Analysis and Valuation of Privately Held Companies Essay

10.1 What is the niftyization say and how does it relate to the price reduction lay? resolution The terms discount rate and capitalization rate atomic number 18 much used inter repositionably. Whenever the growth rate of a dissipateds gold functions is intercommunicate to vary over time, the term discount rate broadly refers to the factor used to convert the projected specie preys to present apprizes. In contrast, if the cash flows of the staunch atomic number 18 non expect to grow or are expected to grow at a constant rate indefinitely, the discount rate employed by practitioners is ofttimes referred as the capitalization rate.10.2 What are the common ways of estimating the capitalization rate? manage capitalisation rates whitethorn be estimated by using the Capital plus Pricing Model, live of capital, price-to-earnings symmetrys, accounting based fall ins such as the return on equity, and the build-up method.10.3 What is the marketability discount and what a re common ways of estimating this discount? fare The risk associated with an illiquid market for the specific stock is very much referred to as the marketability or liquidness discount. Liquidity is the ease with which an investor rouse sell their stock without a serious loss of value. An investor in a small company may find it difficult to sell quickly their shares because of limited recreate in the company. Consequently, the investor may find it necessary to sell their shares at a world-shattering discount from what they paid for the shares.10.4 Give examples of mystic company be that baron be understated and explain why.Answer Examples may include employee cookery and the toll of complying with government regulation such as OSHA and the EPA. Small, in camera own firms tend to under-spend in these areas since they do not contribute directly to true profitability.10.5 How provide an analyst determine if the send firms costs and revenues are understated or overstated? Answer The analyst may determine that revenues have been overstated by comparing the accounting practices to generally accepted accounting principles guidelines and to other comparable firms. It may be determined that costs are understated by comparing the firms accounting practices with generally accepted accounting principles standards and by comparing the firms common size financial statements with those of similar firms.10.6 Why might shell corporations have value?Answer Merging with an living corporate shell of a formerly in in the creation eye(predicate) traded company may be a reasonable alternative for a firm wanting to go public that is unable to provide the 2 yrs of audited financial statements required by the SEC or disinclined to incur the costs of going public through an initial public offering. Thus, merging with a shell corporation may represent an in effect(p) alternative to an initial public offering for a small firm. tap out corporations may too be attrac tive for investors interested in capitalizing on the intangible value associated with the existing corporate shell. This could include name science licenses, patents, and other forms of intellectual properties and underutilized assets such as warehouse space and richly depreciated equipment with some economic life remaining.10.7 Why might succession readiness be more challenging for family possess firms?Answer Succession plan 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 restriction 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 simply do not have the corroboration to beat into a management role.10.8 What are some of the reasons a family-owned or occultly-owned telephone line may want to go public? What are some of the reasons that reprove such firms from going public ?Answer Private or family owned firms are more seeming to go public when valuations are senior high or are increasing. Companies also are inclined to go public when they anticipate an inability to finance future investment opportunities or the sentinel 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 well as concern about interference from public shareholders. Private firms also are less likely to go public when the special privileges that accrue to the compulsory 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 founder 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. Conse quently, 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 expertise. They intend to invest for the semipermanent 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 runniness discount you would leave if you as a byplay 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 tautologic cash balances and other liquid short-term investments, and d) a pool cleaning service whose primary tangible assets consist of a 2- form 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 smal l, 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 secure liquid assets.Selected Practice Problems and Answers10.14 Based on its growth prospects, a private investor values a local bakery at $750,000. She believes that cost nest egg having a present value of $50,000 can be achieved by changing staffing levels and store hours. Based on recent empirical studies, she believes the appropriate liquidity discount is 20 pct. A recent transaction in the aforesaid(prenominal) city required the buyer to earnings a 5 percent bounty 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 Yo u have been asked by an investor to value a restaurant. Last year, the restaurant pull in 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 disparagement 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 Treasury bond rate is 5%, the equity risk 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 intentness are 2 and 1.5, respectively. The business s 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 account 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 be ta = 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. What 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 head start 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