Business valuations

NET ASSET VALUE (NAV)

What is the correct procedure for calculating the Net Asset Value of a target firm?

a) Non-current assets + current assets – total liabilities = Net Asset Value

b) Make adjustments

Question 1

The owners of a private company wish to dispose of their entire investment in the company. The
company has an issued share capital of $1m of $0·50 nominal value ordinary shares. The owners have
made the following valuations of the company’s assets and liabilities.

Non-current assets (book value) $30m

Current assets $18m
Non-current liabilities $12m
Current liabilities $10m

The net realizable value of the non-current assets exceeds their book value by $4m. The current assets
include $2m of accounts receivable which are thought to be irrecoverable.

Required

What is the minimum price per share which the owners should accept for the company?

Solution

They should not accept less than Net Realizable Value of the assets (or Net Asset Value)

Net Asset Value (NAV) = (30m + 18m+ 4m – 2m – 12m – 10m) = $28m

Price per share = Net Asset Value ÷ number of shares

$28m/2m = $14 per share

Question 2

Musasa plc is a listed company which is seen as a potential target for acquisition by financial analysts.
The value of the company has therefore been a matter of public debate in recent weeks and the
following financial information is available:

Year 2012 2011 2010 2009

Profit after tax ($m) 10.1 9.7 8.9 8.5

Statement of financial position information for 2012

$m $m

Non-current assets 91.0

Current assets

Inventory 3.8

Trade receivables 4.5 8.3

Total assets 99.3

Equity finance
Ordinary shares 20.0
Reserves 47.2 67.2

Non-current liabilities
8% bonds 25.0
Current liabilities 7.1
Total liabilities 99.3

The shares of Musasa plc have a nominal (par) value of 50c per share and a market value of $4·00 per
share. The business sector of Musasa ltd has an average price/earnings ratio of 17 times.

The expected net realisable values of the non-current assets and the inventory are $86·0m and $4·2m,
respectively. In the event of liquidation, only 80% of the trade receivables are expected to be collectible.

Required:
(a) Calculate the value of Musasa plc using the net asset value (liquidation basis)
Solution

Net asset value (liquidation basis)

Current Net Asset value

(NAV) = 91·0m + 8·3m – 7·1m – 25·0m = $67·2 million

Workings for adjustments

Decrease in value of non-current assets on liquidation = 86·0m – 91·0m = $5 million
Increase in value of inventory on liquidation = 4·2m– 3·8m = $0·4 million
Decrease in value of trade receivables = 4·5m x 0·2 = $0·9 million

Adjustment of Net Asset Value

NAV (liquidation basis) = 67·2m – 5m + 0·4m – 0·9m = $61·7 million

Question 3

Recent financial information relating to Chucho enterprise, listed company, is as follows.

$m

Profit after tax (earnings) 66.6

dividends 40.0

Statement of financial position information

$m $m

Non-current assets 595

current assets 125

-------

Total assets 720

-------

Current liabilities 70

Equity
Ordinary shares ($1 nominal) 80

Reserves 410

-------

490

Noncurrent liabilities

6% bank loan 40
8% bonds ($100 nominal) 120

-------

160
-------
720
-------

Financial analysts have forecast that the dividends of Chucho enterprise will grow in the future at a rate
of 4% per year. This is slightly less than the forecast growth rate of the profit after tax (earnings) of the
company, which is 5% per year. The finance director of Chucho enterprise thinks that, considering the
risk associated with expected earnings growth, an earnings yield of 11% per year can be used for
valuation purposes.
Chucho enterprise has a cost of equity of 10% per year and a before tax cost of debt of 7% per year. The
8% bonds will be redeemed at nominal value in six years’ time. Chucho enterprise tax at an annual rate
of 30% per year and the ex-dividend share price of the company is $8·50 per share.

Required:
Calculate the value of Chucho enterprise using the net asset value method

Solution

Net asset valuation

In the absence of adjustments (any information about realisable values and replacement costs) net asset
value is on a book value basis. It is the sum of non-current assets and net current assets, less long-term
debt,
i.e. 595 + 125 – 70 – 160 = $490 million.
FREE CASH FLOW METHODS
There are two ways in which you could be given the information needed to be able to arrive at the free
cash flows.

One way is to be given details of the revenues and expenses in which case the free cash flows is
calculated in exactly the same way as the net present value of cash flow for a project.

The other way is to be given accounting information

If you are given accounting information you use the methods below

a) Free cash flow

b) Free cash flow to equity

Comparison of the 2 formulas

Free Cash flow Free Cash flow to Equity

EBIT X X
Less: Taxation (X) (X)
Add: Depreciation X X
Operating cash flow X X
Less: Amount needed to replace (X) (X)
Non-current assets
Less: Additional non-current (X) (X)
assets expenditure
Less: incremental working (X) (X)
capital expenditure
Free cash flow X X
Less: Debt interest and N/A (x)
repayments
Add: Cash Raised from debt N/A X
issues
Free cash flow to equity N/A X

Question 1

Calculate the free cash flow and the free cash flow to equity given the following information:

Operating profit (EBIT) 720

Depreciation 288

Increase in working capital 120

Cost of new non-current assets 36

Interest paid 12

Loans repaid 48

Tax paid 336

Solution

Free cash flow

EBIT 720
Depreciation 288
Taxation (336)
Operating cash flow 672
Less: replacement of existing non-current assets (288)
Less: cost of new non-current assets (36)
Less: increase in working capital (120)
Free cash flow 288

Free cash flow to equity

EBIT 720
Depreciation 288
Taxation (336)
Operating cash flow 672
Less: replacement of existing non-current assets (288)
Less: cost of new non-current assets (36)
Less: increase in working capital (120)
Free cash flow 228
Less: interest paid (12)
Less: loans repaid (48)
Free cash flow to equity 168
Present value of net cash flows
Applicable when the relevant information

Question 2
Kamba Co, a manufacturer of electrical transformers is interested in acquiring certain fixed
assets of Nunuberry Co, an industrial electronics company. Nunuberry which has tax loss carry
forwards from losses over the past 5 years is interested in selling out but it wishes to sell out
entirely, not just to get rid of certain fixed assets. A condensed balance sheet for Nunuberry
company is as follows
Nunuberry company
Balance sheet
Assets
Cash 2000
Marketable securities 0
Accounts receivables 8000
Inventories 10000
Machine A 10000
Machine B 30000
Machine C 25000
Land & Buildings 115000
Total assets 200000

Liabilities & Stockholders’ Equity

Total Liabilities 80000
Stockholders’ Equity 120000
Total Equity & Liabilities 200000

Kamba Company only needs machine B & C and the land and buildings. However, it has made
some inquiries and has arranged to sell the accounts receivables, inventories and machine A for
$23,000. Because there is $2,000 in cash, Kamba Co will get $25,000 for the excess assets.
Nunuberry wants $100,000 for the entire company which means Kamba will have to the
creditors $80,000 and it’s owner $20,000. The actual outlay required of kamba after liquidation
will be $75,000 {(80+20) – 25} which is required before it can enjoy the use of machine B & C as
well as the land and buildings and the benefit of the tax losses
The after tax cash flows that are expected to result from the new assets and applicable tax
losses are $14,000 per year for the next 5 years and $12,000 per year for the following 5 years.
The cost of capital for Kamba Company is 11%.
Required
Calculate the net present value and determine the desirability of Nunuberry

Solution

Net Present Value of Nunuberry Company’s assets

Years Cashflows Present value factor @ 11% Present value

1–5 $14,000 3.696 $51,744

6 $12,000 0.535 $6,420

7 $12,000 0.482 $5,784

8 $12,000 0.434 $5,208

9 $12,000 0.391 $4,692

10 $12,000 0.352 $4,224

Present value of inflows $78,072

Less: Cash outlay required ($75,000)

Net Present value $3,072

Conclusion

Because the Net Present Value of $3,072 is greater than zero (positive), Kamba’s value should be
increased by acquiring Nunuberry’s assets.
Question 3

A company has prepared a forecast of the future cash flows. The cash flows are expected to be
$4.5M in the first year, $8.1M in the second year, $11.7M in the third year, and thereafter to increase
at the rate of 4% per year.
The company has debt with a market value of $50M, and the relevant cost of capital is 10%.
Calculate the value of the firm and the value of the equity.

Solution

1 2 3 4-∞

Free cash flow 4.5 8.1 11.7

D.F @ 10% 0.909 0.826 0.751
P.V. 4.091 6.691 8.787 152.303

Value of the firm = total P.V. = $171.872M

Value of the equity = 171.872 - 50 = $121.872M

Calculation of 4 - ∞ :
Using the dividend valuation formula (which can be used for any inflating perpetuity)

PV at time 3 = 11.7 x 1.04 / (0.10 - 0.04) = 202.8

Discounting 3 years at 10% gives a PV at time 0: 202.8 x 0.751 = 152.303