Suggested questions for the Commercial Fixtures Inc. case are given below.

1. What would you as an outside third party bid under the same conditions (with the same information) for the entire company (both halves)? Why?

2. What do you expect Albert Evans to bid for Gordon’s half interest? Why?

3. What should Gordon Whitlock bid for Albert’s half interest? Why?

4. How would you structure the purchase of the business?

Question #1 is a business valuation question. There are a number of ways to estimate the value of a business. You have probably covered one or more of these ways in a previous class. The next two pages review a few of the various ways to go about it.

For a discounted CF approach of valuing Commercial Fixtures Inc., I will use the following template:

VALUATION APPROACHES – OVERVIEW/REVIEW

1. Comparable Trades Analysis

— Using valuation ratios, or “multiples” of comparable firms

Use one or more valuation ratios, which include (a) Price-Earnings (b) Market-Book (c) Price-CF (d) Price-Revenues (e) Enterprise Value to EBITDA, and (f) Other ratios. The prospective value (price) of the subject firm is quantified into—and compared with—one or more of the valuation ratios of its peers. The better the performance of the subject firm relative to comparable firms in the relevant performance measures (as measured by operating ratios), the higher the appropriate valuation ratio for the firm (and vice-versa).

2. Liquidation Value, aka Book Value approach

Place liquidation values on the net working capital and fixed assets of the firm. Include tax write-off benefits, if any. This approach is rarely useful, and will typically serve as a minimum value (unless the firm is in severe distress).

3. (i.) Discounted Present Value of the Firm’s Free Cash Flows — commonly referred to as DCF Valuation, or WACC valuation

Value of the Firm = PV of future free cash flows + PV of terminal value

a.Estimate the first 3 to 10 years’ free cash flows and calculate the PVs. (A five year horizon is common, but this can vary.) Typically you will use the WACC as your discount rate. Depending on the circumstances, the estimated cash flows may be available for fewer than five years, or more than five years.

b.Estimate the PV of the terminal value. One estimate for the terminal value involves assuming perpetual cash flows after the initial time horizon, e.g.: i.If the cash flow after 5 years is expected to grow at a rate g for the foreseeable future: Terminal Value5 (TV5) = FCF6 /(k – g) = FCF5 (1+ g) / (k – g)., where k is the required rate of return. You must discount the TV to time 0, and then add this to the PV of the FCFs during the projection horizon. ii.If the cash flow at the end of 5 years is not expected to grow, i.e., g=0, then the general formula collapses to the PV of a no-growth perpetuity: Terminal Value5 = FCF6 / (k-g) = FCF5 (1+ g)/(k – g) = FCF5 / k

c.Use the Value of the Firm equation above, i.e. sum PV of free cash flows + PV of terminal value . The Value of the firm’s Equity = Value of the Firm – Debt Currently Outstanding.

3. (ii.) Adjusted Present Value approach

— we will only briefly discuss this approach; a topic for a future finance course.

4. Comments on Valuing the Firm using DCF (or WACC) and APV valuation approaches

a.Watch the free cash flows (not reported earnings)!

In particular, as in the capital budgeting decision process:

–Depreciation charges are not cash outflows.

–Investment in new property or equipment is a cash outflow.

–Increases in net working capital are cash outflows.

–Taxes are cash outflows

b.Do not subtract interest expense from FCFs.

We want to estimate a value for the whole business. The return to creditors is reflected in the discount rate used.

c.Consider other factors, such as a control premium or a lack of marketability discount. These are mentioned in your textbook, and we will discuss these in class.

d.Notice the sensitivity of your estimated firm value to changes in assumptions, particularly the perpetual terminal growth rate, and the discount rate. Typically a range of firm values is calculated from various ranges of these two rates (as suggested in the template on p. 1), particularly when uncertainty is high.

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