Page 51 - Bankruptcy and Reorganization Services

2. Discounted future benefits method. In this method the benefit stream (earnings or cash flows) is
projected out over a finite period of time, or explicit forecast period. At the end of the explicit
forecast period, a terminal value is generally calculated that reflects the present value of the ben-
efits to be received after the explicit forecast period. The terminal value is discounted to the val-
uation date and added to the present value of the benefits projected over the explicit forecast pe-
riod. The discount rate used should reflect the riskiness of the projected future benefits.

In general, in order to effectively implement the income approach, the practitioner must first identify
which method within the income approach to employ: (a) the capitalization of future benefits method or
(b) the discounted future benefits method. The choice of the appropriate income approach methodology
is largely dependent upon the expected earnings growth and earnings volatility of the company being
valued and the ability to project an explicit forecast period. If the company is mature and growth is sta-
ble, a single-period capitalization model may be appropriate. If the company has not reached stable
growth or is anticipated to experience some degree of volatility, a discounted future earnings model
tends to be more suitable.

Capitalization of Future Benefits Method fn 10

The capitalization of future benefits method is most applicable when a firm has reached a steady state
and earnings growth is anticipated to remain flat or stable. Generally, the stable firm’s growth rate
should not significantly, if at all, exceed the long-term growth rate of the industry or economy. If the
characteristics of the subject firm being valued are not reflective of the aforementioned assumption, the
capitalization of future benefits method may not be appropriate.

Companies in bankruptcy are rarely in a state of long-term stable earnings growth and are generally not
good candidates for the capitalization of future benefits method. However, where it is not practical or
feasible to estimate future growth or earnings, a single-period capitalization model may serve as a useful
check to other approaches.

The following are the steps associated with this single-period capitalization method:

1. Normalize the current cash flow associated with the business or asset and forecast cash flow one
period into the future.

2. Estimate the constant growth rate of the cash flow.

3. Estimate the cost of capital associated with the cash flows.

4. Adjust the computed value for excess cash, as well as nonoperating assets and liabilities.

5. Adjust the computed value for ownership characteristics such as marketability and control (in
other words, the level of value)

fn 10 The capitalization of future benefits method is also referred to as the single-period capitalization method, the capitalized cash flow
model, the constant growth model, or the Gordon growth model. Capitalization is the process of computing the present value of a sin-
gle-period cash flow expected to continue into perpetuity at a constant growth rate and a constant cost of capital. The capitalization
rate is the denominator used to convert the single-period cash flow to the present value of all of the cash flows to be generated into
perpetuity. The capitalization rate is the cost of capital, or discount rate, less the earnings growth rate.

© 2020 Association of International Certified Professional Accountants 49