Valuation of brand name. When an acquiring firm purchases another firm with established brand names, it will likely allocate a portion of the purchase price to the brand names. Measuring the fair value of a brand name involves estimating the likely net cash flows from the branded product over the expected number of years the brand name will persist and then computing the present value of the expected cash flows using a risk adjusted discount rate. Exhibit 9.9 illustrates one approach to valuing brand names.

1. The first step is to estimate the cash flow that the brand is expected to generate. This illustration uses projected net income from the brand for the next year, although a more precise calculation would adjust net income for changes in receivables and payables to derive expected cash flow.

2. The second step subtracts an amount for the cost of inventory, fixed assets, and other items of physical capital required to manufacture and distribute the branded products. Assume the cost of capital is 12% and that the brand requires $188.1 million of physical capital.

3. The third step subtracts the estimated amount of income taxes. Assume an income tax rate of 37%.

4. The fourth step applies a capitalization factor to compute the present value of the expected cash flows (based on net brand name profit in this illustration). The Appendix at the back of the book discusses the computation of the present value of cash flows, including the present value of perpetuities starting at Example 12. This illustration assumes that the appropriate discount rate is 12% and that the expected cash flows will last in perpetuity. The capitalization factor is 8.33 (= 1/.12), yielding $217.4 million (= $26.1 × 8.33) as the estimated brand value. If the appropriate discount rate is 10%, the capitalization factor is 10 (= 1/.10), and the estimated brand value is $261 million (= $26. 1 × 10). If the brand name was expected to yield problems for a finite number of years, then the calculation involves using a factor for the present value of cash flows for that number of years. Assume, for example, that the brand name is expected to provide benefits for 20 years and that the discount rate is 12%. Table 4 at the back of the book indicates the factor for the present value of an annuity for 20 years at 12% is 7.46944. The estimated value of the brand is therefore $195 million (= $26.1 X 7.46944). These examples indicate that the value of brand names is sensitive to the discount rate and expected period of benefit.

Ross Laboratories sells various formulations of infant baby food around the world under the brand name Similac. In a recent year, worldwide sales less operating expenses were $600 million. Ross Laboratories employed $500 million of physical capital to produce and sell this food Estimate the fair value of the Similac brand assuming the following:

(a) Ross Laboratories Charges 10%, before taxes, for physical capital, pays income taxes at the rate of $40% of pretax income, and uses a capitalization factor of 17.

(b) Ross Laborites charges 20%, before taxes, for physical capital, pays income taxes at the rate of 40% of pretax income, and uses a capitalization factor of 8.

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Illustration of Steps to Estimate the Value of a Brand Name (all dollar amounts in millions) (Problem 9.36) EXHIBIT 9.9 Worldwide Sales of Branded Product for Next Year $312.7 Cost of Goods Sold and Operating Expenses [1] Operating Margin ... [2] Subtract Return Required on Physical Capital Employed: .12 x $188.1 Pretax Profit Generated by Brand Name (248.6) $ 64.1 (22.6) $ 41.5 [3] Subtract Income Taxes at 37% . (15.4) $ 26.1 X 8.33 Net Brand Name Profit...... [4] Multiply by After-Tax Capitalization Factor. Estimated Brand Value. $217.4