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XYZ Ice Cream Parlor Limited John Doe could not believe when his partner Samuel Jones told him their business was worth $ 1 0 million.

XYZ Ice Cream Parlor Limited
John Doe could not believe when his partner Samuel Jones told him their business was worth $10 million. He asked, how could a business with sales of less than $1.6 million be worth $10 million. said he simply got a financial formula from a textbook to obtain his valuation.
These two have owned an ice cream parlor for 10 years and the parlor has been extremely successful. However, recently, Jones has spent significantly less time in the business and has begun to show that he is disinterested. Doe asked him about it and Jones noted that he would not mind exiting the business and going his separate way. Doe likes the idea of being the sole proprietor as he would reap all the profits of the business. Thus he asked what the business was worth and Jones told him $10 million. However, would not divulge the means of calculating the valuation. Doe insisted on the formula but eventually contacted his accountant (Sam Klein) to get a second opinion on the valuation of the business. During this meeting, the accountant hinted that he believed that Jones was using the dividend discount model to calculate the value. decided to provide some of the estimates included:
$192,000 was the companies EBIT
G =10% which was the growth rate of EBIT over the past 5 years
R =12%
Klein noted that growth over the past two years had decreased to 2% thus the 5 year average was a bit skewed. Doe also asked Moore if he considered the $80,000 after-tax cost of remodeling, or that most area restaurants last about 15 to 20 years before going out of business and that he would have to assume the outstanding debt of the restaurant. Moore admitted he wasn't sure "the formula has considered all this," and then dryly mentioned that he might insist on dividing the restaurant's liquid assets. Klein also pointed out that both of them have been taking below market salaries of $50,000 each versus $75,000 for experienced managers. Klein then attempted to calm an obviously emotional Doe and soften Moore's firm position by pointing out as tactfully as possible that he is confident the restaurant is worth less than $10 million. Klein continued that a good rule of thumb is to use the fair market value of assets plus a premium of 25% less any debt. However, that rule of thumb is at best only an approximation. It can't be expected to apply to a wide range of situations. Finally, he emphasized that there is no magic number of value for a business.
POSTMORTEM
After they left, Klein talked about this with his assistant, Jane Williams, for nearly an hour. Wiliams said it was a good idea for Klein to highlight that there is no magic number for the value of the business. "This gets them in the frame of mind for bargaining. All we can really do is narrow the discussion to a range of reasonable values. Negotiation and personality are likely to determine the final price." Klein agreed and decided to make estimates under three scenarios. (See Exhibit 2.) There were a number of points that Williams and Klein agreed were common to all three scenarios.
1. An estimate should discount the future yearly after-tax cash flow a buyer can expect to receive.
2. The restaurant's present working capital and equipment situation is adequate.
3. The amount of yearly depreciation will be about equal to the yearly principal repayment on the debt.
4. No cash will be necessary to support any future increases in working capital.
5. Any growth in earnings before taxes (EBT) will be used to purchase or maintain equipment.
NOTE: Assumptions 3,4, and 5 imply that the after-tax cash flow a buyer will receive each year equals the net income or earnings after taxes (EAT) estimate of each scenario.
6. The valuation estimate should consider a competitive wage and the renovation cost.
7. The appropriate required rate is 20 percent.
8. The relevant tax rate is 35 percent.
Exhibit 2 presents the assumptions that are specific to each scenario.
EXHIBIT 1
Current Year Balance Sheet and Income Statement
Cash $93,000 Notes payable $45,000
Accounts receivable 57,000 Accounts payable 69,000
Inventory 48,000 Other current 51,000
Equipment 372,000 Bonds 177,000
Equity 228,000 Total assets $570,000 Total liabilities and equity $570,000
Sales $1,530,000
COGS 675,000
Operating expenses 663,000
EBIT 192,000
Interest 27,000
Earnings Before Taxes $165,000
EXHIBIT 2
Assumptions Specific to Each Scenario
Worst Case Base case Bull Case
EBIT $150,000/yr $165,000/yr $180,000/yr
Life of Business 5 years 10 Years 15 years
QUESTIONS
1. Give as many reasons as you can why Jones initial estimate of the value of the restaurant was inappropriate.

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