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Prior to completing this and the excess earnings method, we must reconcile how we are going to treat earnings to ensure that we have a single stream of cash to use for reconstructed net income I prefer the weighted average technique as follows:
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(a) 1998 1999 2000 2001 Totals Weighted Average Reconstructed $116,051 167,336 200,718 272,244
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Assigned Weight (1) (2) (3) (4) (10) Divided by:
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Weighted Product $ 116,051 334,672 602,154 1,088,976 $2,141,853 10 $ 214,185
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Eyeballing column (a), we can conclude that the weighted average reconstructed income seems reasonably fair on the surface; the weighted is slightly higher than the completed 2000 but, based on the track record, may be somewhat inappropriate because the restaurant completed $226,970 during the rst nine months of 2001 Furthermore, there is no compelling evidence that this operation could not complete the 2001 forecast of $272,224 At this stage we need to be conservative because the formula will get us up to par in the end However, I have a leg up on you through experience; thus, I m going to arbitrarily start with $250,000, in spite of what I ve calculated as the weighted average cash ow
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The Valuation Exercise Book Value at 6/30/01 Add: Appreciation in Assets Book Value as Adjusted Weight Assigned to Adjusted Book Value Reconstructed Net Income Times Multiplier Total Business Value $203,392 464,089 $667,481 40% $250,000 30
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$ 266,992 $ 750,000 $1,016,992
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Excess Earnings Method
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(This method considers cash ow and value in hard assets, estimates intangible values, and superimposes tax considerations and nancing structures to prove the most-likely equation)
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Reconstructed Cash Flow Less: Comparable Salary (Industry Composite) Less: Contingency Reserve Net Cash Stream to Be Valued Cost of Money Market Value of Tangible Assets Times: Applied Lending Rate Annual Cost of Money Excess of Cost of Earnings Return Net Cash Stream to Be Valued Less: Annual Cost of Money Excess of Cost of Earnings Intangible Business Value Excess of Cost of Earnings Times: Intangible Net Multiplier Assigned Intangible Business Value Add: Tangible Asset Value TOTAL BUSINESS VALUE (Prior to Proof) Financing Rationale Total Investment Less: Down Payment (25%) Balance to Be Financed $ 250,000 80,000 15,000 $ 155,000 $ 699,174 10% $ 69,917 $ 155,000 69,917 $ 85,083 $ 85,083 50
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$ 425,415 699,174 $1,124,589 (Say $1,125,000) $1,125,000 280,000 $ 845,000
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Valuation of a Restaurant
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At this point, we know that we have a serious problem with nancing because total assets less liabilities equal $667,481, and we know that banks want collateral to make loans We also know that banks don t like to nance restaurants In addition, we know that $280,000 cash is a lot of money to expect from buyers in general; thus, as it is, this cash requirement already puts us into a category of nding perhaps no more than 3% to 5% of all buyers who will qualify to purchase this restaurant business It s important to use a good deal of logic at this stage of valuation or you will waste a lot of time coming up with reliable estimates One can set up the nancing scenario any way appropriate to their local conditions, but my guess is that the following would be pretty close The business s ownership of real property is a key feature that makes this particular restaurant more inclined to locate nancing Combined with a Small Business Administration (SBA) loan, other assets may receive more attention, since banks can receive guarantees on substantial portions of their loans Combine the strength of this operation with a buyer experienced at running a restaurant, and much of the stigma banks recount disappears This business is no mom-and-pop venture, or at least it should not be; therefore, we might safely assume that a buyer will be experienced or not be the buyer Also, the size of down payment cuts the chaff from the wheat and, more than likely, leaves us with a purposeful buyer intent on the restaurant business
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Equipment ($127,610) at 50% of Appraised Value Land/Buildings ($557,410) at 70% of Book Value Leasehold Improvements $ 63,805 390,187 0 * $453,992 (For good measure, say $460,000)
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*Leasehold improvements, traditionally painting, new ooring, etc, have a short life in restaurant operations Subsequently, these are often expensed in years completed Structural changes, new equipment, and furniture/ xtures are booked into their balance sheet categories, and thus, re ected there Restaurant equipment holds a relatively low hammer value, due primarily to mass availability of used, functionally good replacements
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Bank (10% 15 years) Amount Annual Principal/Interest Payment Assume: Owner s Financing (8% x 20 years with a review toward balloon at the end of the fth year [not a balloon provision necessarily]) Amount Annual Principal/Interest Payment
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$460,000 59,318
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The Valuation Exercise Testing Estimated Business Value Return: Net Cash Stream to Be Valued Less: Annual Debt Service (P&I) Pretax Cash Flow Add: Principal Reduction Pretax Equity Income Less: Est Dep & Amortization (Let s Assume) Less: Estimated Income Taxes (Let s Assume) Net Operating Income (NOI)
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$155,000 97,961 $ 57,039 26,396* $ 83,435 27,401 6,700 $ 49,334
*Debt service includes an average $26,396 annual principal payment during the rst few years that is traditionally recorded on the balance sheet as a reduction in debt owed This feature recognizes that the owned equity in the business increases by this average amount each year during the early period of the loan Return on Equity: Pretax Equity Income Down Payment $ 83,435 $280,000 298%
Return on Total Investment: Net Operating Income Total Investment $ 49,334 $1,125,000 44%
Although return on total investment is abysmally low in relationship to conventionally expected investment returns, the return on equity is attractively better than most other optional uses of a buyer s cash Cash ow is strong
Basic Salary Net Operating Income Gain of Principal Tax-Sheltered Income (Dep) Effective Income $ 80,000 49,334 26,396 27,401 $183,131*
*There is also the matter of $15,000 annually into the contingency and replacement reserve that would be at the discretion of the owner if not required for emergencies or asset replacements
At this time we have estimated business value but have we estimated the estimated value $280,000 cash down payment plus $460,000, or $740,000 leaves us with a $385,000 shortfall of the allcash or cash-equivalent target that typi es the general de nition of fair market value If we leave the price at $1,125,000, either the buyer has to make up the difference outside this business, or the seller must become exible toward providing $385,000 of seller nancing, or nd another buyer with more cash; or the estimated price must be squeezed to t the conditions of available nancing We have a dilemma or so