Reading: DCF for Startups

We could assume that there is no going concern after the forecast period and that the firm will "simply" be liquidated thereafter. Now clearly, this is not the desired outcome for most entrepreneurs. But in some cases, it might be the most realistic one.

Think, for example, of a chef who opens a new restaurant with the plan to retire in 5 years. Upon retirement, a realistic scenario could be that she sells the equipment and interior design to a successor and thereby liquidates her venture. 

To estimate liquidation values, we can proceed as follows:

• An acceptable first-pass approximation could be to use the forecasted book value of the firm's assets, net of any operating liabilities. This, of course, assumes that  book values roughly correspond to liquidation values.
• If there are good reasons to believe that the liquidation values will be larger than the book values, we should work with the expected liquidation values. In this case, however, we have to keep in mind that the difference between the liquidation value and the book value will constitute a taxable profit.  Consequently, we should measure these liquidation values on an after-tax basis.
• In some cases, liquidation could be very costly because the company is forced to dismantle property, plants, or equipment. Think of a nuclear power plant. Dismantling such a plant will take years and costs hundreds of millions (if not billions) of dollars. It will therefore be safe to assume that the liquidation value of such a plant will be highly negative.

 

Let's look at a simple example to illustrate these considerations. To do so, let's go back to our hypothetical firm from one of the previous sections, where we have valued a company's explicit forecast period using hurdle rates. There, we have estimated the following cash flows and discount factors for the next 7 years and derived a firm value uf roughly 1.9 million:

 

(thousands)	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
Free Cash Flow	-1'000	-1'000	500	1'000	2'000	3'000	5'000
Discount Factor Hurdle Rate	0.769	0.592	0.455	0.379	0.316	0.263	0.239
PV Cash Flow	-769.2	-591.7	227.6	379.3	632.2	790.2	1'197.3

  

Firm value (forecast period) =  1.866 million.

Now let's assume that the firm does not simply cease to exist in year 7. Instead, let's assume that the firm will be liquidated and that the situation will be as follows in year 7:

• Book value of assets: 6 million
• Resale value of assets: 9 million
• Operating liabilities : 2 million
• Cost to dismantle the equipment: 1 million
• Corporate tax rate: 30%

 

With this information, we can estimate the firm's liquidation value in 7 years:

  

Liquidation value₇ =  Resale value of assets - Operating liabilities - Cost to dismantle - Taxes

 

With the exception of the liquidation taxes, we know all the elements to estimate the liquidation value. In our particular case, we can compute the expected tax burden as follows:

 

 Taxes = (Book gain on resale - Dismantling costs) × tax rate 

 

The book gain on the asset sale is 3 million (=Resale value - book value = 9 - 6 = 3 million) and the dismantling costs are 1 million. Consequently, the liquidation will trigger a tax bill of 0.6 million:

 

Taxes = (Book gain on resale - Dismantling costs) × tax rate = (3 - 1) × 0.3 = 0.6 million.

  

Hence, the firm's liquidation value in 7 years is 5.4 million:

 

Liquidation value₇ =  9 - 2 - 1 - 0.6 = 5.4 million.

 

Remember that this is a cash flow in 7 years. We can use the discount factor from the previous table to compute its present value:

 

PV(Liquidation value₇) = 5.4 × 0.239 = 1.29 million.

 

Consequently, the overall value of the firm is 3.16 million.

 

Firm value = PV(Forecast period) + PV(Liquidation value) = 1.87 + 1.29 = 3.16 million.

 

This section has shown how we can compute the present value of a firm's liquidation value at the end of the forecast period. Because liquidation is always a (theoretical) strategic alternative, we should always estimate the rough liquidation value when considering strategic decisions with far-reaching implications. 

Knowing the liquidation value provides the management with an important (often worst-case) benchmark. In a takeover negotiation, for example, the liquidation value sets the minimum takeover price the selling company should theoretically consider.