Title: Assignment: Competency Assessment: (CU4 M1) Practice with Business Valuation
Course: SkillsCom BA 260 15.0

This practice Competency Assessment will walk you through, step-by-step, the calculations necessary for valuation of a business using 2 methods: discounted future earnings method and the excess earnings method. For the actual Competency Assessment that follows this practice assessment, you will perform a valuation analysis without the step-by-step assistance, therefore it is essential you take the opportunity here to make sure you understand each process.

Discounted Future Earnings Method

Charles has talked to his accountant regarding methods that can be used in valuing his business. His accountant has briefly explained that earnings received today are worth more than earnings received in the future. The accountant therefore recommends the discounted future earnings method. In this method, future earnings are discounted back to their present value (PV) and each year’s estimated earnings are added together to determine the value of his business.

Here is a reminder of the formula for Net Present Value (NPV):

R_t

(1 + i)_t

where

t = the time of the net future earnings

i = the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.)

R_t = the net future earnings at time t

Charles  has decided to use this method in arriving at a valuation. Here is the information he has gathered to help him:

Table: Estimated Net Earnings over the Next 5 years

Year 1 | $100,000
Year 2 | $125,000
Year 3 | $150,000
Year 4 | $200,000
Year 5 | $250,000

Charles also believes that it is best to use a conservative discount rate. He has settled on 24 percent. So using the equation above, Charles earnings in year 1 are calculated as follows:

Calculations:

Year 1 Discounted Earnings:

If estimated earnings for year 1 is of $100,000 (taken from table above), then:

R_t = $100,000

t = 1

i = 24%

NPV = $100,000 / (1 + .24)1

NPV = $80,645

Year 2 Discounted Earnings:

If estimated earnings for year 2 is of $120,000 (taken from table above), then

R_t = $125,000

t = 2

i = 24%

NPV = $125,000 / (1 + .24)2

NPV = $81,295

Take over from here to calculate present value of estimated earnings in years 3, 4 and 5. Sum all years (1, 2, 3, 4, 5) to get the worth of Charles’s business, based on the discounted future earnings method. Fill in the numbers appropriately, as demonstrated in year 1 and 2 examples.

Year 3 Discounted Earnings:

1. R_t =
2. t =
3. NPV =

Year 4 Discounted Earnings:

1. R_t =
2. t =
3. NPV =

Year 5 Discounted Earnings:

1. R_t =
2. t =
3. NPV =
4. What is the worth of Charles's business based on the discounted future earnings method?

Analysis:

1. Is this method is accurate? Why or why not?

Excess Earnings Method

As Charles expects his business to give him greater earnings than the average company in the industry, he wants to ensure that he is not undervaluing his business. To take these greater earnings into account  he asks his accountant for an alternative method. The excess earnings method is proposed using the following steps.

Step 1: Calculate adjustable tangible book value of assets.

Because depreciation and inflation affect the true value of some assets, it is important to adjust the book value of some assets to give their true or fair market value. Consider the following aspects of Charles’s business:

Adjusted Assets only | Book Value | Fair Market Value
Inventory | $100,000 | $125,000
Plant and Equipment | $400,000 | $600,000
Other intangibles | N/A | (-$50,000)
Totals | $500,000 | $675,000

Review the information provided above to convince yourself of how the totals were determined.The adjustable tangible book value is the excess difference between the book value and the total fair market value.

1. What is Charles’s adjustable tangible book value of his assets?

Step 2: Calculate adjusted tangible net worth.

As you learned earlier in the course the net worth of a business is calculated as follows:

Net worth = Assets - Liabilities

Charles determined that his total book value of all assets (not just adjusted assets) is $800,000, and his liabilities equal $475,000. To take into account fair market value of his assets, Charles must adjust his assets by adding the excess $175,000 determined above.

1. What is Charles’s adjusted tangible net worth?

Step 3: Calculate the opportunity cost of investing in the business.

Opportunity cost, in this case, is the cost the buyer will incur buying Charles’s business rather than another. This is approximately the same as the discount rate in the discounted future earnings method that the accountant explained to Charles earlier. Let us assume a discount rate of  25%. This means, essentially, that anyone who buys Charles’s business is paying 25% of the net worth calculated in step 2 for the future opportunities available in the acquisition. In addition to the 25% discount rate applied to the adjusted net worth, the opportunity cost also includes the cost of a reasonable salary that could be earned elsewhere. Let us assume a salary of $50,000.

1. What is the opportunity cost associated with purchasing Charles’s business?

Step 4: Calculate extra earnings power (over and above the industry standard).

Here we can use the final net earnings figure from Charles’s discounted future earnings method, from  question 1. Take the projected net earnings from step 4 above and then subtract  total opportunity cost (from step 3 above). This will give us the  extra earnings power. We then multiply this extra earnings power by the number of years we decide is appropriate. This is subject to negotiation by the seller. Let us assume 5 years.

1. What is the extra earnings power of Charles’s business over the next 5 years?

Step 5: Determine the value of the business.

The valuation  of the business is now possible. This is accomplished by adding the extra earnings power over the number of years established by the seller to the adjusted tangible net worth of the business.

1. What is the value of Charles’s business?