Parrino

Questions and Problems 567

17.11 Dividends and firm value: Explain what the introduction of transaction costs does to the
Modigliani and Miller assumption that dividends are irrelevant. Start with a firm that pays divi-
dends to investors that do not want to receive dividend payments. Do not consider taxes.

17.12 Dividends and firm value: CashCo has been increasing its cash dividends each quarter for
the past eight quarters. While this may signal that the firm is financially very healthy, what else
could we conclude from these actions?

17.13 Dividends and firm value: Currently, dividends are taxed at a maximum rate of 15 percent.
Unless Congress acts by 2012, this favorable tax treatment will lapse and the rate will increase.
What would you expect to happen to the prices of dividend-paying stocks versus those of
nondividend-paying stocks if Congress does not act?

17.14 Dividends: Undecided Corp. has excess cash on hand right now, although management is not
sure about the level of cash flows going forward. If the firm would like to put cash in its stock-
holders’ hands, what kind of dividend should it pay, and why?

17.15 Dividends and firm value: A firm can deliver a negative signal to stockholders by increasing
the level of dividends or by reducing the level of dividends. Explain why this is true.

17.16 Dividends and firm value: A commentator on a financial talk show on TV says that “On
average, firms pay out too little to stockholders. This is why stock prices go up with dividend
increases and down with dividend decreases.” Is the commentator right?

17.17 Dividends and firm value: You own shares in a firm that has extra cash on hand to distribute
to stockholders. You do not want the cash. What course of action would you prefer the firm
take?

17.18 Dividends and firm value: Stock repurchases, once announced, do not actually have to occur
in total or in part. From a signaling perspective, why would a special dividend be better than a
stock repurchase?

17.19 Dividends and firm value: Consider a firm that repurchases shares from its stockholders in
the open market, and explain why this action might be detrimental to the stockholders from
whom the firm buys shares.

17.20 Dividends and firm value: You read that a number of public companies have been financing
their dividend payments in recent years entirely through equity issues. A colleague of yours ar-
gues that this only increases taxes paid by individual stockholders and boosts underwriting and
other transactions costs for the company. He says that such a policy cannot make sense. What do
you say?

17.21 Stock repurchases: Briefly discuss the methods available for a firm to repurchase its shares
and explain why you might expect the stock price reaction to the announcement of each of these
methods to differ.

17.22 Stock repurchases: What is the advantage of a Dutch auction over a fixed-price tender offer?

17.23 In the early 1990s, the amount of time that elapsed between purchasing a stock and actually < ADVANCED
obtaining that stock was five business days. This period was known as the settlement period.
The settlement period for stock purchases is now two business days. Describe what should have
happened to the number of days between the ex-dividend date and the record date at the time of
this change.

17.24 Dividend reinvestment programs (DRIPs) sometimes sell shares at a discount to stockholders
who reinvest their dividends through such plans. Your boss tells you that such plans are just
a scheme to transfer wealth from nonparticipating to participating stockholders and that they
should be stopped. Do you agree? Why or why not?

17.25 WeAreProfits, Inc., has not issued any new debt securities in 10 years. It will begin paying cash
dividends to its stockholders for the first time next year. Explain how a dividend might help the
firm get closer to its optimal capital structure of 50 percent debt and 50 percent equity.

17.26 Shadows, Inc., had shares outstanding that were valued at $120 per share before a two-for-one
stock split. After the stock split, the shares were valued at $62 per share. If we accept that the
firm’s financial maneuver did not create any new value, then why might the market be increasing
the total value of the firm’s equity?

17.27 Saguaro Company currently has 30,000 shares outstanding. Each share has a market value of
$20. If the firm pays $5 per share in dividends, what will each share be worth after the dividend

568 CHAPTER 17 I Dividends, Stock Repurchases, and Payout Policy

17.28 Cholla Company currently has 30,000 shares outstanding. Each share has a market value of $20.
If the firm repurchases $150,000 worth of shares, then what will be the value of each share out-
standing after the repurchase? Ignore taxes.

17.29 You purchased 1,000 shares of Koogal five years ago at $30 per share. Today Koogal is repurchas-
ing its shares through a fixed-price tender offer price of $80 per share. What is the amount of
after-tax proceeds that you will get to keep if only your capital gain is taxed at a 15 percent rate?

17.30 You purchased 1,000 shares of Zebulon Copper Co. five years ago at $50 per share. Today Zebulon
is trying to decide whether to repurchase shares at $70 per share through a fixed-price tender
offer or pay a $70 cash dividend per share. If capital gains are taxed at a 15 percent rate, then at
what rate must dividends be taxed for you to be indifferent between receiving the dividend and
selling your shares back to Zebulon?

17.31 Llama Wool Company is trying to do some financial planning for the coming year. Llama plans
to raise $10,000 in new equity this year and wants to pay a dividend to stockholders of $30,000 in
total. The firm must pay $20,000 interest during the year and will also pay down principal on its
debt obligations by $10,000. If the firm continues with its capital budgeting plan, it will require
$100,000 for capital expenditures during the year. Given the above information, how much cash
must be provided from operations for the firm to meet its plan?

17.32 You are the CFO of a large publicly-traded company. You would like to convey positive informa-
tion about the firm to the market. If you intuitively understand (and agree with) the results from
the Lintner study, will you keep paying your currently high dividend or raise that dividend by a
small amount?

17.33 You are the CFO of a public company that advises distressed companies about how to manage
their businesses in a recessionary environment. Your company has been performing extremely
well since the recession began in 2008. During this period, your company has earned so much
money that the increase in its retained earnings has resulted in a decline in the firm’s debt to total
capital ratio from 30 percent to 15 percent. Much of the retained earnings is sitting in a cash ac-
count because your firm does not need the money fund investments. You would like to increase
the debt-to-total capital ratio to 30 percent, which you view as optimal for your firm. How would
you recommend doing this if you want to complete the adjustment as soon as possible?

Sample Test Problems

17.1 Is it possible to own a stock for a single day and receive the cash dividend paid on the stock al-
though you do not own the stock at the time of payment?

17.2 Is it possible for your voting interest in a firm to increase without your having to purchase addi-
tional shares in that firm?

17.3 Since dividends that are not yet declared by the firm are not legal obligations of the firm, can the
firm alter its dividend payouts without cost?

17.4 Evaluate the statement that the government does not have an impact on the valuation of stocks.
17.5 A recent survey of financial executives found that they favor stock repurchases over dividends.

How does that finding seem to contradict the idea that firms use distribution decisions to signal
future firm prospects to the market?

Business

18Formation,

Growth, and
Valuation

Learning Objectives

©Tibor Bognar/Corbis Images

O 1 Explain why the choice of organizational
n October 5, 2010, managers of Planet Ventures II, LP, a form is important, and describe two financial
considerations that are especially important

venture capital fund, announced that they were investing $4.8 mil- in starting a business. CHAPTER EIGHTEEN

lion in Auro Mira Energy Company Private Limited. Their invest-
ment would be part of a $21 million second round (the company 2 Describe the key components of a business
plan and explain what a business plan is
had successfully raised venture capital once before) of venture capi-
used for.
tal funding for Auro Mira. Other investors included Aueros South

Asia Fund and International Finance Corporation. 3 Explain the three general approaches

Auro Mira is one of the fastest growing clean energy compa- to valuation and value a business using

nies on the Indian subcontinent. The company, which was founded common business valuation approaches.

in 2005, focuses on the production of energy from biomass, small 4 Explain how valuations can differ between
hydroelectric facilities, and wind turbines. At the time of the Planet
public and private companies and between
Ventures II announcement, Auro Mira had two operating biomass
young and mature companies, and discuss
facilities with annual capacities of 7.7 and 10 megawatts (MW) and
the importance of control and key person
had begun developing four new biomass and hydroelectric facili-
considerations in valuation.
ties which would take the company’s total generating capacity above

100 MW by the end of 2012.

Getting to the point of being able to raise the $21 million in

October 2010 required a great deal of careful management by Auro Mira’s founders and man-

agers. They had to identify profitable clean energy technologies, choose an appropriate organi-

zational form, ensure that they had sufficient capital, successfully develop new generating fa-

cilities, and do this all in a way that ensured that the company could sell the energy it produces

at competitive prices and still earn attractive returns for investors.

Of course, Auro Mira would have never even been in a position to raise a second round of

financing if investors had not been willing to provide the company with a first round of financing

earlier in its life. Attracting knowledgeable investors for a first round of financing required that

Auro Mira’s management put together a compelling business plan. Through this plan, they had

570 CHAPTER 18 I Business Formation, Growth, and Valuation

to convince investors that they could overcome any technological obstacles, that there would be
sufficient demand for the energy that the company produced, and that the Auro Mira management
team had the skills necessary to build a business that would produce attractive returns.

This chapter discusses some financial aspects of forming, growing, and financing a new
business. It also discusses, in detail, the methods used to value both small and large businesses.
Business valuation concepts were certainly on the minds of Auro Mira’s owners when they were
raising capital and had to decide exactly how much of the company’s equity they would have to
sell to obtain the funds they needed to grow the business. These concepts are also on their minds
every day as they make business decisions that create value for the company’s investors.

CHAPTER PREVIEW Next we focus on the role that a carefully prepared busi-
ness plan plays in raising capital for a young, rapidly growing
In earlier chapters, we discussed how businesses are orga- business and in providing a road map of where the business
nized and how financial managers make long-term invest- is going for use in managerial decision making. The impor-
ment decisions, manage working capital, and finance the tance of a business plan cannot be understated. The act of
investments and activities of their businesses. In this chapter, preparing a business plan forces an entrepreneur to think
we reexamine these concepts in the context of a discussion carefully about the aspects of the business that are crucial to
of business formation, growth, and valuation. The chapter its success. This helps him or her better communicate to oth-
provides an integrated perspective on how the decisions ers what the prospects for the business are and to manage
that financial managers make affect firm value. the business more effectively.

We begin by considering the decision by an entrepreneur to The last two sections of the chapter address business valu-
start a business and the choice of how the business should ation concepts. These sections provide a broad overview of
be organized. The organizational form of a business affects the business valuation approaches used by financial man-
many important financial decisions through its impact on agers and describe how differences in the characteristics
the availability and cost of capital, the control of the busi- of companies affect valuation analyses. The impact of con-
ness, the ability to attract and retain high-quality managers, trol considerations and key people on business valuations
the taxes that must be paid, and the agency problems that are also discussed.
might arise in the business, among other factors. We then
discuss financial considerations that are important to manag-
ers of young, rapidly growing firms.

18.1 STARTING A BUSINESS

LEARNING OBJECTIVE 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
To learn more about live in an area where there are no attractive employment opportunities for them, and starting
starting a business, see a business is the only way to earn a living. Others simply want to be their own boss.
the Business Owner’s
Toolkit page on the CCH Regardless of their motives, all of these people face the decision of whether to start their
Web site at http://www own business or purchase an already established business. Starting your own business can
.toolkit.cch.com. provide greater potential rewards but is inherently more risky than buying and growing a busi-
ness 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

18.1 Starting a Business 571

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 prod-
ucts. 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 busi-
nesses 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 care-
fully 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 re-
member 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 ex-
ecutives 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 organiza-
tion 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 advan-
tages 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 liabil-
ity 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 organiza-
tion 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 impor-
tant 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 differ-
ent 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

572 CHAPTER 18 I Business Formation, Growth, and Valuation

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.

Sole Partnership Limited Corporation
Proprietorship Liability
General Limited Company (LLC) S-Corp. C-Corp.

Cost to establish Inexpensive More costly More costly More costly More costly More costly
Limited Flexible Flexible Flexible Indefinite Indefinite
Life of entity Limited Less limited Excellent
Very limited Shared Less limited Less limited Depends on Depends on
Access to capital Complete Shared Shared ownership ownership

Control by founder High High High High High Can be low
over business No No Yes Yes
decisions Yes Yes
Some
Cost to transfer No No Some Good Potentially Potentially
ownership Limited Good Good high high
Limited
Specialization of As elected Good Good
management and Limited
investment Unlimited Unlimited Unlimited for Limited Limited
Flow-through Flow-through general partner
Potential owner/ Flow-through Double tax
manager conflicts Limited Flow-through

Ability to provide Limited Limited Limited Less limited
incentives to attract
and retain high-
quality employees

Liability of owners

Tax treatment of
income

Tax deductibility of
owner benefits

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 partner-
ships. 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 partner-
ship. This means that no taxes are paid at the corporate level. However, since the firm is incor-
porated, 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

18.1 Starting a Business 573

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. How-
ever, 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 in-
vestors 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 con-
cern for an entrepreneur. By their nature, sole proprietorships must rely on equity contribu-
tions 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 be-
cause 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 re-
lated 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 partner-
ships, 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

574 CHAPTER 18 I Business Formation, Growth, and Valuation

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 ben-
efits, 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 entre-
preneur to understand the cash requirements of the business.

The margin for error is small. If the entrepreneur miscalculates how much money is nec-
essary, 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 in-
vesting 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:

EBITDA Break-even ϭ Price FC VC
Ϫ Unit

where FC is the fixed costs associated with the business and Price Ϫ Unit VC 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 ex-
pensive, 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 prod-
uct development can harm a business by causing it to lose its competitive advantage. An entre-
preneur should always be looking for ways to maximize the per-unit contribution of the firm’s
products while maintaining the firm’s competitive position.

18.1 Starting a Business 575

Many entrepreneurs also lose sight of the importance of controlling fixed costs. For ex-
ample, 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. Al-
though 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
The cash budget is also a very useful planning tool for entrepreneurs. It summarizes the cash spreadsheet #60 on the
flows into and out of a firm over a period of time. Cash budgets often present the inflows and Web site maintained by
outflows on a monthly basis but can be prepared for any period, including daily or weekly. Pre- Matt H. Evans, is an
paring a cash budget helps an entrepreneur better understand where money is coming from, example of a
where it is going, how much external financing is likely to be needed, and when the need is likely comprehensive Excel
to arise. Understanding where the money is coming from and where it is going helps an entrepre- model for forecasting
neur maintain control of the company’s finances. Knowing how much external financing is likely monthly cash flows. See
to be needed and when helps the entrepreneur plan fund-raising efforts before it is too late. the spreadsheet at
http://www.exinfm.com/
To better understand how a cash budget can help an entrepreneur, let’s consider an free_spreadsheets.html.
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 8 percent (8 percent/12 months per
year ϭ 0.667 percent per month). 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.

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:

$75,000 ϩ $3,000 Ϫ $20,770 Ϫ $333 Ϫ $50,000 Ϫ $800 ϭ $6,097

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

$6,097 ϩ $12,000 Ϫ $22,220 Ϫ $333 ϭ Ϫ $4,457

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 $4,457 ϩ $5,000 ϭ $9,457. 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:

$9,457 ϩ $9,103 ϩ $6,553 ϩ $4,004 ϩ $1,253 ϭ $30,370

2The actual result of the calculation shown here is Ϫ$4,456, rather than Ϫ$4,457. The $1 difference is due to rounding.
The interest expense is actually $333.33 [(0.08/12) ϫ $50,000 ϭ $333.33] and the beginning cash balance is $6,096.67,

EXHIBIT 18.2 Pizza Palace Monthly Cash Budget for the Period March 2012 through February 2013a

A 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.

Row Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec. Jan. Feb. Total

1. Beginning cash balance $75,000 $ 6,097 $ 5,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000 $ 6,497 $ 7,993 $ 9,490 $10,987 $12,483
2. Cash receipts:
3. Cash sales 3,000 12,000 15,000 20,000 25,000 30,000 35,000 35,000 35,000 35,000 35,000 35,000 $315,000
4. Collections from credit accounts – – – – – – – – – – – – –
5. Investments by owner – – – – – –
9,457 9,103 6,553 4,004 1,253 353 30,723
6. Total cash receipts $ 3,000 $21,457 $24,103 $26,553 $29,004 $31,253 $35,000 $35,000 $35,000 $35,000 $35,000
7. Total cash available $78,000 $27,554 $29,103 $31,553 $34,004 $36,253 $40,000 $41,497 $42,993 $44,490 $45,987 $35,353 $345,723
$47,836
Cash payments: $ 1,200 $ 4,800 $ 6,000 $ 8,000 $10,000 $12,000 $14,000 $14,000 $14,000 $14,000 $14,000
8. Operations 10,800 10,800 10,800 10,800 10,800 10,800 10,800 10,800 10,800 10,800 10,800 $14,000 $126,000
9. Food purchases 1,620 1,620 1,620 1,620 1,620 1,620 1,620 1,620 1,620 1,620 1,620 10,800 129,600
10. Gross wages 500 500 500 500 1,620 19,440
11. Payroll expenses 150 600 750 1,000 500 500 500 500 500 500 500
12. Misc. supplies 1,000 1,000 1,000 1,000 1,250 1,500 1,750 1,750 1,750 1,750 1,750 500 6,000
13. Repairs and maintenance 3,000 200 200 200 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,750 15,750
14. Advertising 1,500 1,500 1,500 1,500 1,000 12,000
15. Accounting and legal 1,000 1,200 1,400 1,600 200 200 200 200 200 200 200 5,200
16. Rent – – – – 1,500 1,500 1,500 1,500 1,500 1,500 1,500 200 18,000
17. Telephone and utilities $20,770 $22,220 $23,770 $26,220 1,800 1,800 1,800 1,800 1,800 1,800 1,800 1,500 19,600
18. Other expenses 1,800
$ 333 $ 333 $ 333 $ 333 – – – – – – – –
19. Operations total – – – – $28,670 $30,920 $33,170 $33,170 $33,170 $33,170 $33,170 –
Financing and investments: – – – $351,590
50,000 – – – $ 333 $ 333 $ 333 $ 333 $ 333 $ 333 $ 333 $33,170
20. Interest payments 800 – – – – – – – – – –
21. Principal payments on loans – – – – – – – – $ 333 $ 4,000
22. Capital expenditures $22,553 $24,103 $26,553 – – – – – – – 10,000 10,000
23. Start–up costs $71,903 $ 5,000 $ 5,000 $ 5,000 – – – – – – – – 50,000
24. Withdrawals by owner $ 6,097 – 800
$29,003 $31,253 $33,503 $33,503 $33,503 $33,503 $33,503 – –
25. Total cash payments $ 5,000 $ 5,000 $ 6,497 $ 7,993 $ 9,490 $10,987 $12,483
26. Ending cash balance $43,503 $416,390
$ 4,333

aSome totals do not appear to add up precisely because the actual values computed in the model are rounded to the nearest whole number for presentation in this exhibit.

18.1 Starting a Business 577

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 Feb-
ruary 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 simplic-
ity, 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 $14,000/$35,000 ϭ 0.40, or 40 percent
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:

EBITDA Break-even ϭ Price FC VC ϭ $33,170 Ϫ $14,000 ϭ 3,195 customers
Ϫ Unit $10 Ϫ $4

In other words, your restaurant will have to serve at least 3,195 customers per month (approxi-
mately 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.

Using a Cash Budget DECISION
MAKING
SITUATION: It is January 1, and you have prepared the following cash budget for the
next four months for your new business venture: EXAMPLE 18.1

Monthly Cash Budget Apr. Total
($28,530)
Beginning cash balance Jan. Feb. Mar.
$ 0 ($18,510) ($25,270)
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 $ 1,250 $ 2,500 $ 6,000 $10,000 $19,750
Operations 5,760 5,760 5,760 5,760 23,040
Merchandise purchases 1,000 1,000 1,000 1,000 4,000
Gross wages and payroll 1,500 1,500 1,500 1,500 6,000
Advertising 1,000 1,000 1,000 1,000 4,000
Rent
$10,510 $11,760 $15,260 $19,260 $56,790
Other expenses
$10,000 – Ϫ – $10,000
Operations total 500 – Ϫ – 500
– – – – –
Financing and investments
Capital expenditures $21,010 $11,760 $15,260 $19,260 $67,290
Start-up costs ($18,510) ($25,270) ($28,530) ($27,790)
Withdrawals by owner

Total cash payments
Ending cash balance

(continued )

578 CHAPTER 18 I Business Formation, Growth, and Valuation

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 bal-
ance 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 bal-
ance 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.

> BEFORE YOU GO ON
1 . What are three general reasons that new businesses fail?
2 . How do financing considerations affect the choice of organizational form?
3 . How does a cash budget help an entrepreneur?

18.2 THE ROLE OF THE BUSINESS PLAN

LEARNING OBJECTIVE 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 man-
aging it—is the business plan.

business plan Why Business Plans Are Important
a document that describes the
details of how a business will Recall from Chapter 15 that the equity capital used by entrepreneurs includes their own money,
be developed over time investments from friends and family, investments by venture capitalists, equity raised by sell-
ing 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 invest-
ment. 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 attrac-
tive 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 inves-
tors 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

18.2 The Role of the Business Plan 579

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 To learn more about
business plans and to
The depth and scope of business plans vary widely, but most well-developed business plans see sample plans, visit
include the following: the PlanWare Web site
at http://www.planware
• An executive summary, which summarizes the key points made in the plan. .org or the Bplans Web
• A company overview, which describes what the company does and what its comparative site at http://www
.bplans.com.
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 struc-

ture 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 busi-
ness. 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 suf-

ficient 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.

• Appendixes that contain detailed supporting information for the above discussions and

analyses.

> BEFORE YOU GO ON

1 . Why is a business plan important in raising capital for a young company?

2 . What else can a business plan be used for?

3 . Why is it important to discuss the qualifications of the management team in
a business plan?

580 CHAPTER 18 I Business Formation, Growth, and Valuation

18.3 VALUING A BUSINESS

LEARNING OBJECTIVE 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 deci-
sions that create value without knowing how to identify positive NPV projects or how operat-
ing 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 proj-
ects, 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 pro-
duce, 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 busi-

ness changes over time. Changes in general economic and industry conditions, and deci-

sions 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,

valuation date and financing decisions.
he date on which a value Because the value of a business changes over time, it is important to specify a valuation
estimate applies
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 ex-

BUILDING THE VALUE OF A BUSINESS IS SPECIFIC TO ample, when companies are sued or when stock-
A POINT IN TIME holders are involved in a dispute with the Internal
Revenue Service, the value of the business or its

INTUITION The value of a business is affected by general stock as of some date in the past must often be esti-
mated. A stockholder may claim that managers
economic and industry conditions as well as sold stock for less than it was worth at some time in
the decisions made by managers. All of these the past, or the IRS may claim that the value of
factors affect the cash flows that a business is expected to produce shares passed to an heir was greater than claimed
in the future and the rate at which those cash flows should be dis- when the taxes were filed by the estate of a deceased
counted. Since all of these factors change over time, so will the stockholder. By specifying the valuation date, the
value of the business.

person who values a business makes it clear to any-

one who uses the value estimate precisely what economic, industry, and firm conditions are

reflected in that estimate.

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

18.3 Valuing a Business 581

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 per-

formed 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 investment value

terminology, we would refer to this as an estimate of the investment value of the business to the value of a business to a

that investor. specific 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 esti- fair market value
mating the fair market value of the business. The fair market value of a business is the value of the value of a business to a

that business to a hypothetical person who is knowledgeable about the business. It does not typical investor

include the value of synergies or the effects of any

investor-specific management style. For this rea- THE VALUE OF A BUSINESS IS NOT THE BUILDING
son, the fair market value can differ considerably SAME TO ALL INVESTORS
from the investment value of a business.

The value of a business is not the same to all INTUITION
investors because different investors will ob-
Business Valuation Approaches tain different cash flows from owning a busi-

There are a wide variety of business valuation ness. For example, the cash flows to passive investors will differ
methods, but most can be classified into one of from the cash flows to investors who are active in the management
three general categories: (1) cost approaches, of the business. Cash flows will also differ among active investors
because they will have different skill levels, operating preferences,

(2) market approaches, and (3) income approaches. and abilities to benefit from synergies.

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 poten-

tial 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 busi-

ness 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 replacement cost
the cost of duplicating the
Two cost approaches that are commonly used to value businesses or their individual assets are assets of a business in their
the replacement cost and adjusted book value approaches. present form on the valuation
date
Replacement Cost. The replacement cost of a business is the cost of duplicating the busi-
ness’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

582 CHAPTER 18 I Business Formation, Growth, and Valuation

adjusted book value When using the replacement cost approach in a buy-versus-build analysis, you must be
he sum of the fair market sure to include the cost of all tangible assets, such as property, plant, and equipment, and all
alues of the individual assets intangible assets, such as brand names and customer lists. You must also include the cost of
n a business 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
going-concern value build a business, and until the business is up and running it will produce smaller cash flows
he difference between the than a business you might acquire.
alue of a business as a going
oncern (the present value of Adjusted Book Value. The adjusted book value approach involves estimating the market
he expected cash flows) and values of the individual assets in a business and adding them up. When this approach is used,
he adjusted book value 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 in-
cluded 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 ap-
proach (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 busi-
ness, 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

18.3 Valuing a Business 583

and have decided to shut down the business rather than invest any more money. The current
balance sheet of this business is as follows:

Assets: $ 78 Liabilities and Equity: $ 480
Cash 2,368 Accounts payable 2,000
Accounts receivable 1,600 Loan balance 2,366
T-shirt inventory Stockholders’ equity
Printing press 800 $4,846
Total liab. & equity
Total assets $4,846

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 ex-
pect 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 re-
veals 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:

Cash $ 78 ϫ 100% ϭ $ 78
Accounts receivable $2,368 ϫ 95% ϭ $2,250
T-shirt inventory $1,600 ϫ 80% ϭ $1,280
Printing press $ 800 ϫ 75% ϭ $ 600

Total assets $4,846 $4,208

Therefore, after paying your accounts payable and the loan, your equity ownership interest has
a liquidation value of $4,208 Ϫ $480 Ϫ $2,000 ϭ $1,728.

Using the Adjusted Book Valuation Approach LEARNING
BY
PROBLEM: You are considering purchasing a company that manufactures specialized APPLICATION 18.1
components for recreational vehicles. These components are sold to the companies DOING
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
Net PP&E 1,436
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.

(continued )

584 CHAPTER 18 I Business Formation, Growth, and Valuation

SOLUTION: The liquidation value is:

Cash $ 444 ϫ 100% ϭ $ 444
Accounts receivable
Inventory $ 739 ϫ 93% ϭ $ 687
Net PP&E
$ 1,436 ϫ 85% ϭ $1,221
Total assets
$ 8,463 $6,100

$11,082 $8,452

You can expect to realize $8,452 from the liquidation of this company if there are no liq-
uidation expenses that are not accounted for in these numbers.

multiples analysis Market Approaches
a valuation approach that uses
tock price or other value Two market approaches are commonly used in business valuation. The first approach, which is
multiples for public companies often called multiples analysis, uses stock price or other value multiples that are observed for
o estimate the value of similar public companies to estimate the value of a company or its equity. The second ap-
another company’s stock or its proach, often called transactions analysis, uses information from transactions involving the
entire business sale of similar companies to estimate the value of a company or its stock.

ransactions analysis Market approaches reflect prices that have actually been paid for a company’s stock or for
a valuation approach that uses the entire company. While it is not always obvious why people pay a particular price, the infor-
ransactions data from the sale mation on what they pay can yield useful insights into how those people view the prospects for
of similar companies to similar businesses. Market approaches can also provide useful benchmarks against which
estimate the value of another valuations based on other methodologies can be compared.
ompany’s stock or its entire
business 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 eq-
uity 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 depart-
ment 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 com-
pany 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:

VE ϭ aPb ϫ Net incomeCompany being valued
E Comparable

ϭ 17.63 ϫ $3.65 million

ϭ $64.35 million

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

18.3 Valuing a Business 585

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 situa-
tion. 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 di-
mensions. 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 man-
agement 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 be-
ing 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:

P0 ϭ D1 g
kcs Ϫ

where P0 is the current stock price, D1 is the dividend that is expected next year, kcs is the re- You can learn more
quired return on common stock, and g is the expected growth rate in dividends. If we recog- about business valuation
nize that dividends equal the fraction of earnings distributed to the stockholders times the and find a wide range of
earnings of the firm, we can rewrite Equation 9.4 as: Excel templates that can
be used to value
P0 ϭ E1b g businesses and their
kcs Ϫ securities on the Web
site maintained by
where E1 is the earnings per share expected next year and b is the fraction of the firm’s earnings Aswath Damodaran at
that is paid out as dividends. b is known as the dividend payout ratio, which is discussed in http://pages.stern.nyu
.edu/~adamodar.
Chapter 19. Finally, we can rearrange this equation to obtain the price/earnings multiple:
enterprise value
P0 ϭ b (18.1) the value of a company’s
E1 kcs Ϫ g equity plus the value of its
debt; also the present value
This equation tells us that the P/E multiple can be thought of as equal to the dividend payout of the total free cash flows the
ratio over kcs minus g.4 company’s assets are expected
to generate in the future
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 com-
pany of interest as possible. For example, consider what company characteristics determine
kcs. The Capital Asset Pricing Model (CAPM) tells us that kcs depends on beta, which is a
measure of the systematic risk associated with a company’s stock price. Since this system-
atic 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, g, is determined by the
same factors that affect kcs. 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

3Marketability discounts are also sometimes called discounts for lack of marketability or liquidity discounts.
4This is not strictly true for most firms because it assumes that the stock price can be estimated using a constant-

growth perpetuity model and most firms either do not pay dividends at all or do not increase dividends at a constant

rate. Nevertheless, this model does provide a useful way of thinking about P/E multiples.
5Enterprise value is typically defined as: Market value of common stock ϩ Market value of preferred stock ϩ Market

586 CHAPTER 18 I Business Formation, Growth, and Valuation

the firm was written in Equation 16.1 as VFirm ϭ VDebt ϩ VEquity . In the interest of brevity, we
will write it in this chapter as:

VF ϭ VD ϩ VE

where VF is the value of the firm, VD is the value of the debt, and VE 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 re-
turn to the example in which we were valuing the department store chain. Assume that, in ad-
dition 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:

Enterprise value ϭ VD ϩ VE
ϭ $19.46 million ϩ 1$31.25 ϫ 3.67 million shares2

ϭ $134.15 million

Enterprise value ϭ $134.15 ϭ 9.35
ab Comparable $14.35
EBITDA

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

VF ϭ a Enterprise value b ϫ EBITDACompany being valued

EBITDA Comparable

ϭ 9.35 ϫ $8.67 million

ϭ $81.06 million

LEARNING Using Multiples Analysis
BY
DOING APPLICATION 18.2 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:
Stock price ϭ $10.62 Value of debt ϭ $1.25 million
Number of shares outstanding ϭ 9.55 million EBITDA last year ϭ $2.37 million
Value of outstanding debt ϭ $11.67 million Net income last year ϭ $0.45 million
EBITDA last year ϭ $10.85 million
Net income last year ϭ $2.67 million

Estimate the enterprise value of the company you are valuing using the P/E and enter-
prise 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 in-
come 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. Mul-
tiply 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.

18.3 Valuing a Business 587

SOLUTION: The P/E and enterprise value/EBITDA multiples for the comparable
company are:

P Stock price b
a b ϭ a Earnings
E per share Comparable
Comparable

$10.62 per share
ϭ $2.67 million/9.55 million shares ϭ 38.0

a Enterprise value b ϭ a VD ϩ VE b
EBITDA
EBITDA Comparable Comparable

$11.67 million ϩ 1$10.62 per share ϫ 9.55 million shares2
ϭ $10.85 million

ϭ 10.42

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

VE ϭ a P b ϫ Net incomeCompany being valued

E Comparable

ϭ 38.0 ϫ $0.45 million

ϭ $17.1 million

which suggests an enterprise value of:

VF ϭ VD ϩ VE ϭ $1.25 million ϩ $17.1 million ϭ $18.35 million
Using the enterprise/EBITDA multiple, we estimate the enterprise value to be:

VF ϭ a Enterprise value b ϫ EBITDACompany being valued

EBITDA Comparable

ϭ 10.42 ϫ $2.37 million

ϭ $24.70 million

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 trans-
actions 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 esti-
mates also do not include the value associated with being able to control a business, an impor-
tant consideration that we discuss in more detail later.

When performing a multiples analysis, it is also important to make sure that the numera-
tor 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 compa-
nies 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

588 CHAPTER 18 I Business Formation, Growth, and Valua tion

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 ac-
quired 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 analy-
sis, 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 pri-
vate 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 transac-
tions 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 busi-
ness 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 trans-
action, 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 dif-
ficult to value, could be included in the reported transaction price, and this may not be appar-
ent 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.

nonoperating assets (NOA) Income Approaches
ash or other assets that are
not required to support the At the beginning of this section, we said that the value of a business is determined by the mag-
nitude 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, esti-
mating 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 infor-
mation 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

18.3 Valuing a Business 589

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:

VF ϭ PV1FCFT2 ϩ PV1TVT2 ϩ NOA (18.2)

where VF is the value of the firm, PV(FCFT) is the present value of the free cash flows (FCF) that terminal value
the business is expected to produce over the next T years, PV(TVT) is the present value of all free the value of the expected free
cash flows after year T, and NOA is the value of all of the nonoperating assets in the firm. Note cash flows beyond the period
that the present value of all free cash flows after year T is generally known as the terminal value. over which they are explicitly
Note also that if we only want to calculate the value of the equity, we can do this by first calculat- forecast
ing the value of the firm using Equation 18.2 and then subtracting the value of the debt.
free cash flow from the firm
Free Cash Flow from the Firm Approach. When using the free cash flow from the firm (FCFF) approach
(FCFF) approach, an analyst values the free cash flows that the assets of the firm are expected an income approach to
to produce in the future. The present value of these free cash flows equals the total value of the valuation in which all free cash
firm, or its enterprise value. flows the assets are expected
to generate in the future are
The free cash flows used in a FCFF analysis are almost identical to the free cash flows from discounted to estimate the
the left-hand side of the finance balance sheet that was illustrated in Exhibit 13.1. The only dif- enterprise value
ference 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.

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 (VF) is computed as
the present value of the FCFF, discounted by the firm’s WACC:

VF ϭ q 11 FCFFt (18.3)
ϩ WACC2t
a

t50

In this equation, t equals the period when the cash flow is produced.

Firm value, Current Noninterest-Bearing Value of the
enterprise value, Assets Current Liabilities claims on the
present value of cash flows from
FCFF Property, Plant, Value of Interest-Bearing the firm
and Equipment Debt and Other

Other Assets Long-Term Liabilities

Value of Equity
Claims

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.

590 CHAPTER 18 I Business Formation, Growth, and Valuation

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:

WACC ϭ xDebtkDebt pretax11 Ϫ t2 ϩ xpskps ϩ xcskcs

where xDebt pretax ϩ xps ϩ xcs ϭ 1 and where kDebt pretax, kps, and kcs are the pretax cost of debt
and the after-tax costs of preferred stock and common stock, respectively. Also, t is the tax rate
that applies to interest deductions, and xDebt, xps, xcs are the proportions of the value of the firm
that are represented by debt, preferred stock, and common stock.

When analysts use the WACC approach to value a business, they must make an assump-
tion about how the firm’s operations will be financed in the future. For example, the financ-
ing 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 dis-
cussed 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 esti-
mated 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 18.4 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.

Explanation Calculation Formula

The firm’s cash Revenue Revenue
income excluding Ϫ Op Ex
interest expense ⎛ Ϫ Cash operating expenses
⎢ Earnings before interest, taxes, EBITDA
Adjustments for the ⎢ depreciation & amortization
impact of depreciation ⎨ Ϫ Depreciation and amortization Ϫ D&A
and amortization and ⎢⎢ Operating profit EBIT
investments on FCFF ⎝ ϫ (1 Ϫ Firm’s average tax rate)
ϫ (1Ϫ t)
Net operating profit after tax NOPAT

⎛ ϩ Depreciation and amortization ϩ D&A
⎢ Cash flow from operations CF Opns
⎨ Ϫ Capital expenditures
⎢ Ϫ Additions to working capital Ϫ Cap Exp
⎝ Free cash flow from the firm Ϫ Add WC

FCFF

18.3 Valuing a Business 591

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.

Year

1 2 34 5

Revenue $100.0 $106.0 $112.4 $119.1 $126.3
Ϫ Cash operating expenses 70.0 74.2 78.7 83.4 88.4

Earnings before interest, taxes, $ 30.0 $ 31.8 $ 33.7 $ 35.7 $ 37.9
depreciation & amortization 8.0 8.3 8.5 8.8 9.0
Ϫ Depreciation and amortization
Operating profit $ 22.0 $ 23.5 $ 25.2 $ 26.9 $ 28.9
Ϫ Taxes 7.7 8.2 8.8 9.4 10.1
Net operating profits after tax
ϩ Depreciation and amortization $ 14.3 $ 15.3 $ 16.4 $ 17.5 $ 18.8
Cash flow from operations 8.0 8.3 8.5 8.8 9.0
Ϫ Capital expenditures
Ϫ Additions to working capital $ 22.3 $ 23.6 $ 24.9 $ 26.3 $ 27.8
Free cash flow from the firm 10.0 10.0 11.0 12.0 13.0
0.5 0.5 0.5 0.6 0.7

$ 11.8 $ 13.1 $ 13.4 $ 13.7 $ 14.1

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

VF ϭ PV1FCFT2 ϩ PV1TVT2 ϩ NOA

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

$11.8 million $13.1 million $13.4 million $13.7 million $14.1 million
PV1FCFF52 ϭ 1 ϩ0.11 ϩ 11 ϩ 0.1122 ϩ 11 ϩ 0.1123 ϩ 11 ϩ 0.1124 ϩ 11 ϩ 0.1125

ϭ $48.45 million

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 re-
mainder 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:

TV5 ϭ FCFF5 ϫ 11 ϩ g2 ϭ $14.1 million ϫ 11 ϩ 0.032 ϭ $181.54 million
WACC Ϫ g 0.11 Ϫ 0.03

and:

PV1TV52 ϭ 11 TV5 ϭ $181.54 million ϭ $107.74 million
ϩ WACC25 11 ϩ 0.1125

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

VF ϭ PV1FCFT2 ϩ PV1TVT2 ϩ NOA free cash flow to equity
ϭ $48.45 million ϩ $107.74 million ϩ $14.68 million ϭ $170.87 million
(FCFE) approach
Free Cash Flow to Equity Approach. The free cash flow to equity (FCFE) approach is an income approach to
very similar to the FCFF approach. However, instead of valuing the total cash flows the assets valuation in which all cash
of the business are expected to generate, we value only the portion of the cash flows that are flows that are expected to be
available for distribution to stockholders. To see how the FCFF and FCFE approaches are re- available for distribution to
lated, ask yourself the following question: If you wanted to value only the equity claims, how stockholders in the future are
would you adjust the cash flows that are used in the FCFF approach? The answer is that you discounted to estimate the
value of the equity

592 CHAPTER 18 I Business Formation, Growth, and Valuation

LEARNING Using the FCFF Income Approach
BY
DOING APPLICATION 18.3 PROBLEM: You have decided to use the FCFF income approach to estimate the intrin-
sic 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:

FCFF ($ millions) 1 2 Year 4 5
Ϫ$0.284 $0.108 3 $2.110 $2.857

$0.998

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:

PV1FCFF52 ϭ Ϫ$0.284 million ϩ $0.108 million ϩ $0.998 million
1 ϩ 0.09 11 ϩ 0.0922 11 ϩ 0.0923

$2.110 million $2.857 million
ϩ 11 ϩ 0.0924 ϩ 11 ϩ 0.0925

ϭ $3.95 million

The present value of the terminal value is:

PV1TV52 ϭ TV5 ϭ $2.857 million/10.09 Ϫ 02 ϭ $20.63 million
WACC25 11 ϩ 0.0925
11 ϩ

Therefore, the total enterprise value is:

VF ϭ PV1FCFT2 ϩ PV1TVT2 ϩ NOA ϭ $3.95 million ϩ $20.63 million ϩ $0 million
ϭ $24.58 million

and the value of the equity equals $24.58 million Ϫ $1.25 million ϭ $23.33 million.

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.

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.

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 (kE) is used to discount the cash flows:

VE ϭ q FCFEt (18.4)
11 ϩ kE2t
a

t50

Note that kE equals kcs if the firm has no preferred stock outstanding. Otherwise kE is a weighted
average of kcs and kps. 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

18.3 Valuing a Business 593

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.

Explanation Calculation Formula

The firm’s cash income Revenue Revenue
Ϫ Op Ex
Adjustments for the impact of ⎛ Ϫ Cash operating expenses
depreciation and amortization, ⎢ Earnings before interest, taxes, EBITDA
investments on FCFF, and debt ⎢ depreciation & amortization
repayments and new issues ⎢ Ϫ Depreciation and amortization Ϫ D&A
⎨ Operating profit EBIT
⎢ Ϫ Interest
⎢ Earnings before tax Ϫ Int
⎝⎢ ϫ (1 Ϫ Firm’s average tax rate) EBT

Net income ϫ (1Ϫ t)
ϩ Depreciation and amortization NI

⎛⎢ Cash flow from operations ϩ D&A
⎢ Ϫ Capital expenditures CF Opns
⎨ Ϫ Additions to working capital
⎢ Ϫ Repayment of debt principal Ϫ Cap Exp
⎢ ϩ Proceeds from new debt issues Ϫ Add WC
⎝ Free cash flow to equity Ϫ Debt Pmt
ϩ Debt Proc

FCFE

Dividend Discount Model Approach. The dividend discount model (DDM) approach dividend discount model
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 (DDM) approach
approach values the stream of cash flows that stockholders expect to receive through dividend an income approach to
payments. In contrast, the FCFE approach values cash flows that are available for distribution valuation in which all dividends
to stockholders. The firm may or may not be expected to distribute all available cash flows in that are expected to be
any particular year. distributed to stockholders in
the future are discounted to
The constant-growth dividend model, Equation 9.4, is an example of a DDM: estimate the value of the equity

P0 ϭ D1 g
kcs Ϫ

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

Choosing an Appropriate Valuation Approach DECISION
MAKING
SITUATION: You have decided to make an offer for the recreational vehicle manu-
facturing business that you evaluated in Learning by Doing Applications 18.1, 18.2, and EXAMPLE 18.2
18.3. Your analysis yielded the following enterprise value estimates:

Liquidation value $ 8.45 million
Value from multiples analysis
$18.35 million
P/E multiple $24.70 million
Enterprise/EBITDA multiple $24.58 million
FCFF value

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-con-
cern value, suggest that the fair market value of the business is greater than the seller’s
asking price.

594 CHAPTER 18 I Business Formation, Growth, and Valuation

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 termi-
nal 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.

> BEFORE YOU GO ON

1 . Why is it important to specify a valuation date when you value a business?

2 . What is the difference between investment value and fair market value?

3 . What are the two market approaches that can be used to value a business,
and how do they differ?

4 . What is a nonoperating asset, and how are such assets accounted for in
business valuation?

5 . What are three income approaches used to value a business?

6 . What is the difference between FCFE and dividends?

18.4 IMPORTANT ISSUES IN VALUATION

LEARNING OBJECTIVE 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 finan-
cial 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

18.4 Important Issues in Valuation 595

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 com-
pany 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 estimat-
ing 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 invest-
ment, 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 transac-
tions 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 expendi-

596 CHAPTER 18 I Business Formation, Growth, and Valuation

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.

ontrol premium Controlling Interest versus Minority Interest
n adjustment that is made to
business value estimate to Another important issue that we must consider when we value a business is whether we
eflect value associated with are valuing a controlling ownership interest or a minority interest. The amount of stock
ontrol that is not already required for an investor to exercise control varies depending on the ownership structure
eflected in the analysis 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 con-
trol the public company if friendly stockholders provide enough additional votes. In pri-
vate companies, which tend to have relatively few stockholders, a stockholder must gener-
ally 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 busi-
ness 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 con-
trast, 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 in-
volves 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 control-
ling 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 esti-
mated 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.

Key People

If the cash flows that a business is expected to generate depend heavily on the retention
of a particular individual or group of individuals, then the analyst must also consider

Summary of Learning Objectives 597

that these “key people” may not remain with the firm as long as expected. An example of key person discount
a key person might be the CEO of a service firm who has strong personal ties with the an adjustment to a business
major customers. If an analyst believes that those customers might transfer their business value estimate that is made to
to a competitor if the CEO departs, then a key person discount may be appropriate. The reflect the potential loss of
issue is similar to the one that arises when a firm receives a significant portion of its busi- value associated with the
ness from a small number of customers. In either case, it is difficult to forecast the cash unexpected departure of a
flows for the firm. key person

> BEFORE YOU GO ON
1 . How might financial statements for private companies differ from those for

public companies?
2 . Why is marketability an important issue in business valuation?
3 . What is a key person?

S um m a ry of Learning Objectives

1 Explain why the choice of organizational form is impor- The three general valuation approaches are (1) cost ap-
tant, and describe two financial considerations that are proaches, (2) market approaches, and (3) income approaches.
especially important in starting a business. Cost approaches commonly used in business valuation are the
replacement cost and adjusted book value approaches. The
The choice of organizational form is important because it affects market approaches are multiples analysis and transactions
the returns from a business in a number of ways. For example, it analysis. Three key income approaches are the free cash flow
affects the cost of getting started, the life of the business, manage- from the firm, free cash flow to equity, and dividend discount
ment’s ability to raise capital and grow the business, the control approaches. The application of these approaches is discussed
of the business, the ability to attract and retain good managers, in Section 18.3.
the exposure of the investors to liabilities, and the taxes that are
paid on the earnings of the business. 4 Explain how valuations can differ between public and
private companies and between young and mature
Two especially important financial considerations are the companies, and discuss the importance of control and
cash flow break-even point for the business and its overall cash key person considerations in valuation.
inflows and outflows. The cash flow break-even point represents
the level of unit sales that must be achieved in order for the busi- Valuations differ between public and private companies for a
ness to break even on a cash flow basis. Entrepreneurs must also number of reasons, including (1) the quality of the financial
understand where money is coming from, where it is going, and statements and (2) the marketability of the securities being
how much external financing is likely to be needed and when. valued. Marketability is important because it affects the price
The cash budget helps with this understanding. that investors are willing to pay for a security. The less mar-
ketable a security, the lower the price investors are willing
2 Describe the key components of a business plan and to pay.
explain what a business plan is used for.
Young, rapidly growing companies are more difficult to
The key components of a business plan include the executive value than mature companies because there is less reliable his-
summary, a company overview, a description of the company’s torical information on young companies and their futures tend
products and services, a market analysis, a discussion of market- to be less certain.
ing and sales activities, a discussion of the businesses operations,
a discussion of the management team, the ownership structure of Control is an important consideration in business valuation
the firm, capital requirements and uses, and financial forecasts. because having control of a business provides an investor with
more flexibility in managing the business. Investors value this
A business plan helps an entrepreneur set the goals and ob- flexibility and will, therefore, pay more for a controlling interest
jectives for a company, serves as a benchmark for evaluating and in a company.
controlling the company’s performance, and helps communicate
the entrepreneur’s ideas to managers and others (including in- If the cash flows that a business is expected to generate
vestors) outside the firm. depend heavily on certain employees, those employees are key
people. When valuing a business, an analyst must account for the
3 Explain the three general approaches to valuation and possibility that the key people will unexpectedly leave the com-
value a business using common business valuation pany and must consider the associated impact on the company’s
approaches. cash flows.

598 CHAPTER 18 I Business Formation, Growth, and Valuation

S um m a ry of Key Equations

Equation Description Formula
18.1
Price/earnings multiple based P0 ϭ kcs b g
on constant-growth model E1 Ϫ

18.2 Implementing the income VF ϭ PV1FCFT2 ϩ PV1TVT2 ϩ NOA
approach to business valuation

18.3 FCFF approach VF ϭ q FCFFt
a
11 ϩ WACC2t
t50

18.4 FCFE approach VE ϭ q FCFEt
a
11 ϩ kE2t
t50

Self-Study Problems

18.1 Your sister wants to open a store that sells antique-style jewelry and accessories. She has $15,000
of savings to invest, but opening the store will require an initial investment of $20,000. Net cash
inflows will be Ϫ$2,000, Ϫ$1,000, and $0 in the first three months. As the store becomes better
known, net cash inflows will become ϩ$500 in the fourth month and grow at a constant rate of 5
percent in the following months. You want to help your sister by providing the additional money
that she needs. How much money do you have to invest each month to start and to keep the store
operating with a minimum cash balance of $1,000?

18.2 You have the following information for a company you are valuing and for a comparable
company:

Comparable company Company you are valuing

Stock price ϭ $23.45 Value of debt ϭ $3.68 million
Number of shares outstanding ϭ 6.23 million Est. EBITDA next year ϭ $4.4 million
Value of debt ϭ $18.45 million Est. income next year ϭ $1.5 million
Est. EBITDA next year ϭ $17.0 million
Est. income next year ϭ $5.3 million

Estimate the enterprise value of the company you are evaluating using the P/E and enterprise
value/EBITDA multiples.

18.3 How do the cash flows that are discounted when the WACC approach (FCFF approach) is used
to value a business differ from those that are discounted when the free cash flow to equity (FCFE)
approach is used to value the equity in a business?

18.4 You are valuing a company using the WACC approach and have estimated that the free cash flows
from the firm (FCFF) in the next five years will be $36.7, $42.6, $45.1, $46.3, and $46.6 million,
respectively. Beginning in year 6, you expect the cash flows to decrease at a rate of 3 percent per
year for the indefinite future. You estimate that the appropriate WACC to use in discounting these
cash flows is 10 percent. What is the value of this company?

18.5 You want to estimate the value of a local advertising firm. The earnings of the firm are expected
to be $2 million next year. Based on expected earnings next year, the average price-to-earnings
ratio of similar firms in the same industry is 48. Therefore, you estimate the value of the firm you
are valuing to be $96 million.
Further investigation shows that a large portion of the firm’s business is obtained through con-
nections that John Smith, a senior partner of the firm, has with various advertising executives
at customer firms. Mr. Smith only recently started working with his junior partners to establish
similar relationships with these customers.
Mr. Smith is approaching 65 years of age and might announce his retirement at the next board
meeting. If he does retire, revenues will drop significantly and earnings are estimated to shrink by

Solutions to Self-Study Problems 599

30 percent. You estimate that the probability that Mr. Smith will retire this year is 50 percent. If he
does not retire this year, you expect that Mr. Smith will have sufficient time to work with his junior
partners so his departure will not affect earnings when he departs. How does this information
affect your estimate of the value of the firm?

Solutions to Self-Study Problems

18.1 You will have to invest $5,000 to open the store (the difference between $20,000 and $15,000). You
will then have to invest an additional $3,000 during the first month to cover the cash flow of Ϫ$2,000
and to establish a cash balance of $1,000. Another $1,000 will be required in the second month to
cover the negative cash flow during that month. Since cash flows will be $0 or positive beginning in
the third month, you will not have to invest any additional funds after the second month.

18.2 The P/E and enterprise value/EBITDA multiples for the comparable company are:

aPb Stock price
ϭa b
E Comparable Earnings per share Comparable

$23.45 per share
ϭ

$5.3 million/6.23 million shares

ϭ 27.6

Enterprise value ϭ a VD ϩ VE b
ab
EBITDA EBITDA Comparable
Comparable

$18.45 million ϩ 1$23.45 per share ϫ 6.23 million shares2
ϭ

$17.0 million

ϭ 9.68

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

P ϫ
VE ϭ ab Net income Company being valued
E Comparable

ϭ 27.6 ϫ $1.5 million

ϭ $41.4 million

which suggests an enterprise value of:
VF ϭ VE ϩ VD ϭ $41.4 million ϩ $3.68 million ϭ $45.08 million

Using the enterprise/EBITDA multiple, we obtain:

VF ϭ a Enterprise value b ϫ EBITDA Company being valued

EBITDA Comparable

ϭ 9.68 ϫ $4.4 million

ϭ $42.59 million

18.3 The cash flows that are discounted when the WACC approach is used to value a business are cal-
culated in the same way that the cash flows are calculated for a project analysis. These cash flows
represent the total cash flows that the business is expected to generate from operations. The cash
flows that are discounted when the FCFE approach is used are the total cash flows from the busi-
ness that are available for distribution to the stockholders. In other words, they equal the total cash
flows that the business is expected to generate less the net cash flows to the debt holders. The net
cash flows to the debt holders is equal to the interest and principal payments that the firm makes
less any proceeds for the sale of new debt.

18.4 The present value of the cash flows expected over the next five years is:

PV1FCFF52 ϭ $36.7 million ϩ $42.6 million ϩ $45.1 million
1 ϩ 0.1 11 ϩ 0.122 11 ϩ 0.123

$46.3 million $46.6 million
ϩ 11 ϩ 0.124 ϩ 11 ϩ 0.125

ϭ $163.01 million

600 CHAPTER 18 I Business Formation, Growth, and Valuation

The terminal value is:

TV5 ϭ FCFF5 ϫ 11 ϩ g2 ϭ $46.6 million ϫ 11 Ϫ 0.032 ϭ $347.71 million
WACC Ϫ g 0.1 ϩ 0.03

and the present value of the terminal value is:

PV1TV52 ϭ 11 TV5 ϭ $347.71 million ϭ $215.90 million
ϩ WACC25 11 ϩ 0.125

Therefore, if there are no nonoperating assets, the value of the firm is:

VF ϭ $163.01 million ϩ $215.90 million ϭ $378.91 million

18.5 Mr. Smith is a key person in this firm. An adjustment should be made to the valuation to account
for his potential departure this year.
Taking the possibility that Mr. Smith will retire into account, the expected earnings next year
will be:

1$2,000,000 ϫ 0.52 ϩ 3$2,000,000 ϫ 11 Ϫ 0.302 ϫ 0.5 4 ϭ $1,700,000

Therefore, the adjusted value for the firm is: $1.7 million ϫ 48 ϭ $81.6 million. We can see
that this implies a 15 percent key person discount from the original estimate of $96 million
[($81.6 million Ϫ $96.0 million)/$96.0 million ϭ Ϫ0.15, or Ϫ15 percent].

Critical Thinking Questions

18.1 Given that many new businesses fail in the first few years after they are established, how should
an entrepreneur think about the risk of failure associated with a new business? From what you
have learned in this chapter, what can an entrepreneur do to increase the chance of success?

18.2 Explain how the taxation of a C-corporation differs from the taxation of the other forms of
business organization discussed in this chapter.

18.3 What is a business plan? Explain how a business plan can help an entrepreneur succeed in build-
ing a business.

18.4 You are entering negotiations to purchase a business and are trying to formulate a negotiating
strategy. You want to determine the minimum price you should offer and the maximum you
should be willing to pay. Explain how the concepts of fair market value and investment value can
help you do this.

18.5 You have just received a business valuation report that is dated six months ago. Describe the fac-
tors that might have changed during the past six months and, therefore, caused the value of the
business today to be different from the value six months ago. Which of these changes affect the
expected cash flows, and which affect the discount rate that you would use in a discounted cash
flow valuation of this company?

18.6 Is the replacement cost of a business generally related to the value of the cash flows that the
business is expected to produce in the future? Why or why not? Illustrate your answer with an
example.

18.7 You want to estimate the value of a company that has three very different lines of business. It
manufactures aircraft, is in the data processing business, and manufactures automobiles. How
could you use an income approach to value a company such as this—one with three very dis-
tinct businesses that will have different revenue growth rates, profit margins, investment require-
ments, discount rates, and so forth?

18.8 Your boss has asked you to estimate the intrinsic value of the equity for Google, which does not
currently pay any dividends. You are going to use an income approach and are trying to choose
between the free cash flow to equity (FCFE) approach and the dividend discount model (DDM)
approach. Which would be more appropriate in this instance? Why? What concerns would you
have in applying either of these valuation approaches to a company such as this?

18.9 Explain how the financial statements of a private company might differ from those of a public
company. What does this imply for valuing a private company?

Questions and Problems 601

Questions and Problems

18.1 Organizational form: List some common forms of business organization, and discuss how < BASIC
access to capital differs across these forms of organization.

18.2 Starting a business: What are some of the things that the founder of a company must do to
launch a new business?

18.3 Organizational form: Explain how financial liabilities differ among different forms of
business organization.

18.4 Cash requirements: List two useful tools to help an entrepreneur to understand the cash
requirements of a business and to estimate the financing needs of his or her business.

18.5 Cash requirements: You believe you have a great business idea and want to start your own
company. However, you do not have enough savings to finance it. Where can you get the
additional funds you need?

18.6 Raising capital: Why is it especially difficult for an entrepreneur with a new business to raise
capital? What tool can help him or her to raise external capital?

18.7 Replacement cost: What is the replacement cost of a business?

18.8 Multiples analysis: It is April 4, 2011, and your company is considering the possibility of
purchasing the Chrysler automobile manufacturing business. The private equity investors who
own Chrysler have hinted that they might be interested in selling the firm. Since Chrysler does
not have publicly traded shares of its own, you have decided to use Ford Motor Company as a
comparable company to help you determine the market value of Chrysler.

This morning, Ford’s common stock was trading at $16.69 per share, and the company had
3.47 billion shares outstanding. You estimated that the market value of all of the company’s other
outstanding securities (excluding the common stock but including special shares owned by the
Ford family) is $100 billion and that its revenues from auto sales were $133.4 billion last year.
Chrysler’s revenue in 2010 was $50.0 billion. Based on the enterprise value/revenue ratio, what is
the total value of Chrysler that is implied by the Ford market values?

18.9 Nonoperating assets: Why is excess cash a nonoperating asset (NOA)? Why does it make
sense to add the value of excess cash to the value of the discounted cash flows when we use the
WACC or FCFE approach to value a business?

18.10 Dividend discount approach: You want to estimate the total intrinsic value of a large gas
and electric utility company. This company has publicly traded stock and has been paying a
regular dividend for many years. You decide that, due to the predictability of the dividend that
this company pays, you can use the dividend discount valuation approach. The company is
expected to pay a dividend of $1.25 per share next year, and the dividend is expected to grow
at a rate of 3 percent per year thereafter. You estimate that the appropriate rate for discounting
future dividends is 12 percent. In addition, you know that the company has 46 million shares
outstanding and that the market value of its debt is $350 million. What is the total enterprise
value of the company?

18.11 Public versus private company valuation: You are considering investing in a private
company that is owned by a friend of yours. You have read through the company’s financial state-
ments and believe that they are reliable. Multiples of similar publicly traded companies in the
same industry suggest that the value of a share of stock in your friend’s company is $12. Should
you be willing to pay $12 per share?

18.12 Control: Does the expected rate of return that is calculated using CAPM, with a beta estimated
from stock returns in the public market, reflect a minority or a controlling ownership position?
How is it likely to differ between a minority and a controlling position?

18.13 Organizational form: Compare the characteristics of an LLC with those of a partnership and < INTERMEDIATE
a C-corporation.

18.14 Organizational form: Discuss the pros and cons of an S-corporation compared with a
C-corporation.

18.15 Break-even: You have started a business that sells a home gardening system that allows
people to grow vegetables on the countertop in their kitchens. You are considering two options
for marketing your product. The first is to advertise on local TV. The second is to distribute

602 CHAPTER 18 I Business Formation, Growth, and Valuation

product more effectively and create a demand for 1,200 units per year. The flyer advertisement
option costs only $6,000 annually but will create a demand for only 250 units per year. The
price per unit of the indoor gardening system is $100, and the variable cost is $60 per unit. As-
sume that the production capacity is not limited and that the marketing cost is the only fixed
cost involved in your business. What are the break-even points for both marketing options?
Which one should you choose?

18.16 Going-concern value: Aggie Motors is a chain of used car dealerships that has publicly
traded stock. Using the adjusted book value approach, you have estimated the value of Aggie
Motors to be $45,646,000. The company has $40.5 million of debt outstanding. Its stock price is
$5.5 per share, and there are 1,378,000 shares outstanding. What is the going concern value of
Aggie Motors?

Use the following information concerning Johnson Machine Tool Company in Problems 18.17, 18.18,
and 18.19.

Johnson’s income statement from the fiscal year that ended this past December is:

Revenue $995
Cost of goods sold 652

Gross profit $343
Selling, general, and administrative expenses 135

Operating profit (EBIT) $208
Interest expense 48
Earnings before taxes
Taxes $160
64
Net income
$ 96

All dollar values are in millions. Depreciation and amortization expenses last year were $42 million,
and the company has $533 million of debt outstanding.

18.17 Multiples analysis: You are an analyst at a private equity firm that buys private companies,
improves their operating performance, and sells them for a profit. Your boss has asked you to
estimate the fair market value of the Johnson Machine Tool Company. Billy’s Tools is a public
company with business operations that are virtually identical to those at Johnson. The most
recent income statement for Billy’s Tools is as follows:

Revenue $1,764
Cost of goods sold 1,168

Gross profit $ 596
Selling, general, & administrative expenses 211

Operating profit (EBIT) $ 385
Interest expense 12

Earnings before taxes $ 373
Taxes 147

Net income $ 226

All dollar values are in millions. Billy’s had depreciation and amortization expenses of $71 million
last year and had 200 million shares and $600 million of debt outstanding as of the end of the year.
Its stock is currently trading at $12.25 per share.

Using the P/E multiple, what is the per share value of Johnson’s stock? What is the total
value of Johnson Machine Tool Company?

18.18 Multiples analysis: Using the enterprise value/EBITDA multiple, what is the total value
of Johnson Machine Tool Company? What is the per share value of Johnson’s stock?

18.19 Multiples analysis: Which of the above multiples analyses do you believe is more
appropriate?

18.20 Income approaches: You are using the FCFF approach to value a business. You have
estimated that the FCFF for next year will be $123.65 million and that it will increase at a rate
of 8 percent for each of the following four years. After that point, the FCFF will increase at a
rate of 3 percent forever. If the WACC for this firm is 10 percent and it has no NOA, what is

Questions and Problems 603

18.21 Valuing a private business: You want to estimate the value of a privately owned restaurant
that is financed entirely with equity. Its most recent income statement is as follows:

Revenue $3,000,000
Cost of goods sold 600,000

Gross profit $2,400,000
Salaries and wages 1,400,000
Selling expenses
100,000
Operating profit (EBIT)
Taxes $ 900,000
315,000
Net income
$ 585,000

You note that the profitability of this restaurant is significantly lower than that of comparable
restaurants, primarily due to high salary and wage expenses. Further investigation reveals that
the annual salaries for the owner and his wife, the firm’s accountant, are $900,000 and $300,000,
respectively. These salaries are much higher than the industry median salaries for these two
positions of $100,000 and $50,000, respectively. Compensation for other employees ($200,000
in total) appears to be consistent with the market rates. The median P/E ratio of comparable
restaurants with no debt is 10. What is the total value of this restaurant?

18.22 Valuing a private business: A few years ago, a friend of yours started a small business that
develops gaming software. The company is doing well and is valued at $1.5 million based on mul-
tiples for comparable public companies after adjustments for their lack of marketability. With
300,000 shares outstanding, each share is estimated to be worth $5. Your friend, who has been
serving as CEO and CTO (chief technology officer), has decided that he lacks sufficient manage-
rial skills to continue to build the company. He wants to sell his 160,000 shares and invest the
money in an MBA education. You believe you have the appropriate managerial skills to run the
company. Would you pay $5 each for these shares? What are some of the factors you should
consider in making this decision?

18.23 You plan to start a business that sells waterproof sun block with a unique formula that < ADVANCED
reduces the damage of UVA radiation 30 percent more effectively than similar products on
the market.
You expect to invest $50,000 in plant and equipment to begin the business. The targeted
price of the sun block is $15 per bottle. You forecast that unit sales will total 1,500 bottles in
the first month and will increase by 20 percent in each of the following months during the first
year. You expect the cost of raw materials to be $3 per bottle. In addition, monthly gross wages
and payroll are expected to be $13,000, rent is expected to be $3,000, and other expenses are
expected to total $1,000. Advertising costs are estimated to be $35,000 in the first month, but to
remain constant at $5,000 per month during the following eleven months.
You have decided to finance the entire business at one time using your own savings.
Is an initial investment of $75,000 adequate to avoid a negative cash balance in any given
month? If not, how much more do you need to invest up front? How much do you need to
invest up front to keep a minimum cash balance of $5,000? What is the break-even point
for the business?

18.24 For the previous question, assume that you do not have sufficient savings to cover the entire
amount required to start your sun-block business. You are going to have to get external
financing. A local banker whom you know has offered you a six-month loan of $20,000 at an
APR of 12 percent. You will pay interest each month and repay the entire principal at the end
of six months.
Assume that instead of making a single up-front investment, you are going to finance the
business by making monthly investments as cash is needed in the business. If the proceeds from
the loan go directly into the business on the first day and are therefore available to pay for some
of the capital expenditures, how much money do you need to pull out of your savings account
every month to run the business and keep the cash balances positive?

18.25 Your friend is starting a new company. He wants to write a business plan to clarify the company’s
business outlook and raise venture capital. Knowing that you have taken this course, he has
asked you, as a favor, to help him prepare a template for a business plan. Prepare a template that

604 CHAPTER 18 I Business Formation, Growth, and Valuation

18.26 A friend of yours is trying to value the equity of a company and, knowing that you have read this
book, has asked for your help. So far she has tried to use the FCFE approach. She estimated the
cash flows to equity to be as follows:

Sales $800.0
Ϫ CGS Ϫ450.0
Ϫ Depreciation Ϫ80.0
Ϫ Interest Ϫ24.0

Earnings before taxes (EBT) $246.0
Ϫ Taxes (0.35 ϫ EBT) Ϫ86.1

ϭ Cash flow to equity $159.9

She also computed the cost of equity using CAPM as follows:

kE ϭ kF ϩ bE1Risk premium2 ϭ 0.06 ϩ 11.25 ϫ 0.0842 ϭ 0.165, or 16.5%

where the beta is estimated for a comparable publicly traded company.

Using this cost of equity, she estimates the discount rate as

WACC ϭ xDebtkDebt pretax11 Ϫ t2 ϩ xcskcs
ϭ 30.20 ϫ 0.06 ϫ 11 Ϫ 0.352 4 ϩ 10.80 ϫ 0.1652 ϭ 0.14, or 14%

Based on this analysis, she concludes that the value of equity is $159.9 million/0.14 ϭ $1,142 million.
Assuming that the numbers used in this analysis are all correct, what advice would you give

your friend regarding her analysis?

18.27 Forever Youth Technology is a biochemical company that is two years old. Its main product, an
antioxidant drink that is supposed to energize the consumer and delay aging, is still under de-
velopment. The company’s equity consists of $5 million invested by its founders and $5 million
from a venture capitalist. The company has spent $3 million in each of the past two years, mostly
on lab equipment and R&D costs. The company has had no sales so far. What are the challenges
associated with valuing such a young and uncertain company?

18.28 Mad Rock Inc. is a company that sells mp3 music online. It is expected to generate earnings of
$1 per share this year after its Web site is upgraded and online marketing is stepped up. Given
the popularity of the iPod and iPad devices, the stock price of Mad Rock has rocketed from
$8 to $95 per share in the past 12 months. The cost of capital for the company is 18 percent.
Of course, the future of a young Internet company such as Mad Rock is highly uncertain.
Nevertheless, using the very limited information provided in this problem, do you think $95 per
share could be a fair price for its stock? Support your argument with a simple analysis.

18.29 At the end of 2010 the value of the S&P 500 Index divided by the estimated 2010 earnings for
S&P 500 firms (the S&P 500 P/E multiple) was 18.66. Assume that the long-term Treasury bond
yield was 4.25 percent, the market risk premium was 6.01 percent, and firms in the S&P 500 were
expected to pay out an average of 40.9 percent of their earnings as dividends in the future. At
what rate were dividends paid by S&P 500 firms expected to grow in the future?

18.30 The S&P 500 P/E multiple of 18.66 at the end of 2010 was higher than its historical average of
approximately 15. Some financial commentators argued that this meant that the firms in the S&P
500 were, on average, overvalued at the end of 2010. Based on your analysis in Problem 18.29
and the concepts covered in this book, do you think that these commentators are right or wrong?
Why or why not?

18.31 You own a company that produces and distributes course packets for classes at local universities
via the Internet. You have asked a friend to invest $35,000 in the business. Your friend wants to
know what the business is worth so that he can determine how much of the equity (e.g., what per-
centage) he should expect to receive for his investment. You offer to help him value the business.
The business is expected to generate revenue of $110,000 and incur cash operating expenses
of $70,000 next year. Over the following three years, revenue and cash operating expenses are
expected to increase 15 percent, 10 percent, and 7 percent. After year 4 they are expected to grow
2 percent per year forever. Depreciation and amortization, capital expenditures, and additions to
working capital are expected to equal 5 percent, 6 percent, and 1 percent of revenue, respectively,
in the future. You have determined that a target capital structure of 10 percent is reasonable for
this business. With this capital structure, the pretax cost of debt will be 6 percent and the beta for
the equity will be 1.30. The average tax rate for the business is 10 percent, and the marginal rate is
20 percent. The risk-free rate is 4.25 percent, and the market risk premium is 6.01 percent. What
is a 100 percent equity interest in the business worth? What percentage of the equity should your

Sample Test Problems 605

Sample Test Problems

18.1 You own a business that specializes in designing and producing roofs for houses in central Texas.
Your annual costs include office rent of $14,400, salaries for four designing engineers of $240,000,
design software costs of $12,000, and other overhead costs of $3,000. An average roof in this region
is priced at $3,500. It costs $1,200 in raw material, $1,100 in labor, and $100 in other expenses (for
example, purchasing building permits). What is the minimum number of roofs you need to sell to
earn a profit? What can you do to reduce the break-even level of sales?

18.2 Explain why the replacement cost approach is rarely used to value an entire business.

18.3 Why is the rate used to discount FCFF different from the rate used to discount FCFE?

18.4 You are valuing the equity of a company using the FCFE approach and have estimated that the
FCFE in the next five years will be $6.05, $6.76, $7.36, $7.85, and $8.15 million, respectively.
Beginning in year 6, you expect the cash flows to increase at a rate of 2 percent per year for the
indefinite future. You estimate that the cost of equity is 12 percent. What is the value of equity in
this company?

18.5 You are interested in investing in a private company. Based on earnings multiples of similar publicly
traded firms, you estimate the value of the private company’s stock to be $11 per share. You plan
to acquire a majority of the shares in the company. The expected control premium is 10 percent.
You estimate the marketability discount for such a firm to be 20 percent. The discount for the key
person, one of the founders who may leave the firm upon your control of the firm, is 15 percent.
What price should you be willing to pay for these shares?

Financial

19 Planning and
Forecasting

Learning Objectives

iStockphoto

1 Explain what a financial plan is and why In January 2008 the decline in performance of the Starbucks
financial planning is so important.
Corporation had come to a head. Former CEO Howard
2 Discuss how management uses financial Schultz once again took over the day-to-day operations of
planning models in the planning process, the coffee giant in an effort to restructure the company. The
and explain the importance of sales fore- growth of Starbucks had been meteoric: from six stores in 1987
casts in the construction of financial planning to more than 17,000 stores and outlets in over 40 countries.
models.

3 Discuss how the relation between projected Fast growth for Starbucks had come at a price. Management

sales and balance sheet accounts can be de- was concerned that the company had lost its focus on prod-

termined, and analyze a strategic investment uct quality and the customer experience in Starbucks stores.

decision using a percent of sales model. These issues hindered the company’s ability to attract custom-

4 Describe the conditions under which fixed ers who were willing to pay for its premium priced products.
assets vary directly with sales, and discuss Increased competition for coffee consumers from brands such
the impact of so-called lumpy assets on this as McDonalds and Dunkin’ Donuts, combined with the global
relation. economic downturn, also hurt Starbucks’ bottom line and the
firm’s investors took notice. Fourth quarter net income in 2008
5 Explain what factors determine a firm’s was down 97 percent from 2007, and the company’s stock price
sustainable growth rate, discuss why it is of had declined over 50 percent during the previous year.
interest to management, and compute the
sustainable growth rate for a firm. In a letter to his employees, Schultz summarized the prob-
lems that rapid growth had brought the firm: “If we take an

honest look at Starbucks today, then we know that we are

emerging from a period in which we invested in infrastructure

ahead of the growth curve. Although necessary, it led to bureaucracy. We will now shift our

emphasis back onto customer-facing initiatives, better aligning our back-end costs with our

business model.”

Starbucks management focused its restructuring efforts on slowing growth. Starting in

2008, Starbucks canceled the opening of over 100 stores, closed approximately 900 poorly per-

19.1 Financial Planning 607

costs. At the same time, Starbucks shifted its new store investment to more profitable foreign
markets. Additional efforts were dedicated to improving product quality and customer experi-
ence. For example, warm breakfast sandwiches were eliminated because they competed with
the coffee aroma in stores. The company also required that all employees take a three-hour
training session on making espresso. Finally, Starbucks management made an effort to com-
pete with value-based rivals by introducing a lower-cost brand called Pike Place.

Starbucks’ restructuring has been a success for its investors. In the fourth quarter of
2010, the firm reported net income that was 37 percent greater than net income in the previous
year. The company’s stock price had also risen from a low of $9.00 per share in 2008 to over
$32.00 per share by the end of 2010. Despite its turnaround, Starbucks’ rapid expansion and
severe decline in operating performance serves as a stark reminder of the need for thought-
ful corporate growth, combined with feasible operating and financial strategies. This chapter
discusses how firms plan for the future and manage growth to create value.

CHAPTER PREVIEW components. We then discuss the preparation of a finan-
cial plan. Next, we turn our attention to financial planning
It is often said that a company that fails to plan for the future may models used in the preparation of financial plans. These
have no future. In the short run, a firm may do well being oppor- models generate projected financial statements that esti-
tunistic—reacting quickly to events as they unfold. To succeed mate the amount of external funding needed and identify
over the long term, however, a firm must be innovative and other financial consequences of proposed strategic invest-
must plan and employ a strategy that generates sustainable ments. We end the chapter by examining the relation be-
profits. Top executives spend a lot of time thinking about the tween a firm’s growth and its need for external financing.
types of investments the firm needs to make and how to finance Managing growth is an important topic, because growth
them. The process that executives go through is called financial without sufficient profits can lead to cash flow shortages
planning, and the result is called a financial plan. and bankruptcy.

This chapter focuses on long-term financial planning. We
begin with a discussion of the firm’s strategic plan and its

19.1 FINANCIAL PLANNING

Top management engages in long-term financial planning because experience has shown that LEARNING OBJECTIVE 1
having a well-articulated financial plan helps them create value for stockholders. Planning is
important for established businesses because it forces management to systematically think financial planning
through the firm’s strategies, much like preparing a business plan helps an entreprenuer. Not the process by which
surprisingly, the lack of planning is a common reason for poor performance and bankruptcy. management decides what
For example, the bankruptcy filing by Ronco Corporation in June 2007 was attributed to a types of investments the firm
failure to plan and recognize the importance of the firm’s traditional distribution channels. needs to make and how to
Ronco was the manufacturer of the Veg-O-Matic vegetable slicer and other novelty gadgets, finance those investments
such as Mr. Microphone and a device that mixes eggs inside the shells.1
financial plan
The Planning Documents a plan outlining the investments
a firm intends to make and how
When top management begins to prepare a company’s financial plan, it must answer four basic it will finance them
questions. First, where is the company headed? Second, what assets does it need to get there?

608 CHAPTER 19 I Financial Planning and Forecasting

Third, how is the firm going to pay for these assets? And finally, does the firm have enough
cash to pay its day-to-day bills as they come due?

These questions are answered in four important planning documents: (1) the strategic
plan, which describes where the firm is headed and articulates the strategies that will be used
to get it there; (2) the investment plan, which identifies the capital assets needed to execute the
strategies; (3) the financing plan, which explains how the firm will raise the money to buy the
assets; and (4) the cash budget, which determines whether the firm will have sufficient cash to
pay its bills. These four planning documents provide the foundation for the firm’s financial
plan, which consolidates the documents into a single scheme. Thus, the financial plan is a
blueprint for the firm’s future.

Exhibit 19.1 shows the relations among the various plans and budgets. Notice that infor-
mation from the strategic plan flows down to the financial plan and information from the
other plans and the cash budget flows up to the financial plan.

trategic planning The Strategic Plan
he process by which
management establishes the Strategic planning is the most crucial planning step. The strategic plan sets out the vision for
firm’s long-term goals, the the firm—what management wants the firm to become—and establishes the strategies that
trategies that will be used to management will use to achieve its vision. Overall, the strategic plan provides high-level direc-
achieve those goals, and the tion to management for making business decisions and guidance about what the firm will and
apabilities that are needed will not do.
o sustain the firm’s
ompetitive position Preparing the strategic plan is the responsibility of top management, with the financial man-
ager as a key participant and the board of directors as approver of the plan. The strategic plan
covers all areas in the firm, such as operations, marketing, finance, information systems, and hu-
man resource management. The plan determines the lines of business in which the firm will
compete and the relative emphasis placed on each business activity. It also identifies major areas

INVESTMENT PLAN STRATEGIC PLAN Financial plan
• Corporate strategies Planning documents
• Capital budget Cash budget
• Acquisitions and FINANCIAL PLAN
• Strategic overview FINANCING PLAN
divestitures • Financial goals • External funding needed
• Investment plan • Desired capital structure
• Financial plan • Payout policy
• Cash budget
• Pro forma financial statements

BUSINESS PLANS FOR
OPERATING UNITS

CASH BUDGET

Staff Support Production Sales and Marketing Service
Budget Budget Budget Budget

EXHIBIT 19.1
The Financial Planning Process

Various planning and budget documents flow into a financial plan and form its foundation. The
completed financial plan articulates the firm’s strategic goals and identifies what types of investments
the firm should make to achieve its goals, as well as how to finance those investments.

19.1 Financial Planning 609

for investments in productive assets: capital expen- A FIRM’S STRATEGY DRIVES ITS BUILDING
ditures, the acquisition of a firm, or the launch of a BUSINESS DECISIONS
new line of business. When deemed necessary, the

plan also identifies mergers, alliances, and divesti- The firm’s business strategy drives all of its INTUITION
tures that management may seek to strengthen the
firm’s business portfolio. decisions. It determines the firm’s lines of

business, the products it will sell, its method

of producing them, and the geographic markets in which it will

Investment Plan compete. Thus, a company’s strategy defines its competitive posi-
tion within its industry. To be successful, a firm must formulate the

The investment plan, also known as the capital right strategy and have a management team that can implement it.
Management is always searching for a strategy that gives the firm a
budget, lays out the firm’s proposed spending on sustainable competitive edge.
capital assets for the year.2 The capital expenditures

support the firm’s business strategy. Some capital

expenditures pay for significant new additions,

such as a new building, a new plant, or a new production line. Other capital expenditures are

for more routine items, such as the replacement of old equipment and machinery. Once made,

capital expenditures define a firm’s line of business for years to come. For example, Ford Motor

Company could not suddenly start making tennis shoes instead of cars because Ford’s long-

term assets hardly lend themselves to manufacturing shoes and the cost of conversion would

be prohibitive. The preparation of the capital budget and the decision criteria for selecting

capital projects are discussed in Chapters 10 through 13.

The Financing Plan A source for sample
business plans, including
Once the capital budget is set, management must decide how to finance the assets. The sim- financial plans, is the
plest financing environment is one in which all capital projects are financed using internally Center for Business
generated funds. This means that the firm’s earnings, less cash used to pay dividends or repur- Planning at http://www
chase stock, provide the necessary capital. However, only rarely does a firm finance all its proj- .businessplans.org/
ects in this way, as most firms have more capital projects than they can fund internally. Thus, tabplan.html.
management must seek external financing from a variety of sources, such as bank borrowing,
selling of long-term debt, and issuance of additional equity. Overall, the goal of the financing
plan is to determine how much external funding the firm needs.

The financing plan has three components. First, a financing plan states the dollar amount
of external financing needed and identifies the sources of funds available to the firm. Second, the
plan states management’s desired capital structure for the firm. This is important because it de-
termines the relative amounts of debt and equity funds to be raised externally. Finally, the fi-
nancing plan establishes the firm’s payout policy, which is relevant because it directly affects the
amount of funds available for new investment projects. That is, the more funds the firm pays out
as cash dividends or uses to repurchase stock, the more external capital the firm must raise if its
internally generated funds are not sufficient to fund its investments. Capital structure policy is
discussed in Chapter 16, and payout policy in Chapter 17.

An important point to note here is that the investment (capital budgeting) and financing
decisions cannot be made independently—they must be considered together. The reason is
that when management makes an investment decision, it must already have identified a source
of funds to pay for the investment. This is no different from what you would do in your per-
sonal life. For example, you would not walk into a BMW dealership to buy a high-priced new
car without having lined up a source of financing. Nor, for that matter, would the dealer sell
you the car without having the financing already arranged. The investment decision (buy the
car) and the financing decision (get an auto loan) are made simultaneously and hence are not
independent.

Divisional Business Plans

Another component of the financial plan is made up of the business plans prepared by the
various divisions or operating units within the firm. Each divisional business plan describes

2The investment plan consists of the capital budget plus any acquisitions or divestitures management plans to make.
To simplify our discussion in this chapter, we treat the investment plan and capital budget as one and the same be-

610 CHAPTER 19 I Financial Planning and Forecasting

what the division will do to achieve the firm’s strategic goals. It also identifies the resources the
division needs and includes a detailed budget. It is here at the divisional level that much of the
firm’s budget work is done.

For example, assume that one of Ford Motor Company’s strategic goals is to manufacture
and sell jet water skis through its marine division. The division has some idle capacity in one
of its manufacturing plants. Thus, as part of the division’s business plan, it submits a capital
budgeting request to enter the jet ski market. (Of course, to be included in Ford’s capital bud-
get, the jet ski project must have an NPV greater than $0.)

Cash Budget

The cash budget for the firm is the aggregation (adding up) of the cash budgets from all of
the operating units plus the cash budget for the corporate offices. The cash budget focuses
exclusively on when the firm actually receives and pays out cash. The firm’s cash needs may
vary weekly, monthly, and seasonally, as well as with predictable events such as payroll pay-
ments, payment of cash dividends, and debt retirements. If a shortfall of cash develops, the
cash budget indicates the amount of money the firm needs to borrow and the anticipated
borrowing cost.

As Exhibit 19.1 shows, the planning process drills down deep into the firm and gathers
cash budget information on the myriad of activities that take place. If cash budgets are not well
managed and monitored, serious cash shortages can occur. Tools used in cash management are
discussed in Chapter 14, and the preparation of cash budgets is covered in Chapter 18.

Concluding Comments

The principal benefit of financial planning is that it establishes financial and operating goals
for the firm and communicates them throughout the organization. The financial plan also
helps to align the actions of managers and their operating units with the firm’s strategic goals.
Thus, the plan acts as a catalyst to get everyone in the firm moving in the same direction. To
build support for the financial plan and energize people’s actions, top management should
involve managers and other leaders in the firm at all levels in the planning process. An old
axiom in management says that people support plans when they have had meaningful in-
volvement in the plans’ preparation.

> BEFORE YOU GO ON

1 . What are the four planning documents on which the financial plan is based?

2 . What is the strategic plan?

3 . How are the investment decision and financing decision related?

19.2 FINANCIAL PLANNING MODELS

LEARNING OBJECTIVE Financial planning models are used to analyze how proposed investments and financing al-
ternatives affect a firm’s financial statements. The models are usually run on computer
spreadsheets, which reduce the drudgery of tracing investment, financing, and operating
decisions through a company’s accounting system. While commercial planning models have
an aura of sophistication about them, most are built around the same basic concepts pre-
sented in this chapter.

In this section, we build a simple financial planning model to show how such models are
constructed, how they work, and how their output is generated. Once you understand this

19.2 Financial Planning Models 611

The Sales Forecast

The sales forecast is the most important input for developing a financial planning model. Most
firms generate their own sales forecasts. However, forecasting techniques vary widely, ranging
from “seat-of-the-pants” forecasts—wherein the sales manager and key sales staff members talk
it over and give their best estimate—to forecasts generated by complex multivariate statistical
models. In addition, because the performance of the national and international economies have
an effect on a company’s sales volume, most companies use economic forecasts as part of their
sales forecasting process. Large companies often hire consulting firms that specialize in forecast-
ing to help prepare sales forecasts under different scenarios. As you would expect, their services
are quite expensive; economic forecasts can also be obtained from many regional banks at mod-
est prices.

Building a Financial Planning Model

A financial planning model is no more than a series of equations that are used to generate
projected financial statements for a company, such as an income statement or a balance sheet.
The three basic components of a financial planning model, shown in Exhibit 19.2, are: (1) in-
puts to the model, (2) the model itself, and (3) outputs from the model—the projected finan-
cial statements. Let’s discuss each component in turn.

Inputs to the Model

As shown in the exhibit, important inputs to the financial planning model include current
financial statements, sales forecasts, and investment and financial policy decisions.

Current Financial Statements. The starting point for constructing a financial planning model Hoovers provides
is the firm’s current income statement and balance sheet. These statements serve as a baseline. financial statements
for publicly held firms
Sales Forecasts. For most financial planning models, the principal input variable is a fore- online at http://www
cast of the firm’s sales or sales growth rate. The sales forecast is the key driver in financial mod- .hoovers.com.
els because so many items on the income statement and balance sheet vary with changes in the Another source for
level of sales. For example, if sales increase, it stands to reason that the firm will use more labor financial statements is
and raw materials. Higher sales may also require additional investments in capital assets. the EDGAR database of
the Securities and
Sales forecasts are given for some time period, such as a quarter or a year, and are often Exchange Commission:
expressed as percent change in sales: http://www.sec.gov.

% ¢S ϭ 1Stϩ1 Ϫ St2 (19.1)
St

where:
%⌬S ϭ percent change in net sales
St ϭ level of net sales in period t
Stϩ1 ϭ level of net sales in period tϩ1

Sales are calculated as the number of units sold times the price at which they are sold. For an
example of how equation 19.1 is used, if the current year’s sales (St) are $100 million and the

Inputs to the Model The Financial Planning Model Outputs from the Model

• Current financial statements • Equations generating financial • Projected financial statements
• Sales forecasts statements • Financial ratios
• Investment and financial policy • Cash budget
• Key economic assumptions
decisions

EXHIBIT 19.2
The Components of a Financial Planning Model

We can categorize the parts of a financial planning model as inputs, the model itself, and outputs. Models allow management
to generate projected financial statements which enable them to see the financial impact of strategic initiatives.

612 CHAPTER 19 I Financial Planning and Forecasting

forecasted sales for next year (Stϩ1) are $120 million, applying Equation 19.1 yields the percent
growth in sales over the coming year:

% ¢S ϭ 1Stϩ1 Ϫ St2 ϭ 1$120 Ϫ $1002 ϭ 0.20, or 20%
St $100

Investment and Financial Policy Decisions. Preparing a financial planning model re-
quires top management to make a number of investment and financial policy decisions. These
decisions impose constraints on the financial model’s outputs that must be recognized during
its preparation. Some important investment and financial policy decisions are:

• Investment policy decisions: Identify the investment decisions to be evaluated as part of the

financial planning process. Typically, these are large capital expenditures such as building
a new manufacturing facility, entering a new line of business, or acquiring another firm.

• Financial policy decisions:

- Capital structure decision: Determines management’s targeted capital structure—its
willingness to use financial leverage.

- Financing decision: Determines the acceptable type of financing: retained earnings, eq-
uity, preferred stock, and/or long-term debt.

- Payout decision: Identifies the firm’s dividend and stock repurchase policies for the sales
period.

The Financial Planning Model

A financial planning model is a set of equations that generate projected financial state-
ments. Along with the sales forecast and the investment and financial policy decisions,
management must specify key assumptions regarding how the income statement and the
balance sheet accounts vary with sales. For example, suppose that, based on historical data,
a company finds that cost of goods sold is 80 percent of sales and inventory and accounts
receivables are each 15 percent of sales. In such a case, it might be reasonable to assume that
these relations will hold for the projected income statement and balance sheet. Thus, if sales
are projected to be $100 million next year, the projected cost of goods sold will be $80 mil-
lion ($100 million ϫ 0.80 ϭ $80 million) and inventory and accounts receivable accounts
will both be $15 million ($100 million ϫ 0.15 ϭ $15 million).

LEARNING Financial Statement Items Often Vary with Sales
BY
DOING APPLICATION 19.1 PROBLEM: You have the following information: (1) sales this year are $50 million; (2)
sales are expected to grow by 20 percent next year; and (3) for the current year, accounts
receivable are 7 percent of sales and inventory is 10 percent of sales. Your boss has asked
you to estimate next year’s sales, accounts receivable, and inventory.

APPROACH: You can rearrange Equation 19.1 to find next year’s sales level (Stϩ1). Then,
assuming accounts receivable and inventory grow proportionately with sales, you can use the

result to calculate the expected levels of accounts receivable and inventory for next year.

SOLUTION:

%¢S ϭ 1Stϩ1 Ϫ St2
St

0.2 ϭ 1Stϩ1 Ϫ $50,000,0002
$50,000,000

Stϩ1 ϭ 10.2 ϫ $50,000,0002 ϩ $50,000,000
ϭ $60,000,000

Accounts receivable ϭ $60,000,000 ϫ 0.07 ϭ $4,200,000

Inventory ϭ $60,000,000 ϫ 0.10 ϭ $6,000,000

19.2 Financial Planning Models 613

Outputs from the Model: Projected Financial Statements pro forma financial

The outputs from the financial planning model are projected financial statements called pro statements
forma financial statements. In finance and accounting, the term pro forma means fore- projected financial statements
casted or projected.3 The statements produced by a financial planning model are forecasted that reflect a set of
based on the inputs and assumptions entered into the model. In addition to pro forma finan- assumptions concerning
cial statements, computer-based planning models usually generate a set of financial ratios investment, financing, and
similar to those discussed in Chapter 4 and include features that enable management to operating decisions
prepare a cash budget.

A Simple Planning Model percent of sales model
a simple financial planning
Let’s work through a simple example to see how a financial planning model generates pro model that assumes that
forma financial statements and is used to analyze a strategic investment.4 This simple model, most income statement and
along with the other planning models presented in this chapter, is a percent of sales model, balance sheet accounts vary
in which most of the variables in the model vary directly with the level of sales. Keep in mind proportionally with sales
that more sophisticated planning models are built around the same basic concepts—there are
just more assumptions to deal with. The important point here is to make sure you understand
how the model is built on a set of assumptions and how it generates the pro forma financial
statements.

Generating Pro Forma Statements

Sleepy Hollow Corporation’s financial statements for the current year are shown in simplified
form in the following table:

Sleepy Hollow Corporation
Current Financial Statements ($ millions)

Income Statement Balance Sheet

Net sales $1,000 Assets $600 Debt $400
Costs 700 Total $600 Equity 200

Net income $ 300 Total $600

Sleepy Hollow’s management expects sales to increase by 15 percent for the coming year. An overview of basic
Assume that the financial statement accounts vary directly with changes in sales and that man- concepts related to
agement has no financing plan at this time. Given this information, we can make the following financial planning can
calculations: be found at this site:
http://academic.uofs.
Projected sales ϭ $1,000 million ϫ 1.15 ϭ $1,150 million edu/faculty/gramborw/
Projected costs ϭ $700 million ϫ 1.15 ϭ $805 million tufinfor.html.

We now have the sales and cost figures for the firm’s pro forma income statement:

Sleepy Hollow Corporation
Pro Forma Income Statement ($ millions)

Net sales $1,150
Costs 805

Net income $ 345

Thus, the firm’s projected net income is $345 million.

3The phrase pro forma is a Latin term that literally means “as a matter of form.” In its modern context in finance and

accounting, pro forma refers to data that is hypothetical.
4Note that to simplify the analysis, some of the income statement and balance sheet accounts used in the planning model

614 CHAPTER 19 I Financial Planning and Forecasting

Turning to the balance sheet, since we are assuming that all financial statement items vary
with the change in sales, the projected values for the balance sheet accounts are:

Projected assets ϭ $600 million ϫ 1.15 ϭ $690 million
Projected debt ϭ $400 million ϫ 1.15 ϭ $460 million
Projected equity ϭ $200 million ϫ 1.15 ϭ $230 million

and the resulting pro forma balance sheet is:

Sleepy Hollow Corporation
Pro Forma Balance Sheet ($ millions)

Assets $690 ($90) Debt $460 ($60)
Total $690 ($90) Equity 230 (30)
Total $690 ($90)

The numbers in parentheses are the changes between the current and projected dollar amounts.
Notice that all the balance sheet figures have increased by 15 percent and that the balance sheet
balances. This is because both the sources and use of funds have increased by 15 percent. The
$90 million in new assets is being financed by $30 million from retained earnings (internal fi-
nancing) and $60 million from new long-term debt (external financing).

The balance sheet balances, but if you look back at the income statement, you may notice that
the equity account does not look right. Recall that Sleepy Hollow’s projected net income was $345
million. Adding this amount to the initial equity account balance of $200 million yields a final
equity balance of $545 million ($345 million ϩ $200 million ϭ $545 million). As you can see, the
equity balance in the pro forma balance sheet is $230 million. Why the apparent conflict?

As a general rule, whenever account balances differ or there is some confusion about an
account, the easiest way to determine what is going on is to reconcile the account. For the eq-
uity account, if the firm is not expected to sell or repurchase stock, there are two basic transac-
tions that could take place during the year: (1) the firm could generate income that is added to
retained earnings and (2) management could pay a cash dividend, which is subtracted from
retained earnings. Since the pro forma equity balance is lower than the sum of the initial equity
account balance plus Sleepy Hollow’s net income, the forecasts assume the firm will pay a
dividend. We can calculate how large this dividend is as follows:

Beginning equity balance ϭ $200 million

ϩNet income ϭ 345 million

ϪDividends ϭX

Ending equity balance ϭ $230 million

Solving for X, we find that:

Dividends ϭ 1$200 million ϩ $345 million2 Ϫ $230 million ϭ $315 million

The reconciliation makes the dividend transaction transparent. It is clear that with a net in-
come of $345 million and the constraint that the ending equity balance is $230 million, the
firm must pay a $315 million cash dividend.

Evaluating an Investment Opportunity

Now let’s suppose that Sleepy Hollow is considering building a new manufacturing plant. The
project is estimated to cost $200 million and is to be financed entirely with debt. As in the prior
example, sales are expected to increase by 15 percent for the year, and the plant will be placed in
service the following year. Finally, assume that all financial statement accounts vary directly with
changes in sales and that the current dividend policy is to pay a $315 million cash dividend.

To determine whether the project is feasible as planned, management needs to prepare a
set of pro forma financial statements that include the cost of the new facility. Sleepy Hollow’s
pro forma income statement will not change because of the building project. Thus, we can use
Sleepy Hollow’s income statement shown earlier. The preliminary pro forma balance sheet for

19.2 Financial Planning Models 615

Sleepy Hollow’s Building Project
Preliminary Pro Forma Balance Sheet ($ millions)

Asset $690 ($90) Debt $400
New facility 200 ($200) Equity 230 ($30)
Total $890 Total $630

We can see that total assets are $890 million, composed of the $690 million ($600 million ϫ external funding needed
1.15 ϭ $690 million) we calculated earlier plus $200 million for the new facility. The value of
the equity account remains unchanged at $230 million ($200 million ϫ 1.15 ϭ $230 million), (EFN)
because it is subject to the 15 percent growth limit, and management must pay the $315 mil- the additional debt or equity
lion cash dividend. Since we do not know the amount of debt needed, we enter debt at the a firm must raise from external
current balance sheet amount of $400 million. sources to meet its total
funding requirements
Now, comparing the totals, we see that the balance sheet does not balance: total assets are
$890 million, while total debt and equity equals $630 million. The difference between the two
numbers is $260 million ($890 million Ϫ $630 million ϭ $260 million). This “plug value” is the
amount of external funding needed (EFN) by the firm. EFN is the additional debt or equity a
firm needs to issue so that it can meet its total funding requirements. In this analysis, we refer
to EFN as the plug value because it is the number we have to plug into the balance sheet to get
it to balance. In our example, the firm must issue $260 million of debt because, as you recall,
management made a decision to finance the new project entirely with debt.

The final balance sheet, which includes the building project, is shown in the table below.
Overall, the firm is financing $290 million of new assets: $200 million for the new facility and
$90 million for new assets to support the increase in sales expected next year. The funding is a
combination of internal and external funding, which totals $290 million: $260 million in debt
(external) and $30 million in additions to retained earnings (internal). The firm is also able to
pay the required $315 million of cash dividends. If the firm can borrow the $260 million at a
reasonable rate, it will be able to generate sufficient funds to finance the $200 million capital
project and pay the required cash dividend of $315 million.

Sleepy Hollow’s Building Project
Final Pro Forma Balance Sheet ($ millions)

Asset $690 ($90) Debt $660 ($260)
New facility 200 (200) Equity 230 (30)
Total $890 ($290) Total $890 ($290)

Informed Judgment about Risk DECISION
MAKING
SITUATION: You are given some additional information about Sleepy Hollow Corpo-
ration’s use of financial leverage, as shown: EXAMPLE 19.1

Debt to total assets before capital project ϭ $400/$600 ϭ 66.7%

Debt to total assets after capital project ϭ $660/$890 ϭ 74.2%

Industry average debt to total assets ϭ 40.0%

What should management do in light of this information?

DECISION: Sleepy Hollow’s current leverage ratio of 66.7 percent is already high
compared with the industry average of 40 percent. If the firm goes ahead with the proj-
ect, the leverage ratio will increase to 74.2 percent, which is even higher. The high debt
ratio makes the firm more risky and could negatively affect its stock price, its borrowing
cost, and even its ability to borrow money. A more prudent alternative would be to fund
at least part of the $290 million of new assets ($90 million ϩ $200 million ϭ $290 million)
with internally generated funds by reducing dividends or with externally-raised equity by
selling new stock, or both.

The important point here is that financial planning models do not think for manage-
ment. Even though the balance sheet balances and results are consistent with the firm’s
financing plan, management must apply informed judgment.

616 CHAPTER 19 I Financial Planning and Forecasting

> BEFORE YOU GO ON
1 . Why is the sales forecast the key component of a financial model?
2 . What are pro forma financial statements, and why are they an important part

of the financial planning process?
3 . What is the plug factor in a financial model?

19.3 A BETTER FINANCIAL PLANNING MODEL

LEARNING OBJECTIVE The preceding section presented a simple financial planning model that assumes all income
and balance sheet accounts vary directly with sales. Although that assumption is helpful to
simplify calculations, it does not reflect what happens in the real world. We now relax our
assumptions so that our model is more realistic and generates more accurate forecasts. We
assume that all working capital accounts—current assets and liabilities—vary directly with
sales. For other accounts in the financial statements, independent forecasts may be required,
or values may be set by management based on other criteria. To illustrate the process, we will
work through an example.

The Blackwell Sales Company

The Blackwell Sales Company is a small, privately owned company located in College Station,
Texas. The firm serves the oil and gas exploration industry in Texas and the adjoining states. It
sells and does light manufacturing of rigging equipment for oil and gas exploration. The firm’s
management owns 75 percent of the stock, with the balance owned by friends and outside in-
vestors. Blackwell’s management is projecting a banner year, as sales are expected to increase
30 percent. The reason for the large increase is an oil and gas shortage caused by political in-
stability in the Middle East. Because of the high-risk nature of their business, management is
very conservative with respect to any action that might materially increase the firm’s risk.
Some of the management team is concerned about the risk associated with increasing sales by
30 percent in a one-year period.

The financial manager looks at the firm’s current and historical financial statements and
provides the following information:

• Net sales for the current year are $2 million.
• Historical and current financial data indicate that the total cost of producing the firm’s

services and products averages about 85 percent of sales.

• The firm’s average tax rate is 34.1 percent and is not expected to change.
• The firm’s payout policy is to pay 33.5 percent of earnings as cash dividends.

The Income Statement

Exhibit 19.3 shows the firm’s current and pro forma income statements. Let’s look at the calcu-
lations used to arrive at the pro forma income statement. Management expects sales to increase
by 30 percent next year, and so projected sales are $2 million ϫ 1.30 ϭ $2.6 million. Since total
costs have averaged 85 percent of sales, projected total costs are $2.6 million ϫ 0.85 ϭ $2.21
million. Projected taxes, which are 34.1 percent of taxable income, are 0.341 ϫ $390,000 ϭ
$132,990, which we will round to $133,000 for simplicity. Subtracting taxes from taxable in-
come, we arrive at the firm’s projected net income of $257,000.

Blackwell’s cash dividend is $86,000 (0.335 ϫ $257,000 ϭ $86,095, which we will round to
$86,000), and the remaining $171,000 of net income (0.665 ϫ $257,000 ϭ $170,905) is re-