Over The Edge (OTE) is a good candidate for applying the capitalized cash flow approach of business valuation. In your valuation spreadsheets, be sure to make notes explaining each of your adjustments. Wutang will want to understand exactly what adjustments we are making and why. Often, when estimating future cash flows, we look at the past five years’results. OTE operates in a stable industry and, according to my discussions with Wutang, the results for the company three, four, and five years ago were relatively consistent with those for the prior and current years. Therefore, we’ll rely on the prior year-end and current year-end amounts to set our value range.In this case, I want you to assume that the present value of the tax shield associated with capital reinvestments is about 10% of the amount spent which is projected to be $100,000 per year.

You: What capitalization rate shall I use for the valuation?

Misty: I would like you to do your first draft of the valuation using a weighted average capitalization rate of 12%. Once you have prepared the valuation, you will need to check it for reasonableness. One of the simplest ways to check the reasonableness of the valuation is to compare the value determined in the capitalized cash flow approach to the adjusted net asset value. The adjusted net asset value will provide the “floor value” of the company — in other words, the lowest value Wutang should accept in a transaction.
I also put together a memo for you with some information on non-recurring or unusual items incurred by OTE. I will email it to you. (Exhibit II). Since FCI is public, it would not be able to claim a small business deduction for OTE. I would say that FCI could expect to pay corporate tax at the rate of 30%. You take the information provided by Misty, as well as your notes from the meetings, and return to your desk to address the issues.

REQUIRED: In Excel, prepare a capitalized cash flow valuation for OTE, using the information provided in the exhibits.
Be sure to use the template for this activity.

Problem Template: Estimated maintainabel operating cash flow (normalized EBITDA)

Income before tax notes Current year Prior Year

Add:

Add/Deduct

Exhibit I
	Over The Edge Inc. Balance sheet As at December 31	Current year	Prior year
Cash		$ 4,560	$ 12,720
Investments		—	29,850
Accounts receivable		1,370,150	1,112,457
Income taxes receivable		36,160	—
Inventory		1,196,190	938,945
Prepaids		4,920	4,920
		2,611,980	2,098,892
Property, plant, and equipment		4,244,413	2,998,749
Intangible assets		13,883	—
Due from shareholder		21,500	21,500
Assets		$ 6,891,776	$ 5,119,141
Demand bank loan		$ 375,422	$ 96,800
Accounts payable and accruals		1,409,932	1,175,915
Warranty accrual		315,231	259,412
Deferred revenue		156,500	—
Current portion of term loan		141,000	141,000
Income taxes payable		—	11,700
		2,398,085	1,684,827
Term loan		572,000	713,000
Other long-term liabilities		1,128,570	—
Share capital		150,100	150,100
Retained earnings		2,643,021	2,571,214
Liabilities and shareholder’s equity		$ 6,891,776	$ 5,119,141

Over The Edge Inc.
Statment of income and Retained Earnings, Dec 31, year end
	Current Year	Prior Year
Sales	$ 8,959,800	$ 8,834,000
Cost of sales	5,949,648	6,129,709
Gross profit	3,010,152	2,704,291
Expenses:
Advertising and promotion	357,900	266,500
Amortization	219,163	166,584
Automobile	140,800	102,600
Bad debts	17,250	19,110
Donations	1,200	1,000
Dues and fees	7,500	—
Insurance	69,600	57,200
Interest and bank charges	119,203	46,600
Office	101,200	108,700
Professional fees	67,700	34,800
Property taxes	44,700	40,900
Rent expense	84,654	—
Repairs and maintenance	207,100	155,100
Salaries and wages	1,160,460	1,175,600
Travel	117,666	103,900
Utilities	67,600	60,200
Warranty	72,059	69,482
Income before taxes	154,397	296,015
Income taxes	33,840	76,754
Net income	120,557	219,261
Retained earnings, opening	2,571,214	2,360,953
Dividends	48,750	9,000
Retained earnings, closing	$ 2,643,021	$ 2,571,214

Exhibit II
Additional valuation information
1. The net realizable value of OTE’s inventory and accounts receivable are approximately $1,208,860 and $1,367,000, respectively. Bad debt expense consists of actual accounts receivable written off during the year. OTE does not have an allowance for doubtful accounts.

2. OTE’s prepaids will not have any value to the purchaser of the business but are needed for operations (not redundant).

3. The property, plant, and equipment, including the leased assets, have a fair value of $4,500,000. The present value of the forgone tax shield related to the increased fair value of assets is $26,000. There are no issues associated with transferring the lease to a purchaser, and the lease will be a capital lease for the purchaser. If the assets are sold, the latent taxes/selling costs are $24,000.

4. For the existing capital assets, the present value of the current tax shield is $38,000.

5. In the prior year, OTE decided to expand its product mix to include skis. The product did not do well and, by the time OTE discontinued the product and liquidated the inventory in December, it had recorded a negative gross margin of $75,000. One of the customers for the skis still owed OTE money at the end of the prior year. For reasons unrelated to the skis, that customer went bankrupt in March of the current year; at that time, OTE wrote off the customer’s remaining balance of $8,500. OTE had not previously set up an allowance for this receivable.

6. In the prior year, OTE had a fire in the manufacturing plant. Although most of the damage was covered by insurance, OTE took the opportunity to undertake $25,000 in additional repairs and maintenance that were not covered by insurance. OTE would not have made those repairs if the fire had not occurred.

7. In the prior year, OTE received a $44,500 volume discount from a new raw materials supplier. It was a great deal, and we were hoping to add this amount to our gross
margin every year. However, at the beginning of the current fiscal year, the supplier went bankrupt, so the volume discount ceased.

8. In the prior year, OTE undertook a special marketing campaign that focused on several key business associates and contacts. The campaign cost $20,000 and OTE has no plans to run such a campaign again in the near future.

9. Wutang takes a regular salary from the business and an annual bonus depending on OTE’s financial results and the cash available. His salary was $325,000 in thecurrent year and $300,000 in the prior year. Any other cash withdrawals in the yearare treated as dividends.

10. Included in interest and bank charges on the income statement is interest on all interest-bearing debt (including the capital lease) of $50,000 and $32,000 in the current year and prior year, respectively.

11. $326,625 and $338,216 of amortization was included in cost of sales in the current year and prior year, respectively.