Liquidation Value Method

LIQUIDATION VALUE

• Liquidation value refers to the value of a company if it were dissolved and its assets are sold individually. (CFA
Institute)
• Liquidation value represents the net amount that can be gathered if the business is shut down and its assets
are sold piecemeal.
• In some texts, liquidation value is also known as net asset value
• Liquidation value is the base price or the floor price for any firm valuation exercise.
• Liquidation value should not be used to value profitable companies as this approach does not consider growth
prospects of the business.
• Liquidation prices can be difficult to obtain as these are not readily available.
• Instead, liquidation value should be used for dying or losing companies where liquidation is imminent to check
whether profits can still be realized upon sale of the assets owned.

SITUATIONS TO CONSIDER LIQUIDATION VALUE

a. Business Failures – low or negative returns are signs of business failures that is why it is the common or usual
reason why a certain business closes or liquidates.

Types of Business Failures

1. Insolvency, when a company cannot pay liabilities as they become due.
2. Bankruptcy, when liabilities become greater than an asset balance.

Factors causing Business Failures

1. Internal Factors – can come from mismanagement, poor financial evaluation and decisions,
failure to execute strategic plans, inadequate cash flow planning or failure to manage working
capital.
2. External Factors – are severe economic downturn, occurrence of natural calamities or
pandemic, changing customer preferences, and adverse governmental regulations.
b. Corporate/Project End of Life – normally, corporations have stated their finite life in their Articles of
Incorporation. If there will be no extension on the corporate life, the terminal value may be computed using
liquidation value.
c. Depletion of Scarce Resources – this is most applicable to mining and oil where availability of scarce resources
influences the value of the firm. Liquidation happens in this business when the permits or contracts with the
government expire and the operation will no longer be allowed to execute.

GENERAL PRINCIPLES ON LIQUIDATION VALUE

• Liquidation value is the most conservative approach among all as it is considers the realizable value of the
asset if it is sold now based on current conditions. This captures any markdowns (or markups) that potential
buyers negotiate to buy the assets.

General Concepts considered in liquidation value

• If the liquidation value is above income approach valuation (based on going concern principle) and liquidation
comes into consideration, liquidation value should be used.
• If the nature of the business implies limited lifetime (e.g. quarry, gravel, fixed term company etc.), the terminal
value must be based on liquidation. All costs necessary to close the operations (e.g. plant closure costs,
disposal costs, rehabilitation costs) should also be factored in and deducted to arrive at the liquidation value.
 • Non-operating assets should be valued by liquidation method as the market value reduced by costs of sales and
taxes. Since they are not part of the firm’s operating activities, it might be inappropriate to use the same going
concern valuation technique used for business operations. If such result is higher than net present value of cash
flows from operating the asset, the liquidation value should be used.
• Liquidation value must be used if the business continuity is dependent on current management that will not
stay.

TYPES OF LIQUIDATION

1. Orderly liquidation – assets are sold strategically over an orderly period to attract and generate the most
money for the assets
• Liquidation process will expose assets for sale on the open market with a reasonable time allowed to find a
purchaser, both the buyer and seller having knowledge of the uses and purposes to which asset is adapted
and for which it is capable of being used, the seller being compelled to sell and the buyer being willing, but
not compelled, to buy.
2. Forced liquidation – assets are sold as quickly as possible, such as at an auction.

• Liquidation is done immediately especially if creditors have sued or bankruptcy is filed.

• Assets are sold in the market at the soonest time possible which result in lower prices because of the rush
sale.
• Ultimately drives down the liquidation value.

CALCULATING LIQUIDATION VALUE

• Liquidation value considers the present value of the sums that can be obtained through the disposal of the
assets of the firm in the most appropriate way, net of the sums set aside for the closure costs, repayment of
the debts and settlement of all liabilities, and net of the tax charges related to the transaction and the costs of
the process of liquidation itself.
• It can also be computed on a per share basis by dividing total liquidation value by outstanding ordinary shares
and be considered together with other quantitative and qualitative metrics to justify business decisions to be
made

Present Value of Sale of Asset ₱ xxx.xx

Less: Present Value of Cost for termination for Liabilities xxx.xx

Less: Present Value of Tax Charges for the Transactions and other Liquidation Costs xxx.xx

Liquidation Value ₱ xxx.xx

• Calculation for liquidation value at closure date is somewhat like the book value calculation, except the value
assumes a forced or orderly liquidation of assets instead of book value.
• Book value should not be used as liquidation value.
• Liquidation value can be obtained based on the potential sales price of the assets being sold instead of relying
on the costs recorded in the books.
• Liquidation value is far more realistic as compared to the book value method
• Liquidation value should be based on the potential earning capacity of the individual asset when sold to the
buying party instead of the original capital invested.
• The present value of a business or property on a liquidation basis is computed as: the estimated net proceeds
should be discounted at a rate reflects the risk involved back to the date of the original valuation.
• Liquidation value can be used as basis for terminal cash flow in DCF calculation in order to compute firm value
in case there are years that the firm will still be operational prior to liquidation.
 • Special consideration should be emphasized for intangible assets like patents and internally developed
software programs which are often unsaleable.
• When takeovers occurs, it is usual that goodwill is recognized as part of the transactions.
• Monetary equivalent specific for intangible assets cannot be reliably and separately measured.

Pearl Company below balances based on its accounting books records. Pearl company has 250,000 outstanding shares’

Pearl Company December 31, 2020

Assets

Cash 100,000

Accounts Receivable (A/R) - Net 800,000

Inventories 3,500,000

Prepaid Expenses 100,000

Property, Plant and Equipment(PPE) - net 4,500,000

Total Assets 9,000,000

Liabilities

Notes Payable 1,200,000

Other Liabilities 800,000

Total Liabilities 2,000,000

ILLUSTRATION 1

Pearl Company is undergoing financial problems and management would like to assess liquidation value as part
of their strategy formulation. If assets will be sold/realized, they will only realize amount based on the table on the next
slide.
To compute for the adjusted value of the assets, the current book value should be multiplied by the assumed
realizable value if they are liquidated. Next, the liabilities should be deducted from the asset adjusted value to arrive at
the liquidation value (or net asset Value).
ILLUSTRATION 2

Golden Company, which is a company specifically created for a venture agreement to extract gold, will end its
corporate life in 3 years. Net Cash Flow expected during the years it still operate is at P3,000,000 per year. At the end of
its life. Golden estimates to incur P10,000,000 for closure and rehabilitation costs for its mining site and other costs
related to the liquidation process. Cost of capital is set at 10%. Remaining assets by end of the corporate life will be
bought by another company for P30,000,000 and remaining debt of P4,000,000 will be fully paid off by then. If the
valuation happens now, compute for the value of Golden Company.

Since Golden Company will terminate its life after 3 years, it is more appropriate to use liquidation value as
terminal value input to the DCF model. For the three years prior to the closure, Golden Company will continue to
generate positive Net Cash Flow and this will form part of its value.

Present Value (PV) of Cash Inflows during Years in Operation

Formula: PV factor of 1 = (1 +i)-n

PV Of annual Net Cash flow = Net Cash Flow X PV Factor of 10%

PV of Net Cash Flow (year 1) = P3,000,000 x 0.909091 = P2,727,273
PV of Net Cash Flow (year 2) = P3,000,000 x 0.826446 = P2,479,338
PV of Net Cash Flow (year 3) = P3,000,000 x 0.751315 = P2,253,945
PV of Cash inflow during Years in Operation = PV of NCF (Year 1) + PV of NCF (Year 2) + PV of NCF (Year 3)
PV of Cash Inflows during Years in Operation = P2,727,273 + P2,479,338 + P2,253,945
PV of Cash Inflows during Years in Operations = P7,460,556

Since corporate life ends by Year 3, terminal value will be based on the liquidation value by end of Year 3.

Formula: PV factor of 1 = (1 +i)-n

Present Value of Sale Asset (P30,000,000 x 0.751315) ₱ 22,539,450

Less: Present Value of Cost for termination and settlement for Liabilities (P10,000,000 x 7,513,150
0.751315)

Less: Present Value of Tax charges for the Transactions and other Liquidation Costs 3,005,260
(P4,000,000 x .751315)

Liquidation Value ₱ 12,021,040

 Cash flows during the remaining operating life and liquidation value by end of year 3 should be combined to
arrive at the value of Golden Company now.

Value of Golden Company = PV of Cash Inflows during years in Operation + Liquidation Value

Value of Golden Company = P7,460,556 + P12,021,040

Value of Golden company = P19,481,596

ILLUSTRATION 3

Diamond Company’s statement of financial position revealed total assets of P3 million, total liabilities of P1
million, and 100,000 shares of outstanding ordinary shares. Upon checking with potential buyers, the assets of
Diamond can be sold for P1.8 million if sold today. Additional P300,000 will also be incurred to cover liquidation
expenses. How much is the liquidation value of Diamond Company per share?

To compute for the liquidation value in this example, we need to consider how much the company will receive
from the assets if it will sell today. This money will also be used to pay for the remaining liabilities and liquidation
expenses.

Liquidation Value = Sale of Assets upon Liquidation – Payment for Liabilities – Liquidation costs
Liquidation Value = P1,800,000 – P1,000,000 – P300,000
Liquidation Value = P500,000
Liquidation Value per Share = Liquidation Value / Number of Outstanding Ordinary shares
Liquidation Value per share = P500,000 / 100,000
Liquidation Value per share = P5.00 per share