By Peter Haley
If the present value of the future cash flows a business generates are greater than the value of the tangible assets (less liabilities) that excess value is known as business goodwill.
For example you may have a steel fabrication business that has a total value of future cashflows of $500,000 and the value of plant and equipment, debtors, stock less creditors is $300,000. The extra $200,000 is the value of the goodwill.
However, what if you had a restaurant business in a shopping mall that has traded for 2 years making losses and is expected to continue making losses and its balance sheet shows:
|Rental bond||$ 50,000|
|Equipment and fitout||$440,000|
What is its value?
Value is the amount a prudent investor would be prepared to pay in order to receive the future cashflows, having regard to the level of risk attaching to the business. In this context the future cashflows mean profits (or losses) from operating the business and/or from realising the tangible assets.
In the restaurant example above as you have a business making losses, and expected to continue doing so, the prudent investor would ordinarily realise the tangible assets. But in this example the business still has 8 years left on its lease and the landlord has indicated it is unwilling to allow the tenant to walk away from its obligations under that lease. Furthermore as it is a franchise themed restaurant the fitout is of no value except in situ and the resale value of the equipment is little more than the cost of removing it.
Therefore the business owner has two choices:
- Continue to trade the business in the hope it can become profitable; or
- Close the business and negotiate with the landlord.
Either choice will result in negative cashflows effectively meaning the business has negative goodwill.
Also, the above example has not considered repayment of the debt taken out to acquire the equipment and fitout in the first place, assuming the owner has not financed the acquisition of the equipment and fitout with cash. That debt repayment is in addition to the negative cashflows from the 2 choices facing the business owner regarding the future operation of the business.
In our valuation practice we have recently seen several situations similar to the restaurant example above highlighting that in many cases fitouts and plant and equipment are sunk costs and have little or no value if removed from the operating business. In fact their value could also be negative if the lease contains ‘make good’ provisions for the premises.
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