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Unit 4: Liquidity Based Valuation

Module 4: Liquidation Value and Calculation of Liquidation Value

Learning Objectives

After studying this module, you should be able to:

1. Identify situations that would require liquidation value.

2. Enumerate the principles to apply in liquidation valuation.
3. Understand liquidation value and its importance to business decision making.
4. Determine and calculate the liquidation value to be used in investment
analysis.

Discussion / Lecture

Overview:

There are instances when different circumstances create doubt that going-
concern assumption is still attainable for businesses. These circumstances may
include economic downturn, bankruptcy, financial distress, unfavorable regulatory
environment, depletion of limited resources (e.g. granite, quarry) as source of
business. As a result, it might not be appropriate to use going-concern techniques
when valuing businesses facing these. An alternative approach is the use of
liquidation value. This module describes liquidation value, its uses for business
valuation and decision making and relevant concepts for calculation of liquidation
value.

LIQUIDATION VALUE

It is a value of a company if it were dissolved and its assets were sold

individually. It represents the net amount that can be gathered if the business is shut
down and its assets are sold in piecemeal. This is known as Net Asset Value.

For example, if a restaurant closes, the assets such as the kitchen equipment,
tables and chairs, and so on can be sold separately. The liquidation value indicates
the present value of the sums that can be obtained through the disposal of the
assets of the firm in the most appropriate way, net of the sums set aside for the
repayment of the debts and for the termination of legal obligations, and net of the tax
charges related to the transaction and the costs of the process of liquidation itself.

Liquidation value is the most conservative valuation approach. Liquidation

value can be used for businesses who are closing, are closed, are in bankruptcy, are
in industries that are in irreversible trouble, or going concern firms that isn’t putting its
assets to good use and may be better off closing down and selling the assets. For

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distressed companies, the liquidation value conveys relevant information as it is

typically the lower bound of the valuation range.
Market vs. Book vs. Liquidation vs. Salvage

Market value typically provides the highest valuation of assets although the measure
could be lower than book value if the value of the assets has decreased due to
market demand rather than business use.

The book value is the value of the asset as listed on the balance sheet. The balance
sheet lists assets at the historical cost, so the value of assets may be higher or lower
than market prices. In an economic environment with rising prices, the book value of
assets is lower than the market value. The liquidation value is the expected value of
the asset once it has been liquidated or sold, presumably at a loss to historical cost.

Finally, the salvage value is the value given to an asset at the end of its useful life; in
other words, this is the scrap value.

Liquidation value is usually lower than book value but greater than salvage value.
The assets continue to have value, but they are sold at a loss because they must be
sold quickly.

SITUATIONS TO CONSIDER LIQUIDATION VALUE

a. Business Failures – low or negative returns are signs of business failures

that is why it is the most common or usual reason why a certain business
closes or liquidates.

Types of Business Failures

i. Insolvency, when a company cannot pay liabilities as they
become due.
ii. Bankruptcy, when liabilities become greater than an asset
balance.

Factors causing Business Failures

iii. Internal Factors – can come from mismanagement, poor
financial evaluation and decisions, failure to execute
strategic plans, inadequate cash flow planning or failure
to manage working capital.
iv. External Factors – are severe economic downturn,
occurrence of natural calamities or pandemic, changing
customer preferences, and adverse governmental
regulations.

b. Corporate/Project End of Life – normally, corporations have stated their

finite life in their Articles of Incorporation. If there will be no extension on the
corporate life, the terminal value may be computed using liquidation value.

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c. Depletion of Scarce Resources – this is most applicable to mining and oil

where availability of scarce resources influences the value of the firm.
happens in this business when the permits or contracts with the government
expire and the operation will no longer be allowed to execute.

GENERAL PRINCIPLES ON LIQUIDATION VALUE

Liquidation value is the most conservative valuation approach among all as it

considers the realizable value of the asset if it is sold now based on current
conditions. This captures any markdowns (or markups) that potential buyers
negotiate to buy the assets.

General concepts considered in liquidation value are as follows:

1. If the liquidation value is above income approach valuation (based on going

concern principle) and liquidation comes into consideration, liquidation value
should be used.
2. If the nature of the business implies limited lifetime (e.g. quarry, gravel, fixed
term company etc.), the terminal value must be based on liquidation. All costs
necessary to close the operations (e.g. plant closure costs, disposal costs,
rehabilitation costs) should also be factored in and deducted to arrive at the
liquidation value.
3. Non-operating assets should be valued by liquidation method as the market
value reduced by costs of sales and taxes. Since they are not part of the
firm’s operating activities, it might be inappropriate to use the same going
concern valuation technique used for business operations. If such result is
higher than net present value of cash flows from operating the asset, the
liquidation value should be used.
4. Liquidation value must be used if the business continuity is dependent on
current management that will not stay.

Liquidation value method can also be used as benchmark in making investment

decisions. When a company is profitable with good industry outlook, the liquidation
will typically be lower than the prevailing market price of the share. Share price often
reflects growth prospects of the company which is a consideration that liquidation
value does not have.

For firms that are experiencing decline or industry is consistently declining, prevailing
share prices might be lower than liquidation value. If this happens, the rational
decision for the business is to permanently close the business and liquidate its
assets.

Some corporate investors tend to look for companies whose shares exhibit this
characteristic. Because liquidation value is higher than market price of share, these
corporate investors buy the shares at prevailing market price and sell the company
at the higher liquidation value. This results in risk-free arbitrage profit for these
corporate investors.

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Uses of Liquidation Value Method

For analysts, liquidation value method can be used for making investment
decisions. If the company is profitable and industry is growing too, the company’s
liquidation value will normally be much lower than the share price, since share price
factors growth aspect which liquidation value does not.

For companies going through a decline phase or if the industry is dying, the
share price may be lower than the liquidation value; this would logically mean that
the company should shut business. To have arbitrage benefits, smart corporate
raiders usually are on a lookout for these kinds of companies. Since the liquidation
value is higher than the market share price, they can buy out the company stock at a
lower price and then sell off the company to make risk-free arbitrage profit.

Limitations of Liquidation Value

Summing up the concept, liquidation value reflects the base price for the
company. However, this may not be a very wise tool to measure a profitable
company as it ignores the future growth potential. Nonetheless, this method can be
considered to evaluate a dying company as a potential takeover and sell down for
profit making.

For companies with proprietorship or partnership model; there may be a high

dependence of profitability on the partners. It may be because of the key partners
(their skill, ability, knowledge, network, etc.) that the business enjoys profitability; and
their liquidation value may not reflect true value unless we value the impact of these
key personnel on business profitability. This leads to a need to calculate the goodwill
impact which is built up by the key personnel to arrive at fair liquidation value. This is
model of valuation is suitable only for such special cases where liquidation is the
motive. However, it is to be noted that this method is far more realistic compared to
the book value method.

Why Do Businesses Go into Liquidation?

 If the business cannot pay the debts as they fall due.
 Business liabilities exceed total assets.
 The business is making losses and you do not think you can turn the situation
around.
 The directors are finding it hard to cope with the stress and pressure of
trading.
 The directors are worried that trading is in decline and you will be liable for
wrongful trading if you carry on.
 The directors would like someone else to deal with the creditors and all their
claims.

Types of Liquidation

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1. Orderly liquidation – assets are sold strategically over an orderly period to attract
and generate the most money for the assets. This process will expose assets for
sale on the open market, with a reasonable time allowed to find a purchaser, both
buyer and seller having knowledge of the users and purposes to which the asset is
adapted and for which it is capable of being used, the seller being compelled to sell
and the buyer being willing, but not compelled to buy.

2. Forced liquidation – is a liquidation process at which the assets are sold as

quickly as possible such as an auction. This happens when creditors have sued the
company or bankruptcy is filed, hence liquidation value decreases as it resulted to
lower prices because of rush sale.

3. Replacement value (or cost approach) - represents the amount it would cost a
potential buyer to duplicate assets at current market prices.

CALCULATING LIQUIDATION VALUE

Liquidation value method is also used by analysts as a benchmark in making

investment decisions. Most analysts and investors are looking for a profitable
companies and as perceived, companies with high profitability have less chances of
liquidating, thereby, liquidation value is lower than its prevailing market price per
share.

On the other hand, when firms are experiencing decline or an industry is

consistently declining, liquidation value will be higher than its market share price
which often leads to total closure or liquidation of the business. Share price often
reflects growth prospects of the company which is a consideration that liquidation
value does not have. Investors of the firms usually buy the shares at prevailing
market price and sell the company at the higher liquidation value. This results in risk-
free arbitrage profit for corporate investors.

Liquidation value considers the present value of the sums that can be
obtained through the disposal of the assets of the firm in the most appropriate way,
net of the sums set aside for the closure costs, repayment of the debts and
settlement of all liabilities, and net of the tax charges related to the transaction and
the costs of the process of liquidation itself. It can also be computed on a per share
basis by dividing total liquidation value by outstanding ordinary shares and be
considered together with other quantitative and qualitative metrics to justify business
decisions to be made.

The liquidation value is calculated as follows:

 Get a copy of the latest annual report. This report can be requested by
contacting the Investor Relations department of the company. Besides, it can
also be downloaded directly from the website of the company.

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 Find the line item assets and liabilities where assets refer to the complete
range of assets owned by a company and liabilities represent the debt taken
on by the company to purchase these assets.
 Determine the expected liquidation value. This is done by subtracting the
company’s liabilities from its assets.

Liquidation value Formula:

Present Value of Sale of Asset Php [Link]

Less: Present Value of Cost for termination and
settlement for Liabilities ( xxx xxx )
Less: Present Value of Tax Charges for the
Transactions and Other Liquidation Costs ( xxx xxx )
Liquidation Value Php [Link]

Calculation for liquidation value at closure date is somewhat like the book value
calculation, except the value assumes a forced or orderly liquidation of assets
instead of book value. Book value should not be used as liquidation value.
Liquidation value can be obtained based on the potential sales price of the assets
being sold instead of relying on the costs recorded in the books. Liquidation value is
far more realistic as compared to the book value method. Even if these assets
generate lower than expected return in the present business, liquidation value should
be based on the potential earning capacity of the individual asset when sold to the
buying party instead of the original capital invested in the assets.

In practice, the liabilities of the business are deducted from the liquidation value of
the assets at closure to determine the liquidation value of the business. The overall
value of a business that uses this method should be lower than going-concern value.

In computing for the present value of a business or property on a liquidation basis,

the estimated net proceeds should be discounted at a rate that reflects the risk
involved back to the date of the original valuation. This is important to ensure that all
assumptions are aligned. Liquidation value can be used as basis for terminal cash
flow (instead of going concern terminal cash flow) in a DCF calculation in order to
compute firm value in case there are years that the firm will still be operational prior
to liquidation.

Special consideration should be emphasized for intangible assets like patents and
internally developed software programs which are often unsaleable. When takeover
occurs, it is usual that goodwill is recognized as part of the transaction. Monetary
equivalent specific for intangible assets cannot be reliably and separately measured.
Instead, intangible assets are offset against shareholder's equity to come up with a
conservative liquidation value.

Estimation of liquidation values will be more complex if assets cannot be easily

identified or separated; hence, individual valuation may be impractical.

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Illustrative Example 1:

Assets
Cash 100,000
Accounts receivable – Net 800,000
Inventories 3,500,000
Prepaid Expense 100,000
Property Plant and Equipment 4,500,000
Total 9,000,000

Liabilities
Notes Payable 1,200,000
Other Liabilities 800,000
Total 2,000,000

To compute for the adjusted value of the assets, the current book values should be
multiplied by the assumed realizable value if they are liquidated. Then the liabilities
should be deducted from the asset adjusted value to arrive at the liquidation value or
net asset value.

Asset Valued
Cash 100%
AR – Net 85%
Inventories 60%
Prepaid Expense 25%
PPE - Net 60%

Asset Book Value Valued at Asset Adjusted Value

Cash 100,000 100% 100,000
AR – Net 800,000 85% 680,000
Inventories 3,500,000 60% 2,100,000
Prepaid Expense 100,000 25% 25,000
PPE - Net 4,500,000 60% 2,700,000
Total assets 9,000,000 5,605,000

Asset Adjusted Value Php 5,605,000

Less: Total Liabilities to be settled 2,000,000
Liquidation Value – Pavement Co. Php 3,605,000
Number of Outstanding Shares / 250,000
Liquidation Value per Share Php 14.42

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Illustrative example 2:

Gourmet Company showed below balances from its accounting records. Gourmet
Company has 500,000 outstanding shares.

Asset
Cash 200,000
Accounts Receivable (A/R) – Net 1,000,000
Inventories 4,000,000
Prepaid Expenses 100,000
Property, Plant and Equipment (PPE) – Net 5,000,000
Total Assets 10,300,000
Liabilities
Notes Payable 1,500,000
Other Liabilities 1,000,000
Total Liabilities 2,500,000

Gourmet Company is undergoing financial distress and management would want

determine the liquidation value to decide on the next steps to take for the business. If
assets will be sold/realized, they will only realize based on below table. To computed
for the adjusted value of the assets, the current book values should be multiplied by
the assumed realizable value if they are liquidated. Next, the liabilities should be
deducted from these to arrive at the liquidation value (or net asset value).

Asset Valued
Cash 100%
AR – Net 85%
Inventories 60%
Prepaid Expense 25%
PPE - Net 60%

Asset Book Value Valued at Asset Adjusted Value

Cash 200,000 100% 200,000
AR – Net 1,000,000 85% 850,000
Inventories 4,000,000 60% 2,400,000
Prepaid Expense 100,000 25% 25,000
PPE - Net 5,000,000 60% 3,000,000
Total assets 10,300,000 6,475,000
Asset Adjusted Value 6,475,000
Less: Total liabilities to be settled 2,500,000

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Liquidation Value – Gourmet Company 3,975,000

Number of Outstanding Shares /500,000
Liquidation Value per Share 7.95

Illustrative Example 3:
Golda Company, which is a company specifically created for a joint venture
agreement to extract gold, will end its corporate life in 3 years. Net Cash Flow
expected during the years it still operate is at Php3,000,000 per year. At the end of
its life, Golda estimates to incur Php10,000,000 for closure and rehabilitation costs
for its mining site and other costs related to the liquidation process. Cost of capital is
set at 10%. Remaining assets by end of the corporate life will be bought by another
company for Php 30,000,000 and remaining debt of Php 4,000,000 will be fully paid
off by then. If the valuation happens now, compute for the value of Golda Company.
Since Golda Company will terminate its life after 3 years, it is more appropriate to
use liquidation value as terminal value input to the DCF model. For the three years
prior to the closure, Golda Company will continue to generate positive Net Cash
Flow and this will form part of its value.
Present Value (PV) of Cash Inflows during Years in Operation

PV of Annual Net Cash Flow = Net Cash Flow x PV Factor of 10%

PV of Net Cash Flow (Year 1) = Php 3,000,000 x 0.9091= Php 2,727,273

PV of Net Cash Flow (Year 2) = Php 3,000,000 x 0.8264 = Php 2,479,339
PV of Net Cash Flow (Year 3) = Php 3,000,000 x 0.7513= Php 2,253,944

PV of Cash Inflows during Years in Operation = PV of NCF (Year 1) + PV of NCF

(Year 2) + PV of NCF (Year 3)

PV of Cash Inflows during Years in Operation = Php 2,727,273 + Php2,479,339+

Php 2,253,944

PV of Cash Inflows during Years in Operation = Php 7,460,556

Since corporate life ends by Year 3, terminal value will be based on the liquidation
value by end of Year 3.

Present Value of Sale of Asset Php 22,539,000

Php 30,000,000 x 0.7513)
Less: Present Value of Cost for termination and
settlement for Liabilities (10,000,000 x 0.7513) (7,513,000)
Less: Present Value of Tax Charges for the
Transactions and Other Liquidation Costs
(Php4,000,000 x 0.7513) (3,005,200)
Liquidation Value Php 12,020,800

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Cash flows during the remaining operating life and liquidation value by end of Tear 3
should be combined to arrive at the value of Golda Company now.

Value of Golda Company = PV of Cash Inflows during Years in Operation +

Liquidation Value

Value of Golda Company = Php 7,460,556 + Php 12,021,037

Value of Golda Company = Php 19,481,593

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