Tutorial 9 (Week 11)

Ch10 - Holmes

 Exercises

1. ‘Valuation is not necessary when buying or selling an enterprise because the actual sale price will be
the outcome of negotiation’. Discuss this statement. (q.1)
While it is true that the actual sales price for a business will be the outcome of negotiations, in practice each
party will want to have an assessment of what the business is worth. There is likely to be a range of valuations
for any particular business and the final price is likely to lie somewhere between the estimates. It will be
necessary for the seller to decide what the minimum acceptable price is and for the buyer to decide on the
maximum price that they are prepared to pay. The extent of negotiation will depend on the range of estimates
of value. In some cases, the valuation will be fairly precise and there will be little scope for negotiation. For
example, where a stock market listing is available then the value of the business will be determined by the
share price multiplied by the number of shares. Also, in some businesses there are fairly well-defined rules of
thumb for valuations although any valuation based on earnings will always be subject to differences in opinion
as to assessing the amount of those earnings. In a situation where a business is being sold that has no
earnings or that is not financially viable then, again, the valuation should be more straightforward if the assets
are easily traded and have a recognized market price. Generally speaking, the more specific the asset the
wider the range of valuations since it may be worth considerably more to some purchasers than to others.
Consequently, valuation is still necessary when buying or selling a business in order to establish the range
within which negotiations will take place.

2. List as many different situations involving a change in the ownership of a small enterprise as you
can. Explain why a valuation of the enterprise may be sought in each situation. (q.2)
A number of change of ownership situations are listed on page 312. These are
 acquisition of an enterprise
 sale of an enterprise
 the orderly transfer of a part interest in an enterprise
 the public listing of an enterprise
 the merger of one enterprise with another
 the establishment and operation of an employee share ownership scheme or a management incentive
scheme
Generally it will be important to obtain a valuation to provide a more informed basis for negotiation. This helps
buyers avoid paying too much and sellers receiving too little for the asset. This broad logic can be applied to
each of the specific situations listed above. Valuation also helps in the negotiation process by getting one or
both parties into a realistic negotiation range so that a transaction becomes a possibility.

3. How might an independent valuation assist an enterprise in obtaining finance? (q.3)

Loan applications to financial institutions may be expedited, or granted on more favorable terms and
conditions, where they are accompanied by a recent independent valuation of the enterprise concerned. The
independent nature of the valuation reduces ‘moral hazard’. The additional information provided to lenders
reduces their uncertainty, thereby making them more favorably disposed to the applications for funding. The
valuation can also assist in persuading a financial institution to advance financing to a small enterprise if the
valuation shows the enterprise to be worth more than is suggested by its financial statement. Additional
information might be revealed in the valuation that is not in the financial statement. This additional
information could relate to intangibles such as patents and copyrights, favorable lease commitments and
appreciated or revalued assets.
4. What is meant by the term ‘fair value’? (q.5)
“Fair value” is normally regarded as the price which would be negotiated between a willing, informed, but not
anxious buyer and a willing, informed, but not anxious seller. It is the price which would generally be expected
to result from normal market activity, although in some cases court decisions have deviated from market value
in determining fair value.

5. What particular difficulties are there in determining a capitalization or discount rate for valuing
small enterprises? How has this problem been addressed? (q.10)
The discount rate or capitalization rate takes account of the risk inherent in the enterprise and its activities.
These rates adjust the forecast cash flow or earnings streams respectively to provide a risk-adjusted value of
the enterprise.

A lack of suitable comparative data for small enterprises makes the selection of discount or capitalization rates
more difficult than for larger companies listed on the stock exchange. The capital asset pricing model (CAPM)
provides a theoretical basis for determining an appropriate discount rate, but this also is more suitable for
large publicly traded enterprises where more information is available. As discussed in chapter 3, the CAPM
may need to be modified or prespecified if it is to be relevant for small enterprises. Adding a small enterprise
premium to the CAPM is one suggested specification. This might reflect the undiversified nature of most
investment in small enterprises and its lack of marketability. The use of accounting information to construct
risk measures (or betas) for small enterprise is likely to be unreliable because of the relative lack of market
driven data in financial statements.

 Case Study

Building a discount rate for valuation purposes, pp.324 -326

1. What is the CAPM equation for this company? What discount rate would be indicated by the CAPM?

The CAPM equation is

Ri = Rf + βi(Rm-Rf)

= 7.26 + (1.2 x 7.0)

= 7.26 + 8.4

= 15.66%

2. What further adjustments to the CAPM are suggested by Pratt, Reilly and Schweihs (1996)?

They add a 4.0% small enterprise premium. This is an average figure across all small enterprises based on
empirical research.

They then deduct 1.0% to reflect the specific risk for the small enterprise in question relative to the average
small enterprise in its industry.

3. What do the figures indicate about Pratt, Reilly and Schweihs’s assessment of the performance of this
company relative to similar companies in its industry?

They suggest this company is less risky than small companies in its industry.
 Additional Exercise

Two years ago you invested in a start-up called Eat-Fresh. Today, Eat-Fresh has become one of the
popular eating hangout places in Suva. Due to popular demand, you are considering opening an outlet at
Damodar City. You plan to have an investment period of 5 years. After a thorough feasibility study, you
gather the following information:
 Leasing a shop would involve payment of $55,000 per year for 5 years.
 Another shop, identical to the shop being offered on lease and located just next door, is up for
sale and the current owners are asking a cash price of $240,000. To consider this option, you
would need to obtain a SME loan under Eat-Fresh for the full amount at 6% per annum with
annual ordinary repayments. Interest is applied using reducing balance method.
 Other costs associated with buying the shop would be per year maintenance costs of $2,000.
 As per local tax laws, the applicable tax rate is 20% and straight-line depreciation is allowed.
 After-tax cost of capital would be 3%.

Required:
1. If you consider buying the shop, prepare an amortization table (using the format below) to show
repayment of SME loan over the 5 years.
Period Opening Total Interest Principal Closing
Principal Repayment Repayment Balance

2. Calculate the present total cost of buying the shop.

3. Calculate the present total cost of leasing the shop.
4. Based on (1) above, what would be your final decision?
240000 = (1-((1+0.06)^-5))/0.06
4.212363786
C= 240000/4.212364
56,975.14

Amount 240,000.00
Interest 6%

Period Opening Principal Total Interest Principal Closing

Repayment Repayment Balance
0 240,000.00 - - - 240,000.00
1 240,000.00 56,975.14 14,400.00 42,575.14 197,424.86
2 197,424.86 56,975.14 11,845.49 45,129.64 152,295.22
3 152,295.22 56,975.14 9,137.71 47,837.42 104,457.80
4 104,457.80 56,975.14 6,267.47 50,707.67 53,750.13
5 53,750.13 56,975.14 3,225.01 53,750.13 0.00
Buying
Period 1 2 3 4 5
Costs
Loan Repayment (A) 56,975.14 56,975.14 56,975.14 56,975.14 56,975.14
Maintenance (B) 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00
Total Costs (C = A+B) 58,975.14 58,975.14 58,975.14 58,975.14 58,975.14
Tax Shield Items
Depreciation (D) 48,000.00 48,000.00 48,000.00 48,000.00 48,000.00
Interest (I) 14,400.00 11,845.49 9,137.71 6,267.47 3,225.01
Maintenance (B) 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00
Total Allowable 64,400.00 61,845.49 59,137.71 56,267.47 53,225.01
Deductions
T = (D+I+B)
Tax Shield 12,880.00 12,369.10 11,827.54 11,253.49 10,645.00
S = (20% * T)
Net Cash Flows 46,095.14 46,606.04 47,147.59 47,721.64 48,330.13
(NCF = C - S)
PVCF of NCF @ 3% 44,752.56 43,930.66 43,146.73 42,400.06 41,690.00
Total PVCF
$215,920.01
(Total Cost of Buying)

Leasing
Period CF Tax Shield Net CF PVCF
1 55,000.00 11,000.00 44,000.00 42,718.45
2 55,000.00 11,000.00 44,000.00 41,474.22
3 55,000.00 11,000.00 44,000.00 40,266.23
4 55,000.00 11,000.00 44,000.00 39,093.43
5 55,000.00 11,000.00 44,000.00 37,954.79

Total Cost of Leasing $ 201,507.12

Leasing is chaper by : $14,412.89 , therefore lease the shop.