Analysis and Valuation of Privately Held Companies Essay

10.1 What is the majusculeization ordain and how does it relate to the discount rate? result The edges discount rate and capitalization rate ar often used interchangeably. Whenever the growth rate of a firms interchange flows is projected to vary over time, the bourn discount rate generally refers to the factor used to convert the projected cash flows to present fosters. In contrast, if the cash flows of the firm are not evaluate to grow or are expected to grow at a constant rate indefinitely, the discount rate employed by practitioners is often referred as the capitalization rate.10.2 What are the common ways of estimating the capitalization rate? firmness Capitalization rates may be estimated by using the Capital addition Pricing Model, cost of capital, price-to-earnings ratios, accounting based returns such as the return on equity, and the build-up method.10.3 What is the marketability discount and what are common ways of estimating this discount?Answer The seek associa ted with an illiquid market for the specific stock is often referred to as the marketability or liquidity discount. Liquidity is the ease with which an investor can sell their stock with forbidden a serious injury of value. An investor in a small company may find it difficult to sell quickly their shares because of limited interest in the company. Consequently, the investor may find it demand to sell their shares at a monumental discount from what they paid for the shares.10.4 Give examples of private company costs that might be understated and explain why.Answer Examples may include employee training and the cost of complying with government regulation such as OSHA and the EPA. Small, privately owned firms tend to under-spend in these areas since they do not render directly to current profitability.10.5 How can an psychoanalyst determine if the target firms costs and revenues are understated or overstated?Answer The analyst may determine that revenues have been overstated by c omparing the accounting practices to GAAP guidelines and to other comparable firms. It may be determined that costs are understated by comparing the firms accounting practices with GAAP standards and by comparing the firms common size financial statements with those of homogeneous firms.10.6 Why might shell senss have value?Answer Merging with an existing corporate shell of a formerly publicly traded company may be a reasonable alternative for a firm wanting to go public that is unable to provide the 2 years of audited financial statements demand by the SEC or unwilling to incur the costs of going public through an initial public offering. Thus, merging with a shell corporation may represent an effective alternative to an initial public offering for a small firm. Shell corporations may also be attractive for investors evoke in capitalizing on the intangible value associated with the existing corporate shell. This could include name recognition licenses, patents, and other forms of intellectual properties and underutilized assets such as warehouse plaza and fully depreciated equipment with some economic life remaining.10.7 Why might succession grooming be more challenging for family owned firms?Answer Succession planning is a critical activity in any firm. However, the challenge often is greater in family firms which wish to keep top managementpositions in the family. This hindrance limits the total pool of management talent available to the family owned firm, as some family members may have no interest in the firm and others alone do not have the credentials to step into a management role.10.8 What are some of the reasons a family-owned or privately-owned melody may want to go public? What are some of the reasons that discourage such firms from going public?Answer Private or family owned firms are more likely to go public when valuations are high or are increasing. Companies also are inclined to go public when they anticipate an inability to finance f uture investment funds opportunities or the outlook for the future profitability is unclear. In contrast, private firms are less likely to go public because of the increasing reporting requirements of Sarbanes-Oxley and the SEC, as tumesce as concern about interference from public shareholders. Private firms also are less likely to go public when the special privileges that accrue to the imperious shareholders exceed the anticipated benefits from going public.10.9 Why are family owned firms often attractive to private equity investors?Answer Family-owned firms often encounter succession problems. The crack up wants to retire but either lacks confidence in existing family members as successors or cannot find a family member with the right credentials interested in taking control. Consequently, selling out to a private equity firm may be an attractive alternative. Such firms are interested in not only providing financing but also in providing board and management experience and exp ertise. They intend to invest for the long-term enabling the founder to cash out with some assurance the firm will continue to prosper.10.10 Rank from the highest to the lowest the liquidity discount you would apply if you as a business appraiser had been asked to value the following businesses a) a local, profitable hardware store, b) a money losing laundry, c) a large privately owned but marginallyprofitable firm with significant excess cash balances and other liquid short-term investments, and d) a pool cleaning service whose primary tangible assets consist of a 2-year old motortruck and miscellaneous equipment. Explain your ranking.Answer In descending order of magnitude, the liquidity discounts associated with these businesses would be as follows d) The business is small, with few liquid assets of significant value b) the business is small and unprofitable but does have some equipment that can be liquidated a) the business is financially healthy c) the business is large with s ubstantial liquid assets.Selected shape Problems and Answers10.14 Based on its growth prospects, a private investor values a local bakery at $750,000. She call backs that cost savings having a present value of $50,000 can be achieved by changing staffing levels and store hours. Based on new-fangled empirical studies, she believes the appropriate liquidity discount is 20 percent. A recent transaction in the same city required the buyer to pay a 5 percent premium to the asking price to gain a controlling interest in a similar business. What is the most she should be willing to pay for a 50.1 percent stake in the bakery?Answer The investor should not offer more than $336,672.Maximum Offer Price (50.1%) = ($750,000+$50,000) x (1-.2)(1+.05) x .501 = $336,67210.15 You have been asked by an investor to value a restaurant. Last year, the restaurant realize pretax operating income of $300,000. Income has grown 4% annually during the last five years, and it is expected to continue growing at that rate into the foreseeable future. The annual change in working capital is $20,000, and capital spending for maintenance exceeded depreciation in the prior year by $15,000. Both working capital and theexcess of capital spending over depreciation are projected to grow at the same rate as operating income. By introducing modern management methods, you believe the pretax operating income growth rate can be increased to 6% beyond the second year and sustained at that rate into the foreseeable future. The ten-year exchequer bond rate is 5%, the equity seek premium is 5.5%, and the marginal federal, state, and local tax rate is 40%.The beta and debt-to-equity ratio for publicly traded firms in the restaurant industry are 2 and 1.5, respectively. The businesss target debt-to-equity ratio is 1, and its pretax cost of borrowing, based on its recent borrowing activities, is 7%. The business-specific risk premium for firms of this size is estimated to be 6%. The liquidity risk premium is believed to be 15%, relatively low for firms of this type due to the excellent write up of the restaurant. Since the current chef and the staff are expected to remain after the business is sold, the quality of the restaurant is expected to be maintained. The investor is willing to pay a 10% premium to reflect the value of control. a. What is free cash flow to the firm in year 1?Free cash flow to the firm in year 1 = $300,000 x 1.04 x (1 .4) $20,000 x 1.04 $15,000 x 1.04 = $187,200 $20,800 $15,600 = $150,800 b. What is free cash flow to the firm in year 2?Free cash flow to the firm in year 2 = ($300,000 x 1.042) x (1-.4) $20,000 x 1.042 $15,000 x 1.042 = $194,688 $21,632 $16,224 = $156,832 c. What is the firms cost of equity?Industrys unleveraged beta = 2 / (1 + .6 x 1.5) = 1.05Restaurants leveraged beta = 1.05 (1 + .6 x 1.0) = 1.68Cost of Equity = .05 + 1.68 (.055) + .06 = .2024d. What is the firms after-tax cost of debt?After-tax cost of debt = .07 x (1-.4) = .042e. W hat is the firms target debt-to-total capital ratio? Restaurants target debt-to-total capital ratio = target D/E / (1 + target D/E) = 1 / 2 = .5 f. What is the weighted average cost of capital?Weighted average cost of capital = .5 x .2024 + .5 x .042 = .1012 + .0210 = .1222 g.What is the business worth?PV = $150,800 + $156,832 + ($156,832 x 1.06)/(.1222 .06) = (1.1222) (1.1222)2 (1.1222)2= $134,379 + $124,536 + $2,122,313 = $2,381,228(Note The eldest two terms represent the PV of the firms operating cash flows before the application of modern management methods is fully implemented the third term is the terminal value and reflects the anticipated sustained improvement in cash flows when the benefits of the new management techniques are fully realized.)PV (after the liquidity discount & control premium) = $2,381,228 x (1 .15) x (1 + .10) = $2,226,448