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. 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.

Balance Sheetas 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  
      
-----------------------------------------------------------------------------------------------------------------------------------------------------------   
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

ANSWER:

The Present Value of investment is $2,878.66

This is the worth of business

The company has a lifespan of 3 years.

For such investments, the valuation should be 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