LIQUIDATION BASED VALUATION For mos ‘4 human cna Panies, the value generated by assets working together and Py concern valu applied to managing those assets makes estimated 90d © cicieieeea greater than liquidation value. However, if there will be business. S that occur which doubts the going-concern ability of a future cas sing going-concem value may not be appropriate anymore as the ‘ash flows will not be realizable anymore. An alternative approach is the use of liquidation value. Liquidation value to the value of a lly. Liquidation shut ie is According to the CFA Institute, liquidation value refers company if it were dissolved and its assets are sold individual 4 represents the net amount that can be gathered if the business is n and its assets are sold piecemeal. In some texts, liquidation valu also known as net asset value. mple, for the case of hotel closes, the assets it owns like beds, chairs, d kitchen equipment can be sold as part of a package or y. These assets are priced based on the value it can fetch if buyers ets separately. If these assets will be sold separately, there is antee that they can generate future cash flows anymore as it once did § used in the hotel. Hence, their value is significantly reduced to its For ex furniture liquidation value. Once a business closes, synergies generated by assets working together or by applying managerial skill to these assets are lost which reduces firm value, In addition, liquidation value may continue to erode based on the time frame available for liquidating assets. For example, perishable inventories should be sold immediately or else it cannot be sold anymore if it gets spoiled, Businesses cannot afford to wait for potential buyers that are willing to pay higher price. The most appropriate choice is to sell it at a discount to recover some money from it instead of throwing it away without recovering an money, Businesses can wait longer period to sell other assets like buildin y machineries unless they are other constraints that will require them fae disposed in a shorter time. 2 Circumstances clearly dictates whether it will be appropriate to use liquidati value or going concern a ina valuation exercise. If a business is Para able growth prospects, these wil ‘able sta VOR il normally show future cash or has su wth flows which will result in firm value that is higher than if the assets are just liquidation. separately like in @VALUATION CONCEPTS AND METHODOLOGIES However, if liquidation value becomes higher compared against going concem value, this may signal that a significant business event transpired which makes the liquidation value more appropriate in valuation exercise, Liquidation value is the base price or the floor price for any firm valuation exercise. Liquidation value should not be used to value profitable or growing 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. A unique callout for liquidation value is if the firm is operating under a proprietorship or a partnership model. In these two forms of organization, profits and cash flows are highly dependent on the skills, knowledge, ability or network of the owner or partners. As & result, liquidation value should consider valuing separately the goodwill attributed to these partner-specific qualities as this may not reflect the true value of the assets which will be sold or transferred. In this scenario where liquidation is the motive, goodwill will reduce liquidation value Situations to Consider Liquidation Value s wherein liquidation value will be more The below list shows circumstance: appropriate in valuation exercises « Business Failures Business failure is the most common reason why businesses close or liquidate, Early symptoms of business fallure are low or negative returns. Companies which consistently report operating losses will eventually impact and reduce firm value. If the firm only ears return at a rate lower than its cost of capital, this might signal business failure. When left unresolved, this may lead to insolvency or even bankruptcy. Insolvency happens when a company cannot pay liabilities as they come due. Insolvent firms have asset balance which is still greater than liabilities but is having liquidity problems as a result of depleted cash. Bankruptcy is the most serious type of business failure as this happens when liabilities become greater than asset balance. As 2 result, shareholders’ equity becomes negative balance. This signifi that the firm cannot settle all its liabilities unless the assets ean sald at a higher price than its book value (which is not often the case).VALUATION CONCEPTS AND METHODOLOGIES Business failures can be driven by different internal factors such as mismanagement, poor financial evaluation and decisions, failure 1° execute strategic plans, inadequate cash flow planning of failure to manage working capital. These external factors that would attribute be business failure may take the form of, but not limited to the following: severe economic down-turn dynamic consumer preferences material adverse governmental action or regulation Occurrence of natural disasters or calamities occurrence of pandemic or general health hazards Liquidation value can be used for businesses which are closing, are closed, are in bankruptcy, are in industries that are in irreversible trouble, or going concern firms that isn’t putting its assets to good use and may be better off closing down and selling the assets. For distressed companies, the liquidation value conveys relevant information as it is typically the lower bound of the valuation range. oo0 20 * Corporate or Project End of Life Most corporations only have finite number of years to operate as stated in their Articles of Incorporation. This is also similar in the case of projects like joint ventures with finite life. Once the date arrives and life is not extended, due process takes place to end the life of the corporation and start the liquidation process. Non-extension of corporate life may stem from collective decision of shareholders to stop the operation and realize value from liquidating the company instead, If corporate end of life is already certain, itis more appropriate to compute terminal value using liquidation value. «Depletion of scarce resources In some industries like mining and oil, availability of scarce resources significantly influences firm value. Oftentimes, these are also industries that are highly regulated by the government. Government n often requires that companies seek approval from the 1 commencement of operations, Once the contract it expires or scarce resource become fully depleted pared to support operation, this might signal d valuation should be based on liquidation regulatiot government prior t with the governmen! and no new site is pre potential liquidation an‘ value |eee METHODOLOGIES General Principles on Liquidation Value approach among all as it Id now based on current ps) that potential buyers Liquidation value is the most conservative valuation considers the realizable value of the asset if it is sol conditions. This captures any markdowns (or marku negotiate to buy the assets. General concepts considered in liquidation value are as follows: me approach valuation (based on If the liquidation value is above inco! 7 10 consideration, going-concern principle) and liquidation comes. int liquidation value should be used. Ifthe nature of the business implies limited lifetime (e.g. a quarry, gravel, fixed-term company etc.), the terminal value must be based on liquidation. All costs necessary to close the operations (8.9. 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 market value is reduced by costs of sale an' part of the firm's operating activities, it might be same going concer valuation technique used for bus| If such result is higher than net present value of ce operating the asset, the liquidation value should be use Liquidation valuation must be used if the business continuity is dependent on current management that will not stay liquidation method as the d taxes. Since they are not inappropriate to use the operations sh-flows from Liquidation value method can also be used as benchmark in making investment decisions. When a company is profitable with good industry outlook, the liquidation will typically be lower than the prevailing market price of the share. Share price often reflects growth prospects of the company which is a consideration that liquidation value does not have. For firms that are experiencing decline or industry is consistently declining prevailing share prices might be lower than liquidation value. If this happens, the rational decision for the business is to permanently close the business and liquidate its assets. Some corporate investors tend to look for com S whose shares exhibit this characteristic. Because liquidation value bettie than market price of share, these corporate investors bu A is higher prevailing market price and sell the company at the higher i aa shares This results in risk-free arbitrage profit for these corporate iWveetors. value EENLr market price per ssets in the any time, if all reported a However, if the company can be readily liquidated share should never be below book value per share ! balance sheet is accurate. Types of Liquidation occur is important because it will ion of the property, including in (lawyers, accountants, hese necessary expenses Determining the type of liquidation that will affect the costs connected with liquidati commissions for those facilitating the liquidatio auditors) and taxes at the end of the transaction. T! affect the final value of the business. period to attract and generate be an orderly liquidation. This le on the open market, with a er and seller having tis adapted and for elled to sell and the Assets are sold strategically over an orderly the most money for the assets is known to liquidation process will expose assets for sal reasonable time allowed to find a purchaser, both buy knowledge of the uses and purposes to which the asset which it is capable of being used, the seller being comp yer being willing, but not compelled, to buy. at which the asset or assets are sold as quickly as This is known as forced liquidation. editors have sued or a he soonest time possible le. This ultimately drives as at an auctio y especially if cre 1, Assets are sold in the market att! er prices because of the rush sal jone immediat iquidation value Calculating Liquidation Value ders the present value of the sums that can be h the disposal (i. sale) of the assets of the firm in the most * of the sums set aside for the closure costs, repayment ail liabilities, and net of the tax charges ‘osts of the process of liquidation itself. The liquidation value consi obtained throug appropriate way, ne of the debts and sett! related to the transaction and the ¢ her computed on a per share basis by dividing tanding ordinary shares. Liquidation value per ‘er with other quantitative (@.9. current trics to justify business jement of ion value can be furtl by outst dered togeth DCF) and qualitative me! Liquidati total liquidation value share should be consi share price, going concern decisions to be madeVALUATION CONCEPTS AND METHODOLOGIES Present Value of Sale of Asset Php Xxxx.xx Less: Present Value of Cost for termination and settlement for Liabilities Less: Present Value of Tax Charges for the Transactions and Other Liquidation Costs (__XXXXX) Liquidation Value PIP XXx.xX ( 00%.x) 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. Even if these assets generate lower than expected return in the present business, 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 in the assets. In practice, the liabilities of the business are deducted from the liquidation value of the assets at closure to determine the liquidat V of the business. The overall value of a business that uses this method should be lower than going-concern value In computing for the present value of a business or property on a liquidation basis, the estimated net proceeds should be discounted at a rate that reflects the risk involved back to the date of the original valuation. This is important to ensure that all assumptions are aligned. Liquidation value can be used as basis for terminal cash flow (instead of going concern terminal cash flow) in a 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 takeover occurs, it is usual that goodwill is recognized as part of the transaction. Monetary equivalent specific for intangible assets cannot be reliably and separately measured. Instead, intangible assets are offset against shareholder's equity to come up with a conservative liquidation value. Estimation of liquidation values will be more complex if easily identified or separated; hence, individual Valuation may connote impractical. lay beVALUATION CONCEPTS ANI Illustrative Example 1 unting books Pavement Company reported below balances based on its acco! records. Pavement Company has 250,000 outstanding shares. Pavement Company December 31, 2019 (in ‘000 Philippine Pesos) Cash Assets 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 4,200,000 Other Liabilitie 00,000 2,000,000 Total Liabilities Pavement 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 below table To computed for the adjusted value of the assets, the current book values 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). Valued Asset Book Valued _, Asset Asset At In Php Value At Adjusted ee V Cash 100% | | Cash 100,000 100% eS AR-Net 85% | |AR-Net 800,000 85% nooead inventories 60% | | Inventories 3,500:000 60% 80,000 Prepaid 25% Prepaid 1001000 25% 2,100,000 Expenses Expenses 25,000 PPE - Net 60% PPE -— 60% 2.70 10,000VALUATION CONCEPTS AND Praised a Total 9,000,000 5,608,000) | Gee Asset Adjusted Value Php sete Less: Total liabilities to be settled 2,000,000 _ Liquidation Value - Pavement Company Php s,5805,000 Number of Outstanding Shares _ 250,000 Liquidation Value per Share Php 14.42 Illustrative Example 2 Golda Company, which is a company specifically created for a joint 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 Php3,000,000 per year. At the end of its life, Golda estimates to incur Php10,000,000 for closure and rehabilitation costs for its mining site and other costs rel 9 the liquidation process. Cost of capital is set at 10%, Remaining asse end of the corporate life will be bought by another cor ny for Php ,000,000 and remaining debt of Php 4,000,000 will be fully paid y then. If the valuation happens now, compute for the value of G ars, it is more DCF model continue to Since Golda Company will terminal appropriate to use liquidation value as termin t For the three years prior to the closure, Golda Company w generate positive Net Cash Flow and this will form part of i Present Value (PV) of Cash Inflows during Years in Operation PV of Annual Net Cash Flow = Net Cash Flow x PV Factor of 10% ‘act PV of Net Cash Flow (Year 1) = Php 3,000,000 x 0.9091 = Phi ,000, 9091 = 2,727,273 PV of Net Cash Flow (Year 2) = Php 3,000,000 x 0.8264 Pho 2,479,339 PV of Net Cash Flow (Year 3) = Php 3,000,000 x 0.7513 = Php 2,253,944 PV of Cash Inflows during Years in Operation = PV NCF (Year 2) + PV of NCF (Year 3) ca cia aa PV of Cash Inflows during Years in Operation = Php2,479,339 + Php 2,253,944 premeeite ie tatalees PV of Cash Inflows during Years in Operation = Php 7,460,556Since corporate life 1 liquidation value by end of Year 3, nds by Year 3, terminal value will be based on the Present Value of Sale of Asset Php 22,539,000 (Php30,000,000 x 0.7513) Less: Present Value of Cost for termination and settlement for Liabilities (Php 10,000,000 x 0.7513) Present Value of Tax Charges for the Transactions and Other Liquidation Costs (Php4,000,000 x 0.7513) 3,005,200 Liquidation Value Php 12,020,800 —7.12,020,800_ 7,513,000 Less: Cash flows during the remaining operatin, Year 3 should be com! 9 life and liquidation value by end of bined to arrive at th Ne value of Golda Company now. Value of Golda Company = py Liquidation Value Value of Golda Comp: Value of Golda Com of Cash Inflows during Years in Operation + any = Php 7,460,556 + Php 12,021,037 pany = Php 19,481,593 Illustrative Example 3 Droid Company's balance sheet reve liabilities of Php1 million, and 100 Upon checking with potential buye Php1.8 million if sold tod cover liquidation expen: Company per share? aled total as: 0 shares of o: s, the a y. Additional Phy Ss. Hoy ts of Php3 million, total anding ordinary shares S of Droid can be sold for 000 will also be incurred to much is the liquidation value of Droid 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 Asse — Liquidation Costs Liquidation Value = Php 1,800,000 ~ Php 1,000,000 — Php 300,000 Liquidation Value = Php500,000 {S upon Liquidation — Payment for Liabilities Liquidation Value per Share = Liquidation Value / Number of Outstanding Ordinary Shares Liquidation Value per Share = Php 500,000 / 100. Liquidation Value per Share = Php 5.00 per s' ,000 shares hareTOT reese Mairead yy if it were dissolved and its f a compan’ Liquidation value refers to the value of Pp nits the net amount that can assets sold individually, Liquidation value represe! be gathered if the business is shut down and its assets are te aie Liquidation value is considered as the minimum or floor value for any firm valuation exercise, Liquidation value is the most conservative valuation approach among all as it considers the realizable value of the asset ifit is sold now based on current conditions. Liquidation value is appropriate in the cases of business failures, end of life of the business or project and depletion of scarce resources: Liquidation value should be used: «When liquidation value is greater than going concern value « When business has finite life * To value non-operating assets © If business continuity is dependent on current management who will not stay The liquidation value considers the present value of the sums that can be obtained through the disposal (i.e. sale) of the assets of the firm in the most appropriate way, net of the sums set aside for the closure payment of the debts and settlement of all liabilities, and net of the tax ct to the transaction and the costs of the process of liquidation i For better appreciation of shareholders, liquidation value N the number of outstanding ordinary shares to arrive at the liquidation value per share. Liquidation value per share should typically price per share in times of profitable operations. If liq | exceeds market price, this might signal significant downturn fo low market @ per share he business,