The historical cash flows are a good basis from which to project future
cash flows. Cash flows are computed to include the following:
The net profit or loss of the business.
The owner's salary (in excess of an equivalent manager's
Discretionary Benefits paid to the owner (such as automobile
allowance, travel expenses, personal insurance and entertainment).
Interest (unless the buyer will be assuming the interest payment).
Non-Recurring Expenses (such as non-recurring legal fees).
Non-Cash Expenses (such as depreciation and amortization).
Equipment Replacements or Additions. (This figure should be deducted
from the other numbers since it represents an expense the buyer will
incur in generating future cash flows).
future cash flows may be projected out for a number of years, for
many small businesses it is not possible to predict very far into the
future before the projections become meaningless. Even with somewhat
larger and more substantial businesses, it is difficult to project cash
flows for more than 5 years.
Once the future cash flows have been projected, they must be discounted
back to their present value. This is done by selecting a reasonable rate
of return or capitalization rate for the buyer's investment. The
selected rate of return varies substantially from one business to the
next and is largely a function of risk. The lower the risk associated
with an investment in a business, the lower the rate of return that is
required. The rate of return required is usually in the 20-50% range
and, for most businesses, it is in the 30-40% range. The present value
of the future cash flows can then be determined by using a financial
calculator or a set of present value tables that are available in most
book stores. The following example demonstrates how the conversion is
made with a 40% rate of return.
Year Projected Discount Present
Cash Flow Factor *
Year 1 $360 .714
Year 2 $383 .510
Year 3 $397 .364
Year 4 $413 .260
Year 5 $438 .186
* - Based on 40% rate of return. The discount factor declines in each
* * - Present value of the sum of discounted projected cash flows. This
figure is added to the residual value of the business to arrive at the
total value of the business.
One more calculation must now be done – the residual value of the
business. The residual value is the present value of the business's
estimated net worth at the end of the period of projected cash flows (in
this example, at the end of five years). This is calculated by adding
the current net worth of the business and future annual additions to the
net worth. The annual additions are defined as the sum of each year's
after-tax earnings, assuming no dividends are paid to stockholders.
These additions are added to the current net worth, and that total is
discounted to its present value to yield the residual value.
The residual value is added to the present value sum of the projected
future cash flows previously computed to arrive at a price for the
business. An example follows.
After Tax Income
Year 1 $125
Year 2 $131
Year 3 $138
Year 4 $144
Year 5 $152
Total Additions to net worth $690
Current net worth
Total net worth
Residual Value (1600 x.186) $298* * *
*** - Multiplying the total net worth by the discount factor used in the
final year of projected cash flows yields the residual value. Adding the
residual value of $298 to the present value sum of projected cash flows
of $785 yields a value for the business of $1,083.