THE SIMPLE CAPITAL METHOD FOR DETERMINING ECONOMIC CAPITAL FOR BUSINESS VALUATION PURPOSES

THE SIMPLE CAPITAL METHOD FOR DETERMINING ECONOMIC CAPITAL FOR BUSINESS VALUATION PURPOSES

In the previous paper, https://bit.ly/3XmZoqr, an examination was offered regarding the purposes of business valuation and a specific focus on the income method of determination. In the present paper, however, it is deemed appropriate to deal with the capital method of determining economic capital, in its differentiation of "simple."


DEFINITION

Capital methods aim at quantifying the amount of capital that an investor would have to employ to establish a company with the same balance sheet composition, assets and liabilities, as the one being bought and sold: in fact, in these methods prospective profitability is not to be considered, but an analytical estimation of assets and liabilities at current replacement values takes place. Specifically:

  • analytical means that it is made separately for each element of the company's assets,
  • at current values indicates that it is directly or indirectly based on the contextual values at the time of valuation,
  • of substitution since it considers the assumption of repurchase or renegotiation of the asset elements under consideration.

THE SIMPLE EQUITY METHOD

For the simple capital method, the value of the company will be equal to the adjusted net worth

W = K,

where

  • K = book equity + increasing equity adjustments - decreasing equity adjustments - deferred tax charges. 

The starting point will therefore be the book equity at the time of the estimate, given by the difference between assets and liabilities; the value is considered on the basis of the financial statements, where a more up-to-date situation is needed the infra-annual financial statements specially prepared for the purpose of the estimate are used; consequently all elements are valued to try to arrive at an adjusted equity, instead of which is accounting in nature.

The adjustment is made to take into account significant events that have occurred since the financial statements were prepared and the current value of non-cash assets in order to bring out any latent capital gains or losses.

The estimation procedure involves the review of accounting items in an analytical manner, thus carried out at each balance sheet item; with regard to individual items, the following may be considered:

  • with regard to shareholders' equity, it should be noted that the reserve for the purchase of treasury shares is considered net of the treasury shares already purchased and that the profit for the year is considered net of both interim dividends already allocated and the share of profit due to the directors;
  • with regard to other items, it is necessary to verify that all individual items in the financial statements meet correct accounting principles with regard to their carrying value and, where necessary, make adjustments.

Typically, adjustments originate from distortions in carrying values due to the influence of tax regulations, budget policies adopted by the company, other alterations.

The step of re-expressing each balance sheet item at current values is central to valuation; the usual methodologies with respect to major balance sheet items are given below:

  • land and buildings, are valued according to 3 main criteria depending on the use of the property, such as
    • the reconstruction cost, for which the property is valued based on the total costs that the company would have to incur to construct a property with similar characteristics and is adjusted for natural physical deterioration,
    • the market value, for which the prices of similar assets are taken into account, so the method arrives at the current value and not the value as new,
    • the income capitalization value, through which the income obtainable from the asset over an interval of time is estimated, based on rents, and then its value is discounted at a risk-free rate;
  • tangible fixed assets, with regard to those assets for which it is possible to identify a secondary market, it is then possible to refer to second-hand market values, e.g. for industrial buildings, machinery, general equipment and motor vehicles; where this is not possible, the value is estimated through the identification of the repurchase or reproduction cost, subsequently abated to take into account the obsolescence of the asset in its current state
  • intangible fixed assets, to be considered only those recorded in the balance sheet whose valuation is susceptible to independent transfer from the business; the method for determining their value is the estimation of the current cost and related abatement to take into account the actual situation in the concrete;
  • equity investments, valued on the basis of the value of the company broken down according to the percentage of the company held, distinguished according to their nature 
    • controlling shareholdings in accordance with Article 2359 of the Civil Code (majority of votes exercisable in the ordinary shareholders' meeting; votes sufficient to exercise a dominant influence in the ordinary shareholders' meeting; dominant influence due to particular contractual constraints) and IAS 27 (adds the power to appoint or remove the majority of the members of the Board of Directors; possession of voting rights, including potential voting rights through share warrants or call options on shares)
    • shareholdings in associated companies (Art. 2359 Civil Code, significant influence in the ordinary shareholders' meeting for 1/5 of the votes, or 1/10 if the company is listed) and minority shareholdings;
  • inventories, the valuation should be carried out separately for each category of inventory, as this item is significant within current assets, especially for industrial and commercial enterprises: therefore, it is essential to value them at current values in order to arrive at a correct balance sheet estimate. Specifically:
    • for commercial companies, the most recent purchase cost or the current price of the asset can be easily used,
    • for industrial companies the distinction is made according to the nature of the assets
      • raw materials (current value criterion or based on the price of the last purchase made), 
      • finished goods (market price, net of costs incurred),
      • semi-finished goods (valued by their cost of production, taking into account the state of progress of the work, i.e., price of the work for the percentage of work done);
  • receivables and payables, of primary importance is the assessment of the appropriateness of the allowance for doubtful accounts recorded in the financial statements: it is appropriate to take into account the accruals related to them. 
    • Receivables cannot always be valued at their nominal value, in some cases discounting is required on the basis of the time of deferral of eventual realization, such as receivables from public bodies that are paid with long time delays, as well as also assets on job orders and in general fixed assets receivables: it is necessary to discount them when no interest accrues on them or their yield is not in line with the market yield; in addition, receivables with a maturity of less than one year or with a short-term maturity are usually excluded from discounting; for receivables included in current assets, the adjustment is made when they are in foreign currency, thus considering the exchange rate on the date of the appraisal.
    • Discounting may also be necessary for financial debts, in cases where negotiated rates differ from market rates: this is done only for medium- to long-term liabilities that generate interest expense, since the rates of short-term liabilities adjust daily to market rates, such as for the bank account; on the other hand, when it is possible, as in the case of listed bonds and other market-traded securities, market prices are used. To estimate the value of all other liability items, including severance pay and all other liabilities of a pension nature, discounting of flows is used, comparing if necessary the value with similar securities: when discounting, the rate must incorporate the risk in a manner consistent with the business;
  • financial assets not held as fixed assets, constitute the firm's excess liquidity usually invested in fixed-income securities, whether listed or unlisted. To proceed with the valuation:
    • if the securities are listed, it is sufficient to refer to the current price at the time of valuation or average prices; 
    • if the security is unlisted, it is assumed that it will be disposed of in the short term, so they are valued based on the present value at current rates of expected cash flows for interest and principal, taking into account any capital losses or gains;
  • provisions for risks and charges, the adequacy should be assessed, also taking into account the risks that can be inferred from the comments set out in the notes to the financial statements.

In any case, with regard to the valuation of capital items, the criteria applied must be consistent with the valuation objective of a going concern.

 

Edited by: Antonio Russo, Chartered Accountant and Statutory Auditor

You can download the article in PDF here

For more information:

antoniorusso@valoreassociati.it

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