Business Valuation 609paying market rents to Bob, and she makes the corresponding adjustment to rent
expense. As ref lected in Exhibit 18.2, ACME has elected to be treated as an
S corporation for income tax purposes. Thus, ACME does not pay income taxes
since the income is reported on Bob’s personal income tax return. Bob pays the
income taxes instead of the corporation. Victoria determines that the most likely
buyer of ACME would be a large corporation that would not be able to maintain
ACME’s S corporation tax status. (The most likely buyer is a C corporation that
pays its own taxes.) Therefore, Victoria makes an economic adjustment to
ACME’s pro forma income statement to include income tax expense. The after-
tax income is what a typical buyer expects to earn from purchasing this business.
After these adjustments are made on a pro forma income statement, the result
indicates ACME’s true profitability to a typical buyer of the business.
Once Victoria determines ACME’s actual earnings base, she continues
her appraisal by applying the most appropriate valuation methodologies for the
business.
INCOME APPROACH: DISCOUNTED
CASH FLOW METHOD
As previously discussed, the income approach is based on the concept that the
value of an asset today represents its perceived future benefits discounted to
present value. Victoria uses the discounted cash f low (DCF) methodology in
her valuation. This method forecasts ACME’s cash f lows into the future and
discounts them to their present value. In addition, this method assumes that
ACME will be sold at some point in the future and the owner will receive the
sales proceeds at that time. The estimated future sales price, also know as the
residual value(or terminal value), is also discounted back to present value. The
sum of the present values of future cash f lows and the residual value are added
together to determine the value of ACME. This concept is summarized here:
This methodology can be applied to different forms of earnings—net in-
come, cash f low to equity holders, or debt-free cash f low. Many business valu-
ators prefer to use cash f lows as the earnings base rather than net income
because it is cash f low that is available for shareholder distributions. As previ-
ously discussed, cash f lows may be determined after the inclusion of debt costs
(referred to as equity net cash f low) or on a debt-free basis (referred to as in-
vested capital net cash f low). The formulas for these types of cash f lows are
presented below. The use of either type of cash f low is valid when the appro-
priate discount rate is applied in the DCF model.
Discounted Cash Flow Valuation Method (simplified)
Annual future cash flows, discounted to present value
Future residual value of the company, discounted to present value
Value (today)+
=