You Are The Owner Of A Small Business And You Want

you Are The Owner Of A Small Business And You Wan

You are the owner of a small business and you want to sell your business, and you are deciding what price you should ask for the company. The first three years the company will have cash inflows of $20,000 at the end of each year. The next 5 years the cash flows will grow at 5% per year. In year 8, the company will sell some of its assets at the beginning of year 8 for $10,000 cash. The owner’s cost of money is 10%. How much should the owner ask for the business?

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The valuation of a small business involves estimating its current worth by analyzing future cash flows and determining an appropriate discount rate. In this scenario, the owner needs to compute the asking price based on projected cash inflows over a specified period, along with asset sale proceeds and considering the cost of capital to reflect the time value of money.

Initially, the company generates annual cash inflows of $20,000 for the first three years. These cash flows are relatively stable, and their present value can be calculated using discounted cash flow (DCF) analysis. The discount rate, given as 10%, accounts for the owner's required rate of return, reflecting the opportunity cost of capital. For the first three years, the present value (PV) of these cash flows is computed as follows:

PV of first 3 years' cash flows = $20,000 × [(1 - (1 + r)^-n) / r], where r = 10% and n = 3. Plugging in the numbers:

PV = $20,000 × [(1 - (1 + 0.10)^-3) / 0.10] ≈ $20,000 × 2.4869 ≈ $49,738

Next, for years 4 through 8, the cash flows grow at 5% annually. To determine these, we first project the cash flows for each year, starting from year 4:

  • Year 4: $20,000 × 1.05 = $21,000
  • Year 5: $21,000 × 1.05 = $22,050
  • Year 6: $22,050 × 1.05 ≈ $23,152.50
  • Year 7: $23,152.50 × 1.05 ≈ $24,310.125
  • Year 8: $24,310.125 × 1.05 ≈ $25,525.631
Alternatively, since each year's cash flow grows at a constant rate, the present value of these cash flows can be calculated as a growing annuity, or more straightforwardly, by discounting each year's cash flow separately at the discount rate and summing their present values.
Specifically, the present value of these cash flows from year 4 to year 8 is:

PV of cash flows from year 4 to 8 = sum over t=4 to 8 of {Cash flow in year t} / (1 + r)^t

Calculating each:

  • Year 4: $21,000 / (1.10)^4 ≈ $14,350
  • Year 5: $22,050 / (1.10)^5 ≈ $13,650
  • Year 6: $23,152.50 / (1.10)^6 ≈ $12,955
  • Year 7: $24,310.125 / (1.10)^7 ≈ $12,274
  • Year 8: $25,525.631 / (1.10)^8 ≈ $11,607

Summing these discounted cash flows gives the total present value for years 4 to 8: ≈ $64,836.

Furthermore, at the beginning of year 8, the company will sell some assets for $10,000 cash. The PV of this sale, discounted back to the present (year 0), is calculated as:

$10,000 / (1.10)^8 ≈ $4,299

Adding this asset sale value to the PV of the cash flows during years 4-8, the total valuation is:

Value during years 4-8: ≈ $64,836

Total valuation = PV of years 1-3 + PV of years 4-8 + PV of asset sale

= $49,738 + $64,836 + $4,299 ≈ $118,873

Therefore, the owner should ask approximately $118,873 for the business, considering the projected cash flows, asset sale, and the 10% discount rate. This valuation provides a comprehensive estimate of the company's worth based on expected cash flows and asset liquidation, aligning with standard financial valuation principles.

References

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