with the Capital Asset Pricing Model (CAPM) discussed in Chapter 7 are based on small stock transactions. If having control would enable an investor to better manage the systematic risk associated with a business, a discount rate based on small transactions would be higher than a discount rate estimated from a transaction that involves a controlling position. Therefore, a discount rate estimated using public stock market information and CAPM might be too high for a valuation that involves a controlling position.
Unfortunately, while the discount rate we estimate using CAPM might be too high when we value a controlling interest, the CAPM theory provides us with no insights concerning how we might adjust that rate. As a result, analysts typically adjust for the effects of an incorrect discount rate (as well as for any possible cash flows that are not reflected in an income-based valuation) by adding a control premium. For instance, if the value of a firm’s equity is estimated to be $100 million using an income approach, a 20 percent premium might be added to arrive at a final value of $120 million. Of course, the magnitude of the adjustment depends on the situation.