Calculations:

Year 1 Discounted Earnings:

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

Rt = $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

Rt = $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. Rt = $150,000

  2. t = 3

  3. NPV = $150,000 / (1 + .24)3 = $78,674

Year 4 Discounted Earnings:

  1. Rt = $200,000

  2. t = 4

  3. NPV = $200,000 / (1 + .24)4 = $84,595

Year 5 Discounted Earnings:

  1. Rt = $250,000

  2. t = 5

  3. NPV = $250,000 / (1 + .24)5 = $85,277

  4. What is the worth of Charles's business based on the discounted future earnings method?

Total NPV of projected earnings = sum of years 1, 2, 3, 4, 5 = $410,486

Analysis:

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

No, it doesn’t take into account things such as inventory, debts, or increased popularity of Charles’s product/service as time goes by.

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?

ATBV of assets = $675,000 - $500,000 = $175,000.  

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?

ATNW = $800,000 + $175,000 - $475,000 = $500,000

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?

OC = $500,000 x 25% = $125,000 + $50,000 = $175,000

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?

EEP = $410,486 - $175,000 = $235,486

EEP over 5 years = $235,486 x 5 years = $1,177,430

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?

$1,177,430 + $500,000 = $1,677,430