VALUATION IN BUSINESS DIVORCE DISCOUNTED CASH FLOW METHOD AND ITS COMPONENTS

Transcription

1 VALUATION IN BUSINESS DIVORCE DISCOUNTED CASH FLOW METHOD AND ITS COMPONENTS ABA BUSINESS DIVORCE COMMITTEE SEPTEMBER 15, HURON CONSULTING GROUP INC.

2 DISCLAIMER These materials are presented solely to facilitate discussion, they should not be construed as specific advice nor grounds for reliance on any issue. (Copyright They are not to be reproduced or redistributed in any form.) HURON CONSULTING GROUP INC.

3 Today s presenters: Peter Wollmeringer, ASA Managing Director Huron Business Advisory New York T E John Levitske, CPA, CFF, ABV, CGMA, CFA, ASA, CIRA, CFLC Senior Director Huron Business Advisory Chicago T E HURON CONSULTING GROUP INC.

4 TABLE OF CONTENTS 1 Overview 5 Cost of capital 2 Cash flow forecasts 6 Other considerations 3 4 Discounted cash flow methods Enterprise value / equity value HURON CONSULTING GROUP INC..

5 Overview - Business divorce cases will often need a valuation of the equity or interest in a business that is subject of the dispute - For a private company, valuation methodologies must be used to determine fair value Unless operating agreements et al use specific valuation formulas - The discounted cash flow method is a direct valuation approach that measures the cash flows of a business over a reasonable period of time (business cycle). Often viewed as a superior method because it is represents the entity s views on the future, but the view needs to be reasonable and supportable - Market-based methods are relative valuation approaches Comparable public companies or comparable precedent transactions Subject company transactions HURON CONSULTING GROUP INC.

6 Why do we care about the DCF? - It is a complex method that can incorporate many assumptions that are specific to the business, which other methods cannot - Do Courts favor the DCF over other approaches? - Understanding the core elements of a DCF is important from the perspective of supporting your expert and challenging the other party s expert - The standard of value is fair value, which varies by state - Application of discounts are subject to state statutes and legal precedents HURON CONSULTING GROUP INC.

7 Cash flow forecast - Primary measurement component of methodology - Typically should reflect business planning scenarios - Should represent operating cash flows non-operating items should be dealt with separately - Typically a five year horizon, but could be more or less depending on the company or industry - Benchmarking of forecast to test reasonableness Databases Public companies Industry trends Is it believable? - Adjustments General view that risk should be adjusted in cash flows rather than the discount rate, but the opposite is true in practice Expected cash flows vs. conditional cash flows HURON CONSULTING GROUP INC.

8 What do operating cash flows give you? E n t e r p r i s e V a l u e Net Working Capital Non-Interest Excess Cash / Bearing Liabilities Non-Operating Assets Interest-Bearing Operating Fixed Debt Operating Assets Assets p Assets = ~ ~ Intangible Assets & Other Equity T o t a l I n v e s t e d C a i t a l HURON CONSULTING GROUP INC.

9 Methods - Cash flow to the firm Essentially a debt free valuation model which results in an estimate of enterprise value - No interest expense on debt - No principal payments on debt - Operating lease payments are included as an expense Enterprise value is the value of the operations, which excludes nonoperating assets Total invested capital is enterprise value plus non-operating assets Equity would be determined by subtracting the current balance of debt obligations Terminal value the value of the continuing operations is measured using a capitalization rate or a multiple and discounted to PV Cash flows are discounted at the weighted average cost of capital - Cash flows are available to both debt and equity investors WACC More common DCF approach EBITDA - Deprec. & Amort. = EBIT Income tax = Debt-free Net Income + Deprec. & Amort. - Capex +/- Working capital investment = Free Cash Flow to Firm * Present value factor (y1-5) = Present value of Cash Flow + Terminal Value = Enterprise Value HURON CONSULTING GROUP INC.

10 Methods - Cash flow to equity Cash flow includes debt service - Interest expense on debt - Principal payments on debt - New draws of debt - Operating lease payments are included as an expense Equity cash flows plus the terminal value are discounted at the cost of equity Less common / more complex forecast required Other methods - Adjusted Present Value (APV) Argued to be a better measurement tool EBITDA - Deprec. & Amort. = EBIT - Interest expense = Pre-tax Income - Income tax = Net Income + Deprec. & Amort. - Capex +/- Working capital investment - Principal payments + Additions of debt = Free Cash Flow to Equity * Present value factor (y1-5) = Present value of Cash Flow + Terminal Value = Equity Value HURON CONSULTING GROUP INC.

11 Cost of Capital - Capital asset pricing model (CAPM) derives the cost of equity - Widely used and accepted - Components of Cost of Equity Ke = Rf + β (ERP) + RPs + α Risk free rate long term US Treasury yield (20+ years) Equity risk premium return on stocks vs. government bonds Beta measure of volatility of subject company relative to the market Size premium measure of returns not captured by beta and organized by size Alpha an additional premium of company specific risk not measured (unsystematic) - Weighted Average Cost of Capital WACC = We*Ke + Wd*Kd (1-Tax) Weights the cost of equity and the after-tax cost of debt based optimal capital structure Alternatives existing capital structure is used in certain circumstances HURON CONSULTING GROUP INC.

12 Net operating losses - Tax rules allow companies to carryforward historical losses to offset current taxable income - NOLs can be valuable - if they can be used - Tax law limits companies benefit from buying loss companies by reducing the amount of NOL that can be used in any given year (IRC 382) - NOLs can be measured in a DCF, or separately If the NOLs are expected to last or be utilized for more than five years, options include extending the forecast, or separately valuing the NOL and add it to the equity value as a non-operating asset HURON CONSULTING GROUP INC.

13 Key Person - Businesses may suffer if a key person leaves the business Private businesses do not always address succession planning - The impact of key person(s) expected to leave the business should be incorporated into the forecasts Loss of revenue / profit Cost to replace - Do courts accept key person discounts? Owner-specific Issues - Owner(s) own real estate and lease to business at off market rates - Owner(s) own business that provides services to business at off market rates - Owner compensation is in excess or below normal market rates HURON CONSULTING GROUP INC.

14 Control / Minority - Value may be greater as a controlling shareholder versus minority Legal venues may treat this concept differently, e.g., tax court vs. Delaware However, economically there should be no difference unless the control party is receiving a disproportionate share of the business (fraud / oppression) - Does penalizing a minority shareholder for lack of control violate fair and equitable statute? HURON CONSULTING GROUP INC.

15 Lack of Marketability / Illiquidity - Private companies do not have access to an efficient market for their equity shares, which theoretically reduces the value - Why? A controller could sell the company, but it would take several months and cost money to have an investment bank or broker involved A minority shareholder cannot force a sale, and would likely have a harder time attempting to sell shares in a private enterprise, which makes the minority shares relatively less marketable - DLOMs are often applied in business divorce cases NY courts Questions arise related to the support for a DLOM Restricted stock studies / IPO studies have wide ranges 10% - 55% Quantitative models such as put option techniques HURON CONSULTING GROUP INC.

16 Lack of Marketability / Illiquidity (continued) - Application of DLOM using a DCF - DCF model for a private company generally gives a controlling, illiquid value - DLOM is applied because the company is not traded on a market Control interest the DLOM typically small may be heavily driven by time and cost to sell company or its equity interests (~<10%) Non-controlling DLOM typically larger HURON CONSULTING GROUP INC.

17 Questions? HURON CONSULTING GROUP INC.

18 THANK YOU