Determining value when a sale is a creditor’s best recovery option
For creditors dealing with bankrupt debtors, selling the debtor or its assets is sometimes a more efficient way to realize cash than working through a reorganization plan. Sales through Section 363 of the Bankruptcy Code are attractive to debtors and investors due to the expedited nature of the court process and the ability of a buyer to purchase assets free and clear of any liens and encumbrances. Section 363 sales may discourage some interested parties that do not want to compete in an auction or cannot move quickly. However, the process may encourage buyers who are familiar with an industry, have completed due diligence (or can do so quickly) or are ready to close with limited contingencies. To determine whether a sale or reorganization is the better option, the value of the debtor is critical.
Approaches to Business Valuation
No single formula can be used to determine the value of every business in every situation. Therefore, a number of generally accepted valuation methods have been developed. The right approach in a given situation depends on the purpose of the valuation, type of business being valued, available data and other factors. Following are the three most generally accepted valuation approaches.
Discounted cash flow (DCF) method. This method determines value based on the company’s projected future cash flows and tends to be more appropriate when future financial results are expected to be different from current results. The indicated value is determined by discounting future cash flows or free cash flows (FCFs) to their present worth using a discount rate that reflects both the current market rate of return and the risks inherent to the specific investment.
In its simplest form, the discount rate represents the rate of return an informed investor would expect to receive on an investment in the business, given the degree of risk inherent to that investment. Factors considered in developing the discount rate include the nature of the business and its outlook at the valuation date, the risks involved, and the stability of earnings. The discount rate can be the sum of the risk-free rate and a risk premium. The risk-free rate is the return that an investor could obtain from an investment with no risk to principal recovery, where such return is normally equivalent to the yield to maturity of long-term U.S. Treasury bonds. The risk premium is the additional return received or expected in exchange for the perceived risk of the investment. The riskier that the investment is perceived to be, the higher the risk premium.