Page 52 - Bankruptcy and Reorganization Services

The type of model assumes that cash flow is the measure of earnings being used to value the business or
asset. It is important to note that the estimated cash flow should be the cash flow that is expected one pe-
riod in the future (for instance, the Gordon growth model).

Capitalization of future benefits models may also be appropriate to value individual income-producing
assets of a business if cash flows attributable to the asset can be individually calculated.

In general, the capitalization of future benefits method tends to be highly sensitive to the cost of capital
and constant growth rate assumptions.

The steps involved in this single-period capitalization model are similar to those in the discounted future
benefits method, which are addressed in detail in the following section.

Discounted Future Benefits Method

The discounted future benefits method is commonly employed in valuations where the subject company
being valued is not in a steady growth state or is anticipated to grow or change in a manner that cannot
be reasonably approximated with the results of the capitalization of benefits method. This method sums
up the present value of the benefits generated during the discrete projection period and adds the present
value of a derived terminal value to estimate the valuation of the company’s future benefits.

In bankruptcy engagements, the practitioner is generally retained to critique (accept, modify, or reject)
cash flow projections prepared by management. Typically, the cash flow projections used in the dis-
counted future benefits method are based on a set of assumptions regarding future events. These as-
sumptions often reflect the most likely future scenario for the company. Frequently, alternative projec-
tions that reflect alternative assumptions for the company, such as "worst case" and "best case," are pre-
pared. These projections are conditional projections because they are based on the occurrence of an as-
sumed set of future events. These conditional projections reflect discrete alternative future outcomes.
Each set of projections can be present valued to arrive at the value of the company under the alternative
assumptions (best case, worst case and most likely case). This is common for companies in financial dis-
tress because the range of alternative outcomes can be very different and can include business failure
and liquidation of assets.

An alternative technique that be used to incorporate a wide range of outcomes into the discounted future
benefits method is the expected present value technique. This technique starts with the conditional pro-
jections prepared for the company under each set of alternative assumptions and then weights each set of
projections based on probability. The probability-weighted projections are then combined (summed to-
gether) to produce an expected cash flow projection which is not conditional on any single set of as-
sumptions. The benefit of this technique is that the expected cash flow projection explicitly includes the
risk (probability) of each alternative set of assumptions. The fact that the projection risk is incorporated
into the expected cash flows reduces the required discount rate as compared to the conditional projec-
tions. It should be noted that this technique does not produce certainty-equivalent cash flows, so a dis-
count rate above the risk-free rate is still required. fn 11

fn 11 A more thorough discussion of the expected present value technique is contained in paragraphs 4.27–.28 of the AICPA Account-
ing and Valuation Guide Valuation of Privately-Held Company Equity Securities Issued as Compensation.

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