Valuation for Financial Reporting : Fair Value Measurements and ...

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Case Study 1: Determining Goodwill and Other Intangible Assets 69those asset groups would have been using projections that include buyer-specificsynergies.Assumptions were made on the basis of internal company projections as presentedto us. Also forecast are sales growth, product cost, operating expenses, and depreciation.As shown in Exhibit 3.4, principal assumptions utilized in developing theestimates of cash flow are: Sales are projected to increase from $60,000,000 in 2006 to $69,000,000 in 2007,growth of 15%, due to conversions, upgrades, new customers, and price increases.This increase is based largely on estimated growth in one of its key markets of20%. However, the growth rate of the key market is expected to decline after2008. The 10-year compound annual growth rate is 9.96%. Cost of sales (40% in 2007, improving to 39% thereafter) and operating expenses(30% in 2007, improving to 29% thereafter) excluding depreciation (tax basis—separately forecast using IRS MACRS tables) and amortization are also forecast.The prospective financial information is in line with Target Company’s historicalaverages and with management’s expectations at the time of the acquisition, andwere felt to represent the best estimate of these costs. These assumptions are alsoin line with growth rates and margins expected by similar products from similarcompanies in the marketplace. Working capital requirements (debt free) were forecast at 15% of sales, based on theCompany’s historical working capital position, expected needs, and industry benchmarks. Capital expenditures are projected at 1% of net sales. This level of capitalexpenditures is considered adequate to support future levels of sales. Tax amortization of total intangible asset value is based on Sec. 197 of theInternal Revenue Code, which provides for such amortization over a 15-yearperiod. 8 The amortization acts as a tax shield and is added back to cash flow.Annual amortization is $8,433,000 ($126,500,000 15). The reader should notethat this example is an asset purchase. In a stock purchase, the intangible assetsgenerally are not amortizable for tax purposes absent a Sec. 338 election. However,a market participant in a business combination, namely the buyer forpurposes of this discussion, is generally assumed to be an enterprise qualifyingfor Sec. 197 tax treatment and therefore an amortization benefit typically applies. Other Assumptions: Required Rate of Return (discount rate) * 16.00% Residual Growth Rate 5.00% Tax Rate 40.00%* Discussed more fully in the next section, entitled ‘‘Discount Rate’’Assumptions are summarized in Exhibit 3.4, which presents the prospectivefinancial information for a period of ten years.
Exhibit 3.4 Target Company Business Enterprise Analysis — Assumptions as of December 31, 2006 ($000s)Actual Forecast2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 20161. SALESSales Growth Percentage 15.0% 15.0% 12.5% 10.0% 10.0% 7.5% 7.5% 7.5% 7.5% 7.5%Net Sales $60,000 $69,000 $79,350 $89,269 $98,196 $108,015 $116,116 $124,825 $134,187 $144,251 $155,0702. EXPENSESCost of Sales $24,000 $27,600 $30,947 $34,815 $38,296 $42,126 $45,285 $48,682 $52,333 $56,258 $60,477Cost of Sales Percentage 40.0% 40.0% 39.0% 39.0% 39.0% 39.0% 39.0% 39.0% 39.0% 39.0% 39.0%Operating Expenses$18,000 $20,700 $23,012 $25,888 $28,477 $31,324 $33,674 $36,199 $38,914 $41,833 $44,970Operating Expenses Percentage 30.0% 30.0% 29.0% 29.0% 29.0% 29.0% 29.0% 29.0% 29.0% 29.0% 29.0%Depreciation (MACRS) $1,750 $3,097 $5,171 $3,961 $3,120 $2,544 $2,649 $2,762 $2,011 $1,246 $1,551Other Income (Expense), Net Percentage 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%3. CASH FLOWCapital Expenditures $690 $794 $893 $982 $1,080 $1,161 $1,248 $1,342 $1,443 $1,551Capital Expenditures Percentage 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0%Projected Working Capital as Percent of Sales15.0%(1) Projected Working Capital Balance $16,500 $10,350 $11,903 $13,390 $14,729 $16,202 $17,417 $18,724 $20,128 $21,638 $23,260Projected Working Capital Requirement (6,150) 1,553 1,488 1,339 1,473 1,215 1,306 1,404 1,510 1,6234. OTHEREffective Tax Rate 40.0%Required Rate of Return 16.0%Residual Growth Rate 5.0%AMORTIZATION OF INTANGIBLES (TAX)Assumption: Intangibles receive 15-year tax life per Sec. 197Purchase Price $150,000Plus: Liabilities Assumed 59,000Adjusted Purchase Price 209,000Less: Current and Tangible Assets 82,500Amortizable Intangible Assets $126,500Divide: Sec. 197 Amortization Period (Years) 15Annual Amortization of Intangibles, Rounded $8,433Footnote:(1) Balance at December 31, 2006 stated at fair valueNote: Some amounts may not foot due to rounding.# Copyright 2007 by FVG Holdings, LC and Financial Valuation Solutions, LLC. All rights reserved. Used with permission.70
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VALUATION FORFINANCIALREPORTINGFair
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To our familiesnear and faryoung an
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PrefaceThe second edition of this b
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AcknowledgmentsTo Deanna Muraki, th
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Valuation for FinancialReportingFai
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210 IndexBusiness Enterprise Analys
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212 IndexGoodwill (continued )111,
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214 IndexLong-termcapital, 71debt,
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216 IndexSecurities and Exchange Co
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