Think about the cash flows associated with putting in the bank for five years, assuming you draw out the interest each year and then close the account. Now think about a set of hypothetical cash flows associated with putting the same money in a business, operating for five years, and then selling out. Write an explanation of why the IRR on the business project is like the bankâs interest rate. How are the investments different?
Think about the cash flows associated with putting in the bank for five years, assuming you draw out the interest each year and then close the account. Now think about a set of hypothetical cash flows associated with putting the same money in a business, operating for five years, and then selling out. Write an explanation of why the IRR on the business project is like the bankâs interest rate. How are the investments different?
Related questions
Although the founders of Friendsâ had never even considered selling their business, they were caught completely off guard when a hospital approached them about buying the entire operation. In the surprise call, the hospital president let Betty and Joan know that he would buy them outright now for $400,000, and furthermore, he wanted the founders to stay on with the business. The hospital would provide the founders a guaranteed two-year management contract at $90,000 per year per person, plus 15 percent of the yearly profits during those two years. The hospital president presented this deal to the founders of Friendsâ claiming that the total package was worth approximately $800,000 (assuming that profits grew respectably), which he claimed was the value of the business right now. The resulting conversation among the two partners focused on three critical issues. First, should they even consider selling the business at this point? Second, if they did consider selling, what would be a reasonable price for the business? Third, what were their personal long-term goals, and did this offer get them closer to those goals?
To consider these questions, Betty and Joan had to figure out how much the business was worth. For advice, they approached a friend who had worked in mergers and acquisitions (M&As) as a consultant to manufacturers, and he suggested that the real value of a business was simply the market value of the assets of the firm plus a premium (which he referred to as goodwill), which represented the future value of the firm. He suggested that many M&A deals pay a 20 percent premium above the market value of an established public Âbusiness. Using this calculation, the founders estimated that the business was worth $180,000 ($150,000 in equity capital and equipment plus 20 percent). However, this number did not seem to account for the potential of the business, and in any case, was substantially less than what the hospital had offered.
The founders contacted two members of their board of advisors and asked for their advice. They quickly discounted the friendâs advice regarding M&As as not applicable to a services business. They told the founders to forecast net cash flow for the next five years (five years was chosen as a reasonable return period) and then discount that number back to the present time using a reasonable discount rate for risky newer ventures (say, 20 percent). So, the founders estimated net cash flow for the next five years as follows:
| Year 1 $94,296 | 5-Year Total Earnings $322,159 |
| Year 2 $15,075 | Discount Rate @ 20% 2.488 |
| Year 3 $102,305 | 322,159/2.488â=â$129,485 |
| Year 4 $132,066 | |
| Year 5 $167,009 |
Questions
1. What do you think is a fair value for this firm?
2. Assuming that a fair value can be calculated, should the founders sell the firm at this point? Why or why not?1.
