Chapter 3



Chapter 7 An Introduction to Financial Accounting and Valuation

Outline

Chapter 7 An Introduction Financial Accounting and Valuation

A. Financial Accounting Demystified

• accounting principles 

o Generally Accepted Accounting Principles 

o assumptions:  separate entity, continuity, constant units of measure, time periods

o principles - cost, consistency, full disclosure, materiality, conservatism

• financial statements 

1. Balance Sheet 

▪ fundamental equation:  A = L - Eq  

▪ snapshot of nature of assets and claims against them

2. Income Statement

▪ revenues minus expenses

▪ movie picture of how making money, change in balance sheets over time

3. Statement of cash flows 

▪ operating, investing and financing activities

▪ movement of cash indicates value of firm

• accounting issues 

o accrual versus cash accounting 

o cost of inventory 

▪ cost of goods sold = opening inventory + purchases - value of closing inventory 

▪ average cost / FIFO (higher profits) / LIFO (lower profits)

o depreciation 

▪ reflect use of asset - Matching Principle

▪ goodwill - account for as asset if acquired / new GAAP does not require depreciation

B. Valuing the Enterprise

1. the old man and the tree: a parable of valuation

o Salvage value

o Current production

o Future (undiscounted) production

o Market price

o Book value

o Discounted future earnings 

2. some additional thoughts on valuing businesses

o Methods of valuation 

▪ Discounted Cash Flow

▪ Comparable approach.

Class Notes

|A. Financial Accounting Demystified |

|What is "profit" |Accounting answer: |

|Exco buys building for $100,000.  It has monthly upkeep|Income Statement |

|of $2,000, but finds a tenant who pays monthly rent of | |

|$2,000.  At year's end, Exco gets and refuses offer to |Revenues |

|sell building for $105,000.  Any profit? |$24,000 |

| | |

| |Expenses |

| | |

| | |

| |    Upkeep |

| |$24,000 |

| | |

| |    Depreciation |

| |$  5,000 |

| | |

| |Net income |

| |($5,000) |

| | |

| |Economic answer:  |

| |Change in value  |

| | |

| |Net cash flows  |

| |$0 |

| | |

| |Appreciation |

| |$5,000 |

| | |

| |Cost of money - inflation |

| |($3,000) |

| | |

| |Net change in value |

| |$2,000 |

| | |

|Cookie Business |Balance Sheet (at day's end) |

|  | |

|You go into business, buying and selling items from your cookie |Assets |

|jar.  To keep track of your money-making efforts you kept a journal:|  |

|  | |

|  |  Cash |

|Cookie jar - accounting entries |$9 |

| | |

|  |  Pens |

|Assets = |$2 |

|Liabilities | |

|+ Equity |  Scissors |

| |$5 |

|Put $12 in cookie jar | |

|$12 | |

|$0 |Liabilities |

|$12 |  |

| | |

|Borrow $10 from Mom (put in IOU)  |  IOU - Mom |

|$22 |$10 |

|$10 | |

|$12 |  Scissors |

| |$0 |

|Buy two $2 felt-tip pens  | |

|$22 |Total liab |

|$10 |$10 |

|$12 | |

| | |

|Buy $5 scissors on credit |Equity |

|$27 |  |

|$15 | |

|$12 |  Mine |

| |$6 |

|Sell one of the felt-tip pens for $3 | |

|$28 |Total equity |

|$15 |$6 |

|$13 | |

| | |

|Repay the $5 scissors debt | |

|$23 |Total assets |

|$10 |$16 |

|$13 | |

| | |

|Pay $2 rent for using the jar |Total L + Eq |

|$21 |$16 |

|$10 | |

|$11 | |

| | |

|Take our $5 to go to movies |  |

|$16 |Income Statement (day 1) |

|$10 | |

|$6 |Net sales  |

| |$3 |

|At the end of the first day, you want to know where you stand.  What| |

|are your current assets and liabilities, and how much in the cookie |Operating expenses |

|jar is yours?  Did you make any money today?   And where did the |  |

|money go?  | |

|In reviewing the financial statements: |  Cost of goods sold |

|Balance sheet:  |$2 |

|how is the rental arrangement for the cookie jar accounted for on | |

|the balance sheet?   |  Rent (jar) |

|what would be the effect on the balance sheet if you bought the |$2 |

|cookie jar?    | |

|what if you sold some of the pens on credit - how would that affect |  Selling/adm expenses |

|the balance sheet?    |$0 |

|what is the value of your inventory - the pens and scissors?  what | |

|if their price went up?  |  Total operating expenses |

|if you had the only cookie jar in the neighborhood, wouldn't this |$4 |

|have value?   | |

|suppose you sell a pen to your sister who writes on the kitchen wall|Operating income |

|and you might be shut down, how account?   |($1) |

|Income statement  | |

|was the payment you made to yourself, a dividend or compensation for|   Interest expense (Mom/scissors) |

|services?  |$0 |

|should you amortize the rental payment, which only happens once a | |

|month?  |   Income taxes |

|suppose you sold a pen on credit, is that a sale?    |$0 |

|does the the net income of minus $1 indicate that this is a | |

|money-losing business?  |Net income  |

|  |($1) |

|You also contemplate whether your business has any value. Are you | |

|making money? Should you continue the business tomorrow? Could you |Dividends paid |

|sell it to your sister?  For how much? Do the financial statements |$5 |

|give an answer? What is "net book value"?  | |

| | |

| | |

| |  |

| |Cash Flow Statement (day 1) |

| | |

| |Operating Activities |

| |  |

| | |

| |Net income |

| |($1) |

| | |

| |Dec (Inc)) inventories |

| |($7) |

| | |

| |Total operating activities  |

| |($8) |

| | |

| |  |

| | |

| | |

| |Investing activities |

| |-- |

| | |

| |  |

| |  |

| | |

| |Financing activities |

| |  |

| | |

| |Inc (Dec) short-term debt  |

| |$0 |

| | |

| |Inc (Dec) long-term debt  |

| |$10 |

| | |

| |Investment by owner |

| |$12 |

| | |

| |Distribution to owner |

| |($5) |

| | |

| |Total financing activities |

| |$17 |

| | |

| |  |

| |  |

| | |

| |Inc (Dec) cash position |

| |$9 |

| | |

| | |

| | |

| |  |

| |  |

| |  |

|Precision Tools, Inc. |

|Balance Sheet  |

|(as of Dec 31) |

|Assets |

|   2005 |

|   2004 |

| |

|Current assets |

|  |

|  |

| |

|   Cash |

|   150,000 |

|   275,000 |

| |

|   Accounts receivable |

|1,380,000 |

|1,145,000 |

| |

|    Inventories |

|1,310,000 |

|1,105,000 |

| |

|   Prepaid expenses |

|     40,000 |

|     35,000 |

| |

|Total current assets |

|2,880,000 |

|2,560,000 |

| |

|  |

|  |

|  |

| |

|Fixed assets |

|  |

|  |

| |

|   Land |

|   775,000 |

|   775,000 |

| |

|   Buildings  |

|2,000,000 |

|2,000,000 |

| |

|   Machinery |

|1,000,000 |

|   935,000 |

| |

|   Office equipment |

|   225,000 |

|   205,000 |

| |

|Total PP&E |

|4,000,000 |

|3,915,000 |

| |

|   Less accumulated depreciation |

|1,620,000 |

|1,370,000 |

| |

|Net fixed assets |

|2,380,000 |

|2,545,000 |

| |

|  |

|  |

|  |

| |

|Total assets |

|5,260,000 |

|5,105,000 |

| |

| |

|Liabilities |

|2005 |

|2004 |

| |

|Current liabilities |

|  |

|  |

| |

|   Accounts payable  |

|  900,000 |

|825,000 |

| |

|   Notes payable |

|  600,000 |

|570,000 |

| |

|   Accrued expenses payable |

|  250,000 |

|   235,000 |

| |

|   Total current liabilities |

|1,750,000 |

|1,630,000 |

| |

|Long term liabilities |

|  |

|  |

| |

|   Notes payable (12.5% 2008) |

|2,000,000 |

|2,000,000 |

| |

|   Notes payable (11% 2000) |

|       ---  |

|   355,000 |

| |

|Total Liabilities |

|3,750,000 |

|3,985,000 |

| |

|  |

|  |

|  |

| |

|Stockholders' Equity |

|  |

|  |

| |

|Common stock (1000 sh) |

|  |

|  |

| |

|   Paid-in capital |

|   200,000 |

|200,000 |

| |

|   Retained earnings |

|1,310,000 |

|   920,000 |

| |

|Total equity |

|1,510,000 |

|1,120,000 |

| |

|  |

|  |

|  |

| |

|Total Liabilities and Equity |

|5,260,000 |

|5,105,000 |

| |

| |

| |

| |

|Analyze the balance sheet: |

|Do accounts receivable reflect the possibility of delinquent customers?  Is there an allowance for doubtful accounts?  How might this be |

|computed?  |

|Does it make any difference that the company's land, a tract in an industrial park, was purchased 15 years ago and is actually worth far |

|more?  A comparable tract recently sold for $3.5 million.   |

|What would be the effect of re-valuing the land and buildings to reflect current market value?  What accounts would this affect on the |

|balance sheet?   |

|What is the company's financial strength for each of the two years--  |

|Working capital (current assets minus current liabilities) =   |

|FY2002:  2,880,000 - 1,750,000 = $1,130,000 / FY2001:  2,560,000 - 1,630,000 = $930,000  |

|What does this tell you?   |

|Current ratio (current assets divided by current liabilities) =   |

|FY2002:  2880/1750 = 1.65  / FY2001:  2560/1630 = 1.57  |

|What does this tell you?  |

|Liquidity ratio (quick assets [cash, mkt securities, accts rec'ble] divided by current liabilities) =  |

|FY2002: 1530/1750 = 0.87 / FY2001: 1420/1630  = 0.87  |

|What does this tell you?  |

|Debt-equity ratio (long-term debt divided by equity)  |

|FY2002: 2000/1510 = 1.32 / FY2001:  2335/1120 = 2.08  |

|What does this tell creditors?   |

|Book value (Assets minus Liaiblities)   |

|FY2002: $1,510,000 / FY2001: $1,120,000  |

|What does this tell owners?   |

|Precision Tools Inc |

|Income Statement |

|(Year ended Dec 31) |

| |

|2005 |

|2004 |

|2003 |

| |

|Net sales |

| 7,500,000 |

|7,000,000 |

|6,800,000 |

| |

|Operating expenses  |

|  |

|  |

|  |

| |

|   Cost of goods sold  |

|4,980,000 |

|4,650,000 |

|4,607,000 |

| |

|   Depreciation |

|250,000 |

|240,000 |

|200,000 |

| |

|   Selling and administrative expenses |

|1,300,000 |

|1,220,000 |

|1,150,000 |

| |

|   Research and development |

|     50,000 |

|   125,000 |

|   120,000 |

| |

|  |

|  |

|  |

|  |

| |

|Operating income  |

|920,0000 |

|765,000 |

|723,000 |

| |

|   Interest expense  |

|   320,000 |

|   375,000 |

|   375,000 |

| |

|Income before taxes  |

|600,000 |

|390,000 |

|348,000 |

| |

|   Income taxes  |

|210,000 |

|136,000 |

|  122,000 |

| |

|Net Income |

|   390,000 |

|254,000 |

|   226,000 |

| |

|Analyze the income statement: |

|Can you tell where the business makes its money -   |

|who are its customers?  are they loyal?  |

|who manages and how?  are they competent and honest?  |

|who are the suppliers? are they reliable?  |

|What is the financial position of the company?  |

|cost of goods sold (cost of goods divided by net sales)  |

|FY2002 = 4980/7500 = 6.6% / FY2001:  4650/7000 = 6.6% / FY 2000 = 4607/6800 = 6.8%  |

|what does this tell you?    |

|profit margin (net sales minus operating expenses, divided by net sales)  |

|FY2002 = 920/7500 = 12.3% / FY2001:  765/7000 = 10.9% / FY 2000 = 723/6800 = 10.6%  |

|what does this tell you?  why has it gone up?  is this "window dressing"?  |

|return on equity (net income divided by stockholders' equity as of prior year)  |

|FY2002 = 390/1120 = 34.8%  |

|what does this mean?  assuming that long-term government bonds are returning 8.4%, does this suggest anything about the value of |

|Precision Tools?  |

|Precision Tools Inc |

|Statement of Cash Flows  |

|(Year ended Dec 31) |

| |

|2005 |

|2004 |

| |

|From operating Activities  |

|  |

|  |

| |

|Net income |

|390,000 |

|254,000 |

| |

|Decrease (increase) in accts receivable  |

| (235,000) |

| (34,000) |

| |

|Decrease (increase) in inventories |

|(205,000) |

|(28,000) |

| |

|Decrease (Increase) in prepaid expenses |

|(5,000) |

|(3,000) |

| |

|Increase (Decrease) in accounts payable |

|75,000 |

|25,000 |

| |

|Increase (Decrease) in accrued expenses payable |

|     15,000 |

|   7,000 |

| |

|Depreciation |

| 250,000 |

| 240,000 |

| |

|Total from Operating Activities |

|285,000 |

|461,000 |

| |

| |

|  |

|  |

| |

|From Investing Activities |

|  |

|  |

| |

|Sales (Purchases) of machinery |

|(65,000) |

|(378,000) |

| |

|Sales (Purchases) of office equipment |

|  (20 ,000) |

|(27,000) |

| |

|Total from Investing Activities |

|(85,000) |

|(405,000) |

| |

| |

| |

| |

| |

|From Financing Activities |

| |

| |

| |

|Increase (Decrease) in short-term borrowings |

|30,000 |

|(40,000) |

| |

|Increase (Decrease) in long-term borrowings |

|(355,000) |

|   -----  |

| |

|Total from Financing Activities |

|(325,000) |

|(40,000) |

| |

|Increase (Decrease) in Cash Position |

|(125,000) |

|16,000 |

| |

|Analyze the cash flow statement:  |

|Can you tell whether the business is better off in 2001, compared to 2000? -   |

|are there any danger signs?  |

|what happened to "accounts receivable" and "inventories"? |

|Why doesn't this "cash bleeding" show up on income statement? |

|Why did management cut back on "research and development"? |

|does this suggest anything about the value of Precision Tools?  |

|B. Valuing the Enterprise |

|[pic] |

|Adapted from Solomon, Schwartz & Bauman, |

|Corporations - Cases and Materials at 143 (4th ed. 1996). |

|The Old Man and the Tree: |

|A Parable of Valuation |

|  |

|Once upon a time there was an old man who owned an apple tree. It was a fine tree. With modest care it yielded a crop of apples which he |

|sold for $100 each year. The man wanted money for new pursuits and thought of selling the tree. So he placed an ad in the Business |

|Opportunities section of the Wall Street Journal: "For sale, apple tree - best offer." |

|Six prospective buyers answered the ad, with six methods for valuing the tree: |

|Salvage value  |

|Current production  |

|Future (undiscounted) production  |

|Market price  |

|Book value  |

|Discounted future earnings  |

|From this we can draw a moral of the story |

| |

|[pic] |

|  |

|  |

|Present value |

| |

|Year |

|Cash flow |

|(8% discount rate) |

|(15% discount rate) |

| |

|1 |

|50 |

|$ 46.30 |

|$ 43.48 |

| |

|2 |

|50 |

|$ 42.87 |

|$ 37.81  |

| |

|3 |

|50 |

|$ 39.69  |

|$ 32.88  |

| |

|4 |

|50 |

|$ 36.75  |

|$ 28.59  |

| |

|5 |

|50 |

|$ 34.03  |

|$ 24.86  |

| |

|6 |

|40 |

|$ 25.21  |

|$ 17.29  |

| |

|7 |

|40 |

|$ 23.34  |

|$ 15.04  |

| |

|8 |

|40 |

|$ 21.61  |

|$ 13.08  |

| |

|9 |

|40 |

|$ 20.01  |

|$ 11.37  |

| |

|10 |

|40 |

|$ 18.53  |

|$ 9.89  |

| |

|11 |

|40 |

|$ 17.16  |

|$ 8.60  |

| |

|12 |

|40 |

|$ 15.88  |

|$ 7.48  |

| |

|13 |

|40 |

|$ 14.71  |

|$ 6.50  |

| |

|14 |

|40 |

|$ 13.62  |

|$ 5.65  |

| |

|15 |

|40 |

|$ 12.61  |

|$ 4.92  |

| |

|Salvage |

|50 |

|$ 15.76  |

|$ 6.14  |

| |

|  |

|Total |

|$ 398.07  |

|$ 273.56  |

| |

| |

|[pic] |

|Moral of the story |

|There are several morals. First, you should have noticed that the prospective buyers used essentially three methods to value productive |

|assets -- |

|asset approach  |

|salvage value  |

|book value  |

|income (cash flow) approach  |

|current production  |

|future (undiscounted) production  |

|discounted future earnings  |

|market (comparables) approach  |

|price-earnings ratio  |

|market price |

|  |

|Second, asset valuation methods are useful tools, but valuation is an art that combines methods, good judgment and experience. And |

|experience comes from mistakes. |

|Third, you should listen closely to the experts -- focus not only on what they say, but on what they don't say. Behind their elegance, |

|there is much discordance and uncertainty. One wrong assumption can carry you off track. |

|  |

|Finally, you're never too young or too old to learn. |

|Remember the financial statements for Precision Tools.  What is the company's value, using the following methods |

|• Salvage value  |

|• Current production  |

|• Future (undiscounted) production  |

|• Market price  |

|• Book value  |

|• Discounted future earnings  |

|Precision Tools, Inc. |

|Balance Sheet  |

|(as of Dec 31) |

|Assets |Liabilities |

|   2002 |2002 |

|   2001 |2001 |

| | |

|Current assets |Current liabilities |

|  |  |

|  |  |

| | |

|   Cash |   Accounts payable  |

|   150,000 |  900,000 |

|   275,000 |825,000 |

| | |

|   Accts receivable |   Notes payable |

|1,380,000 |  600,000 |

|1,145,000 |570,000 |

| | |

|    Inventories |   Accrued expenses payable |

|1,310,000 |  250,000 |

|1,105,000 |   235,000 |

| | |

|   Prepaid expenses |   Total current liabilities |

|     40,000 |1,750,000 |

|     35,000 |1,630,000 |

| | |

|Total current assets |Long term liabilities |

|2,880,000 |  |

|2,560,000 |  |

| | |

|  |   Notes payable (12.5% 2008) |

|  |2,000,000 |

|  |2,000,000 |

| | |

|Fixed assets |   Notes payable (11% 2000) |

|  |       ---  |

|  |   355,000 |

| | |

|   Land |Total Liabilities |

|   775,000 |3,750,000 |

|   775,000 |3,985,000 |

| | |

|   Buildings  |  |

|2,000,000 |  |

|2,000,000 |  |

| | |

|   Machinery |Stockholders' Equity |

|1,000,000 |  |

|   935,000 |  |

| | |

|   Office equipment |Common stock (1000 sh) |

|   225,000 |  |

|   205,000 |  |

| | |

|Total PP&E |   Paid-in capital |

|4,000,000 |   200,000 |

|3,915,000 |200,000 |

| | |

|   Less accum depreciation |   Retained earnings |

|1,620,000 |1,310,000 |

|1,370,000 |   920,000 |

| | |

|Net fixed assets |Total equity |

|2,380,000 |1,510,000 |

|2,545,000 |1,120,000 |

| | |

|  |  |

|  |  |

|  |  |

| | |

|Total assets |Total Liabilities and Equity |

|5,260,000 |5,260,000 |

|5,105,000 |5,105,000 |

| | |

|Precision Tools Inc |

|Income Statement |

|(Year ended Dec 31) |

| |

|2002 |

|2001 |

|2000 |

| |

|Net sales |

| 7,500,000 |

|7,000,000 |

|6,800,000 |

| |

|Operating expenses  |

|  |

|  |

|  |

| |

|   Cost of goods sold  |

|4,980,000 |

|4,650,000 |

|4,607,000 |

| |

|   Depreciation |

|250,000 |

|240,000 |

|200,000 |

| |

|   Selling and administrative expenses |

|1,300,000 |

|1,220,000 |

|1,150,000 |

| |

|   Research and development |

|     50,000 |

|   125,000 |

|   120,000 |

| |

|  |

|  |

|  |

|  |

| |

|Operating income  |

|920,0000 |

|765,000 |

|723,000 |

| |

|   Interest expense  |

|   320,000 |

|   375,000 |

|   375,000 |

| |

|Income before taxes  |

|600,000 |

|390,000 |

|348,000 |

| |

|   Income taxes  |

|210,000 |

|136,000 |

|  122,000 |

| |

|Net Income |

|   390,000 |

|254,000 |

|   226,000 |

| |

|Precision Tools Inc |

|Statement of Cashflow |

|(Year ended Dec 31) |

| |

|2002 |

|2001 |

| |

|From operating Activities  |

|  |

|  |

| |

|Net income |

|390,000 |

|254,000 |

| |

|Decrease (increase) in accts receivable  |

| (235,000) |

| (34,000) |

| |

|Decrease (increase) in inventories |

|(205,000) |

|(28,000) |

| |

|Decrease (Increase) in prepaid expenses |

|(5,000) |

|(3,000) |

| |

|Increase (Decrease) in accounts payable |

|75,000 |

|25,000 |

| |

|Increase (Decrease) in accrued expenses payable |

|     15,000 |

|   7,000 |

| |

|Depreciation |

| 250,000 |

| 240,000 |

| |

|Total from Operating Activities |

|285,000 |

|461,000 |

| |

| |

|  |

|  |

| |

|From Investing Activities |

|  |

|  |

| |

|Sales (Purchases) of machinery |

|(65,000) |

|(378,000) |

| |

|Sales (Purchases) of office equipment |

|  (20 ,000) |

|(27,000) |

| |

|Total from Investing Activities |

|(85,000) |

|(405,000) |

| |

| |

| |

| |

| |

|From Financing Activities |

| |

| |

| |

|Increase (Decrease) in short-term borrowings |

|30,000 |

|(40,000) |

| |

|Increase (Decrease) in long-term borrowings |

|(355,000) |

|   -----  |

| |

|Total from Financing Activities |

|(325,000) |

|(40,000) |

| |

|Increase (Decrease) in Cash Position |

|(125,000) |

|16,000 |

| |

|Salvage value:  $5,215,000 - $3,750,000 = $1,465,000 |

|  |

|Assets |

|   2002 |

|   Salvage |

| |

|Current assets |

|  |

|  |

| |

|   Cash - 100% |

|   150,000 |

|   150,000 |

| |

|   Accts receivable - 75% |

|1,380,000 |

|1,035,000 |

| |

|    Inventories - 50% |

|1,310,000 |

|655,000 |

| |

|   Prepaid expenses - 75% |

|     40,000 |

|     30,000 |

| |

|Total current assets |

|2,880,000 |

|1,870,000 |

| |

|  |

|  |

|  |

| |

|Fixed assets |

|  |

|  |

| |

|   Land - FMV minus selling expense |

|   775,000 |

|   1,000,000 |

| |

|   Buildings  |

|2,000,000 |

|2,000,000 |

| |

|   Machinery - 30% |

|1,000,000 |

|   300,000 |

| |

|   Office equipment - 20% |

|   225,000 |

|   45,000 |

| |

|Total PP&E |

|4,000,000 |

|3,345,000 |

| |

|  Less accum depreciation |

|1,620,000 |

|              0 |

| |

|Net fixed assets |

|2,380,000 |

|3,345,000 |

| |

|  |

|  |

|  |

| |

|Total assets |

|5,260,000 |

|5,215,000 |

| |

| |

|Liabilities |

|2002 |

| |

|Current liabilities |

|  |

| |

|   Accounts payable  |

|  900,000 |

| |

|   Notes payable |

|  600,000 |

| |

|   Accrued expenses payable |

|  250,000 |

| |

|   Total current liabilities |

|1,750,000 |

| |

|Long term liabilities |

|  |

| |

|   Notes payable (12.5% 2008) |

|2,000,000 |

| |

|   Notes payable (11% 2000) |

|       ---  |

| |

|Total Liabilities |

|3,750,000 |

| |

| |

| |

|Current production:  $7,500,000 (FY 2001 Net sales) |

|[pic] |

|Future (undiscounted) production:  $75,000,000 (assuming ten more years) |

|[pic] |

|Market price:  who last offered? market price of individual share? |

|[pic] |

|Book value:  $1,510,000 (from balance sheet) |

| |

|Stockholders' Equity |

|2002 |

| |

|Common stock (1000 sh) |

|  |

| |

|   Paid-in capital |

|   200,000 |

| |

|   Retained earnings |

|1,310,000 |

| |

|Total equity |

|1,510,000 |

| |

|[pic] |

|Discounted future earnings  |

|  |

|2002 |

| |

|Net income  |

|$390,000 |

| |

|       Depreciation  |

|   $250,000 |

| |

|       Bonuses |

|$120,000 |

| |

|Net cash flows     |

|$760,000 |

| |

|Adjusted free cash flow |

|$500,000 |

| |

|  |

|  |

| |

|Discount rate |

|33% |

| |

|Growth rate |

|8% |

| |

|Capitalization rate (discount minus growth) |

|25% |

| |

|Capitalization multiplier |

|4 |

| |

|  |

|  |

| |

|Discounted cash flow |

|$2,000,000 |

| |

| |

| |

|  |

|[pic] |

|  |

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