Foundations of New Venture Finance 277many times the value of the business itself. Examples of this phenomenon include land-
based businesses such as hotels, parking lots, and golf courses.
Land value can be adjusted downward if, for example, a parcel of property has major
environmental problems and incurs cleanup costs. Sometimes neighborhoods and areas
deteriorate for a variety of reasons, and once-valuable property is worth less than its his-
torical cost.
Inventory valuations are sometimes adjusted downward because the parts, supplies,
or stock have become obsolete. A computer store retailer with a stock of machines pro-
duced by out-of-business manufacturers might have to write down the value of the
inventory. A clothing retailer who over-ordered and has a large stock of last year’s fash-
ions is in a similar position. On the other hand, if held long enough, obsolete invento-
ry and out-of-fashion stock can be a source of increased value. Eventually, this merchan-
dise becomes rare, and long-held worthless goods can become a source of revenue.
Replacement Value Replacement value is the amount it would cost to duplicate the
firm’s current physical asset base at today’s prices. When valuation is used for buying or
selling a business, the replacement value of the assets can be a point of reference in nego-
tiations between buyer and seller. Because inflation is the historical trend in developed
Western economies, the replacement cost of an asset is frequently higher than the orig-
inal cost. But not always: Because of technological and productive improvements, the
replacement cost of computers and computing power is an example of a downward
trend in replacement costs.
Liquidation Value. This is the value of the assets if they must be sold under pressure.
Sometimes firms face extreme cash shortages and must liquidate assets to raise cash to
pay their creditors. At other times, courts order liquidation under bankruptcy proceed-
ings. When buyers know that a venture is being forced to raise cash by liquidating, they
can negotiate to pay below-market prices. Often liquidation is done at auction, and the
prices paid might be only 10 to 20 percent of the market value of the assets. The liqui-
dation value of assets represents their absolute floor value. From the investor’s point of
view, the difference between the value of the investment and the liquidation value of the
assets (after priority claims are met) represents the maximum risk or exposure for the
investment.^29
Earnings-Based Valuations
Earnings valuations entail multiplying the earnings of the venture by a price-earnings
ratio or dividing the earnings by some capitalization factor (mathematically equivalent
techniques). There are two inherent problems: The evaluator must determine which
earnings to use for the calculation and which factor is most appropriate for capitaliza-
tion. The resolution of these issues is not trivial. Differences in valuation provide arbi-
trage opportunities that can be practically riskless and very lucrative.^30
Which Earnings? Three possible earnings figures can be used to calculate an earnings
valuation.
Historical earnings are the record of past performance. This is no guarantee of