BUSINESS APPRAISAL: THE RIGHT FORMULA WHEN CASH FLOWS ARE VARIABLE (PART 2)

Previously, we attempted to price a business assuming there is no debt and no residual value of the underlying asset. This time we will reprise our latest exercise adding liabilities and an expected residual value or rescue value of the assets behind our investment.

 

SELF CENTERED SOCIETY is hired to carry out a due dilligence process for ICU, Inc. After several researches the following information is found out. The operational cash flow for the next year is expected to be 500k, there is a 10 year debt demanding 200k yearly, the historical rate of change in percentage for incomes is 5% per year, with the current assets and forthcoming market conditions ICU is expected to last 20 years and the discount rate applied to ICU operations is fixed at 10% the liabilities are discounted at the free-risk rate of 7%. On the other hand, buildings, equipment and machinery might be sold at the end of year 20 at 1000

Question: PV of ICU with g, discounting debt and adding market rescue value? Answers as follow:

PV=500*[1-(1.1/1.05)^-20/(0.1-0.05)]=6056.042028k

We could have discounted the value out of the 500 but that would be wrong, why? Because, while the operational cash flow grows yearly around 5% on average; the installments for the debt stay the same. So, the liabilities need to be priced separately.

200*[1-(1.07)^-10/(0.07)]=1404.716308

Although most authors recommend to price the liabilities on their own. It is also true the fact that when a net cash flow is accounted, the word by itself states is NET. Liabilities may not have the same life span than that of the incoming cash flows or by the time the business to be taken over has engaged itself with a new loan.

Now the residual value = 1000 *(1.1)^20 = 6727.5k (#)

The business new price is given by: 6056.042028 + 6727.5 - 1404.716308 = 11378.8256k

You might have noticed the usage of a risk free rate not equal to that used to discount the operational cash flow. There is absolute certainty about the reimbursements to the lender while there is uncertainty about the incomes and the amounts of those incomes to the business. According to several authors, liabilities have to be discounted at the market's risk free rate and not "the market rate" nor the nominal rate of the liabilities.

(#)The residual value of certain assets is bigger now than in the future. Why? It is because of 2 reasons: DEPRECIATION AND OUTDATING opposed to soils and premises which are sensitive to market gains as time goes by.....

Sources: Bloomberg, Chicago Mercantile Exchange Group, RiskCenter, Investopedia, Wikipedia, MIT-OCW, Coursera.org, Edx.org