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CHAPTER 9 Increasing the Value of Your Business
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and the financial information We will focus on the risk in the business first and deal with the risk to the buyer later in the chapter There are two broad categories of sources of risk/volatility in a business: operational risk and financial risk Operational risk factors are those risks that exist in the nature of the business They include the business cycles of the industry, fixed costs, and dependence on the owner Financial risk arises from the presence of debt financing An all equity firm has no financial risk It has only operational risk We will discuss these various risk factors in the following several pages, with dependence on the owner as the last item, since this is the most important source of risk to your business I call it the Big Banana
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Industry Business Cycles
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The US economy has business cycles of booms, normal growth, recessions, and depressions Some industries have their own cycles Agricultural staples such as grains and vegetables tend not to be cyclical They are affected by the weather, but people have to eat these staples whether their income is high or low In contrast, people don t have to eat caviar, so luxuries are more dependent on national income Construction and heavy equipment industries are more dependent on the overall economy So, business cycles affect different industries differently, and these are an operational risk inherent in each business Does that mean you should diversify if your business is cyclical No A potential buyer of your company can diversify his or her assets more easily than you can diversify your company s operations Academic finance literature tells us that diversification within the firm tends to destroy value, not enhance it For example, researchers found that focus-decreasing (diversifying) mergers decreased stockholder wealth by 18 percent, and mergers that preserve business focus or enhance it do not decrease shareholder wealth13 So, if the nature of your busi13
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William L Megginson, Angela Morgan, and Lance Nail, The Determinants of Positive Long-term Performance in Strategic Mergers: Corporate Focus and Cash, a working paper, June 2002
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PART ONE Business Valuation
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ness is cyclical, make sure you are very profitable, in order to outweigh the negative effects on value of being cyclical but don t diversify to try to solve the problem On the other hand, any portion of the cyclical nature of the business that you can control and smooth out should enhance your company value as long as you are not unintentionally reducing net income by bending into a pretzel to artificially smooth out your net income
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Fixed Costs
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Fixed costs are those the business will incur even when there are no sales Depreciation on equipment, rent on the building, and salaries of high administrative personnel are examples Variable costs are those that vary directly with sales, and are typically expressed as a percentage of sales If variable costs are 60 percent, then for every $100 increase in sales, they should increase by 60 cents Your break-even volume should be approximately your fixed costs divided by one minus variable costs If fixed costs are $2 million and variable costs are 60 percent, then your break-even volume is $2 million divided by 40 percent, or $5 million To check the accuracy of this calculation, we can work it back in the other direction At sales of $5 million, variable costs will be $5 million 60% $3 million, and fixed costs are $2 million, for a total of $5 million, leaving a zero net profit For every dollar of sales above $5 million, your net income will be 40 percent times sales above $5 million Let s create an extreme example to illustrate the principle that high fixed costs exaggerate the effect of cycles If you spend, for example, $5 million on a high-tech piece of equipment that makes production go very quickly and requires virtually no personnel to manufacture your product, your variable production cost is zero percent If the equipment has a five-year life, your fixed cost is $1 million per year of depreciation expense If your sales are $100 million, you will make $99 million net income If your sales are $500,000, you ll lose $500,000 ($500,000 sales $1 million depreciation) If instead you had a low-tech machine that requires personnel to operate it, in the good years your net income will be high, but not as high as with the high-tech machine, and in bad
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