Page 42 - FINAL CFA II SLIDES JUNE 2019 DAY 8

LOS 33.e: Explain cash flow estimation issues READING 33: PRIVATE COMPANYVALUATION
related to private companies and adjustments
required to estimate normalized earnings.
MODULE 33.2: INCOME-BASED VALUATION
Consider treating owned real estate separately: Why?

Usually has different risk characteristics and growth prospects than firm operations.
• Remove any income and expenses from real estate on the income statement, and include market-estimated rental!
• If leased from a related party, the lease rate should be adjusted to a market rate.
• The value of real estate is therefore treated as a nonoperating asset

Other adjustments include:
• Adjustments for differences in depreciation and inventory methods;
• Some private firm AFS are reviewed rather than audited; some may be only compiled (i.e., no auditor opinion is provided

EXAMPLE: Tim Groh is the principal shareholder, CEO, and founder of AG with the following details:
1. Groh’s compensation of $2,500,000 is included in the firm’s selling, general, and administrative (SG&A) expenses.
2. AG’s leases a warehouse for $100,000 a year from one of its largest suppliers.
3. AG owns a vacant office building with reported SG&A expenses of $150,000 and $25,000 of depreciation expense.
4. AG’s capital structure has too little leverage.

An analyst determines that a market-based compensation figure for Groh’s position is $1,000,000 and that the office building is not needed
for core operations. The market lease rate of the warehouse is $130,000.

Based on 1–4 above, what adjustments do we need to estimate normalized earnings (earnings), assuming the firm will be acquired?

1. Cr./Reduce. Compensation/Salaries (Reduce SG&A expenses) by $1,500,000: Groh is overpaid!

2. Dr./Increase Warehouse Rental (Increase SG&A expenses) by $30,000: Market rate is $130,000 but supplier helping at $100,000!

3. Credit/Reduce Depreciation by $25,000 and Cr./Reduce SG&A expenses by %150,000: Office building is non-core!

4. As capital structure is non-optimal, drop interest expense from the calculation of operating income under the assumption that the capital
structure will be changed if the firm is acquired (Interest expense will be added back when calculating FCFF –alternative method).