Economic Value of the Business

Question: Discuss about the Economic Value of the Business. Answer: Introduction: Valuing ones business is a method which provides the estimate of the economic value of the business. A valuation is a tool in financial markets that helps the owner of business to determine the value of they will receive for their business if they sell it in the current market scenario. It is processed by which present value of the business is determined, by discounting the expected cash flows and other factors taken into consideration. Business valuation is done for various purposes such as mergers, acquisitions, etc. There are various accounting principles which require the assets of an organization to be shown at their historical values in the financial statements (Albrecht et. al, 2011). Because of this reason it is very difficult to determine the true value of business in the current market. While valuing the business these assets are taken at their market values which help to determine the true value or worth of the business. In the given case, we need to value a small hotel wh ich is situated on the outskirts of a large town. Key factors affecting the value of the hotel An indepth local knowledge along with sector knowledge is required to come at proper valuation of a hotel. In order to derive the proper valuation of the hotel, the valuation officers need to consider both trading performance and transactions market. The major factors affecting the value of a hotel include profitability, location, threats, demographics, conditions and also risk involved in investments. Profitability in hotel business is best estimated from the net profit earned. Now this net profit figure will have to be adjusted upward or downwards keeping in mind the management of the hotel. Good management adds value to the business whereas bad management declines it. Location of the hotel is one of the major factors affecting its value (Eugene Philip, 2011). Whether it is located in the city or outside the city, whether it is a holiday spot, convenience such as public transport, traffic flow, etc. all affects the value of a hotel. Talking about threats, if there are competitors in that area, then the profit margins is likely to be in the same level. If they are new in the business and operating only in a single area then the margin of profit is bound to increase that will have a strong impact on the profits (Williams, 2012). The value should also keep in his mind the demographic trends. It should see what age group of people mainly use their service so that they can make arrangements accordingly. There is risk involved in hotel management so the capitalization rate includes a lot of adjustments; the calculation of this rate is very challenging for the person valuing the hotel. Other factors such as condition of the building, efficiency of the bar, fire prevention measures, entertainment facilities etc. effects the value of a hotel (Eugene Philip, 2011). Methods to Value Hotel Business There are majorly three approaches which are used to value a hotel. These are the income capitalization method, sales comparison and cost approach. In order to select the method of valuation the nature of hotel and also the strengths of each method should be evaluated so that the best approach suitable can be identified. Also there are thumb rules which help to provide a rough value of the hotel. But mostly income capitalization approach is mostly used to value the hotel business (Christensen, 2011). The basis of income capitalization approach is that the value of business is based on the profits earned, or future benefits that can be earned from them. The value of the income generating properties such as hotels is based on future estimated incomes and expenses of such properties along with the estimated sale value of such property on near future. Now these cash flows are discounted using the capitalization rate, which help to determine what can be the value of hotel in future. The e stimated cash flows under this process are adjusted and then discounted in order to determine the value of the hotel. The methods which is used by the investors is very similar to that of income capitalisation approach because of which it is most commonly used approach for valuation. The cost approach of valuation of hotel business involves considering the current replacement value of the property which is adjusted with depreciation (Parrino et. al, 2012). Also the value of the land is then added to this net value of the property to have a total estimate. This cost approach is valuation is effective mostly in the cases of new properties. The old properties are prone to depreciation and improvements which make it difficult to determine the correct value. This method is given very less preference while valuing hotels since it requires a lot of estimates for depreciation which makes it unreliable (Davies Crawford, 2011). The sales comparison approach involves valuing the property usin g the recent sale value of a similar property. In order to determine a correct value, the sale value of this property is adjusted keeping in mind the similarities and dissimilarities among these properties. This approach is suitable for vacant lands, family homes or other properties where there is relatively less number of adjustments (Spiceland et. al, 2011). Whereas for more complex properties such as market buildings, shopping malls, etc; this approach loses its reliability. Within the income capitalisation approach there are two variants used to value hotels. One is an after tax model that provides estimates for investment value and the other is income capitalization approach used in valuation of hotels which are owned by publically traded lodging companies (Christensen, 2011). The former variant incorporates the tax rate in order to derive the net benefits derived from the hotel business, whereas the later, incorporates the concept of Economic value added. There are a lot of fa ctors which affect the value of a business. It is very difficult to incorporate all these factors while valuing the hotel. But income capitalization approach is the one which almost covers all these factors. Hence, providing the valuation officers a correct basis for valuation of hotel business (Graham Smart, 2012). Need to make adjustments before valuation While valuing a business by from of balance sheet one simply cannot rely on them to present the true value of business because they dont reflect the economic reality. They are based on mere assumptions, accounting principles and income tax regulations. The accounts may also include some transactions which are not recorded at correct amounts or certain adjustments have been made in them to meet requirements. Adjustments in the accounts of an entity are made before valuation so that reflect the economic reality. This adjustment procedure is known as normalization. Normalized accounts of an entity provide improved comparison to industrial statistics and other similar companies. They also provide a better picture of the companys earnings capacity, on which the business is valued. Here are few examples of adjustments and reasons for the same. Adjustments made in transactions entered into with related parties. The actual position is not reflected when it comes to the method of arms length. There are various transactions that need to be removed when determination of the business is being done. Certain expenses are not necessary and do not relate with the business and therefore the expenses needs to be eliminated. Accounting principles helps the financial statements in computing the estimates. It is immaterial that these expenses should be in tune to the actual estimation. Hence, it is vital that such uncertainty should be eliminated (Needles Powers, 2013). This is done by normalization of the financial statements. In order to eliminate the effect of non-recurring and sudden events and transactions from the financial statements, these adjustments are required. This helps the valuators to find the value the business correctly under normal circumstances (Brealey Myers, 2011). This helps to provide a value which is comparable with other entities working in the same industry under same circumstances. Critique of the profits methods Therefore we see that this hotel operates in the outskirts of the town and has increasing revenue every year. This year it reported having a profit of 300,000. This shows that there are no many competitors in the area and also the location of the hotel is good to attract customers. This hotel should be valued using income capitalization approach, as it would be the most suitable method of valuation for this type and nature of business. It is very necessary to value the business from time to time so that the investor can make an estimate of how his business has been performing. It helps the investor to know how much value has been created by his investments. While valuing an asset or business, the reason behind its valuation should be known. The method of valuation should be selected keeping in mind the users of this valuation report (Brealey Myers, 2011). The method which is best suitable for the situation should be applied. Hence, the valuator should apply due diligence also while carrying out the valuation process. 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