# Reading: DCF for Startups

### 5. Modeling Continuing Value

#### 5.1. Liquidation value

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 value_{7} = 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 value_{7} = 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 value_{7}) = 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.