Question

Assume that today is January 1, 2021. Assume that you are a management consultant. One of your clients comes to you for advice. Your client has the opportunity to buy a small business, Finance Experts’ Fine Food Store. The purchase must be made today. What do you think the business is worth given the projected financial statements? The lease on the building that houses the business will expire on December 31, 2023 at 11:59 p.m. It cannot be renewed. In other words, the business only has a life of 3 years. All assets will be sold on December 31, 2023. Assume that investments of like risk are giving a 10% return every year.

SEE BALANCE SHEET BELOW:

Finance Experts’ Fine Food Store
Balance Sheet
as of December 31

ASSETS                   2020       2021       2022       2023
______________________________________________________________________________

Current Assets
Cash               $   50       150       250       0
Accounts Receivable           100       100       100       0
Inventory               150       250       250       0
---------------------------------------------------------------  
TOTAL           300       500       600       0

Fixed Assets                  
Net Plant and Equipment       2000       1900       1800       0
--------------------------------------------------------------

TOTAL ASSETS               2300       2400       2400       0
      
      

LIABILITIES AND EQUITY
______________________________________________________________________________

Current Liabilities
Accounts payable           100       100       100       0
Notes payable               200       200       200       0
-------------------------------------------------------------
Total               300       300       300       0

  
Long-term debt               0       0       0       0

Stockholders' Equity
Common Stock and Paid-in Surplus   100       100       100       0
Retained Earnings           1900       2000       2000       0
---------------------------------------------------------------
Total Stockholder’s Eq   2000       2100       2100       0

TOTAL LIABILITIES & EQ           2300       2400       2400       0  
      
      

  

Finance Experts’ Fine Food Store
INCOME STATEMENT
as of December 31

                   2021           2022           2023

Net Sales               1,000           2,000           3,000
Cost-of-goods sold           600           1200           1500
Depreciation               100           100           100

                   ------           ------           -----
Earnings before interest and taxes   300           700           1400

Interest                   0           0           0
------           ------           -------
Taxable Income           300           700           1400          

Taxes                   50           200           300
---------           -------           ------

Net Income               250           500           1100

Retained Earnings           100           0           0  

Dividends               150           500           3100

Answer 1

The company has a short lifespan of 3 years. For such investments, we have to do valuation based on the dividend payments and not on Profitability.

Dividend at end of 1st year = 150 = D1

Dividend at end of 2nd year = 500 = D2

Dividend at end of 3rd year = 3100 = D3

Interest rate = 10%

Value of such business = (D1/0.1) + (D2/(0.1)^2) + (D3/(0.1)^3)

= (150/1.1) + (500/(1.1)^2) + (3100/(1.1)^3)

= 136.3636 + 413.2231 + 2329.0759

= 2,878.6626

The Present Value of investment is $2,878.66

This is the worth of business