608 Making Key Strategic Decisions
arrive at a proper value of ACME. This methodology determines the earn-
ings of ACME without regard to its debt service. Thus, net income on a debt-
free basis will be higher than the company’s net income, which typically
includes interest expense. The resulting higher value using the debt-free
methodology is not only for equity holders but also debt holders. This com-
bined value of equity and debt is known as the market value of invested capital
(MVIC). Once the value of ACME’s MVIC is determined, then the value of
debt capital is subtracted resulting in the value of ACME’s equity. Victoria
summarizes this concept for Bob. The debt-free methodology results initially
in the combined value of equity and debt (total invested capital) of the busi-
ness. Interest bearing debt is then subtracted to determine the value of the
company’s equity. This methodology is more complicated but it is frequently
necessary to obtain a correct valuation when the business’s debt and equity
blend is not optimal.
ADJUSTMENTS TO EARNINGS
FOR VALUATION PURPOSES
As previously mentioned, financial statements of private companies sometimes
do not ref lect the true profitability. Victoria tells Bob that valuation adjust-
ments to the financial statements are sometimes necessary.
These adjustments fall into two categories. The first type of adjustment is
the elimination of unusual or nonrecurring items. These adjustments eliminate
the effect of past events that are not expected to occur again in the future,
such as a profit center that has been eliminated, legal expenses that were in-
curred to defend an extraordinary lawsuit, or a nonrecurring capital gain from
the sale of an asset. A buyer of the business does not expect these items to
recur in the future and, therefore, they are eliminated. The second type of ad-
justment are the economic adjustments. These include adjustments to expenses
that are not ref lected at their market values, such as the officers’ compensa-
tion being paid at an above-market amount, the company’s rent expense being
paid on a shareholder-owned building at an amount different than market rent,
or the shareholder ’s extra perquisites being expensed by the business. In addi-
tion, some closely held businesses fail to report all of their revenues and these
amounts should be considered in the adjustments. Any expenses related to non-
operating assets (e.g., a ski condominium) would also be eliminated.
After the valuator identifies the adjustments, the reported earnings of
the company are modified to ref lect the economic earnings of the business on
an ongoing basis.
In the case of ACME, Victoria determines that officers’ compensation ac-
tually being paid is in excess of the amount the business would need to pay by re-
placing the family members. Thus, officers’ compensation expense is reduced to
the market level and earnings increased accordingly. In addition, Bob owns some
of the factory locations personally. Victoria also determines that ACME is not