Georgia Isaacson and her son Rubin have been thinking about buying a business. After talking to seven entrepreneurs, all of whom have expressed an interest in selling their operations, the Isaacsons have decided to make an offer for a retail clothing store. The store is very well located, and its earnings over the past five years have been excellent. The current owner has told the Isaacsons he will sell for $500,000. The owner arrived at this value by projecting the earnings of the operation for the next seven years and then using a discount factor of 15 percent. The Isaacsons are not sure the retail store is worth $500,000, but they do understand the method the owner used for arriving at this figure. Georgia feels that since the owner has been in business for only seven years, it is unrealistic to discount seven years of future earnings. A five-year estimate would be more realistic, in her opinion. Rubin feels that the discount factor is too low. He believes that 20 to 22 percent would be more realistic.
In addition to these concerns, the Isaacsons feel they would like to make an evaluation of the business using other methods. In particular, they would like to see what the value of the company would be when the adjusted tangible book value method is employed. They also would like to look at the replacement value and liquidation value methods.
"We know what the owner feels his business is worth," Georgia noted to her son. "However, we have to decide for ourselves what we think the operation is worth. From there, we can negotiate a final price. For the moment, I think we have to look at this valuation process from a number of different angles."
1. If the owner reduces the earnings estimates from seven to five years, what effect will this have on the final valuation? If he increases the discount factor from 15 percent to 20 to 22 percent, what effect will this have on the final valuation?
2. How do the replacement value and liquidation value methods work? Why would the Isaacsons want to examine these methods?
3. If the Isaacsons conclude that the business is worth $410,000, what will be the final selling price, assuming a sale is made? Defend your answer.