Pert 6 Intro To Business Valuation

Fundamentals of Corporate Finance
Fifth Edition
Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.;
Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D.
Chapter 18
Business Formation, Growth, and
Valuation
Copyright ©2022 John Wiley & Sons, Inc.
Chapter 18: Business Formation,
Growth, and Valuation
Copyright ©2022 John Wiley & Sons, Inc. 2

Learning Objectives
1. Explain why the choice of organizational form is important, and

describe two financial considerations that are especially
important in starting a business
2. Describe the key components of a business plan, and explain
what a business plan is used for
3. Explain the three general approaches to valuation, and value a
business using common business valuation approaches
4. Explain how valuations can differ between public and private
companies and between young and mature companies, and
discuss the importance of control and key person considerations
in valuation

18.1 Starting a Business
LEARNING OBJECTIVE
Explain why the choice of organizational form is important, and
describe two financial considerations that are especially important
in starting a business
• Starting a business
• Making the decision to proceed
• Choosing the right organizational form
• Financial considerations
L.O. 18.1 Copyright ©2022 John Wiley & Sons, Inc. 4

Starting a Business
• Entrepreneurs enter into business for a variety of reasons
• The first decision they must make is whether they want to
found a business or acquire an existing business
• Starting a business is inherently riskier than buying and
growing a business that someone else has already
established

Making the Decision to Proceed
• To be successful founders and early investors need to
thoroughly evaluate the decision to proceed
• Businesses fail for many reasons, including:
o Lack of acceptance of the products by customers
o Poor strategy
o Poor management skills to properly execute a good strategy
o Underestimating how much money it will take to get their
businesses up and running

Improving the Chances of Success
• Chances of success in a business can improve if one
o Doesn’t jump into a business without careful thought
o Doesn’t overanalyze opportunities to the point where you
are just convincing yourself not to proceed
o Doesn’t think that failure will ruin your chances of
ultimately achieving business success

Other Start-up Considerations
• The founder of a company must start from scratch and
make several decisions, including:
o Choosing the product(s) to sell
o Choosing the markets to sell them in
o Choosing the best strategy for selling them
o Raising the money needed to develop the product(s)
o Acquiring the necessary assets
o Hiring the right people

Choosing the Right Organizational
Form
• Limited liability companies (LLC)
o The LLC is a hybrid of a limited partnership and a
corporation
o Like a corporation, and LLC provides limited liability for
the people making business decisions while enabling all
investors to retain the tax advantages of a limited
partnership
o The lifespan of the partnerships and LLCs are flexible
o Limited partnerships and LLCs are less constrained than
general partnerships because they can raise money from
limited partners or “members”
Characteristics of Different Forms of
Business Organization (1 of 2)
Limited Liability
Sole Partnership: Partnership: Corporation: Corporation: Partnership (LLP)
Proprietorship General Limited S-Corp. C-Corp. or Company (LLC)
Cost to
establish Inexpensive More costly More costly More costly More costly More costly
Life of entity Limited Flexible Flexible Indefinite Indefinite Flexible

Control by
founder over
business Depends on Depends on
decisions Complete Shared Shared ownership ownership Shared
Access to
capital Very limited Limited Less limited Less limited Excellent Less limited
Cost to
transfer
ownership High High High High Can be low High

Characteristics of Different Forms of
Business Organization (2 of 2)
Separation of
management and
investment No No Yes Yes Yes Yes
Potential owner/ Potentially
manager conflicts No No Some high Potentially high Some
Ability to provide
incentives to attract
and retain high-
quality employees Limited Good Good Good Good Good
Unlimited
for general
Liability of owners Unlimited Unlimited partner Limited Limited Limited
Tax treatment of Flow- Flow- Flow-

income Flow-through through through through Double tax As elected
Tax deductibility of
owner benefits Limited Limited Limited Limited Limited Limited

Financial Considerations - Cash Flow
Break-Even
• Cash flow (EBITDA) break-even analysis is used to
compute the level of unit sales necessary to break even on
operations from a pre-tax operating cash flow perspective
o Focuses the entrepreneur’s attention on the importance of
optimizing its associated overhead costs
o Provides a means of estimating how much money will be
needed to launch a new product or business
FC
EBITDA Breakeven =
Price  Unit VC

Financial Considerations - The Cash
Budget
• The cash budget
o A very useful planning tool for entrepreneurs
o Summarizes the cash flows into and out of a firm over a
period of time
o Often present the inflows and outflows on a monthly basis,
but can be prepared for any period, including daily or
weekly

Financial Considerations - Cash
Inflows and Outflows
• Other important financial considerations
o Helps an entrepreneur better understand where money is
coming from, where it is going, and how much external
financing is likely to be needed and when
o Knowing how much external financing is likely to be
needed and when helps the entrepreneur plan fundraising
efforts before it is too late

Exhibit 18.2: Pizza Palace: Monthly Cash
Budget for the Period March 2022 through February 2023

18.2 The Role of the Business Plan
LEARNING OBJECTIVE
Describe the key components of a business plan, and explain what
a business plan is used for
• The role of the business plan

• Why business plans are important
• The key elements of a business plan

The Role of the Business Plan
• Financing a business is not always simple
• An important tool in financing a young, rapidly growing
business, as well as in managing it, is the business plan

Why Business Plans are Important (1 of 3)
• A road map for a business.
• Focuses on how the business will be developed over time
• Used to convince potential investors that purchasing debt
or equity in the firm will yield attractive returns
• To overcome the skepticism of outside investors, many
entrepreneurs prepare a business plan

• A well-prepared business plan makes it easier for an
entrepreneur to communicate to potential investors
precisely
o What the business will look like in the future
o How to get it to that point
o What returns an investor might expect to receive

• A business plan is a tool that
o Can help raise capital
o Can help an entrepreneur set the goals and objectives for the
company
o Serve as a benchmark for evaluating and controlling the
company’s performance
o Communicate the entrepreneur’s ideas to managers, outside
directors, customers, suppliers, and others

Key Elements of a Business Plan (1 of 3)
• An executive summary summarizes the key issues
• A company overview describes what the company does and
what its comparative advantages are
• The products and services the company will sell, its 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 industry and
highlights the important characteristics of the industry as
they relate to the company

• A detailed discussion of the marketing and sales activities
that will enable the business to achieve the sales and
margin levels reflected in the financial forecasts
• A detailed discussion of the operations of the business
• Detailed information on the management team and
ownership structure of the business

• A detailed discussion of capital requirements and uses
• Historical financial results when they are available and
financial forecasts
• Appendixes providing detailed support for the analyses that
are presented in the report

18.3 Valuing a Business
LEARNING OBJECTIVE
Explain the three general approaches to valuation, and value a
business using common business valuation approaches
• Valuing a business
• Fundamental business valuation principles
• Business valuation approaches

Valuing a Business
• The value of a business is determined by the magnitude 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
• Decision makers must understand business valuation
concepts in order to be able to identify the optimal capital
structure and payout policy

Fundamental Business Valuation
Principles
• There are two important valuation principles
o The value of a business changes over time
o There is no such thing as the value for a business

The First Valuation Principle
• The value of a business changes over time because of the

impact of:
o Changes in general economic and industry conditions
o Actions by competitors
o The investment, operating, and financing decisions made by
managers

The Second Valuation Principle
• The value of a business can be different to different
investors
o A strategic investor has an interest in acquiring the business.
The investment value of the firm to a strategic investor will
consider the benefits that can accrue from the acquisition and
hence is likely to carry a higher value
o A financial investor is only interested in financial
performance of the firm as it is and is not interested in
acquiring the whole business. The fair market value of a
business is the value of that business to a hypothetical person
who is knowledgeable about the business. This fair market
valuation, will typically be lower than the investment value
Business Valuation Approaches
• Business valuation approaches can be classified into one of

three general categories:
o Cost approaches
o Market approaches
o Income approaches

Cost Approaches – Replacement Cost
• The replacement cost of a business is the cost of
duplicating the assets of the business in their present form
as of the valuation date
o Generally used for assets within a business when they are
being insured
o In a buy-vs.-build analysis, you must include the cost of all
tangible assets and all intangible assets, and the cost of
hiring people to run the business and the time that it would
take to build the business
o The timing of the cash flows is very important and must be
taken into consideration as, generally, acquired businesses
lead to quicker cash flows
Cost Approaches – Adjusted Book
Value
• The adjusted book value approach involves estimating the
market value of the individual assets in a business
o The fair market value of each individual asset is estimated
separately, then totaled
o An adjusted book value analysis should include all tangible
and intangible assets
o Useful in valuing holding companies whose main assets are
publicly traded or other investment securities but is
generally less applicable for operating businesses

Cost Approaches – Going-Concern
Value
• The value of an operating business is usually greater than
the sum of its individual assets, and the excess value is
called the going-concern value
• The going-concern value of an asset reflects the value
associated with additional future cash flows the business
produces because of the way in which the individual assets
are managed together

Usefulness of the Adjusted Book Value
Approach
• The adjusted book value approach does not capture the
going-concern value of a business, however it is useful in
estimating a floor value for a business under certain
circumstances, such as when
o It is especially difficult to forecast the cash flows that a
business is likely to produce
o You suspect that the going-concern value of the business is
negative
o Liquidation is being explicitly considered

Market Approaches
• Two commonly used market approaches used in business

valuation are:
o Multiples analysis
o Transactions analysis

Multiples Analysis (1 of 3)
• Multiples analysis uses stock price or other values that are

observed for public companies to estimate the value of a
company’s stock or an entire business
o Identify publicly traded companies engaged in similar
activities to those of the company being analyzed
o Use the prices at which shares of those comparable are
trading, along with accounting data, to estimate the value of
the company of interest
o Often used to help price a company’s shares for an IPO, or
when 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
o By focusing on the variables that drive the P/E multiple, we can
see the importance of identifying comparable companies that are
as similar to the company of interest as possible
o Analysts either use the average multiple from other publicly held
peers, or a multiple from a single comparable company to
estimate the value of the company of interest
Equation 18.1
P0 b

E1 kcs  g
• While doing a multiples analysis, one needs to be aware of

certain issues
o A marketability discount that can be sizable
o Identifying one or more comparable firms is not an easy task
o Prices and accounting data should be from the same period
• Because P/E ratios are sensitive to leverage, many analysts
use ratios that utilize enterprise value
o the value of the company’s equity plus the value of its debt,
which is also the present value of the total free cash flows
the company’s assets are expected to generate in the future

Transactions Analysis (1 of 2)
• In the transaction approach analysts use information on what someone
has paid for a comparable company in a merger or acquisition to
estimate the value for the firm
o This transaction information is used to compute the same types of
multiples that are used in a multiples analysis, and these multiples are
used in the same way to value the company of interest
• Since transaction data reflects the price that a particular investor paid
for an entire company, it provides an estimate of the investment value
to that investor
• Transaction information is obtained from the financial statements of
public companies that have acquired other companies or from services
that collect and sell this type of information

Transactions Analysis (2 of 2)
• Transactions analysis approach is difficult to use in practice

for several reasons
o Transactions data are not typically as reliable as the data
available for multiples analysis, especially when they
associated with a private firm
o Transactions involving the purchase or sale of an entire
business in an industry tend to occur relatively infrequently,
and hence the data is not very timely
o The terms of the transactions can be difficult to assess

Income Approaches
• The most direct approaches for estimating the value of the

cash flows a business is expected to produce are the
income approaches
• Like NPV analysis, they directly estimate the value of
those cash flows
• These approaches provide the intrinsic value for the firm,
which can be different from the market value.
• While market value reflects what people are willing to pay
for the firm, the intrinsic value reflects what the firm is
truly worth

Considerations when using the
Income Approaches
• Unlike with projects, it is difficult to estimate the life of a
business
• Businesses often have cash or other assets that are not
necessary for operations, which can complicate the
valuations

Estimating the Value of the Firm
using Income Approaches
• VF is the value of the firm, PV(FCFT) is the present value of
free cash flows that the business is expected to produce over the
next T years, PV(TVT) is the terminal value (present value of all
free cash flows after year T), and NOA is the value of all of the
non-operating assets of the firm
Equation 18.2
VF  PV  FCFT   PV(TVT )  NOA

Free Cash Flow from the Firm
Approach (1 of 2)
• In the free cash flow from the firm (FCFF) approach, an
analyst values the free cash flows that the assets of the firm are
expected to produce in the future
• The present value of these cash flows equals the total value of
the firm, or its enterprise value
• We do not include the cash 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 non-interest-bearing current
liabilities, which are included in the firm’s cost of sales and
other operating expenses, are subtracted in the calculation of
FCFF
Free Cash Flow from the Firm
Approach (2 of 2)
• Computation of the Free cash flow from the firm (FCFF)
approach
o VF is computed as the present value of the FCFF, discounted by
the firm’s weighted average cost of capital (WACC)
o When analysts use the WACC approach to value a business, they
make an assumption about how the firm’s operations will be
financed in the future
Equation 18.3

FCFFt
VF  
t  0 (1  WACC)
t

The Finance Balance Sheet and Firm
Value

Exhibit 18.4: The FCFF Calculation

FCFF Forecasts
for Bell Mountain Manufacturing Company ($ millions)
Year: 1 Year: 2 Year: 3 Year: 4 Year: 5
Revenue $100.0 $106.0 $112.4 $119.1 $126.3

− Cash operating expenses 70.0 74.2 78.7 83.4 88.4
Earnings before interest, taxes,
depreciation and amortization $ 30.0 $ 31.8 $ 33.7 $ 35.7 $ 37.9
− Depreciation and amortization 8.0 8.3 8.5 8.8 9.0
Operating profit $ 22.0 $ 23.5 $ 25.2 $ 26.9 $ 28.9
− Taxes 7.7 8.2 8.8 9.4 10.1
Net operating profits after tax $ 14.3 $ 15.3 $ 16.4 $ 17.5 $ 18.8
+ Depreciation and amortization 8.0 8.3 8.5 8.8 9.0
Cash flow from operations $ 22.3 $ 23.6 $ 24.9 $ 26.3 $ 27.8
− Capital expenditures 10.0 10.0 11.0 12.0 13.0
− Additions to working capital 0.5 0.5 0.5 0.6 0.7
= Free cash flow from the firm $ 11.8 $ 13.1 $ 13.4 $ 13.7 $ 14.1

Free Cash Flow to Equity Approach
(1 of 2)
• The free cash flow to equity (FCFE) approach uses only

the portion of the cash flows that are available for
distribution to stockholders
o Stripping out the cash flows to or from the lenders
• interest expense on existing debt
• repayment of debt principal
• proceeds from new debt issues

Free Cash Flow to Equity Approach
(2 of 2)
• In using the FCFE valuation approach, the cost of equity,

kE, is used to discount the residual cash flows
Equation 18.4

FCFE t
VE  
t 0 (1  k E ) t

Exhibit 18.6: The FCFE Calculation

Dividend Discount Model Approach
• The dividend discount model (DDM) approach estimates
the value of equity directly by discounting cash flows to
stockholders
o The DDM approach values the stream of cash flows that
stockholders expect to receive through dividend payments
• The constant-growth dividend model (Equation 9.4) is an
example of a DDM
• However, only some firms have a constant growth
• More often use of the DDM approach involves discounting
dividends that either do 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

18.4 Important Issues in Valuation
LEARNING OBJECTIVE
Explain how valuations can differ between public and private companies
and between young and mature companies, and discuss the importance
of control and key person considerations in valuation
• Important issues in valuation

• Public versus private companies
• Young (rapidly growing) versus mature companies
• Controlling interest versus minority interest
• Key people

Important Issues in Valuation
• Important issues can make a difference in valuation
including:
o Whether a business is public or private
o Whether it is young or old
o Whether a minority interest or a controlling interest is
involved
o What is the role of key employees

Public versus Private Companies (1 of 2)
• Financial Statements
o Incomplete and unreliable financial statements can
complicate the process of valuing a private business, making
it more difficult to accurately assess its value
o Some private companies have complete, audited financial
statements
o Others have incomplete financial statements that are not
prepared in accordance with the GAAP
o All public companies are required to file audited financial
statements with the SEC
o Private company financials often include personal expenses
of the owner and excess compensation expenses
Public versus Private Companies (2 of 2)
• Marketability
o The shareholder of a private firm may have to spend
considerable resources (both money and time) to sell shares
o The shareholders of publicly held firms find it much easier
to liquidate their holdings
o The higher transaction costs will result in a lower price for a
holding in a private firm
o This must be taken into account as a marketability discount
when estimating the value of any claim to the cash flows of
a firm

Young versus Mature Companies (1 of 2)
• Young, rapidly growing companies tend to be more
difficult to value than mature, stable companies
o Less-reliable historical information is available
o Much of the young company’s future growth depends on
investment, operating, and financing decisions that have not
yet been made
o Without 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

Young versus Mature Companies (2 of 2)
• In order to grow, many young companies have to invest a
considerable amount of money
• The cash flows will be negative until the business becomes
profitable, and its investment expenditures fall
• Positive cash flows, which represent the value of the
business, are further into the future and are therefore less
certain

Controlling versus Minority Interest
(1 of 2)
• Is a controlling ownership interest or a minority interest is
being valued?
• The amount of stock that is required for an investor to
exercise control can vary depending on the ownership
structure of the company
• Whether a controlling ownership interest is being sold has
important implications for a valuation analysis

Controlling versus Minority Interest
(2 of 2)
• An adjustment must be made to reflect the benefits of control if
one used multiples based on public stock market prices to
estimate the value of a controlling interest
• Similarly, when you use an income approach to value a
business, the cash flow forecasts and discount rate assumptions
will differ depending on whether you are valuing a minority or a
controlling ownership interest
• A discount rate based on CAPM might be too high for a
valuation that involves a controlling position. To adjust for the
effects of an incorrect discount rate and for any possible cash
flows that are not reflected in a valuation based on an income
approach, analysts add a control premium
Key People
• Is it appropriate to adjust the estimated value of the
business for the likelihood that these “key people” may not
remain with the firm as long as expected?
• If an analyst believes that those key people may go to
another firm if the CEO departs, then a key person discount
may be appropriate

Copyright
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Fundamentals of Corporate Finance

Copyright ©2022 John Wiley & Sons, Inc. 2

1. Explain why the choice of organizational form is important, and

Copyright ©2022 John Wiley & Sons, Inc. 3

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Life of entity Limited Flexible Flexible Indefinite Indefinite Flexible

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Tax treatment of Flow- Flow- Flow-

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• The role of the business plan

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• The value of a business changes over time because of the

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• Business valuation approaches can be classified into one of

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• Two commonly used market approaches used in business

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• Multiples analysis uses stock price or other values that are

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• While doing a multiples analysis, one needs to be aware of

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• Transactions analysis approach is difficult to use in practice

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• The most direct approaches for estimating the value of the

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Revenue $100.0 $106.0 $112.4 $119.1 $126.3

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• The free cash flow to equity (FCFE) approach uses only

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• In using the FCFE valuation approach, the cost of equity,

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• Important issues in valuation

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