cbvinstitute.com · i Table of Contents Level II - Intermediate Business Valuation Contents Preface

INTERMEDIATE BUSINESS VALUATION

SPRING / SUMMER 2017LEVEL II

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Table of ContentsLevel II - Intermediate Business Valuation

ContentsPreface ................................................................................................................ viiCourse Introduction and Learning Objectives ................................................ ixModule 1 ............................................................................................................... 1

Taxation Issues for Valuation1.1 Valuation Impact of Canadian Tax Principles ........................................................................3

1.1.1 Going Concern Approaches ...........................................................................................3

1.1.1.1 Earnings Capitalization Method ................................................................................4

1.1.1.2 Cash Flow Capitalization Method .............................................................................4

1.1.1.3 Discounted Cash Flow Method .................................................................................7

1.1.1.4 Adjusted Asset Method .............................................................................................7

1.1.2 Liquidation Method .........................................................................................................8

1.2 Forms of Business Organization ........................................................................................ 11

1.2.1 Sole Proprietorship (Individual) .................................................................................... 11

1.2.2 Corporation ..................................................................................................................12

1.2.3 Trusts ...........................................................................................................................13

1.2.4 Partnerships .................................................................................................................14

1.2.5 Joint Ventures, Syndicates and Co-ownerships ...........................................................16

1.3 Types of Income .................................................................................................................18

1.3.1 Business Income ..........................................................................................................18

1.3.2 Property Income ..........................................................................................................20

1.3.3 Capital Gains ................................................................................................................21

1.4 Tax Rates ..........................................................................................................................22

1.4.1 Income Taxes ...............................................................................................................22

1.4.2 Refundable Part I Tax .................................................................................................22

1.4.3 Commodity Taxes .......................................................................................................23

1.4.4 Part IV Tax ...................................................................................................................24

1.5 Common Tax Assets ..........................................................................................................25

1.5.1 Non-depreciable Capital Property ................................................................................25

1.5.2 Depreciable Property ...................................................................................................25

1.5.2.1 A. UCC Balance > Deduction ...............................................................................26


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1.5.2.2 B. UCC Balance < Deduction ................................................................................27

1.5.3 Intangibles (or Eligible Capital Property) ......................................................................29

1.6 Other Tax Issues ...............................................................................................................30

1.6.1 Losses ..........................................................................................................................30

1.6.2 SR&ED and Investment Tax Credits ............................................................................31

1.7 Tax Liabilities .....................................................................................................................33

1.7.1 Transfer Pricing .............................................................................................................33

1.7.2 Characterization of Transactions ..................................................................................33

1.7.3 Interest Deductibility .....................................................................................................34

1.7.4 Unrealized Gains ..........................................................................................................35

1.7.5 Reserves ......................................................................................................................35

1.8 Application of a Transfer Pricing Study to an Equity Valuation ...........................................36

1.8.1 Reviewing a Transfer Pricing Study ..............................................................................36

1.8.2 Transaction-specifi c Considerations When Evaluating Intercompany Transactions ....37

1.8.3 Impact of Intercompany Transactions on a Valuation ...................................................37

1.8.4 Tax Reserves and Transfer Pricing Policies .................................................................41

1.8.5 Jurisprudence Involving Transfer Pricing and Valuations .............................................41

1.8.6 Conclusion on Transfer Pricing and Valuations ............................................................42

Module 2 ............................................................................................................. 49Comparable Company Multiples and Other Valuation Concepts2.1 Introduction to Comparable Company Multiples .................................................................51

2.1.1 Common Multiples Used in Practice .............................................................................53

2.1.1.1 EBITDA (Enterprise Value-to-EBITDA Ratio) .........................................................53

2.1.1.2 EBIT (Enterprise Value-to-EBIT Ratio) ...................................................................54

2.1.1.3 Revenue (Enterprise Value-to-Revenue Ratio) ......................................................54

2.1.1.4 Net Book Value (Price-to-Book Ratio) ....................................................................54

2.1.1.5 Net Earnings (Price-to-Earnings Ratio) ..................................................................55

2.1.2 Rules of Thumb ............................................................................................................56

2.1.3 Public Company Multiples ............................................................................................56

2.1.3.1 Similar Lines of Business .......................................................................................57

2.1.3.2 Liquidity of Comparable Companies .....................................................................57

2.1.3.3 Valuation Multiples ................................................................................................59

2.1.3.4 Business Enterprise Value Versus Equity Value ...................................................60

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2.1.3.5 Important Considerations and Potential Adjustments to Multiples .........................65

2.1.3.6 Professional Judgment ...........................................................................................70

2.1.4 Precedent Transaction Multiples ..................................................................................78

2.1.4.1 Key Advantages and Disadvantages .....................................................................78

2.1.4.2 Application of the Precedent Transaction Multiples ...............................................79

2.2 Analyzing Financial Statements ........................................................................................86

2.2.1 Financial Ratios ............................................................................................................86

2.2.2 Forecasts and Budgets ...............................................................................................88

2.2.3 Trend Analysis ............................................................................................................89

2.3 The Asset-Based Valuation Approach —An Overview ......................................................91

2.3.1 Liquidation Value ..........................................................................................................91

2.3.1.1 Orderly Liquidation Value Approach .......................................................................92

2.3.1.2 Forced Liquidation ................................................................................................92

2.3.1.4 Going-Concern Business — Risk Measurement ...................................................97

2.3.1.5 Liquidation Value of Value to Owners ....................................................................97

2.3.2 Adjusted Net Book Value ...........................................................................................101

2.3.2.1 Calculating Adjusted Net Book Value ..................................................................102

2.3.2.2 Adjustment of Assets and Liabilities ....................................................................102

2.3.2.3 Adjustment for Lost Tax Shield ............................................................................103

2.3.3 Tangible Asset Backing ..............................................................................................109

2.3.3.1 Calculating Tangible Asset Backing .....................................................................109

2.4 Risk Measurement ........................................................................................................... 111

2.5 Real Estate and Equipment Valuations ............................................................................ 112

2.5.1 Real Estate Valuations ............................................................................................... 112

2.5.2 Equipment Valuations ................................................................................................ 112

Module 3 ............................................................................................................115Comparable Company Multiples and Other Valuation Concepts3.1 Majority Positions and Control .......................................................................................... 117

3.1.1 Types of Control .......................................................................................................... 117

3.1.1.1 Legal or De Jure Control ....................................................................................... 117

3.1.1.2 Eff ective or De Facto Control ............................................................................... 118

3.1.1.3 Group Control ......................................................................................................120

3.1.1.4 Joint Control .........................................................................................................120


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3.1.2 Premium for Control ...................................................................................................121

3.2. Acquisition of Control Rules ............................................................................................122

3.2.1 Losses ........................................................................................................................122

3.2.2 SR&ED Pools, ITCs and Unused Surtax Credits .......................................................125

3.3 The Sale of Assets Versus Shares ...................................................................................137

3.3.1 Tax Consequences .....................................................................................................137

3.3.1.1 Sale of Assets ......................................................................................................137

3.3.1.2 Sale of Shares .....................................................................................................138

3.3.2 Goods and Services Tax (GST) ................................................................................. 151

3.3.2.1 GST and Holding Companies ..............................................................................152

3.3.2.1 GST and Takeover Fees ......................................................................................152

3.4 Trapped-in Capital Gains .................................................................................................153

3.4.1 Timing of the Realization of Income Tax Liability .......................................................153

3.4.1.1 Additional Tax Issues ............................................................................................154

3.4.2. Book Value Versus Tax Values .................................................................................154

3.4.3 Future Income Taxes .................................................................................................155

3.5 The Canadian Business Corporations Act (“CBCA”) ........................................................157

3.5.1 The Position of Majority Shareholders .......................................................................157

3.5.2 Statutory Rights of the Majority Shareholders ...........................................................157

3.5.3 The Position of Minority Shareholders .......................................................................158

3.5.3.1 Minority Rights Strengthened in 1970s ...............................................................159

3.5.4 Statutory Rights of Minority Shareholders and Creditors ...........................................159

3.5.4.1 Right of Access to Corporate Information ............................................................159

3.5.4.2 Right to a Degree of Participation in Management ..............................................160

3.5.4.3 The Dissent (Appraisal) Remedy .........................................................................162

3.5.4.4 The Derivative Action — The Right to Bring an Action on Behalf of the Corporation .........................................................................................................164

3.5.4.5 Right to Set aside a Contract in which a Director has an Undisclosed Interest ...164

3.5.4.6 General Right to Enforce Compliance with the CBCA .........................................165

3.5.4.7 The “Oppression Remedy” ..................................................................................165

3.6 Minority Positions .............................................................................................................170

3.6.1 Minority Discounts ......................................................................................................170

3.6.2 Publicly Traded Minority Shares ................................................................................170

3.6.3 Privately-held Company Minority Shares ................................................................... 171

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3.6.4 Factors Aff ecting Minority Value ................................................................................ 171

3.6.5 Valuation Approaches ................................................................................................172

3.6.5.1 Approach #1 ........................................................................................................172

3.6.5.2 Approach #2 ........................................................................................................173

3.6.6 Factors Aff ecting Minority Discounts .........................................................................173

3.6.6.1 The Size of the Shareholding and its Relative Importance .................................. 174

3.6.6.2 Existing Shareholders’ Agreement ...................................................................... 174

3.6.6.3 Articles of Incorporation and By-laws ..................................................................175

3.6.6.4 Shareholder Relationships ...................................................................................175

3.6.6.5 Familial Relationships ..........................................................................................175

3.6.6.6 Nuisance Value ...................................................................................................176

3.6.7 Determining the Quantum of Discount or Premium ....................................................177

3.6.7.1 Determining a Minority Discount ..........................................................................181

3.7 Discounts For Illiquidity ...................................................................................................182

3.7.1 Controlling Interests ....................................................................................................182

3.7.2 Minority Interests ........................................................................................................182

3.7.3 Canadian Jurisprudence ............................................................................................183

3.7.4 U.S. Jurisprudence .....................................................................................................184

3.8 The Application of a Minority Discount in the Determination of the Fair Value of the Shares of a Minority Shareholder ......................................................................................................186

3.9 Portfolio Discount .............................................................................................................187

3.10 Blockage Discount ..........................................................................................................188

3.11 Discounts for Restricted Shares .....................................................................................192

3.11.1 Empirical Studies ......................................................................................................192

3.11.2 Quantitative Analysis ................................................................................................193

3.11.3 Restricted Shares Off ered as Employee Compensation ..........................................194

3.12 Quantifying the Special Purchaser Premium ..................................................................202

3.12.1 Levels of Value ..........................................................................................................206

3.12.2 Levels of Value and Valuation Methodologies ..........................................................208

3.12.2.1 Income Approach ...............................................................................................208

3.12.2.2 Market Approach ...................................................................................................209

3.13 Agreements ....................................................................................................................210

3.13.1 Shareholders’ Agreements .......................................................................................210

3.13.1.1 Key Objectives of a Shareholders’ Agreement ...................................................210


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3.13.1.2 Defi ning Value .................................................................................................... 211

3.13.1.3 Defi ning Liquidity ................................................................................................217

3.13.2 Other Key Considerations ........................................................................................222

3.13.3 Control ......................................................................................................................222

Assignment Questions .................................................................................. 231Assignment 1 .........................................................................................................................232

Assignment 2 .........................................................................................................................236

Assignment 3 .........................................................................................................................244

Assignment Solutions ..................................................................................... 255Assignment 1 Solutions ..........................................................................................................256

Assignment 2 Solutions ..........................................................................................................262

Assignment 3 Solutions ..........................................................................................................280

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PrefaceLevel II - Intermediate Business Valuation

PrefaceWelcome to the Level II — Intermediate Business Valuation course of The Canadian Institute of Chartered Business Valuators’ Program of Professional Studies. This course is the second in a series of four compulsory courses on the theory, application and professional practice of business valuation required to be eligible to become a Chartered Business Valuator/Expert en Evaluation D’Entreprises (CBV/EEE).

A team of CBVs under the direction of the CICBV collaborated to write Level II — Intermediate Business Valuation. The CICBV thanks them for their sustained eff orts and contribution to the profession. This team has worked diligently to ensure that this course is relevant and up-to-date, yet these course notes are subject to the ever-evolving theory and practice of business valuation. If you have any questions or comments about the material in these course notes, you are encouraged to communicate them to your course instructor.

The Institute wishes you the best in your studies, continuing here with Level II — Intermediate Business Valuation.

© CICBV 2017All rights reserved: no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or in any other means, electronic, mechanical, photocopying, or otherwise, without the written permission of the Institute; it may not be lent, resold, hired out, or otherwise disposed of by way of trade.

PrefaceLevel II - Intermediate Business Valuation

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Required Reading

Byrd, Clarence and Chen, Ida. Byrd and Chen’s Canadian Tax Principles. Toronto: Pearson, 2013.

Campbell, Ian R., Johnson, Howard E., Nobes, H. Christopher. Canada Valuation Service — Student Edition 2012. Toronto: Carswell, 2012.

Johnson, Howard E. Business Valuation. Toronto: The Canadian Institute of Chartered Accountants, 2012.

CICBV Website Resources

CICBV Website resources are available to download at www.cicbv.ca under Intermediate BV Course — Required Reading Articles. To access these readings, log on to the “Students Only” section of the website with your password and user ID

If you encounter any problems, please contact the CICBV offi ce at 416-977-1117.

From the Level II — Intermediate Business Valuation Web page:

• Valuation of Shares: Some Areas of Controversy (Wolfe D. Goodman, Q.C.). • Shareholders’ Agreements — A Valuato Perspective (Jeremy Webster). • “Imbedded Taxes” and the Valuation of Holding Companies (Stan Laiken, PhD, CBV

and Martin Pont, CBV).• Key Lessons from the BCE Decision (Osler, Hoskin & Harcourt LLP).• Trapped-In Capital Gains Revisited (Line Racette, CA, CBV, ASA, CFE).

From the “About” section of the CICBV website:

• CICBV By-laws (included in “Governance”).• CICBV Code of Ethics (included in “Standards & Ethics”).• CICBV Practice Standards (included in “Standards & Ethics”).

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IntroductionLevel II - Intermediate Business Valuation

Course Introduction and Learning ObjectivesWelcome to the Level II — Intermediate Business Valuation course of the CICBV’s Program of Studies.

This course focuses on a number of valuation issues, and also delves into various tax-related matters that can impact a valuation. While at fi rst glance, many valuation assignments will seem unrelated to tax matters — such as a valuation of shares for an off ering in the open market or in the case of a fairness opinion — a number of important tax considerations are inherent in most valuation assignments. As a result, the valuator must understand the fundamental principles of the Canadian tax system on a theoretical and practical level. An integral part of the valuator’s work is to know how the organization will be taxed, which is impacted by the type of ownership and the types of income the organization is earning.

Module 1 focuses on the impact of taxation on an enterprise. In many cases, when the valuator reviews the assets and liabilities of a business to determine whether there are any value implications, it will be equally as important for them to understand the tax issues associated with those assets and liabilities. Doing so will ensure that any enhancements to value are captured, or conversely, that any contingent liabilities receive appropriate consideration. In this module, you will learn about valuing the after-tax cash fl ow streams of a business; providing valuation services to support transactions, such as corporate reorganizations; transfer pricing; and various forms of business organization. By the end of Module 1, you will be able to:

• Compare and contrast diff ering business structures, including sole proprietorships, partnerships, corporations, trusts, and joint ventures, syndicates, and co-ownerships.

• Describe diff erent types of income, including (but not limited to) business, property, and investment income; and be able to identify diff erences in such income, including how they are earned, how they are incorporated into taxable income, and how they are taxed.

• Describe common tax assets and liabilities, discuss how they arise, and demonstrate an understanding of their impact on value calculations.

• Discuss when a transfer pricing study may be necessary, describe transaction-specifi c considerations when evaluating intercompany transactions, and describe the impact of intercompany transactions on value calculations.

Module 2 focuses on comparable company multiples and other valuation matters. Used as a primary approach towards valuation — or as a way to assess the reasonableness of another valuation method(s) — comparable company multiples are key tools for the valuator. By the end


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of this module, you will have a comprehensive understanding of comparable company multiples (precedent transactions and public company multiples), fi nancial statement analysis, asset based valuation approaches, and real estate and equipment valuations. By the end of Module 2, you will be able to:

• Demonstrate an in-depth understanding of the methodology (including the rationale for choosing, and the mechanics and calculations) of the public company multiple approach and the precedent transactions multiple approach.

• Demonstrate an in-depth understanding of the methodology (including the rationale for choosing, and the mechanics and calculations) of asset-based valuation approaches, including the liquidation approach and the adjusted net book value approach.

• Perform professional and technically correct calculations using the valuation approaches noted above, taking into account case-specifi c factors.

• Demonstrate an understanding of the signifi cance behind a company’s tangible asset backing, including how it can be used in a valuation, and be able to perform professional and technically correct calculations.

• Describe typical real estate and equipment valuation methodologies, and describe their eff ect on value calculations.

Module 3 focuses on a number of taxation topics and corporate law concerns relevant to the valuation process. In this module, you will gain a comprehensive understanding of topics including majority positions and control, losses and acquisition of control, tax implications of sales of assets versus sales of shares, the Canadian Business Corporations Act, minority positions, discounts for illiquidity, portfolio discounts, special purchaser premiums and shareholder agreements. As well, the module focuses on recognizing circumstances where specifi c shareholdings require a discount or premium from rateable value. By the end of Module 3, you will be able to:

• Demonstrate an in-depth understanding (through calculations) of majority-control-related issues, including legal (de jure) vs. eff ective (de facto) control, group and joint control, special-interest purchasers, and control premiums.

• Describe acquisition of control rules.• Understand the diff erence in tax consequences, of a share sale vs. an asset sale, and

illustrate such understanding in professional and technically correct calculations.• Describe how trapped-in capital gains arise, and perform reasonable calculations based

on given a set of facts.• Identify and discuss issues involving minority shareholder rights, including the rights and

limitations of minority shareholders, and legal remedies under the Canadian Business Corporations Act (CBCA).

• Discuss diff erent types of discounts, including minority (non-controlling), illiquidity, marketability, blockage, and portfolio discounts; and be able to perform professional and

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technically correct calculations with respect to such discounts (including incorporation into a value calculation).

• Discuss the rationale for, and perform a reasonable calculation of, a special interest purchaser premiums

The course concludes with a number of assignments intended to test and reinforce your knowledge of intermediate valuation skills. Completion of these assignments is integral to your success in this course. Suggested answers are also provided.

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MODULE 1Taxation Issues for Valuation

Module OverviewWelcome to Module 1. In this module, you will gain an understanding of:

• Valuation impact of tax principles.• Forms of business organization.• Types of income.• Tax rates.• Common tax assets.• Tax assets.• Tax liabilities.• Transfer pricing.

The acronyms used throughout this module are:

CCPC Canadian controlled private corporation

CCA Capital cost allowance

PSB Personal service business

SIB Specifi ed investment business

ABIL Allowable business investment loss

CEC Cumulative eligible capital

ITC Investment tax credits

RDTOH Refundable dividend tax on hand

SR&ED Scientifi c research and experimental development

UCC Undepreciated capital cost

CUP Comparable Uncontrolled Price

Module 1Level II - Intermediate Business Valuation

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Required Reading

Byrd, Clarence and Chen, Ida. Byrd and Chen’s Canadian Tax Principles. Toronto: Pearson, 2013.

• Chapter 1 — Introduction to Federal Taxation in Canada• Chapter 5 — Capital Cost Allowances & Cumulative Eligible Capital• Chapter 6 — Income or Loss from a Business• Chapter 7 — Income from Property• Chapter 8 — Capital Gains and Capital Losses• Chapter 11 — Taxable Income and Tax Payable for Individuals Revisited• Chapter 12 — Taxable Income and Tax Payable for Corporations• Chapter 13 — Taxation of Corporate Investment Income• Chapter 15 — Corporate Taxation and Management Decisions • Chapter 21 — GST/HST

Campbell, Ian R., Johnson, Howard E., Nobes, H. Christopher. Canada Valuation Service, Student Edition 2012. Toronto: Carswell, 2012.

• Chapter 5 — The Capitalized Cash Flow Methodology• Chapter 6 — The Discounted Cash Flow Methodology• Chapter 5A (Valuation Methodologies)• Chapter 9 (Taxation pages 9-21 to 9-30 and 9-90 to 9-92)

CICBV Code of Ethics and Practice Standards, By-Laws

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1.1 Valuation Impact of Canadian Tax PrinciplesValuations for any purpose must consider the impact of taxation on the enterprise. Whether it is in the context of valuing the after-tax cash fl ow of a business, or determining the tax consequences of selling assets in an asset-based approach, a valuator must be able to recognize the key tax issues inherent in the business and assess their impact on value.

There are a lot of readings in Canadian Tax Principles for this module and the course itself. The extensive background is provided given that some students will have a greater knowledge of the tax system in Canada than others. There are students taking the course from other countries with very little knowledge of Canadian Tax. Students are responsible for the information in these readings, however students may already be familiar with a lot of the material, such as how to calculate recapture and capital gains. It is suggested to students to start with the course notes and review the topics in the texts. Any issues in the course notes or topics students are unfamiliar with can be referred to in greater detail in the required readings.

1.1.1 Going Concern Approaches

When determining the appropriate tax rates to use in utilizing any going-concern approach, the valuator must consider the following:

The type of corporation:

• Canadian controlled private corporation (CCPC) — Has access to the small business deduction and other tax benefi ts

• Private corporation — Can have varying tax implications • Public corporation, etc. — Has no access to the small business deduction

And the type of income:• Capital gain — a company is generally taxed on 50% of the actual gain• Active business income — The small business deduction, if applicable, can be used on

active business income• Income from property — Has various tax implications, including additional tax and RDTOH• Various other types and sub-types of income (capital losses, personal services income,

foreign income, etc).

If the corporation type is expected to change after the purchase (for example, a CCPC being purchased by a public corporation would no longer be a CCPC), the valuator should exercise care to ensure that they use a rate in the going-concern approach that will be appropriate for the entity after the purchase. In the above example, the valuator should not include the small business deduction in the valuation.


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Using a specifi c rate is only possible if a likely purchaser is being considered. For a notional fair market value calculation, a specifi c purchaser would usually not be identifi ed. However, a valuator must determine the most likely purchaser and consider taxes accordingly. For example, if an industry is in a consolidation phase where a number of large companies are buying small, private companies, this should be considered when assessing taxes. The appropriate treatment will depend on the variables in the situation but a Valuator should get in the habit of considering options and key information.

The income tax implications that aff ect the going-concern calculations of value are briefl y discussed under the following methods:

• Cash fl ow capitalization• Earnings capitalization• Discounted cash fl ow• Adjusted asset or adjusted net book value(Note: students are expected to have a solid understanding of these valuation approaches as a foundation to this course,

as these approaches are testable on the examination).

1.1.1.1 Earnings Capitalization MethodWhen using the earnings capitalization method, the following tax issues will impact the determination of fair market value:

• The selection of the appropriate tax rate to apply to the estimated maintainable earnings. In order to determine if the corporation qualifi es for the small business deduction, the appropriate provincial tax rate(s), any rate reductions, and surtaxes (if any) it is necessary to consider the type of corporation. To do this, the valuator can review the tax returns of the vendor or purchaser as appropriate, although any changes in tax rates or status of the corporation will also need to be considered.

• The selection of the appropriate tax rate and computation of taxable income on the realization of any redundant assets, including corporate taxes on any inherent gains associated with redundant assets.Redundant assets will be considered later in this module.

• The value of any tax pools (such as loss carry-forwards and investment tax credits) available for utilization in the future.In valuing the tax pools, the valuator should consider the expected time period over which the pools will be utilized, as well as the tax implications on the claim of any pools (e.g., the eff ect of tax loss carry-forwards on future income streams).

1.1.1.2 Cash Flow Capitalization MethodBefore learning about the cash fl ow capitalization method, it is useful for you to understand the underlying diff erence between the earnings and cash fl ow valuation methods. This will help you understand the “tax shield” that is created by CCA and ECE.

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The main diff erence between the cash fl ow capitalization method and the earnings capitalization method relates to depreciation and amortization as compared to actual capital asset needs in the future for a company. The earnings capitalization method assumes that depreciation and amortization are the best estimate of expected future capital asset needs, and therefore does not make any adjustments in this regard.

On the other hand, the cash fl ow capitalization method replaces the depreciation and amortization with the expected future sustaining capital reinvestment to arrive at expected future cash fl ow.

A simple example would be that a company with $500,000 of annual amortization, perhaps relating mostly to a building that is not actually decreasing in value, but only requires $100,000 of capital assets each year, would be valued using the cash fl ow capitalization method. A company with $500,000 of annual amortization and $500,000 of annual capital asset needs would be valued using the earnings capitalization method.

Taxes should be calculated as a percentage of the cash fl ows, but then must also be adjusted for the tax shield on the current asset base.

The Tax Shield is the present value of the future tax savings that result from the company’s asset base. Without considering the tax shield, the company’s value would be understated because there can be a signifi cant value to future tax savings related to capital assets. Similarly, the tax shield must also be calculated on the expected future capital asset reinvestment.

Generally, the fair market value of a business under the cash fl ow capitalization method can be calculated as follows:

Calculate EBIT (make normalizing adjustments to pre-tax income+ Non-cash expenses (i.e. depreciation and amortization)= Normalized EBITDA– Income taxes on the cash fl ow at the appropriate rate– Sustaining capital reinvestment, net of associated tax shield= Maintainable cash fl owsX Multiplier/capitalization rate (which refl ects the risk inherent in the cash fl ows)= Capitalized maintainable cash fl ows+ Present value of the tax shield on existing assets= Enterprise Value+ Redundant assets, net of associated tax costs– Debt= En bloc Fair Market Value


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Tax ShieldThe tax shield is identifi ed in several steps in the above calculation. It relates to the ability to claim capital cost allowance (for income tax purposes) on depreciable capital assets and therefore reduce the income tax the company would otherwise owe. The tax shield formulas are set out in the Exhibits below (1.1 and 1.2)

Note: The formulas below are only for declining balance amortization tax classes as opposed to straight line tax classes or US-style tax classes that are based on a fi nite life. Under the Canadian Income Tax Act, the majority of CCA classes are based on declining balance rates.

EXHIBIT 1.1: CALCULATING AN EXISTING TAX SHIELD(Investment cost (UCC) X income tax rate X CCA rate)

(Rate of return + CCA rate)

EXHIBIT 1.2: CALCULATING A TAX SHIELD ON ADDITIONS — CCA HALF-YEAR RULE APPLIES

An adjustment is made for new additions, since only 1/2 of the CCA rate is allowed in the year of acquisition

(Investment cost (UCC) X income tax rate X CCA rate) X 1 + (0.05 X rate of return) (rate of return + CCA rate) (1 + rate of return)

In the calculation of the tax shield, it is important to ensure that the estimated taxable income levels are suffi cient to absorb the full capital cost allowance claims. When estimated taxable income levels are insuffi cient to absorb CCA, the above method should not be used. Instead, the valuator will need to predict the value of each year’s future CCA deduction in future periods using a present value calculation.

Redundant AssetsRedundant assets are assets that not used directly in the business. Examples would be vacant land held for future sale or potential use, or cash/GICs not required for to sustain working capital.

In a valuation using the going-concern method, the redundant assets are valued net of income taxes and selling costs.

Income earned by the corporation is also adjusted for the loss of the redundant assets. In the computation of redundant assets, the valuator must consider the following:

• The tax rate of the corporation, whether it is entitled to refundable tax treatment, etc.• The type of income realized, i.e., recapture, capital gains, dividends, business income, etc.• The province(s)/countries in which the corporation is taxable.

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EXAMPLE 1.1 REDUNDANT ASSET CALCULATION

FMV $100,000Cost 25,000Capital gain $ 75,000Taxable capital gain (50%) $ 37,500Corporate tax (46.6%) $ 17,475Less: refundable tax (26.67% on taxable capital gain) (10,000)Net corporate tax payable $ 7,475 FMV of Redundant Asset Gross redundant asset $100,000Less: corporate tax on liquidation (7,475)Value of redundant assets within corporation $ 92,525

Note: Examples used throughout this course will use a gross up of 38%, a federal tax credit of 15% and a provincial tax credit of 10%.

1.1.1.3 Discounted Cash Flow MethodThe tax considerations that impact the discounted cash fl ow (DCF) method are similar to those that aff ect the earnings and cash fl ow capitalization methods, but with the following exceptions:

• The income taxes that factor into the DCF formula are on a cash basis.• The present value of the remaining tax shield is calculated in determining the residual

value of the business.

1.1.1.4 Adjusted Asset MethodThe adjusted net book value method is an asset-based technique, meaning that fair market value is generally determined by adjusting the assets and liabilities to their current market values. When shares are valued (i.e., as opposed to net assets), a further adjustment is made for the tax shield diff erences between the market values of the depreciable assets and their cost base for income tax purposes. The purpose of this adjustment is to recognize the diff erence in future tax benefi ts

ABC Co. is a small retail clothing store in Quebec. The owner of ABC Co. has asked you to determine the value of its shares to a prospective buyer. As the valuator, you must consider how the redundant assets aff ect the fair market value of the shares. The illustration below shows the eff ect of marketable securities that are redundant to the operations of the company.

• ABC Co. owns marketable securities in

the company with a FMV of $100,000. The original cost of these securities was $25,000.

• The combined federal/provincial corporate tax rate on investment income in Quebec is 46.6%, including RDTOH of 26.67%

• The net value of the redundant asset of $92,525 is calculated as follows: The net value of the redundant asset is calculated as follows:


8

(in the form of CCA deductions) when purchasing shares vs. purchasing assets. For instance, when the market value of a depreciable asset is greater than its tax cost base, the tax shield is deducted from overall value.

The potential tax liability that accrues to a company when the assets are eventually sold (e.g., tax on recaptured CCA and capital gains) needs to be considered in the calculation. Some valuators would argue that under a going-concern approach, the assets would not be sold and therefore no such tax costs would be incurred while other valuators would argue that a potential purchaser of the company would consider these potential tax liabilities and as such the tax costs would be deducted from value.

Unlike depreciable assets, the concept of a tax shield foregone on the goodwill (over and above identifi able intangibles) inherent in a share valuation, is not usually taken into account in a share valuation. However, the tax shield formula could be equally applied to calculate the negative impact of not acquiring the goodwill (over and above identifi able intangibles) directly.

1.1.2 Liquidation Method

When calculating the tax liability associated with the disposition of the assets of the corporation, the valuator must determine the appropriate rate to use. This calculation requires consideration of the following factors:

• The type of corporation - Canadian controlled private corporation (CCPC)

- Private corporation

- Public corporation, etc.

• The type of income - Capital gain

- Active business income

- Income from property

The seller will incur the liability if the assets are sold individually and the purchaser will acquire these assets with the new adjusted cost base and no inherent tax liability. Therefore, it is appropriate to use the seller’s tax rate.

Since the liquidation approach assumes the disposal of the assets of the corporation, GST/HST needs to be considered. However, it should not have any eff ect on the value of the corporation since any GST/HST collected on the sale of the assets would be remitted to the CRA.

Losses that the corporation had available would be utilized to off set any income arising on the realization of the assets.

Example 1.2, illustrates the tax calculation on a liquidation of a Canadian Controlled Private Corporation in Ontario (incorporated post V-Day) eligible for the small business deduction. The valuator must select the appropriate tax rates to apply to the taxable income created under the liquidation approach

9


EXAMPLE 1.2 TAX CALCULATION ON A LIQUIDATION OF A CORPORATION

EXAMPLE 1.2AABC IncorporatedApril 30, 20XYShareholders’ equity as at April 30, 20XY $1,300,000 Add: Excess of fair market value (FMV) 1,000,000 of investments over net book value (NBV) 800,000 200,000 Add: Excess of fair market value (FMV) 900,000 of capital assets (original cost of $500,000) over net book value (NBV)

500,000 400,000

Less: commissions on investments (32,000)Less: termination payroll costs (50,000)Add: refundable dividend tax on hand (RDTOH) Note 1 140,403Less: corporate taxes on liquidation (see below) (67,270)Cash available for common shareholders 1,891,133

Distributed as: Paid-up capital (given) 100,000 Capital Dividend account 84,000 Note 2 Deemed dividend (remainder) 1,707,133 1,891,133 Less: tax on dividend: Deemed dividend per above 1,707,133 Dividend gross up 38% 648,710 Taxable dividend 2,355,843 Tax at 40.16% 946,107 Less: dividend tax credit (Use combined rate 25%) (588,961) 357,146Liquidation proceeds to the shareholders $1,533,987


10

EXAMPLE 1.2BABC IncorporatedApril 30, 20XYTaxable income: Recaptured CCA (lesser of FMV of $400,000 and cost of $500,000 less UCC of $0)

$400,000

Termination payroll costs (50,000)Taxable capital gain 84,000

434,000Taxes (assumped a CCPC, and since below $500,000 limit, all at 15.5%)

67,270

Refundable taxes (1/3 of Taxes) 22,403

Notes

1

RDTOHOpening balance (given) $118,000Created on liquidation 22,403Ending RDTOH 140,403

2 Capital gain on investments $200,000 less: commissions (32,000)Net capital gain 168,000Taxable capital gain (50%) 84,000Capital dividend account 84,000

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1.2 Forms of Business OrganizationA business or undertaking can be structured using many diff erent forms of business organization. The choice of which organization will often depend on the tax objectives of the relevant stakeholders. Under the Canadian tax system, there are only three types of entities recognized as taxpayers under the Income Tax Act:

• Sole proprietorships (individuals)• Corporations• Trusts

However, individuals, corporations and trusts can also develop their own business undertaking using the following additional forms of business organization:

• Partnerships• Joint ventures• Syndicates• Co-ownerships

Because partnerships, joint ventures, syndicates and co-ownerships are not separately recognized under the Income Tax Act, the tax implications related to these types of organizations will be attributed back to the individual, corporate or trust investor.

The many business structures that have evolved over the years have become quite complex, but they can all be distilled into the basic elements noted above. It is important for the valuator to have a solid understanding of each type of structure so that they can assess the tax implications inherent in a proposed transaction and the eff ect on the ultimate value conclusion.

1.2.1 Sole Proprietorship (Individual)

One of the simplest forms of organizing a business is the sole proprietorship. Under this type of arrangement, one individual operates an unincorporated business and that individual has no separate legal existence from the business. As such, not only will the individual personally reap the rewards of the business, but they may also be personally liable for both the debts of the business and any additional business risks that may arise through the operation of the business.

The Income Tax Act does not separate the taxation of a proprietorship from that of the individual. As such, the individual must include all income and eligible expenses from every business operated in this manner on his/her personal income tax return each year. That income, accordingly, will be taxed at the appropriate marginal tax rate applicable to the individual. Similarly, if expenses exceed income, then any losses incurred in the operation of the business will become losses of the individual that may be deductible from other sources of income earned by the individual (subject to certain qualifying provisions of the Income Tax Act).


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Because of the simplicity of this form of business organization, and the tax deductions that may be available from start-up losses, many businesses will often begin as a sole proprietorship. Any transfer, or sale, of a proprietorship will necessarily be a sale of assets, since there is no share ownership of the separate legal entity in this business structure. This does not mean a valuation of the business entity will not be required, since the business will have to be valued in order to determine the value of goodwill that will be transferred. In the course of such a valuation, it will be necessary to determine the likely purchaser of the business and the tax rate that they would pay on the earnings generated by the business.

1.2.2 Corporation

A corporation is considered a separate legal entity. As a separate legal entity, a corporation can enter into contracts, borrow money, and pay its own taxes. The use of a corporation allows for the ownership of a business to be widely distributed in the form of a shareholder’s investment in the stock and permits that ownership to be easily bought and sold. Additionally, an investor in a corporation will enjoy limited liability since only the assets of the corporation are exposed to the claims of creditors, thereby protecting the investor’s personal assets.

The Income Tax Act distinguishes between a variety of forms of corporations in order to diff erentiate between “large” and “small” corporations.

Public CorporationA public corporation is defi ned in subsection 89(1) of the Income Tax Act to be a corporation resident in Canada whose shares are listed on a Canadian Stock Exchange. In addition, if a corporation’s shares are widely held, certain private corporations may be deemed to be a public corporation or may elect to be treated as a public corporation. These rules can be found in subsection 4800(1) of the regulations regarding the number of shareholders, dispersal of ownership, public trading of the corporation’s shares, and size of the corporation.

Private CorporationA private corporation is also defi ned in subsection 89(1) of the Income Tax Act. A private corporation is a corporation resident in Canada that is neither a public corporation, nor controlled (directly or indirectly) by one or more public corporations. Control, in this case, is defi ned as de jure control, meaning ownership of more than 50% of the voting shares of the corporation.

Canadian Controlled Private CorporationThe Income Tax Act provides for an additional distinction between private corporations to allow certain qualifying corporations access to a number of tax benefi ts. These qualifying corporations are referred to as “Canadian controlled private corporations” or “CCPCs.” Section 125(7) of the Income Tax Act defi nes a CCPC as a private corporation that is not controlled (directly or indirectly) by one or more non-residents, by one or more public corporations or by any combination of non-residents and public corporations. The concept of control, for these purposes, is de facto control [subsection 256(5.1)], or control in fact, and may arise without de jure control. Thus, a CCPC can have up to 50% of its voting shares held by a non-resident and still retain its CCPC status as long as Canadian individuals or other private corporations hold de facto control. The concepts of de jure and de facto control will be discussed in more detail in Module 3 of this course.

13


Additional reading on the types of corporations can be found in Interpretation Bulletin IT 391R, “Status of Corporations” which is also posted on the Canada Revenue Agency (“CRA”) website at : www.cra-arc.gc.ca/E/pub/tp/it391r/it391r-e.txt and in IT 458R2, Canadian Controlled Private Corporations at www.cra-arc.gc.ca/E/pub/tp/it458r2/README.html.

Taxation of CorporationsFor tax purposes, a corporation will calculate its taxable income in accordance with the distinct rules applicable to corporations under the Income Tax Act. If the corporation incurs a loss, that loss can only be used to off set future (or past) income of the corporation and cannot be used by the shareholders to off set other sources of personal income.

Corporations are subject to diff erent tax rates than individuals, which may have certain advantages. An individual (or sole proprietorship) carrying on a business will pay tax based on the progressive marginal rates applicable to that individual, whereas the rate of tax payable by corporations will be based on a fl at rate that varies depending on the type of corporation and the nature of the income.

It should be noted, however, that distributions from corporations (i.e., dividends) will also be taxed in the hands of the shareholder, notwithstanding that a level of tax has already been paid at the corporate level. While the Income Tax Act has rules in place to mitigate the potential for double taxation, the eff ectiveness of these rules will depend on the rates applicable to the corporation and individual. The Canada Revenue Agency and the large accounting fi rms publish the eff ective tax rates (both federal and provincial) for various types of corporations.

1.2.3 Trusts

A trust is a legal relationship between persons and is created when a person (or settlor) transfers legal title of one or more assets to a trustee. The trustee, in turn, manages that property for the benefi t of others (the benefi ciaries). Thus, a trust separates the legal title, holding and management of the property (the trustee) from the use or enjoyment of that property (the benefi ciaries).

The Income Tax Act contemplates two basic categories of trusts:

• Testamentary trust — A trust or estate created upon the death of an individual.• Inter vivos trust — Any other form of trust.

In a business context, the most common form of trust is an inter vivos trust. There are many forms of these trusts trading on Canada’s stock exchanges, including royalty trusts, real estate investment trusts (REITs) and income trusts.

Taxation of TrustsUnder Canadian tax law, a trust is considered a taxpayer, much like a separate individual. The taxable income of a trust will be calculated using similar rules applicable to individuals (with some exceptions).

One major exception to the above paragraph is that a trust may deduct from income amounts paid or payable to benefi ciaries. The income allocable to the benefi ciaries in this manner will instead be taxable to the benefi ciaries, and the amount of tax so payable will depend on the rules and rates applicable to that benefi ciary. This type of entity is therefore often referred to as a “fl ow-through


14

entity” because of this capability to eff ectively shift the burden of tax to the individual benefi ciary (or investor). However, if income is retained and accumulated in the trust, it will be taxed at the trust level, where an inter vivos trust will pay tax at the highest individual marginal rate on such retained income.

The ability to shift the burden of tax from the trust to the benefi ciaries/investors makes trusts attractive to investors. While an investor in a corporation may see its distributable profi ts depleted by taxes paid at both the corporate and personal level, a trust investor will pay tax only at a personal level. The capacity of a trust to eliminate taxation is particularly attractive to investors that may not be subject to tax, such as pension funds or RRSP investors. The tax effi ciency of this type of organization leads to the higher valuations that have been achieved by businesses that chose to restructure to this type of model. This is an example of how the value of an enterprise can change as a result of the tax the entity will be required to pay.

Due to the tax effi ciency of the income trust model, there were a large number of conversions from corporations to income trust structures. The government experienced signifi cant tax leakages from the use of fl ow through entities and as a result designed legislation to deal with this problem.

A separate class of partnerships and trusts were developed to which diff erent rules would apply. These were Specifi ed Investment Flow-through Partnerships and Specifi ed Investment Flow-through Trusts. These entities are designed to be subject to tax at the same rates as publicly traded corporations. For further discussion on this topic see Canadian Tax Principles “SIFT (Specifi ed Investment Flow Through) Partnerships and Trusts” Chapter 19.

1.2.4 Partnerships

Like a sole proprietorship, a partnership is not legally recognized as a separate entity apart from its owners. Instead, it is simply a relationship that exists between two or more persons who are carrying on a trade or business together. While there is no specifi c defi nition of a partnership under The Income Tax Act, there are a number of specifi c rules that will apply if a partnership exists. Before these rules can be applied, the valuator, with assistance of legal counsel, must determine whether a valid partnership exists between the entities. Often this determination will depend on the applicable provincial legislation and common law principles.

Many of the provinces have similar provisions that provide guidance on the characteristics of a partnership. Briefl y, the Ontario Partnerships Act provides that the following three elements are essential to a partnership:

• There must be a business• The business must be carried on in common by two or more persons• The objective of the business must be profi t

Taxation of PartnershipsFor tax purposes, the calculation of income in a partnership is relatively straightforward. Although it is not considered a separate legal person, the Income Tax Act requires that a partnership calculate its taxable income as if it were. Specifi cally, Section 96 of the Income Tax Act provides

15


rules for the partnership to compute its taxable income as if it were a taxpayer separate from its partners. This includes calculating the total income for tax purposes and subtracting the relevant tax deductions, including deductions such as capital cost allowance (CCA).

Once taxable income has been calculated, the net result is then allocated to the partners based on their respective interest in the partnership. Each partner will include his/her share of the partnership’s taxable income on his/her tax return (along with income earned from other sources, if any), and the partnership income so allocated will be subject to tax at the rates applicable to each partner. For instance:

• If the partner is an individual, the income will be subject to the personal marginal rates of that partner.

• If the partner is a corporation, the income will be subject to tax based on the prevailing corporate tax rate.

If the partnership suff ers a loss, the loss will be allocated to the partners and will be deductible by the partners against their other sources of income (subject to certain qualifying provisions of the Income Tax Act).

Partnership InterestIt is important to note that although a partnership is not considered a separate legal entity from its partners, the partners do not necessarily have a direct interest in the assets of the partnership. Instead, the asset the partner owns is a “right” — a right to participate in profi ts or losses and a right to an interest in the partnership property (on dissolution). This right is considered a partnership interest and represents an undivided interest in the underlying property of the partnership as a whole.

This is somewhat analogous to a share in a corporation — that is, a shareholder of a corporation does not own the operating assets of that corporation, but only a share interest in the corporation, the value of which is derived from the underlying assets of the corporation. Unlike a share investment, however, a partner’s interest is not represented by a number of stock certifi cates, but by his/her proportionate legal entitlement to the net assets of the partnership.

A partnership interest can also be bought and sold by a partner, in which case it may be necessary for a valuator to ascribe a value to such an interest. This would fi rst require a valuation of the underlying business and the related assets of the partnership as a whole. Then, the value would be allocated to the partnership interest based on the proportion of ownership attributable to the partner.

For tax purposes, a partnership interest represents capital property, so any disposition of the interest could give rise to a capital gain or loss, depending on the value of the property relative to the partner’s cost base of the interest.

The Income Tax Act provides for a number of rules that deal with how the cost of a partnership interest is calculated. Amounts that are considered to increase the cost base of a partnership interest are detailed in subsection 53(1) (e) of the Income Tax Act, while amounts that must be


16

deducted from the cost base of a partnership interest are listed in subsection 53(2)(c) of the Income Tax Act.

Additional information on the types of adjustments made to the cost base of a partnership interest can be found in Adjusted Cost Base of a Partnership Interest, Chapter 18, of Canadian Tax Principles — Professional Edition 2013, Byrd & Chen.

Limited PartnershipsAs noted earlier, an ordinary partnership (or general partnership) is not distinct from its owners. Partners have joint and several liability for the debts of the partnership, and where a large number of unrelated partners are involved, this is often unacceptable. To overcome this issue of unlimited liability, a limited partnership is often formed.

A limited partnership consists of at least one general partner with unlimited liability (although in most cases the general partner can be a shell corporation (i.e. an entity that is generally incorporated but has no assets or operations), which itself has limited liability. In addition to the general partner, one or more limited partners can invest in the partnership, and the liability of these limited partners will be confi ned to the capital they have invested in the partnership. In other words, in a limited partnership structure, it is only the general partner(s) that will have unlimited liability, while the liability of the limited partner(s) will be capped by their investment amount.

As limited partnerships are often popular in more speculative ventures or in start-up businesses where losses may accrue, there are a number of tax rules that deal specifi cally with limited partnerships. These rules are typically referred to as the “at-risk rules” and are designed to ensure that taxpayers do not claim losses (or other tax benefi ts) that have been allocated from the limited partnership in excess of the amount they have invested or are “at risk” in the partnership.

For more detail on these rules, see subsection 96(2.1) to (2.7) of the Income Tax Act and At-Risk Rules in Canadian Tax Principles, Chapter 18.

1.2.5 Joint Ventures, Syndicates and Co-ownerships

A joint venture must be distinguished from a partnership for a variety of reasons. Not only will a joint venture have very diff erent tax implications than a partnership, but the legal ramifi cations of a joint venture are distinct as well.

Like a partnership, a joint venture is not separately defi ned under the Income Tax Act, nor is it considered its own legal entity. Under common law principles, the concept of a joint venture has evolved to represent those situations where two or more persons carry on a business, where the relationship does not legally constitute a partnership.

Factors that distinguish a joint venture from a partnership include the following:

• Co-venturers cannot contractually bind other co-venturers• Co-venturers retain ownership of property contributed to the joint venture• Co-venturers are not jointly and severally liable for debts

17


• Co-venturers share gross revenues, not profi ts (can deduct their own discretionary expenses)

• A joint venture usually involves a single (or a limited-time) undertaking (Such as an investment in an apartment complex)

A number of elements will distinguish a joint venture from a partnership. A more detailed description of these types of business undertakings, along with syndicates and co-ownerships, can be found in Canadian Tax Principles, Chapter 18.

Taxation of Joint VenturesBecause a joint venture and a partnership have diff erent tax obligations, it will be important to properly characterize this type of organization that is being valued. For instance, unlike a partnership, the income or loss of the venture will be determined at the level of the individual venturers, rather than at the level of the venture. This means that each venturer will compute his/her share of every element of income earned by the venture and deduct his/her share of each allowable deduction. This gives each venturer the ability to claim various discretionary deductions (such as capital cost allowance) at his/her option. A partner in a partnership has no such discretion as the partner is merely allocated his/her share of taxable income after all discretionary deductions are claimed.

The income claimed by each venturer is included on the tax return for each respective venturer, together with any other sources of income earned by the venturer in the tax year. Similarly, any losses incurred by the venture will be deductible from the other income of the venturer (subject to certain qualifying provisions of the Income Tax Act). As such, a joint venture is another form of “fl ow-through” entity whereby the income is fl owed through to the venturers for tax purposes.

Venturer’s InterestFrom a legal perspective, a venturer will have a direct interest in the underlying assets in the joint venture (unlike a partnership, where the partner’s interest constitutes a right to the underlying assets). This distinction is important from a valuation point of view. For instance, where a valuation of a partner’s interest requires a valuation of the partnership as a whole (with an allocation of that value then attributed to the partner based on his proportionate share interest), the valuation of a venturer’s interest will be confi ned to a valuation of the venturer’s respective share of the underlying assets only. Because the venturer has the fl exibility to vary the write-off s associated with their share of assets (e.g., capital cost allowance), this may have implications for the valuation as well.

Be aware of the importance of determining the form of the subject organization. Organizations will be taxed diff erently, depending on what form they are operating under. Also be aware that it is sometimes diffi cult to determine the form of the organization. For example a joint venture and a partnership have some characteristics in common. In addition, joint ventures are not defi ned under the Income Tax Act and therefore identifi cation can be more diffi cult.

For more detailed discussion of this topic see Canadian Tax Principles, Section entitled “Co-ownership, Joint Ventures and Syndicates” in the Chapter on Partnerships.


18

1.3 Types of IncomePart I of the Income Tax Act distinguishes between the following types of income for corporations:

• Business income • Property income• Capital gains

In order for the valuator to properly assess the tax consequences specifi c to a particular stream of income, it is important to fi rst recognize the rules applicable to the diff erent types of income and the diff erent tax rates applicable thereto.

1.3.1 Business Income

The taxation of income derived from a business is covered in Sections 9 through 37 of the Income Tax Act. In this context, subsection 248(1) of the Income Tax Act defi nes a business as a “profession, calling, trade, manufacture or undertaking of any kind whatever, and… an adventure or concern in the nature or trade but does not include an offi ce or employment.”1

Most taxpayers report business income under the accrual method of accounting, which means that the business income is included in the income of the taxpayer in the year it is earned and, accordingly, is subject to tax at the rates applicable to the taxpayer for that year. For example, an individual taxpayer will pay tax on business income based on his/her relevant marginal tax rate, whereas a corporate taxpayer will pay tax on business income based on the fl at rate applicable to corporations. However, in the corporate context, certain types of business income are subject to particular rules and the valuator must be able to recognize these types of businesses to ensure proper tax rates are applied.

Active Business IncomeActive business income is defi ned in Section 125(7) of the Income Tax Act as income from any business other than a specifi ed investment business (“SIB”) or personal service business (“PSB”) and includes income from an adventure or concern in the nature of trade.

A special tax rate is applied through a small business deduction against income from an active business. The small business deduction is a tax rate reduction on active business income carried on in Canada and is only available to a CCPC. The maximum amount of active business income eligible for this deduction has varied in recent years and varies by province. The current federal annual business limit can be found in subsection 125(2) of the Income Tax Act and in Canadian Tax Principles, Chapter 12, Annual Business Limit. For the purpose of this textbook, we will use a threshold of $500,000, though this amount will vary by province.

In addition to the federal small business deduction, most, if not all, provincial jurisdictions also off er favorable tax rates for CCPCs earning income in an active business. To prevent a taxpayer from incorporating several companies in an attempt to multiply the small business deduction, the “association rules” were introduced. These rules are explained in more detail in Canadian Tax

1 Additional information on business income can be obtained from: Canadian Tax Principles, Chapter 6 “Income or Loss from a Busi-ness. Interpretation Bulletin IT 459,” also available on the CRA website at: www.cra-arc.gc.ca/E/pub/tp/it459/

19


Principles, Chapter 12, Allocation Among Associated Companies. The valuator must consider the associated corporation rules when evaluating the application of the small business deduction to a particular situation, as associated corporations must share the annual business limit.

Specifi ed Investment BusinessThe defi nition of a specifi ed investment business is found in Section 125(7) of the Income Tax Act. A specifi ed investment business has a principal purpose to derive income from property.

There are exceptions for the following corporations:

• Companies that have more than fi ve full-time employees throughout the year.OR

• Where an associated corporation provides managerial, fi nancial or similar services to the company, it could reasonably be expected that the company would require more than fi ve full-time employees throughout the year if those services were not so provided.

The courts have interpreted that the phrase “more than fi ve full-time employees” means six or more full-time employees (The Queen v. Hughes & Co. Holdings Ltd.). The Canada Revenue Agency has confi rmed this position in IT-73R6, available at www.cra-arc.gc.ca/E/pub/tp/it73r6/.

It is important to determine whether a corporation carries on a specifi ed investment business (SIB) will determine the rate of tax that the corporation must pay. If the corporation carries on a SIB, it will not be eligible for the small business deduction. Instead the corporation will pay tax at full corporate rates, including an additional refundable Part I tax and be eligible for refundable tax treatment on the SIB income.

If the corporation has more than fi ve full-time employees, it is exempt from the SIB provisions and is entitled to the small business deduction, up to the annual business limit each year. In addition, where the investment income is earned from an associated corporation, such income is deemed to be active business income, and is eligible for the small business deduction, provided the associated corporation earns the active business income.

Personal Services Business (or Personal Services Corporations)When corporate tax rates are substantially lower than individual tax rates, an employee may choose to incorporate a company to earn their employment income and achieve the tax savings. In this case, additional fl exibility may also be available in writing off expenses, since a business can generally deduct all expenses incurred to generate income, whereas an employee is limited in what can be expensed.

To limit potential abuse, the Income Tax Act defi nes a personal services business in Section 125(7). If a corporation is deemed to be carrying on a PSB, the small business deduction is not available (maximum corporate rates apply) and no deductions are allowed in computing income except for those generally available to employees.


20

1.3.2 Property Income

Property income is the income derived from invested capital where the investor has more of a passive role in producing that income. Such as rental, interest, dividend and royalty income. Notably, if the investor is actively engaged in producing this type of income, the income could be considered business income. For example, a fi nance company may actively manage a lending portfolio, and the interest income earned from this portfolio would constitute business income.

Certain deductions ordinarily deductible from business income are not allowed where income is earned from passive investments in property. Examples of deductions that may be restricted include interest expense and capital cost allowance. More detail on the computation of property income is found in Canadian Tax Principles, Chapter 7.

Interest, rents and royalty income earned by an individual or corporation will be taxable based on the personal or corporate tax rate of the taxpayer. However, special rules apply for dividends.

The taxes on dividends paid to an individual shareholder are designed to recognize that the corporate payer of the dividend has already paid taxes on the underlying business income. As such, the government has established a mechanism to integrate the corporate and personal taxes, where, in theory, the resulting tax paid by both the corporation and the individual should be the same as that paid by the individual if he earned the income directly.

Under this mechanism, a dividend received by an individual shareholder is subject to a gross-up calculation so that the individual taxpayer includes an amount greater than the actual dividend amount in the computation of his/her income. To compensate for this extra inclusion, a federal dividend tax credit is also allowed equivalent to a percentage of the grossed-up dividend. Since 2013 a corporation can issue eligible or ineligible dividends. If a corporation pays dividends out of income that has not benefi ted from the small business deduction or any other special tax rates, the dividends are called eligible dividends.

EXHIBIT 1.3: %’S ON ELIGIBLE AND NON-ELIGIBLE DIVIDENDS

Gross-up Federal Tax CreditEligible dividend 38% 15%Non Eligible dividends 18% 11%

Certain dividends may also be received tax-free.

These include:

• Dividends received by a corporation, where the payer is another taxable Canadian corporation (see S. 112 of the Income Tax Act, but see also discussion of Part IV tax below).

• Dividends paid and designated from a private corporation’s capital dividend account. In general terms, the capital dividend account is the aggregate of the non-taxable portion of

21


the cumulative capital gains realized by the corporation in prior years. Additional information on the corporation’s capital dividend account is found in Canadian Tax Principles, Chapter 14, Tax Basis Shareholders’ Equity.

1.3.3 Capital Gains

Capital gains are distinct from business and property income. A capital gain (i.e., a profi t from the sale of property or of an investment) could arise on the disposition of the assets used in a business or on a disposition of the investments used to derive property income.

A gain on the disposition of an investment or business property is treated as a capital gain for tax purposes. The taxation of capital gains has varied over the years, from a time when such gains were not taxable, to a time when almost 75% of such gains were taxable. Today, only 50% of capital gains are considered taxable. Similarly, the allowable loss on the disposition of these types of properties is limited to 50% of the loss incurred. The relevant inclusion rates for a particular year can be found in Section 38 of the Income Tax Act.

Notably, capital losses may not be deducted from other sources of income such as business, property or employment income, but may only be deducted against capital gains from other sources. Additional information on the treatment of capital gains and losses is found in Canadian Tax Principles, Chapter 8, “Capital Gains and Capital Losses.”


22

1.4 Tax Rates A number of diff erent forms of tax are levied on businesses in Canada. This section discusses the more common taxes the valuator should be aware of, including the following:

• Income taxes• Refundable part I tax• Capital taxes• Commodity taxes• Part IV tax

1.4.1 Income Taxes

There are two types of income tax rates that the valuator must consider — federal and provincial. Because these rates are changing on a regular basis, the valuator will need to continually have access to updated rates. A good summary of current tax rates can be found at the Canada Revenue Agency website or on many websites of professional accounting fi rms.

Specifi c references may be found in the Preface of Canadian Tax Principles or as follows:

Personal tax rates:• CRA website at: www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html• KPMG website at: www.kpmg.com/Ca/en/IssuesAndInsights/ArticlesPublications/

Pages/taxratespersonal.aspx• Ernst & Young website at: www.ey.com/CA/en/Home (search for individual tax rates)

Corporate tax rates:• KPMG website at: www.kpmg.com/Ca/en/IssuesAndInsights/ArticlesPublications/

Pages/taxrates.aspx • Ernst & Young website at : www.ey.com/CA/en/Home (search for corporate tax rates)

Tax rates will be provided in exam questions. If tax rates are not provided, students should make a reasonable assumption of the rate.

1.4.2 Refundable Part I Tax

The Income Tax Act imposes an additional tax under Part I equal to 6 2/3% of the investment income of a CCPC (total refundable taxes are 26.67%, comprised of 20% refundable tax and 6.67% additional refundable tax). For these purposes, investment income includes both income from property (as discussed above) and net capital gains income. Most dividends received from Canadian corporations are excluded from the calculation because they are not subject to Part I tax.

The imposition of this tax is designed to discourage individuals from using holding companies to defer tax on investment income where the corporate tax rate is otherwise lower than the personal tax rate. For example, in some provincial jurisdictions, the combined corporate tax rate could be as low as 38%, compared to a marginal personal tax rate of 46.41% (the marginal tax rate for

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Ontarians with between $135,000 and $509,000 of income). With the addition of the refundable tax, the corporation will temporarily pay an additional tax of 6 2/3%, bringing the combined corporate rate more in line with the personal rate (38% plus 6.67% equals 44.67%).

As noted, the imposition of this tax is only temporary. This is because there is a mechanism available whereby the tax will be refunded once the investment income earned by the CCPC is distributed to the shareholders in the form of dividends (where it will then be subject to personal tax rates instead, thereby ending the deferral period). Essentially, any Part I taxes paid on investment income are added to a refundable dividend tax on hand account (“RDTOH” account).

Each year, 26 2/3% of the aggregate investment income will be added to the RDTOH account. If dividends are not paid in the year, the balance in the RDTOH account will carry over to subsequent years, and be aggregated with any refundable Part I taxes paid in the following years. When a dividend is ultimately paid out, the corporation will then receive a refund equal to 1/3 of the taxable dividends paid in the year (up to the balance in the RDTOH account). If a company ceases to be a CCPC, the RDTOH account (and the entitlement to a dividend refund) will be lost. As such, it may be prudent to distribute dividends to recover any balance in the RDTOH account prior to any transaction that results in a change in status for the corporation (e.g., taking a corporation public).

For more thorough discussion of refundable taxes and the dividend refund mechanisms, see Refundable Taxes on Investment Income, in Canadian Tax Principles, Chapter 13.

1.4.3 Commodity Taxes

Commodity taxes represent sales or use taxes such as goods and services tax (“GST”), harmonized sales tax (“HST”), or provincial retail sales taxes (“PST”). While a detailed discussion of these types of taxes is beyond the scope of this course, the valuator should be aware of several common implications. For instance, as only certain assets are subject to the imposition of GST and/or PST, the allocation of value to particular assets may have additional tax consequences that will need to be factored into a valuation exercise. For example, the purchase of a share is not subject to GST or PST, whereas the purchase of manufacturing equipment will be. If such taxes cannot be recovered, this additional cost should be considered in any assessment of related value.

The valuator should also be aware of certain exceptions that might apply in the context of the purchase or sale of a business. For example, for GST purposes there is an election under Section 167 of the Excise Tax Act whereby the vendor and the purchaser can elect not to have GST apply where all or substantially all of the assets used in the business are being sold. Where the election is made, the supply of the assets is considered “zero-rated.” As such, the purchase of the assets can be made without the application of GST. In the context of a signifi cant transaction, this election can result in considerable cash fl ow savings.

For further information on GST, see Canadian Tax Principles, Chapter 4 and GST/HST, Chapter 21.


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1.4.4 Part IV Tax

As noted earlier in the discussion on property income, Canadian inter-corporate dividends are not subject to tax under the Income Tax Act. Such tax is instead deferred until the corporate recipient of such dividends makes a distribution to its individual shareholders. However, to discourage the use of holding companies as a means of deferring tax on portfolio investment income that would otherwise be earned personally, Part IV of the Income Tax Act imposes a tax on certain dividends at a fl at rate of 33 1/3% on the recipient corporation (with some exceptions.) The Part IV tax is added to the RDTOH account (described above) and, like Refundable Part I tax, is refundable to the corporation when it pays a taxable dividend to its shareholders through the computation of the dividend refund mechanism. In theory, after the dividend refund, the corporation is not taxed on the dividend that it received from the other corporation, as the tax burden has subsequently been shifted to the shareholder.

For additional information, see Refundable Part IV Taxes on Dividends Received, in Canadian Tax Principles, Chapter 13.

A CCPC is able to pay tax at a benefi cial rate on active business income, due to the Small Business Deduction. To the extent that this corporation is paying dividends out of active business income to a connected corporation, there will be no dividend refund and no Part IV tax to be paid by the recipient corporation.

However, if a dividend is paid out of investment income, and the payor corporation receives a dividend refund, unless there is some tax imposed on the recipient corporation, there would be a signifi cant deferral of tax.

As a result, if a dividend is paid from investment income to a connected private corporation and the payor receives a dividend refund, the recipient will be liable for a Part IV tax equal to its share of the recipients dividend refund.

For examples and defi nitions of connected corporations, refer to the Canadian Tax Principles, Chapter entitled “Taxation of Corporate Investment Income” under the Section Dividends from a Connected Corporation.

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1.5 Common Tax AssetsTypically, the types of assets that will fl ow through to a purchaser who acquires either assets or shares are:

• Non-depreciable capital property.• Depreciable property.• Intangibles (or eligible capital property).

The next section discusses how these tax assets may impact a business valuation.

1.5.1 Non-depreciable Capital Property

Capital property is represented by investments in property that derive business or property income. Certain capital property is depreciable (such as fi xed assets) but other capital property may not be depreciable (and indeed may appreciate over time, depending on the level of income that is generated from the investment).

Typical examples of non-depreciable capital property include:

• Land.• Share investments in subsidiary corporations.• Portfolio share investments.• Partnership interests and possible bond or debt obligations held as investments.

It is important for the valuator to recognize that the tax cost associated with capital property may be diff erent from the historical cost or book value in the fi nancial statements. In some situations, a business may have made appraisal adjustments to the original cost, or other GAAP adjustments may have been made to vary the book value from the original cost. Additionally, depending on how the property was acquired (such as on a rollover transaction), the tax cost of the property may vary from what would have been recorded for accounting purposes at the time of the transaction. Thus, it may be prudent for the valuator to review the original acquisition transaction to ensure that the appropriate tax value is considered.

1.5.2 Depreciable Property

As the acquisition cost of capital property cannot be expensed immediately for tax purposes, the Income Tax Act provides for a mechanism whereby a portion of fi xed assets can be written off each year. While similar to the depreciation concept in accounting, this system of writing off the assets is called the capital cost allowance (“CCA”) system. The Income Tax Regulations divide assets into diff erent “classes” with each class having a prescribed allowance rate. As such, similar properties will be pooled in a class and the allowable CCA deduction will be based on the balance remaining in the class at the end of the year (i.e., the CCA rate is applied to the declining balance of the class).

The balance of the class at a particular time is referred to as the undepreciated capital cost (or “UCC”). However, because the Income Tax Act prescribes the CCA rates and property classes,


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the UCC balance will typically be diff erent than the book value of the assets recorded in the fi nancial statements.

In addition, while accounting depreciation is taken every year, a taxpayer has discretion in claiming CCA. Therefore, in loss years or in years of below average income, the taxpayer may deduct less than the maximum available CCA and preserve the UCC balance of the class so that CCA can be claimed and applied to income in future years.

As UCC represents future deductions that may be made against prospective income, it is often referred to as the existing tax shield and will be an important consideration in assessing the future after-tax cash fl ow streams of a business.

Acquisition of Depreciable PropertyWhen a depreciable property is acquired and the appropriate CCA class is determined, the acquisition cost of that property is added to the respective UCC balance in that year. The acquisition cost for these purposes will include both the cost of the asset, as well as any costs associated with acquiring and installing the asset (i.e., legal fees, taxes, freight or delivery costs, etc.).

However, if the asset is not “available for use,” the Income Tax Act prohibits the taxpayer from claiming CCA until such property is put in service. Such as on the occasion where a building is being constructed over a long period of time, all the costs related to the construction of the building would be capitalized. CCA deductions would begin once the building was actually fi nished or “available for use.”

Additionally, while CCA is not prorated for the number of months the asset is in service for the year, the rules generally prescribe that for most classes only one-half of the maximum CCA claim may be deducted in the fi rst year.

Disposition of Depreciable PropertyWhen a taxpayer disposes of capital property of a particular class, the lesser of:

• The original cost of the propertyAND

• The proceeds must be deducted from the UCC balance of that class.

As described below, the tax implications of this deduction will vary, depending on the amount of this deduction relative to the UCC balance.

1.5.2.1 A. UCC Balance > Deduction If the UCC balance (after refl ecting the above-noted deduction in respect of the disposition) is positive and there are still other properties remaining in the UCC class after the disposition, then the eff ect of the UCC reduction is simply a corresponding reduction in CCA deductions available in future years in respect of the remaining assets in the class.

However, if there are no other assets remaining in the class, there will be an immediate tax result. In that case, the Income Tax Act recognizes this excess UCC balance as a terminal loss, which is fully deductible from income in the period of disposal of the last asset in the class. The terminal loss provisions are designed to recognize that the CCA write-off s taken in prior years may not

27


necessarily refl ect the actual impairment of the value of the asset. Thus, the provision allowing the excess UCC balance to be deducted in the year of fi nal disposition eff ectively permits a taxpayer to “catch up” on CCA claims that may have been inadequate in the past.

EXAMPLE 1.3: POSITIVE UNDEPRECIATED CAPITAL COST (UCC) BALANCE

EXAMPLE 1.3AOriginal cost of property: $10,000Proceeds $5,000UCC balance before disposition: $ 8,000

EXAMPLE 1.3B (A) Properties

Remain in Class?(B) PropertiesRemain in Class?

NO YES UCC Balance, before disposition $8,000 $8,000Lesser of cost and proceeds ($5,000) ($5,000)Closing UCC balance $3,000 $3,000Terminal loss — deducted from income 3,000 nil Adjusted UCC balance nil 3,000

Notes:

In [A], we have disposed of all/the last asset in this UCC class. However, based on the above calculations we see that there is a remaining UCC balance of $3,000. As all of the assets have now been disposed of we must recognize the tax implications, which is to write off /expense the residual UCC balance. This is called a terminal loss. This terminal loss is not a capital loss. It is treated as a deduction against business income in the year of disposal.

In [B], the remaining $3,000 UCC balance represents the residual tax shield on the remaining assets in the class, and CCA will continue to be deducted from this balance in future years.

1.5.2.2 B. UCC Balance < DeductionIf the deduction from the UCC class results in a negative balance in the class and such negative balance remains at the end of the taxation year (i.e., it has not been off set with additional acquisitions in that class), the result is an immediate inclusion in income, irrespective of whether there are any assets left in the class. Known as “recapture,” this income inclusion is designed to recognize that CCA claims made in prior years may has exceeded the UCC pool available, meaning that too much CCA has been recognized as a tax deduction in prior years. In order to compensate for overclaiming of expenses over the assets life, there is a income inclusion of the overclaimed amount, called recapture.


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Capital GainSince the amount that is deducted from the UCC pool is limited to the lesser of the original cost and the proceeds, if the proceeds exceed the original cost, there remains an additional amount that has not yet been accounted for in the mechanisms described above. For tax purposes, this excess amount (proceeds in excess of original cost) is considered a capital gain.

Note, however, that if the proceeds of the property are less than the original cost of the property (i.e., the taxpayer incurred an economic loss), the rules of the Income Tax Act prohibit a capital loss from being recognized by the taxpayer.

EXAMPLE 1.4: NEGATIVE UNDEPRECIATED CAPITAL COST (UCC) BALANCE

EXAMPLE 1.4AOriginal cost of property: $10,000Proceeds $11,000UCC balance before disposition: $ 8,000

EXAMPLE 1.4B (A) Properties

Remain in Class?(B) PropertiesRemain in Class ?

NO YES UCC Balance, before disposition $8,000 $8,000Lesser of cost and proceeds ($10,000) ($10,000)Closing UCC balance ($2,000) ($2,000)Recapture — addition to income 2,000 2,000 Adjusted UCC balance nil nil

In addition to the $2,000 recapture that will be included in income (which is the excess depreciation claimed on the property, namely the diff erence between the original cost of $10,000 and the UCC balance of $8,000), the property has appreciated in value above its original cost. This gain is computed as follows:

EXAMPLE 1.4CProceeds $11,000Less: Original cost $10,000Equals: Capital Gain $1,000 Taxable capital gain (50%) $500Increase to CDA (non-taxable portion) $500

The proceeds in excess of the original cost of $1,000 is considered a capital gain. As such, 50% of the gain will be taxable in the year of disposition, and the 50% non-taxable portion is added to the Capital Dividend Account (“CDA”).

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For additional information regarding the complete rules of depreciable property, see Capital Cost Allowances in Canadian Tax Principles, Chapter 5.

1.5.3 Intangibles (or Eligible Capital Property)

Eligible capital property (“ECP”) is comprised of certain intangible assets that include:• The acquisition cost of goodwill.• The acquisition of customer lists.• Trademarks.• Patents, franchises and licenses that have an indefi nite life.• Incorporation, reorganization or amalgamation expenses.• Milk quotas or other governmental rights or licenses. • Appraisal costs “on account of capital.”

For tax purposes, 75% of the expenditure made in respect of these above-noted items is added to a cumulative eligible capital (“CEC”) account and that account is amortized on a declining balance basis at the rate of 7% per year. Like CCA, the amount a taxpayer may claim is discretionary. CEC is not subject to the half-year rule.

On a disposition of eligible capital property, three-quarters of the proceeds are deducted from the CEC account. If an amount remains in the CEC pool after this deduction, then the pool continues to be amortized at 7% per year.

Similar to the rules applicable to depreciable property, if these proceeds exceed the balance in the CEC account, the negative pool balance must be included in income. However, the taxation of this negative amount is broken down to refl ect the following components:

• To the extent that the negative amount is less than or equal to previously amortized CEC, the negative amount will be included in income. This is similar to the recapture provisions under the CCA rules and results in three-quarters of the negative amount being taxed as ordinary income.

• Any excess of the negative amount over previously amortized CEC will also be taxed, however, at a lower rate. The intended result is that proceeds in excess of the original “cost” of the eligible capital property are treated similar to a capital gain.

For additional information regarding eligible capital property and the cumulative eligible capital account, see cumulative eligible capital (CEC) in Canadian Tax Principles, Chapter 5.


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1.6 Other Tax Issues 1.6.1 Losses

It is important to understand the categories of losses recognized under the Income Tax Act and the related rules in respect of their application as losses may, for example, have value in cases where losses can be used by the buyer of a company to off set future income. There are fi ve categories of losses that can be sustained:

• Non-capital Losses — Sustained from a business or partnership business, similar to “operating losses” in an accounting context.

• Net Capital Losses — Realized on the disposition of non-depreciable capital property.• Allowable Business Investment Loss (“ABIL”) — Realized on the disposition of shares

of, or debt owing by, a small business corporation (generally one carrying on an active business).

• Farm Losses — Sustained by a farm business.• Restricted Farm Losses — Farm losses that are limited if farming does not represent the

taxpayer’s chief source of income.

EXHIBIT 1.4 RULES GOVERNING THE APPLICATION OF UNUTILIZED LOSSESType of Loss Carry-Back Provisions Carry-Forward ProvisionsNon-capital Loss: Incurred in a taxation year ending before March 22, 2004

May be applied to taxable income in any of the preceding 3 taxation years

May be applied to taxable income in any of the 7 taxation years following the loss year

Incurred in a taxation year ending after March 22, 2004



Incurred in 2006 and subsequent taxation years



Net Capital Loss May be applied to taxable income in any of the preceding 3 taxation years

May be carried forward indefi nitely, but can only be applied against net taxable capital gains

Allowable Business Investment Loss (ABIL)

Same as non-capital losses Same as non-capital losses, except if unutilized at end of period they become net capital losses

Farm Loss Same as non-capital losses Same as non-capital lossesRestricted Farm Loss Same as farm losses, but can

only be applied to farming incomeSame as farm losses, but can only be applied to farming income

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With the exception of ABILs, which convert to net capital losses at the end of the carry-forward period of ten years, any unused losses remaining at the end of the carry-forward period will expire.

For additional information on the types of losses under the Income Tax Act and the rules relevant to their utilization, see Treatment of Losses in Canadian Tax Principles, Chapter 11.

From a valuation perspective, taking the tax rate of the corporation and applying it to the loss can compute the value of losses. However, it is important that the valuator fi rst:

• Assess the likelihood of utilizing the losses to ascertain whether any value can be so ascribed.

• Make a reasonable determination of when such losses might be utilized (i.e., time value of money).

• Assess the risk; as such losses may not be available for utilization following an acquisition of control. Capital losses would expire on an acquisition but non-capital losses will still be available subject to certain restrictions, such as the entity continuing in the same or similar line of business. Capital losses and non-capital losses will be described later in this course.

1.6.2 SR&ED and Investment Tax Credits

To encourage research and innovation in the Canadian economy, the federal government has provided a number of incentives under the Income Tax Act for taxpayers engaged in scientifi c research and experimental development (“SR&ED”) activities. Similarly, a number of provincial governments off er their own package of incentives for activities carried on within their particular province.

SR&ED generally involves the undertaking of an activity for the advancement of scientifi c knowledge that has elements of uncertainty.

• Scientifi c research is either basic research or applied research. • Experimental development involves the use or application of scientifi c research or existing

knowledge to develop or improve the materials from which a product is made, to create a new product or device, to develop or enhance a product or to improve a manufacturing process. Included in this defi nition are projects conducted to create a prototype product and to develop certain computer software projects.

Certain activities are excluded from SR&ED, such as market research, sales promotion, quality control or routine testing, prospecting, exploring or drilling for, or producing minerals, petroleum or natural gas, style changes, routine data collection and commercial production.

Federally, taxpayers engaged in SR&ED activities are off ered two types of incentives:

1. Tax deductions and 2. Investment tax credits.


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Tax Deductions Taxpayers may deduct 100% of all qualifying current and in some cases, capital expenditures incurred before December 31, 2013. While current expenditures (such as researchers’ salaries, materials, etc.) would be deductible in any event, the main advantage in deducting capital expenditures (such as machinery and equipment) is to benefi t directly from deductions that would otherwise only be available over time through CCA. Capital expenditures made after December 31, 2013 can no longer be claimed for SR&ED purposes.

The amount that may be deducted in any given year will be reduced by any federal investment tax credits claimed in the prior year and any provincial investment tax credits accrued in the current year (whether claimed or not). Additionally, any grants, rebates or other assistance received or receivable by the taxpayer to fund the SR&ED expenditures will reduce the qualifying deduction.

A taxpayer has the discretion to claim the deduction for eligible SR&ED expenditures in a particular year. If unclaimed, the expenditures are pooled with unclaimed expenditures of past years and this SR&ED pool may be carried forward indefi nitely to deduct in any subsequent year. This may be of particular appeal to a new research company that has little income in the early years, but may become quite profi table after launching a new product.

Investment Tax CreditsIn addition to the SR&ED deductions described above, a taxpayer may earn investment tax credits (“ITCs”) on both current and capital SR&ED expenditures incurred in Canada. ITCs may be deducted against federal income taxes payable and if unutilized may be carried back three years and forward 20 years. (Note that for investment tax credits earned prior to 2006, the carry forward period was only 10 years). Additionally, in some cases (i.e., small businesses) if federal tax is not payable in a particular year, all or a portion of the credit may be refundable.

For a summary of the rules regarding investment tax credits and their applicable rates, see Investment Tax Credits in Canadian Tax Principles, Chapter 14.

Again, as unclaimed ITCs can be carried forward to apply to taxes payable in subsequent taxation years, any unclaimed ITCs could be transferred to a prospective purchaser of a corporation, subject to the acquisition of control rules.

For both unclaimed SR&ED expenditures and unutilized ITCs, the valuator needs to assess both the likelihood and timing of potential claims to ensure after-tax cash fl ows are properly discounted.

Additional information regarding the SR&ED incentives available federally can be found on CRA’s website at: www.cra-arc.gc.ca/txcrdt/sred-rsde/menu-eng.html

Information on the provincial and territorial research incentives can be found at: www.cra-arc.gc.ca/txcrdt/sred-rsde/prv-eng.html.

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1.7 Tax Liabilities In addition to capturing all value inherent in the assets, the valuator should exercise the appropriate due diligence to confi rm that there are no hidden or contingent tax liabilities inherent in the business. This is particularly important in the context of a share transaction, as any purchaser will assume all the liabilities of the corporation, including those that are contingent or uncertain at the time of purchase (unless indemnifi ed by the vendor as part of the purchase and sale agreement).

In this regard, the valuator should ascertain whether there any risky tax fi ling positions that the business has taken in the past and which may still be exposed for reassessment upon a future tax audit of the corporation. This information can be obtained from a discussion with management, a review of the fi nancial statements and notes (which may disclose any contingent liabilities of the corporation) and by performing a detailed review of the income tax provision and tax returns.

This section provides a brief overview of common tax risks that may be inherent in a corporation with regards to:

• Transfer pricing.• Characterization of transactions.• Interest deductibility.• Unrealized gains.• Reserves.

1.7.1 Transfer Pricing

If the corporation buys or sells goods or services from a related non-resident person, the pricing of these goods and services will be relevant to the measurement of the profi t taxed in Canada. Corporations are required to report transactions with related non-resident persons each year (Form T106) and, where these transactions are signifi cant, the methodology used to ascertain the transfer prices will be subject to close scrutiny by the CRA. The valuator should be aware of these rules to ensure that the corporation is not exposed to a signifi cant transfer pricing adjustment that could create a liability for a prospective purchaser. A transfer pricing study prepared by specialists in this area may be required to ensure goods and services are transferred at the appropriate prices. The reason that this is a hot topic is that certain countries (such as Bahamas and Ireland) have lower corporate tax rates than Canada. Therefore, companies with subsidiaries or related companies located in countries with lower tax rates would prefer to transfer profi t to these subsidiaries or related companies to lower their eff ective tax rate (or taxes payable).

1.7.2 Characterization of Transactions

Expenditures incurred to earn income from a business are generally deductible, unless such expenditures are considered on account of capital. Capital expenditures include the acquisition cost of assets, but also include expenditures incurred in connection with the acquisition of that asset. Therefore, if the asset is a non-depreciable asset, such costs are capitalized to the cost of the asset (i.e., form part of the cost base) and are not currently deductible.


34

If the asset is depreciable property or a CEC property, the expenditure is included in the cost of the property and any deductions will be taken over time in accordance with the CCA or CEC amortization rules, as the case may be.

Similarly, an amount received by a business could either be income (taxed at 100%) or a capital gain (taxed at 50%), depending on the transaction that gave rise to the receipt (See Business Income vs. Capital Gains in Canadian Tax Principles, Chapter 6).

Because the characterization of the transaction could aff ect the extent and timing of a deduction, or the amount of income that is ultimately taxed, the valuator may want to review the tax treatment of recent unusual transactions to ensure the corporation has properly classifi ed these transactions for tax purposes. Failure to properly report these transactions could result in a signifi cant tax liability to a corporation should the characterization ever be successfully challenged by CRA.

1.7.3 Interest Deductibility

Generally, interest paid or payable on borrowed money used for the purpose of gaining income from a business or property is deductible if it meets the following tests:

• The interest must be incurred pursuant to a legal obligation to pay interest.• The debt must be borrowed for the purpose of earning income that will be taxable when

received.

Jurisprudence has held that interest will be deductible only when it can be “directly” related to an income-producing purpose. Thus, once the use of borrowed funds changes to a non-income producing purpose, the interest charges are no longer deductible, nor can they be capitalized.

Special rules on interest deductibility apply in the following situations:

Interest on Vacant LandFor most corporations, the deductibility of interest on the vacant land is limited to the amount of income earned from the land. Interest in excess of the income must be capitalized to the cost of the land.

Some corporations, known as principal business corporations, may deduct the interest up to the income earned from the land, but may also deduct an amount known as a base level deduction. The base level deduction is defi ned in subsection 18(2.2) of the Income Tax Act as that amount of interest, computed at the prescribed rate, in respect of a loan of $1 million outstanding for the year.

Therefore, if the prescribed rate was 5%, the amount of excess interest that could be deducted by a principal business corporation is $50,000 for the year. A principal business corporation is defi ned as a company whose principal business is the “leasing, rental or sale, or the development for lease, rental or sale, of real property.”

Interest During Construction, Renovation or AlterationInterest and other soft costs relating to periods of construction, renovation or alteration must be capitalized to the cost of the building. Typical examples of soft costs for these purposes include

35


property taxes, insurance, site costs and legal and other fees associated with fi nancing the construction activity.

Thin Capitalization

Interest paid or payable to certain non-resident shareholders is disallowed where the debt/equity ratio (computed as prescribed) is in excess of a threshold amount. The amount of interest disallowed is the interest attributable to the excess debt. For more information on the thin capitalization rules, see Interest as a Deduction in Canadian Tax Principles, Chapter 7.

1.7.4 Unrealized Gains

A purchaser acquiring shares will also acquire the underlying property in the corporation. To the extent there are “unrealized” gains (or recapture) inherent in that property, then the purchaser will bear the tax cost of a future disposition of that property.

While this may not have as much signifi cance to the valuation if no disposition of the property is anticipated, it becomes more of an issue if the purchaser plans to divest of any property in the near term (after completion of the transaction). This may be the case if the purchaser plans to spin off an unwanted division of the corporation or dispose of redundant assets.

Where the valuator might be required to build in the value of the subsequent disposition for the purchaser, the related tax implications of these transactions should be considered.

1.7.5 Reserves

While accrual accounting may provide that expenses attributable to a particular period be provided for in the fi nancial statements, the Income Tax Act generally provides that a particular reserve cannot be deducted unless it is specifi cally provided for. Examples of allowable reserves include:

• Reserves for doubtful accounts. • Reserves for undelivered goods or services. • Reserves for unpaid amounts (deferred revenue).

The valuator should be aware of possible reserves that may have been deducted for accounting purposes that may not be deductible for tax purposes. In particular, reserves for contingent liabilities will only be deductible once the liability has been incurred.


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1.8 Application of a Transfer Pricing Study to an Equity ValuationWhile transfer pricing is a specialized area and the preparation of a transfer pricing study to support non arm’s length intercompany transactions is not part of this valuation course, there are several areas of a valuation that are impacted by intercompany transactions (such as inventory, gross profi t, earnings, etc.) as well as similarities between transfer pricing studies and valuation reports that make a transfer pricing study a useful tool when preparing a valuation.

This section provides a summary of:

• What a valuator should consider when reviewing a transfer pricing study.• What impact intercompany transactions can have on a valuation and relevant jurisprudence

related to their impact. • Where a transfer pricing study can help a valuator avoid duplication of activities when

performing a valuation where the subject company has intercompany transactions covered by a transfer pricing study.

Transfer pricing and valuation reports have the following in common:

• Industry analysis• Business overview/functional analysis• Potentially the use of a market approach to establish a benchmark which relies on

comparable transactions and/or companies

A transfer pricing study can be a good source of comparable companies to apply a market approach in a going-concern valuation. However, the valuator should assess whether the comparables used in a transfer pricing study are appropriate and are representative of the business being valued.

For example, if a subject valuation company is a manufacturer of products that it sells to related parties and distributes products purchased from third parties, it will be the manufacturing transaction that will be benchmarked separately in the transfer pricing study, whereas the manufacturing and distribution businesses of the company are the subject for the valuation. In this case, the manufacturing comparables used in the transfer pricing study might not be appropriate companies to use in the application of a market approach to the subject company as a whole. The valuator should carefully review the comparable companies used in a transfer pricing study before relying on them for a valuation.

1.8.1 Reviewing a Transfer Pricing Study

When performing a valuation in which transfer pricing is involved, the valuator should consider consulting a transfer pricing specialist to conduct a transfer pricing study. Some considerations that a valuator should have in relying on a transfer pricing study:

• Is the documentation completed to the standards set by the relevant tax jurisdiction?

37


• Is/are the transfer pricing method(s) applied reasonable given the nature of the transaction?• Is there exposure to transfer pricing penalties? • Are the comparable companies and/or transactions selected appropriate?• Are all of the material intercompany transactions documented?• Is the tested party within the arm’s length range? If not, why?• Are there adjustments to the tested party’s fi nancial statements that resulted from the

analysis?• Will the current transfer pricing model continue past the valuation date?

Where no transfer pricing study exists, the valuator should consider what the intercompany pricing policies are that relate to the subject valuation company, review the Form T-106s (information return for non-arm’s length transactions with non-residents) for the subject company and discuss with management how its intercompany prices are determined.

1.8.2 Transaction-specifi c Considerations When Evaluating Intercompany Transactions

There are some transaction-specifi c attributes of intercompany transactions that a valuator should consider when evaluating a company’s transfer prices. Two examples include:

• Management fees.• Interest rate on intercompany loans and principal amounts of loans.

Management fees may or may not include a profi t element. Many companies will charge a fee for the services rendered to or on behalf of a related company in another country. However, many of the intra-group services provided and charged for at cost might reasonably include a profi t element. Certain tax authorities mandate the inclusion of a profi t element on all or certain services. When assessing the arm’s length nature of a management fee, the valuator should examine if a mark-up is used, required or warranted. Also, the valuator should consider whether the service recipient will continue to receive the services past the valuation date, in the case of the sale of a division or other spin-off transaction.

The interest rate on an intercompany loan may be nominal and not refl ective of the arm’s length cost of debt of the borrower, due to the various legislative exemptions off ered under tax laws. Many valuation methods do not consider interest expense as part of the cash fl ows used in a valuation so the interest rate in those cases is not an issue for valuation purposes.

1.8.3 Impact of Intercompany Transactions on a Valuation

Transfer pricing is important to a valuation where there are signifi cant intercompany transactions between the company that is being valued and a related entity. Incorrect transfer prices could mean that the fi nancial statements (historical, current year and forecasted statements) are not appropriately stated. The following examples illustrate the impact that intercompany prices can have on a valuation.


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EXAMPLE 1.5: IMPACT OF TRANSFER PRICING ON A VALUATION (DISTRIBUTION RIGHTS USING MAINTAINABLE EARNINGS)

CanCo is a manufacturer of school supplies in Canada for distribution in the US market. USCo, a related distributor in the US, has the exclusive distribution rights in the US.

CanCo is seeking a valuation of the US distribution rights as it is considering the sale of those rights. As part of the arrangement between CanCo and USCo, USCo purchases products from CanCo. The unadjusted income statement, ratios and estimated capitalized earnings for the distribution of school supplies are shown in Example 1.5A:

EXAMPLE 1.5AUS Inc. USD $000s Sales $100,000Cost of sales 70,000Gross profi t $ 30,000Operating expenses 27,000Operating profi t $ 3,000Taxes (at 50%) 1,500Net income $ 1,500 Gross profi t percentage [=$30,000/100,000] 30%Operating profi t percentage [=$3,000/100,000] 3% Maintainable after-tax earnings $ 1,500Earnings multiple (given/assumed) 10xEst. capitalized earnings $ 15,000

A transfer pricing analysis performed for the company indicated that an arm’s length range of gross margins earned by comparable US distributors was between 35% and 40%. USCo’s gross margin of 30% is below the range. The adjusted fi nancial statements demonstrated in Example 1.5B, leave USCo with an arm’s length return.

EXAMPLE 1.5B US Inc. USD $000s Sales $100,000Cost of sales [$100,000 x (1 – 0.35 Market GP)] 65,000Gross profi t $ 35,000Operating expenses 27,000Operating profi t $ 8,000Taxes 4,000Net income $ 4,000 Gross profi t percentage [$35,000/100,000] 35%Operating profi t percentage [$8,000/$100,000] 8% Maintainable after-tax earnings $ 4,000Earnings multiple 10xEst. capitalized earnings $ 40,000

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The impact on the estimated maintainable earnings is more than double. A lack of consideration for the non-arm’s length nature of the intercompany transactions between CanCo and USCo resulted in a misstatement of the value of the distribution rights of USCo.

Let’s reconsider Example 1.5 with an additional transaction included in the fi nancial statements — a management fee paid by CanCo to USCo. In t hat example, we are assuming that USCo is the parent company that has centralized its administrative activities. The arm’s length nature of the management fee should be examined. The impact of the management fee misstatement could be the same as the impact of non-arm’s length product prices; it could result in a misstatement of the overall value of the distribution rights, as shown in the example below, or it could off set the misstatement on the other transaction. The valuator should consider any off sets or interactions between transactions when determining the appropriate maintainable earnings.

Consider also the common case of the manufacturer that manufactures on behalf of a related party. This is another case where multiple transactions interact and can have an impact on the value of a company.

EXAMPLE 1.6: MULTIPLE TRANSACTIONS

Manufacturing Co. is a manufacturer of automotive parts for the North American market located in Canada. Manufacturing Co. sells 100% of its production to ParentCo, its US-based parent. Manufacturing Co. also purchases a signifi cant portion of its raw materials (but not all) from ParentCo. ParentCo owns the customer relationships.

The terms of the arrangement are such that ParentCo compensates Manufacturing Co. for its manufacturing activities on a net cost-plus basis via a mark-up of 5% on its total costs. As a result, the sales fi gure of Manufacturing Co. represents an intercompany transaction.

ParentCo is considering selling some of Manufacturing Co.’s shares to a new investor. The value of ManufacturingCo’s shares is dependent on its sales to ParentCo and on the arm’s length nature of two transactions:

• The price charged by ParentCo to Manufacturing Co. for the products or inputs

• The arm’s length nature of the 5% net cost-plus mark-up earned by Manufacturing Co.

The two transactions are interrelated because of the mechanics of the transfer pricing model and as such have an impact on the sales and profi ts of Manufacturing Co. The transfer cost of the raw materials from Parent Co. to Manufacturing Co. must be arm’s length because the cost of the materials will aff ect the ultimate sales of Manufacturing Co. The cost base will be marked up on the sales from Manufacturing Co. to ParentCo. and will include the cost of the materials purchases made by Manufacturing Co. from ParentCo.


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Missing TransactionsThere are instances where intercompany transactions exist but to which no dollar value is assigned. An example of this is intra-group services. A parent company might provide management, technical or sales support services to a subsidiary for which it does not charge the subsidiary. The impact this will have on the valuation of the subsidiary is that its profi t may be overstated relative to as if it were a standalone entity and would incur those costs. Similarly, the subsidiary may provide services to the parent for which it does not charge the parent, which would result in an understatement of profi ts for the subsidiary.

EXAMPLE 1.7: IMPACT OF TRANSFER PRICING ON A VALUATION

Consider Example 1.5, but this time with an adjustment to operating expenses to account for intra-group services, for which no charge exists. Imputing an arm’s length fee for those services would have the following impact:

US Inc. USD $000s Sales $100,000Cost of sales 70,000Gross profi t $ 30,000Operating expenses 29,000Operating profi t $ 1,000Taxes 500Net income $ 500 Gross profi t percentage 30%Operating profi t percentage 1% Maintainable after-tax earnings $ 500Earnings multiple 10xEst. capitalized earnings $ 5,000

Comparing this to the unadjusted estimated capitalized earnings demonstrates that the inclusion of a management fee of material size results in a signifi cant reduction in the estimated capitalized earnings ($5,000 vs $15,000).

One caution with respect to missing service charges is that the missing charges may not be missing at all. In this vein, the valuator must consider the transfer pricing model in place before making adjustments to the fi nancial statements for uncharged services. An example of this is a contract manufacturer who receives access to the intellectual property of the service recipient (in this case the entity that has engaged the contract manufacturer to provide manufacturing services) on a royalty-free basis. It appears as though the contract manufacturer should pay a royalty for the use of the intellectual property to the related owner. However, under a contract

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manufacturing model, the manufacturer is providing services to the owner of the intangibles and does not receive any benefi ts from the use of the intangible property other than those attributable to sales to the owner of the intellectual property. Therefore, the contract manufacturer would not be willing to pay separately for the intellectual property.

The previous examples (1.5 - 1.7) only consider the impact on maintainable after-tax earnings that are capitalized. The same principles apply when using forecasted data in the application of a discounted cash fl ow method.

1.8.4 Tax Reserves and Transfer Pricing Policies

Companies might take a reserve for transfer pricing on their fi nancial statements to allow for potential changes in transfer prices upon audit in the future. These reserves provide guidance on the level of risk of a transaction, what transactions might be missing from the fi nancial statements, and insight into the transfer pricing policies of the company.

The valuator should examine any tax balances or reserves taken for transfer pricing and consider the impact those reserves and policies may have on the company in the future. A particularly aggressive transfer pricing regime might increase the risk of audit and subsequent adjustments on audit, leaving the company being valued with a potentially large future tax liability that should be considered.

As mentioned earlier, the valuator should consult a transfer pricing specialist to assess the risk of a transaction, but some basic guidelines will help understand the level of aggressiveness of a transfer pricing regime, such as:

• Has the tested party been in a loss position for an extended period of time?• Is one of the parties to the transaction in an off shore tax haven?• Are the returns earned by the tested party unusually high or low (e.g., above or below the

range)?• Is one of the parties to the transaction under consideration characterized as a low-risk

entity (e.g., low-risk distributor, contract manufacturer)?

1.8.5 Jurisprudence Involving Transfer Pricing and Valuations

While there are many Canadian transfer pricing cases, few of the cases involve specifi c valuation issues. One Canadian case was Ford Motor Company of Canada Ltd. v. Ontario Municipal Employees Retirement Board, [2004] OJ no. 191.

The case concerned a “going-private” or “squeeze-out” transaction in which Ford US moved in 1995 to acquire the approximately 6 percent of Ford Canada shares that it did not own. Minority shareholders, including the Ontario Municipal Employees’ Retirement System (OMERS) and others, dissented over the $185 per share price, alleging that they had been unlawfully oppressed through the transfer-pricing regime between Ford US and Ford Canada from 1985 to 1995.

Each of OMERS’ transfer-pricing experts used a diff erent transfer-pricing method (profi t-split, transactional net margin method or TNMM, and an unspecifi ed method that employed a


42

return-on-investment analysis) to determine Ford Canada’s arm’s length profi ts, which they independently concluded was $2.6 to $3 billion above the actual profi ts reported by Ford Canada over the period. The judge presiding over the case stated that the profi t-split method, which would result in an inclusion in Ford Canada’s income of $3.036 billion during 1985-1995, not only better represents arm’s-length results but also accords with the substantive reality of the Ford enterprise.

The judge also noted that it is not suffi cient for a taxpayer to simply have a transfer pricing system to which the tax authorities do not object; rather, the system must not result in unfairness to minority shareholders that constitute oppression within the meaning of the Canada Business Corporations Act.

Other transfer pricing cases in Canada have dealt considerably with transactions involving off shore purchasing entities such as Indalex Ltd. v. the Queen (88 DTC 6053); Irving Oil v. R (91 DTC 5106) and, more recently, FPI Fireplace Products International Ltd. v. R., Can. T.C., No. 2001-671(IT)G. The focus of these cases has been the arm’s length nature of the spread on purchases kept by the off shore entity that bought and sold product on behalf of related parties in Canada.

In addition, transfer pricing cases have dealt with attribution of profi ts to a Permanent Establishment (PE) in Cudd Pressure Control Inc. v. Canada (1995 CTC 2382) and more recently, Norand Data Systems Ltd. v. The Queen, Can. T.C., No. 2003-3525(IT)G. The Cudd Pressure case involved a notional rent paid to a US company by its Canadian PE for the use of drilling equipment. While the case centred on an appropriate attribution of profi ts to the PE, several valuation experts testifi ed as to the value of the drilling equipment rented. In relation to this area, you are encouraged to review a recent case, 2008 Canada v. GlaxoSmithKline Inc (https://en.wikipedia.org/wiki/Canada_v_GlaxoSmithKline_Inc).

1.8.6 Conclusion on Transfer Pricing and Valuations

Transfer pricing studies and valuation reports related to the same subject company have many similar components and therefore a valuator can fi nd a lot of useful information in a transfer pricing study that can be used for a valuation.

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MQE QUESTION 1.1

MQE QUESTION TABLE 1.1ACleanco Common Shares Mr. Hover 2,000 Billy Hover (son) 1,000 Sellco Common Shares Class A preferred sharesMr. Hover 2,000Billy Hover (son) 100 Betty Hover (daughter) 100 Bobby Hover (son) 100

Cleanco is a manufacturer of vacuum cleaners and Sellco is a distribution and marketing company set up to sell Cleanco’s product. The Hover family owns both companies. Mr. Hover started the business 25 years ago and although they have been through some tough years, the business is now generating signifi cant profi ts.

A U.S. competitor set up Sellco initially because Mr. Hover had the opportunity to distribute a high-end vacuum cleaner produced in Canada. Mr. Hover also sells some other appliances that Cleanco doesn’t produce although the profi ts from these lines have always been nominal.

Approximately ten years ago, Mr. Hover completed an estate freeze for Sellco. At this time the fair market value of 100% of the common shares was determined to be $200,000. Mr. Hover obtained Class A preferred shares of Sellco and the common shares were issued to his children. The Class A preferred shares are voting, redeemable for $100 per share, they are retractable and carry a 4% dividend. The share structure of the two companies is as follows (Table 1.1A):

All of the vacuums manufactured by Cleanco are sold to Sellco. There are no arm’s length customers. Sellco then distributes the vacuums to major appliance and department stores throughout Canada. Sellco is responsible for carrying inventory, ensuring supply, negotiating contracts with retailers, and providing point of sale and brand advertising.

Mr. Hover died on January 1 of the current year, and his family has approached you to help them in reporting the deemed disposition of their father’s shares on the date of death. While the functions have been divided between the two companies, they recognize their father controlled both of the companies until his recent death and wonder if the companies should be valued together or as separate entities. In addition they have recently collected the proceeds of the $1,000,000 life insurance policy that Cleanco had taken out on the life of Mr. Hover. They have provided you with the summarized fi nancial statements for the companies shown below. In your initial research into the industry you have come across a number of comparable companies to Cleanco. The information regarding these companies is shown below as well.

Required:Respond to the family’s concerns.


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MQE QUESTION TABLE 1.1B

Cleanco Balance SheetAs at December 31, last year (000’s)Assets Cash 321Accounts receivable — related party 2,150Inventory 4,598Income tax recoverable 130Life insurance (cash surrender value) 53Equipment 857Less: accumulated depreciation (510) 7,599 Liabilities & Shareholder’s Equity Accounts payable and accrued charges 3,254Bank loans 3,891Common shares 1Retained earnings 453 7,599

MQE QUESTION TABLE 1.1CCleanco Income StatementFor the years ended December 31 (000’s)

Last Year 2nd Last

Year 3rd Last

Year 4th Last

YearSales $26,741 $20,156 $18,466 $15,555Cost of goods sold Direct materials 9,150 6,911 6,257 5,289 Direct labour 7,843 5,924 5,363 4,534 Variable overhead 5,899 3,860 3,282 2,414 Fixed overhead 3,250 3,050 2,975 2,875Cost of goods sold 26,142 19,745 17,877 15,112Gross profi t 599 411 589 443Selling, general and administrative 215 198 201 186Earnings before tax 384 213 388 257Provision for income taxes 162 108 158 142Net income 222 105 230 115

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MQE QUESTION TABLE 1.1DSellco Balance SheetAs at December 31, last year (000’s) Assets Cash 100Accounts receivable 8,541Prepaid expenses 125Fixed assets net of accumulated depreciation 1,719Land 2,530 13,015 Liabilities & Shareholder’s Equity Accounts payable and accrued charges 3,891Bank indebtedness 645Management fee payable 6,320Share capital 1,600Retained earnings 559 13,015

MQE QUESTION TABLE 1.1ESellco Income StatementFor the years ended December 31 (000’s)

Last Year 2nd Last

Year 3rd Last

Year 4th Last

YearRevenue 57,823 48,181 40,215 37,465Cost of goods sold 39,652 29,899 24,125 25,111Gross profi t 18,171 18,282 16,090 12,354Direct selling expenses 9,566 9,751 8,752 7,988Offi ce and administrative expenses 2,145 1,999 1,897 1,850Management fee 6,260 6,300 5,300 2,300Earnings before tax 200 232 141 216

MQE QUESTION TABLE 1.1F

Comparable Manufacturing CompaniesGross Profi t (%)

Powerco 11.26%Hurlco 15.02%Godirt Limited 13.65%Rugged Inc. 10.31%Carpit Limited 5.20% Average 11.09%Average without Carpit (outlier) 12.56%Average without high and low 11.74%


46

Solution:

Memo to Hover File

From: CBV

Re: Deemed disposition of Mr. Hover’s estate

Date: Today

I have met with the Hover family with respect to the deemed disposition of their father’s estate. This memo outlines my analysis and preliminary conclusions with respect to the valuation of Cleanco and Sellco in connection with the deemed disposition of Mr. Hover’s common shares of Cleanco and Class A preferred shares of Sellco.

The only user of the value determined herein is Canada Revenue Agency.

IntroductionIn preparing my valuation, I have used a valuation date immediately before the date of death. For this purpose, I have assumed a valuation date of January 1 of this year.

A key consideration in the approach to value relates to the transfer price charged by Cleanco to Sellco. The transfer price will determine the allocation of value between Cleanco and Sellco. It is unlikely that Canada Revenue Agency will accept a consolidated value for the two entities.

I understand that Cleanco and Sellco are two separate companies with diff erent shareholders. The shareholders are related and there may be no overall cost or benefi t to either company if the transfer price between the two companies is incorrect. However, because the shareholder groups are diff erent, the allocation of value may still be critical to the specifi c shareholders groups. The allocation will be based on the choice of transfer price.

Transfer Price Issues/AnalysisIn considering the choice of the transfer price, I have considered the following:

Is there a written agreement or other support with respect to the current transfer price?1. Industry information suggests that the current transfer price is too low. Cleanco’s gross

margin was approximately 2.2% last year as compared to the comparable manufacturing companies, which have experience gross margins in the range of 5.2% to 15.02%. The average gross margin exhibited by these companies is approximately as shown below:

Powerco 11.26% Hurlco 15.02% Godirt Limited 13.65% Rugged Inc. 10.31% Carpit Limited 5.20% Average 11.09% Average (x Carpit-outlier) 12.56% Average (x high and low) 11.74%

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Based on the foregoing, I have valued the two companies separately assuming that a fair market value gross margin for Cleanco is approximately 12%. Therefore, I have adjusted Cleanco’s earnings based on the adjusted transfer price.

Calculation of Value of CleancoI have used an income approach to value Cleanco because it is a going concern as exhibited by its history of profi ts and its signifi cant adjusted profi tability.

I have used the capitalized earnings approach to value Cleanco because the company appears to be in a plateau life cycle stage and future cash fl ow is likely refl ected in historical earnings.

Determination of Maintainable EarningsIn a schedule below, I have estimated maintainable earnings before tax for Cleanco. I used the results for the last four years as a starting point and I adjusted them to refl ect a gross margin of 12% based on industry information. I used 12% based on the average of the companies excluding Carpit as it appears to be an outlier in the sample.

Based on the foregoing, I estimate pre-tax earnings to be in the range of $2.7 to $3.4 million based on the most recent results and the weighted average results over the past four years. Assuming a 45% tax rate indicates a maintainable after-tax earnings range of $1.485 million to $1.870 million.

Capitalization RateI have used a range of earnings multiples of 6 to 8 based in part on the following factors:

• The industry has been operating for 25 years• The industry appears to be in a slow growth stage• There may be some personal goodwill attributable to Mr. Hover’s experience and personal

contacts• Rates of return on alternative investments

Capitalized Earnings ValueBased on the estimated range of maintainable earnings and range of earnings multiples, I have estimated the en bloc capitalized earnings value of Cleanco to be in the range of $11.22 million to $11.88 million as per schedules provided below.

Redundant AssetsI have considered that the cash surrender value of the life insurance policy is not required for the day-to-day operations of the business. I understand that the cash surrender value of the policy is $53,000 as at the valuation date. I have not used the $1,000,000 policy value because this amount would not accrue to a potential purchaser of Cleanco.

Conclusion of Value of CleancoAdding the cash surrender value of the life insurance policy of $53,000 to the capitalized earnings value yields an overall en bloc value for Cleanco of approximately $11.27 million to $11.93 million.

Mr. Hover’s pro-rate 2/3 share of the en bloc value is approximately $7.5 million to $7.95 million. Since Mr. Hover’s shareholding represents a controlling block of Cleanco, I have not considered a minority discount. I have also not considered a possible control premium with respect to his shareholding.


48

Value of Preferred SharesIn addition to owning common shares of Cleanco, Mr. Hover also owns preferred shares of Sellco. In estimating the value of these shares, I have considered the following:

• The preferred shares of Sellco owned by Mr. Hover do not allow for any participation in the profi ts of the company.

• The preferred shares are not convertible.• If sold to an arm’s length party the purchaser of the preferred shares would only be entitled

to the redemption amount.• Sellco appears to have suffi cient net assets to be able to redeem the shares if required• The shares appear to have all of the attributes that would indicate a fi xed redemption value

(they are retractable, redeemable and carry a fi xed dividend).

Based on the foregoing, it appears that the preferred shares owned by Mr. Hover should be valued at the redemption amount of $200,000 (2,000 x $100 per share).

Value of Cleanco (000’s) Low HighAdjusted earnings before tax $3,400 $2,700Income tax (45%) 1,530 1,215Maintainable earnings after tax 1,870 1,485Earnings multiple 6 8Capitalized earnings value 11,220 11,880Redundant assets 53 53En bloc fair market value 11,273 11,933Fair market value of 66.7% 7,519 7,959

Adjusted earnings of Cleanco Last Year2nd Last Year

3rd Last Year

4th Last Year

Adjusted Sales $29,707 $22,438 $20,315 $17,172Cost of goods sold 26,142 19,745 17,877 15,112Adjusted gross margin (12%) 3,565 2,693 2,438 2,060Selling, general and administrative 215 198 201 186Adjusted earnings before tax 3,350 2,495 2,237 1,875 Weighting 4 3 2 1Weighted average 2,723Maintainable range, say 2,700 to 3,400

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MODULE 2Comparable Company Multiples and Other Valuation Concepts

Module OverviewWelcome to Module 2. Comparable company multiples can be used as a primary approach towards valuation or as a test check against other valuation methods. The module also focuses on asset based valuation approaches and adjusted book value, which are diff erent from the earnings/cash fl ow based approaches. In this module you will also learn methods for analyzing fi nancial statements. By the end of this module, you will have a comprehensive understanding of:

• Comparable company multiples (precedent transactions and public company multiples).• Analyzing fi nancial statements.• Asset based valuation approaches.• Adjusted book value.• Real estate and equipment valuations.

The acronyms used throughout this module are:

EV Enterprise value

EBITDA Earnings before interest, tax depreciation and amortization

FIFO First in, fi rst out

IPO Initial public off ering

LIFO Last in, fi rst out

LTM Last twelve months

WACC Weighted average cost of capital


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Required Reading

Johnson, Howard E. Business Valuation. Toronto: The Canadian Institute of Chartered Accountants, 2012.

• Chapter 2 — Business and Financial Analysis• Chapter 3 — Asset Valuation Methodologies• Chapter 4 — Valuation Based on Multiples

Campbell, Ian R., Johnson, Howard E., Nobes, H. Christopher. Canada Valuation Service, Student Edition 2012. Toronto: Carswell, 2012.

• Chapter 5A — (Valuation Methodologies)• Chapter 5B — (Rates of Return pages 5B-30 to 5B-33, 5B-70 to 5B-86)• Chapter 11 — (Financial Statements)

CICBV Code of Ethics and Practice Standards, By-Laws

CICBV Website Resources

Hawkins, George, B. “Public and Private Company Diff erences have Major Valuation Implications.” Business Valuation Digest, 3.1 (1997).

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2.1 Introduction to Comparable Company MultiplesSometimes, in the process of valuing a company, a valuator will consider comparable companies — other businesses that are similar to those of the subject company. Considering comparable data about other companies — when it is adequate and relevant — can be a very useful tool in the valuation of businesses, business ownership interests and/or securities. A market approach that typically assumes a going-concern premise, comparable company multiples can provide insight into value, and may also be used for corroborative purposes against that of other valuation approaches as well.

Comparable company empirical data can be found in market-based valuation ratios of comparable companies that are engaged in the same or similar lines of business, and that are actively traded on a free and open market. Market approaches based on comparable company information can also provide objective, empirical data for developing valuation ratios for use in business valuation. They can be classifi ed into the following approaches:

• Public Company Multiples

An analysis of multiples based on the publicly traded equity prices for the securities (typically common shares) of a public company listed on a given stock exchange.

• Precedent Transaction Multiples

Multiples based on open market transactions (that are not based on stock exchange trading prices), whether public or private.

The valuator can use these market multiples as:

• A primary approach.• A secondary approach to support the reasonability of the results of the multiples implied by

a primary approach, such as the conclusions derived using a cash fl ow based methodology (such as the discounted cash fl ow approach).

• Not at all.

While market multiples can have limitations (e.g., data is not available, lack of “true” comparable companies, inclusion of purchaser-specifi c synergies in multiples and/or transaction prices, impact of special interest purchasers, impact of accounting policies on historical results and multiples, etc.), generally comparable company multiples can provide some insight into the value of a particular subject company. Further, insight into the risk of the industry can be determined by reviewing comparable companies against the market as a whole. Notional valuations, including fairness opinions and court-related valuations, often include comparable company multiples to support the valuation conclusions derived using another approach.

Comparable companies have similar investment attributes, such as risk profi le, industry, size, locations and diversity of revenue base, etc. to the subject company being valued. Ideal


52

comparable companies operate in the same industry as the subject company. In situations where there is insuffi cient transaction information available in that industry, it may be necessary to select other companies and/or transactions that have a similar having an underlying business similar to the subject company in terms of relevant investment characteristics, markets, products, growth, cyclical variability and other relevant factors.

A thorough and objective search for comparable companies and/or precedent transactions is required to establish the credibility of the valuation analysis using comparable company multiples. The procedures undertaken during a thorough and objective search will include documenting the criteria used for screening and selecting comparable companies and/or precedent transactions. There is a range of situations in which valuators will struggle with the challenge of fi nding observable evidence to support a valuation.

After the multiples are calculated (or assembled from an information service) for each comparative public company and/or precedent transaction, the valuator must determine a single or range of multiple(s) that will be used to value the subject company. The multiple(s) chosen may be based on the average and/or median of the comparatives. Multiples that are unrealistically high or low (often referred to as outliers) should be excluded. The process of choosing multiples is inevitably based on professional judgment of a valuator and as such, subjective adjustments are typically made to the selected multiple based on the review of the subject company relative to the comparatives.

The valuator, in selecting a multiple, must establish a framework from which a defensible judgment may be formulated. The valuator must properly interpret and use the information available, and must use due care. A valuator should view comparables as information for framing or disciplining a valuation judgment.

It has been noted that reviewing comparables is a matter of determining the relevance of various variables (profi t ratios, growth rates, turnovers, capital per dollar of revenue etc.) for the comparable companies in order to decide how the overall comparable data should be applied to the subject company. The challenge in using multiples is learning how to use the data to allow you to make the necessary judgments.

It is important to distinguish between absolute and relative comparisons. Absolute comparisons of characteristics (such as the size of comparable companies versus the size of the subject company) are likely to be relevant in considering how the data should be used — e.g. by noting that generally a smaller company is more risky than a larger company and therefore requires a lower multiple.

Relative comparisons allow for two companies that are diff erent in some way to be compared to each other. For example, if Company A is 5 times bigger than Company B, then one could compare Company B’s profi tability to one-fi fth of Company A’s profi tability, and so on. Various ratios can be used to somewhat mitigate size and other diff erences when making relative comparisons.

It is also possible to make relative comparisons between industries, although this must be done with extreme care. For example, one could compare ratios and returns for companies of two very inelastic industries, such as gasoline and food distribution, in assembling comparable data. The underlying premise for this view would be a contention that business values are “always”

53


a function of the return, risk, growth attributes and state of the investment attractiveness of the market at the valuation date. Comparability is often limited when taking this approach.

Remember that the comparable data is just that — data. In and of itself, the data does not provide any valuation conclusion. The valuator must interpret the data and use his/her professional judgment to allow the data to lead to a reasoned conclusion.

2.1.1 Common Multiples Used in Practice

As mentioned earlier, comparable valuation methods estimate a subject company’s value by multiplying a valuation multiple estimated from comparable companies times certain measures of the subject company’s ongoing ability to operate. The most common multiples used in practice include multiples of:

• Earnings before interest, taxes, depreciation, and amortization (EBITDA). • Earnings before interest and taxes (EBIT).• Revenue.• Net book value. • Net earnings.

It is important for the valuator to be aware of the distinctions between these possible multiples methods. Each of these is discussed in further detail below.

2.1.1.1 EBITDA (Enterprise Value-to-EBITDA Ratio)In general, EBITDA is the most commonly used measure on which to base valuation multiples as it incorporates the eff ects of profi tability/return and eliminates the eff ects of fi nancial leverage. EBITDA multiples are useful for comparing values or considering a range of bases for estimating values for the following reasons:

• EBITDA multiples implicitly assume that capital expenditures are proportionately similar amongst all companies in the industry.

• EBITDA multiples also assume that what gets depreciated and what gets included in maintenance operating expenses are fairly uniform across the industry so that there is no risk of an overstated EBITDA by virtue of higher capitalized and depreciated expenses, which can be an issue for capital-intensive businesses (see EBIT multiple below).

A valuator must be aware that EBITDA multiples may or may not include deferred costs that may constitute a signifi cant component of the subject company’s normal business operations, (i.e., some accounting jurisdictions may require certain costs to be capitalized, while other jurisdictions would have to expense such costs, resulting in diff erences in the resultant multiples). These can include certain operating expenditures (product development), fi xed assets, leasing transactions, etc. Valuators should attempt where possible to adjust multiples for signifi cant deferred costs that can impact the EBITDA level of not only a comparable company, but the subject company being valued.


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EBITDA multiples, which are “debt-free” multiples, are derived from comparable companies on the basis of Enterprise Value to EBITDA relationships (i.e., EV/EBITDA) which can be used to estimate EV for a subject company.

2.1.1.2 EBIT (Enterprise Value-to-EBIT Ratio)In general, multiples of EBIT, with the exception of the deduction for depreciation (which is a measure of capital recovery), are:

• Relatively similar to EBITDA multiples.• One of the most relevant measures of earnings, since they already incorporate eff ects of

profi tability/return and eliminate eff ects of fi nancial leverage.

They can be a relatively better measure than EBITDA for capital intensive companies (i.e., since they directly consider depreciation), but these multiples still exclude the explicit consideration of capital expenditures.

EBIT multiples, which are “debt-free” multiples, are derived from comparable companies on the basis of Enterprise Value to EBIT relationships (i.e., EV/EBIT) which can be used to estimate EV for a subject company.

2.1.1.3 Revenue (Enterprise Value-to-Revenue Ratio)Some valuators argue that this multiple is intended to eliminate biases in diff ering accounting policies, capital structure, tax rates, profi tability and other diff erences, whether actual or accounting based, that may impact earnings and provide a relatively common basis to assess value. Other valuators meanwhile would argue that, except for a few cases of small businesses with fairly standard cost structures, these kinds of non-earnings based multiples are most commonly used in situations where there are no earnings to estimate values with (as per discussion below).

Using revenue multiples can be misleading as it requires an assumption regarding the comparability of the cost structure between the business on which the multiple is based, and the subject company to which it is applied. This can be very far removed from the cash-generating ability of a given comparable company versus the subject company.

As a result, diff erences between revenue multiples of comparables are primarily attributable to diff erences in profi tability and are most useful if current EBITDA/EBIT is negative or a typical buyer would not consider the existing cost structures of the subject company in analyzing a potential acquisition or is simply buying customers. For example, revenue multiples are often referred to in start-up technology companies, and were often discussed in the pre-bubble early 2000s.

Revenue multiples, which are “debt-free” multiples, are properly calculated based on a multiple of enterprise value (i.e., EV/revenue).

2.1.1.4 Net Book Value (Price-to-Book Ratio)Net book value-based multiples are most commonly used in industries where tangible assets are an important component of value. In such cases, the price-to-book ratio may prove to be a

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constraint. Where trading prices appear to be driven primarily by price-to-book ratios (i.e., the value of the underlying assets), a more relevant measure will be the price-to-book ratio.

However, this ratio requires data for a specifi c date (which may not be available) rather than for a period of time. For this reason, the valuator typically uses this approach only as a means of assessing their value conclusions from other valuation approaches.

In addition, the price-to-book ratio is also diffi cult to use in non-capital intensive businesses where there are limited tangible assets on the balance sheet and where these can also be signifi cantly impacted by accounting policies (e.g., FIFO versus LIFO for inventory, capital versus operating leases, straight-line versus declining balance for depreciation, and capitalization versus expense for research and development). It may also not be appropriate when comparing newer versus older businesses, where capital assets may have just been acquired for the former versus assets that have predominantly been amortized for the latter.

This multiple is simply the market capitalization divided by the book value of the shareholders’ equity on the books of the comparable company (i.e., P/B). An alternative calculation not impacted by debt is the enterprise value-to-book value multiple.

2.1.1.5 Net Earnings (Price-to-Earnings Ratio)Net earnings ratios are most useful in industries where investment and debt are more closely related to operations than to pure fi nancing activities (e.g., fi nancial institutions), in which case EBITDA and EBIT multiples are not particularly relevant. In addition, net earnings ratios are also relevant in industries where:

• P/E ratios are relied upon.• Companies have materially diff erent income tax rates or tax positions.

Since EBITDA and EBIT multiples are based on pre-tax amounts, any diff erences in tax rates or tax positions between the comparable and the subject company would not be refl ected in EBITDA/EBIT multiples, which could be an issue since any given company’s tax rate and/or tax position will typically have an impact on its value.

However, net earnings ratios, such as price/earnings (or P/E) may result in diff ering results for otherwise identical companies, if the capital structures have diff erent debt-to-equity ratios. In order to perform a comparability analysis using net earnings ratios, the valuator must make notional adjustments to debt and/or interest expense for all of the comparables and the subject company in order to have consistent assumptions related to its fi nancial structures. Since such adjustments are typically complex, the use of the net earnings ratio as a valuation multiple is limited to the industries noted above. Moreover, diff erences in tax rates and accounting policies between each of the comparable companies and/or the subject can also have a material impact on the comparability of multiples.

Where the use of net earnings ratios is limited, preference is usually given to enterprise value multiples (e.g., sales, EBITDA and EBIT), since these multiples are not impacted by the fi nancial


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structures of a given company and are infl uenced, to a lesser extent, by a given company’s accounting policies and income tax rates.

Net earnings ratios, which are “after-debt” and “after-tax” ratios, are typically calculated based on a multiple of the market value of equity.

2.1.2 Rules of Thumb

Rules of thumb within a specifi c industry are based on experience, observation or professional wisdom, or a combination of these factors. The application of rules of thumb can also be based on what active acquirers indicate they are willing to pay for comparable companies and can be determined by performing the following steps:

• Identifying companies that have made acquisitions of companies comparable to the subject company.

• Determining the basis on which they have been valuing acquisition targets with specifi c characteristics (companies will generally express these in terms of a multiple or in terms of a required rate of return).

• Applying the multiples or threshold rate of return requirement to the subject company.

While rules of thumb can corroborate the validity of value conclusions obtained through other approaches, the valuator should also consider factors such as:

• Whether the selected approach calculates the value of the subject company as a whole or only for goodwill.

• If such an approach produces a value for the subject company’s shares or its assets.• If adjustments are required in instances where the subject company is not operating at

normal industry levels (i.e., the subject company can be performing better, equal to, or worse than the overall industry).

• Review the overall value conclusions derived using rules of thumb and determine if the conclusions reconcile to other valuation approaches.

As discussed in Level I (Introductory Business Valuation), rules of thumb should not be used as a primary valuation approach for a number of reasons. Rather, rules of thumb should be used as a mechanism to check the reasonability of value calculated under a primary valuation approach.

2.1.3 Public Company Multiples

The use of public company multiples to value a given business is a market-based approach that requires the stock exchange trading prices and underlying fi nancial data of the publicly traded comparable companies selected. The application of these multiples to the corresponding data of the subject company is used to arrive at a value. There are many services that provide/publish such data on a regular basis.

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A value multiple represents a ratio that uses a comparative company’s stock price as the numerator and a measure of the comparative company’s operating results, fi nancial position or other metric (e.g., capacity, employees, assets under management, etc.) as the denominator.

The decision as to whether to use public company multiples as a primary approach, a secondary approach or not at all would require considering, among other things:

• The extent to which the public companies are comparable to the subject company.• The amount of dispersion within the trading company multiples.

When applying public company multiples, market multiples are ideally derived from trading prices of shares of companies that are:

• Engaged in similar lines of business.• Actively traded in a free and open market.

2.1.3.1 Similar Lines of BusinessFor example, market multiples of companies identifi ed as being engaged in either of the following could be used as comparables within each of their respective industries:

• Hotels• Airlines• Industrial manufacturing

However, within these specifi c industry segments, the valuator must be cognizant of relevant diff erences between the selected comparable companies and the subject company, which could have a material impact on the market multiples. In particular, the hotel industry can have diff erent market multiples for luxury hotels versus discount hotels. Likewise, airlines could have diff erent market multiples for national versus regional carriers, and industrial manufacturers could have varying levels of market multiples for well diversifi ed companies versus companies engaged only in specifi c and/or specialized lines of business (e.g., chemical production).

2.1.3.2 Liquidity of Comparable Companies Public company multiples are more meaningful when derived from widely-held and/or liquid securities (i.e., high trading volume) with relatively stable operations. Where publicly traded securities are not widely held and/or liquid, risk is increased, due to the lack of an immediately available market in which the securities can be sold in the short term at a predictable price. This in turn results in lower value and lower market multiples, all else being equal. This can often be seen in public equity markets where liquid and broadly-held securities are often traded at higher multiples of historical results (e.g., multiples of revenue, EBITDA, earnings, etc.) as compared to securities of thinly-traded companies. As a result, adjustments may need to be made to market multiples in order to eliminate the eff ect of illiquidity on thinly-traded public securities.

There is one underlying assumption to this observation above relative to the private company that is to be valued. There is a need to provide some sort of discount to the observed liquid company data multiples to arrive at the multiples relating to the private company (non-publicly/non-traded).


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Professional judgment is required to determine the level of discount that is required to move from a liquid publicly traded company to an non-liquid privately held company. As well, it is important to note that publicly traded multiples include an inherent minority discount that would need to be removed (or off set against the above adjustment) when using publicly traded multiples for purposes of valuing a private company. This adjustment will be discussed later in this course.

An assessment of the amount of liquidity in terms of share volumes can be made through an analysis of the trading data of a given public company. The Exhibit below provides an analysis of trading volumes of a hypothetical group of three companies.

EXHIBIT 2.1: ANALYSIS OF TRADING VOLUMES ACROSS THREE COMPANIES

Average Daily

Volume Public Float1 Outstanding

Shares2

Public Float/ Shares

Outstanding

Average Daily

Volume/ Public

Float

Average Daily

Volume/ Shares

OutstandingABC Company 97,000 40,500,000 42,000,000 96.4% 0.24% 0.23%XYZ Company 300,000 23,000,000 30,000,000 76.7% 1.30% 1.00%123 Company 50,000 500,000 1,000,000 50.0% 10.00% 5.00%

Based on the above exhibit:

• ABC Company is the most widely-held security of the group (i.e., the public fl oat as a percentage of shares outstanding is the highest for ABC Company), which would positively impact an assessment of its liquidity. However, given that both the public fl oat and average daily volume of ABC Company comprise such a small percentage of its shares outstanding, one may consider this security to be illiquid relative to the others as it would likely take some time for a large block of shares (blockage, as discussed below) to be fully absorbed by the market (based on historical trading volumes).

• 123 Company could be argued as the most actively-traded relative to the other entities since the average daily volume as a percentage of both its public fl oat and shares outstanding is the highest for this company as compared to ABC Company and XYZ Company. Whereas one could also argue that XYZ Company is the most actively traded given it has the highest average daily volume.

As noted above, liquidity is also impacted by factors related to blockage. As such, discounts for blockage (further discussed in Section 3.10) can also be applied to market multiples where a large holding of shares creates an imbalance in the average trading volumes. The greater the block of shares, as compared to average daily volumes, the greater the downward infl uence on value, since it will take a greater amount of time for the market to fully absorb the shares (assuming average trading volumes).

1 The number of shares that are held by public investors.2 The number of shares that are held by all shareholders.

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As a result, a valuator must be aware of these and any other key diff erences in valuing a private subject company and should make the appropriate adjustments for these diff erences in selecting the valuation multiples. In particular, the adjustments a valuator may make using their professional judgement may include the following:

• Illiquidity • Blockage (discussed above)• Premiums for control and market perceived synergies (further discussed in Section 3.1.2)• One-time capital and/or other expenditures• One-time working capital requirements• Implication of income taxes, tax credits and the present value of loss carry-forwards• Signifi cant litigation claims and/or awards• Environmental obligations and other contingencies• Redundant assets

2.1.3.3 Valuation Multiples It is important to note that public company multiples provide an indication of value for a given industry at a point in time. As such, the multiples selected to value the subject company should be applied to the normalized results of the subject company in that the earnings of the subject company need to be normalized so that they are indicative of its future maintainable earnings. As well, the earnings measure of the comparable companies must be the same as those of the subject company. For instance, one company may lease space and another company may own its own locations.

Note: The valuator must apply the public company multiple to the same metric of the subject company. For instance, if a public company has a market value that is 10 times the next years’ forecasted earnings, you cannot apply the same multiple to the subject company’s earnings from the previous year. This is particularly true when income is expected to trend signifi cantly higher or lower in the upcoming year versus that of the historical year. One could have a 10x multiple of a forecasted year and only have a multiple of 6x of the historical year.

These multiples can be based on several diff erent sources of historical and/or projected information, including:

• Operations (e.g., revenue, EBITDA, EBIT) from the most recent 12 months.• Operations (e.g., revenue, EBITDA, EBIT) from the most recent fi scal year.• Projected operating results (e.g., revenue, EBITDA, EBIT). • Average of historical results.• Timing (historical, forecast).• Normalized, unadjusted.• Recent 12 months.• Recent fi scal year.• YTD.


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• Average of several of the above metrics.

The valuation multiple is calculated by dividing a metric of the public company’s shares (such as price per share, enterprise value) by a fi nancial variable (such as earnings, cash fl ow, EBITDA, or revenue), based on the fi nancial data of the public company. The valuation multiples arrived at are then reviewed and used as “comparables” in applying valuation multiples to the subject company, after making the appropriate adjustments to ensure consistency in accounting conventions between entities as the selection of the accounting policies can impact the calculation of multiples, the timing of the price data used in the valuation multiples, and the selection of the underlying data used to compute the valuation multiples. Important considerations in making such adjustments are listed later in this module.

There are two basic types of multiples:

• Enterprise value.• Equity value.

In performing the comparable company multiples (public company multiples or precedent transactions), the valuator should distinguish between enterprise value (invested capital) and equity.

2.1.3.4 Business Enterprise Value Versus Equity Value According to generally accepted fi nance theory, any given company or “fi rm” is made up of the market value of two primary components, which collectively comprise the total value of the business enterprise (i.e., “enterprise value” or total “invested capital”). These components can be summarized as follows:

• Market value of “equity” — Based on current trading price of the common shares (i.e., market capitalization).

• Market value of “net debt” — Represents the market value of all other fi nancial claims against the corporation, including bank loans, long-term debt, capital leases, minority interests, and preferred shares, net of redundant cash and cash equivalents (i.e., non-operating cash), which are collectively referred to as “net debt.”

EXHIBIT 2.2: ENTERPRISE VALUE

FVBusinessEnterprise

FVNet Working Capital

FVTangible Assets

FV Intangible Assets

FVDebt Capital

FV Equity Capital= =

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Under comparable company multiples, the value of the subject company can be determined using the following two basic approaches:

• Enterprise value — This is a “debt-free” approach, which is based on the multiples of the comparable companies calculated using the enterprise value of the comparables (i.e., the market value of the common shares plus the market value of net debt). Once enterprise value is calculated by applying “debt-free” multiples to the subject company’s EBIT, EBITDA, or revenues, a deduction is made for actual net debt in order to estimate equity value of the subject company. Enterprise value should exclude non-operating assets and the EBITDA should be adjusted to exclude earnings from these non- operating assets.

• Equity value — This approach is based on the market capitalization of the selected comparable companies (i.e., market value of equity).

The multiples derived using both of these approaches are discussed in further detail below.

Enterprise Value MultiplesEnterprise value multiples are the most widely used in practice, as it is generally believed that these multiples are not infl uenced by the given capital structure (i.e., debt and equity composition) of a particular business. In general, the most common enterprise value-based multiples used in practice are EBIT, EBITDA and revenue multiples. After incorporating relevant adjustments based on the given circumstances, the valuator applies these multiples to the subject company’s normalized EBIT, EBITDA and/or revenues to arrive at an estimate of the enterprise value of the subject company. This approach ignores the existing capital structure of the subject company (i.e., it is a “debt-free” approach, which uses debt-free multiples such as EBIT, EBITDA, and revenue to calculate the total value of the business enterprise). Once enterprise value is calculated, the actual amount of debt outstanding can be deducted to arrive at the market value of equity.

In practice, a number of other adjustments (also discussed below), based on the given circumstances, may be required to arrive at equity value. These adjustments can include, amongst other items, additions and/or deductions for redundant assets, one-time capital expenditures, restructuring activities, present value of loss carry-forwards, signifi cant legal claims, and other items specifi c to the subject company, to the extent that these features are not captured in the comparable company market multiples.

Enterprise Value Normalization AdjustmentsIn calculating enterprise value for the comparable companies as well as for the subject company, the valuator may fi nd it necessary to make certain normalization adjustments, which generally include consideration of the following items, among others (i.e., these normalization adjustments must be made not only to the comparable companies but also to the subject company).

Price and Number of Shares OutstandingThe stock price of each of the comparable companies is typically based on the quoted market price on the valuation date. This type of measure would be most relevant for relatively stable companies that have not been subjected to unjustifi ed fl uctuations in their stock prices. However, for comparable companies with relatively volatile and/or highly fl uctuating stock prices, an


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alternative measure of the stock price, such as an average over the previous month or longer, would be more appropriate.

The valuator must also be aware of the number of shares outstanding that are used in the valuation analysis because the number of shares in the enterprise value calculation refers to the number of shares outstanding if all warrants, stock options, and other equity arrangements were fully used (i.e., based on the diluted number of shares, which would include the exercise proceeds as additional cash on hand). The valuator must also identify and account for stock dividends or stock splits before computing the market capitalization and then deriving the multiple.

Interest-Bearing DebtThe valuator should carefully consider the defi nition of interest-bearing debt and determine whether operating lines should be classifi ed as long-term debt or, alternatively, as a component of net working capital. An assumption commonly made in practice is that all interest-bearing debt should be included in enterprise value. However, the key factor is that there is consistency between the comparable company multiples and the basis to which the multiples are applied for the subject companies.

Cash and Cash EquivalentsA determination should be made as to the amount of cash-on-hand that is required for ongoing operations, as it impacts the amount of cash that is deducted from the enterprise value calculation (i.e., cash classifi ed as being non-operational in nature is netted against interest-bearing debt in the standard calculation of enterprise value). As a result, the classifi cation of cash as operating versus non-operating (i.e., redundant) can signifi cantly impact the calculation of enterprise value and the related enterprise value multiples. If a determination of redundant cash is not made for each of the comparable companies in computing their multiples, then no adjustment should be made in computing the value of the subject company - consistency is essential.

Some valuators would argue that one would always deduct all the cash and cash equivalents from the debt number. The premise underlying this view is that it is intended to recognize that the cash is the worst of all assets in terms of contributing to return (generally zero) and it can, as it were, always be obtained from a bank.

Redundant Assets and LiabilitiesRedundant assets should be excluded for purposes of calculating enterprise value-based multiples and, to the extent that redundant assets are fi nanced by long-term debt, they should be netted as a cash equivalent.

In addition, income and/or expenses relating to redundant assets (e.g., income earned from excess cash not required in the business and instead invested in GICs) should be removed from the income statement and balance sheet of both the comparable and subject companies. However, if the impact of redundant assets is relatively small, the calculation can be cumbersome and without major infl uence on the fi nal outcome.

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One-time and/or Other AdjustmentsBased on the given circumstances, one-time and/or other adjustments, which may not have been captured in the valuation multiples selected, can include company specifi c adjustments for items such as:

• The present value of loss carry-forwards.• One-time capital expenditures.• One-time working capital requirements.• Signifi cant legal claims.• Restructuring activities.• Tax credits.

Equity MultiplesIn practice, equity multiples are less commonly used than enterprise value multiples. This is due to the widely held belief that equity levels may be distorted due to diff erences in the subject company’s capital structure or book value (related to compliance with accounting standards, capitalization versus expense). Further, since pre-debt cash fl ows are considered to be more useful than cash fl ows net of interest expense in determining future economic value, equity-based approaches are less commonly used than enterprise value-based approaches. One common exception is with respect to fi nancial services businesses such as banks and insurance companies, where much of the debt on the balance sheet is supported and matched by like- duration assets on the balance sheet. However, a multiple of the market value of equity to tangible net assets can provide an indication of the amount of “goodwill” in a given business. This can be useful in assessing the value (calculated using the discounted cash fl ow or other earnings based approaches).

These multiples are calculated as the ratio obtained by dividing the market capitalization by either the book value or net earnings after all prior claims (interest, taxes, preferred dividends, etc.), respectively. After incorporating all relevant adjustments, the valuator would apply these multiples to the subject company’s normalized earnings, including normalization for capital structure (i.e., level of debt and the resulting interest expense) to arrive at the value of the subject company’s equity. The most common multiples are price/book and/or price/earnings.

Enterprise Value or Equity Multiples: Which is the Preferred Approach?The amount of fi nancial leverage (i.e., the mix of debt-to-equity) used by various businesses within a given industry can have wide variations. Notional adjustments must be made to the amount of debt outstanding and/or the interest included in earnings in order to appropriately calculate equity multiples for otherwise identical businesses.

Exhibit 2.3 illustrates the calculation of enterprise value and equity multiples of two businesses, which are identical other than their relative capital structures (i.e., Comparable A has a 33.3% debt-to-equity ratio and Comparable B has a 5.3% debt-to-equity ratio):


64

EXHIBIT 2.3: ANALYSIS OF MULTIPLESAs at December 31, last year($ millions)

Pre Interest EBITDA

Pre Interest

EBIT SalesPost Interest

Earnings

Market Capitalization

(Equity)Net

DebtDebt/

EquityEnterprise

Value

Enterprise Value/

EBITDA

Enterprise Value/

EBIT

Enterprise Value/ Sales

Price/ Earnings

ABC Company 300 150 1000 125 1500 500 33.3% 2000 6.7 13.3 2.0 12.0

123 Company 300 150 1000 138 1750 250 14.3% 2000 6.7 13.3 2.0 12.7

Based on the Exhibit 2.3, the enterprise value multiples (i.e., EBITDA, EBIT and sales) are identical and are not infl uenced by fi nancial leverage and/or the capital structure of the two companies (i.e., since the total value of the business enterprise does not change, the selected fi nancial structure and/or debt- to-equity composition does not directly impact pre-interest multiples). However, without adjusting post- interest earnings or the amount of debt and or equity of the comparables, the equity value multiples (e.g., price to earnings, as seen above) are directly infl uenced by the capital structure and result in diff erent multiples.

As a result, enterprise value multiples are often preferred due to their simpler application and given that enterprise value multiples are not subject to a great degree of infl uence based on the fi nancial structure of the comparable companies (i.e., a comparable company analysis can be done using enterprise value multiples without having to make notional adjustments to earnings and/or the capital structure of the comparatives).

Private Versus Public CompaniesPublic trading prices can provide empirical evidence of appropriate capitalization rates and multiples in a given industry since current trends in public equity markets refl ect market consensus with respect to general and specifi c industry conditions, which can act as benchmarks in developing values for public and private subject companies. However, there are diff erences between the public equity markets and the market for private companies that can make a comparison relatively more diffi cult for a private subject company. Some of the diff erences between the purchase of shares of a publicly traded company on the stock market and the purchase of all the outstanding shares of a private company can be summarized as shown in Exhibit 2.4.

EXHIBIT 2.4: DIFFERENCES IN PURCHASE OF SHARES BETWEEN PRIVATE / PUBLIC

Public Company Private CompanySize Large SmallTransactions Between Minority shareholders Buyers and sellers of large interestsShareholders Not active in management Active in managementInvestments Liquid Illiquid

To a signifi cant degree, the usefulness of public company information in developing values for private companies is related to the size of the private company being valued; however, size is not

65


the beginning and end of whether a public and private company can be compared as you have to consider the entire risk profi le of both the public and private companies being compared.

Generally, other diff erences between public and private companies can include:

• Public companies are often vertically or horizontally integrated, while private companies usually are not.

• Management, fi nancial stability, strategic planning, board of directors, products, supply-chains, and market presence are more developed and/or mature for public companies than private companies.

• Private companies typically have limited geographic reach as compared to public companies.

• Public companies generally have a greater management depth as compared to private companies.

• Management typically focuses on accounting-based earnings for public companies while private companies tend to focus on taxable income.

• Public companies generally have greater access to fi nancial markets and funding sources and have a greater amount of fi nancial resources as compared to private companies.

In pointing out diff erences between public and private companies, one should be careful to consider that there are, of course, some very large private companies which are often subsidiaries of even larger public companies, yet they are not the same as the parent. As such, some of the comments above are more relevant to smaller private companies rather than private companies.

2.1.3.5 Important Considerations and Potential Adjustments to MultiplesAs discussed earlier, under comparable company multiples, comparisons are made on the basis of valuation multiples. The computation, analysis and use of such multiples should provide meaningful insight about the value of the subject company, with consideration of all relevant factors. Accordingly, the valuator should exercise care with respect to the following issues:

• The selection of the underlying data used to compute the valuation ratios• The selection of the time periods and/or the averaging methods used to generate the

underlying data• The computation of the valuation multiples• The timing of the market price data used in the valuation multiples• How the valuation multiple(s) were selected and applied to the subject company’s

underlying data

In addition, comparable companies typically have diff erences in terms of size, product mix, markets served, liquidity, trading volumes, ownership structure (i.e., widely versus closely held), management, etc. As a result, simply using data from public stock exchanges and/or transactional databases and calculating valuation multiples, without considering such diff erences, could lead


66

to unreasonable conclusions, since the selected multiples may need to be adjusted to take into account the subject company’s specifi c circumstances.

Moreover, the valuator should consider all the operational, fi nancial, commercial and technological diff erences between the subject company and the comparable companies selected. Where the distribution of the multiples is not symmetrical and has no pattern, the selection of the average mean and/or the median may not be appropriate. This kind of situation can occur in industries where product diff erentiation is important (e.g., the high-technology or pharmaceutical industries) and where each comparable company may have an innovative technology that is not comparable to others.

As noted earlier, several valuation ratios may be selected for application to the subject company. However, these ratios may require adjustments for diff erences in qualitative and quantitative factors (with a high degree of cross-over between most factors) between the comparable companies and the subject company. Adjustments to the fi nancial data of the subject and the comparable companies should be considered when such diff erences are signifi cant. Here are some items to think about when making comparisons:

Qualitative (considerations and/or adjustments):• Industry• Management experience, depth, commitment, etc.• Accounting and risk management practices• Growth prospects (analysis of growth prospects must be based on historical growth, as

well as on the industry’s and the company’s growth prospects)• Size (diff erences in size do not automatically mean incomparability and large companies

can be less effi cient than smaller ones)• Geographical benefi ts, constraints, degree of diversifi cation, and prospects• Technological advancement• Nature, type, uniqueness, and diversifi cation of products and services• Customer loyalty• Market share• Ability to protect intellectual property• Maturity of the business and/or relative stage of development• Nature of type of customers and suppliers• Relationships with lenders• Political environment• Regulatory compliance• Degree of control• Degree of marketability and liquidity• Timing diff erences between the market information and the valuation date

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• Dividend paying ability• Strategic risk

Quantitative (considerations and/or adjustments)• Non-recurring items• Accounting policies and diff erences (i.e., diff erent asset capitalization policies)• Growth trends in revenue and profi ts• Gross margins• Profi tability (e.g., EBIT, EBITDA, free cash fl ow, net earnings, etc.)• Price diff erences• Quantity discount and other effi ciencies• Tangible asset backing• Return on tangible capital employed• Relative size of capital• Capital structure (e.g., debt versus equity)• Financial risk, as estimated by the level of debt included in the capital structure• Operational risk• Foreign exchange exposure• Liquidity of the company (e.g., quick and current ratios)• Dividend paying ability (e.g., free cash fl ow from operations, less cash fl ow needed for

fi nancing and investment activities)• Off -balance sheet assets and liabilities

Discount for Illiquidity/MarketabilityPublic trading prices of equities refl ect amounts that investors are willing to pay for investments in highly liquid/marketable assets, whereas the acquisition of a private company represents a relatively illiquid investment (i.e., a “ready” market does not typically exist for the shares of a private company). As a result, a relatively lower multiple should be applied to a private company valued using comparable company multiples, assuming that everything else is held constant. This discount represents the lack of liquidity/marketability of the private company’s shares relative to the public company comparables.

There are numerous studies that provide commentary on discounts for illiquidity and lack of marketability, but there is no clear consensus in this area. While most commonly used discounts for lack of liquidity/marketability range from 10% to 30%, it must be noted that such broad rules of thumb may not be appropriate in all circumstances and should only be applied after consideration of all relevant facts to the specifi c circumstance being evaluated.

Premium for Control

A control premium represents the following three elements:


68

1. Pure control — Market trading prices represent the price paid for a minority interest, and a minority interest is generally considered to be worth less than a control interest due to lack of control (and lack of liquidity, in the context of a privately-held corporation). Therefore, a minority interest in a public company would normally be expected to trade at a minority discount.

2. Strategic or synergistic premium — A purchaser of 100% of shares may be able to achieve strategic and/or synergistic benefi ts, which may or may not be relevant in a notional value, depending on whether value is being assessed on the basis of intrinsic value or strategic value.

3. Under-priced securities — Trading prices may not be refl ective of value (thinly traded, access to information, etc.).

In general, publicly traded equities represent transactions between minority shareholders (i.e., no exchange of controlling interest) and contain no strategic or synergistic benefi ts. As a result, these market multiples derived from trading multiples from public exchanges of minority shares contain an implied minority discount for lack of control. A premium for control can be applied to such multiples that refl ect minority discounts in order to arrive at Enterprise Value on a controlling basis. However, control premiums (if any) should only be applied to common equity value multiples, since one would not pay an additional amount to “control” the debt or preferred shares of a subject company (absent convertibility or de facto control).

For the transaction approach, a premium for control is typically not required if the particular comparable transaction being reviewed represented an exchange of a controlling interest.

EXHIBIT 2.5: PUBLIC COMPANY MULTIPLESIn general, the application of trading multiples from public companies deemed to be comparable to a subject company (private or public) requires the following three steps:

1. Identifi cation of public companies comparable to the subject company (based on size, product, market, etc).

2. Establish valuation multiples for the comparable companies based on their related trading price and other fi nancial information.

3. Select and apply multiples from public company comparables to the subject company to estimate its market value (enterprise value and/or equity value).

Each of these steps is briefl y discussed below:

Step 1: Identifi cation of comparable public companies• Research, analyze and select comparable companies.• Identify and consider all relevant factors, some of which are outlined later in this module.Step 2: Establish valuation multiples• Develop valuation multiples based on enterprise value (e.g., EBIT, EBITDA, revenues)

and/or equity value (e.g., price/book, price/earnings).

69


• Multiples typically use the last twelve months (LTM) of fi nancial results and an industry median and average, calculated as illustrated in Exhibit 2.5A

EXHIBIT 2.5AAnalyses of multiples (Public company trading Multiples)As at December 31, last year ($Millions)

Trading Price

Outstanding Shares

Market Capitalization Net Debt

Enterprise Value

EV/EBITDA

EV/EBIT

EV/Sales Book

Price/Earnings Price/Book

Comparable

Comparable A 30.64 55,000,000 1,685,200,000 -96,700,000 1,588,500,000 8.9 9.7 2.8 1.9 17.3 1.8

Comparable B 9.64 177,400,000 1,710,100,000 2,962,900,000 4,673,000,000 6.4 7.6 1.5 1.1

Not Meaning-

ful 1.4

Comparable C 28.00 28,100,000 786,800,000 321,400,000 1,108,200,000 9.1 11.5 1.7 1.3 17.8 1.5

Comparable D 31.45 540,500,000 16,998,700,000 7,603,900,000 24,602,600,000 10.8 15.6 2.6 1.5

Not Meaning-

ful 1.9

Comparable E 31.20 42,800,000 1,335,400,000 318,300,000 1,653,700,000 5.5 9.9 2.4 1.3 18.5 1.4

Comparable F 14.08 100,200,000 1,410,800,000 401,200,000 1,812,000,000 11.1 11.9 4.4 1.1 19 1.1

Comparable G 16.50 11,400,000 188,100,000 45,200,000 233,300,000 15.1 17.8 3.2 1.8 27.8 2.3

Comparable H 16.00 26,900,000 430,400,000 154,400,000 584,800,000 9.5 11.9 1.5 1.7 11.6 2.3

Industry

Median 1,373,100,000 319,850,000 1,621,100,000 9.3 11.7 2.5 1.4 18.2 1.7

Average 3,068,187,500 ,463,825,000 4,532,012,500 9.6 12.0 2.5 1.5 18.7 1.7

Standard Deviation 5,657,148,149 2,668,777,413 8,219,990,306 3.0 3.3 1.0 0.3 5.2 0.4

Minimum 188,100,000 -96,700,000 233,300,000 5.5 7.6 1.5 1.1 11.6 1.1

Maximum 16,998,700,000 7,603,900,000 24,602,600,000 15.1 17.8 4.4 1.9 27.8 2.3

Note: Price in “Price/Book” and “Price/Book” refers to market capitalization

• Normalization of income statement and balance sheet

As part of Step 2 in establishing valuation multiples, the valuator must understand the business being valued (i.e., operations, fi nancial structure, position in the marketplace, industry, competition, growth, etc.) and adjust the subject company’s historical results for non-recurring and/or unusual items, and eliminate any redundant results. (However, the above provided Example does not provide suffi cient detail of the Comparable Companies to determine/calculate the normalizing adjustments, A much deeper analysis and research would need to be done to determine what, when and why to adjust) Redundant items must be identifi ed because redundant assets and liabilities not required for operations will not generally be captured in the valuation of the subject company when applying the public company multiples to the subject company’s normalized results. Enterprise value does not include redundant assets.

• Selection of market multiples

After considering potential normalization adjustments for each of the comparable companies, specifi c qualitative and/or quantitative factors (e.g., diff erences in gross margins, EBITDA margins, revenues, operational risk, market share, diversifi cation, etc.), illiquidity/marketability discounts, premium for control, and other items as outlined earlier in this module must also be considered. Moreover, the valuator then uses the average industry multiples (and adjusts


70

these as determined to be necessary) in selecting the market multiples to apply to the subject company.

In particular (and assuming that there are no material diff erences between the subject company and the industry averages of the normalized multiples of the comparables), the valuator would select market multiples using the “industry” averages from the Exhibit for EBITDA, EBIT, sales, book, price-to-earnings, and price-to-book of 9.6X, 12.0X, 2.5X, 1.5X, 18.7X, and 1.7X, respectively.

Step 3: Apply selected multiples (enterprise value and equity value)The selected public company multiples (or range of multiples) are then applied to the subject company’s normalized results for the related measure (e.g., LTM EBITDA, LTM EBIT, LTM revenues, book value, and/or net earnings) to arrive at an estimate of value, as shown in the Exhibit 2.5B and 2.5C.

EXHIBIT 2.5BAnalysis of Multiple (Use of Enterprise Value Multiple)Enterprise vs. Equity MultiplesAs at December 31, last year ($Millions)

Enterprise Value-Subject Company

Last Twelve

Months MultipleEnterprise

ValueNet

DebtEquity Value

EBITDA 300 9.6 2,880 500 2,380 EBIT 350 12 4,200 500 3,700 Sales 1,000 2.5 2,500 500 2,000

EXHIBIT 2.5CAnalysis of Multiple (Use of Equity Value Multiple)Analysis of Public Company Trading MultiplesAs at December 31, last year ($Millions)

Enterprise Value-Subject Debt

Last Twelve Months Multiple

Enterprise Value

Net Debt

Equity Value

Book value 2,000 1.5 n/a n/a 3,000 Net earnings 200 18.7 n/a n/a 3,740

2.1.3.6 Professional JudgmentValuation multiples are derived by relating transaction prices of comparable companies to the appropriate underlying fi nancial, operating or physical data of these respective companies. The valuator may select several valuation multiples when analyzing the subject company. However, these multiples may require adjustment for diff erences in qualitative and quantitative factors between the comparable companies and the subject company (discussed earlier in this module). When a range of potential values result, the valuator must consider the relative importance or weight applied to each potential value within the range to arrive at the value conclusion.

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Due in part to the various factors noted above, the value generated by simply multiplying the subject company’s EBITDA by the EV/EBITDA multiple of a public company may need to be adjusted to take into account the subject company’s unique circumstances. Moreover, the valuator must be able to select comparable companies and their related multiples, which are suffi ciently similar to the subject company. Accordingly, signifi cant experience and judgment are also required in accurately selecting and applying given multiples to a particular business, which includes the experience of valuators in a given industry, and to eliminate irrelevant multiples of the comparable companies selected.

As a result, valuators with experience in any given industry can be extremely helpful as their understanding and insight in having worked on many transactions within the industry provides them with the judgment needed to make both accurate and reasonable valuation decisions.

MQE Question 2.1 Below is a partial subset of a question/answer from a prior Membership Qualifi cation Examination (“MQE”) to illustrate public company trading multiples:

MQE QUESTION 2.1

Adam Forestry Corporation (“Adam Forestry”) is a leading integrated forest products company based in British Columbia. Adam Forestry employs approximately 7,100 personnel across Canada, and has production facilities in British Columbia, Alberta, Manitoba, Quebec and the Maritimes. For the Last Year, Adam Forestry reported sales of $2.12 billion compared to $2.61 billion in the 2nd last year.

However, a series of worse-than-expected fi nancial results along with certain other developments have recently led Liam Benedict, the CEO of Holdco, to question whether it might be prudent for it to sell its shares of Adam Forestry sooner rather than later. Liam has retained Tremblay Advisors LLP to be Holdco’s valuation advisors in respect of a potential sale and valuation of Holdco’s shares. A DCF valuation has shown that Adam Forestry’s Enterprise Value is approximately $2.0 billion, which implies an EV/EBITDA of 9x.

Background Information regarding Adam ForestryAdam Forestry has three main operating segments — lumber, pulp and paper, and panel products.

Lumber operations consist of harvesting trees and processing the timber into wood materials of various lengths and dimensions for use in residential and commercial construction. Adam Forestry has the capacity to produce 4.5 billion board feet of lumber annually, and holds harvesting rights to 6 billion board feet annually.

Pulp and paper operations consist of processing wood chips, sawdust and other interim wood product into pulp, which is then used to make various grades of paper (specialty paper, craft paper, container board, newsprint, etc.). Adam Forestry currently has the capacity to produce 1 million tonnes of pulp annually. Adam Forestry sells the majority of the pulp that it produces, but also uses some of its pulp to manufacture approximately 140,000 tonnes of paper per year.


72

The company’s panel product operations consist of processing timber into wood sheet materials, which can then be used for fl ooring (hardwood strips, laminate etc.), wall panels and roofi ng. The company has the capacity to produce 1.7 billion square feet of panel materials annually. Approximately 80% of Adam Forestry’s product is sold into the US market; 10% is sold in Canada; the remaining 10% is exported to Europe and China.

Disappointing ResultsAdam Forestry’s fi nancial results have been consistently below expectation. Quarterly and annual sales, EBITDA and net income have, with a few exceptions, been below management forecasts.

Adam Forestry management has pointed out that actual results for many companies in the forestry products industry have been below forecast. However, some industry insiders feel that Adam Forestry’s new management team has demonstrated a lack of vision with respect to helping reposition the company for the future. Competitors have aggressively cut production capacity in response to reduced global demand for forestry products, while focusing on more profi table products such as specialty papers instead of “declining” products such as newsprint. However, Adam Forestry has been much slower to implement such changes.

Industry and Economic DevelopmentsEconomic and industry developments have compounded Adam Forestry’s challenges. In particular, three developments have impacted the company (and many of its competitors):

1. The continued strength of the Canadian dollar against the US dollar2. The introduction of a new 15% export levy tax on forestry product shipments from Canada

to the US3. The need to harvest and destroy dead pine trees in areas aff ected by a pine-beetle

epidemic

To provide some measure of assistance to forestry product companies, the Canadian Federal Government introduced the “Green Transformation Program” which pays funds to forestry product companies if they invest in qualifying energy and environment capital projects.

Information with respect to trading multiples of somewhat comparable Canadian public companies is contained in the schedule below. As each transaction in this industry is unique, you have been requested not to consider industry transaction multiples.

73


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74

[1] Wilfred Murison Corp. specializes in the production of pulp and paper (specialty, craft paper, container board, newsprint). The company operates production facilities in British Columbia, Quebec, Newfoundland, Japan and the US. The company also operates hydroelectric facilities to supply power to its pulp and paper operations, and sells excess power to local utilities. All timber is sourced from external producers.

[2] Cedar West Forestry Ltd. specializes in the harvesting of timber from various properties located in British Columbia, Alberta, Ontario and the State of Oregon. The company has cut back its pulp and paper production in recent years and currently maintains nominal capacity. Various subsidiaries also engage in paper recycling operations for municipalities across Canada.

[3] Barkwoods Incorporated engages in the harvesting of timber, production of pulp and paper, commercial electricity generation and production of pre-fabricated wood products (shelves, garden sheds). Production operations are focused in Ontario, Quebec and the Maritimes. The company owns some of the most valuable timber harvesting rights (hardwood species) in Eastern Canada.

[4] Avenida Co. Ltd. engages in the harvesting of timber and production of pulp and paper. Operations are focused in British Columbia. Most of the company’s timber properties comprise of softwood species.

[5] Pemberton Corp. is engaged in the generation of electricity from hydroelectric, coal-fi red, gas-turbine and wind power facilities located in almost every Province in Canada. Many hydroelectric facilities are located adjacent to pulp and paper mills.

[6] North Forest Products Inc. is a vertically integrated company that owns timberlands, pulp and paper facilities, wood remanufacturing facilities, furniture factories, and homebuilding joint ventures, with a presence in China, Japan and South America.

Required:Use comparable company information to test the reasonableness of your DCF valuation conclusion.

Solution:Other indicators of value (somewhat comparable companies)

We were provided with a listing of Canadian public company trading multiples as at Last Year for companies in the forestry products industry (as provided above).

To determine if a company was comparable to Adam Forestry, we considered the following:

1. Size in terms of market capitalization /enterprise value2. Similarity in lines of business in which the company operated / scope of services off ered3. Similarity in terms of geographic location of operations

Our analysis of public companies is as follows:

1. Wilfred Murison Corp. has a somewhat smaller enterprise value than Adam Forestry. The company engages in pulp and paper operations and hydroelectric power generation, but does not own its own timber rights. Like Adam Forestry, it has operations in Canada and the US.

2. Cedar West Forestry Ltd. is smaller than Adam Forestry in terms of enterprise value. Unlike Adam Forestry, however, Cedar focuses on harvesting timber and paper recycling operations, with nominal pulp and paper production. Like Adam Forestry, it has operations in Canada.

75


3. Barkwoods Incorporated is smaller in terms of enterprise value. Like Adam Forestry, it engages in pulp and paper, electricity generation and wood product operations. Like Adam Forestry, its operations are focus in Canada and owns its own timber rights.

4. Avenida Co. Ltd is comparable in terms of enterprise value. Avenida’s operations are focused on timber production and pulp and paper, with no power generation. Its geographic operations are focused in British Columbia only.

5. Pemberton Corp. is signifi cantly smaller than Adam Forestry in terms of enterprise value. Unlike Adam Forestry, its operations are focused on power generation.

6. North Forest Products Inc. is smaller in terms of enterprise value. It has a wider scope of operations than Adam Forestry, however, which include pulp and paper, timber, homebuilding and home sales. Its geographic operations include Canada as well as Asia and South America.

Based on our above analysis, Wilfred Murison Corp., Barkwoods Incorporated, Avenida Co. Ltd., and North Forest Products are the most closely comparable to Adam Forestry.

We have compared the enterprise value to EBITDA multiples implied from our DCF valuation of Adam Forestry to the comparable companies we have identifi ed.

The average public comparable company EV / EBITDA multiple is 63 as compared to 9 for Adam Forestry. The multiple for Adam Forestry is lower than the average for somewhat comparable companies. The lower multiple may refl ect the fact that there is a greater degree of risk (and hence lower value) associated with Adam Forestry, relative to its competitors in the forestry products industry. This may be due, in part, to the fact that Adam Forestry has had diffi culties adapting to changes in the industry, has missed its forecasts and appears to have underperformed relative to competitors. In addition, the shares of public companies tend to be more liquid and therefore easier to trade, and this may be refl ected in their comparatively higher valuations and higher EV to EBITDA ratios.

It should however be noted that Adam’s multiple is relatively close to Wilfred Murison Corp. We have not utilized other ratios, such as EV to annual timber harvesting rights, and EV to annual pulp capacity. Neither Adam Forestry nor the somewhat comparable companies identifi ed engage exclusively in timber harvesting, or exclusively in pulp and paper operations; these ratios tend to assume a focus on one or the other operation. Therefore, using these ratios and comparing diff erent companies on this basis may potentially result in misleading comparisons.

Based on our analysis above, in our view, the enterprise value calculated for Adam Forestry and the implied EV multiples are reasonable as compared to the multiples for somewhat comparable public companies.

Note: When completing an analysis such as the one above on an examination question, students are encouraged to provide a detailed analysis of potentially comparable companies. Simply describing the companies is not suffi cient; one is expected to relate each descriptive point to whether or not the company being looked at was therefore comparable.


76

Below is another example from a prior MQE (2010, Question #1)3.

MQE ANSWER 2.2: “ADAM FORESTRY CORPORATION”

Market-Based Method Using Trading MultiplesIn order to identify appropriate comparable public companies, we reviewed publicly available information of companies engaged in owning and operating ethanol plants in North America. The public companies considered in our analysis along with their valuation, fi nancial, trading multiple and profi t margin information.

EIC is a private company headquartered in London, Ontario. Sam Hunt and Larry Jordan founded EIC to distribute ethanol imported from the US. EIC’s customers in the initial years were various manufacturing companies in Ontario. After a few years of modest growth, EIC secured a number of contracts to supply fuel ethanol to several gasoline refi ners in Ontario. As the demand from the gasoline refi ners grew over the years, EIC built an ethanol production facility in Delhi, Ontario. Last year approximately 60% of ethanol sold by EIC was produced at the Delhi plant while remaining 40% was imported from the US.

The process of analyzing valuation multiples implied by comparable public companies and applying these valuation multiples to EIC (company subject to valuation operating within the Ethanol Industry) involves professional judgments and assumptions concerning the fi nancial performance and operating characteristics of the selected public companies as compared to EIC’s business. Based on our review, we made the following observations with respect to these comparable companies:

1. Archie is a diversifi ed company engaged in corn processing (40%), ethanol production (40%), and bio-diesel production (20%) in the US. It is signifi cantly larger than EIC in terms of production capacity and sales. As Archie operates only in the US, is diversifi ed and is much larger than EIC we believe Archie is not directly comparable to EIC for the purpose of deriving valuation multiples.

2. Andy is a diversifi ed company engaged in the production and sale of grain and ethanol fuels (65%), bio-diesel (20%), and oilseed (15%) in the US. It is signifi cantly larger than EIC in terms of production capacity and sales. As Andy operates only in the US, is diversifi ed and much larger than EIC, we believe Andy is not directly comparable to EIC for the purpose of deriving valuation multiples.

3. Avenue is a company engaged in production and sale of fuel grade ethanol in the US. It is signifi cantly larger than EIC in terms of production capacity and sales. Compared to EIC, it had a higher profi t margin in Last Year and is forecasted to have a higher profi t margin in Next Year. As Avenue operates only in the US, is much larger than EIC and has higher profi t margins than EIC, we believe Avenue is not directly comparable to EIC for the purpose of deriving valuation multiples.

3 Note that we have shown only a portion of the suggested response and not the question itself and as such we have provided a reference to the year and question above should students seek further information.

77


4. Miller is a diversifi ed business engaged in distillery products, which comprise food-grade alcohol, including beverage alcohol and industrial alcohol, fuel ethanol, and distillers’ grain and carbon dioxide in the US. It is signifi cantly larger than EIC in terms of production capacity and sales. As Miller operates only in the US, is diversifi ed and much larger than EIC, we believe Miller is not directly comparable to EIC for the purpose of deriving valuation multiples.

5. Verity is a company that is engaged in production, import and sale of fuel-grade ethanol in Canada. It is signifi cantly larger than EIC in terms of production capacity and sales. Compared to EIC it had a higher profi t margin in last year and is forecasted to have a higher profi t margin in next year. As Verity is an ethanol company operating in Canada we have considered it to be an appropriate comparable, while recognizing that it is larger than EIC and has higher profi t margins than EIC.

6. Atlantic is a company that is engaged in production, import and sale of fuel-grade ethanol in Canada. It is larger than EIC in terms of production capacity and sales. Compared to EIC it had a slightly higher profi t margin in last year and is forecasted to have a slightly higher profi t margin in next year. As Verity is an ethanol company operating in Canada we have considered it to be an appropriate comparable while recognizing that it is larger than EIC.

7. DDG is a development stage company that develops specialty enzymes and customizes enzymes for manufacturers within the alternative fuel, industrial, and health and nutrition markets. It is larger than EIC in terms of production capacity and is forecasted to have signifi cant sales growth in next year when compared to EIC. Therefore we believe DDG is not comparable to EIC for the purpose of deriving valuation multiples.

8. Yethanol is a development stage company that intends to produce ethanol by the fermentation of sugars found in grains and other biomass. It is smaller than EIC in terms of production capacity and is forecasted to have signifi cant sales growth in next year when compared to EIC. Therefore, we believe Yethanol is not comparable to EIC for the purpose of deriving valuation multiples.

9. Green is a development stage, renewable energy company that engages in the production and sale of ethanol in the US. It is smaller than EIC in terms of production capacity and sales. Compared to EIC it had a lower profi t margin in last year and is forecasted to have a higher profi t margin in next year. Therefore, we believe Green is not comparable to EIC for the purpose of deriving valuation multiples.

Based on the above analysis we selected the trailing and forward EBITDA multiples for Verity and Atlantic to estimate the value of EIC. We applied a discount of 15% to 25% to the selected multiples to account for the relatively smaller size of EIC. The discount was selected judgmentally based on our experience valuing similar companies.

Market trading activity refl ects the trades of minority interest. As such it may be appropriate to consider a control premium as the purpose of this analysis is to estimate the en-bloc value of EIC shares. However, as EIC is a private company it may be appropriate to apply a liquidity discount


78

to the market derived valuation multiples to recognize the extended period of time required to dispose a private company compared to disposing shares in a public market.

We have assumed that any control premium would likely be off set by the need for a liquidity discount and therefore we have not made any adjustment with respect to a control premium or a liquidity discount.

2.1.4 Precedent Transaction Multiples

In the precedent transaction multiples, valuation multiples are derived from open-market transactions of companies engaged in the same or similar line(s) of business as the subject company. This method is very similar to public company multiples, except that instead of looking at public companies trading on a stock market, the valuator develops valuation multiples by reviewing and analyzing companies that have recently been bought or sold in the marketplace. As a result, a precedent transaction analysis involves a review of recent transactions in similar companies to obtain evidence of valuations factors employed by investors in the open market.

Furthermore, an analysis of precedent transactions can provide broad value indications that, as mentioned earlier, can be used as either a primary valuation approach or to further support the value conclusions determined based on other approaches to value.

2.1.4.1 Key Advantages and Disadvantages The key advantage of this approach is that many comparable precedent transactions can involve smaller private companies and thus be relatively more comparable to the subject company. Since most comparable precedent transactions represent the purchase of the en-bloc interest in an acquired company, instead of a minority interest (as is the case with securities bought and sold on public stock exchanges), comparable precedent transactions can often be a better refl ection of the value of an entire business enterprise (i.e., a controlling interest). Moreover, enterprise value to sales multiples are most commonly used in analyzing open market transactions because, in the majority of cases, this is the only fi nancial information made publicly available by the parties to the transaction.

In this regard, the key disadvantage of the comparable precedent transactions is that relevant information is generally not publicly available, can be diffi cult to identify and obtain, and can often require a signifi cant amount of investigation to derive relatively small amounts of relevant data. Furthermore, information can vary depending on whether the companies to the transaction are public or private, possibly creating diffi culties in obtaining and applying the comparable company information to the subject company. That is, transaction information regarding public companies purchased by other public companies is fairly easy information to obtain, while transaction information regarding private companies purchased by public companies is somewhat more diffi cult to obtain, and transaction information regarding private companies purchased by other private companies is extremely diffi cult to obtain. The development of valuation multiples from transactions of signifi cant interests in comparable companies should be considered in the

79


valuation of businesses and securities, to the extent that suffi cient and relevant information is available.

Furthermore, in order to apply such an approach, suffi cient information about the transactions and the target company must be obtained to be able to reasonably interpret the transaction and properly apply the implied multiples to the fi nancial results of the subject company. Accordingly, all precedent transaction information must be thoroughly analyzed to ensure it is comparable to the subject company being valued, in instances where such information is available. Valuators must also be highly cognizant that such data, when available, may not apply to any given situation.

It must be noted that improvements in on-line databases and third-party research information services have made the application of the comparable precedent transactions increasingly effi cient and eff ective from a valuation perspective, where such information is publicly available.

2.1.4.2 Application of the Precedent Transaction Multiples In applying the precedent transaction multiples, a three-step process, similar to the approach used in the public company multiples, is typically used. However, the multiples for the precedent transaction multiples are calculated based on fi nancial information obtained (if available) from and implied by actual transactions involving controlling interests (i.e., open market takeovers, mergers, amalgamations, etc.), instead of publicly traded prices on open exchanges. Similar to the enterprise value and equity value approaches, the market value of the subject company is calculated using the implied multiples of the precedent transactions. As a result, these multiples are based on the price paid for a given comparable company relative to measures such as earnings, cash fl ows, revenues or equity.

When such information is available, this approach, if used appropriately in conjunction with the public company comparable multiples, can either increase the reasonability of a given valuation analysis (i.e., support capitalized cash fl ow based on a weighted-average cost of capital) or, as mentioned earlier, can be used as a primary and/or secondary valuation approach.

In an ideal situation, background transactional details can be obtained from fi rst-hand knowledge of fi nancial and other data specifi c to the transaction (perhaps the valuator had worked on a particular comparable company transaction and therefore had intrinsic knowledge of the underlying background specifi cs concerning, among other things, the parties to the transaction, the value of the consideration paid, and the other substantive terms of the deal. With respect to the value of the consideration paid, there may have been an analysis and quantifi cation of the post-acquisition synergies and/or strategic advantages perceived by the buyer when pricing the target).

In most cases, the valuator will not have benefi ted from hands-on experience (either as a valuator, analyst, advisor or negotiator) and would seek pricing, fi nancial and other data from comparable company information. Industry transactions often assist valuators in identifying special interest purchasers, and in some cases, quantifying synergies.

Important ConsiderationsWhile the calculation and use of valuation ratios (i.e., market multiples) based on precedent transactions are intended to provide meaningful insight as to the value of the subject company


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being reviewed, analyzed, and/or valued, consideration must be given to all relevant factors. Moreover, there must be suffi cient similarity and/or comparability of qualitative and quantitative investment characteristics between the precedent transactions and the subject company in order to have a reasonable and supportable analysis. At the same time, and assuming that a degree of comparability is present, certain adjustments may still be required to position the subject company’s relevant fi nancial data on a basis that is consistent with that of the comparable precedent transactions selected. Adjustment can be related to diff erent accounting policies (e.g., LIFO versus FIFO for inventory, straight line versus declining balance for depreciation, timing of revenue, capitalization versus expenditure for research and development, etc.), diff erent tax rates when comparing ratios based on earnings and/or equity, diff erent fi nancial structures, and/or diff ering levels of expected growth.

In instances where there is insuffi cient information as to the specifi cs of the selected precedent transactions and it is not possible to understand the given reasoning behind the price paid by the purchaser, the valuator should exercise caution and their professional judgment in using publicly available transactional data in valuing a business. In addition to the factors listed earlier in this module, following is a list of additional considerations that may be relevant in applying the precedent transaction multiples.

Considering the Structure of the Precedent Transaction• Review the available transaction data to determine if the information represents business

enterprise value or equity value, as this can impact the manner in which equity and enterprise value multiples are calculated, which can help to ensure that the calculations of value are based on the correct value assumptions.

• Determine if the transaction was an acquisition of shares or the underlying operating assets of the comparable company. This can impact, among other things, the determination of the consideration paid (i.e., the purchase price may not represent an “enterprise value” and may include certain considerations for tax benefi ts or could exclude the intangible value associated with the business if shares were not transferred, which could impact the manner in which the market multiples should be calculated and/or adjusted).

• Determine if the transaction was for 100% of the shares or for another ownership interest. Non-controlling interests are typically exchanged at a discount and may require an adjustment and/or premium for control (discussed earlier) to render the transaction comparable to the other companies selected and/or in comparison to the subject company.

• Review whether the transaction was on an arm’s length basis, included or excluded the compulsion to act, or involved negotiations under distress. This could have had an impact on the consideration paid and the risks and rewards implied by the transaction. Where such circumstances exist, the degree of comparability of multiples based on such data would be reduced to the extent that these factors do not represent transactions that other companies in the industry would engage in. Moreover, the existence of such factors could require that certain adjustments be made to allow for a reasonable comparison to the other companies selected and/or to the subject company. In addition, diff erences in negotiating ability, highly competitive bidding, vendor and/or specialized knowledge, and

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post acquisition synergies could distort the purchase price paid, which may need to be adjusted if it does not present market conditions. However, without direct knowledge of the transaction and related information, such adjustments will likely not be possible.

• Determine if the consideration paid included earn-out provisions, non-competition agreement(s), an employment contract above or below market value, and other non-cash and/or intangible components, which would not be obvious in the transaction price and may require certain adjustments in order to calculate the total consideration paid. To the extent that such consideration was paid and not included in the transaction data, the multiples would not refl ect the actual consideration paid without making the appropriate adjustments. However, without direct knowledge of the transaction and related information, such adjustments will likely not be possible.

• Determine whether the transaction was based on internal or external fi nancing, as this could impact the total purchase consideration calculation if it was only based on external consideration (i.e., the valuation has to ensure that the purchase price and other transactional data are complete, accurate and appropriately represent both the nature and intent of the transacting parties and market and/or industry conditions).

• Determine special purchaser considerations, post-acquisition synergies, or strategic advantages included in the purchase price, and the results of negotiation with material customers and/or suppliers, as these factors could have an impact on the purchase price paid. They could also provide insight into the reasoning behind the multiples paid and/or inherent in the industry and assist in understanding the valuation parameters employed by industry participants. In addition, they could help the valuator reconcile other valuation approaches being utilized.

• Consider the strategic reasoning (if any) for premiums paid. This could provide additional insight into the industry, the subject company, and the comparable companies selected.

Reviewing the Characteristics of the Comparable Companies• Consider the comparability of the industry in which the comparable companies operate

versus the subject company’s industry. This can have an impact on the multiples selected (e.g., if the comparable companies operate in the luxury hotel industry, they may have higher multiples than the subject company, which may be operating in the discount hotel industry) and could help the valuator reconcile other valuation approaches being utilized.

• Consider the extent and verifi ability of data known about the comparable companies, as this could provide the valuator with an understanding and/or comfort with the data being used.

• Review the amount of contingent assets and/or liabilities and their impact (if any) on the transaction data, as these amounts would not be obviously apparent and could have had an impact on the purchase price without being directly disclosed and explicitly included in the transaction data.

• Review the level of dependency on any given customer, supplier, employee, management, and/or a key person(s), as this could have had an impact on the transaction, which may


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need to be adjusted if the comparable companies and/or the subject do not have similar circumstances.

• Determine the nature, extent, and timing of new products to be launched by any of the comparable companies, as these could have an impact on the transaction data, future growth and multiples paid, and may require adjustment if the comparable companies and/or the subject do not have similar products and/or new launches.

• Review historical and projected research and development expenditures and the potential impact of the transaction data, as this could have a potential impact on the selection of multiples where there are diff erences between the subject company and the comparables.

• Determine the impact of unionization status (if any) on the transaction, so that where there are diff erences between the subject company and the comparables, the appropriate adjustments can be made to identify and obtain a better understanding of industry multiples. Multiples adjustments relating to unions could cause the multiple of the subject company being valued to either increase or decrease from industry multiples depending upon the situation.

Other Considerations• The timing of the data for developing the respective valuation ratios related to the selected

transactions, relative to the valuation date, as multiples change over time (i.e., multiples that are closer to the valuation date are more relevant than older multiples).

• Length of time the comparable company was exposed for sale in the marketplace, which could have impacted the transaction price (i.e., while it is debatable, in general some valuators believe, the longer the company has to expose itself to the market, the higher the price it should be able to obtain while others may feel that a longer time frame shows that there was diffi culty in fi nding a buyer interested in the business which would equate to a lower value).

• Consider whether the industry is “over heated” or if the precedent transactions occurred during a time when the industry was in a cyclical downturn. This could impact the selection of multiples, normalization adjustments and could provide valuable insight in selecting other comparable companies (i.e., the liquidity in a given industry could be enhanced at a given point in time, which could have a positive impact on the multiples buyers are willing to pay) and assessing the risk and rewards inherent in the industry. Consideration should also be given as to whether the earnings level (i.e., the denominator) is unusually high or low and inconsistent with today’s environment.

Sources for Identifying Comparable Precedent TransactionsThere are many information sources on which a valuator can rely to identify and locate comparable precedent transactions including, but not necessarily limited to, the following:

• Mergerstat Review — Published annually by Houlihan Lokey Howard & Zukin. It includes general statistical information as well as information on current year transactions.

• Merger and Acquisition Sourcebook — Published annually by Quality Services Company. It includes information on recent and pending transactions and on 3,000 major transactions.

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• Weekly Corporate Growth Report — Published weekly by Quality Services Company and includes current information, especially on transactions currently being negotiated.

• The Merger Yearbook — Published annually by Securities Data Publishing Inc. and includes information on smaller companies.

• Mergers and Acquisitions — Published bimonthly by Investment Dealers’ Digest• Capital IQ.

Since all companies are not publicly traded, the valuator will often have to look at other sources of information for private transactions. US databases are also available that track private company transactions including, but not necessarily limited to, the following:

• Pratt’s Stats, Bizcomps and MergerstatCPS www.bvmarketdata.com• Done Deals: www.donedeals.com

While the valuator can use U.S. data as a benchmark, adjustments may be required for geographical, economical and other diff erences between the two markets.

Additional sources of information include:

• Discussions with management.• Discussions with other valuation professionals.• On-line data providers, such as Bloomberg (www.bloomberg.com), Thomson Financial

Securities Data (www.thomson.com/solutions/fi nancial/), The Mergers and Acquisitions Advisor, (www.maadvisor.com), and CapitalIQ (www.capitaliq.com).

• Search engines such as EDGAR (www.edgar-online.com) and SEDAR (www.sedar.com), which provide information on publicly traded companies (as well as 10K Wizard (www.10kwizard.com).

• Internet and stock market studies; and• Brokerage fi rm studies (i.e., analysts will often prepare a detailed report to evaluate an

off er).


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Below is an example from a prior MQE (2007, Question #1)4.

MQE ANSWER 2.3: “MARKET BASED METHOD USING TRANSACTION MULTIPLES”

Market-Based Method using Transaction Multiples

In order to identify appropriate transactions of comparable businesses, we reviewed publicly available information of transactions and fi nancings involving companies engaged in owning and operating ethanol plants in North America during 2nd last year and last year and not anything in 3rd last year or previous. We selected this period because its transactions and fi nancings would refl ect recent ethanol industry specifi c factors such as market dynamics, growth prospects and risks. The transactions and fi nancings considered in our analysis, along with the acquired business’ implied valuation, fi nancial information and implied valuation multiples information as presented.

EIC is a private company headquartered in London, Ontario. Sam Hunt and Larry Jordan founded EIC to distribute ethanol imported from the US. EIC’s customers in the initial years were various manufacturing companies in Ontario. After a few years of modest growth, EIC secured a number of contracts to supply fuel ethanol to several gasoline refi ners in Ontario. As the demand from the gasoline refi ners grew over the years, EIC built an ethanol production facility in Delhi, Ontario. Last year approximately 60% of ethanol sold by EIC was produced at the Delhi plant while remaining 40% was imported from the US.

Given the diff erences in timing, market dynamics, growth prospects and risks inherent in the comparable transactions, we determined transaction multiples approach was generally consistent with the guideline company approach but was unreliable, as explained below.

1. There were only three publicly disclosed transactions of ethanol companies in calendar 2nd last year and last year.

2. Atlantic is a company engaged in production, import and sale of fuel-grade ethanol in Canada. Its current trading multiple with respect to EBITDA (7.9x) is approximately equal to the EBITDA multiple (7.7x) at which its initial public off ering (“IPO”) was completed in May last year, implying the relative valuation of Atlantic has not changed signifi cantly since the IPO. Although Atlantic is larger than EIC in terms of production capacity and sales and had a slightly higher profi t margin in last year and is forecasted to have a slightly higher profi t margin in next year it could be considered to be a suitable comparable.

3. Eagleye is a company engaged in production and marketing of ethanol in the US. Its transaction multiple with respect to EBITDA (8.0x) in January last year is approximately equal to the EBITDA multiple (7.9x) at which Atlantic’s IPO was completed in May last year. Eagleye is similar in size to EIC. Nevertheless we believe Eagleye is not directly comparable to EIC for the purpose of deriving valuation multiples as it a US based company (i.e. foreign exchange exposure, sovereign risks, etc.).

4 Please note that only a portion of the answer is shown and not the question itself. The question includes signifi cant detail involving other valuation concepts and issues unrelated to somewhat comparable companies and is not included in herein for simplicity.

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4. Stratos is a development stage, renewable energy company that engages in the production and sale of ethanol in the US. Therefore we believe it is not directly comparable to EIC for the purpose of deriving valuation multiples.

As there were only three transactions of ethanol companies in the past two years and two of these transactions were considered not comparable to EIC for the purpose of deriving valuation multiples, we have not applied the transaction multiples based method to derive an enterprise value estimate for EIC. However, we have considered that the implied multiples for Atlantic and Eagleye are generally consistent and supportive of the enterprise value of EIC otherwise determined.

MQE ANSWER 2.4: “MERGER/ACQUISITION”5

The Creditvalley Group (Merger/Acquisition) and Trojan Investments (Merger/Acquisition): These transactions are both US transactions from the 2nd last year. Given the transactions occurred before the meltdown and volatility in the equity markets, they may not be refl ective of current Canadian transaction multiples. In addition, the transaction prices may have been motivated by purchaser synergies, which have not been disclosed. Also, both companies acquired were signifi cantly larger than our company being valued. As a result, the implied transaction multiples may not be meaningful.

Schlieff er Advisors (Merger/Acquisition): This is a Canadian transaction from last year and, as such, is more comparable and relevant than that of the two US transactions above. The transaction multiples are higher than the implied EV/AUM and EV/fee revenue multiples of the company being valued. This may be due to the fact that the purchaser involved may have stood to realize synergies from the acquisition and therefore was willing to pay a premium price. In addition, the acquisition closed last year, shortly after the recession in Canada had begun. Therefore the implied transaction price and multiples may not have been impact by ongoing economic events as of yet.

Based on our analysis above, in our view the enterprise value calculated for the company being valued and the implied EV to AUM and EV to fee revenue multiples are reasonable as compared to the multiples for private company transactions occurring in the last three years. The transactional data represents the acquisition of control and therefore no control premium needs to be added.

5 This is another example from a previous MQE Question. You have only been provided a portion of the answer and not the question itself. The question involves signifi cant detail involving other valuation concepts and issues unrelated to somewhat comparable companies and is not included in herein for simplicity.


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2.2 Analyzing Financial Statements Analyzing a company’s balance sheet provides information concerning the amount of security available to creditors as well as the company’s liquidity and fi nancial fl exibility. It also forms the basis used to calculate various fi nancial ratios that can provide insights concerning the risk profi le of a business and its ability to embark on new ventures, as well as assessing the comparability of one company to another.

The income statement is useful for evaluating a company’s overall profi tability levels and growth levels (or lack thereof) and predicting future earnings. Information from the income statement is also used to calculate fi nancial ratios.

The statement of cash fl ows provides information as regards to a company’s operating, investing and fi nancing cash fl ows. Knowledge of the cash available to service debt, pay dividends and fund future growth is extremely important to investors because this is the primary source of cash. If a company’s operating activities are not able to generate a positive cash fl ow, the business will eventually fail.

2.2.1 Financial Ratios

Calculating and reviewing fi nancial ratios enable a valuator to isolate strengths and weaknesses, which may be inherent in a company’s capital structure. More often than not, ratio analysis will identify issues, which may not otherwise be evident.

An accurate interpretation of the results will hinge on the quality of information upon which the ratios have been calculated. It is important to understand all of the infl uences, which may skew the resulting ratios such as:

• Changes in accounting policies can render comparison between years meaningless.• Diff erences in accounting policies can also render comparison between competitors

meaningless. • Non-recurring revenues and/or expenses may distort the results of a particular year.

Consolidated fi nancial statements are generally too brief to perform meaningful ratio analysis. A meaningful analysis may only result by calculating ratios for each distinct operating entity/division.

Determining which ratios are applicable will depend on the industry, the specifi cs of the organization and the objective of the analysis. To assess whether or not a capital structure is distressed, the valuator should analyze, at a minimum, the liquidity and leverage ratios.

Liquidity Ratios

The diff erence between a business’ current assets and its current liabilities is referred to as liquidity. If the liquidity of a business diminishes, it will not be able to continue normal operations.

An acceptable level of working capital and liquidity must be established, which must consider a company’s historical liquidity levels and industry conditions. Also, a company’s projected growth

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should be accounted for when assessing the level of liquidity; a company that anticipates a high level of growth will require a higher level of liquidity than it had maintained in the past. Liquidity can be measured by calculating an organization’s current, quick or acid test and cash fl ow to current liabilities ratio.

Current Ratio = Current Assets/Current Liabilities

The current ratio measures the relationship between current assets and current liabilities. A strong current ratio is an indicator of a strong fi nancial position. One must, however, not depend on this ratio exclusively; it would be prudent to review the quality of the assets (accounts receivable for collectability and inventory for obsolescence) and the completeness of the liabilities when interpreting this ratio.

An overly high current ratio may be an indication that the Company is not making good use of cash or liquid assets, or may be carrying too much inventory. This may impact your risk evaluation of the subject company, and may indicate that there are redundant assets or liabilities present.

Quick Ratio = Cash + Accounts Receivable/Current Liabilities

The quick ratio measures a company’s ability to meet its obligations in the immediate term and is a more stringent ratio than the current ratio.

Cash Flow to Current Liabilities = After-Tax Cash Flow From Operations /Current Liabilities

This ratio measures an organization’s capacity to weather interim fl uctuations in operating cash fl ows. Like the quick and current ratios, it also indicates a company’s ability to satisfy its obligations as they come due. Cash fl ow from operations is determined by adding all non-cash items, such as depreciation, amortization and write-off s to net income. This ratio is most relevant in analyzing those companies whose net income may be minimal or even negative but whose cash fl ow generated from operations is strong. For example, capital intensive cable company that has large amounts of depreciation but could be cash fl ow positive on operations.

Leverage Ratios

Leverage ratios measure a company’s ability to meets its long-term obligations and to provide security to creditors. Simply put, these ratios provide an indication of the extent to which a company is fi nanced by debt. As leverage increases so does the risk of failure.

Leverage ratios include debt to equity, total debt ratio, times interest earned, and cash fl ow from operations divided by total debt.

Debt-to-equity Ratio = Interest-bearing Debt/Equity

This ratio indicates the proportion of assets contributed by the shareholders in relation to those contributed by creditors. A low ratio indicates that a company is not highly leveraged and vice-versa. A company that is experiencing a high debt-to-equity ratio has less ability to raise additional fi nancing and is, therefore, less likely to be able to withstand a downturn in its business.


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Total Debt Ratio = Tangible Assets/Total Debt

This ratio measures a company’s ability to protect its creditors’ investments; that is, the level of security available to creditors. A low ratio may be an indication of excessive leverage and possibly fi nancial weakness.

Times Interest Earned = EBITDA/Interest Expense

This ratio provides creditors with an indication of a company’s ability to meet its debt obligations. A high ratio is indicative of a strong fi nancial position and implies that a decline in operating profi ts can be experienced before a company’s creditors are put at risk. This ratio is most important in an economy where interest rates are rising.

Cash Flow from Operations/Total Debt = After-Tax Cash Flow from Operations/Total Debt

This ratio also measures a company’s ability to meet its debt obligations and leverage itself. Cash fl ows are often a better indicator of a company’s viability (because of the existence of non-cash charges in a company’s income statement) and, as a result, this ratio is important to creditors and investors.

The Exhibit below highlights the optimal level for the above-noted ratios in one industry sector.

EXHIBIT 2.6: OPTIMAL LEVEL FOR RATIOSRatio Industrial Company Utility CompanyLiquidity

Current 2:01 N/AQuick 1:01 N/ACash fl ow to current liabilities N/A N/A

Solvency

Debt to equity 5:01 1.5:1Total tangible assets to debt 2:01 1.5:1Times interest earned 3 times 2 timesCash fl ow from operations Cash fl ow equal to 30% of total

debt outstanding Cash fl ow equal to 20% of

total debt outstanding

Note: When analyzing fi nancial ratios, the valuator should compare the results of each ratio to a company’s competitors as well as industry benchmarks. For example, a company whose leverage ratios are higher than industry standards is likely in a weak fi nancial condition.

2.2.2 Forecasts and Budgets

A company’s forecasts and budgets are useful for assessing its future viability. The valuator should ensure that the forecast or budget includes a monthly cash fl ow analysis for at least 12 months. This will help to identify any short-term liquidity crisis that may be on the horizon. Forecasts and budgets are equally important for viable businesses to ensure an appropriate ROE is being earned.

When assessing the plausibility of a forecast, the valuator must consider the following items:

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• Who is responsible for preparing the forecast? Is/are the individual(s) knowledgeable in all aspects of the business?

• What are the assumptions underlying the forecast? Are they reasonable in light of historical results and current economic conditions?

• Are growth rates reasonable when compared to past performance? • Are projected revenues supported by purchase orders? • Has the company prepared forecasts in the past? If so, how accurate have they been? • Can sensitivity analysis be performed on the projections? If so, what are the eff ects of

manipulating key business drivers?

2.2.3 Trend Analysis

Financial statement analysis, forecasting, and the calculation of ratios should be done over a number of years. In practice, most Valuators will begin by analyzing 5 years of historic information. Performing ratio and fi nancial statement analysis over successive fi nancial statement periods will not only provide insight into the evolution of a business but will also provide a gauge to assess an entity’s future prospects (or lack thereof). For example, if a company’s leverage ratios have been consistently increasing over the past three years, this may indicate a weakening fi nancial position.

Evaluating the change and the rate of change in specifi c ratios or items on a fi nancial statement over two or more successive periods is commonly referred to as a “horizontal analysis.” A “vertical analysis” relates an item on a fi nancial statement to another item within the same statement such as expenses as a percentage of sales and net income as a percentage of sales. Horizontal analysis is commonly used in conjunction with a vertical analysis. Where trends and changes in trends occur, these relationships should be assessed both together and in isolation to assess their impact on the company under consideration.

There are, however, limitations to trend analysis. Distortions in the results of trend analysis may result from:

• Comparing ratios in a highly infl ationary environment. In these circumstances, fi nancial statements should be adjusted to common dollars by using a price index, such as the Consumer price index or gross national expenditure implicit price index.

• Changes in accounting policies, such as depreciation rates and the methodology used to value inventory. In cases where a company has changed accounting policies, all prior period fi nancial statements under review should be restated to refl ect consistent policies. An alternative may be to perform trend analysis on a cash fl ow basis; this would eliminate most of the eff ects of changes in accounting policies.

• Changes in tax rates. Where possible, trend analysis should be performed on a pre-tax basis. If this is not possible, all periods under review should be restated to refl ect a consistent tax rate or at least the impact of changes in tax rates should be considered on some basis if the change is signifi cant.


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• The existence of unusual or extraordinary revenues and/or expenses. The valuator should ensure that he/she is aware of all unusual items. These items should be eliminated from the fi nancial statements. In eff ect, the statements under review should be normalized.

• Some businesses, by their nature, are more complex and volatile. It will require a Valuator to spend an appropriate amount of time obtaining an understanding of the business and its variables, and the drivers.

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2.3 The Asset-Based Valuation Approach —An OverviewAsset-based techniques calculate value based solely on the value of the net assets of the business without consideration of its future earnings capacity. Asset-based techniques include:

• Liquidation value.• Adjusted net book value.• Tangible asset backing.

The asset-based approach can be used for valuing both businesses which are going concerns and those which are not. However, the approach is used diff erently depending on whether or not the business is a going concern.

When the Business is Not a Going Concern When the valuator believes that a business is not viable as a going concern, it is valued on a liquidation (or net realizable) basis.

In this approach, the business’ assets are assumed to be sold for cash, and the proceeds of asset liquidation, net of the liabilities of the business, are assumed to be distributed to the owners.

When the Business is a Going ConcernWhen the valuator determines a business is a going concern, the liquidation value (or net realizable value) approach can be used to assess risk. However, the liquidation approach will not be applied as a primary approach if the business is a going concern.

EXHIBIT 2.7: IS THE BUSINESS A GOING CONCERN?No Asset-based approach is the principal valuation methodYes Asset-based approach is used for risk assessment, or is used as the main approach in

situations where the business is an investment-holding business that would require an asset-based approach

Even where the business is clearly a going concern, the valuator should always invest a minimum amount of time on the asset-based approach. The calculation of a business’ net tangible asset backing is a key aspect of assessing a business’ risk and contributes to the selection of the required return. Furthermore, in practice, pricing considerations for small and medium-sized businesses are often measured as an amount over the value of the net assets.

2.3.1 Liquidation Value

The liquidation approach is appropriate where:

• The operations of the business are not viable as a going concern.• Liquidation value is higher than going-concern value, even if the business is viable.


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The liquidation approach to value quantifi es the net proceeds available to shareholders in the event of a liquidation of a business after the business’ assets are sold and the costs of liquidation are deducted. The costs of liquidation include:

• Commissions on disposal.• Income taxes.• Legal and accounting fees.• Shutdown costs.• Severance pay.

Liquidation value may be determined on the basis of one of two underlying assumptions:

• An orderly liquidation — where a reasonable period of time is used to maximize proceeds received for specifi c assets.OR

• An immediate or forced liquidation — where an immediate cessation of business and disposition of assets is assumed.

The decision as to whether the liquidation will be immediate, or extended over a period of time, depends to a great extent on the nature of the underlying assets and the specifi c circumstances of the business.

2.3.1.1 Orderly Liquidation Value ApproachWhen using an orderly liquidation value approach, the valuator must take into account the “time value of money” over the period of liquidation. For example, if the income taxes that will be incurred on the disposition of assets are $1,000, but such taxes will not be incurred for six more months, the present value of such taxes will be less than $1,000.

The valuator must also take into account the risks associated with the liquidation. For example, if the business is a manufacturer with a signifi cant inventory of work in progress or component parts, the valuator must determine whether the inventory would fetch a higher price if it were completed and sold as fi nished goods or if the items should simply be sold in their existing stage of completion. If the goods are to be completed, the valuator must also evaluate the overhead costs of operating the plant over the completion period.

Under most circumstances, an orderly liquidation will be the appropriate approach in order to meet the highest price requirement of the fair market value concept. However, in certain circumstances, a forced liquidation will result in higher net proceeds (e.g., if the market is expected to have an adverse impact on the price of the assets over time). In this case, fair market value should be determined assuming an immediate liquidation.

2.3.1.2 Forced Liquidation Where a business is not viable as a going concern, a forced liquidation is normally employed since there is no option of winding down the business over time. It is likely that under this scenario, assets would be sold at a discount.

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2.3.1.3 Calculating Liquidation ValueThe liquidation approach to value quantifi es the net proceeds available to business owners (after providing for income taxes and disposition costs) on the liquidation of all assets and liabilities of the business.

EXHIBIT 2.8: STEPS FOR CALCULATING LIQUIDATION VALUE Realizable value of the assets– Direct costs associated with the disposition of the assets (such as real estate fees or legal

fees)– Debt, at its net realizable value± Net-of-tax operating profi ts/losses during the liquidation period– Liquidation costs (such as payroll severance costs)± Corporate income taxes on the sale of assets= Funds available for distribution to shareholders– Corporate Tax costs on distribution (which are generally discounted)= Liquidation value of assets/net realizable value

To determine the liquidation value, the valuator must evaluate each individual asset and liability of the business in terms of its likely net realizable value. Generally, the fundamental assumption is that the business assets are sold as individual items, rather than as a group of operating assets being used for a specifi c purpose. However, some groups of assets might be worth most when sold as a group.

As the business may own real estate and/or machinery and equipment, the valuator will likely require the services of specialist real estate and/or equipment appraisers for determining the value of these fi xed assets. They must be valued on the basis of their value-in-exchange (i.e., what they would sell for on the open market if disengaged from the existing business operations).

The value must also take into consideration all liquidation costs such as commissions, legal and accounting fees, severance pay to employees, tax costs on the disposition of the various assets, etc.

After the valuator estimates the net realizable value of the assets and liabilities of the business and deducts the applicable liquidation costs, the resultant amount represents the amount of cash that would be left in the corporation prior to the wind-up, that is, the funds available for distribution to the shareholders.

Tax costs on distribution are usually assumed to occur at the maximum marginal personal tax rate for purposes of determining net proceeds to shareholders, after giving consideration to the Capital Dividend Account and/or any other available tax-free surplus. A purchaser has the option of retaining the disposal proceeds in the corporation for some period of time rather than distributing them and attracting immediate tax. It is important to determine the timing for the fi nal wind-up of the business, as the net proceeds on winding up is a relevant measure of value for a


94

purchaser. The valuator should consider the appropriateness of discounting the tax costs for time value of money.

The following example illustrates the application of the liquidation approach.

EXAMPLE 2.2: LIQUIDATION APPROACH — MBC INVESTMENT HOLDING COMPANY

MBC is an investment holding company. The shareholder intends to liquidate his investment in the company on an immediate basis and requires a determination of the fair market value of his ownership interest. MBC is an investment holding company. The shareholder intends to liquidate his investment in the company on an immediate basis and requires a determination of the fair market value of his ownership interest. Wind-up costs would total approximately $5,000.

One of MBC’s investments is in Quickcraft, a manufacturer of recreational speedboats located in Edmonton. The Quickcraft brand name is well known among boaters, although recent competition has caused the company to lose market share and cut sales prices to boat dealerships. The speedboat industry has always been extremely competitive, although the industry has been particularly fi erce in the last few years in the face of declining consumer demand.

Quickcraft is currently in breach of certain covenants contained in its credit agreements with its bank and long-term debt holders. These parties are not willing to extend further fi nancing to the company. Management has been in discussions with other lenders in an attempt to raise fi nancing, although discussions are at a very preliminary stage.

As shown in the chart below, Quickcraft’s business has been relatively stagnant in recent years due to competition. The company has cut prices in an attempt to maintain sales levels.

EXAMPLE 2.2AQuickcraftSummary of Operations (C$000s)For the fi scal years ended December 31 and six months ended June 30 of this year

4th Last Year

3rd Last Year

2nd Last Year Last Year

This Year (6 months)

Revenue 50,000 51,000 49,000 47,000 24,000Gross margin 20,000 18,870 16,170 15,040 7,680Operating costs 14,000 14,200 15,600 14,700 7,150EBIT-DA 6,000 4,670 570 340 530Depreciation 2,200 2,400 2,300 1,700 800Interest expense 500 2,700 2,870 2,920 1,650Earnings (loss) before tax 3,300 (430) (4,600) (4,280) (1,920)

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EXAMPLE 2.2B

QuickcraftBalance Sheet (C$000s)As at June 30 of this yearAssets Cash 950 Accounts receivable 10,500 Inventory 24,000 Prepaids and other assets1 11,850 Fixed assets2 15,300 Total assets 62,600 Liabilities and Shareholders’ Defi cit Bank operating line 10,000 Accounts payable 30,400 Long term debt 33,000 Shareholders’ defi cit (10,800)Total liabilities and shareholders’ defi cit 62,600

Notes:

1. Other assets include $8,100 (NBV) of goodwill related to the purchase of the technology related to a state-of-the-art boat motor that Quickcraft eventually manufactured. This is the only asset in the CEC account, which had a balance of $6,600 at June 30 of this year.

2. The fair market values of the fi xed assets are approximated by their net book values. Additional information found below:

Undepreciated Capital Cost

(UCC) Cost Net Book ValueManufacturing equipment 2,900 6,700 2,300 Land 4,200 4,200Building 4,700 11,400 8,800 Total 7,600 22,300 15,300

3. MBC has not guaranteed the debt of Quickcraft

Required:It is September 1 of this year. Provide your analysis of the fair market value of Quickcraft to be used in your assessment of the fair market value of MBC.

Before reading the suggested solution that follows, complete the answer to this sample question and then compare your responses.


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Solution:Liquidation ValueIn estimating the fair market value of Quickcraft, a liquidation approach is considered appropriate as:

• Quickcraft has generated historical losses;• There is recent intense competition in the industry and overall consumer demand is

decreasing, putting downward pressure on margins, which may further increase losses in the future.

• The year-to-date results indicate losses; and• There is a breach of the bank covenants, coupled with the fact the bankers appear unwilling

to provide further fi nancing, and it is unclear whether the company will continue as a going concern.

As such, Quickcraft is not expected to generate a positive return on investment in the future.

An orderly liquidation is assumed in these circumstances, since the shareholder intends to liquidate its investment and would do so on an orderly basis in order to maximize the net proceeds. There is no indication that the company will be forced into liquidation by the bank.

Note: For full marks, students should state whether an orderly or forced liquidation has been assumed and why.

QuickcraftEstimated FMV (CDN $000s)As at August 31 of this year Book Value

at June 30FMV at

August 31Notes

Cash 950 950 1

Accounts receivable 10,500 10,500 1

Inventory 24,000 24,000 1

Prepaids and other 11,850 3,750 2

Fixed assets 15,300 15,300 3

Total assets 62,600 54,500

Bank operating line 10,000 10,000

Accounts payable 30,400 30,400

Long-term debt 33,000 33,000

Total liabilities 73,400 73,400

Net proceeds before items below (18,900)

Less: Wind-up costs incurred (5,000)Add: after-tax earnings (loss) during stub period (640) 4

Liquidation value/estimated fair market value Nil 5

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Notes:

1. Assume fair market value approximated by book value. Note that in a forced liquidation, accounts receivable and inventories are often worth less than book value.

2. Assumes goodwill has nil fair market value given the speed at which new technology comes to market.

3. Income tax consequences on disposition of fi xed assets:

Recaptured depreciation: Manufacturing Equipment

Building ECE Total

Lower of cost and proceeds 2,300 8,800 — Less: UCC (2,900) (4,700) (6,600) Recapture/(terminal loss) (600) 4,100 (6,600) (3,100) Income tax Nil (6)

Note: while the calculation above does not include calculations for capital gains or losses, students are reminded to always consider whether capital gains and losses will result in income tax implications.

4. Based on a two-month proration of the results of Quickcraft up to June 30 of this year to account for the period from July 1 to August 31 of this year.

5. In general, the value cannot be less than $Nil. In this case, MBC has not guaranteed the debt of Quickcraft. However, if MBC had guaranteed the debt, a negative value may be attributable to Quickcraft, equal to the expected shortfall in the debt relative to its assets.

6. Due to losses for the past several years and the fact that UCC is lower than NBV (meaning that CCA has been higher than accounting depreciation and therefore taxable income has been lower than accounting income), it is assumed that the losses can’t be carried back.

2.3.1.4 Going-Concern Business — Risk MeasurementWhere a business is a going concern, the valuator may use the liquidation approach as a risk measurement to approximate what a purchaser might expect to realize in the event the business had to be wound up shortly after acquisition. In this context, liquidation value measures the purchaser’s downside risk or fl oor value as at the date of acquisition and is referred to as modifi ed tangible asset backing.

2.3.1.5 Liquidation Value of Value to OwnersWhen adopting the liquidation approach, it is important to determine whether a share value or an asset value is being calculated. In the context of a non-going concern business, the liquidation value generally represents an asset value, i.e. the net amount available to the equity owners, if any, on the liquidation of the assets and liabilities of the business.

If a valuation of shares is required (an uncommon situation), and two additional steps would be required (points 1 and 2 below are illustrated in the Exhibit above):

The net liquidation value of the assets of the business must be estimated, that is, the net cash proceeds that would remain in the corporation after payment of all corporate liabilities including corporate level income taxes and costs of the liquidation.


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1. The result must be reduced by the related tax and other costs of distributing the net after tax liquidation proceeds. The net result is referred to as the liquidation amount.

2. However, assuming the liquidation amount is positive after above, it will likely diff er from the liquidation value of that company’s shares. Assuming the shareholder will incur capital gains tax on a sale of shares (if the capital gains exemption does not apply in full or is not available), the shareholder would not sell for the liquidation amount of the assets but rather would carry out the liquidation personally since a higher amount would be realized. As a result, the share value of a company valued on a liquidation basis must be determined based on the liquidation value of the assets, grossed up by an amount suffi cient to net the shareholder, after income tax, the same amount as would be received upon a disposition of the assets.

If a purchaser paid this grossed-up minimum share value and immediately liquidated the company, he/she would receive the net proceeds (the liquidation amount calculated in steps 1 and 2) and would sustain a capital loss.

Generally, the vendor and purchaser would reach a compromise value between the liquidation amount and the minimum share value.

Note: Also review the detailed example of the liquidation approach in Chapter 3 of Business Valuation (page 97).

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EXAMPLE 2.3 LIQUIDATION VALUE — PLASTIC MOULDERS LTD.

Plastic Moulders Ltd. (the “Company”) manufactures various plastic components for a variety of industries. The Company has had signifi cant operating losses for the past fi ve years due to decreased demand for its products, and the Company’s owner, Colette Smith, has decided to retire permanently in France.

Required:As a result of her permanent relocation to France, Colette requires a valuation of the Company’s shares for personal income-tax purposes.

Example 2.3A shows the Company’s balance sheet at October 31 of this year.

EXAMPLE 2.3APlastic Moulders Ltd.Balance SheetAs at October 31 of this yearAssets Investments1 25,000 Accounts receivable2 145,000 Inventory3 250,000 Prepaids and other 20,000 Capital assets4 600,000 Total assets 1,040,000

Liabilities and Shareholders’ Equity

Bank indebtedness 213,000 Accounts payable 230,000 Future income taxes5 20,000 Shareholder loan 275,000 Share capital 2,000 Retained earnings 300,000 Total liabilities and shareholders’ equity 1,040,000

Important information:

1. The Company’s investments are mutual funds, with a market value of $50,000.

2. Colette believes that she would only be able to collect approximately 80% of the accounts receivable.

3. Colette believes that the inventory could be sold for at least its book value.

4. Information with respect to the Company’s capital assets is shown as follows:


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Original Cost

Accumulated Amortization

Net Book Value UCC

CCA Rate

Market Value

Manufacturing equipment 1,500,000 960,000 540,000 500,000 30% 650,000Computer equipment 125,000 90,000 35,000 35,000 30% 15,000Offi ce equipment 90,000 65,000 25,000 40,000 20% 100,000Total 1,715,000 1,115,000 600,000 575,000 765,000

5. Future income taxes relate entirely to timing diff erences with respect to the recognition of capital cost allowance vs. amortization.

6. During the wind-up process, Colette expects to incur $10,000 in professional fees to dissolve the company.

7. The Company’s income tax rate is 20% for business income and 50% for taxable capital gains. Colette’s personal rate of tax on dividend income is 30%.

Note: The 30% personal tax on the dividends that are distributed to the shareholder is an eff ective rate. A more detailed calculation would show the gross up, tax, and tax credit calculation. This is merely an approximation if the shareholder is in the high tax bracket.

Solution:When estimating the fair market value of the Company, a liquidation approach is considered appropriate as:

• The Company has generated signifi cant operating losses for the past fi ve years due to decreased demand for its products.

• The owner has decided to halt operations.

As such, the Company is not expected to generate a positive return on investment in the future. An orderly liquidation is assumed in these circumstances, since the owner intends to liquidate her Investment prior to her retirement and would do so on an orderly basis in order to maximize the net proceed

Note: For full marks on any examination question, students should state whether an orderly or forced liquidation has been assumed and why.

Net

Realizable Value

Business Income (Loss)1

Taxable Capital

Gain

Capital Dividend Account RDTOH2

Investments 50,000 — 12,500 12,500 3,333Accounts receivable 116,000 (29,000) — Inventory 250,000 — — Prepaids and other 20,000 — — Capital assets 765,000 180,000 5,000 5,000 1,333Total net proceeds 1,201,000 151,000 17,500 17,500 4,667Bank indebtedness (213,000) Accounts payable (230,000) Future income taxes — Shareholder loan (275,000) Adjusted shareholder equity 483,000

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Notes:

1. Business loss from writedown of A/R ($145,000 x 20%)Recapture on manufacturing equipment ($500,000-$650,000)Terminal loss on computer equipment ($35,000-$15,000)Recapture on offi ce equipment ($40,000-$90,000)Capital gain on offi ce equipment ($100,000 – 90,000)

2. 26.67% of the taxable capital gains.

Adjusted shareholder equity $483,000Liquidation costs (10,000)Net proceeds before taxes 473,000Corporate income taxesBusiness income ($151,000 x 20%) 30,200Taxable capital gains ($17,500 x 50%) 8,750Liquidation costs ($10,000 x 20%) (2,000)Refundable dividend tax on hand (“RDTOH”)* (4,667)Net corporate taxes (32,283)Proceeds available for distribution 440,717Less personal taxes (see below) (139,507)Net proceeds after tax — rounded 301,000

Deemed dividend 440,717Less paid up capital (2,000)Deemed dividend on wind-up 438,717Less capital dividend account (17,500)Deemed taxable dividend 421,217Dividend Gross Up (38%) 160,062Taxable Dividend 581,279Personal Tax (49%) 284,827Less: Dividend tax credit (25%) (145,320)Personal Tax 139,507

Notes:

* RDTOH is a refund on taxes triggered upon the payment of a dividend from a company. Taxable capital gains create amounts to an RDTOH account at a rate of 26.67%. The refund is paid out at a rate of $1 for every $3 declared Students should perform a “check calculation” to determine if there is suffi cient Net Proceeds available to pay out to receive the full balance of RDTOH Account.

2.3.2 Adjusted Net Book Value

Where there is no expectation of any type of non-identifi able intangible value (i.e., there is no commercial goodwill), going-concern value can be determined through the use of an asset-based technique referred to as adjusted net book value.

The adjusted net book value technique involves adjusting the business’ tangible assets and liabilities to their current fair market values with the resultant net equity representing the going-concern value of the business.

The going-concern value approach to asset valuation diff ers from liquidation value approaches in that it contemplates asset values within a business continuing as a going concern (i.e.,


102

value-in-use), and there are adjustments for diff erences in tax shield resulting from diff ering tax and current market values.

An adjusted book value approach is appropriate in the valuation of:

• An investment or real estate holding company (since value is closely related to the company’s underlying assets as opposed to its earnings capacity).

• An operating business that does not generate suffi cient earnings to realize a reasonable return on the net tangible assets, but value as a going concern is still higher than liquidation value. For instance, if a business has annual earnings of $100,000 and a multiplier of 5 is appropriate, the capitalized value of that business is $500,000. If that business has net tangible assets of $550,000, the business is not earning suffi cient earnings to realize a reasonable return on the net tangible assets.

• An operating business where all of the income is attributable to personal goodwill. That is, the goodwill is not transferable to a purchaser, as in the case of a medical doctor’s professional corporation whereby clients identify with their actual doctor as opposed to the business itself as doctors usually have a relationship with the client on a personal level. As such, if the doctor were to leave the practice, the clients would move to a new doctor.

2.3.2.1 Calculating Adjusted Net Book ValueThe Exhibit below presents a summary of the adjusted net book value method:

EXHIBIT 2.10 — THE ADJUSTED NET BOOK VALUE METHOD

Shareholders’ equity per the fi nancial statements± Adjustment of assets and liabilities to market value± After-tax income (loss) for stub period (between balance sheet date and valuation date)± Present value of the tax shield not available to a purchaser of shares, if applicable± Future income taxes (deferred income taxes), if applicable (liabilities are added and assets

are deducted)= Adjusted net book value

2.3.2.2 Adjustment of Assets and LiabilitiesAll of the assets and liabilities recorded on the balance sheet are restated to refl ect value-in-use. For example:

• The net book value of real property is adjusted to refl ect its fair market value• The net book value of equipment is adjusted to refl ect its depreciated replacement cost

values or fair market value in continued use values.• Inventory book value is adjusted to refl ect its replacement value. • Accounts receivable book value is adjusted to its market value. Accounts receivable must

be reviewed for collectability in the event audited statements are quite stale-dated, or in periods of rapidly changing (deteriorating) economic conditions.

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• Mortgages and notes receivable book values are adjusted to their market value. These assets or liabilities must be reviewed for collectability and as to interest rates vis-à-vis prevailing market rates. If the interest rate of a mortgage receivable is 7%, and the prevailing interest rate is lower (say, 2%), the market value of the mortgage receivable may be greater than the book value. However, if the prevailing interest rate is higher (say, 13%), the market value of the mortgage receivable may be less than the book value.

• Where a business accounts for intangible assets resulting from goodwill or deferred charges, intangible assets are assigned a value of nil.

• Liabilities are usually taken at face value, except in situations where existing debt has interest rates that diff er materially from current rates. If the interest rate of the debt is 7%, and the prevailing interest rate is lower, the market value of the mortgage payable may be greater than the book value. However, if the prevailing interest rate is higher, the market value of the mortgage receivable may be lower than the book value.

2.3.2.3 Adjustment for Lost Tax ShieldReal estate and equipment appraisers value assets on a “free and clear” basis, without considering the overlying shares of the corporation. Accordingly, they implicitly assume that the purchaser of the depreciable asset will be able to claim capital cost allowance (CCA) from a cost base position equivalent to the appraised value. The tax shield is the present value of the anticipated future tax savings that will accrue in the future as a result of claiming capital cost allowances by the owner of the particular capital (depreciable) asset.

When a purchaser acquires a business through a share purchase, the purchaser also inherits the company’s existing bases of tax costs. The existing tax cost base of an asset is most often less than its appraised value. When valuing on a going-concern basis, the business valuator must take into account the quantum of tax shield not available to a purchaser of shares (as compared to a purchaser of the asset directly), because the existing tax cost base of assets is usually less than the assets’ appraised values. As a result, the appraised market value provided by the real estate valuator is generally not applicable to a share valuation without adjustment.

The Exhibit 2.11 illustrates the formula for calculating the tax shield where full capital cost allowance is available in the year (there have been no assets acquired in the current year, and therefore no ½ year rule to apply to current year acquisitions).

EXHIBIT 2.11 — CALCULATING TAX SHIELD — FULL CCA AVAILABLE IN YEAR:

(Investment cost (UCC) X income tax rate X CCA rate)(Rate of return + CCA rate)

Exhibit 2.12 provides the formula where capital cost allowance is restricted to 50% in the year of acquisition. This formula will also be used in conjunction with tax shield on sustaining capital reinvestment which forms part of cash fl ow approaches to valuation.


104

(i.e., the half-year rule).

EXHIBIT 2.12 — CALCULATING TAX SHIELD — CCA HALF-YEAR RULE APPLIES:

Above tax shield formula X (1 + 0.5 X rate of return)(1 + rate of return)

EXAMPLE 2.4: TAX SHIELD CALCULATIONS

To the right are tax shield calculations based on the following facts:

UCC = $100,000Income tax rate = 25%CCA rate = 20%Rate of return = 15%

Tax shield = ($100,000 X 25% X 20%) / (15% + 20%) = $5,000 / 35% = $14,286

Half-Year tax shield = ($14,286 X (1 + 0.5 X 15%)) / (1 + 15%) = $15,357 / 115% = $13,354

Note: Tax shield calculations need to be performed for each individual class of assets, as the calculation will depend on the appropriate CCA rates, as well as whether or not there have been any additions during the year.

Future Tax ConsiderationsFuture tax debits/credits are adjusted to their market values. The valuator must review these items in terms of the manner in which they have arisen in the fi rst place, as well as consider the likelihood of reversal in the future.

Where there has been an adjustment for lost tax shield (above), the future income taxes relating to the assets in question should be eliminated in calculating adjusted net book value (assuming the starting point for the calculation is net book value/shareholders’ equity) in order to avoid double counting the related tax/accounting timing diff erences. That is, a tax asset is deducted and a tax liability is added back.

For example, suppose the adjusted book value is being determined for a company whose only capital asset is a building with the following values:

Market value: $100

Net book value: $50

105


UCC: $25

Future tax credit: $12

When calculating adjusted book value, the lost tax shield must be calculated using the above formulas to recognize the purchaser of shares will not receive the benefi t of the tax savings on the diff erence between the market value of $100 and the UCC of $25. This amount must be deducted from shareholders’ equity in calculating adjusted net book value.

The future tax credit represents the “liability” for tax savings realized from claiming CCA faster than accounting depreciation, i.e., the benefi t of having reduced the UCC to $25 as compared to the NBV of $50. This amount is encompassed in the lost tax shield adjustment and, therefore, must be added back to shareholders’ equity in calculating adjusted net book value to avoid double counting.

EXAMPLE 2.5: ADJUSTED BOOK VALUE APPROACH — ABV COMPANY

Required: You have determined that ABV Co. has no commercial goodwill and therefore, an adjusted book value technique is appropriate.

Example 2.5A (right) shows the company’s balance sheet and asset values for its most recent fi scal year ending December 31.

EXAMPLE 2.5AABV Co. Balance Sheet as at December 31

Cash 1,000Accounts receivable 2,000Capital asset (equipment) 4,000Total assets 7,000 Current liabilities 2,000Future income taxes 400Long-term debt 2,000Shareholders’ equity 2,600Total liabilities and equity 7,000 Additional information re: equipment: CCA rate 30%Original cost 5,000Accumulated depreciation (1,000)Net book value 4,000 Undepreciated capital cost (UCC) 3,000Estimated market value (per appraisal) 8,000


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Other information:• Appropriate return for purposes of tax shield 10%• Income tax rate 36%• Future income taxes relate to timing diff erences between CCA and accounting

depreciation.• The book values of the company’s other assets and liabilities approximate their fair market

values.

Solution: Adjusted Book Value Determination

EXAMPLE 2.5BAdjusted book value of ABV Co.’s sharesAdjusted net book value: Shareholder’s equity 2,600 Add: fair market value increment 4,000 Less: lost tax shield (below) (1,252) Add: future income taxes 400 Adjusted net book value 5,748 Lost tax shield: Tax shield implicit in appraised value 2,062 [(8,000 x 36% x 30%)/(10%

+ 30%)] x [(1+(0.5 x 10%)/ (1+10%)]

Less: tax shield based on UCC value (810) [(3,000 x 36% x 30%)/(10% + 30%)]

Lost tax shield from purchase of shares 1,252 Note: Students should also review the detailed example of the adjusted book value technique in

Chapter 3 (page 114) of Business Valuation.

EXAMPLE 2.6: ADJUSTED BOOK VALUE APPROACH — ML LODGING INC.

Required:Mike Lodge owns 100% of the shares of a company, ML Lodging Inc. (“ML”). ML owns and operates a small (but successful) inn and other related assets.

Mike has recently separated from his spouse, and his lawyer has requested a valuation of ML at the date of separation (June 30th of the most recent year) for family law purposes.

ML’s balance sheet at June 30th is shown on the right, Example 2.6A:

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EXAMPLE 2.6AML Lodging Inc.Balance sheetAs at June 30 of this yearASSETS Cash 40,000Accounts receivable 55,000Supply inventory 25,000Prepaids and other 15,000Goodwill 135,000Fixed assets 1,750,000Future income taxes 95,000Total assets 2,115,000

LIABILITIES Bank operating line 150,000Accounts payable 35,000Mortgage payable 1,295,000Total liabilities 1,480,000

SHAREHOLDER’S EQUITY Retained earnings 634,000Share capital 1,000

635,0002,115,000

Additional information related to ML’s fi xed assets, goodwill, and other items is as follows:

EXAMPLE 2.6BML Lodging Inc.Asset InformationAs at June 30 of this year

Original Cost

Accumulated Amortization

Net Book Value

Undepreciated Capital Cost

(UCC)CCA Rate

Market Value *

Land 250,000 — 250,000 N/A N/A 400,000Building 1,700,000 1,150,000 550,000 625,000 4% 2,500,000Groundskeeping equipment 400,000 275,000 125,000 80,000 30% 70,000Furniture and fi xtures 1,400,000 650,000 750,000 800,000 20% 600,000Offi ce equipment 150,000 75,000 75,000 50,000 30% 40,000Total 3,900,000 2,150,000 1,750,000 1,555,000 3,610,000

Notes

* Based on appraisals performed by independent, third party appraisers

• Mike recently learned that a corporate customer has gone bankrupt. The accounts receivable from this customer accounted for 40% of ML’s accounts receivable.


108

• Future income taxes relate entirely to timing diff erences with respect to the recognition of capital cost allowance vs. amortization.

• ML’s income-tax rate is 30%.• ML’s cumulative eligible capital balance relating to its acquired goodwill is $90,000.• An appropriate rate of return for purposes of tax shield calculations is 15%.

Solution:In the process of estimating the fair market value of ML, an adjusted book value approach is considered appropriate because the value of the company lies in the value of the assets it owns. Further, ML is a successful company and is most likely a going-concern, thus the liquidation approach would not be applicable.

Shareholder’s equity 635,000Less: After-tax uncollectible accounts receivable ($55,000 * 40% * (1 – 30%)) – rounded

(15,000)

Less: Net book value of goodwill (135,000)Less: Net book value of fi xed assets (1,750,000)Add: Market value of fi xed assets 3,610,000Less: Future income tax asset (95,000)Less: Lost tax shield — rounded (see below) (53,000)Adjusted net book value 2,197,000

Tax shield based on appraised values:Building [(2,500,000 x 30% x 4%) / (15% + 4%)] x

[(1+(0.5 x 15%))/(1+15%)] 147,597 Groundskeeping equipment [(70,000 x 30% x 30%) / (15% + 30%)] x

[(1+(0.5 x 15%))/(1+15%)] 13,087 Furniture and fi xtures [(600,000 x 30% x 20%) / (15% + 20%)] x

[(1+(0.5 x 15%))/(1+15%)] 96,149 Offi ce equipment [(40,000 x 30% x 30%) / (15% + 30%)] x

[(1+(0.5 x 15%)) / 1+15%)] 7,478 264,312 Tax shield based on UCC values:Building [(625,000 x 30% x 4%) / (15% + 4%)] 39,474 Groundskeeping equipment [(80,000 x 30% x 30%) / (15% + 30%)] 16,000 Furniture and fi xtures [(800,000 x 30% x 20%) / (15% + 20%)] 137,143 Offi ce equipment [(50,000 x 30% x 30%) / (15% + 30%)] 10,000 Goodwill [(90,000 x 30% x 7%) / (15% + 7%)] 8,591 211,207 Lost tax shield from purchase of shares (53,104)

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2.3.3 Tangible Asset Backing

Tangible asset backing is the value of the operating assets minus operating liabilities of a business. Thus, tangible asset backing does not include redundant assets or debt. Tangible asset backing (TAB) is not a primary valuation technique but rather it is generally used in conjunction with an income-based technique (e.g., capitalized earnings or cash fl ows) to assess risk. The value of the operating assets when calculating TAB is based on a going-concern assumption.

Mathematically, the calculation of TAB is identical to adjusted net book value. However, diff erent terminology is used to distinguish whether the result is a measure of value or a measure of risk. TAB is a measure of risk. Adjusted net book value represents the value of a business as a going concern when there is no expectation of any type of non-identifi able intangible value or commercially transferable goodwill.

TAB value is higher than liquidation value because:

• TAB includes the value of assets as part of an ongoing operation rather than the value of each asset if sold individually.

• TAB does not consider costs of disposition.

From a risk assessment perspective, TAB measures the portion of the purchase price backed by net tangible assets (the remainder being attributable to all intangible assets including goodwill and identifi able intan gibles) whereas liquidation value measures what a purchaser might expect to realize in the event the business had to be wound up shortly after acquisition.

2.3.3.1 Calculating Tangible Asset BackingMathematically, the same adjustments to shareholders’ equity should be made as for adjusted book value. However, in assessing risk, redundant assets should be excluded since little if any risk attaches to net redundant assets.

EXAMPLE 2.7: TANGIBLE ASSET BACKING

EXAMPLE 2.7ATAB $500,000Goodwill* $300,000Net redundant assets $200,000Fair market value $1 million

Notes:

* This does not represent the NBV of Goodwill from the Balance Sheet at the Valuation Date. Rather, it is equal to Enterprise Value (as calculated in a Cash Flow Approach) minus TAB.

Risk Assessment

For purposes of risk assessment, TAB as a percentage of Enterprise Value is 62.5% ($500,000/ ($1 million — $200,000). However, if redundant assets were included in the analysis, the percentage


110

would be 70% ($500,000 + $200,000)/$1 million) and risk would be perceived as less than it really is. As discussed in Level I, TAB is the value of the net underlying tangible assets, and as such, is eff ectively the “fl oor” value. The higher the value of a company’s underlying assets, the less risky the business operations. Conversely, lower TAB would indicate higher risk - if active operations cease, then owners would still hold the value of underlying assets, which could be recognized through an asset sale.

Practically speaking, the calculation of TAB is generally done in conjunction with the analysis of redundant assets. The value of redundant assets are considered separately as they are not necessary to maintain ongoing operations. In the event of a sale of the company, current owners would likely either remove these assets from the company prior to the sale, or would ask a higher selling price if a potential buyer wanted to acquire these non-business-essential assets.

After completing a valuation, the valuator should then calculate and assess the amount of goodwill implied by their valuation conclusion. Expressing the implied goodwill as a multiple of after-tax cash fl ows or after-tax earnings commonly accomplishes this. In the example above, assume normalized after-tax earnings of $100,000.

EXAMPLE 2.7BCalculation of implied goodwillfair market value of shares $1 millionLess: Net redundant assets (200,000)Less: TAB (500,000)Implied goodwill 300,000After-tax earnings 100,000Number of years of after-tax earnings 3 years

The fair market value conclusion of $1 million in this situation implies a period of 3 years for a potential purchaser to “earn” the goodwill implicit in the purchase price.

The valuator should assess the reasonableness of this conclusion in light of economic, industry and business-specifi c factors.

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2.4 Risk MeasurementThe comparison of tangible asset backing, liquidation value and going-concern adjusted net book value acts as a test on the reasonableness of value conclusions.

The total cash fl ow of a business can be viewed as being built in three distinct levels:

• An appropriate return on the liquidation value provided by the net tangible assets.• A return on any value in excess of liquidation value, up to the adjusted book value of the

net tangible assets. The required rate of return applied to these cash fl ows would be higher than the return on liquidation value due to the greater risk attached to it.

• A return on intangible assets, being the diff erence between the aggregate value of the business (Enterprise Value) and the going-concern value of the net tangible assets. The required rate of return applied to these cash fl ows would be higher than the return on the going-concern value of the net tangible assets due to the yet greater risk attached to it.

Generally, the greater the underlying net tangible value base (measured in terms of both its going-concern value and its valuation date liquidation value), the lower the required rate of return on invested capital and the greater the en bloc value of all of the outstanding shares, as set out in Principle #4.


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2.5 Real Estate and Equipment ValuationsA value opinion from a real estate appraiser and/or equipment appraiser may be required in calculating adjusted book value or TAB. At a minimum, the valuator should request copies of any recent appraisals from management.

2.5.1 Real Estate Valuations

Real estate appraisers generally use a combination of three approaches when valuing a property:

• The income approach, whereby the appraiser assesses the future income-producing potential of the property.

• The market value approach, where the appraiser develops a property value based on sales of comparable properties around the valuation date.

• The cost approach, where the appraiser estimates the cost of constructing new facilities with the same utility, and then applies depreciation factors refl ecting wear and tear, economic obsolescence and functional depreciation.

When using the services of a real estate appraisal expert, the valuator must clarify at the outset the appraiser’s specifi c terms of reference. That is, the appraiser needs to know whether market value (value-in-exchange), or going-concern value (value-in-use), or both, are required.

Real estate values can be problematic where the property is not being utilized in its highest and best use, where excess land has value that is separable from the component currently being used (i.e., resulting in redundant assets being identifi ed), or where a building is of a special-use nature.

In particular, where a business has a building requirement peculiar to it (such as a free-standing restaurant location without alternate uses, or heavily reinforced fl oors comprising part of the structure that are expensive and not required for alternate uses), real property may have a diff erent value-in-use relative to the existing occupant than its market value if it were sold for general use.

2.5.2 Equipment Valuations

Equipment appraisers consider a wide range of value, depending on the terms of reference set out in their assignment. In light of their possible use in business valuation applications, the diff erences in values can be signifi cant. As a result, the valuator must ensure that the machinery appraiser understands how the appraised values will be used.

When assessing the going-concern value of a business’ tangible operating assets, the appraiser will usually use fair market value in continued use. This concept assesses equipment value on an installed basis (i.e., in the context of similar equipment that has the same functional utility). Value-in-use must be determined with reference to whether the business can generate suffi cient cash fl ow to justify the investment in the value-in-use of the tangible assets.

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Where machinery is several years old, technological changes may be such that an identical replacement does not exist. Thus, the equipment appraiser considers either the fair market value of purchasing it in the used equipment market or replacing its functional utility, subject to a depreciation allowance to refl ect the age of the existing equipment, plus an adjustment to allow for installation costs.

Orderly and forced liquidation values are two other equipment valuation approaches typically used in business equipment valuations. Liquidation values are determined relative to what individual pieces of equipment might fetch on the equipment market, either on an “as is — where is” basis or after reconditioning.

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MODULE 3Comparable Company Multiples and Other Valuation Concepts

Module OverviewWelcome to Module 3. In this module, you will gain a comprehensive understanding of:

• Majority positions and control.• Losses and acquisition of control.• Assets versus shares.• Trapped in capital gains.• Canadian Business Corporations Act.• Minority Positions.• Discounts for illiquidity.• Minority discounts.• Portfolio discounts.• Blockage discounts.• Restricted shares.• Special purchaser premium.• Levels of Value• Agreements.


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Required Reading

Byrd, Clarence and Chen, Ida. Byrd and Chen’s Canadian Tax Principles. Toronto: Pearson, 2013.• Chapter 17 — Other Rollovers and Sale of an Incorporated Business — see Sale of

an Incorporated Business

Campbell, Ian R., Johnson, Howard E., Nobes, H. Christopher. Canada Valuation Service — Student Edition 2012. Toronto: Carswell, 2012.• Chapter 6 — (Intangibles pages 6-34 to 6-42)• Chapter 7 — (Control: Minority Shareholdings pages 7-1 to 7-100E)• Chapter 8 — (Special Situations pages 8-1 to 8-30)• Chapter 9 — (Taxation 9-69 to 9-89)• Chapter 13 (Decisions)

CICBV Code of Ethics and Practice Standards, By-LawsJohnson, Howard E. Business Valuation. Toronto: The Canadian Institute of Chartered

Accountants, 2012.• Chapter 8 — Controlling and Minority Interests• Chapter 11 — Open Market Transactions

The Canadian Business Corporations Act

• Students are required to read those sections noted in this module

Website Resources

Goodman, Wolfe D, Q.C. “Valuation of Shares: Some Areas of Controversy.”

Webster, Jeremy. “Shareholders’ Agreements — A Valuator’s Perspective.” Business Valuation Digest 3:1 (1997).

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3.1 Majority Positions and ControlA controlling shareholder typically has:

• The power to elect a majority of the board of directors. This gives the controlling shareholder the ability to indirectly govern the aff airs of the company however one should not assume away the roles and responsibilities of directors — see discussion entitled “The Position of Majority Shareholders” later in this module.

• The right to place a company in liquidation (subject to the statutory provisions of the incorporating jurisdiction). This gives the controlling shareholder the ability to minimize his/her losses in the event that the company proves unsuitable as a going concern.

• The right to sell control of the company (subject to the statutory provisions of the incorporating jurisdiction). This is vital to being able to entertain an off er by a potential purchaser, especially for a special purchaser who would require control to eff ect economies of scale and/or strategic advantage that might arise upon a combination of the two companies. This right also gives the ability to dictate the timing of liquidation.

• The power to be appointed an offi cer of the company. This means receiving remuneration and other perquisites for management services rendered.

• The right to determine the timing and amount of dividend distributions.

3.1.1 Types of Control

Control is often considered to exist when a shareholder holds in excess of 50% of the voting stock; however, control in the context of business valuation can be considered to arise under the following four main categories:

• Legal (“de jure”) control• Eff ective (“de facto”) control• Group control• Joint control

It is important to fi rst understand the concept of control of a corporation. There are essentially two types of control that are acknowledged in some way, specifi cally de jure control (legal control) and de facto control (control in fact).

3.1.1.1 Legal or De Jure ControlLegal or de jure control describes a shareholding of 50% plus one of the issued voting shares in a corporation. In other words, this control provides a suffi cient number of votes to elect the board of directors and thus control the direction of the corporation’s aff airs. Again, there is an obligation of directors to make independent decisions on the proposals set forth by a company (Refer to the discussion “The Position of Majority Shareholders” later in this module). In certain provinces, a larger number of votes (Super-Majority) may be necessary to eff ect certain fundamental changes or specialized events such as amalgamations and liquidations.


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The concept of de jure control has evolved through case law, and is generally accepted to mean the right of control that rests in ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the board of directors. (Buckerfi elds Ltd. v. MNR, 64 DTC 5301, (1964) CTC 504)

De jure control may be direct (shareholder owns shares directly in the corporation) or it may be indirect, as could be the case where a person controls a corporation (the parent), that in turn controls one or more subsidiary corporations. The person controlling the parent corporation is considered to control any corporation that is controlled by the parent corporation (Vineland Quarries and Crushed Stone Ltd. v. MNR, 66 DTC 5092, (1966) CTC 69).

3.1.1.2 Eff ective or De Facto ControlEff ective or de facto control refers to the ability to direct a company’s aff airs while at the same time not possessing enough votes to constitute legal control. As the name implies, de facto control is a question of looking at the factual circumstances. Eff ective control can be proven to exist by reference to such things as contracts, the balance of ownership being represented by small minority holdings, the ability to obtain proxies and so on.

While de facto control is relevant to business analysis/valuation contexts, we also provide herein a discussion from an income tax point of view below:

Subsection 256(5.1) of the Income Tax Act sets out particular rules regarding the concept of de facto control. Specifi cally, whenever the expression, “controlled, directly or indirectly in any manner whatever” is used within any subsection of the Income Tax Act, the concepts of both de jure and de facto control is applied.

This concept is particularly relevant with respect to the association rules under the Income Tax Act, as associated corporations are required to share a number of benefi ts under the Income Tax Act, including:

1. The annual business limit relevant to the small business deduction.2. The annual expenditure limit with respect to the enhanced investment tax credit.

De facto control broadens the concept of control and includes the ability to control “in fact” the corporation by any direct or indirect infl uence, whether through ownership of shares or not.

Some examples of de facto control could include: and/or evidence of the existence of de facto control might arise from:

1. The ability to change the composition of the board of directors.2. The ability to terminate the corporation or its business.3. The ability to appropriate profi ts or property from the corporation.

The above is considered despite lacking more than 50% of the voting shares of a corporation.

As noted, simply having the ability to infl uence will constitute de facto control, even if such infl uence is never exercised. Factors that might be considered in determining whether de facto control exists could include:

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1. The percentage of ownership of shares relative to other shareholders — e.g., holding a signifi cant block of shares in a widely-held corporation could represent a position of de facto control.

2. The provisions of shareholders’ agreements, including the rights assigned to particular shareholders.

3. Commercial or contractual relations of the corporation — e.g., economic dependence on a single supplier or customer.

4. The composition of the board of directors and the control of the day-to-day management of operation of the business.

Additional information regarding the concepts of control for tax purposes can be found in the following CRA publications:

• IT 302R3, “Losses of a Corporation — The Eff ect that Acquisitions of Control, Amalgamations and Windings-Up Have on Their Deductibility,” at the CRA website: www.cra-arc.gc.ca/E/pub/tp/it302r3/it302r3-e.html

• IT 64R4, “Corporations: Association and Control,” at the CRA website: www.cra-arc.gc.ca/E/pub/tp/it64r4-consolid/it64r4-consolid-e.html

In assessing the impact of a particular transaction, the valuator needs to understand these concepts of control. For example, a share sale that results in an acquisition of control may have a number of tax consequences that need to be addressed in a particular valuation (e.g., availability of loss carryovers, credits, etc. to the prospective purchaser). Typically, this kind of concerns fi ts most readily in contexts where the valuator works on the buy side of a possible transaction and is concerned to identify the valuation consequences for that bidder.

Similarly, in a transaction where the ownership of the shares is changed, the association rules should be reviewed to ensure that any tax benefi ts the corporation currently enjoys (e.g., small business tax rates, enhanced investment tax credits, etc.) will continue to be available to the corporation after the transaction.

Failure to incorporate these tax considerations into the valuation could result in not only an inappropriate tax rate being used in the valuation, but also an infl ated tax shield should certain benefi ts be unavailable to the prospective purchaser.

EXAMPLE 3.1: WIRELESS INC.

Wireless Inc. is a company specializing in the development of wireless communication devices. Formed eight years ago by a pair of computer graduates, the company has invested over $20 million in the development of wireless communication devices. Three years ago, the company patented its fi rst product.

The company has accumulated unclaimed scientifi c research and development expenditures (SRED) of $15 million, and unclaimed investment tax credits of $3 million. The company has also accumulated non-capital loss carryovers of $7.5 million.


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In order to secure additional funding for the company, at the end of this year, Wireless Inc issued shares to Rogets Ltd. Rogets Ltd now owns 55% of the shares of Wireless Inc. The president of Rogets Ltd intends to transfer the assets of its highly profi table television manufacturing division to Wireless Inc. in order to shelter the income from taxation by the use of the available losses, SRED expenditures and investment tax credits.

In a situation such as this, the following points must be considered:

1. As a result of the purchase of 55% of the company there has been an acquisition of control.2. The acquisition of control triggers a deemed year end for the company.3. As a result of the deemed year end the expiry date of the ITC’s will be accelerated4. Only the new company can use non-capital losses. If the wireless business is carried on

continuously, it is carried on with a reasonable expectation of profi t, and losses from this business are only off set by income from the same business or a similar business. In this case television manufacturing wouldn’t be similar. Another way of looking at this situation would be to frame this as a question “Would television manufacturing qualify as making another form of wireless communication device?”

5. The same rules apply to limit the application of the SRED expenditures and ITC’s. SRED claims must be made within 18 months of spending.

6. In addition, any unrealized losses in the asset balances of Wireless Inc will need to be recognized on the change in control.

7. If any unrealized gains exist in the asset balances the company could elect to trigger the gain to use some of the loss carry forwards.

3.1.1.3 Group Control Group control is control under either legal or eff ective control. The concept of group control has developed in connection with valuations made for income tax purposes. Generally, what must be proven is that some group of shareholders — perhaps related by kinship — has acted in concert to direct the aff airs of the enterprise. Canada Revenue Agency (CRA) generally accepts the notion of “family control” when related shareholders act in concert to control the company, barring family disputes. Group control often exists where there are restrictions on the shareholders’ right to sell shares independently and restrictions on their right to vote on group members’ shares independently.

3.1.1.4 Joint ControlJoint control occurs when two or more people agree to share control of a business. Where two shareholders both equally own 50% of a company, no one party has control of the business and both shareholders are, in eff ect, minority shareholders. Under such a structure, both shareholders may be related and act in concert (i.e., thus being deemed as group control). Where both shareholders are arm’s length parties, they would typically try to protect each other’s interest and liquidity.

However, when these shareholders have a disagreement and there is no easy resolution, it can be detrimental to the operations of the business. A potential acquirer may fi nd a 50% interest

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undesirable, as it would not provide control of the company. It is more likely a potential acquirer would require both interests (i.e., 100%). If the other shareholder does not want to sell his/her 50% interest, he/she could thwart the sale. Shareholders’ agreements can be a means to resolve these issues as they would stipulate the prices and circumstances under which the shares would be sold. Shareholders’ agreements can also detail courses of action to be taken in the event of a stalemate between the two shareholders.

In the absence of a shareholders’ agreement, the laws specifi c to each jurisdiction specify the rights of each shareholder and the courses of action available under various circumstances.

3.1.2 Premium for Control

Takeover bids for publicly traded companies usually occur above the market-traded price (which is refl ective of a liquid minority position), and the diff erence is usually considered to be a “premium for control” however, one must be careful when using market data as this premium can relate to either or both of the following:

• The post-acquisition synergistic benefi ts that the purchaser perceives. • The elimination of the implied discount in a public market context, since share prices of

publicly traded companies is generally considered to refl ect a minority discount.

When using market data it is important to exclude transactions where the purchaser was a strategic buyer so as to eliminate the impact of expected synergies on the premium paid.

Note: The term “premium for control” can be misinterpreted. It should not be misconstrued to mean that a premium is added to the en bloc fair market value of a company (as the en bloc value is representative of a control position).


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3.2. Acquisition of Control RulesAn acquisition of control is considered to occur when there has been a change in the de jure control of the corporation. Ordinarily this would be the case when a majority shareholder sells his/her shares to an arm’s length person; however, it could also happen where the shares of a majority shareholder are redeemed (leaving the minority shareholder with 100% of the remaining outstanding shares).

Because losses and other tax assets inherent in a corporation may be transferred to a prospective arm’s length purchaser, the Income Tax Act contains a number of rules designed to inhibit the use of these benefi ts after an acquisition of control. The Canadian government fi rst introduced these rules in November 1981 to target perceived areas of abuse involving a number of unprofi table corporations that were becoming takeover targets simply for tax reasons, not because of any potential economic profi tability.

An example of such a case would be a loss corporation that is acquired simply for its signifi cant amount of unutilized losses, which is subsequently combined with a profi table corporation via a wind-up or amalgamation to utilize the losses of the acquired company with the income of the profi table corporation. Absent any rules to the contrary, the combined corporation would suddenly have losses available to off set against its income when, in many cases, the profi table company might not even be in the same line of business as the original loss company.

3.2.1 Losses

To limit the “trading” in these types of corporations, the acquisition of control (or change of control) rules were brought in. These rules provide that upon an acquisition of control, the following applies.

Acquisition of Control Rules1. The taxation year of the acquired corporation is deemed to end immediately before the

acquisition of control. Note that this may result in a taxation year that is less than 12 months, which will have implications on the amount of CCA that may be claimed and may also accelerate the expiry of any unutilized losses.

2. Any unutilized net capital losses (including such losses incurred in the year ending upon the acquisition of control) will be deemed to expire. As such, an acquiring corporation will not be able to apply such losses to any net taxable capital gains realized after the acquisition of control.

3. Any unutilized allowable business investment losses (ABILs) will also be deemed to expire.4. Any net capital losses incurred after the acquisition of control cannot be carried back to

taxation years preceding the acquisition of control. 5. Any unrealized losses (sometimes referred to as “pregnant losses”) that are inherent in the

non-depreciable capital property of the corporation will be deemed to be realized. That is, if the fair market value of the non-depreciable capital property at the time of the acquisition of control is less than its original cost, the subject property must be written down to its FMV for tax purposes. The resulting capital loss, to the extent it cannot be applied to capital

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gains in the year or any of the preceding three years, is treated like any other net capital loss carryover and is deemed to expire.

6. Conversely, where a corporation has non-depreciable capital properties with unrealized gains at the time of the acquisition of control, the corporation may elect to trigger a deemed disposition of one or more of these properties. The corporation can determine the appropriate amount of proceeds of disposition for the properties, provided the amount is greater than the original cost and does not exceed the respective FMVs of the subject property. The eff ect of this election is that the corporation will trigger a capital gain as a result of the deemed disposition and, to the extent that net capital losses might otherwise expire on the acquisition of control, such net capital losses can be applied to shelter the resulting capital gain from tax.

Thus, as a tax-planning tool, this mechanism could provide some relief for net capital losses that might otherwise be unutilized. At the same time, because the corporation is deemed to “reacquire” the property at a cost equivalent to the elected proceeds (e.g., FMV), then the purchaser will have realized some benefi t because it is only subject to capital gains on a future disposition of the property if the property subsequently appreciates beyond the FMV at the acquisition date.

EXAMPLE 3.2: CORPORATION WITH TWO NON-DEPRECIABLE CAPITAL PROPERTIES

Consider a corporation with two non-depreciable capital properties — one is a share investment in a subsidiary corporation and the other is an investment in land. At the time of the acquisition of control, the respective cost and FMVs of each of these properties is as follows:

Sha res: FMV = $10,000 Land: FMV = $3,000 Tax cost = 5,000 Tax cost = 5,000

In this situation, the land has an inherent loss of $2,000. The corporation will be required to write down the value of the land and recognize the loss as a capital loss. If the capital loss cannot be applied to off set capital gains realized in the year or in any of the preceding three taxation years, the corporation could elect to trigger a deemed disposition of the shares to recognize a capital gain, that would then be off set by the capital loss on the land in that year. If the gain were not triggered, the loss on the land would be lost.

In that case, although the corporation could elect for maximum deemed proceeds of disposition of $10,000 (the FMV), this would trigger a $5,000 capital gain. Since the capital loss incurred on the deemed write-down is only $2,000, the corporation would have a net tax liability if maximum proceeds were elected. Instead, the corporation would elect to have proceeds established at $7,000, triggering a $2,000 capital gain, which will be fully off set by the deemed loss. The new tax cost of the shares (which will carry over to the purchaser) will therefore be $7,000 and the purchaser will only be taxed on gains that accrue beyond this value.

Certain write-downs of value may also be required for depreciable property and eligible capital property. In that case, if the FMV of the property is less than the respective UCC or CEC balance,


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as the case may be, then the corporation must write down the UCC or CEC balances to the relevant FMVs. These write-downs are treated as CCA or CEC claims and are deducted from income for the corporation in the taxation year ending immediately before the acquisition of control.

If, as a result of these write-downs, a loss is created in that taxation year, the loss is considered a non-capital loss. If the non-capital loss cannot be carried back to reduce income in the preceding three taxation years, it will carry forward based on the limitation periods illustrated the Exhibit 3.1.

EXHIBIT 3.1: ACQUISITION OF CONTROL - ILLUSTRATION OF IMPACT ON CERTAIN ASSETS

However, the use of this loss will be subject to additional limitations as noted in Exhibit 3.2.

Pre-Acquisition Post Acquisition

Net Capital Losses Expired, no carryforward availableNon Capital Losses Subject to restrictions under ss. 111(5)Farm Losses Subject to restrictions under ss. 111(5)SRED Pool Subject to restrictions under ss. 37 (6.1)Unused ITCs Subject to restrictions under ss. 127(9.1), (9.2)

Losses Incurred before Acquisition of Control:

Deemed Y/E:-write-down of capital properties

-write-down of UCC/CEC -election to trigger gain on capital property

No carryback available Net Capital LossesSubject to restrictions under ss. 111(5) Non Capital LossesSubject to restrictions under ss. 111(5) Farm LossesSubject to restrictions under ss. 37 (6.1) SRED PoolSubject to restrictions under ss. 127(9.1), (9.2) Unused ITCs

Deemed Y/E:-write-down of capital properties

-write-down of UCC/CEC -election to trigger gain on capital property

Losses Incurred after Acquisition of Control:Pre-Acquisition Post Acquisition

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EXHIBIT 3.2 USE OF NON-CAPITAL LOSSES AFTER ACQUISITION OF CONTROLNon-capital losses incurred prior to the acquisition of control (including those incurred in the taxation year deemed to end immediately before the acquisition of control) may be carried forward to apply to income earned in a taxation year after the acquisition of control, subject to the following three restrictions:

1. The corporation must carry on the business that gave rise to the loss continuously after the acquisition of control.

2. Such business must be carried on for profi t, or with a reasonable expectation of profi t, throughout the particular year.

3. Such loss may only be applied to the extent of the corporation’s income from that same or similar business.

These rules, sometimes known as the “loss streaming rules” are conceptually similar to rules in the U.S. under Internal Revenue Code S. 382. Similar restrictions will apply to carrying back a non-capital loss incurred after the acquisition of control to a taxation year that ended prior to the acquisition of control.

For additional information about the consequences of loss carryovers after an acquisition of control, see Restrictions on the use of Losses in Canadian Tax Principles, Chapter 14.

See also the CRA’s publication, IT 302R3, “Losses of a Corporation — The Eff ect that Acquisitions of Control, Amalgamations and Windings-Up Have on Their Deductibility,” at CRA’s website: www.cra-arc.gc.ca/E/pub/tp/it302r3/it302r3-e.html.

3.2.2 SR&ED Pools, ITCs and Unused Surtax Credits

Undeducted SR&ED expenses will be reduced to nil on an acquisition of control, but may be reinstated if the business to which the expenses relate is carried on by the purchaser with a reasonable expectation of profi t in a subsequent taxation year to the extent of the income from that, or a similar, business. Similarly, the Income Tax Act imposes various restrictions on the ability of the purchaser to utilize any unused ITCs or surtax credits of the corporation following an acquisition of control. In these cases, the premise of carrying on the same or similar business is essential to the continuing availability of these credits.


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MQE QUESTION 3.1

Furniture Components Importer Ltd. (“FCIL” or the “Company”) is an importer of offi ce furniture parts such as chair castors, drawer slides and shelving brackets. FCIL’s customer base includes several major North American furniture manufacturers. Due to the Company’s focus on a very narrow component of the manufacturing process, the larger furniture companies highly value FCIL’s sourcing capabilities. FCIL has been historically profi table with strong cash fl ows and anticipates continued future growth. To date, none of the growth of FCIL has come as a result of mergers or acquisitions.

FCIL’s shareholders are very interested in obtaining a listing for FCIL on the Toronto Stock Exchange. After discussions with several Canadian securities dealers, it is apparent that an initial public off ering (“IPO”) of FCIL would be very diffi cult in the current market and could result in a signifi cant discount in the pricing of the IPO in order to entice investors.

FCIL’s advisor is recommending that FCIL achieve its public listing through a reverse takeover (“RTO”) of a publicly listed shell company. The structure of this transaction is that the shell or inactive company would purchase FCIL utilizing its shares as currency. As the shell company is eff ectively inactive and with only a nominal value it would be required to issue so many shares to acquire FCIL that FCIL’s shareholder would control the shell. Subsequent to the transaction, FCIL would be amalgamated with the shell and would inherit the shell’s public listing.

FCIL’s advisor has identifi ed Pharma Research Corporation (“Pharma”) as a potential candidate for the RTO transaction. Pharma had been a promising biotechnology company with technology in the area of synthetic blood products. However, due to unsuccessful clinical trials, unsuccessful Food and Drug Administration (“FDA”) applications and the arrival of competing products onto the market, Pharma’s operations had been discontinued. Pharma is eff ectively dormant with its only activity being basic administration. The President (and only employee), Phil Nakka, of Pharma has indicated that he is interested in the proposed FCIL transaction further. Pharma has cumulative operating losses for tax purposes are approximately $30 million.

Required:Prepare a discussion of the applicability of the tax losses to the valuation of the company upon takeover.

Solution:The relative value of the two organizations is the key element of the transaction. Our review of Pharma indicates that the business is essentially dormant with cash, tax losses and the public listing being the primary assets of the company.

As the President of Pharma has indicated that he is interested in pursuing the transaction, it is plausible that there are no parties who are interested who could readily use the loss carry forward for tax purposes of $30 million. Also, it is unlikely that earnings from FCIL could be shielded from the losses from the biotech operations given that they are very diff erent in nature. Accordingly, it would not make sense to attribute any value to the tax losses.

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MQE QUESTION 3.21

Citrus Co. (“Citrus” or the “Company”) is an importer and distributor of exotic fruits and vegetables. Citrus began operations ten years ago but over the past fi ve years has not performed as expected. As a result, signifi cant non-capital income tax loss carry forwards have accumulated.

Prior to June 30, this year, Mr. Orange owned 75% of the common shares of Citrus. He acquired the remaining 25% of the common shares of Citrus from the minority shareholders (the “Citrus Minority Shareholders”) on June 30, this year for $2 million cash.

Mr. Orange is considered somewhat of a mogul in the fresh produce industry, having owned or operated companies in the industry for over 30 years. Presently, one of Mr. Orange’s holdings is a 45% interest in the common shares of Lettuce Corp. (“Lettuce”), Citrus’ principal competitor in the produce distribution business. Lettuce has been extremely profi table over the past three years and is expected to continue to be due to its solid customer base and its lean operating structure. The remaining 55% of Lettuce is widely held in the public, with no one person or entity owning greater than 3% of the remaining common shares.

Mr. Orange was concerned that the tax loss carry forwards in Citrus would not be utilized. Therefore, in order to derive maximum benefi t from the Citrus loss carry forwards, Mr. Orange has directed the sale of all of the common shares of Citrus to Lettuce. Mr. Orange had been correctly advised that Lettuce would likely be able to utilize Citrus’ loss carry forwards pursuant to the rules of the Income Tax Act (Canada). The sale of Citrus occurred on August 15 of this year. In exchange for his common shares in Citrus, Mr. Orange received cash proceeds of $12 million.

In light of the sale of Citrus to Lettuce, the Citrus minority shareholders feel they were treated unfairly and have approached a litigation fi rm, MacIntosh LLP, for legal assistance. A senior partner at MacIntosh LLP has approached you, CBV, for analysis on whether the Citrus minority shareholders have any fi nancial basis for their complaint. Specifi cally, counsel would like to discuss the merits of the premium received by Mr. Orange in the sale of Citrus to Lettuce in August this year relative to the proceeds received by the Citrus minority shareholders in June this year.

Additional information regarding Citrus and Lettuce is attached. Also attached is your preliminary research regarding transactions involving the sale of the shares of companies that had minimal operations and signifi cant accumulated loss tax carry forwards.

Additional Information Regarding Citrus Co:The company began importing and distributing high quality produce mainly to high-end restaurants throughout southern Ontario. After a relatively short period, the Company began a phase of rapid expansion with the goal of serving all of Canada within fi ve years.

The company began setting up regional distribution centers in major areas across the country with the sales and purchasing functions decentralized from the corporate headquarters that continued to service Southern Ontario. It was felt at the time that this structure would allow the company

1 A second question related to this topic that appeared on a previous MQE is included below. Complete the question and check your answers. The question has been modifi ed since its inclusion on the MQE due to changes in legislation related to loss carry forward provisions.


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to be responsive to regional diff erences and therefore be more responsive to the needs of their customers.

Due to the rapid pace of the expansion, management had been unable to eff ectively monitor the operations of the regional centers and ensure that consistent and high quality products are acquired.

In addition, fi ve years ago, extreme and uncharacteristic weather conditions in South America limited the supply and increased the price of some of the major products imported. While the Company made every attempt to pass on the price increases to their customers, they had to accept less than their full margins in order to avoid holding quantities of perishable goods.

Given the Company’s poor performance over the past fi ve years, the Company’s management chose not to fi le any capital cost allowance on the Company’s corporate tax fi lings. In addition, the most recent audited balance sheet of Citrus indicated that the company has minimal reported equity. Excerpts from a recent interview with Mr. Orange are shown below along with the historical fi nancial results of Citrus as well as projected fi nancial results of Lettuce.

Excerpts from a recent interview with Mr. Orange:

• Mr. Orange has indicated to you that he was aware of a rule of thumb that tax loss carry forwards could be purchased from $0.10 to $0.20 for every dollar of loss and provided some support below. He is also convinced that no other losses were available in the marketplace that could have been utilized by Lettuce, and if the transaction with Lettuce did not take place, the Citrus losses would have expired.

• Mr. Orange indicated that he feels that the cost of importing the product has not been managed well and a 2% drop in the cost of sales of Citrus would be possible by co-coordinating the purchasing with Lettuce and providing less autonomy to the regional offi ces.

• Mr. Orange anticipates that 10% of the general and administrative costs for both Citrus and Lettuce could be saved by the sale to Lettuce. Although the operations of the companies are not the same, the fi nancing and other administrative duties could be combined.

• He is also looking into whether the warehousing and distribution facilities owned by Citrus could improve the operations of Lettuce. He has had some preliminary estimates that 15% of the warehousing costs of Lettuce could be eliminated if the warehousing of Citrus could be used to store fi nished goods in closer proximity to their markets.

• Mr. Orange is in agreement with various research analysts who conclude that Lettuce’s cost of capital is in the order of 12% to 15%.

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MQE QUESTION TABLE 3.2ACitrus Co.Statement of Operations (000s)For the Year-Ended December 31

Five Years Ago

Four Years Ago

Three Years Ago

Two Years Ago

One Year Ago

Revenues $290,700 $219,460 $259,010 $251,180 $275,060Cost of sales 255,123 175,024 217,800 198,416 220,741Gross margin 35,577 44,436 41,210 52,764 54,319Operating expensesTruck operating costs 8,966 4,367 3,970 6,673 7,233Driver salaries and benefi ts 17,952 13,140 12,036 14,060 15,747Depreciation expense 5,831 4,268 2,803 4,567 5,115Warehousing costs 13,352 11,041 13,674 13,674 12,835Selling expenses 7,787 5,700 3,643 6,099 6,831General and administrative 17,870 15,544 13,222 17,562 17,430Net income (loss) before taxes (36,181) (9,624) (8,138) (9,871) (10,872)

MQE QUESTION TABLE 3.2BLettuce CorpProjections (000s)For the Year-Ended December 31

This Year Next Year 2nd Next

Year 3rd Next

YearRevenue $86,541 $94,586 $104,521 114,954Cost of Goods Sold 55,352 60,497 66,852 69,475Truck Costs 5,058 5,120 5,654 6,012Driver Costs 2,875 3,041 3,421 3,851Selling Expenses 4,517 4,743 4,980 5,123Warehousing Expense 5,693 5,761 5,830 6,142Rent 1,868 1,912 1,957 1,996General and Administrative 2,740 2,758 2,776 2,801Net income before taxes 8,438 10,754 13,051 19,554

MQE QUESTION TABLE 3.2CPreliminary ResearchSale of Shares of Companies with Loss Carryforwards

Industry Date

Purchase Price ($millions)

Quantum of Losses (Pre tax $millions) Note

Software November 4 years ago 16 26 1Manufacturing September 2 years ago 8 80 2Retail January 3 years ago 5 25 3


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Notes:

1. Represents the sales of non capital losses to a related party. The losses were set to expire equally over a four year period, commencing 3 years ago. The consideration paid was in the form of an earnout. No cash was exchanged. Transaction details were obtained from a publicly available fairness opinion.

2. The loss entity was sold to an unrelated private party pursuant to the wind up of the loss company. Although details of the transaction were not publicly disclosed, the newspaper reported that the nature of the losses were such that a very limited market existed for their future use. It is unclear when the losses were set to expire.

3. The loss company was sold to an industry competitor pursuant to an industry wide reorganization. Details of the transaction were not disclosed.

Required:Prepare a memo to your fi le that will be used as a basis for a meeting with MacIntosh. Be sure to include a thorough discussion of all relevant issues and include calculations as appropriate.

Solution:Memorandum

Date: Today

To: File

From: CBV

Re: Sale of shares of Citrus Co.

PurposeThe purpose of this memorandum is to assess the merits of the premium received by Mr. Orange in the sale of Citrus to Lettuce in August this year relative to the proceeds received by the Citrus minority shareholders in June this year.

RestrictionsGiven the nature of the required from MacIntosh, it is important to emphasize the following in our communications:

• We have not been engaged, nor are we providing an opinion of the fairness of any transaction.

• Our communications and conversations are privileged and should be marked in contemplation of litigation.

• We are not providing, nor are we qualifi ed to render any legal advice with respect to the issue of oppression.

• Our analysis is based on limited information provided by Counsel and our scope of review was restricted as we have not had an opportunity to discuss our fi ndings with any party.

• We have not been engaged to provide an opinion of value.

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FindingsWe understand that the Citrus minority shareholders received $2 million for their 25% interest in Citrus on or about June this year in a sale to Mr. Orange (the majority shareholder of Citrus).This could imply an en-bloc value of $8 million assuming no minority discount considerations. In August this year, Mr. Orange sold 100% of the shares of Citrus to Lettuce (a Company in which he is a signifi cant shareholder) for $12 million. The Citrus minority shareholders are questioning the fi nancial basis for the $4 million diff erence in the transaction price (the “Premium”). In order to determine whether the Citrus minority shareholders have any fi nancial basis for their complaint it is necessary to determine the fair value of Citrus in June and August of this year.

It appears that we do not have suffi cient information to address any diff erences in the fair market value of Citrus that would originate from any economic events occurring between June and August 2005. Therefore, we have assumed that the source of the Premium does not originate from any economic event that impacted Citrus between June and August 2005. We will need to obtain additional information to support this assumption.

In assessing the fair value of Citrus, we have considered an asset-based approach to value. Given Citrus’ history of operating losses, it appears that an income-based approach to valuing Citrus on a standalone basis would not be appropriate. Based on the limited information provided, it appears that Citrus’ most valuable asset would be its tax losses. Therefore, it is possible that the source of the Premium could relate to the following three factors that could impact the value of the Citrus minority shareholders interest in Citrus at June this year, as discussed herein:

1. The value of tax losses2. Special purchaser synergies/premium (not discussed below)3. A minority discount (not discussed below)

Tax LossesA potentially signifi cant component of the value of Citrus is in the loss carry forwards and the potential tax savings from sheltering future income with the tax losses.

In order for the company to utilize the losses, either

1. A reorganization has to take place without a change in control which introduces a source of income into the company.

OR2. A purchase of the shares can take place by a company in a same or similar business.

We should highlight to MacIntosh that we are not tax experts and are not qualifi ed to render any taxation advice. We have assumed that Lettuce would qualify as a same or similar business since Lettuce and Citrus are both competitors in the industry. We have also assumed that another industry participant would be able to use the losses of Citrus to shelter its income. It must be realized that on a change in control there is a deemed year-end and therefore a year of loss carry forward expires.

We have quantifi ed the total losses available in a schedule below to approximately $52 million.


132

We have assumed that the taxable income is equal to Citrus’ earnings before tax.

Value of Losses

We have considered that the tax losses will likely have no value in use given the standalone operations of Citrus. Citrus does not have operations that can seemingly generate enough taxable income to use up the losses before they expire, and it does not appear that there is any latent tax liability to be generated on the sale of Citrus’ other assets. Therefore, it would appear that the losses would only have value in the context of a purchaser’s operations. In this regard, we have calculated the value of the losses under two separate scenarios:

1. On a rule of thumb basis2. The value of the losses if applied to Lettuce’s operations

Rule of Thumb BasisIn this regard, we have considered somewhat comparable transactions, as well as the comments of Mr. Orange that the rule of thumb for the use of such losses is 0.10 cents to 0.20 cents per dollar of tax loss. It should be noted that such rules of thumb are dangerous and should be used with caution (perhaps as a sanity check). Our analysis of comparable transactions is as follows: Price/LossSoftware 0.62Manufacturing 0.10Retail 0.20

When reviewing the comparable transactions the following points must be considered:

• None of the comparables are in the same industry as Citrus.• The Software transaction is a non-arm’s length transaction and may not be at FMV.• The Software transaction was not for cash and therefore a cash price may be lower.• There was a fairness opinion attached to the Software transaction, which would only

indicate that the shareholders were not disadvantaged.• The nature of the Manufacturing losses were such that they had a limited market, which

may aff ect the price, low end of rule of thumb range. A limited market may mean not all losses could be utilized by the available purchasers

• The Manufacturing transaction was at arms length and is therefore a more reliable indication of FMV.

• A lack of information regarding the Retail transaction could make it a less reliable indication, however it is in the high end of the range of rule of thumb values

• The retail transaction was arms length.• The comparables may be a diff erent size than Citrus.

133


Citrus Co.Analysis of Available LossesFor the Year-Ended December 31

Five Years Ago

Four Years Ago

Three Years Ago

Two Years Ago

One Year Ago

Net income (loss) before taxes

($36,181) ($9,624) ($8,138) ($9,871) ($10,872)

Add back depreciation 5,831 4,268 2,803 4,567 5,115Taxable income (loss) (30,350) (5,356) (5,335) (5,304) (5,757)Total losses (52,102) Rule of thumb 0.15 Rule of thumb $ (7,815)

Based on the above, we have assumed that a rate of $0.15 per dollar of loss may be reasonable. This would imply a value to the losses of approximately $7.8 million.

It should also be noted that there might be value attributable to the UCC tax pools of Citrus. We would require additional information in this regard to assess such value.

Value of Losses if Applied to Lettuce’s OperationsWe have also contemplated that the value of the losses may be attributable to the tax savings that could be realized by Lettuce. Given that Lettuce and Citrus operate in the same industry, and share common owners, it would be reasonable to consider Lettuce a potential purchaser which may benefi t from such losses. In order to utilize the losses Lettuce would have to purchase the shares of Citrus and then either amalgamate the entities, transfer productive assets, or wind up Citrus into the shares of Lettuce.

Our analysis of the tax savings to Lettuce is based on a diff erential discounted cash fl ow analysis below. Our analysis in this regard is based on the following:

• We have assumed that the pre-tax earnings of Lettuce is equal to the taxable income.• We have assumed a corporate tax rate of 35%.• We have generated a continuity schedule for using the losses.• We have assumed a discount rate of 15% based on the high end of comparable discount

rates for companies operating in this industry. We have used this rate to refl ect: - The risk in the projections of Lettuce.

- The risk associated with Lettuce’s operations.

- The use and application of the tax losses is not certain.


134

Lettuce CorpValue of Tax LossesFor the Year-Ended December 31

This Year Next Year 2nd Next

Year 3rd Next

Year

Opening balance of losses $52,102 $43,664 $32,910 19,859 Less: losses utilized (net income from above) (8,438) (10,754) (13,051) (19,554) Remaining balance 43,664 32,910 19,859 305

Losses utilized 8,438 10,754 13,051 19,554 Tax benefi t at 35% 2,953 3,764 4,568 6,844 Discounted at 15% 2,568 2,846 3,003 3,913Present value of tax benefi ts 12,331

Based on the foregoing, we have calculated a present value to the losses that approximates $12.3 million.

Therefore, it appears that the losses may have a value of approximately $10 million, (i.e. the average of $7.8 million and $12.3 million) when considered on a rule of thumb basis or applied to Lettuce’s operations.

Value of SynergiesOur analysis of the incremental after-tax cash fl ows to Lettuce is based on a diff erential or incremental discounted analysis. Our analysis in this regard is based on the following assumptions:

• The average earnings before tax and depreciation of Citrus over the last four years are considered maintainable, on average, into perpetuity.

• Savings of 2% of Citrus’ Cost of Goods Sold upon integration with Lettuce. (Citrus’ average Cost of Goods Sold over the last four years is considered maintainable into perpetuity)

• Savings of 15% of Lettuce’s warehousing costs upon integration with Citrus.• Savings of 10% of combined administration costs upon the integration of the two entities.

(The average General and Administrative costs for Citrus over the last four years is considered maintainable)

• Residual cashfl ow based on the 2nd next year’s combined earnings before tax. • Corporate tax rate of 35%.

We have generated a continuity schedule for using the losses.

We have assumed a discount rate of 20% in order to refl ect the following:

• The risk in the projections of Lettuce and Citrus• The risk associated with operations in this industry• The use and application of tax losses is not certain• The incremental risks associated with realizing synergies

135


Lettuce CorpValue of Tax LossesFor the Year-Ended December 31

Synergistic Value This Year Next Year2nd Next Year Residual Residual

Applied to combined entity Savings Pre-money EBT — Citrus (5,438) (5,438) (5,438) Pre-money EBT — Lettuce 8,438 10,754 13,051 Citrus COGS savings 2% 4,060 4,060 4,060 Lettuce warehousing 15% 854 864 875 Admin savings 10% 1,868 1,870 1,872 Total combined EBT 9,782 12,110 14,420 14,420 14,420

Opening balance of losses 52,101 42,319 30,209 15,789 1,369Less: Utilized (9,782) (12,110) (14,420) (14,420) 1,369Remaining balance 42,319 30,209 15,789 1,369 —

Combined taxable income — — — — 13,051Combined after-tax income 9,782 12,110 14,420 14,420 8,483Lettuce standalone income after tax 5,485 6,990 8,483 8,483 8,483Diff erence 4,297 5,120 5,937 5,937 —Present value at 20% refl ecting higher risk 20% 3,581 3,555 3,436 2,863

Total Present Value 13,435

Based on the foregoing, we have calculated a present value of the combined business that approximates $13.4 million. Additionally, it must also be realized that when Citrus’ operations are combined with Lettuce there are costs to be considered. Severance and costs of integrating the two operations will reduce the benefi t post acquisition. We have considered that the $12 million price received by Mr. Orange represents a discount on the value of $13.4 million, which may be attributable to the fact that a prudent purchaser in the marketplace may not pay full value for the combined synergies to be realized post acquisition.

Therefore, assuming another synergistic purchaser would exist in the marketplace for Citrus other than Lettuce, a fair market value of $12 million for the en bloc operations of Citrus may not be unreasonable. In which case, the $8 million implied value received by the Citrus Minority Shareholders would represent a 50% discount to the en-bloc value. This discount could be attributable to a minority discount as the Citrus Minority Shareholders cannot impact the timing of the sale, the cash fl ows of Citrus, nor can they readily liquidate their shareholdings. In which case, it could be argued that they should not share in the fair value of Citrus on an equal, pro-rata basis as the controlling shareholder. That is, if it is determined that the $12 million represents the en-bloc fair market value of Citrus, a 50% discount to refl ect their lack of control may not be unreasonable for the following reasons:

• Mr. Orange held signifi cant majority (75%);• There is a history of losses;• It appears that the value of Citrus on a standalone basis is tied to tax losses, which cannot

be realized internally;


136

• The majority of the tax losses was about to expire;• Citrus is a private company and there is no evidential source of liquidity; and• There is no evidence of an active M&A market.

If legal counsel determines that an oppression remedy is appropriate, such a minority discount would not likely apply. These courts have generally determined that a minority discount should not be applied in oppression cases. However, an oppression remedy may not apply to this situation because the minority shareholders were not forced out. Mr. Orange purchased their shares and they willingly sold. It is a legal determination as to whether the Citrus Minority Shareholders were dealt with in an oppressive manner.

Other considerations in this regard could be related to Mr. Orange’s duties as a director of Citrus and a signifi cant shareholder of Lettuce. Mr. Orange as a director and majority shareholder has the following duties to the other shareholders:

• Duty to the corporation in general• Duty to act honestly in the best interests of the Corporation• Duty to disclose an interest in a contract to which the corporation is a party• Duty to not appropriate corporate opportunity• Fiduciary duty to the shareholders where he, (as a director,) acts as an agent for the

shareholder in the sale of shares or where a takeover bid is made

In this case there is an argument that Mr. Orange used insider information regarding a potential purchase by Lettuce to profi t himself to the detriment of the other shareholders.

Should the minority shareholders be successful in an oppression remedy situation they would receive fair value for their shares. This has been determined by the courts to be fair market value without consideration of a minority discount. In this case, if it were proven that Mr. Orange withheld information about a potential purchase by Lettuce and therefore oppressed the minority shareholders, the fair value of the shares could be 25% of $12 million (the basis of which was discussed above) or $3 million rather than the $2 million they received.

ConclusionBased on the foregoing, it appears that the premium could be related to a control premium/synergistic premium. The Citrus Minority Shareholders receive a value for their shares that is refl ective of the value of the losses to a likely purchaser considered on a standalone basis (i.e., $8 million). Meanwhile, they did not receive the premium associated with being a controlling shareholder. Absent a legal view that this is an oppressive situation, the fi nancial merits of the premium appear reasonable in light of seemingly distressed nature of the expiring tax losses. However, it should be noted that additional information would be required to render a more defi nitive analysis. In this regard, we should suggest that a fairness opinion be conducted, to provide a more thorough analysis of Citrus’ projected operating results, fi nancial position, and potential of purchasers.

137


3.3 The Sale of Assets Versus SharesWhen a business valuator is associated with the purchase and/or sale of a business, it is important to realize that the vendor’s starting position for negotiations may be the fair market value of the company. However, the vendor’s most important consideration is the net proceeds at the completion of the sale. Therefore, when a vendor is presented with alternative ways to structure a sale or alternative compensation arrangements, the only consideration is what will net the most value to the vendor at the end of the transaction.

In this section, dealing with the sale of assets versus the sale of shares we will be calculating the net amount realized by the shareholder on the sale, rather than the fair market value of the assets or the shares.

It is important to remember that whether purchasing assets or the shares of the company, one is purchasing the same business entity. The tax considerations on a sale of assets or shares are diff erent, however, as long as all of the assets are being sold and all of the liabilities are being assumed, the same business is being disposed of. Therefore, if the shares of the corporation are valued using an earnings approach, and then when considering a sale of assets, please keep in mind that any intangible assets such as goodwill, that may not be recorded on the fi nancial statements of the company, must also be considered. A vendor would want to be compensated for the intangibles whether the shares or the assets are being sold.

3.3.1 Tax Consequences

The valuator should realize that the decision to sell/purchase shares or assets can have enormous tax consequences. In most cases, the vendor will prefer to sell shares, unless the corporation has unutilized tax losses that may be applied to off set income generated on an asset sale.

A vendor’s preference for a share sale is usually based on the availability of the capital gains exemption and the reduced rate of tax eligible on capital gains. The vendor will also usually avoid recaptured depreciation on a share sale.

The purchaser, on the other hand, will usually prefer an asset purchase rather than a share purchase. In a purchase of shares, the purchaser inherits the existing UCC balances related to the assets of the corporation. In an asset purchase, the fair market value of each asset is set up as the UCC. The purchaser can allocate the purchase price to depreciable assets and can claim capital cost allowance. However, the actual allocation of the purchase price is normally the result of negotiation between the vendor and purchaser.

3.3.1.1 Sale of AssetsWhen a vendor sells the assets of his/her company, a liquidation approach will aid in determining what cash the vendor will ultimately realize. It is important to realize, however, that if the assets of a successful business are being sold, one of the assets will be the goodwill associated with the business. This goodwill will likely not be listed as an asset on the balance sheet of the company. If it is listed as an asset, it will not likely be at the current fair market value. In either case, the


138

valuator will need to determine the goodwill associated with the business before being able to calculate the proceeds realizable on a sale of assets. In order to determine the fair market value of the goodwill associated with the business, the valuator will have to determine the fair market value of the business and then deduct the fair market value of the tangible assets and identifi able intangible assets.

3.3.1.2 Sale of SharesWhen determining the net proceeds available to the shareholder on a sale of shares, the valuator must consider the income tax payable on the sale. This will include consideration of whether the shareholder has used their capital gains deduction for qualifi ed small business corporation shares and whether the shares being disposed of are qualifi ed small business shares. For a discussion of the capital gains deduction and the criteria for a corporation to be considered a qualifi ed small business, see Lifetime Capital Gains Deduction in Canadian Tax Principles, Chapter 11.

It is necessary to determine the fair market value of the shares in order to determine a reasonable price for the shares. This must be done before the calculation of the net proceeds available to the shareholder can be completed. The implication here is that the FMV and Price off ered for a business is diff erent.

The example below illustrates the calculation where the vendor is considering whether to accept an off er for the purchase of the shares or the assets of the company.

EXAMPLE 3.3: SALE OF ASSETS VERSUS SHARES

Evelyn owns all of the shares of Notime Ltd, a CCPC that has been fairly successful over the past several years. Evelyn, however, has determined it is time to retire and therefore is entertaining off ers for her company. The current off er is to purchase the shares of the company for $135,000 or the assets of the company for $159,000.

EXAMPLE 3.3AFinancial information of Notime Ltd.Assets Cost UCC FMVCash $3,500 $3,500Accounts receivable 9,000 7,500Inventory 35,000 39,000Land 20,000 30,000Buildings 35,000 10,000 39,000Equipment 25,000 15,000 14,000Goodwill 0 0 26,000

127,500 25,000 159,000

Liabilities Current liabilities 18,000Long term debt 10,000Paid up Capital/ACB 5,000

Capital dividend account balance $15,000

139


Which off er would be more benefi cial to Evelyn? Assume: Corporate tax rate on business income 15% Corporate tax rate on investment income / capital gains 46% Personal combined federal and provincial tax rate 40%

Calculations:Sale of Shares

The Sale of Shares is a simple capital gains calculation. Shares are held personally by Evelyn and therefore there are no corporate tax implications on the calculation.

EXAMPLE 3.3BProceeds of disposition $135,000 Cost 5,000 Capital gain $130,000Taxable capital gain 50% 65,000Tax at 40% $26,000Proceeds (135,000 - 26,000) $109,000

This capital gain may be eligible for the QSBC Lifetime Capital Gains Exemption, if not used previously by Evelyn. If the LCGE is available, the calculation of proceeds would be as follows:

EXAMPLE 3.3CProceeds of disposition $135,000 Cost (5,000) Capital gain $130,000Lifetime Capital Gains Exemption (up to $750,000) (130,000)Adjusted Taxable capital gain $NilTaxable capital gain (50%) $NilPersonal Tax at 40% $NilProceeds (135,000 - Nil) $135,000

Sale of Assets:EXAMPLE 3.3D

Income Generated Notes Proceeds Business Investment CDA RDTOHOpening balance 15,000 Cash 3,500 Accounts receivable 1 7,500 (1,500) Inventory 2 39,000 4,000 Land 3 30,000 5,000 5,000 5,000Buildings 4 39,000 25,000 2,000 2,000 2,000Equipment 5 14,000 (1,000) Goodwill 6 26,000 13,000 13,000 Liabilities (28,000) 131,000 39,500 7,000 35,000 7,000Income Tax (9,145) 5,925 3,220 RDTOH 7 1,867 Amount available for distribution 123,722


140

EXAMPLE 3.3E Calculation of deemed taxable dividend on wind-up Funds available for distribution $123,722 Less: paid-up capital (5,000) Deemed dividend on wind-up $118,722 Less: capital dividend (35,000) Deemed taxable dividend $83,722

EXAMPLE 3.3FCalculation of taxable capital gain on disposition of shares Actual proceeds of distribution $123,722 Less: deemed dividend (118,722) Proceeds of distribution $5,000 Cost (5,000) Capital gain $0

EXAMPLE 3.3GNet cash retained after sale of assets Funds distributed on wind-up $123,722 Tax on income from distribution: Deemed taxable dividend 83,722 Gross up (38%) 31,814 Grossed-up dividend 115,536 Combined federal and provincial tax (40%) 46,214 Less: dividend tax credit (federal 15% and provincial 10%) (28,884) (17,330)Net cash retained 106,392

Conclusion: In both cases (LCGE available/LCGE unavailable) , it would be more benefi cial to sell the shares of the company.

Notes:

1. Accounts Receivable

Section 22 of the Income Tax Act allows a transfer of accounts receivable to a purchaser when all or substantially all of the shares of the company are being transferred. Section 22 allows the loss on receivables to be treated as a business loss rather than a capital loss. For a discussion of the mechanics of Section 22, see Accounts Receivable - ITA 22 Election in Canadian Tax Principles, Chapter 6.

2. Inventory

Section 2 of the Income Tax Act treats the sale of inventory as a regular business sale. No election is required.

141


3. Land

Proceeds of disposition $30,000 Adjusted cost base (20,000) Capital Gain 10,000 Taxable capital gain 5,000 Capital dividend account 5,000

4. Building

Proceeds of disposition $39,000 Adjusted cost base (35,000) Capital gain 4,000 Taxable capital gain at 50% 2,000 Capital dividend account 2,000 Original cost 35,000 UCC 10,000 Recaptured depreciation 25,000

5. Equipment

Proceeds of disposition $14,000 UCC 15,000 Terminal loss 1,000

6. Goodwill

Active business income (2/3(3/4 x 26,000))

$13,000

Capital dividend account (2/3(3/4 of 26,000))

13,000

7. RDTOH

Refundable portion of Part 1 tax to RDTOH

26 2/3 of investment income

$1,867


142

MQE QUESTION 3.3

On the morning of September 1st, this year, your boss, a well-respected CBV and partner in your fi rm rushes into your offi ce with a pressing matter. The two of you travel down the hallway to meet with Albert Aldersen. You’ve never met with Aldersen before, but on the way to the conference room, your partner gives you a quick rundown. Your fi rm has provided tax advice to Aldersen’s company, The Assorted Battery Company (“ABC”), for many years.

Your boss tells you that ABC is owned by two wealthy businessmen, Albert Aldersen and Bernie Butler. Both men own a series of independent high dividend paying businesses, and are only otherwise connected as they each own 50% of the outstanding shares of ABC. ABC distributes all sorts of batteries manufactured in China to commercial and industrial customers from their rented distribution warehouse in Toronto. The business has been around for 15 years, and sells across Canada, and approximately 15% into the U.S. Approximately fi ve years ago, the company embarked on a signifi cant expansion, purchasing a special battery handling machine from Germany, and entering the solar battery market. Your boss also hands you the client fi les for ABC, excerpts of which are attached in Table 3.3A. He also hands you their fi nancial statements, excerpts of which are attached as Table 3.3C-E.

After exchanging quick pleasantries with Albert, he begins to describe an awful feud between Albert and Bernie that has been simmering for a few years but has boiled over after Bernie’s daughter, broke up with Albert’s son last month. Albert shows you their shareholders’ agreement signed seven years ago, which clearly states the existence of a shotgun clause for one partner to get out of the business. Neither Albert nor Bernie are involved in the business (aside from collecting the steady dividends) as there are professional managers who run it.

Albert informs you that yesterday, a private equity fi rm out of New York, Fancy Suits LLC has sent a formal letter to ABC. The letter outlined the terms of a deal where Fancy Suits has off ered to purchase the assets necessary to operate the business from ABC for $3 million.

The letter indicates that the assets required are to be the working capital (accounts receivable, inventory, prepaids, accounts payable and accruals), warehouse equipment, distribution trucks and all intangible assets. Bernie indicates that he strongly wishes to vote his shares in favour of Fancy’s Suits’ off er as he thinks this is a good price, and that Fancy Suits is unwilling to entertain any type of share purchase. Albert says there are investors asking if ABC is for sale all the time and was not surprised about this recent off er.

After his son’s breakup with Bernie’s daughter, Albert doesn’t want to be partners with Bernie anymore. He doesn’t care if he holds 0% or 100%, just not 50%. Albert is not sure about his strategy, but realizes he needs help on what to do and quickly. He doesn’t know if the off er is good, and always has the shotgun if it isn’t.

Required:Prepare a memo to your boss outlining a draft strategy for Albert over the coming days. Comment on the engagement issues you see.

143


Client fi le excerpts

MQE QUESTION TABLE 3.3A• ABC was founded 15 years ago with the investment of $100,000 each by Albert, Bernie and

Curtis Calvary.• Curtis was bought out equally by Albert and Bernie just over seven years ago, for a total of

$250,000, valuing the whole company’s equity at $750,000.• There is a month-to-month lease for the warehouse rented from Albert at $75,000 per year

higher than market as compensation for Albert acting as chairman of the board of ABC.• The corporate tax rate on business income is 27.5%, investment income is at 48% and the

personal dividend tax rate is 31%. The UCC balances at August 31 this year were $900,000 for the warehouse equipment and $800,000 for the distribution trucks. The cost bases were $1.2 million for the warehouse equipment and $850,000 for the trucks.

• Neither Albert nor Bernie has ever used their lifetime small business capital gains exemption.• Robbie, the offi ce junior valuation student, has dug up several stats for you. His research,

that you have reviewed and agreed with, indicates that for companies like this, a Beta of 1.5 and an equity risk premium of 5% are appropriate. Robbie has not determined what specifi c risk premium is appropriate. Government bonds are yielding about 4%, and ABC’s capital structure and debt costs are similar to the rest of the industry.

• The battery industry is very stable with their major competitors being of comparable size and market share. There has been some consolidation lately by some of the well-funded players as they attempt to gain market share. ABC imports approximately 100 battery products from several suppliers in China, and they are of reasonable quality. The company has never had a recall issue. Customers know ABC for their prompt delivery schedules, and courteousness of the drivers of their ten trucks.

• Albert has always taken signifi cant dividends from the business based on the results of the company. He generally uses the money to fund his lavish lifestyle. His investing style includes investments in both shares in public companies that pay hefty dividends and 100% ownership of smaller companies that pay large dividends. When an investment isn’t yielding in the range Albert likes, he usually thinks it’s overvalued, and he sells it and reinvests his money in other higher yielding companies (see MQE Question Table 3.3F).

• Albert says that the distribution trucks are probably worth about $200,000 more than what the balance sheet says because they keep it in good shape. He says the warehouse equipment is worth about book value along with the rest of the working capital.

MQE QUESTION TABLE 3.3BCurrent Management team salariesDavid Dough, GM $ 110,000Edwin Ernie, controller $ 90,000Frannie Furgusen, warehouse, mgr. $ 90,000Albert Aldersen $ 25,000Bernie Butler $ 25,000


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Financial StatementsMQE QUESTION TABLE 3.3C

Balance Sheet As At August 31,The Assorted Battery Company

4th Last Year 3rd Last

Year2nd Last

YearLastYear

This Year

Cash 287,000 224,000 460,000 232,000 265,000Accounts receivable 600,000 590,000 700,000 680,000 730,000Inventory 1,300,000 1,400,000 1,350,000 1,480,000 1,580,000Prepaid expenses 50,000 40,000 50,000 65,000 60,000Interest free private mortgage to Gordon’s Discount Trucks

100,000 100,000 100,000 100,000 100,000

Warehouse equipment 1,250,000 1,144,000 1,039,000 983,000 918,000Distribution trucks 600,000 612,000 650,000 677,000 677,000Future tax assets 112,000 110,000 106,000 105,000 101,000Total assets 4,299,000 4,220,000 4,455,000 4,322,000 4,431,000

Accounts payable and accruals 1,000,000 950,000 1,210,000 1,100,000 1,215,000Bank loan 1,100,000 1,000,000 900,000 800,000 700,000Share capital 300,000 300,000 300,000 300,000 300,000Retained earnings 1,899,000 1,970,000 2,045,000 2,122,000 2,216,000Total liabilities and equity 4,299,000 4,220,000 4,455,000 4,322,000 4,431,000

MQE QUESTION TABLE 3.3DIncome Statement for the Year end August 31,The Assorted Battery Company

4th Last Year 3rd Last Year

2nd Last Year

LastYear

This Year

Revenue 5,000,000 5,100,000 5,202,000 5,306,000 5,412,000Cost of sales 3,305,000 3,361,000 3,444,000 3,528,000 3,572,000Gross margin 1,695,000 1,739,000 1,758,000 1,778,000 1,840,000 33.9% 34.1% 33.8% 33.5% 34.0% Distribution expenses 500,000 502,000 511,000 522,000 532,000Selling and marketing 450,000 459,000 468,000 478,000 487,000Administrative expenses 250,000 255,000 260,000 265,000 271,000Operating income 495,000 523,000 519,000 513,000 550,000Interest expenses (8%) 88,000 80,000 72,000 64,000 56,000Amortization 233,000 239,000 232,000 229,000 225,000Earnings before taxes 174,000 204,000 215,000 220,000 269,000Income taxes 52,000 61,000 65,000 66,000 81,000Net income 122,000 143,000 150,000 154,000 188,000 Retained earnings, beginning 1,838,000 1,899,000 1,970,000 2,045,000 2,122,000Net income 122,000 143,000 150,000 154,000 188,000Dividends (61,000) (72,000) (75,000) (77,000) (94,000)Retained earnings, ending 1,899,000 1,970,000 2,045,000 2,122,000 2,216,000

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MQE QUESTION TABLE 3.3ECash Flow Statement As at August 31, The Assorted Battery Company

4th Last Year 3rd Last Year

2nd Last Year

LastYear

This Year

Net income 122,000 143,000 150,000 154,000 188,000Future tax expense 6000 2,000 4,000 1,000 4,000Amortization 233,000 239,000 232,000 229,000 225,000 Changes in working capital Accounts receivable 110,000 10,000 (110,000) 20,000 (50,000) Inventory (70,000) (100,000) 50,000 (130,000) (100,000) Prepared expenses 10,000 10,000 (10,000) (15,000) 5,000 Accounts payable and accruals

(50,000) (50,000) 260,000 (110,000) 115,000

Cash fl ows from operations 361,000 254,000 576,000 149,000 387,000

Capital expenditures (1,050,000) (170,000) (190,000) (225,000) (185,000)Proceeds on disposal 25,000 25,000 25,000 25,000 25,000Cash fl ows from investing (1,025,000) (145,000) (165,000) (200,000) (160,000)

Dividends (61,000) (72,000) (75,000) (77,000) (94,000)Debt borrowings 1,000,000 0 0 0 0Repayment of debt (100,000) (100,000) (100,000) (100,000) (100,000)Cash fl ows from fi nancing 839,000 (172,000) (175,000) (177,000) (194,000)

Total cash fl ows 175,000 (63,000) 236,000 (228,000) 33,000Cash beginning of the year 112,000 287,000 224,000 460,000 232,000Cash, end of the year 287,000 224,000 460,000 232,000 265,000

Porfolion of Investments owned by Albert and BernieMQE QUESTION TABLE 3.3F

Portfolio of investments owned by Albert and BernieMarket

Cap DebtEnterprise

Value Revenue EBITDAAnnual

DividendsWee Toys 35 5 40 37 5 3.5Boxes R US 150 125 275 200 50 17.0Glasses, Glasses, Glasses 5 1 6 6 1 0.4Fantastic Flooring 425 50 475 220 75 38.0High Brow Furniture Mart 110 5 115 90 50 10.5Gordon’s Discount Trucks 60 120 180 200 15 5.5Cross Country Pipelines 1100 2,000 3,100 1,405 100 70.0

Notes:

1. Wee Toys is a distributor of toys to the North American market. They sell to big box retailers and small corner stores. Their products are weak and generally “throw-away” type.

2. Boxes R US is a manufacturer of cardboard boxes for moving companies. They sell directly to the moving companies throughout Canada and provide all the additional disposable supplies used in a move as well.


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3. Glasses, Glasses, Glasses is a high end luxury wine glass importer. The company operates a small manufacturing site in Estonia, and purchases the rest of their product line from glassmakers in Germany, Switzerland and Italy.

4. Fantastic Flooring retails carpet, hardwood and ceramic fl ooring in downtown Toronto. Known for consistently low prices, the store has a key location on Toronto’s main shopping sheet.

5. High Brow Furniture Mart is a furniture retailer with several stores across the Western Canadian provinces. In business since 1911, they are on track to continue their pace of opening one store a year.

6. Gordon’s Discount Trucks supplies pickup and heavy-duty trucks to the oil fi elds of Alberta.

7. Cross Country Pipelines operates two oil pipelines that carry crude from Montreal to Ontario, and from Moncton to New York City. The company has long term supply contracts in place for the next 20 years.

Notes:

Albert owns signifi cant minority positions in Boxes R US, Fantastic Flooring and Gordon’s Discount Trucks.

Bernie owns a majority of the shares of Gordon’s Discount Trucks and Glasses, Glasses, Glasses and a minority position in Cross Country Pipelines.

The equity markets have rebounded signifi cantly over the past year, but neither Albert nor Bernie signifi cantly adjusted their portfolios either before or after the market downturn. Albert believes the markets will go up and down, but his dividend paying stocks will be around for a while. He really likes the stocks he owns and uses them as benchmarks whenever he looks at other investments.

Solution:To: Boss, CBV

From: Me, CBV

Re: ABC

September 1st, this year

I have prepared a preliminary memo with respect to Albert’s situation.

Engagement issues:We have been asked to advise Albert with respect to the valuation of his shares in ABC.

We should provide an advisory report to Albert as he is requesting advice as to what to do with this off er for the company’s assets.

With an advisory report we are not independent.

Albert’s issues have many tax attributes. We should get someone from our tax group to review our calculations and advice prior to sharing with Albert.

Calculation of Fancy Suits’ off er:Please fi nd my analysis of Fancy Suit’s off er in terms of net cash proceeds for Albert.

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Asset Sale CalculationFancy Suits’ Off er for assets

ProceedsTax Cost

Base T.C.G. ABI RDTOH CDAAccounts receivable $730,000 $730,000 Inventory 1,580,000 1,580,000 Prepaid expenses 60,000 60,000 Warehouse equipment 918,000 900,000 18,000 Distribution trucks 877,000 800,000 13,500 50,000 3,600 13,500Accounts payable (1,215,000) (1,215,000) Intangibles 50,000 0 25,000 25,000 3,000,000 2,855,000 13,500 93,000 3,600 38,500 48% 30% 6,480 27,900 Asset sale proceeds 3,000,000 Cash 265,000 Redundant asset 100,000 Taxes payable (34,380) RDTOH 3,600 Term debt (700,000) Funds for distribution 2,634,220 2,634,220 Less: PUC (300,000) Capital dividend (38,500) Deemed taxable dividend

2,295,720

Dividend Gross up 38%

872,374

Taxable Dividend 3,168,094Personal tax 49% 1,552,366Dividend Tax Credit 25%

792,024

Dividend taxes (760,342) (760,342) Net cash to shareholders

1,873,878

50% ownership 936,939 Say 937,000

Note: the $50,000 of intangibles is calculated as the $3 million total price less the tangible net assets of $2,950,000.

Capital Loss on WindupTotal Distribution 2,634,220Deemed Dividend (Total distribution less PUC) 2,334,220Deemed Proceeds of Disposition 300,000ACB 450,000Capital Loss 150,000

Fancy Suits’ off er is worth $937,000 to Bernie in after tax dollars.


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Dividends from ABC:

Albert is a cash fl ow investor and wants a dividend stream from his investments. If the dividend isn’t high enough, he liquidates the asset and re-invests the proceeds in higher yielding securities.

Albert wants to know how much the company is worth to him. He has no interest in growing it, nor is he sentimental about it.

Dividend YieldWee Toys 10.0%Boxes R Us 11.3%Glasses, Glasses, Glasses 8.0%Fantastic Flooring 8.9%High Brow Furniture Mart 9.5%Gordon’s Discount Trucks 9.2%Cross Country Pipelines 6.4%

Based on a review of his portfolio, his other investments provide a dividend yield of 9-10%. This is the benchmark for performance.Capitalized Dividend ApproachYears ending August 31st

4th Last Year

3rd Last Year

2nd Last Year

LastYear

This Year

Dividends $61,000 $72,000 $75,000 $77,000 $94,000 Maintainable dividends A 94,000 100,000 (Increasing trend expected to continue) Above Market Rent 75,000 75,000

Tax benefi t (20,625) (20,625)Albert and Bernie Salaries 50,000 50,000

Tax benefi t (13,750) (13,750)Subtotal 90,625 90,62550% Payout Ratio of dividends to Net Income B 45,312 45,312 Adjusted maintainable dividends A + B 139,312 145,312 Dividend yields 9% 10% Capitalized dividends 1,547,911 1,453,120 Redundant asset 100,000 100,000 Equity value 1,647,911 1,553,120 Say 1,600,000 50% interest 800,000

Based on maintainable dividends from the Company of $94,000–100,000/year, and an adjustment for the rent charge and salaries (net of tax benefi ts), the company is worth approximately $1.6 million to him. Therefore, his shares are worth about $800,000 to him if he keeps it and continues to receive dividends. This value is less than the Fancy Suits off er, as it is likely that the $800,000 would be tax free due to the capital gains exemption. Given the dividend yield, Albert will not wish to hold on to this investment and hold 100% of it.

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Alternative valuation of ABC:An alternative to accepting Fancy Suits’ off er is to sell the shares of the ABC to someone else for FMV, as it appears that there are many willing buyers on the market. There are two methods of determining FMV for ABC: cash fl ow approach and adjusted book value. The cash fl ow approach is appropriate as the company is stable and producing growing cash fl ows. The adjusted book value approach is also appropriate as the assets of the company are signifi cant.

WACC Calculation Cost of equity: Risk free rate 4.0% Equity risk premium 5.0% 1.5x Beta 7.5% Company specifi c risk 7.5%

19% Equity weighting * 13.0% A

Cost of debt: 8% less taxes at 30% 5.6% Debt weighting * 1.7% B WACC (A + B) 14.6%

* 70/30 weightings, based on the recent FS

In determining the WACC, I have applied a 7.5% specifi c risk premium:

Reasons for a high premium:

• Small size• Commodity product• Lack of ownership of the land and building (which Bernie owns)• Fragmented industry in which ABC is not dominant

Reasons for a low premium

• Stable industry• Stable management• No product issues• Good reputation for courteous drivers


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Capitalized Cash Flow ApproachYears ending August 31st

4th Last Year

3rd Last Year

2nd Last Year

LastYear

This Year

Net income $122,000 $143,000 $150,000 $154,000 $188,000Rent normalization 75,000 75,000 75,000 75,000 75,000Salary normalization 50,000 50,000 50,000 50,000 50,000Income tax expense 52,000 61,000 65,000 66,000 81,000Interest expense 88,000 80,000 72,000 64,000 56,000Amortization 233,000 239,000 232,000 229,000 225,000Normalized EBITDA 620,000 648,000 644,000 638,000 675,000

Maintainable EBITDA 650,000 675,000 Taxes (178,200) (185,700) CAPEX (200,000) (200,000) Tax shield on CAPEX 40,332 40,332 Maintainable cash fl ow 312,132 329,632WACC 15% 14%Enterprise value 2,080,880 2,354,514Present value of tax shield 342,819 342,819Private mortgage (redundant asset)

100,000 100,000

Debt on hand (700,000) (700,000)Cash on hand 265,000 265,000Equity value 2,088,699 2,362,333Midpoint (rounded) 2,200,000

The valuation of the Company using a capitalized cash fl ow approach gives a value of approximately $2.2 million for 100% of the equity.

Asset based approach: Book value $2,516,000Plus: FMV increase in equipment 200,000Less: tax shield adjustment (note 1) (4,000)Less: future tax asset (101,000)Adjusted book value — rounded 2,598,000

Note 1 Foregone tax shield:A 310,884 (1,795,000 x 27.5% x 30%)/(14.6%+30%) x (1+.5 x 14.6%)/1+14.6%)B 314,462 (1,700,000 x 27.5% x 30%)/(14.65+30%)A-B 3,578 Rounded to 4,000

The valuation of the Company on an adjusted asset based approach is considerably higher than the other method performed.

There is also an open market transaction seven years ago when Albert and Bernie bought out Curtis. This transaction is too old, and the company was signifi cantly diff erent (no solar battery sorter) than today. This transaction is disregarded.

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After a quick review of the balance sheet of ABC, it appears that it qualifi es for ABC to use his $800,000 capital gains exemption. More than 90% of the assets are used in the business (only one $100k redundant asset), the assets are in Canada, and he has owned the shares for many years.

What Albert should do:The FMV of ABC is higher than the Fancy Suits’ off er, and therefore, Albert should not vote in favour of it. As neither Albert nor Bernie has more than 50% of the votes, Fancy Suits’ off er will not be accepted.

As Bernie feels that the value of the Fancy Suits’ off er is advantageous, he will be receptive to an off er of $960,000 (the value of his 50% interest) plus $1, and tender his shares to Albert if shotgun is triggered. This will be after tax proceeds as the capital gain exemption ($750k) plus his ACB ($100k original cost + $125K share of Curtis buyout) is greater than the proceeds.

After obtaining 100% of the shares of ABC, Albert will be free to sell the company for FMV to a willing suitor. We will need to assess if Albert has the capital to fund this $937,000 purchase.

Highest Proceeds $2,598,000Original cost base ($100k + $125k) (225,000)Cost base in buyout of Bernie (937,001)Capital gain 1,436,999Capital gains exemption (800,000)Capital gain after exemption 636,999Taxable capital gain 50% 318,500Taxes 46% 144,670After tax net proceeds (rounded) 1,500,000

Therefore, Albert should turn down the off er, shotgun Bernie at $937,001 and sell the company to someone else at FMV. He will net $1.5 million.

3.3.2 Goods and Services Tax (GST)

GST would not be payable on the acquisition of shares, since shares are an exempt fi nancial instrument. However, GST would be payable when the operating assets, such as inventory and equipment, are purchased directly. GST would not be payable on exempt fi nancial instruments, such as shares, bonds, notes and accounts receivable.

To the extent that the purchaser is registered, the GST would be recoverable through its input tax credit. Some cash fl ow relief is provided where over 90% of the property used in a commercial activity is being sold. In such a case, the purchaser and vendor can jointly elect not to be subject to GST.

Note: For purposes of this discussion we have not included a discussion of the Harmonized Sales Tax (HST) as HST varies by province.


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3.3.2.1 GST and Holding CompaniesSince a holding company is not engaged in a commercial activity, it cannot register for GST and therefore cannot recover any GST paid.

However, in certain circumstances, GST may be recoverable if it relates to shares or debt of a related company that is engaged exclusively in a commercial activity.

3.3.2.1 GST and Takeover FeesIf a registrant (the acquirer) were to acquire over 90% of the voting shares of a company engaged exclusively in commercial activities, GST paid on the takeover fees will be recoverable. The GST will also be recoverable if the proposed acquisition is abandoned. In other cases, where shares are acquired, the GST on the takeover fees will not be recoverable.

Fees paid to advisors would be part of the acquisition expenses.

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3.4 Trapped-in Capital GainsThe issue of trapped-in capital gains arises on the valuation of holding companies, or in fact with any company where the value is dependent on the value of the individual assets. If there has been any appreciation in the value of the individual assets held by the corporation, there will be a tax liability associated with this gain. The tax liability will only be realized when the corporation disposes of the asset.

Therefore, if the assets of the corporation are purchased, the vendor will have an immediate tax liability associated with the assets and the purchaser will acquire the assets at their full fair market value. This will be the new cost base for the purchaser. However, if the shares of the holding corporation are sold, the cost base of the assets does not change. When the corporation disposes of the assets, the purchaser will realize a tax liability associated with the gain that was accrued prior to their purchase of the shares, unless there has been a subsequent decline in value.

Obviously, a purchaser is interested in acquiring the assets and not paying more than the fair market value of the assets net of the income tax liability. However, the vendor recognizes that the income tax liability can be deferred indefi nitely if the assets are not disposed of, and hence these are the two extreme positions — the fi rst position being that the full income tax liability should be deducted from the assets and the second being that a large discount should be taken on the income tax liability since there may be an indefi nite deferral.

When calculating the amount realizable by the shareholder on a sale of assets, the tax on the sale of the assets is recognized in the corporation and the personal tax on distribution of the proceeds to the shareholder is calculated.

When there is a sale of shares, a potential purchaser will assume the tax gains or losses inherent in the corporation. In other words if the corporation owns land and building that have increased in value, the corporation will have to pay the tax on this gain at the point that the corporation disposes of the land and building. Therefore a potential purchaser will want to factor this future liability into the amount they would be willing to pay for the shares.

The theory is that if a potential purchaser is planning to sell the asset immediately they would include the full taxes in the calculation of what they would pay for the shares. If they plan to hold the asset indefi nitely, they would factor in the lost tax shield. When determining the fair market value of the shares, the intention of a potential purchaser is not always known. In these cases it can be argued to include the mid point between full taxes and the foregone tax shield to account for the future tax liability. There are articles included in with the course notes that discuss these points more fully.

3.4.1 Timing of the Realization of Income Tax Liability

Theoretically, the appropriate approach to the issue is to determine the timing of the realization of the income tax liability and then discount this eventual payment back to the present time.


154

Even if it were possible to determine the timing of the liability, two key assumptions would have to be made, including:

• What the income tax rates for the type of income being dealt with would be in the future. • The appropriate discount rate to present-value the future liability.

In practice, it will be exceedingly diffi cult to determine the timing of the eventual disposition of the assets with any degree of certainty. It must be realized that each situation is diff erent and every indication of the timing of the disposition should be considered when determining the quantum of the discount, if any, to be applied to the income tax liability inherent in the assets.

When there is no indication when the assets will be disposed of, the common practice has been to discount the income tax liability by 50%. This is considered the compromise position between immediate recognition and an indefi nite hold. This is straightforward and simplistic; however, in any given situation, a number of other factors may be considered.

3.4.1.1 Additional Tax IssuesA presentation on this issue by Stan Laiken, University of Waterloo, and Martin Pont, Rudson Valuation Group Inc., ap Valuations Limited, identifi es a number of additional issues to be considered. The presentation examines the various scenarios that are possible with a holding company and concludes that for non-depreciable property, potentially, no tax liability should be considered. This is because a “bump” is available on non-depreciable property through subsection 88(1)(d) of the Income Tax Act. This “bump” allows a purchaser corporation to purchase the shares of the holding company and then wind up the holding company into the purchaser corporation.

Subsection 88(1)(d) allows a bump to the adjusted cost base of the asset on the wind-up and therefore the purchaser will have an increased ACB of the asset and a decrease in the tax liability eventually realized on disposition. This bump eff ectively eliminates the inherent tax liability on non-depreciable assets. This makes intuitive sense since the shares of the subsidiary have a cost base equal to the fair market value of the company. On the windup, the shares will be eliminated. The assets of the subsidiary will move into the parent company. Therefore the cost base of the shares that will no longer exist will be transferred to the assets.

The presentation continues to consider depreciable property. The range of possible discounts considered was again from immediate disposition to indefi nite hold. This equated to 100% of the taxes on an immediate disposition, to the tax shield foregone on an indefi nite hold. If the depreciable assets are acquired through an acquisition of the shares and held indefi nitely, the only disadvantage the purchase would realize is the tax shield foregone on these assets. It is still necessary to choose either end of this range or a point between this range; however, the range has been narrowed from a consideration of no taxes to full taxes.

3.4.2. Book Value Versus Tax Values

When completing a valuation assignment, the valuator must analyze the fi nancial statements of the company. It is important to analyze the fi nancial statements to determine fi nancial risk and

155


redundant assets, as well as the various operational issues associated with the company. These issues must be considered when contemplating the purchase of a company.

It is also important to realize that the current and future income tax liabilities that the company will experience is based on tax values that do not always correspond to the book values on the fi nancial statement. The most obvious example of this is book value versus UCC.

As you are aware, depreciation and CCA do not correspond in most instances. CCA is based on the Income Tax Act and the rate assigned to each class of assets. Depreciation for fi nancial statement purposes does not have to correspond to the same method or rate as the Income Tax Act. In addition, CCA is a discretionary deduction; i.e., if there is a year when the company has a net loss and a CCA claim would only increase the loss, it does not need to be claimed. As a result, there could be a greater or lesser income tax shield associated with the assets of the company than indicated by the fi nancial statements.

Similarly, various reserves that would be taken for fi nancial statement purposes will not be allowed for tax purposes. Reserves for obsolescence, allowance for doubtful accounts, etc. can be deducted for fi nancial statement purposes but not for tax purposes.

One of the greatest concerns for a purchaser would be if expenses recognized for tax purposes have not been refl ected in the fi nancial statements of the company and therefore may cause greater income tax liabilities in the future. One example of this would be computer software, which is eligible for a CCA rate of 100%. The software will have been fully deducted for tax purposes but still carried on the fi nancial statements at a potentially signifi cant value. As well as these timing diff erences, there will be items that are not deductible for tax purposes. For example, some legal fees and some interest expenses may not be deductible at all and yet will appear on the fi nancial statements of the company and therefore potentially give the impression the income tax liability will be smaller than will actually be the case.

3.4.3 Future Income Taxes

It is important for the valuator to note that current accounting standards allow some private companies to elect to do their tax accounting on what used to be called a fl ow through or cash taxes basis (i.e., no future income taxes) and thus there is no fi nancial statement indication that there are diff erences between the accounting and tax basis of assets and liabilities.

All of the diff erences between book values and tax values of assets and deductions from taxable income will be refl ected in the future income tax account of the company. A complete understanding of the diff erences between what has been expensed for fi nancial statement purposes and what has been allowed as a deduction for tax purposes is required in order to understand the impact on the future income tax liability for the company.

A future income tax liability is the result of a company claiming expenses for tax purposes that have not yet been claimed for accounting purposes. Conversely, a future tax asset is a result of expenses being claimed for accounting purposes that have not yet been claimed for tax. A common example is when CCA is claimed for tax purposes but a diff erent amount is expensed for depreciation in the accounting records.


156

Future income tax liabilities or assets will not have an eff ect on a valuation if a liquidation approach is taken. All of the tax eff ects of the disposition of the assets will be considered in the liquidation calculations, so the future income tax balance will have no eff ect and therefore should be eliminated from net assets.

For an adjusted asset value approach, however, the future income tax account will need to be considered. When assets are restated to their fair market values, these fair market values must be compared to the tax basis of the asset to determine the economic value of the future income tax liability.

When the shares of the company are being purchased and therefore the asset values are not being adjusted to fair market value, there may be a foregone tax shield that will need to be deducted from the fair market value of the assets.

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3.5 The Canadian Business Corporations Act (“CBCA”)Please note that any references to sections of the CBCA are required reading. These readings can be found by using an Internet search engine such as Google. These readings are not shown here as they are constantly being updated.

3.5.1 The Position of Majority Shareholders

The position of the majority shareholder(s) (the “majority”) of a corporation at common law in its dealings with the minority shareholder(s) (the “minority”) and with the corporation itself is defi ned more by what the majority may not do rather than what it may do. Prior to 1975, the basic common law rule regarding the rights of the majority in respect of the corporation was that it could exercise its rights as it saw fi t. The majority controlled the election of the board of directors and the directors had the authority to manage the company and to act on the company’s behalf.

The directors had, at common law, a duty to act honestly and in the best interests of the company. The majority was under no duty to act in the best interests of the corporation — it could vote its shares in its own interests, absent fraud or oppression toward the minority. The duties of directors are discussed in greater detail later in this section.

The common law developed through the 20th century provided for the greater protection of minority interests and, correlatively, the greater limitation of the rights of the majority. However, the major step forward in the protection of minority shareholder interests came in 1975 by amendments to the Canada Business Corporations Act (CBCA) and to the provincial corporation’s legislation in the years following. These limitations upon the power of the majority, being rights accorded to the minority to enable the minority to protect its interests as against the majority, are dealt with later in this section.

The majority, in the normal course, still controls the board of directors and the board has the power to manage the company. Therefore, this section focuses more upon the rights and responsibilities of directors (through whom the will of the majority is expressed) to the corporation and to the shareholders.

3.5.2 Statutory Rights of the Majority Shareholders

Although minority shareholders have by statute been accorded signifi cant rights, there is one substantial right accorded to the majority as against the minority. It is that the maker of a take-over bid within the meaning of that term in the CBCA may, in certain circumstances, acquire the shares of the minority by statutory authority. (See elimination of minority shareholders by compulsory acquisition — Section 206 of the CBCA).

A take-over bid is defi ned in the CBCA as being an off er to shareholders to acquire shares of any class, which, if acquired, would give the off eror (the person making the off er) more than 10% of the shares of that class. If the take-over bid is accepted by not less than 90% of the shares to


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which the take-over bid relates, the off eror has the right to acquire all of the remaining shares of that class. Where the off eror does so, he/she has to notify those reluctant shareholders, defi ned as “dissenting off erees,” that he/she has acquired 90% of the shares that he/she off ered to buy (and which he/she did not already own) and that the dissenting off erees are now obligated to tender their shares either at the off ered price or to demand payment of fair value for the shares pursuant to specifi c provisions of the CBCA. If the latter course is taken, then the off eror or, failing it, the off erees, may apply to the court to fi x a fair value for the shares.

By way of example, in Ontario, under the Ontario Business Corporations Act (OBCA), where the acquirer of 90% of the shares has the right to compulsorily acquire the remaining shareholders’ shares but chooses not to exercise that right, the remaining shareholders may compel the acquirer to purchase their shares at fair value. Fair value and fair market value will be discussed later in the chapter.

3.5.3 The Position of Minority Shareholders

The basic rule of company law with respect to the operation of corporations is referred to as “the rule” in Foss v. Harbottle, an English court decision from 1843. In that case:

1. The aff airs of the corporation were the exclusive preserve of the majority of shareholders of that corporation.

2. The directors of the corporation, who were the majority shareholders, sold their personal property to the corporation at infl ated prices.

The “rule” that came out of the consequent litigation was that, notwithstanding the injury to both the corporation and to minority shareholders, it was only the corporation that could bring an action to redress injury to it and that it was for the majority of shareholders to decide whether action would be taken in the company name. Therefore, the courts would not interfere with any expression of the will of the majority shareholders, short of outright fraud, even where there had been injury to the corporation and to the minority shareholders. Majority rule meant what it said.

The courts made some modifi cations to the rule in Foss v. Harbottle based on fairness. These modifi cations placed limitations upon the ability of the majority of shareholders to vote their shares without regard to the interests of minority shareholders, or to ratify acts that were irregular under the company’s articles and by-laws.

An aggrieved shareholder could apply to the court to have the corporation wound up and its assets distributed to the shareholders. However, unless one could show dishonesty or fraud on the part of the majority, relief to the minority shareholder was very diffi cult to achieve.

As one might expect, the court was reluctant to give the minority shareholder a remedy that had the eff ect of putting out of existence an otherwise viable corporation. Therefore, the position of the minority shareholder in a corporation continued to be one of considerable disadvantage concerning the majority shareholders of the corporation.

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3.5.3.1 Minority Rights Strengthened in 1970s In the early 1970s, a major change in dealing with the unfair treatment of minority shareholders occurred when the federal and provincial legislatures statutorily strengthened the rights of these shareholders. When it came into force, the CBCA provisions provided the most substantial protection of its kind compared with other countries with similar corporate systems. Not only has the range of conduct (of the corporation, the majority shareholders and the directors) triggering a protective right on the part of the minority shareholder been expanded, the protective remedies themselves are also diverse. This increased diversity in the kind of remedy the court may grant has made obtaining relief more likely.

3.5.4 Statutory Rights of Minority Shareholders and Creditors

The rights of a minority shareholder (or creditor) that protect his/her interest in a corporation are now almost entirely statutory and are found in the CBCA or Business Corporations Acts of each of the provinces.

These rights are discussed under the following headings:

1. Right of access to corporate information.2. Right to a degree of participation in management.3. The dissent (appraisal) remedy.4. The derivative action — the right to bring an action on behalf of the corporation.5. The right to set aside a contract in which a director has an undisclosed interest.6. General right to enforce compliance with the CBCA.7. The “oppression remedy.”

3.5.4.1 Right of Access to Corporate InformationThese rights include:

• Basic shareholder lists

Every corporation is required to keep a list of shareholders, their addresses, and the number of shares held by each. Any shareholder (or agents and legal representatives of any shareholder) and creditors of the corporation can require the corporation to furnish such a list.

• Access to documents

A corporation is required to keep at its registered offi ce all of the following documents, and every shareholder, voting and non-voting, is entitled access to them:

- Articles, by-laws and unanimous shareholder agreements.

- Minutes of shareholders’ meetings (but not minutes of directors’ meetings).

- Shareholders’ resolutions.

• Notice of meetings

Every shareholder entitled to vote is entitled to notice of shareholders’ meetings.


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Where “special business” is intended to be transacted at the meeting (“special business” is defi ned as all business transacted at shareholders’ meetings except the basic business trans-acted at the annual meeting, namely consideration of fi nancial statements, of the auditor’s report, election of directors and reappointment of the incumbent auditor), the notice must state the nature of the special business in suffi cient detail to permit the shareholder to form a rea-soned judgment upon it. The standards of such notice are high.

• Financial disclosure

The directors of the corporation must send to the shareholders not less than 21 days before the annual meeting comparative fi nancial statements and the auditor’s report. Such statements and report must be placed before the shareholders at the annual meeting.

The shareholders and their agents and legal representatives also have access to the fi nancial statements of any subsidiaries of the corporation.

3.5.4.2 Right to a Degree of Participation in ManagementThese rights include:

• Annual meeting

The directors must call an annual shareholders’ meeting, at which, at least, the fi nancial statements and auditors’ report are placed before the shareholders, and the directors are elected.

• Right to vote at the shareholders’ meetings

Every share entitles the holder to one vote at the shareholders’ meetings, unless the corporation’s articles provide otherwise. The vote may be exercised personally or by proxy.

• Right to requisition a meeting

Holders of 5% or more of the voting shares may require the directors of the corporation to call a meeting for special purposes. If the directors do not call the meeting within 21 days, the requisitioning shareholder may call the meeting. The availability of the shareholders’ list to all shareholders gives the shareholders the means by which to communicate with all other shareholders.

• Right to make a proposal at a shareholders’ meeting

A shareholder may raise any matter at the shareholders’ meeting, including a proposal to elect a certain director (if the proposing shareholder has 5% of the voting shares, or shares that have a value of at least 1% of the value of all the shares outstanding). If the corporation is soliciting proxies prior to the meeting, a shareholder may require the corporation to include the proposal and a supporting statement in the management proxy circular that must be sent to all shareholders.

• Election of directors

The shareholders control the constitution of the board of directors by their power of election of directors and by their power of removal of directors from offi ce. Election and removal is by ordinary resolution (simple majority) at the annual meeting or a special meeting.

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• Right of approval over by-laws passed by directors

The directors of a corporation may not unilaterally pass by-laws of the corporation. By-laws passed by the directors must be put before the shareholders at the next shareholders’ meeting and may be accepted, rejected, or amended by simple majority. This also applies to the repeal of, or the amendment of, by-laws by the directors.

• Right of approval by special resolution over amendments to the articles of incorporation

The CBCA sets out the kinds of changes that may be made to the articles of a corporation for which a special resolution of the shareholders is necessary. Such changes include changes in name, place of head offi ce, restrictions upon the kind of business that may be carried on, and, most importantly, changes aff ecting the share structure of the corporation that might aff ect the value of any share interest in the corporation. A special resolution under the CBCA requires a 2/3 majority of the shares voted. In some provinces, it is a three-fourths majority. Notice of the intention to amend the articles must be given to the shareholders, which notice must contain the proposed amendment.

• Right to vote as a separate class, whether that class of share carries with it the right to vote

This is a very important right of both voting and non-voting shareholders. In addition to the requirement that certain amendments to the articles of the corporation and certain other acts described below (referred to as “fundamental changes”) be passed by special resolution, each class or series of shares is entitled to vote separately, whether the class or series of shares carries the right to vote. Therefore, the proposed corporate act must be passed by two-thirds (or 3/4 in some provinces) of each class of shareholder. This vote takes place at a special meeting called for this purpose. Notice of this special meeting must be given to all shareholders and the notice must include suffi cient information about the proposed corporate act to permit the shareholders to make an informed judgment about it at the time of the meeting.

This special resolution requirement and right of separate vote for each class arises: 1. When the proposed amendment would aff ect the share structure or privileges and

rights attaching to that class or series of that class. Therefore, the holders of one class of shares cannot be disadvantaged by an amendment to the share structure aff ecting the value of those shares (creating a new class of shares ranking ahead of an existing class in participation and dividend rights, for example) unless that class itself passes the amendment by special resolution (2/3, or 3/4 majority depending on the province).

2. Where the directors propose to sell, lease or exchange “substantially all of the property of a corporation.”

3. Where the directors resolve to amalgamate the corporation with another corporation. 4. Where the directors resolve to wind up the corporation.

• Right of control over appointment of auditor.

The shareholders, by ordinary resolution, appoint the auditor at the annual meeting and may remove the auditor by ordinary resolution. Pursuant to the CBCA, the auditor or former auditor who becomes aware of a material error or misstatement in a fi nancial statement must inform


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each of the directors accordingly. This advice imposes a duty on the directors to prepare and issue revised fi nancial statements. Note that closely-held corporations (i.e., corporations that do not off er their shares for sale to the public) do not have to appoint an auditor if the shareholders vote unanimously not to do so.

• Right to solicit proxies

A shareholder may solicit proxies of other shareholders provided that the shareholder sends to each shareholder of the corporation a circular stating the purposes of the solicitation. Solicitations by management for votes must be accompanied by a management proxy circular, paid for by the company, whereas a solicitation by a (often dissenting) shareholder must be accompanied by a dissident proxy circular paid for by the shareholder.

Note: If a management proxy solicitation contains a false or misleading statement, a shareholder may apply to the court for an order restraining the solicitation.

3.5.4.3 The Dissent (Appraisal) RemedyThe dissent (or appraisal) remedy is the right to have all of one’s shares purchased at fair value, where the majority of the corporation resolves to eff ect specifi ed fundamental changes in the way the corporation is to carry on business. The rationale is that the investment was made on the basis of the initial business operations and corporate structure and, if changes are made notwithstanding sound business reasons, an investor who disagrees with the new direction should have the right to exit the company.

The eff ect of the dissent remedy is to entitle a holder of any class of shares of a corporation that proposes to make a fundamental change in its structure or operations to obligate the corporation to purchase all (but not less than all) of the shareholder’s shares of that class at the fair value of those shares. If the corporation does not off er an amount for the shareholder’s shares that the shareholder believes to represent the fair value of them, both the shareholder and the corporation are entitled to apply to the court for a determination of that fair value.

This dissent remedy permits the minority shareholder to walk away fully paid from the corporation when certain changes, specifi ed in the CBCA, are made with which the shareholder does not agree. This is an important remedy because, historically, the minority shareholder has been “locked in” to the corporation despite the fact that he/she may disagree with a new and fundamental change in the direction the corporation is taking. The reason for the lock-in is that there is usually no market, aside from the other shareholders, for the minority shareholder’s shares. This dissent right gives the minority shareholder a right to refuse to participate in ventures not originally contemplated by the corporation by providing a way for that shareholder to terminate his/her participation without suff ering a substantial fi nancial loss.

The extent of the specifi ed fundamental changes giving entitlement to dissent remedies under the CBCA essentially relates to a change in share structure, or fundamental direction of business operations, and more specifi cally covers the situations below. It is important to be familiar with fundamental changes as to know when a shareholder can potentially employ a dissent remedy:

1. Where the corporation resolves to amend its articles of incorporation under section 173 or 174 to add, change or remove any provisions restricting or constraining the issue,

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transfer or ownership of shares of that class. This provision seeks to protect the minority shareholder from a diminution in the value of his/her shares as a result of a restriction in the issue, transfer or ownership of his/her class of shares.

2. Where the corporation resolves to amend its articles of incorporation in a manner that would change the corporation’s share structure or the characteristics of any class of shares in a manner that would adversely aff ect the holder of any class of shares. Section 176 is the provision in the CBCA that gives to the shareholder of any class of shares (or any series of any class of shares, in certain circumstances) the right to vote on corporate resolutions to change the share structure of that corporation or to change the characteristics of authorized share capital, whether or not that class of shares carries with it the right to vote. Such a resolution would not pass unless it received suffi cient votes (having regard to whether an ordinary or special resolution is required) from each class of shares issued by the corporation, as described earlier. The purpose of this provision is to protect the rights of a shareholder of a class of shares in relation to the corporation and to the other shareholders. Otherwise, the majority of voting shareholders could reduce the value of any class of non-voting shares by creating and issuing a class of shares that ranks ahead of the class in question in terms of voting, dividend or participation on wind-up rights. Section 176 sets out in detail the kinds of corporate resolutions aff ecting share structure or share characteristics giving rise to the right to vote as a class. The theme of these resolutions has to do with the creation of new shares or classes of shares, the modifi cation of characteristics of existing classes of shares or the exchange of one class of shares for another with diff erent characteristics. In all of these cases, the shareholder may be adversely aff ected by the creation, modifi cation or exchange. For example, if the corporation resolved to cancel all class A preferred non-voting shares and substitute therefore class B preferred non-voting shares with inferior participation rights upon wind-up, the class A shareholders could not only vote as a class on the proposed resolution but they could also dissent all of their shares and be paid fair value for them if the resolution passed. This right of dissent is provided by subsection 190(2) of the CBCA.

3. Where the corporation resolves to amend its articles of incorporation under section 173 to add, change or remove any restriction on the business or businesses that the corporation may carry on, a dissent remedy may be pursued.

4. Where the corporation resolves to amalgamate with another corporation, a dissent remedy may be pursued (however, this right of dissent does not apply to an amalgamation of a holding corporation and one or more of its subsidiaries or to the amalgamation of two subsidiaries of the same holding company).

5. Where the corporation proposes the sale, lease or exchange of all or substantially all of its property under subsection 189(3), a dissent remedy may be pursued. In the event that a corporation proposes to pass one of these specifi ed fundamental changes, a notice of a meeting at which the proposal will be presented and voted on must be sent to all shareholders along with a copy of the proposed resolution and a statement that shareholders may dissent their shares and be paid fair value for them in accordance with the CBCA.


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6. 6. Where a dissenting shareholder and the corporation cannot agree to a fair value of the dissenting shareholder’s shares, either party may apply to the court to fi x a fair value.

3.5.4.4 The Derivative Action — The Right to Bring an Action on Behalf of the Corporation Where a corporation’s interests are being injured and a remedy is available either at common law (i.e., breach of contract) or under the CBCA, it is the directors of the corporation who have the authority to take action on behalf of the corporation. For example, where directors representing the majority shareholders enter into contracts on the corporation’s behalf benefi ting the directors (or the majority) personally but harming the corporation, the directors are unlikely to cause the corporation to bring an action against themselves. In this circumstance, a shareholder (or, with the permission of the court, a creditor) may apply to the court for the authority to bring an action on behalf of the corporation, whatever that proper action may be (e.g., breach of directors’ duties to the corporation, breach of contract, an action for negligence). Such an action is called a derivative action.

This permission (called “leave”) of the court to the shareholder to bring a derivative action is dependent upon the shareholder showing that:

1. The shareholder has notifi ed the directors that he/she will apply to the court for leave to bring an action on behalf of the corporation if the directors take no action to remedy the situation (e.g., the harmful contracts situation).

2. The shareholder is acting in good faith. 3. The bringing of an action by or on behalf of the corporation is in the corporation’s interests.

In other words, the derivative action must be taken from the standpoint of righting a wrong that has been done to the corporation. It is not meant to rectify a wrong done to an individual shareholder Where the economic injury caused by the directors and/or the majority shareholders causes direct economic injury to the minority shareholder, the proper remedy is the “oppression remedy,” the specifi cs of which are set out in the statute, as discussed later in 3.5.4.7 below.

3.5.4.5 Right to Set aside a Contract in which a Director has an Undis-closed InterestUnder the CBCA, a director or offi cer must disclose his/her interest in any ‘material’ (as opposed to ‘insignifi cant’) contract with a corporation. If the director does not, a shareholder may apply directly to the court to have the contract set aside without having to fi rst apply to the court for standing to bring an action on behalf of the corporation (a derivative action).

However, if the director does disclose his/her interest to the board of directors and does not participate in the vote on the matter, the contract is not invalid by reason only of the confl ict of interest, provided that the contract was approved by the directors and it was fair and reasonable to the corporation at the time it was approved. Even in circumstances where disclosure was not made to the directors, the shareholders have the ultimate right to approve the contract provided that disclosure was then made and that the contract is fair and reasonable to the corporation.

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3.5.4.6 General Right to Enforce Compliance with the CBCAA shareholder may apply to the court for an order directing the corporation or any offi cer or director or auditor (among others) to comply with the provisions of the CBCA, or an order restraining such person from acting in breach of the Act. This is in addition to any other remedy a shareholder might have under the CBCA. It is a very wide provision and even permits shareholders with a very small shareholding to enforce the corporation’s or majority shareholder’s compliance with the Act. A compliance order may also be sought with respect to a unanimous shareholders’ agreement.

3.5.4.7 The “Oppression Remedy”The “oppression remedy” is a powerful remedy: it is the right of personal action against the corporation, majority shareholders or directors of the corporation where the actions of any of these are oppressive to, are prejudicial to, or unfairly disregard the interests of the minority. Prior to the major overhaul of the CBCA and provincial legislation in the early 1970s, the only eff ective remedy available to the minority shareholder in cases of oppression by the majority was the wind-up of the corporation.

The CBCA provides a remedy to oppressed minority shareholders without forcing the break-up of the company. Relief may be given to a minority shareholder upon proof of oppressive behaviour, unfair prejudice to, or disregard of his/her interests by the corporation through its shareholders or directors.

The access by an oppressed minority shareholder to a court remedy is signifi cantly easier under the oppression remedy provisions of the CBCA than was the case at common law. Further, the range of remedies available to a court to rectify the situation complained of is much more extensive than at common law.

• Who may bring an application for an oppression remedy?

Section 241 permits a “complainant” (a shareholder or a holder of a debt obligation) to make an application to court to rectify the matter complained of where:

1. Any act or omission of the corporation eff ects a result.2. The aff airs of the corporation are being carried out in a manner that is oppressive or

unfairly prejudicial to, or that unfairly disregards the interests of any security holder.3. The powers of the directors are being exercised in a manner, that is oppressive or

unfairly prejudicial to, or that unfairly disregards the interests of any security holder.

• What is oppressive?

The critical question regarding the application of section 241 is what kind of conduct constitutes conduct that is oppressive. Section 241 describes “oppression” as an act or omission which is “unfairly prejudicial to or that unfairly disregards the interests of any security holder, creditor, director or offi cer”. It is always a matter of fact in any event whether the conduct complained of satisfi es the above test.

With regard to the meaning of “unfairly prejudicial to or unfairly disregards the interests of any security holder”, the courts have accepted that these characterizations of conduct, in addition to the term “oppressive”, widen the kind of conduct giving rise to an oppression remedy. On the other hand, not every corporate act resulting in the disregard of or prejudicial to the minority’s


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interest gives rise to a remedy under section 241. In 1991, the Ontario Court of Appeal in Brant Investments Ltd. v. Keeprite Inc. (1991) 3 O.R. (3d) 289 held that: …the provisions of s. 241 curtail the rights and powers of the majority only to the extent

expressly provided, and by implication recognize that such rights and powers may be exercised to the prejudice of the minority (if not unfairly) and may disregard the inter-ests of the minority (if not unfairly).

It is useful to group the circumstances in which the courts have found the oppression remedy applicable:

• Exclusion from participation in the closely-held corporation

In Ferguson v. Imax Systems Corp., (1983) 43 o r (2d) 128, the Ontario Court of Appeal found that, where the majority shareholders of a corporation refused to declare dividends on preference shares held by a minority shareholder beyond a minimum rate (although capable of doing so), and proposed to redeem the preference shares to shut the minority shareholder out from further participation in the corporation, the majority shareholders were guilty of conduct oppressive or unfairly prejudicial to the applicant. The minority shareholder in this case was the former spouse of one of the founding shareholders in the company. The court found that her exclusion from the corporation was not incidental, but rather quite intentional on the part of the directors of the corporation. In essence, the conduct was motivated by personal interest, and not those related to the best interest of the corporation.

In another Ontario case involving a 50-50 shareholder deadlock situation, the court held that it could fi nd oppression by one shareholder of the other. The rights and obligations of the two were governed by a shareholders’ agreement, which set out that both were to participate in the management of the company. One of the shareholders had tried to oust the other from participation in the company by, among other things, having him arrested on what the court accepted as a groundless weapons charge. The court held that the deadlock had been caused by this one shareholder and that the act of trying to force the other out of participation in the company by these means was in contravention of the shareholders’ agreement and constituted oppression within the meaning of section 247 (now 248) of the Business Corporations Act of Ontario.

• Denial of legitimate expectation of minority shareholders

Recent cases have discussed, from a diff erent perspective, the underlying rationale behind the oppression remedy, namely, the protection of reasonable shareholder expectations. These cases constitute new thinking in this area, as shareholder expectations historically have not been the touchstone of whether unfair prejudice to the interest of a minority shareholder has taken place.

The Ontario Court of Appeal in Naneff v. Con-Crete Holdings Ltd. (1995), 23 O.R. (3d) 481 held that in the context of a family-run corporation, the dismissal of a shareholder-director-offi cer-employee from his offi ce and employment constituted oppressive conduct on the part of the corporation and its directors. The applicant was one of two sons to whom 50% equity ownership in a group of companies — RCG — had been given by the father in an estate freeze. The father

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still controlled RCG through preference shares in the holding company — CCHL — in which the two sons held the common shares. The intention and expectation of the parties following the estate freeze was that the applicant and his brother would control, as well as being equity owners of, RCG when the father retired. Serious diff erences arose between the applicant on the one hand and the father and other brother on the other hand. The applicant’s personal lifestyle was unacceptable to the father and other brother from both a personal and business perspective, as a consequence of which the father and the other brother colluded to:

- Create a new class of voting shares in CCHL and issue them to the father and his wife.

- Change the dividend policy of CCHL to pay out large dividends and bonuses to the father who then lent the money back to CCHL. This had the eff ect of diminishing the value of the common shares of CCHL and replacing that value with debt to the father.

- Increase the salaries to the father and the brother, which was done without notice to or suffi cient information to the applicant.

- Dismiss the applicant as an employee and offi cer of the RCG.

- Refuse to pay him the large shareholder loans owed him by RCG.

- Render his presence meaningless as a director and shareholder of RCG.

The court held that the underlying theme of the oppression remedy is its emphasis on the protection of reasonable shareholder expectations in the context of the shareholder relationship. This being the case, the reasonable expectation of the applicant was that he and his brother would inherit control of RCG along with the equity ownership they already had. The applicant had worked for a long time in the business and had lent back to the corporation a great deal of the dividends which he had been paid in the past years. In this context, the above-noted steps taken constituted oppression, in particular step 1, above which was an expression of the intention to leave control of RCG to the other brother, again contrary to legitimate expectations of the applicant. Had the steps taken been warranted from a corporate and business perspective, they may not have been oppressive. However, there was no evidence before the court that the objected-to lifestyle of the applicant had any materially adverse impact upon the company’s operations.

The remedy given was the purchase of the oppressed party’s shares at fair value by the corporation.

• Issuance of shares to the disadvantage of the minority

The issuance of shares for the purpose of creating or maintaining a majority shareholding has been consistently held to be an act that is oppressive to the minority shareholder and which should be set aside on application to the court. In one case, a sole director issued shares to himself that would have given him majority control of the company. The director was the holder of two of six common shares, the other four common shares being held by four individuals. The four individuals called a shareholders’ meeting for the purpose of changing the number of directors from one to three. The day before the meeting, the sole director had issued to himself


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four new common shares in consideration for the forgiveness of a debt owing to him by the corporation. The Ontario Supreme Court in Bernard v. Valentini, 83 DLR (3d) 440 approved an earlier UK decision holding that: ...when the company is in no need of further capital, directors are not entitled to use

their power of issuing shares merely for the purpose of maintaining their control, or the control of themselves and their friends, over the aff airs of the company, or merely for the purpose of defeating the wishes of the existing majority shareholders.

Again, the theme of personal interest as opposed to interests of the business determines the result.

On the other hand, the issuance of shares for the sound corporate purpose of raising funds to fi nance an asset purchase necessary to the diversifi cation of the company, even though the minority was not in a fi nancial position to subscribe for the shares off ered, has been held not to constitute conduct unfairly prejudicial to the minority. The courts have dismissed the claim that the share issue had aff ected a result that was unfair or oppressive within the meaning of section 241. The courts will not second-guess management in every corporate decision made, although it will make a thorough review of the evidence presented to determine whether the share issue in question was in the interest of all of the shareholders of the company.

• Possible relief that the court can grant

The scope of relief is very wide and includes the power to: - Restrain the conduct complained of.

- Appoint a receiver-manager.

- Amend the corporation’s articles or by-laws.

- Order the corporation, or any other person (usually the majority shareholders) to purchase the shares of a shareholder.

- Replace existing directors with new directors, or add new directors to the existing directors.

- Set aside any contract to which a corporation is a party and order compensation to the corporation or to any party to the contract.

However, all of these remedies are subject to two qualifi cations. First, the remedy must rectify the conduct complained of and not be designed to punish the wrongdoer. That is, the oppressed party should not be put by the court in a better position than he/she would have been in had no oppression taken place. Second, the remedies must protect the interests of the complainant in his/her capacity as a security holder (shareholder or debt holder) and not in any other capacity.

Note: The last of the remedies noted above allows the court to order a corporation or any person to purchase the securities of any security holder. The paragraph does not give guidance as to the method of ascertaining the price of the purchase. The courts have accepted, however, that the purchase price should be at fair value (i.e., fair market value, without the application of a minority discount), as is the case of the dissent remedy.

• Eff ect of the oppression remedy provisions

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In conclusion, the eff ect of the oppression remedy provisions, as they now stand, is that shareholders may no longer vote as selfi shly as they wish. They may vote in a way advantageous to themselves but the limit on such right is that they cannot vote their shares in a way that is either:

- Harmful to the company.

OR - Oppressive to, unfairly prejudicial to, or unfairly disregards the interests of the

minority shareholders.

The application of the oppression remedy involves a balancing of interests of the rights of the majority to operate the corporation in an eff ective manner, and of the minority not to be trampled by the interests of the majority. In the Brant Investments case discussed above, the Ontario Court of Appeal approved of the following statement:

The jurisdiction under section 241 must be exercised with care. On the one hand the minority shareholder must be protected from unfair treatment; that is the clearly expressed intent of the section. On the other hand the court ought not to usurp the function of the board of directors in managing the company, nor should it eliminate or supplant the legitimate exercise of control by the majority.


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3.6 Minority PositionsA minority shareholder is defi ned as:

Any shareholder in either a public company or privately held company that does not own or control more than 50% of the outstanding voting shares of a company.2

3.6.1 Minority Discounts

Minority discounts relate to the value of a particular shareholding where the rateable value (which refl ects a control position) is discounted to refl ect the lack of control over operations (discount for non-control). A discount for illiquidity (illiquidity or marketability discount) may also be applicable. The illiquidity discount generally relates to a minority shareholder position in a private company. However, when the en bloc value of a private company already refl ects an illiquidity discount, it can be argued that a minority shareholder in a private company is still less liquid than a controlling position, and therefore another layer of illiquidity discount is appropriate

In practice, when calculating fair market value in a notional context, a valuator normally assumes that a market readily exists for the shares of a private company, such that liquidity is not in fact an issue on value at the en bloc value.

Discounts for non-control and illiquidity are related as a non-controlling interest is less marketable than a controlling interest. In practice, these factors are often combined and refl ected in one discount. However, the discount for non-control relates to the lack of control and refl ects the relationship between the shareholders while the discount for illiquidity relates to the external market at that time.

Some authors take a more conceptually straightforward approach and consider minority discounts to be a discount only for non-control, with a separate discount for illiquidity relating to the lack of available market for the disposal of private company shares.

Note: Understanding how en bloc value was determined is important in assessing illiquidity discount. For example, public market data inherently refl ects a minority position and possibly more liquidity.

3.6.2 Publicly Traded Minority Shares

In the context of widely-held, publicly-traded shares, small minority shareholdings do not usually suff er from a discount related to illiquidity. A small minority shareholder of a large public corporation has virtually no control over the economic direction of his/her investment and no control over the rate of return directly realizable on the investment. They do however; have control over whether they want to continue to hold the shares.

In the situation where there is a large public company, and the shares are freely traded in suffi cient volumes so that the small minority shareholders can freely trade their shares, one theory is that the lack of control would be off set by the liquidity of the shares. In cases such as this it could be argued that there is either no minority discount or only a very small discount.2 Glossary of Defi ned Terms, “Business Valuation.”

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Another theory is that minority discounts do apply to public companies and takeover bids are cited as evidence that minority discounts exist. In a takeover bid situation premiums are paid over the market trading price in order to attain control. Proponents of no minority discount for publicly traded shares would argue that the premiums are being paid based on anticipated post acquisition synergistic benefi ts and not for control in itself. This could be the case if there were strategic purchasers in the market (i.e. purchase is being made to attain synergistic benefi ts).

Clearly, a premium over the trading price of the shares would only be paid if it was anticipated that a change in control could bring about a change in the management and direction of the company that would increase its value. This change could be a result of synergistic benefi ts or it could be the result of better management, etc. This ability to change the direction and decisions related to the company would be a premium for control. This could be the case if there were fi nancial purchasers in the market (i.e. purchase is being made to increase the value based on better management and direction).

There is not a clear consensus in the valuation community on this issue mostly because it’s not always easy to reconcile the diff erences between price and value and that liquidity and control are not always dissociable. From a conceptual standpoint it’s important for a valuator to exercise judgment and recognise that public company shares may require liquidity discounts if their shares are illiquid (lack of volume/market) and minority discounts if the shares being valued have no control or infl uence over the actions of the company (if shares are not widely distributed and a block of shareholders control the company for example).

An additional factor in stock market pricing relates to the amount of detailed knowledge stock analysts and others have with respect to any particular company. Where a public company’s shares are thinly traded or are not of great interest to investors, it may be that simple market disinterest results in prices not indicative of intrinsic value. Accordingly, the public shares trade at amounts diff erent than would be derived through an in-depth analysis of that company’s asset base, earnings/cash fl ow potential, appropriate discounts, etc.

3.6.3 Privately-held Company Minority Shares

In the context of minority shareholders in a private, closely-held business, the shareholder lacks control over the economic direction of the investment and over the rate of return directly realizable on the investment. This is the same as in the case of the minority shareholder in a publicly-traded company. A further lack of control exists as well, in that there is less ability to dictate the liquidation of the investment.

3.6.4 Factors Aff ecting Minority Value

In the valuation of a minority shareholding in a closely-held company, the three principal factors that aff ect the value of any particular interest are:

• The current dividend yield, being the minority shareholder’s current return on investment.• The potential for future dividend distributions.


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• The likelihood of capital appreciation and the likely ability to crystallize such capital appreciation.

3.6.5 Valuation Approaches

The valuation of minority interests in private companies can be accomplished by using one of two diff erent approaches:

3.6.5.1 Approach #1

Application of discount to the rateable fair market value This is where the en bloc fair market value of a given company is determined and divided by the number of issued and outstanding shares to obtain the rateable FMV per share. The result is discounted to refl ect the disadvantages of a particular minority position (i.e., a minority discount).

EXAMPLE 3.4: APPLICABILITY OF DISCOUNTS ON SPECIFIC SHARE CLASSES

Bruce owns a 30% interest in Twin Power Corporation’s (a private company) common shares and a 20% interest in its preferred shares. Twin Power Corporation has non-voting preferred shares valued at $1.5 million. The total en bloc equity value of the company is $2 million. Public company data indicate that minority discounts range between 20% — 50%. Bruce would like to know how much his shares are worth.

SolutionThe value of the en bloc common shares is calculated by deducting the value of the preferred shares from the total en bloc equity value. The pro-rata value of Bruce’s interest in each share class is determined by multiplying his interest by the respective en bloc value as illustrated below

En BlocPercentage Interest

Pro-rata Interest

Applicable Discounts Minority

Value of Shares

Total en bloc equity value $2,000,000 Value of preferred shares $1,500,000 20% $300,000 n/a $300,000Value of en bloc common shares

$500,000 30% $150,000 20% $120,000

Public company data minority discounts typically represent an extremely low ownership interest. Accordingly, for Bruce’s common share value, a minority discount on the lower end of the range would be appropriate. As discussed below in 3.6.6.2, if there is no shareholder agreement, then the discount would be adjusted higher.

The preferred shares do not have any voting rights and this characteristic would already be incorporated into the en bloc value of the preferred shares. Accordingly, whether a preferred shareholder owns more than 50% of preferred shares is not relevant in this case, as they do not control the company and a minority discount is relevant.

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3.6.5.2 Approach #2

Yield approach As an alternative, the yield approach involves dividing 100% by the required yield expressed as a percentage, and then multiplying the quotient by the actual or expected dividend, expressed as a formula as illustrated below:

EXHIBIT 3.3: THE YIELD APPROACH 100% X Actual/expected dividend

(Required yield)%

Although this approach may prove useful where a history and future projection of dividend payments are available, more often than not, a privately-held company will pay:

• Nominal dividends (often paid at irregular intervals).• No dividends.• Dividends determined solely for income tax reasons.

Accordingly, the future expected dividends would not be indicative of value. Since it is unreasonable to conclude that minority interests have no value where dividends are not paid, this approach is usually not considered a practical method for approaching the minority share valuation problem.

Where this approach can be applied, both approaches should be used to supplement each other and assess the reasonableness of the ultimate value conclusion.

EXAMPLE 3.5: YIELD APPROACH

Neeta owns a 2,000 common share interest in ABC Limited. The company has issued annual dividends over the past four years ranging from $0.135 to $0.15 per share. Based on the nature of the operations and expectations for the company, Neeta has determined the required yield to be 7%. What is the value of each individual share?

Solution:Based on the yield approach, the value of each share ranges from $1.93 to $2.14 as calculated below:

• 100%/7% x $0.135 = $1.93• 100%/7% x $0.15 = $2.14

3.6.6 Factors Aff ecting Minority Discounts

In selecting an appropriate minority discount in a notional market sense, the valuator must assess the minority interest level of infl uence or potential infl uence. In general, the more severe the restrictions and limitations attached to a minority interest, the greater the discount applicable to its rateable value and the lower the value.


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There are many factors that can aff ect the quantum of discount, if any, that are applied to rateable value to refl ect minority position. Among these, the following factors are often the most signifi cant:

1. The size of the shareholding and its relative importance2. Existing shareholders’ agreement3. Articles of incorporation and by-laws4. Shareholder relationships5. Familial relationships6. Nuisance value

These are discussed as follows.

3.6.6.1 The Size of the Shareholding and its Relative ImportanceThe valuator must consider the size of the shareholding and its importance relative to the size of other shareholdings (i.e., the valuator must focus on the specifi c shareholding in the specifi c company that is under consideration). Both the absolute size of the particular holding and its relationship to the size of other holdings may be important factors in the valuation analysis.

For example:

• If no single shareholder controls the company, then it is necessary to consider the implication of various possible combinations of shareholdings that might be put together. A 40% minority shareholder would, for example, be at greater disadvantage if a husband and wife each held 30% of the shares, compared to a situation where the 30% blocks were held independently.

• It is possible to observe a potential for competition amongst more than one existing shareholder for the shares of the minority (i.e., a special interest purchaser market) in relation to a particular minority holding. Thus, if one shareholder held 10% and two others held 45% each, the possibility of either of the large shareholders being able to gain control by purchasing the small 10% holding could provide grounds for viewing it as having a value approximating its pro-rata share value, or perhaps even higher (see the discussion later on under the heading ‘’nuisance value’’).

• A minority shareholder who can prevent the passing of special resolutions is arguably less disadvantaged than one who cannot. Typically, depending upon the legal jurisdiction, a special resolution requires a vote greater than 50% (e.g., 66 2/3% or 75%) to pass. A minority shareholder who is in a position to prevent the expropriation of his/her shares following a successful takeover bid is arguably less disadvantaged than one who cannot. Thus, a somewhat lesser discount from rateable value would likely be appropriate if the minority shareholder holds suffi cient shares to block a special resolution.

3.6.6.2 Existing Shareholders’ AgreementA shareholders’ agreement can have signifi cant infl uence in establishing the minority discount. The agreement might:

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1. Restrict the transfer of shares by, for example, requiring the approval of the other shareholders, thus increasing the minority discount.

2. Provide the minority with an increased measure of control over the operations of the company, thereby reducing the discount.

3. Also require that, where shares are sold, they must be sold (or at least off ered) to specifi c parties (usually the other shareholders). The shareholders’ agreement may stipulate how the price will be determined, as well as specifying whether a minority discount will be applied.

3.6.6.3 Articles of Incorporation and By-lawsIncluded in this area are the specifi c rights and restrictions contained in the corporate documents, as well as consideration of the state, as at the valuation date, of the statutory rights of the minority shareholder. In most jurisdictions in Canada, these rights currently include dissent, appraisal and oppression remedies, which may provide the minority shareholder with liquidity and access to the pro-rata portion of the en bloc fair market value not usually available to minorities, but only under certain specifi c circumstances.

3.6.6.4 Shareholder RelationshipsThese include the intent of the various shareholders with respect to their dealings with one another vis-à-vis their shareholdings. One should also consider the historical behavior of each shareholders’ past actions (i.e., co-operative or not) and whether this historical behavior might be indicative of their future actions.

3.6.6.5 Familial RelationshipsPersonal or blood relationships between shareholders may indicate that they act in concert, aff ecting the applicability and size of a discount from the rateable values of those holdings. Where minority shareholding interests are valued for income tax purposes, the guidelines for group and family control are set out by the CRA in Information Circular 89-3 — Policy Statement on Business Equity Valuations (www.cra-arc.gc.ca/E/pub/tp/ic89-3/README.html)

Note: These are CRA guidelines and may not be applicable in other circumstances.

Group control may exist in a number of informal ways, such as in circumstances where no single person has de jure control, but where two or more shareholders act in each other’s interest and own, in the aggregate, at least 50% plus one of the issued shares.

In 1976, the CRA defi ned group control to exist where shareholders’ voting shares aggregating more than 50% of the votes cast at a general meeting of shareholders could demonstrate a pattern of acting in concert with respect to their shareholdings, and that they were restricted in their right to:

• Sell their shares independently. • Vote their shares independently.

To satisfy the CRA, such evidence could be contained in the articles of incorporation, the by-laws or in a shareholders’ agreement. Information Circular 89-3 includes a discussion of the considerations to be made in assessing whether group control exists.


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A strict reading of Information Circular 89-3 suggests that the CRA is off ering taxpayers the option of claiming group control. This is somewhat puzzling as the current tendency of Canadian taxpayers undertaking estate planning or other non-arm’s length transactions is to opt for lower rather than higher current notional values.

Family control refers to the valuation of an individual minority shareholding in a corporation collectively controlled by individuals within a familial relationship. Family control, as group control, is a concept that is applied in connection with notional market valuation requirements for income tax purposes. The CRA has accepted a premise that, barring family disputes, family members who collectively control may be presumed to act in concert to exercise some control over the economic direction and the liquidity of their investment.

The rationale underlying this theory is that related shareholders who hold in the aggregate more than 50% of the shares are in a position to realize proceeds not less than the rateable value of their respective shareholdings by acting in concert to sell a control shareholding. Information Circular 89-3 also includes discussion as to the considerations to be made in assessing whether family control exists.

The wording of Information Circular 89-3 suggests that minority shareholders related to a family control group have the option of associating themselves with the family group. In other words, in those situations where such minority shareholders are desirous of establishing a lower notional value for their shares rather than a higher value, it would appear that the CRA is off ering the option of not claiming family control, or vice versa.

3.6.6.6 Nuisance Value Minority shareholdings occasionally have a “nuisance value”, making them more valuable than they otherwise might have been. Nuisance value is diffi cult, if not impossible, to identify in the absence of an open market transaction.

To illustrate the eff ect of nuisance in the actual market, assume a prospective purchaser of the shares of a closely-held company was only prepared to complete the transaction if he/she could acquire 100% of the outstanding shares. An 11% minority shareholder expressed disinterest in selling. The other shareholder or shareholders might then be inclined to off er the 11% minority shareholder a special, and possibly substantial, bonus price for his/her shares (relative to their pro rata value) to consummate the transaction.

Some of the reasons that a minority shareholding might realize a nuisance value premium include realization by a controlling shareholder that a minority shareholder might:

• Be able to prevent, or cause the alteration of corporate planning initiated by the controlling shareholder for his/her own benefi t.

• Delay proper corporate planning by initiating arbitrary actions against the company and its controlling shareholder.

• In either of the above cases, cause a diversion of executive time away from the day-to-day business of the corporation, at a potentially signifi cant corporate cost.

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• Eff ectively be in a position to thwart the sale of a control position, where a purchaser of such control is insistent upon acquiring all of the outstanding shares of the target corporation.

The valuator must also consider whether an organized market exists for minority shareholdings. An organized market for minority shareholdings is somewhat unusual, and may not be particularly relevant due to thin trading and the likelihood of inadequate knowledge on the part of those trading in the minority shares in relation to the knowledge possessed by the majority. Further, the concept of nuisance may well be excluded from the notional fair market value by defi nition (i.e., willing seller, knowledgeable parties). Therefore it should be considered that nuisance implications are more of a price determinant than a value determinant.

Each of the foregoing factors can have an eff ect on the amount of discount applied to the rateable value of a minority shareholding.

3.6.7 Determining the Quantum of Discount or Premium

In summary, when valuing a specifi c minority shareholding, the valuator must consider at least the following factors when determining the quantum of discount or premium, if any, from or to rateable value:

1. Sale of similar share blocks in that company.2. The historical and prospective yield, and overall return on investment.3. The basis upon which en bloc value has been determined and general market conditions

at the time of such determination.4. The terms, conditions, and enforceability of agreements among the shareholders.

Agreements often provide for the basis of election of directors and have provisions for areas of importance in overall corporate direction where all shareholders have a voice in decision-making.

5. The provision of the incorporating statute, incorporating documents and by-laws, and the apparent future direction of the law as it pertains to shareholders’ rights and protections.

6. The size of the shareholding to be valued in absolute terms and as compared with the size of the other outstanding shareholdings.

7. Circumstances particular to a given fact situation, such as negotiations or pending negotiations with prospective purchasers, the intent of a controlling shareholder at a particular date in dealing with minority shareholders, the nature of the business of the company itself, and the anticipated timing of the sale of that investment.

8. Whether the potential purchasers in the market are strategic or fi nancial purchasers.

A valuator might also consider transaction activity as a possible indicator of how control/minority relationships might be viewed.


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EXAMPLE 3.6: CONSIDERATIONS IN ASSESSING APPROPRIATE DISCOUNTS

Brad owns 10% of the common shares in Calind Enterprises Incorporated. His mother owns 45%, while a third party (unrelated to Brad and his mother) recently purchased the other 45% for $1.5 million from a former shareholder (also unrelated to Brad and his mother). Management had since been considering selling the company. The controller of the company had valued the en bloc equity of the company at $4.5 million.

Brad’s girlfriend, Lindsay, was interested in buying his shares. Brad has approached you to provide an independent valuation of his shares. What are the factors that need to be considered?

Precedent transactions in the company

The $1.5 million share price for the 45% interest can be used as a benchmark if the circumstances warrant it. Certain questions need to be asked to determine whether the price can be indicative of value such as:

• Was the vendor under duress to sell thereby willing to accept a lower price to eff ect the sale (i.e., willing seller)?

• Did the purchaser have all the required information to make an informed decision on the price? If not, he/she may have overpaid (i.e., knowledgeable parties).

• Were the shares off ered to other parties (i.e., open market)?Agreements • Are there shareholders’ agreements (or other agreements) that may prevent Brad

from selling his shares to his girlfriend without the consent of the other shareholders?Relative shareholding

Brad holds a minority interest in the company but, combined with his mother’s interest, both parties hold a controlling interest.

• What is the relationship between Brad and his mother? Have they acted in concert in the past?

• What is the relationship between Lindsay and Brad’s mother? Could they potentially act in concert in the future?

Potential sale of Calind

In the event of a sale of the company, barring any specifi c restrictions, Brad may be paid his pro-rata share, in which case a discount need not be applied.

• How far along is the sales process?

• Is management serious about selling the company?

• How many buyers have been contacted?

• Does the shareholders’ agreement have any clauses pertaining to the sale of the company which would dictate the payouts to the shareholders?

The third party purchased his 45% interest for $1.5 million. At an en bloc value of $4.5 million for the company, his pro-rata interest would be $2.025 million. This implies a discount of approximately 26% to his original purchase and could be used as a benchmark for a minority discount for his 45% interest. If the relationship between Brad’s mother and Lindsay is amicable, group control could exist in which case a low minority discount might be considered. Given that there is an interested party in purchasing Calind, it is likely that Lindsay’s shares could be bought out on a pro-rata basis. Accordingly, a 10% minority discount might be considered for Brad’s shares.

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Exhibit 3.4 summarizes a few high-level considerations, including relative shareholdings, in assessing an appropriate discount range for minority shareholdings. As valuation is a somewhat subjective exercise, students should be aware that the table below represents one possible solution for discount ranges and is not meant to be an authoritative reference and other solutions are entirely possible. That said, a valuator should rely on 1) their experience, 2) minority discount/illiquidity studies 3) their experience and 4) the specifi c facts of the situation to be valued to determine a minority discount.

EXHIBIT 3.4: HIGH-LEVEL CONSIDERATIONS IN ASSESSING AN APPROPRIATE DISCOUNT RANGE FOR MINORITY SHAREHOLDINGS

EXHIBIT 3.4A

Subject Shares

Other Shareholder

Other Shareholder Suggested Discount Range

20% 80% Subject to other facts of the situation, a 30% to 50% discount may be applicable.

Comments If a controlling shareholder owns more than the percentage required to pass special resolutions (66 2/3 % or 75%), then a signifi cant discount would be considered for a minority shareholding. In this case, the controlling shareholder has majority control and is also able to pass a special resolution and would therefore be less interested in acquiring the subject shares.

EXHIBIT 3.4B

Subject Shares

Other Shareholder


20% 40% 40% Subject to other facts of the situation, a 20% to 35% discount may be applicable.

Comments In this situation, there are no controlling shareholders.There are two potential buyers (the other shareholders) for the subject shares, which would provide each of them with control, but would not allow them to pass a special resolution.

EXHIBIT 3.4C

Subject Shares

Other Shareholder



Comments Subject shareholder can block a special resolution.In this scenario, one shareholder could gain majority control (35% + 20%) and the other shareholder full control (35% + 45%) if they purchased the subject shares.


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EXHIBIT 3.4D

Subject Shares

Other Shareholder



Comments Subject shareholder can block a special resolution.Other shareholder may be less inclined to buy subject shares as he/she already has control.

EXHIBIT 3.4E

Subject Shares

Other Shareholder



Comments In some jurisdictions, shareholdings of less than 10% are subject to mandatory acquisition provisions where a company is entitled to acquire the remaining shares if it has already acquired at least 90% of the shares.The advantage to this is that the subject shareholder has the opportunity of being bought out at a pro-rata price if the other shareholder sold his shares.The disadvantage is that the subject shareholder has very little infl uence in the aff airs of the business and the other shareholder does not need the subject shares to control the business or pass special resolutions.

EXHIBIT 3.4F

Subject Shares

Other Shareholder



Comments In this situation, there are no controlling shareholders.The other two shareholders could be special purchasers of the subject shares as it would provide either of them with control, although neither of them would be able to pass a special resolution.The subject shareholder would not be subject to mandatory buyout provisions as with the 9% shareholder interest above but would be able to block a 100% acquisition of the company.

EXHIBIT 3.4G

Subject Shares

Other Shareholder



Comments May ensure each other’s liquidity if amicable relationship existed between the two shareholders.In such a situation, it is likely that a shareholders’ agreement exists which would address stalemates and provide a means of liquidity for the shares.

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If group or family control were to exist in all of the cases above with one or more of the other shareholders, the discount could decline to 0%. This is because any of the other shareholders could, in combination with the subject shareholder, control the company (i.e., combined interest is greater than 50%).

Note: There is only no discount applied to a 9% shareholding when there is an acquirer interested in purchasing 100% of the company. In the case above it does state the 30%-50% discount is subject to other facts of the situation. This discount would apply if valuing the 9% shareholding only and there wasn’t a party interested in acquiring 100%. The mandatory acquisition provisions are for the situation where the acquirer wants to purchase 100% of the company and has acquired over 90%.

3.6.7.1 Determining a Minority DiscountFor an examination, students should be able to state all relevant factors in determining a minority discount applicable to a share valuation, including the following:

• Defi ne minority discount and state why one needs to be applied (or doesn’t need to be applied) in the situation.

• State whether an illiquidity discount is also applicable and determine a rate with the appropriate support.

• Consider the other shareholders as potential buyers for the shares. If the subject share interest is less than 50%, the other shareholders could be likely purchasers, in which case the relative shareholdings would need to be addressed.

• Consider how the en bloc value was determined. Does it refl ect private company data? If public market data was used, the en bloc value may already implicitly refl ect a minority position.

• Support the discount selected with stock market data provided in the exam.• Look at the relationships between shareholders. If group or family control is present, a

lower or no discount may be appropriate.• The size of the interest and inherent level of control should be considered. Typically, the

larger the interest, the lower a minority discount, all things being equal• Consider specifi c terms that would provide an advantage or disadvantage to the shareholder

(i.e., shareholders’ agreement).Note: Discounts should only be applied to the pro-rata value of common shares (voting or non-

voting) and not preference shares.


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3.7 Discounts For Illiquidity The discount for illiquidity (also called the marketability discount) is defi ned as:

The amount by which the en bloc value of a business or ratable value of an interest therein is reduced in recognition of the expectation that a ready market for the disposition of said interest does not exist.3

This discount represents the lack of liquidity/ marketability of the private company’s shares relative to the public company comparables.

As noted above, some authors defi ne the minority discount to include both a discount for non-control and a discount for illiquidity. However, they recognize that, in relation to minority interests, these discounts while distinct, are often combined and expressed as one percentage.

The valuator should consider the following factors in deciding if a discount for illiquidity should be applied and, if so, to what extent:

• Whether a controlling interest or minority interest is being valued • General economic conditions• The level of merger and acquisition activity in a given industry• The size of the company in which the interest is being held• Post-acquisition synergies• The shareholding structure of the company

3.7.1 Controlling Interests

It takes time to sell a private business and, in theory, a discount could be estimated based on the time value of money (off set by profi ts in the interim period) and the potential for price fl uctuation in the interim period.

Factors that may be more signifi cant in the liquidity of the controlling interest include:

• A shareholders’ agreement that places restrictions on the majority’s ability to sell. • Known prospective purchasers that would be unlikely to acquire less than 100% of the

company even if a controlling interest were off ered for sale.

3.7.2 Minority Interests

In valuing a minority interest, where the value is derived by pro-rating the en bloc value, the valuator must consider if an incremental discount is required relating to the illiquidity of that specifi c minority discount.

The shareholders’ agreement can have a signifi cant infl uence on the liquidity of a minority interest. For example, requiring the remaining shareholders to acquire the exiting shareholders’ interest

3 Glossary of Defi ned Terms, “Business Valuation.”

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at rateable value would indicate an illiquidity discount is not required. Alternatively, restrictions placed on the transfer may indicate the need for such a discount.

The following factors should be considered when quantifying discounts for illiquidity of specifi c minority interests:

• Shareholders’ agreements• Whether an organized market for the shares exists.• Size of the ownership interest or degree of infl uence of the shareholding (for example,

if the shareholder holds the balance of power, it is more likely that one of the existing shareholders will acquire the shares).

• The likelihood of a near-term en bloc sale.• The likelihood of a statutory-related triggering event.

A minority interest in a publicly traded company that was larger than the usual trading block may require a discount to refl ect the potential negative infl uence of price that the additional supply may cause or the time value of money related to selling the holding in smaller increments over time.

Assessing the amount to apply for a discount for illiquidity requires the valuator to exercise his/her professional judgment in assessing the individual circumstances, as illustrated in the discussion of cases that follows.

3.7.3 Canadian Jurisprudence

In Canada, most cases involving a minority discount and illiquidity discount do not diff erentiate between the two. Certain judgments mention the notion of lack of marketability without applying a separate discount. For example, in Moynihan v. MNR4 and Connor v. The Queen5, the courts applied a combined discount for minority and lack of marketability.

In Black v. Black, the question of marketability was not addressed directly, but the judge declared:

...I found the following facts to be most determinative of the value of the husband’s business interest [a 50% interest in a holding company in which the shareholder’s brother owned the other 50%]: the highly-illiquid nature of those interests and the substantial third party debt to which they were subject; that a purchaser of them would not be buying control or a route to control of their underlying public companies...6

Furthermore, in an unreported 1993 decision, Michelle Hermitage et al v. Kruger Inc., where the court was asked to fi x the fair value of a small minority interest in Kruger Inc., a marketability discount of 35% was applied. The judge stated: “...the notion of a non-liquidity or non-marketability discount can be applied in determining the fair value of the shares of Respondent, by reason of the fact that Respondent is a private company and not a publicly traded one.”

It is evident that the concept of lack of marketability discounts are not readily applied as a separate concept to discounts for a lack of control in Canada. The numerous decisions on the subject in 4 62 DTC 64 (TAB).5 78 DTC 6497 (FCTD), aff ’d. 79 DTC 5256 (FCA).6 (1988), 18 RFL (3d) 303, at 313 (Ont. HCJ).


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Canada can be used for guidance in determining the size of the marketability discount to apply in valuing interests in closely-held companies in Canada where the distinction from a minority discount is relevant.

3.7.4 U.S. Jurisprudence

In Estate of Mark S. Gallo7, the U.S. Tax Court valued the shares at less than one-quarter of the estimate of the IRS. The court found it unsupportable that the IRS granted only a 10% marketability discount, rejecting the IRS’s contention that the company’s size and market dominance justifi ed a low discount. The estate’s expert, in arriving at a per-share value of $237, applied a 36% discount to refl ect the lack of marketability of the shares. The Tax Court held the value was $237 per share.

In Estate of Samuel I. Newhouse,8 the U.S. Tax Court concluded that a combined discount of 35% for minority shareholding and lack of marketability was appropriate to value a 44.44% minority shareholding in a privately-held corporation. The Court justifi ed its 35% combined discount on the decisions on Estate of Watts9, Drybrough v. United States,10 and Roy O. Martin, Jr.11

In Estate of Joyce C. Hall,12 the U.S. Tax Court found the IRS valuation of Hallmark Cards was more than 25% higher than fair market value. Because the shares were privately held, the Appellant’s expert (First Boston) discounted the stock price of the comparable public companies by 35% to estimate the private company’s share value for each comparable. The U.S. Tax Court accepted such discount and concluded:

We have no reason, however, to reject the opinion of First Boston. That opinion coincided with the admission on the estate tax return and with the price determined under the agree-ments. We are persuaded that it is the most reliable evidence of fair market value and we adopt it.13

In Bernard Mandelbaum,14 the only issue was the size of the lack of marketability discount for gifts of stocks of Big M Inc. (a retail chain of women’s apparel stores) made in the years 1986 to 1990. The IRS expert maintained a 30% discount, relying on third-party restricted stock studies. The taxpayer’s expert found 75%, using restricted stock studies, but arguing that a willing buyer would require a rate of return of 35% to 40% during a holding period of 10 to 20 years. The Court concluded that a 30% discount was appropriate, indicating that “an appreciation of the fundamental elements of value that are used by an investor in making his or her investment decision”15 must be made.

7 50 TCM 470 (1985).8 94 TC 193 (1990).9 51 TCM 60 (1985), aff ’d. 823 F.2d 483 (11th Cir. 1987).10 208 F. Supp. 279 (D. Kan. 1962).11 50 TCM 768 (1985).12 92 TC 312 (1989).13 Ibid at 324.14 69 TCM 2852 (1995).15 Ibid at 2864.

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In Estates of Anthony J. Frank, Sr.,16 the decedent Anthony made a gift of 91 shares of Magton Inc. (operating and owning three seaside motels in Ocean City, New Jersey), reducing his interest from a controlling 50.3% to a minority of 32.1% two days before his death. The Court adopted the net asset value approach with a deduction of a 30% lack of marketability discount and a 20% minority discount.

The U.S. jurisprudence appears relatively consistent. However, there is a recent trend to not blindly follow the numerous studies performed on lack of marketability discounts but rather to analyze the facts and circumstances surrounding each case prior to concluding on the size of the discount.

16 69 TCM 2254 (1995).


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3.8 The Application of a Minority Discount in the Determination of the Fair Value of the Shares of a Minority Shareholder It is now largely accepted that the fair value of the shares of a minority shareholder can be determined without reference to a minority discount, regardless of the context in which the fair value valuation takes place (i.e., regardless of whether the shareholder is being forced out of the corporation or chooses to leave.) It is useful, however, to examine the arguments the courts have considered in arriving at this conclusion.

A rationale for applying a minority discount in a fair value determination was given by the British Columbia Supreme Court in Johnston v. West Fraser Timber Co. (1982) 17 B.L.R. 16 in the context of an oppression remedy application. There, having accepted that the remedy would be that of the purchase of the minority shareholder’s shares at fair value, the court stated:

To value Mr. Johnston’s shares on the basis of a proportionate share of the value of the entire company as a going concern is to equate his position to that of a majority shareholder and provide Mr. Johnston a windfall profi t that could never have been realized had there been no oppression.

On the other hand, the Ontario Court of Appeal, in Mason v. Intercity Properties Ltd. (1987) 37 B.L.R. 6, decided that the application of a minority discount in an oppression remedy situation would give eff ect to the very disadvantage of the position of a minority shareholder, which the legislation was designed to overcome. If this were not the case, stated the court, the majority would be able to oppress the minority with the only consequence being that the majority might have to pick up the shares of the minority shareholder at a discount.

The Court of Appeal then went on to consider whether the fact that the minority shareholder had been less than easy to get along with aff ected the non-application of the minority discount. It concluded that to justify the inclusion of a minority discount in the valuation of the minority’s shares, the conduct of a minority shareholder would have to be “of such a grave character that he/she deserved to be excluded from the company.”

Although this case was decided in the context of an oppression remedy application, the non-application of a minority discount has been generally accepted in cases involving the dissent remedy provided under the CBCA and provincial and territorial corporate legislation.

The topic of shareholder disputes and the related diff erences in valuation methodology (including further discussion of the minority-interest discount) can be found in the Level IV — Special Topics in Business Valuation course.

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3.9 Portfolio DiscountAlso called the non-homogeneous asset discount, the portfolio discount applies to certain companies involved in more than one separate business. It is also a discount that is applied to real estate holding companies where the underlying assets are diff erent types of properties (e.g., commercial, residential, industrial, etc.).

The portfolio discount refl ects that a company owning a combination of dissimilar operations or assets would be unattractive to a buyer. Consider a holding company that owns businesses in pharmaceuticals, forestry, and computer software. A potential purchaser that could realize synergies would only want to buy the operations in its’ own industry. The portfolio discount represents the additional cost and/or time that management would have to expend in selling the three businesses separately compared to the cost and/or time required for one transaction to one buyer.

Shareholders themselves can ensure that their portfolio has diversifi cation (by having several holdings) as opposed to an individual holding that has diversifi cation and as such, at the corporate level, diversifi cation could be argued as not relevant.

As discussed in the article “Business Valuation Discount and Premiums” in The Journal of Business Valuation, 2003, support for the portfolio discount includes:

• Observations of the increased trading price of a conglomerate after the break-up was announced.

• Stock market analysts’ estimates of break-up values that are above trading prices. Analysis estimates of the portfolio discount in this study range from 15% to 65%. indicating this type of discount can be signifi cant.

• Court cases have recognized a portfolio discount.


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3.10 Blockage DiscountGenerally considered in relation to large minority holdings of publicly-traded stock, a blockage discount is defi ned as:

The decrease in market price resulting from the imbalance of supply and demand that results when market supply is increased pursuant to unusual market activity. In the context of the public stock markets, it is the decrease in stock market trading price created by the forces of supply and demand when a block of shares larger than a normal trading lot is exposed for sale at one time.17

As a quick example, if a shareholder holds 3,000,000 common shares in a public company, and the average daily trading volume is only 80,000 shares, a blockage discount would likely apply. One of two things would occur if the shareholder wanted to sell his/her 3,000,000 shares — either the shares would be put on the market and supply would greatly outweigh demand and share price would drop, or the shares would have to be sold over a long period of time which results in risk of price decreases. Either of these outcomes causes actual or possible price erosion, and therefore the blockage discount is applied to account for the value impact.

The case law on blockage is not entirely consistent.

Several Australian cases have allowed the deduction of a discount for blockage (for example, Kent and Martin v. FCT (unreported), Gregory v. FCT (1971), 123 CLR 547, Myer v. Commissioner of Taxes (1937) VLR 106, and Re Haunstrup (1960) v. T 302.

The leading Australian case on this issue is probably Barbara Bruce-Smith Estate v. Commissioner of Taxes (unreported), which suggests that the sale of an extraordinarily large block of shares through the normal public market process would not be usual. Selling such a block in small pieces over time would take an exceptionally long time and would not provide an accurate measure of its value. Rather, a large block would normally be sold through the secondary market system (i.e., through private placement or other means of direct purchaser/vendor interaction), which could be completed within days. This case also suggests that any block large enough to confer control on the holder would have special value, in some cases, outweighing the inability to readily market the same.

In the Canadian case of Henderson Estate v. MNR, Bank of New York v. MNR [1973] CTC 636; 73 DTC 5471, the Court disallowed the taxpayer’s claim for a blockage discount, ruling that the taxpayer had not demonstrated either the impact of imperfect information on the market or the fact that the deceased taxpayer had been able to manipulate the market.

Overall, the case law suggests that:

• The particular “value” being addressed will impact the conclusion (i.e., is it fair market value, real value or some other term?)

• The facts in each case must be considered.

17 Glossary of Defi ned Terms, “Business Valuation.”

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• Stock market transactions are important to the courts.• Blockage discounts have been accepted where particularly large blocks are in question; • There is a semi-organized market for large blocks of shares. (This must be taken into

account when valuing unusually large blocks of shares).

Example 3.7 below, demonstrates the use of stock data and other considerations required to support a blockage discount.

EXAMPLE 3.7 — BLOCKAGE DISCOUNT CONSIDERATIONS

Helga owns 1,000,000 common shares of the public company RST Corporation and would like to know how much her shares are worth. Mutual fund and pension fund companies hold approximately 2 million shares of the public fl oat. Share data is provided below:

Share price

Average daily volume

Total shares outstanding

Total public fl oat

One year price volatility

Minimum daily volume

Maximum daily volume

RST Corporation

$35.65

7,000

20 million

5 million

83%

0

14,000

Prior Day Last Month Last Year

Low High Low High Low High RST Corporation

$30.75

$41.00

$28.09

$37.39

$18.09

$45.11

Solution:If Helga could easily sell these shares on the exchange, her shares (before consideration of any discounts) could be worth $35.65 million (1,000,000 x $35.65). The likelihood of Helga receiving this price for all of her shares needs to be assessed.

Liquidity• The trading volume is erratic, as indicated by the minimum and maximum daily volume

(some days there is no trading at all).• RST has fl oated 25% of its shares to the public market (5 million/20 million) which is a

relatively low fl oat. • Helga owns approximately 20% of the fl oated shares or 33% excluding the fund company’s

interest. The average daily volume over the total fl oated shares is approximately (7,000/5 million) 0.14%.

Given that RST has a relatively low fl oat, has an extremely low trading volume, and that Helga owns a sizeable block of shares, it is evident that the market lacks the capacity to easily absorb Helga’s shares. The above data suggests a sizeable blockage discount would be warranted.

If Helga were to sell all her shares at once on the public exchange, there would be excess supply in the market, in which case the share price would drop. Accordingly, Helga would likely receive something signifi cantly less than the market price, all things being equal. However, it is generally diffi cult to quantify this impact on price.


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Market RiskGiven the low liquidity of RST, Helga would have to gradually sell her shares in small portions over a period of time. In such an event, Helga would be subject to the risk that the price of the stock would decline (market risk).

• If Helga was the only person selling shares, it would take approximately 143 days (1,000,000/7,000) or about 5 months to sell all of her shares. However, as she would likely not be the only shareholder, it would take her longer to sell her shares without materially depressing the share price.

• The price volatility of 83% is high given that companies with relatively stable prices can range from 30% to 60%.

• The wide spreads between the high and low prices for each time period (calculated below) indicate that it is unlikely that prices would remain steady.

One day: +/- 14% [ (high-low)/2 ÷ (high + low)/2]One month: +/- 14.2%One year: +/- 42.75%

• Some public companies with normal levels of liquidity have annual spreads between 10% and 30%.

• Helga would also be disadvantaged by the time value of money (i.e., proceeds received today versus those received months from now).

The above data suggests that it is unlikely the price will remain where it currently is. Assuming that this historic data is indicative of the future, and given that the current share price of $35.65 sits in the higher end of the annual price range ($18.09 to $45.11), it appears more likely that Helga will realize less than $35.65 per share and a sizeable blockage discount would be warranted.

One method to estimate the value of her shares (i.e., which would imply a blockage discount), would be to forecast the price of the shares and trading volume and the present value of Helga’s estimated proceeds to the valuation date. The discount rate should consider the risk of actually realizing the share price.

BenchmarksTypically, discounts on restricted shares (discussed in Section 3.11) can be used as a basis for determining the blockage discount as Helga is restricted, to some extent, in selling her shares in the public market. Restricted share discounts, which tend to also incorporate market risk, could be used as a basis for a blockage discount.

Any history of other block trades or secondary off erings of RST should also be considered. The implied discount for these can be used as a benchmark to assess the appropriate discount for Helga’s shares.

BuyersHelga could sell her shares privately. As noted, a number of institutions already own RST shares and could be interested in buying her shares. In such an event, the blockage discount would be minimal or even 0%. In some cases, a premium over market price can be achieved if the potential buyers:

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• Find the block attractive.• Wouldn’t be able to buy these shares immediately from the public market (due to same

market and liquidity issues noted above).• Could combine Helga’s interest with their own and have a greater infl uence on the aff airs

of the business (e.g., obtain board seat).

Blockage discounts can range from 0% to 20%. Given the above factors, the blockage discount on Helga’s shares is estimated at 10%.

For the exam, students should be able to provide support for the blockage discount they select, including the following:

• Indicate why a blockage discount is required.• Use the stock data provided in the question to support the blockage discount selected.• Look at liquidity. How many days would it take to sell the block of shares? What is the

average trading volume as a percentage of total fl oated shares? Do the shares trade every day?

• Consider market risk by assessing price volatility. What is the average range of share prices?

• Consider the other potential buyers for the shares. If institutions are existing shareholders, a low or no blockage discount may be applicable.

• State any precedent transactions of the company that would imply a blockage discount and explain the adjustments for the subject shares.

• Consider the outlook for the company (i.e., expected future stock price). Is the historical data representative of the future or did it refl ect a one-time event which is now rectifi ed?


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3.11 Discounts for Restricted SharesIn many circumstances, shares of a corporation will be subject to a restriction that limits the ability of the shareholder to vote and/or freely trade the shares. This section focuses on the inherent disadvantages associated with restrictions on transfer.

3.11.1 Empirical Studies

The impact of restrictions on fair market value (FMV) has been the subject of numerous studies. For example, in one of the fi rst studies in the area, William L. Silber noted in “Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices” (Financial Analyst Journal, July/August 1991), that, based on comparisons between restricted securities ineligible for resale for a two-year holding period and unrestricted (but otherwise identical) shares of the same company, the restricted shares are off ered, on average, at a discount of more than 30%, although the discount varies widely from company to company. Students should be aware that there are more recent articles and studies in this area and are encouraged to conduct their own review.

Other studies suggest, however, that the stocks analyzed in these cases have other attributes that aff ect value and therefore make a poor proxy for estimating marketability discount.

While Silber’s article (and other similar studies) may provide a starting point for determining the impact of transfer restrictions on the discount from rateable value, an analysis of the variance in discounts noted in those studies is required. The following factors may be considered:

• Duration of the restriction period.• Nature of the restriction.• Financial performance of the company.

Duration of the Restriction PeriodIn general, the longer the restriction period, the greater the disadvantage of not being able to trade the shares (and as a result, the greater the indicated discount for the restriction period).

A prevalent feature of many employer-sponsored restricted stock plans is that the restrictions on transfer are lifted for some fraction of the total award on each anniversary following the date of the award. For example, the employee may be awarded 1,000 shares with the transfer restriction lifted on 100 shares on each anniversary for 10 years. The discount applicable to each portion of the award will vary according to the length of the restriction period. The aggregate discount should refl ect the early or progressive release provisions. Conceptually, the valuator can calculate a separate discount for each component of the restriction period as illustrated below:

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EXHIBIT 3.5: CALCULATING % DISCOUNT — RESTRICTION PERIOD% Discount

Yr.1 Yr.2 Yr.3 Yr.4 Yr.N Restriction Period

Nature of the RestrictionThe size of the discount depends on the specifi c restriction provisions associated with a particular shareholder. For example, in the case of shares issued by private corporations to employees, it is rare for the issuer to permit any other transfer while the individual remains employed with the company. In general, the applicable discount will vary inversely with the liquidity and transferability of the shares.

3.11.2 Quantitative Analysis

Empirical studies of the inherent disadvantage of restrictions on transfer can provide a useful benchmark for the analysis. However, it is important to consider the specifi c circumstance of the matter at hand.

Several quantitative methodologies have been developed to help assess the particular attributes of a company that aff ect the discount from FMV. While these quantitative methodologies merit consideration, they must be applied with caution, given that the determination of the appropriate discount is by no means an exact science.

Option pricing models can provide a useful basis for quantifying the appropriate discount. In particular, the Black Scholes option-pricing model is often used because this model is based on European options18 that exhibit many similar traits to restricted shares. The date on which the European option may be exercised is akin to the expiry date of the restriction on transfer.

18 European options are exercisable only on one specifi c date. In contrast, American options are exercisable at any time between the date of issue and the stipulated expiry date.


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While the mathematical derivation of the Black Scholes model is beyond the scope of this course (and is discussed further in the Advanced Business and Securities Valuation course), the data inputs required for the Black Scholes model are as follows:

• The market price of the shares.• The exercise price, which is often based on the price that would allow the holder to earn a

reasonable return over the holding period19

• The time to expiry, which is the period of the resale restriction• The dividend yield on the stock• The risk-free rate of return, which is often returned to the yield on Government of Canada

bonds (the term of the bonds should be approximately equal to the period of restriction)• The volatility of the stock, which can be obtained from services such as Bloomberg20

however this source of information is only relevant for public stocks

It is, of course, useful to compare the results derived using the Black Scholes model or other quantitative methodologies to the empirical studies.

3.11.3 Restricted Shares Off ered as Employee Compensation

More and more executives are fi nding their compensation is tied to the success of their employer company through vehicles such as stock options, restricted shares and employee share ownership plans. Since this type of compensation is on the increase, it is important to know how the characteristics of these investments aff ect their valuation for income tax and other purposes.

In the case of restricted shares, the shares issued to the executive are not immediately transferable or saleable and are vested only after a specifi ed period of future service.

Upon termination of employment for any reason before the date of vesting, the shares are usually forfeited by the employee and reacquired by the employer. This section examines the valuation of such shares and the impact of the “value to owner’’ concept advanced by the CRA.

Restricted shares issued by public companies can usually be traded freely after they are vested. There- fore, the period from the date of the award to the date of vesting (the vesting period) and the restriction period are one and the same. The shares of a private corporation, however, are not usually freely tradable after they vest. They cannot be transferred to a third party or sold back to the issuer, directly or indirectly, during the individual’s employment with the company. They may, however, be sold if some extraordinary triggering event occurs (i.e., if the entire business is sold to a third party).

19 In a February 1988 article published by ASA entitled “Valuation of Restricted Stocks: An Option Theory Approach,” Reynolds Griffi th states that the proper exercise price is that price which, if received at the end of the period of restriction, would give the holder an adequate return, taking into account the expected dividends of the period.

20 To reduce the impact of fl uctuations caused by unusual trades, a volatility factor based on trading results for the 100 days prior to the valuation date may be used. Bloomberg provides volatility factors for 10, 30, 50 and 100-day periods.

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Assessment of Value to Owner: Discount from Rateable FMVFor Canadian tax purposes, an employee is generally deemed to have acquired the shares and received a taxable benefi t on the date that the restricted stock is awarded. According to paragraph 7(1)(a) of the Income Tax Act (the Act), the benefi t is calculated as the “value” of the restricted shares at the time of the award, less any amount paid or payable to the corporation by the employee for the shares.

Where the issuer of restricted shares is a Canadian-controlled private corporation (CCPC), and the employee deals at arm’s length with the CCPC, tax becomes payable only when the shares are ultimately sold by the employee. (Unless otherwise indicated, this section focuses on shares issued by public corporations and private corporations other than CCPCs.)

In general, the term “value,” as used in the Act, is interpreted to mean FMV. The CRA has indicated, however, that in assessing the benefi t to the employee, a “value to owner” concept is appropriate. Hence, the determination of the taxable benefi t begins with a quantifi cation of the rateable FMV of the underlying shares.

Generally, these “value” calculations will be relevant to private companies. With public companies, the trading price will most often be the starting point in determining FMV. The valuator can then determine the appropriate discount (if any) to refl ect the specifi c characteristics, terms and conditions of the shares under consideration (including the impact of the restriction period) and the employee’s specifi c circumstances.

The size of the appropriate discount will depend on the valuation methodology used. Any specifi c circumstances that might aff ect the discount should be separately assessed. They include the likelihood that:

• The shares may not be freely tradeable during the restriction period (“restriction period risk”).

• The shares will not be vested because the employee will leave the company during the restriction period (“risk of forfeiture”).

• Other attributes, terms and conditions of the shares and the issuer corporation may aff ect the ultimate benefi t to the employee (“other attributes”).

The appropriate discount is usually expressed as a percentage reduction from rateable FMV.

Most plans provide that if employment ceases before the date of vesting, the shares are forfeited by the employee and reacquired by the company. Therefore, the determination of the benefi t to the employee at the date of the award (i.e., value to owner) must include an evaluation of the likelihood that the employee will remain with the company until the date of vesting.

For example, consider the case of an employee who received restricted shares and resigns shortly thereafter (i.e., before the shares are irrevocably vested). Assuming that the valuator could have reasonably predicted the resignation at the date of valuation (if, for instance, the employee’s dissatisfaction had been well documented, he/she was actively searching for other employment, etc.), the discount from rateable value would refl ect the uncertainty of continued employment as of the date of valuation.


196

In general, as the vesting period is increased, the risk of forfeiture also increases. A review of the average annual turnover among employees participating in the restricted stock plan can provide an initial benchmark. The analysis should focus on plan participants (as opposed to all employees) because participation in the restricted stock plan may suggest above-average performance and may reduce the likelihood of termination before vesting (i.e., plan participants may be a more homogeneous comparator group). The benchmark can then be adjusted according to the employee’s specifi c circumstances.

The valuator may also consider the following factors:

• The employee’s tenure• The employee’s career progression with the corporation• The possibility of death or disability• Corporate character and performance

These are discussed as follows.

The Employee’s TenureSince most employees with signifi cant tenure may be considered less likely to leave the company before the expiration of the vesting period, tenure should be compared to the average tenure of employees within the corporation (particularly employees who have been awarded restricted shares), as well as industry norms. The employee’s position should be considered, along with average tenures of that position in the relevant industry. For example, CEOs in certain industries have notoriously short employment tenures.

The availability of alternative employment should also be considered. It should be noted that many restricted stock plans provide compensation for employees who have been laid off . To the extent that these provisions are available, the risk of forfeiture may be reduced.

The Employee’s Career Progression within the CorporationThe valuator may wish to interview the appropriate parties and review the employee’s personnel fi le and documented performance appraisals.

The Possibility of Death or DisabilityIn the spirit of compassion, the death of an employee sometimes gives rise to full vesting. The valuator needs to consider the terms of the plan and the impact of a premature death. The concept of mortality has been accepted by the courts in the determination of benefi ts (e.g., in personal injury matters involving the determination of an individual’s lost future income). Given the age of the participants, and the relatively short vesting periods typical of these plans, mortality will generally have a limited eff ect on value. The same can be said for disability, which is a more common occurrence.

Corporate Character and Performance Corporate size, stage of development, and performance aff ect the risk of forfeiture. Successful companies are likely to keep good employees and good employees are more likely to stay with successful fi rms than with those experiencing diffi culties.

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When calculating the benefi t of a particular employee’s shareholding, there are, of course, many other considerations that may give rise to a discount (particularly in the case of private corporations). A careful review of the agreement between the employer and the employee, for instance, will indicate the rights and privileges bestowed on the employee (i.e., the shareholder). To the extent that the shareholder’s rights, privileges and benefi ts are further curtailed, the discount should be adjusted accordingly.

MQE QUESTION 3.4

Michael Rich, a resident of Canada, graduated last year with a bachelor degree in computer science. He immediately gained employment in a highly regarded developer of health care related software, HealthRecords Inc. (“HealthRecords” or “the Company”). HealthRecords went public approximately 15 months prior to the commencement of Michael’s employment with the Company. The public stock market price of HealthRecords enjoyed considerable gains over the period since its IPO in May last year to the end of last year. A signifi cant component of Michael’s compensation is restricted stock in the Company.

Specifi cally, on June 30 last year, Michael received 25,000 restricted shares of HealthRecords (“the Restricted Shares”). The conditions and characteristics of the Restricted Shares are outlined below. Michael’s tax accountant has correctly informed that restricted shares are taxable to Canadian residents immediately upon issuance. As such, Michael understands that on his last year’s tax return that he had not fi led yet, he must include the fair market value of the restricted shares. Michael’s brother, Joel, has told him that “Obviously, the fair market value of the restricted shares is equal to the stock market trading price as at the date of issue.” Confused by his brother’s statement, Michael has approached you, CBV, to provide insight in this regard.

Furthermore, Michael has heard rumours that next year, HealthRecords may give him the choice to receive either stock options in the Company or additional restricted shares. As such, Michael would like you to advise him on the issues he should consider prior to making his decision.

A listing of the stock market price for HealthRecords shares over the relevant period is included below along with projections prepared by the Company for additional fi nancing purposes. As well you have looked into some comparable companies as outlined below.

Characteristics of the Restricted SharesThe following is an overview of the relevant characteristics of the Restricted Shares

• The Restricted Shares have voting rights that are identical to HealthRecords common shares.

• The Restricted Shares cannot be sold, assigned, transferred (to anyone other than a spouse, child, grandchild or trust), pledged, or otherwise disposed of until vested.

• Vesting of Restricted Shares automatically ceases upon the termination of employment with HealthRecords.

Vesting PeriodParticipants who hold Restricted Shares in HealthRecords are subject to the following vesting schedule:


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• 25% in each of June 30 this year, December 31 this year, June 30 next year and December 31 next year.

MQE QUESTION TABLE 3.4AStock Market PricesHealthyRecords Inc.

May 31 last year $7.00June 30 last year $7.50July 31 last year $7.75August 31 last year $10.00September 30 last year $15.00October 31 last year $22.75November 30 last year $21.25December 31 last year $17.50January 31 this year $9.50February 28 this year $4.00March 31 this year $2.50April 30 this year $2.25May 31 this year $1.75June 30 this year $1.50July 31 this year $1.75August 31 this year $2.50September 30 this year $2.25

MQE QUESTION TABLE 3.4BOther Companies Market Price As at August 31 This Year Earnings RevenueComputers are US $3.50 (3,452,100) 10,000,000Programmers Plus $28.75 865,000 25,000,000Shrink Wrap Inc. $0.14 (114,524) 2,000,000

MQE QUESTION TABLE 3.4CHealth Records Inc.Projections For the fi scal year ending August 31 (000’s)

YearNext Year 2nd Next

Year3rd Next

Year4th Next

Year5th Next

Year

Gross Revenues 1,052 2,014 4,208 8,416 16,832

Direct costs 106 175 314 592 1,148Staff 1,034 1,187 1,494 2,107 3,333Administration 53 94 175 338 663Occupancy 92 134 218 386 721Telephone and travel 42 78 151 295 585Marketing 210 242 307 437 697Amortization 69 82 109 162 269Total expenses 1,606 1,992 2,768 4,317 7,416

Net income (554) 22 1,440 4,099 9,416

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Required:Provide the requested advice to Michael.

Solution:Memorandum

To: Michael Rich

From: CBV

Re: Restricted stock

Fair market value

Joel is likely incorrect in suggesting that the fair market value of the Restricted Shares is equal to the public market trading price of the HealthRecords shares. The defi nition of fair market value suggests, among other factors, “highest price obtainable in an open and unrestricted market.” As a result of the signifi cant restrictions that the Restricted Shares are subject to, a third party purchaser would not be indiff erent to owing a freely tradable common share of Health Records relative to the Restrictive Share. That is, a third party purchaser of the Restricted Shares would require a discount relative to the price of a freely tradable share of HealthRecords, due to the relative illiquidity of the Restricted Share as compared to a freely tradable share (since HealthRecords shares are publicly tradable, the trading price includes liquidity value), including:

• The risk that during the period restriction (“restriction period”) the public market trading price of HealthRecords shares will increase, and due to the illiquidity of the Restricted Shares, Michael will not be permitted to realize the gains.

• The risk that during the period of restriction (“restriction period”) the public market trading price of HealthRecords shares will decrease, and due to the illiquidity of the Restricted Shares, Michael will not be permitted to liquidate his Restricted Shares to minimize losses.

• Time value of money considerations.• Opportunity costs of not being permitted to liquidate the Restricted Shares and use the

proceeds in alternative investment opportunities.

Factors that Impact the Quantum of DiscountThere are various factors that impact the quantum of discount that can be applied to the publicly traded price of HealthRecords shares in order to arrive at the fair market value of the Restricted Shares. For example, factors include:

• The volatility of the HealthRecords common shares. The greater the price volatility, the greater the risk there is to the holder of the Restricted Shares of having illiquidity. My preliminary review of HealthRecords’ recent share trading prices indicates that signifi cant volatility exists. This would have the eff ect of increasing the discount.

• The duration of the restriction period. The longer the period of illiquidity, the greater the risk of holding the Restricted Shares, and the greater the discount. Since the restriction period in respect of the Restricted Shares elapse over a two-year period, diff erent illiquidity discounts would be required for each tranche of Restricted Shares.


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Determination of DiscountThe quantum of an illiquidity discount that a third party purchaser would require is subjective. There are several methodologies that are commonly employed in helping to estimate this discount, such as:

Restricted Stock StudiesVarious North American studies have been undertaken over the past 50 years on the values of non-marketable or restricted shares. Some material considers “letter stock,” which is stock identical in all respects to freely traded stock except that it is restricted from trading in the open market for a specifi ed period under the regional securities guidelines. The restrictions on the transfer of letter stock usually lapse within two years, which is generally longer that the restriction period of the Restricted Shares. In addition, volatility characteristics of the letter stock may be diff erent for the Restricted Shares. The studies referred to above indicate average trading discounts in the range of 25% to 45%. More recent studies, however, indicate discounts in the lower end of this range.

The foregoing studies also indicate that the length of the period of share restriction would also impact the size of the discount. Generally, the longer the restriction period, the larger the discount.

Option PricingAn option-pricing model can be used to estimate the cost of a put option on freely tradable HealthRecords shares as a means of estimating an appropriate discount to refl ect the illiquidity of the restricted shares. Theoretically, the put option would allow the holder of the restricted shares to sell the restricted share at the market trading price on the valuation date at the end of the vesting period. This would allow the holder of the restricted shares to minimize possible losses as a result of a drop in the value of the freely tradable HealthRecords shares during the restriction period. By purchasing put options, the holder can theoretically protect their position at the market price, as at the valuation date, over a specifi c time period. The cost of the put option refl ects a cost required of a theoretical hedge on the shares over the applicable restriction period.

I suggest engaging the services of a qualifi ed CBV in order to assist you in determining the fair market value of the Restricted Shares so that you will have support of the income inclusion should the tax authorities request it.

Restricted Shares vs. OptionsIn Canada, there are diff erences between stock options and restricted shares that should be considered prior to making your decision. Below is a summary of some of these factors:

• Stock options are not taxable upon issuance; restricted shares are taxable upon issuance. As such, there is a tax deferral opportunity to you Michael if you selected the stock option alternative.

• Stock options will usually expire; restricted shares do not.• Stock options generally have a cash cost to you when they are exercised; restricted shares

do not.• Restricted shares usually participate on an equal basis with freely tradable common

shares in terms of voting, dividend rights, etc. Stock options are usually not regarded as in the same manner as freely tradable stock. Since it is unlikely that HealthRecords will pay

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dividends given its start-up nature, and given the insignifi cant minority voting position you would hold in the Company, this feature is not valuable to you at this time.

Given the signifi cant preferential tax treatment accorded to stock options in Canada, the relative unlikelihood of HealthRecords paying dividends, and based on the other factors above, I would suggest the stock option alternative.


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3.12 Quantifying the Special Purchaser PremiumAs you learned in the Level 1 — Introductory Business Valuation course, a special purchaser for a particular business can pay a unique price because of its ability to utilize these assets in a distinctive manner. Stated another way, an open market purchaser will review an acquisition candidate not only with respect to the value of the target’s business on a stand-alone basis, but also in relation to the incremental value created from the combination of his/her existing business with the target’s business.

The special purchaser premium is a function of:

• The quantum of economic benefi t the business combination will provide.21

• The risk associated with achieving these benefi ts (i.e., likelihood).• The number of potential special purchasers that exist.

The quantum of economic benefi t the business combination will provide is a function of:

• Synergies due to economies of scale that can be identifi ed and quantifi ed in terms of incremental cash fl ows to the combined entity in the form of incremental revenues or cost reductions. For example:

- Lower administrative costs by having only one accounting department

- Increased purchasing power and a consequent reduction in the costs of goods sold

- Increased plant capacity utilization manifested as improved plant effi ciency

• Synergies due to strategic advantages that can be identifi ed and quantifi ed in terms of incremental cash fl ows to the combined entity in the form of incremental growth opportunities. For example:

- Elimination of a competitor since the business may have the ability to raise prices for its products in future periods

- Better market coverage by integration of product lines

- Improved distribution of products from better utilization of the marketing organization and distribution channels

- Immediate entries into industries/markets not previously accessible to the purchaser

- Acquisition of technology that would otherwise have to be developed internally

- Cost to reproduce the business being considered

- Vertical or horizontal integration of the businesses

21 In an open market, the quantum of economic benefi t that the purchaser and vendor perceive determines the price that is ultimately paid. Even if a purchaser is able to identify and quantify possible synergistic benefi ts, the vendor is not usually knowledgeable enough about the purchaser to quantify the benefi t, and therefore may not take the potential benefi t into account in negotiating the fi nal price.

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• Financial synergies that can be identifi ed and quantifi ed in terms of lower costs of fi nancing or other benefi ts from a more effi cient capital structure as a result of the lower business risk to the combined entity. For example:

- Diversifi cation of products, fi nancial risk, production capabilities

- Increase in the size of a given business to make it more attractive to the capital markets

EXHIBIT 3.6: THE QUANTUM OF ECONOMIC BENEFIT

Economic Benefi t of Business Combination = Economies of Scale + Strategic Advantage + Financial Synergies

Quantifying Economic Benefi tThe valuator’s approach to obtain information to quantify the special purchaser premium (in addition to the steps outlined above to identify special purchasers) may include:

• Reviewing annual reports of public company competitors and customers to see whether they were active acquirers of other businesses and/or whether the annual reports contained any commentary as to management’s philosophy concerning acquisitions (i.e., value drivers, synergistic benefi ts, etc.).

• Reviewing public information concerning reported transactions in the industries in which the business operates, including the annual reports and U.S. Securities and Exchange Commission Form 10K reports of the participants, to assess whether premiums were available in the market for similar companies.

• Reviewing industry literature, trade journals, etc. for articles or references to approaches to valuing enterprises in the industry.

• Reviewing decisions where the industry is regulated and the regulator may render public decisions with respect to acquisitions. These decisions may sometimes provide signifi cant detail with respect to the transaction.

Having identifi ed and quantifi ed the economic benefi t, the valuator then has to assess the likelihood or risk associated with achieving these benefi ts.

Risks Where a purchaser perceives the availability of economies of scale in combination with a target business, that purchaser will assess the risk of such cost savings materializing. There is obviously more risk associated with projections of income as opposed to income that has been demonstrated in the past. As a result, purchasers will normally require a higher rate of return on projected increments in economies of scale than on the existing earnings of the target company.

Strategic AdvantageAs discussed above, the second type of value-added that a purchaser might perceive is long-term growth or strategic advantage. This is generally less clear-cut than projections of economies of scale. As a result, any incremental earnings that a purchaser attributes to strategic advantage


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would generally carry an even higher risk rate than what might be ascribed to the economies of scale.

Capitalization RatesThe existence of special purchasers must be factored into the selection of appropriate capitalization rates in a manner consistent with how the issue was considered in the earnings selection. Where an investigation of the market reveals that special purchasers are likely in existence, and:

• Where the valuator is unable to quantify with any certainty the incremental earnings that might be achieved by such purchasers, the existence of the special purchasers might be refl ected entirely as a reduction of the capitalization rate that would otherwise be selected. In other words, the value calculation would consider only the stand-alone earnings potential of the subject business, but reduce the discount rate otherwise attributable to those earnings by virtue of the likely existence of special purchasers. Some valuators would argue that the adjustment to the capitalization rate is not intended to refl ect the incremental value (since the valuator could not quantify it in the fi rst place). Rather, the adjustment to the capitalization rate is made to refl ect the additional liquidity of investment available to the purchaser by virtue of the existence of other purchasers with a special interest in acquiring the business; while other valuators would argue that the lower cap rate may refl ect additional value to a particular buyer.

• Where the valuator is able to reliably quantify the incremental earnings that might be achieved by the special purchasers, those incremental earnings will likely be valued separately; they would likely carry a higher risk than the existing earnings of the business under review. As noted above, the valuator may segregate the expected value-added into components of near-term economies of scale and long-term growth prospects and ascribe a diff erent risk rate to each.

The valuator must remember that where only one special purchaser exists, that purchaser will generally pay only a nominal amount more than an ordinary purchaser to ensure that it gets the deal, assuming that the special purchaser knows that it is the only one. The so-called special purchaser premiums would only be available where several competing purchasers are known to exist. The breadth of the perceived special purchaser market is an important factor to consider in selecting appropriate capitalization rates.

We should also acknowledge that there also can be adverse consequences of a business combination to be recognized is some business combinations, particularly, perhaps, relative to realizing expected synergy benefi ts. For example, the need to deal with costs of exiting some facilities in order to concentrate production in the most effi cient location. Another example would be the added costs of regulatory compliance when the business combination moves the entity into a market territory where public policy on competition becomes an issue.

Below is a question from a prior MQE relating to this section.

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MQE QUESTION 3.5

Ms. Vidalia is a 70-year old widow. She is a 100% shareholder in a manufacturing company, Shingles Inc. (“the Company”), left to her by her late husband. The Company manufactures tar-based asphalt roofi ng shingles and has been in business for 35 years. During this time, the Company has been able to develop a strong customer base of large residential and commercial builders, and has certain exclusive distribution rights with large “big-box” home improvement retail outlets. As a result, the Company has had historic profi tability and built up a 25% market share within a highly fragmented shingle manufacturing industry.

Prior to his sudden death, Mr. Vidalia was heavily involved in the management and the operation of the Company. Ms. Vidalia has never been involved in the day-to-day operations of the Company. The Vidalias’ three adult children have full-time careers and besides working part-time as students, they have never been interested in becoming successors to their parents’ business. After considering the relatively inexperienced existing management team, Ms. Vidalia decided to hire a new Chief Executive Offi cer from a large competitor, Roofi ng Corporation, Shaun.

The shingle manufacturing industry is currently undergoing signifi cant change as a result of the recent introduction of stronger aluminum based shingles. While asphalt shingles generally last a maximum of ten years before they require placing, the newly developed aluminum shingles have guaranteed lives of 50 years. In addition, the new aluminum shingles will not warp, crack or rust and are maintenance free over their expected lives. However, these new shingles may cost up to three times the cost of the tar shingles.

Although the ultimate impact of the new shingles is uncertain at this time, the Company is beginning to experience a decline in profi tability. Consequently, Ms. Vidalia believes that it is time to sell the company. She has heard that potential buyers may sometimes be willing to pay “extra” for companies. She has approached you to explain this concept and its applicability to her business.

Required:Respond to Ms. Vidalia’s concerns.

Solution:September this year

Ms. Vidalia

Street #

Anytown, Anyprovince

Dear Ms. Vidalia:

This letter comes in response to the concern you raised with respect to your company, Shingles Inc. (“Shingles”)


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SPECIAL PURCHASERS

The issue you raised relates to a buyer’s willingness to pay “extra” for a business. “Extra” may refer to a special purchaser premium. That is, certain purchasers may be willing to pay more for a business for their own particular reasons, such as the ability to achieve synergies. But this premium may be realized only to the extent that identifi able special purchasers exist (more than one) and synergies exist for which those special purchasers are willing to pay.

With respect to your business, a special purchaser market may exist as evidenced by:

• Highly fragmented market-consolidation trend/economies of scale• Many participants indicates many potential buyers• Shingles has potentially attractive features (customer base, name, etc.)

Based on what I understand about Shingles, and the industry in which it operates, I have identifi ed the following possible examples of special purchasers and the possible synergies that could be achieved:

• Roofi ng Corporation — Possibility to buy out a competitor in Shingles and build market share.

• A home builder — Vertical integration, economies of scale, access to supply• Roofi ng Contractors — Vertical integration, cheaper building materials• Other purchasers who may be able to realize synergies such as redundancy of management

(new CEO), distribution network, and customer base, etc.

Even though the profi tability of Shingles is declining, special purchasers may be willing to pay extra for the customer base and/or distribution channel already in existence.

The quantum of this premium synergy may be represented by net economic value added (reduction in costs, economies of scale, addition of volume with little incremental infrastructure costs). But a special purchaser may not be willing to pay for all the NEVA (Net Economic Value Added) because there would be no point in doing a deal.

That is, it is likely that a special purchaser will reach a negotiated position. However, in a bidding situation, a purchaser may be willing to pay for most, if not all NEVA.

3.12.1 Levels of Value

Valuators identify two initial levels of value — Controlling Value and Non-controlling Value. The controlling level of value has the power to direct a company’s management, strategic direction and operating policies. Typically, a controlling shareholder owns more than 50% of the company’s equity. The owner of a non-controlling interest would usually hold less than 50% of the company’s equity and could not unilaterally exert control over the company.

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Valuations yield a specifi c level of value (controlling or non-controlling) depending on the assumptions used in the valuation. As such, valuation adjustments may be required to conclude on a level of value diff erent from that yielded by the initial valuation.

Control PremiumA premium for control is required when the engagement is to value a controlling interest and the valuation yielded a non-controlling value.

The International Glossary of Business Valuation Terms defi nes a control premium as “an amount or percentage by which the pro rata value of a controlling interest exceeds the pro rata value of a non-controlling interest in a business enterprise to refl ect the power of control.”

Discount for Lack of ControlA discount for lack of control (“DLOC”) - also referred to as a minority discount - is required when the engagement is to value a non-controlling interest and the valuation yielded a controlling value.

The International Glossary of Business Valuation Terms defi nes a discount for lack of control as “an amount or percentage deducted from the pro rata share of value of 100% of an equity interest in a business to refl ect the absence of some or all of the powers of control.”

Discount for Lack of MarketabilityThe International Glossary of Business Valuation Terms defi nes a discount for lack of marketability as “an amount or percentage deducted from the value of an ownership interest to refl ect the relative absence of marketability.”

Although a distinction is made between a decrease in value due to the inability to control a business’ operations and direction and a decrease in value due to the inability to liquidate the investment in a timely fashion, the two concepts are sometimes related.

Specifi cally, a non-controlling investor cannot control a company’s operations and remains subject to the controlling investor’s decisions. As such, a non-controlling interest in a privately held company may be viewed as “less liquid” given the diminished demand for a fractional interest relative to a controlling interest. The Levels of Value are illustrated Exhibit 3.7.


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EXHIBIT 3.7 : LEVELS OF VALUE

Control Value

Non-controllingMarketable Value

Non-controllingNon-marketable Value

A control premium is used when moving from a Non-controlling

Marketable Value to a Control Value

A discount for lack of control is used

when moving from a Control Value to a

Non-controlling Marketable Value

A discount for lack of marketability is used when moving from a

Non-controlling Marketable Value to a

Non-controlling, Non-marketable Value

Synergistic Value

Non-controlling marketable value is derived from a non-controlling interest that does not suff er from a lack of marketability. This is best illustrated as a non-controlling interest in a publicly-held company whose shares are actively traded on a public exchange.

Non-controlling, non-marketable value is best illustrated as the value held by a non-controlling investor in a closely-held business that cannot access a public exchange.

Synergistic value (or investment value) includes the economies of scale that would be gained in the combination of two companies. It is most often greater than control value. It should be noted that synergistic value is typically not considered in the preparation of notional valuations due to a lack of information regarding the synergies that could be obtained by a strategic buyer.

3.12.2 Levels of Value and Valuation Methodologies

3.12.2.1 Income ApproachAs previously discussed, the level of value is a direct result of the valuation method applied and the assumptions underlying the analysis. Accordingly, valuation professionals must:

• Assess the level of value required in the engagement;• Understand the levels of value which results from the method used; and• Make adjustments as needed

The application of control adjustments (control premium or DLOC) is based on the level of cash fl ows used in the income approach. In Exhibit 3.8 adjustments were made to add back above-market offi cer compensation and above market rent, common way in which a controlling shareholder could distribute income to themselves.

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EXHIBIT 3.8: ADJUSTMENTS MADE TO ADD BACK ABOVE-MARKET OFFICER COMPENSATION AND ABOVE MARKET RENT.

Sales $ 1,000

ExpensesOffi cer salary 250Building rent 50General and administrative 655

955

Reported earnings 45 Minority level

AdjustmentsOffi cer salary 125Building rent 25Adjusted earnings $ 195 Control level

If the $195 of income is used in an income approach, the resulting value would be considered a control level value, as only a controlling shareholder would have the ability to access the value.

If the $45 of income is used in the income approach, the resultant value would be considered non-controlling, as a non-controlling shareholder could only access the $45 of reported income.

3.12.2.2 Market Approach

Conventional valuation wisdom suggests that the application of a market, or guideline company, approach, results in a marketable minority interest, due to the nature of stock prices.

However this wisdom is being challenged by modern valuation theory that suggests that public company pricing multiples do not necessarily result in minority level values. Rather, control or minority level characteristics are determined by adjustments made to the benefi t stream.

EXHIBIT 3.9: LEVELS OF VALUE ASSOCIATED WITH VALUATION APPROACHESMethod Level of Control Level of MarketabilityMarket Approach (Guideline Company) Control or Minority MarketableTransaction Approach Control or Minority MarketableIncome Approach (DCF or capitalization) Control or Minority Marketable or non-

marketableIncome Approach (Excess Earnings) Control Marketable or non-

marketableAsset Approach Control Marketable or non-

marketable


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3.13 AgreementsAgreements entered into in the course of establishing an organization (shareholders’ agreement), purchasing or selling a business (purchase and sale agreement, non-compete) or those entered into during the course of doing business (fi nancing agreements, leases, distribution agreements, union agreements, etc.) may have a signifi cant impact to that business’ operation, tax position, fi nancial situation and, ultimately, valuation. Accordingly, it is imperative for valuators to have a reasonable understanding of these agreements, the implications of such on value and possibly the risks and opportunities associated with them.

This section does not describe all of the agreements that may be encountered, nor does it provide a complete list of the potential areas that a valuator needs to be aware of within a particular agreement. Rather, it highlights some of the key elements and the importance of carefully considering all existing agreements when preparing or reviewing a valuation. The reason for this, in particular, is that certain risks and opportunities that exist in a review of a legal agreement may not be readily apparent in a review of fi nancial information. Furthermore, in this process, the valuator should always consult legal counsel to assist in interpretation to ensure a complete and comprehensive understanding of the implications is acquired.

The following sections discuss:

• Shareholders’ agreements• Non-compete agreements• Management agreements• Other agreements, including union, royalty and distribution agreements

3.13.1 Shareholders’ Agreements

A shareholders’ agreement is essential for private companies with more than one shareholder, as it defi nes the relationship of the shareholding parties and addresses the privileges, protections and obligations that exist by mutual agreement. It is unique from the other agreements listed in the introduction, as not only can a shareholders’ agreement have an impact on value because of certain possibly restrictive or opportunistic clauses, but it also often defi nes value under a number of circumstances.

3.13.1.1 Key Objectives of a Shareholders’ AgreementIt is important for the individuals entering into a shareholders’ agreement to ensure it adequately addresses their collective intent. As times change, so do the requirements under a shareholders’ agreement. For this reason, shareholders are advised to periodically review the shareholders’ agreement and modify or update it as necessary.

In eff ect, “an ounce of prevention is worth a pound of cure.” At the outset of a relationship, the task of drafting a shareholders’ agreement is often viewed as a waste of time; however, when the storm hits, a solid agreement between the shareholders will help them map their way to a resolution in a more organized fashion based on a pre-defi ned set of rules as set out in their agreement.

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Some of the key objectives of a shareholders’ agreement are to defi ne:

• Value.• Liquidity.• Other key relationship elements.

EXHIBIT 3.10: KEY OBJECTIVES OF A SHAREHOLDERS’ AGREEMENT

Defi ne Value

Provide a method for determining a fair price of a shareholder’s interest (in most circumstances).

• Defi ne Liquidity• Provide a mechanism to liquidate a shareholder’s interest (in the event of mental or physical

disability, bankruptcy or fi ring, retirement or death, or in the event of a disagreement among shareholders).

• Provide the shareholders with a means to acquire another shareholder’s interest.• Prevent the sale or transfer of an interest to a party deemed undesirable.• Provide liquidity protection to majority shareholders through drag-along provisions and

provide liquidity to all shareholders through tag-along provisions.

Defi ne Other Key Relationship Elements• Address non-competition.• Outline control relative to the shareholders and the board of directors.

Each of these objectives is discussed below.

3.13.1.2 Defi ning ValueValue terms in a shareholders’ agreement have signifi cant implications to the shareholders and must clearly be defi ned to ensure the intent of the parties for a “fair” exit value is established. All too often, the value defi nition is misunderstood, misapplied or disregarded. For example, many agreements will merely state that an independent person will determine fair market value, yet will not provide guidance as to how that fair market value is to be determined:

• Does the value defi nition mean intrinsic value or are special purchasers considered?• Does it consider the application of minority discounts or is it intended to mean “rateable”

value?

Regardless of the circumstances, no pricing method in the shareholders’ agreement will satisfy all of the parties involved. In addition, whatever the method, there may be diffi culties with the interpretation of the price defi nition.


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Shareholders’ agreements most frequently use the terms “net book value,” “adjusted book value,” and “fair market value.” These terms are defi ned below.

• Net book value

The total shareholders’ equity appearing in the corporation’s balance sheet.

• Adjusted net book value

The amount by which the fair market value of the tangible assets of a business, determined on the basis of their value in continued use, exceeds the fair market value of the liabilities of the business.

• Fair market value

The highest price in an open and unrestricted market between informed and prudent parties, acting at arm’s length under no compulsion to act, expressed in terms of cash.

The above clearly shows how problems can arise in interpretation. In particular, with defi nitions such as net book value or adjusted net book value, these approaches may not, in many cases, satisfy the intent on value between the parties. Among other concerns, these value approaches neglect the profi tability and cash fl ow of the business and may exclude the value of certain tax attributes (loss carry forwards).

Even with defi nitions such as fair market value, there are still issues around that defi nition requiring consideration. For example:

• Should minority discounts apply and, if so, should the discount percentage be pre-determined?

• Should special interest purchasers be considered with estimated synergies or should it be stand-alone, intrinsic value?

• Does personal goodwill exist and, if so, what is the impact on value?• Does a subsequent sale by the acquiring shareholder, within a defi ned period of time,

obligate any excess value received on such subsequent sale to be reimbursed to the original selling shareholder?

• How should fi nancing impact value?• Should this valuation take into account the proceeds received from a life insurance policy?• Does the event that triggered the valuation impact the value determination (e.g., does a

defaulting shareholder receive a further discount taken on value, i.e., fraud, etc.)?

Because of these factors, the best advice for those who are preparing to draft a shareholders’ agreement is to consult both legal counsel and a business valuator to ensure that their rights are adequately protected should a future transaction take place involving the pricing provision or the share valuation provision set out in the agreement.

Two other areas of value determination must also be considered:

• The valuation of shares for tax purposes in the event of the death of a shareholder• Valuation considerations on default of the shareholders’ agreement.

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Valuing Shares of a Deceased ShareholderTypically, in shareholders’ agreements the shareholders will agree that, on death of a shareholder, the shares will be sold to the other shareholders at an agreed price or at a price based upon an agreed formula. The Canada Revenue Agency (CRA) (formerly CCRA) states in Interpretation Bulletin IT-140R3, dated August 9, 2002, that:

When determining the proceeds deemed to have been received by the deceased pursuant to subsection 70(5), the fair market value of the property subject to the buy-sell agreement must be determined at the time immediately before death. The Department’s view is that, where the deceased and the surviving party to the buy-sell agreement (survivor) did not deal at arm’s length, it is a question of fact whether the fair market value for the purpose of subsection 70(5) will be determined with reference to the buy-sell agreement.22

In terms of the “question of fact” test for non-arm’s length parties, the CRA in IC89-3, “Policy Statement on Equity Valuations,” states in paragraph 28 that:

In order for a buy-sell agreement to be considered determinative of value pursuant to subsec-tion 70(5), it must meet all the following requirements: (a) The agreement must obligate the estate to sell the shares at death either under a mandatory sales and purchase agreement or at the option of a designated purchaser. (b) The agreement must restrict the shareholder’s right to dispose of his/her shares at any price during his/her lifetime. (c) The agreement must fi x a price for the shares or set out a method for determining the price on a current basis. (d) The agreement must represent a bona fi de business arrangement and not a device to pass the decedent’s shares to his/her heirs for less than an adequate and full consideration.23

The Canada Revenue Agency (CRA) TestIn terms of parties acting at arm’s length, the CRA still requires that certain tests be met to enable the value defi nitions in the shareholders’ agreement to apply (as outlined in IC89-3):

• It is a bona fi de business arrangement. • The stipulated price or formula price in the agreement provides full and adequate

consideration, and represents the fair market value of shares determined without reference to the agreement at the time it is executed.

• It is a legal and binding contract.

The issues surrounding whether the shareholders’ agreement is to apply are important in the circumstances surrounding the death of a shareholder, as subsection 70(5) requires that the fair market value of the property be determined “immediately before death.” This poses the question as to whether death is to be contemplated in the valuation and therefore the provisions of the shareholders’ agreement would apply, or whether death is not contemplated and therefore the value in the shareholders’ agreement does not apply.

The Supreme Court of Canada in Beament Estate v. M.N.R., [1970] S.C.R. 680 supports the premise that the value determination must contemplate death and therefore the shareholders’ agreement applies.

22 www.cra-arc.gc.ca/E/pub/tp/it140r3/README.html23 www.cra-arc.gc.ca/E/pub/tp/ic89-3/ic89-3-e.html


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In Beament Estate, there were two special classes of shares, both of which had voting rights. The Class A shares were entitled only to a fi xed cumulative preferential dividend, while the Class B shares were entitled to receive the whole of the remaining earnings, other than capital gains. On dissolution of the company, however, the positions of these classes of shares were reversed, with the Class B shares being entitled only to return of paid-up capital and the Class A shares being entitled to the remaining assets.

Beament owned 2,000 Class B shares, while his two children each owned 12 Class A shares. He had agreed with his sons during his lifetime that, in the event of his death, the company should be dissolved. The Supreme Court of Canada held that, for estate tax purposes, his Class B shares could not be valued at a fi gure in excess of the amount realizable on dissolution.

If a stranger had negotiated to buy Beament’s shares immediately before Beament’s death, in the knowledge that on Beament’s death the company would have to be dissolved, he would not have paid more for the shares than the amount realizable on dissolution. This principle should equally apply to subsection 70(5) of the Income Tax Act.

Additional support for this view is provided by the decision of Mr. Justice Andrews of the Supreme Court of British Columbia in West Estate v. Minister of Finance, [l976] C.T.C. 313, a decision under the British Columbia Succession Duty Act.

The deceased held a minority share interest in Wood Gundy Securities Ltd., a private company, subject to the terms of a shareholders’ agreement by which the shares of a deceased shareholder had to be sold to certain employees designated by a shareholders’ committee at their value as determined by the committee, less a deduction of one-third (said to be for lack of marketability).

West’s shares were, in fact, sold after his death for $5.33 per share, which was the value declared by the executors in the succession duty return. The Minister valued the shares at $10 per share, but Mr. Justice Andrews held that the price of $5.33 per share, which was fi xed pursuant to the shareholders’ agreement, was binding for succession duty purposes. This case supports the premise that contemplation of death must be considered and therefore the shareholders’ agreement should apply.

Whether shares are valued in contemplation of death or not, the tax results to the individual’s estate are often the same. This is best refl ected by the following example.

EXAMPLE 3.8: DEATH OF A SHAREHOLDER

Assume that Shareholder A dies and the shareholders’ agreement values the shares at $50,000, while the CRA values the shares at $100,000.

• If the shares are valued at $100,000 immediately before A’s death and if the adjusted cost base of the shares in his hands was $10,000, A will be deemed to have realized a $90,000 capital gain immediately before his death.

• His estate will be deemed to have acquired his shares at a cost of $100,000, but when the estate sells these shares during its fi rst taxation year for $50,000, it will realize a $50,000 capital loss.

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• Subsection 164(6) has the eff ect of off setting the $50,000 capital loss suff ered by the estate against the $90,000 capital gain deemed to have been realized by A, resulting in a net capital gain of $40,000.

• The net capital gain of $40,000 is the same result which would have occurred if A’s shares had been valued at $50,000 immediately before his death.

However, the valuation of A’s shares for the purpose of subsection 70(5) is not always as simple as illustrated in the above example. In particular, there are three circumstances where the shareholders’ agreement remains quite important:

• If the sale to the other shareholders is delayed past the end of the estate’s fi rst taxation year.

• If the other shareholders merely have an option to buy A’s shares, which they have not yet exercised, or have declined to exercise.

• If A did not deal at arm’s length with the other shareholders, in which case paragraph 69(1)(b) precludes the deduction of the subsequent capital loss.

As a result of the above, on the death of a shareholder, it is a question of fact whether the shareholders’ agreement applies. If it does, then the valuation is based upon the mechanisms provided in the agreement. Otherwise the value would be based upon other means for tax purposes, which without the contemplation of death and the shareholders’ agreement, could have a material impact on the value calculation.

Valuation Considerations under DefaultShareholders’ agreements will typically address the impact of:

• A breach by a shareholder of an important provision of the shareholders’ agreement.• The consequences if a shareholder defrauds the enterprise. • The consequences if a shareholder seriously prejudices the enterprise’s interest.

Defaulting ShareholderUnder these circumstances, a shareholder becomes a “defaulting shareholder,” which can have various consequences defi ned pursuant to the agreement. Typical consequences to a defaulting shareholder include:

• Termination of employment (with or without cause).• Loss of voting power.• Mandatory sale by the defaulting shareholder or repurchase of the shares by the corporation.• Punitive discount from defi ned value.• Pay-out of the purchase price of the shares by installment, with low or no interest.• Requirement to immediately repay outstanding loans from the company.• Indemnity or hold-harmless provisions not provided on repurchase.• Additional time for release of any guarantees off ered by the defaulting shareholder in

favour of the corporation.


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• Immediate liquidation of the company.

The key is to ensure that the shareholders’ agreement sets out consequences that are suffi ciently punitive on value to ensure shareholders abide by their obligations and commitments and perform duties in the best interests of the company.

Methods of Determining ValueOne of the more diffi cult issues in a shareholders’ agreement relates to the method of valuing the shares. There are three methods of determining the price at which a shareholder buy-out would take place:

• Valuation by periodic agreement among the shareholders.• Valuation by formula. • Valuation by a third party.

Valuation by Periodic Agreement Among the ShareholdersThis approach requires the business to be valued on some regular basis, typically annually, with that value becoming the amount used for any transaction of shares between the shareholders during the upcoming period. Although this approach appears to have certain benefi ts (i.e., the value is known and regularly updated, the approach is consistent, and it provides a good track record), it has some practical limitations in that value is “determined at a specifi c point in time.”

This presents a problem for the annual or periodic valuation approach because within a reasonably short period of time after the value is determined, a material change in value could occur that would render the valuation inappropriate. This could be a result of market forces, company-specifi c issues or other factors.

This problem is further exacerbated by the fact that, more often than not, these provisions are not followed and a periodic valuation does not occur. Shareholders often will not want to pay professional fees to have the valuation completed/updated every year. Accordingly, the valuation becomes out of date.

Valuation by Formula

Valuation by formula could be based upon an earnings approach, asset approach, or even a rule of thumb, if appropriate. This approach can be very useful as the shareholders are able to assess the value at almost any point in time, so long as the defi nition of value is well described and the outcome is predictable.

The key issue is creating a well-defi ned formula and ensuring it is fully understood by the shareholders. The treatment of items such as minority discounts, treatment of life insurance proceeds, normalization adjustments, treatment of personal goodwill, if any, etc., need to be clearly outlined. This will typically result in an intrinsic value approach, without consideration to special interest purchasers. The values derived pursuant to a formula may be distorted, as formulas do not account for fundamental changes over time or specifi c anomalies at a point in time that may infl uence value. These fundamental changes would include a business moving from start-up, to maturity, to wind-down phases of the life cycle. It is unlikely that one formula would most appropriately refl ect value throughout these phases.

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This approach is seen to be a cost eff ective and a simple and effi cient way to determine Price. The concern is that the determined price is unlikely to be accurate or a correct refl ection of FMV the majority of the time.

Valuation by a Third Party

A third party may include an independent expert such as a CBV, a mediator or an arbitrator.

Having the valuation performed by a third party will typically lead to the fairest result, as it is an unbiased independent view of the business, at the point in time the valuation is required. It will, however, be a more lengthy and costly process than the formula approach, as the third party undertakes due diligence and the appropriate review and research to assess value.

Under this approach, the selection of the valuator is an important consideration. Quite often, the company’s auditor is designated to assume this responsibility; however, this places the auditor in a position of confl ict. The key is ensuring the third party is competent in valuation, knowledgeable with respect to the industry, independent, and reputable.

The other key consideration is the value defi nition, as discussed previously. That is, do the shareholders wish the independent to consider minority discounts, special interest purchasers etc., as these could yield very diff erent results? Although the shareholders wish to let the valuator undertake an independent assessment, there are elements where direction is required and these should be well thought out in advance.

3.13.1.3 Defi ning LiquidityIn a private enterprise, one of the key valuation objectives is defi ning liquidity. Liquidity becomes important when certain “triggering events” occur, such as:

• Death of a shareholder.• Permanent disability of a shareholder.• Bankruptcy or insolvency of a shareholder. • Retirement of a shareholder. • Marital breakdown.• Corporate divorce.• Third party off ers.

When these triggering events occur, the shareholders are at odds due to a default, a disagreement on business strategy or the termination of a shareholder from employment; or a third party makes an off er on the business to one of the shareholders. In each of these circumstances, the shareholders may be aff ected by the lack of liquidity, as there is no active market for the shares.

Typically, the provisions addressing a sale between shareholders (i.e., excluding third party off ers) will address the method of valuation and the defi nition of price, the method of payment (immediately or over time, with or without interest, etc.) and who the purchaser will be (the company or the other shareholders).


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Defi ning the purchaser is important in value determination at the shareholder level, due to the personal tax considerations. With respect to tax, it is important to recognize that if the company repurchases the shares at a premium over cost, the transaction results in a deemed dividend to the shareholder; whereas if the other shareholders purchase the shares at the same premium, then it results in a capital gain.

Whether a capital gain or deemed dividend is most favourable depends upon the circumstances. For example, with life insurance paid on the death of a shareholder, these proceeds may be paid out virtually tax-free, as the insurance proceeds fl ow through the capital dividend account. In other circumstances, a capital dividend may not be available (i.e., no life insurance) and a capital gain may be more favourable due to the availability of the capital gains exemption.

In addition to the tax considerations, the various Corporations Acts typically have restrictions surrounding a company’s ability to repurchase its own shares. When a repurchase occurs, it will be required that “solvency tests” be met by the company prior to the repurchase. If the tests are not met, then technically the company cannot undertake the repurchase.

Impact of Triggering EventsTriggering events relate to circumstances where the parties typically have had a strong business relationship and have not been approached by a third party, yet events require a severing of the relationship, such as death, disability, retirement, marital breakdown, or personal bankruptcy.

In these cases, the severing of the relationship is not confrontational; however, the parties need a defi ned mechanism for transferring their shareholders’ interest at a fair price with fair payment terms. Although this has been discussed in a general context, there are certain specifi c elements that need to be addressed in the case of specifi c triggering events.

Death of a ShareholderIn the event of the death of a shareholder, the purchase requirements under a shareholders’ agreement are often funded by the proceeds from a life insurance policy. This has the benefi t of eliminating the fi nancial burden on the company or its remaining shareholders to raise the appropriate capital to fund the purchase. In that regard, it is important for the parties to review the adequacy of the life insurance proceeds on a regular basis. However, in the event that insurance proceeds are not available for the funding, then the valuation needs to consider the source of fi nancing and the parties need to review the ability to source such funds on a regular basis. Furthermore, if fi nancing is not available or adequate, then the payment terms need to be clearly considered.

The other key item to be considered in the death of a shareholder is whether the valuation includes the proceeds available from the life insurance policy. This is a key consideration that may have a material impact on value. For example, if a company has two shareholders each holding 50% of the business and the business were valued at, say $2 million, then the requisite life insurance would be $1 million. However, when the life insurance proceeds are paid into the business, arguably the business value increases by $1 million to $3 million. Does this mean the deceased shareholders’ interest is the $1 million (prior to life insurance proceeds) or is it $1.5 million (after the receipt of life insurance)?

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Permanent Disability of a ShareholderIn the event of a permanent disability of a shareholder, the valuator must address certain special considerations. Specifi cally, how does one defi ne a permanent disability and how does one confi rm that a permanent disability has occurred? How is the buy-out to be funded and has the company acquired critical illness insurance as a possible means of funding the buy-out? Is disability coverage available to the shareholder or are interim payments from the company necessary? What is the eff ective date of the buy-out requirement?

Bankruptcy or Insolvency of a ShareholderThis is a critical requirement as it is not benefi cial if the rights of one shareholder pass to the control of a trustee or receiver. This is even more critical if it is a controlling interest. In this respect, it is necessary to ensure the agreement clearly spells out what the triggering event is, how it is defi ned and whether the triggering event occurs prior to transfer to a third party.

Retirement of a ShareholderThe retirement of a shareholder must be considered as an eventuality — it will occur. This has a number of considerations, which starts with age. For example, does the agreement have provisions for a mandatory retirement age and/or an early retirement option? In the case of mandatory retirement, the retiring shareholder usually has some form of put option, whereas on the election of early retirement, an option to call rests with the remaining shareholders.

Irrespective of the reason for retirement, it is necessary that there be some form of non-competition and non-disclosure requirement, otherwise the retirement of the shareholder would clearly aff ect value.

In addition, other considerations may include the payout method and form as well as access to company assets or limited work schedules.

Marital BreakdownIn the event of marital breakdown, there is the possible transfer of shares from a shareholder to a spouse who is currently not participating in the business. To avoid this possible outcome, the shareholders should have included provisions in the agreement addressing that shares do not form part of the marital property pool and that an agreement is to be struck with the non-participating spouses that any court order in a family law context will not be satisfi ed by shares of the company.

If the above two provisions are not possible, then a mandatory call option on any shares transferred to the non-participating spouse should be added.

Corporate Divorce Corporate divorce provisions relate to circumstances where shareholders no longer agree on corporate strategy or one shareholder has defaulted under the agreement or is terminated from employment for cause.

Under an event of default or a termination for “cause,” the typical result is a call option on the part of the non-defaulting or remaining shareholders. Such a call option could have all the other potential punitive clauses attached to it, as discussed previously under the valuation of shares under default (i.e., discount from value, payout over time without interest, etc.).


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Where the parties no longer agree or have an unresolved impasse on corporate aff airs, the typical “exit” method involves the use of buy/sell provisions, alternatively known as “shotgun clauses.” This type of provision requires one shareholder to set a specifi ed price at which he/she is prepared to buy the other shareholder’s interest or at which he/she is prepared to sell his/her interest. The other shareholder then has the option of choosing which option to accept. These provisions are set with mandatory time periods over which certain notices or responses are required or the outcome is pre-determined for the non-responding party.

The premise behind this clause is to allow an exit or resolution to the impasse at an amount that should be viewed as fair because the party commencing the process is somewhat bound to make an off er that is not too high or not too low. For example, if the off er price is too high, then the result would be overpayment because the other shareholder would likely sell. The opposite result occurs if the off er price is too low.

The diffi culty with these provisions is that they favor certain shareholders, either due to higher fi nancial resources at their disposal or due to a higher percentage shareholding, thereby creating a higher fi nancial burden on one party. Other inequities arise if one shareholder has more of a fi nancial interest where the other is employed in the operations of the business. In this instance, the employed shareholder may have more to lose (loss of employment income), or may be at an advantage due to intimate knowledge of the business and its potential. Regardless, it is rare that a shotgun clause will be enacted because of the risks to either party; rather, the intention is to force the parties into level-headed resolution.

If the shareholders do not include a buy-sell clause and they wind up at an impasse, then the only fallback to resolution may be the provisions under the applicable Corporations Act. These provisions enable a court-ordered wind-up on the corporation, on a just and equitable basis.

Third Party Off ersDefi ning the process surrounding third party off ers to a shareholder forms another aspect of liquidity. In the case of restrictions on share transfers, and the use of rights of fi rst refusal, these provisions work to reduce the liquidity of shares. In the event of tag-along and drag-along provisions, these provisions work to improve the liquidity of shares. Tag-along and drag-along provisions are discussed later in this section.

Restrictions of Share TransfersIn shareholders’ agreements, or articles of incorporation, restrictions may exist on the sale of shares, such that approval is fi rst required from the board of directors or the other shareholders. These provisions work to reduce liquidity and have a negative impact on value, although these approvals are usually not to be unreasonably withheld.

Right of First RefusalThere are eff ectively two types of rights of fi rst refusal:

• The fi rst, often referred to as a “basic” or “hard” right, requires the selling shareholder to solicit bids from third parties and present the highest off er to the remaining shareholders. The remaining shareholders have the option to either approve the transaction or acquire the shares at the price and terms presented.

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• The second approach, referred to as a “right of fi rst off er” or a “soft” right, requires the selling shareholder to fi rst off er the shares to the remaining shareholders at the price and terms the selling shareholder wishes to set and if none of the shareholders accepts, then the selling shareholder is free to sell the shares at those terms, or more favourable terms.

The “hard” right may be viewed as more advantageous for the remaining shareholders as:

• It allows them the opportunity to see who the prospective purchaser is before agreeing • Few purchasers will proceed in expending costs and time in discussions if they believe

that the right will be exercised by the other shareholders.

A “soft” right favours the selling shareholder as:

• The right of the other shareholders to acquire is gone prior to approaching the market (thereby improving liquidity).

• The fear that the selling shareholder will sell to an undesirable purchaser may eff ectively coerce the remaining shareholders to pay a higher price and avoid the marketing of the shares.

Two key elements of the right of refusal clause are that it should:

• Provide time restrictions around notice periods and responses (thereby keeping the process moving).

• Require consideration to be expressed all in cash (avoiding value issues around non-cash consideration).

Whether the right of fi rst refusal is a “hard” or “soft” right is an important consideration that will impact the value attributable to such shares.

Tag-along and Drag-along ProvisionsThe rights bestowed by these provisions work to increase liquidity to the shareholders.

• A tag-along off ers the non-selling shareholders the opportunity to force the purchaser to acquire not just the selling shareholders’ shares, but rather acquire all of the shares at the same price per share. This clause aff ords protection typically to minority shareholders by allowing them to sell if the majority shares are being sold to an incompatible third party.

• A drag-along provision off ers liquidity to the majority shareholders, whereby the minority shareholders are forced to sell their shares on the same terms and conditions accepted by the majority. This allows the majority to sell their interest as eff ectively a 100% sale as opposed to the impact on value in negotiation where a minority interest group does not want to sell.

Liquidity Clauses: Impact on ValueDespite the type of clause that adds or detracts from liquidity in the shareholders’ agreement or in the articles and by-laws, they all have an impact on value and need to be considered. In the event of reduced liquidity, it obviously has a negative value impact.

On the other hand, an agreement which places a value on the shares upon the happening of a certain event (for example, one which requires a shareholder to sell at a specifi ed price on death)


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does not necessarily limit the fair market value of the shares to the price specifi ed, as discussed previously. An exhaustive analysis of the case law is beyond the scope of this discussion, but a cursory glance at the cases may provide some insight into the complexity of the problem.

The leading English cases, Attorney-General of Ireland v. Jameson, [1904] 2 Ir. R. 644; [l905] 2 Ir. R. 218, Salvesen’s Trustees v. C.l.R., [1930] Sc. L. T. 387 and C.l.R. v. Crossman, [1937] A.C. 26, enunciated the position that, notwithstanding provisions attaching to shares which restricted transferability and granted pre-emptive rights to other shareholders to purchase the shares at ascertainable prices, such shares should be valued at the price they would bring if sold on the open market on the footing that the purchaser would take and hold them as a registered shareholder, subject to the benefi ts and burdens of the restrictive provisions. This solution obviously ignores the fact that such shares will probably never be subject to an open market sale. The Crossman doctrine was subsequently followed in Holt v. I.R.C., [1953] 2 All E.R. 1499 and Re Lynall, [l971] 3 All E.R. 914.

In Canada, it would appear that the Crossman doctrine will not be followed but this conclusion is not entirely free from doubt. In the case of Emerson v. Provincial Secretary-Treasurer, I5 M.P.R. 406, [1941] 2 D.L.R. 232, the Appeal Division of the New Brunswick Supreme Court approved the Crossman decision in obiter. However, the Newfoundland Supreme Court in the case of Re Harvey; Assessor of Taxes v. Walsh, 24 M.P.R. 360, [1950] 3 D.L.R. 257, held that the decision was only applicable to the particular wording of the English legislation and not to a situation arising under the Newfoundland Death Duties Act.

The case of the Estate of Arthur Warwick Beament v. M.N.R., 70 DTC 6130, would appear to indicate that the Crossman decision is of little relevance in Canada. In that case, the Supreme Court of Canada held that an agreement to cause the company to be wound up on the death of the controlling shareholder must be considered in arriving at the value of the shares of such company for estate tax purposes. The fair market value was therefore what a willing purchaser would have paid for the shares on the assumption that the contractual commitment would be fulfi lled.

3.13.2 Other Key Considerations

Certain other items should be considered in the course of reviewing or preparing shareholders’ agreements (including control and non-competition agreements). These include:

• Control.• Financing.• Real property leases.

3.13.3 Control

Each party to a shareholders’ agreement must determine the level of control it can reasonably anticipate exercising over the aff airs of the corporation (whether directly or indirectly through the board of directors). Generally, absent a shareholders’ agreement, the shareholder with a majority shareholding will exercise eff ective control, through the right to elect all of the board of directors. Furthermore, if the shareholder carries in excess of two-thirds of the voting shares, he/she will

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be able to carry any matter determined by shareholder vote, including the passing of a special resolution. As a result, unless the actions of the majority in these circumstances are determined to be oppressive or unfairly prejudicial (giving rise to oppression remedies and appraisal rights), then the minority has little ability to change any course of action chosen by the majority.

It is for this reason that shareholders’ agreements typically outline:

• Who will be on the board of directors and require the shareholders to vote for those agreed nominees.

• Certain decisions that require unanimous shareholder approval or at least approval by a super majority.

These types of unanimous shareholders’ agreements, in eff ect, restrict the decisions of the board of directors and place these decisions back in the hands of the shareholders, such as:

• Restrictions on share transfers.• Purchase and sale provisions of the company’s shares or assets. • Valuation of share interests.• Election of dividends.• Financing.• Amendments to by-laws, etc.• Appointment of key management.• Amount of bonuses (if some shareholders are not part of operating management).

It is important to understand the control structure within the organization in view of both the by-laws and the provisions of the shareholders’ agreement as these can drastically aff ect value through minority discounts or majority premiums. Keep in mind that by-laws and charter provisions can usually be changed by a person, or persons, controlling generally two-thirds of the voting shares, in absence of unanimous or super-majority shareholder vote requirements. In such a case, the provisions in the organizational documents are not relevant in determining the value of the shares held by a shareholder who is in a position to change the by-laws. (See Estate of Frank Frederik Barber v. M.N.R., 66 DTC 315).

Note: Non-compete agreements will often be embodied in a shareholders’ agreement. Although non-compete agreements are discussed elsewhere in this course, they are briefl y mentioned here in view of this discussion.

The non-compete agreement between parties is typical in any third-party purchase or sale and, accordingly, is no diff erent in the case of a purchase and sale between shareholders of the same corporation. This is also important in the establishment of an exit value, because an exiting shareholder who has knowledge regarding corporate secrets, customers, employees, suppliers and the like could dramatically impact value if not restricted from competing post sale. The specifi ed time frame and the geographic region must be reasonable, otherwise the clause may be found to be unenforceable due to a restraint on trade.


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MQE QUESTION 3.6: “TOTTLES R US”

Mr. Michele Milke, age 45, is the sole shareholder of Tottles R US (“Tottles” or the Company”). Michele has been approached by Mega Tottles (“Mega”), a Canadian publicly traded competitor of Tottles. Mega is a potential purchaser of the Company.

As part of the draft Purchase and Sale Agreement (the “Agreement”) Mega is insisting that Michele sign a non-competition agreement, precluding her from competing against Mega and Tottles for a 50 kilometre radius for a period of three (3) years subsequent to the close of the transaction.

Tottles has been in business in Canada for 40 years. Michele’s father, Symore, founded the Company after returning from a trip to Europe, during which he purchased a Jettle stamping machine from a used equipment dealer. He had the Jettle stamping machine transported to Canada, incorporated Tottles, and grew Tottles into the largest Jettle manufacturer in Canada, serving markets in both Canada and the U.S.

The simple manufacturing process of Jettles, and the inexpensive capital cost of the manufacturing equipment, has attracted the attention of many competitors. As a result, competition among Jettle manufacturers is very intense and is large based on quality of products and service. There is relatively little price diff erentiation between products. Symore has developed many key relationships with suppliers and customers. As Symore introduced Jettles to Canada, he is widely recognized as the leading Jettle expert in the country.

Michele joined the management team of the Company 25 years ago, after graduating from Harvard University. Michele became President and CEO of Tottles after her father passed away 23 years ago.

Michele does not have plans on retiring if she sells the Company to Mega. Rather, given her young age, she expects to continue working.

Various fi nancial information in respect to the Company is included in Appendix A.

It is now September of this year and the various parties would like to close the sale of Tottles to Mega by December 31 of this year. A major factor in Mega’s decision as to whether to acquire Tottles relates to the value that will be ascribed to the non-competition agreement for fi nancial reporting purposes. Given that Michele and you, CBV, are good friends, Michele suggests that your services be engaged to assist in the manner.

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MQE QUESTION TABLE 3.6ASelected Historical Results and Thee Year ForecastFor the years ending December 31CAD (000’s) Actual

2nd Last Year

Actual Last Year

Forecast This Year

Forecast Next Year

Forecast 2 Years From Now

Revenue Note 1 $54,670 $59,137 $64,873 $68,976 $71,345Cost of good sold 35,768 38,440 41,679 44,742 46,589Gross margin 18,902 20,697 23,194 24,234 24,756Expenses Sales & marketing Note 2 2,490 2,614 2,745 2,882 3,020General & administration 1,980 2,020 2,060 2,100 2,140Employee salaries & benefi ts 2,600 2,730 2,860 3,010 3,160Management salaries & benefi ts

Note 3 3,200 3,250 3,690 3,780 4,000

EBITDA 8,632 10,083 11,839 12,462 12,436Depreciation and amortization Note 4 1,234 1,342 1,343 1,356 1,348Interest Note 5 245 237 256 258 255Earnings before tax 7,153 8,504 10,240 10,848 10,833Tax @ 32% 2,289 2,721 3,277 3,471 3,467Earnings after tax 4,864 5,783 6,963 7,377 7,366

Note 1: If allowed to compete directly with Mega, Michele estimates that she could capture 15%, 12% and 10% of Tottles revenue in each of the forecast years respectively.

Note 2: If allowed to compete directly with Mega, Michele estimates, that Mega would have to incur additional sales and marketing expenses of 5% to 10% of forecast levels each year to “defend” against such competition.

Note 3: These salaries & benefi ts are in line with industry standards for such a management team.

Note 4: Depreciation and amortization approximates the sustaining capital reinvestment of the Company.

Note 5: Interest expense relates to a $2.7 million loan from the Company’s bank at an annual interest rate of 9%.

Required:a) Quantify the value of the non-competition agreement. Ensure you provide Michele with a discussion of the approaches you have used, the factors that you have considered, and the assumptions you have made.b) Several days after you commence your assignment, you receive a call from the CFO of Mega who states, “I believe the value of the non-competition agreement is equivalent to the purchase price, as our acquisition of Tottles will not occur without the execution of the non-competition agreement.” Provide your comments in this regard.


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Solution:September this year

Michele Milke

123 Milke DriveAnywhere, ON123 ABC

Re: Non Competition Agreements

Dear Madam:

Further to our recent conversation, enclosed is my response to your recent request. You have requested that I quantify the value of the non-competition agreement (“NCA”) with respect to yourself in connection with the sale of Tottles R US (“Tottles”) to Mega Tottles (“Mega”). You have also asked that I provide a direct response as to whether the NCA may represent the entire purchase price of Tottles.

PART A

OverviewMega’s objectives of requiring an NCA is to eliminate post sale competition from you or other senior members of the management team, which from the viewpoint of Mega, could erode goodwill and profi tability for which Mega is paying. If you were able to freely compete with Mega, it is likely that a portion of Tottle’s customers would move with you, thereby reducing cash fl ow to Mega. This is particularly likely given your long lasting relationship with Tottles customers. The NCA is a mechanism by which Mega can mitigate such erosion. To the extent that you refuse to sign the NCA, you can expect that Mega will negotiate the off er price downward.

I have considered that the value of the NCA can be measured as the lost profi ts experienced by Mega if Michele is permitted to compete in the marketplace (“diff erential cash fl ow approach”).

Diff erential Cash Flow ApproachUnder this approach, I have calculated the diff erence in the discounted cash fl ow of Tottles over the term of the NCA, being three years, under the assumptions that:

a. You execute the NCA b. You do not execute the NCA

To the extent that reduced cash fl ow to Mega beyond three years would be expected as a direct result of the non execution of the NCA, a longer period of diff erential cash fl ow could be considered. I note that in general, the further one is from the date of the execution of the NCA (transaction), the lower the diff erential cash fl ows, because of the:

• Increasing ability of the purchaser to protect against competition (i.e. through marketing, etc.)

• The reduced ability to directly link the loss of cash fl ow/revenue to the lack of an NCA, relative to other factors

• Present value considerations

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Assuming the non execution of an NCA, any change in post purchase cash fl ow during the three year period may not be due entirely to the absence of a NCA. Factors that may aff ect cash fl ow, apart from competition by you include:

• The purchaser’s ability to integrate Tottles with its existing operations.• The purchaser’s ability to retain the existing customer base by providing the same degree

of service and quality as provided by you.• The purchasers ability to retain staff , post sale.

For the purposes of this report we have assumed that subsequent to the sale of Tottles, Mega will not materially change the existing operations of the Company and any change from the non execution of the NCA is related to you directly competing with Mega.

Also, in considering the diff erential cash fl ow, I have relied on the Tottles cash fl ow forecast that you have provided to me, without adjustment, audit or review. I have also not reviewed the actual transaction particulars in this situation (i.e. Purchase and Sale agreement etc.) and had not had the opportunity to speak with Mega. Therefore my comments and calculations are preliminary and are subject to change.

CalculationIn calculating the expected cash fl ow of Tottles without the NCA being executed, I have adjusted the revenue downward and the expenses upward, as per the information provide to me (See Schedule below).

It is assumed that without the NCA, Tottles will suff er a loss of revenue and the resultant gross margins (35%), as you would be able to freely compete with Mega for the Tottles business. The quantum of such loss gross margins is highly fact specifi c, and depends on various factors such as your desirability to compete with Tottles. Such factors are discussed further below. It is important that in our estimate of foregone gross margins, we only consider losses that can be directly attributed to the non-execution of the NCA. If, for example, Tottles is expected to experience gross margin loss related more generally to the change in management of Tottles, this would not be included in the diff erential cash fl ow because the NCA would not protect against this leakage.

It is further assumed that but for the NCA, Mega would incur additional expenses to protect against competition from you, such as incremental marketing costs. Such costs would not have to be incurred to the same degree if the NCA was executed.

I have discounted the diff erential cash fl ow by a range of 20% to 25%. Factors I have considered in my discount rate selection, and factors that impact the value of the NCA include:

Factors increasing likelihood of competition, but for the NCA:

• You have the fi nancial ability to compete directly with Mega (self-made millionaire).• Service and quality is the key to business, you have the requisite experience.• You have long standing relationships with customers and suppliers.


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• You have no plans to retire and plan on continuing the business or similar business and the resultant eff ect on value of NCA.

• Business has low barriers to entry (all that is required is a stamping machine to compete directly).

Factors decreasing likelihood of competition, but for NCA

• Reputation of Tottles brand name will help to retain market share.• Tottles has a long-standing brand name in the marketplace; customers would be hesitant

to change suppliers.• You are independently wealthy and do not need to work.

Conclusion Based on my analysis, the value of the NCA is approximately $5.15 million (See Schedule I below). Other valuation approaches to the NCA may yield alternative value calculations. I would be pleased to explore such approaches with you if you wish.

Forecast Forecast Forecast

Schedule I

This Year

Next Year 2 Years

From Now

Cash fl ow with NCA executed $11,839 $12,462 $12,436Sustaining capital reinvestment 1,343 1,356 1,348Discretionary pre-debt cash fl ow (i.e., depr=capex) 10,496 11,106 11,088Diff erential cash fl ow Normalized, discretionary cash fl ow with NCA (A) 10,496 11,106 11,088Loss of gross margins (15%, 12%, 10% revenue loss @ 35% margins)

3,406 2,897 2,497

Adjustment to expenses (used mid-point 7.5% increase) 206 216 227Cash fl ow without NCA executed (B) 6,884 7,993 8,364Diff erential pre tax cash fl ow protected with NCA (A-B) 3,612 3,113 2,724Income tax (32%) 1,156 996 872After tax diff erential cash fl ow 2,456 2,117 1,852

High 20% PV factor 2,347 1,686 1,229Sum of PV 5,261

Low 25% PV factor 2,323 1,602 1,121Sum of PV 5,046

Mid point, rounded 5,153

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PART BThe NCA could represent the total value of business in a service business (i.e., law practice/accounting practice) where personal interaction is the key drive of business. This argument is not likely in a manufacturing business due to:

c. The simple manufacturing process and inexpensive initial cost of manufacturing equipment.

d. Competition is based on quality of products and service.e. There is relatively little price diff erentiation between products.

A NCA is put in place to minimize the eff ects of personal goodwill, not commercial goodwill. Given Tottles history of operations, reputation and market share, commercial goodwill likely exists. Therefore, not all goodwill of the Company can be ascribed to personal goodwill; therefore the value of the NCA is not equal to the full purchase price.

You have now completed the Level II — Intermediate Business Valuation course of the Chartered Business Valuators’ Program of Professional Studies.

Please ensure that you review all assignment material as well as practice examinations to ensure that you are well prepared for the examination.

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ASSIGNMENT QUESTIONS

Assignment 1Level II - Intermediate Business Valuation

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Assignment 1Question 1.1

Situation #1Mr. Gray and Mr. Black have each invested $2 million in a new 10-unit apartment building in Winnipeg, Manitoba. Subsequent to the purchase, legal title to the apartment building was registered as “Mr. Gray and Mr. Black.” On advice from their accountant, both Mr. Gray and Mr. Black consulted with a lawyer, who drafted an agreement that specifi es that Mr. Gray and Mr. Black will each share revenue and expenses related to the apartment building on a 50/50 basis. Additionally, all decisions regarding the management of the apartment will require unanimous consent between the two parties. With a zero vacancy rate, the apartment generates leasing revenue in excess of $400,000 per year. Both Mr. Gray and Mr. Black have other investments which derive income in excess of this leasing income.

Situation #2Marko Ltd. is a manufacturer of ballpoint pens, operating in Quebec. 51% of its common voting shares are owned by Penco Inc., a Canadian public corporation. The remaining voting shares are held by Inkblot Ltd., a U.S. distributor of offi ce supplies. Marko Ltd. had net taxable income of $300,000 for its current tax year that ended December 31.

Situation #3Quantum Investments Ltd. is an Alberta corporation jointly owned by Mr. and Mrs. Jones, both Canadian residents. This company’s assets consist of investments in the following:

• 5% of Cooper Publishing Ltd., is a Canadian publishing corporation. In the current year, Quantum received dividend income of $50,000 from Cooper.

• 15% of Quality Holdings Ltd., is a real estate holding corporation. In the current year, Quantum received $35,000 from this investment.

• 2% of Purity Income Fund, is a mutual fund investment. In the current year, Purity distributed interest of $15,000, and capital gains of $45,000 to Quantum.

Assume that neither Cooper nor Quality received a dividend refund upon payment of the dividend.

Required:For each of the above independent situations, identify the following:

1. The form of organization (e.g. sole proprietorship, partnership, trust, joint venture). If the organization is a corporation, identify if the corporation is public, private, CCPC or “other.”

2. Identify the nature of the income earned by the organization and the tax rate on the applicable income, including eligibility for small business deduction where applicable.

Question 1.2 Mr. Lee owns 100% of Lee Enterprises which in turn owns 100% of three operating companies. Each of these operating companies carries on an active business primarily in Canada. Lee Enterprises employs Mr. Lee and charges each of the operating companies $30,000 as management fees for

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Mr. Lee’s time. Mr. Lee gets paid from Lee Enterprises and is the president and chairman of each of the operating companies as well as Lee Enterprises.

Required:Discuss whether or not Lee Enterprises is eligible for the small business deduction.

Question 1.3Microtech Inc. is a company specializing in robotics research formed by a group of computer science graduates, the company invested over $15 million in the development of robotic devices for common household use. Last year, the company patented its fi rst product, The Autosweeper, a robotic vacuum.

In its previous fi scal year ended December 31, the company had accumulated unclaimed Scientifi c Research & Development (“SRED”) Expenditures of $13 million and unclaimed federal investment tax credits (“ITCs”) of $2.5 million. In addition, the company had non-capital loss carryovers of $5 million. The losses will begin to expire at the end of the next year, and the ITCs will begin to expire in fi ve years.

Johnson Electric Ltd. is a multi-national consumer product distribution company and has recently made an off er to the shareholders of Microtech to acquire 49% of its voting common shares for $30M. Article 15 of the purchase agreement also specifi es, that “upon the successful commercialization of The Autosweeper, the purchaser shall have the option to acquire 100% of the remaining shares of the Company. The purchase price for the additional shares shall be determined by an independent valuator.”

According to the agreement, successful commercialization is defi ned to be achieved when the fi ve year average of gross profi t derived from Autosweeper sales exceed the purchase price under the agreement.

Shareholders of Microtech have accepted the off er and eff ective March 1, of this year, Johnson Electric Ltd., owned 49% of the issued and outstanding common shares of Microtech. Just prior to the closing of the transaction, the shareholders of Microtech also entered into a unanimous shareholder agreement with Johnson Electric Ltd. The shareholders agreement dictates certain powers and responsibilities of the shareholders regarding the operating, strategic and overall management of Microtech.

With the successful launch of its Autosweeper product at the National Home Show in April, sales revenue for Microtech in its current year (ended December 31) exceeded $12 million, and its net profi t before taxes was $7 million.

Required:1. Compute the taxes payable and the remaining non-capital losses, SRED and tax credit

carryovers for Microtech for its current taxation year, assuming a combined federal and provincial tax rate of 35% and a net profi t for tax purposes of $7 million, before any deductions for losses or SRED carryovers.


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2. Discuss whether Microtech and Johnson would be considered associated corporations at any time during the current taxation year.

3. Assume that the management of Johnson Electric Ltd. decide in January of next year to transfer the assets of its television electronics division to Microtech. After negotiation with the shareholders of Microtech, an agreement is struck and the assets are transferred to Microtech on February 28 of the next fi scal year. As partial consideration for the transfer of assets, Microtech issues another block of shares to Johnson, such that their aggregate holdings in Microtech represent ownership of 55% of the voting common shares. The transfer was done because the television and electronic business is highly profi table, and Paul Corbett, the CFO of Johnson, is hoping to shelter these profi ts from tax by utilizing some of Microtech’s available losses, SRED and investment tax credits. Advise Mr. Corbett of the tax implications of his decision.

Question 1.4

Required:Discuss the income tax issues that should be examined when adopting a going concern approach to the valuation of shares of a corporation. Illustrate your discussion with examples of how varying income tax assumptions can aff ect the overall valuation conclusion.

Question 1.5

Required:What are the similarities and diff erences between fair market value and the arm’s length principle? Why is an arm’s length price not necessarily the fair market value of a transaction?

Question 1.6As companies become more global, their intercompany pricing structures tend to become increasingly complicated and involve multiple tax jurisdictions.

Required:Describe the impact on a valuation of this fact.

Question 1.7On September 1, 2013, Mr. Lemonts purchased 60% of the common shares of Fly By Night Inc., (a small manufacturer of parts for the automotive industry). Fly By Night Inc. has experienced a period of losses since they were slow to adapt to the economic downturn. In addition, some of the inventory held by Fly by Night has become obsolete and will have to be sold for scrap. Mr. Lemonts wants to know what benefi t the losses will have in the future, since he plans on making the company profi table once again.

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Mr. Lemonts has provided the following selected fi nancial information and loss balances:

EXHIBIT A1.1: FLY BY NIGHT INC., FINANCIAL INFORMATION

Cost UCC FMVInventory 10,000 7,000Accounts receivable 20,000 17,000Equipment 35,000 31,000 13,000Marketable securities 25,000 9,000Goodwill 52,000 35,000 39,000

Net capital losses Non capital losses1997 20,000 14,0002010 8,000 10,0002011 5,000 12,0002009 SRED

expenditures5,000

Required:Provide Mr. Lemonts with an analysis (including calculations) of the benefi t available from the losses after his purchase of shares.

Question 1.8When assisting with the purchase of a business, the valuator is required to complete a number of due diligence steps to ensure that the assets of the business are valued correctly, and the liabilities of the business are complete. This is particularly important in the context of a share transaction, as the purchaser will assume all of the liabilities of the corporation, including those that are contingent or uncertain at the time of purchase. One of these areas of risk relates to potential tax reassessments in the future.

Required:Identify fi ve areas that should be considered in relation to your due diligence regarding potential tax liabilities and explain the risk relating to each of these areas.


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Assignment 2Question 2.1 You have been asked to determine the fair market value of a small manufacturing enterprise. A number of years ago, the company purchased land on which to expand operations. This expansion never happened, and the company is currently operating at 80% capacity in its existing facilities. The land was originally purchased for $165,000, but due to the development in the area is currently appraised at a value of $310,000.

Required:Calculate the eff ect of the vacant land on the fair market value of the company. Explain your reasoning.

Question 2.2Nitrogen Corporation Inc., is incorporated under the Canadian Business Corporations Act and trades on the Toronto Stock Exchange. The company has been in business for over 75 years and has a great reputation in the industry. While many of the company’s competitors produce fertilizers based on the three primary plant nutrients/fertilizers (nitrogen, potash and phosphate), Nitrogen Corporation Inc., decided to primarily concentrate on producing nitrogen. The fertilizer industry is very cyclical and nitrogen pricing is the most volatile of all fertilizer types (with potash being the least volatile). Management has avoided growing the company over the last decade given industry cyclicality, however, they have bought back shares of the company in each of the last four years. Previously, the company had not conducted any share buybacks.

The company’s chief input cost for the production of nitrogen is natural gas, for which pricing has been rising lately. As everyone knows, the fertilizer industry has been performing very strongly given demand for increased crop yields and rising grain and corn prices. As a result, Nitrogen Corporation Inc., has produced record results as of late. However, some market experts believe the industry has reached its cyclical peak. A number of industry research reports point towards several new fertilizer plants that will be commencing production over the next couple of years. Additionally, these research reports state that the U.S. market is poised for a recession. Luckily, Nitrogen Corporation Inc. (operating at 100% capacity in year ended August 31st) is highly profi table and has had strong cash fl ow. Additionally, Nitrogen Corporation Inc. also has access to a C$500M 364-day revolving credit facility which is typically undrawn, as is the case at the present time. The credit facility, which expires on December 31st, Next Year, is renewed annually every summer and is provided by a group of ten Canadian and international banks.

Nitrogen Corporation Inc. typically conducts derivatives trading to protect/hedge itself from increases in the cost of natural gas. Unknown to management, a rogue trader in its derivatives trading department has committed a fraud exceeding the trading limits that normally applies to their position. Management discovered the fraud after market close on Friday September 19th, This Year and has worked over the weekend to determine the extent of the fraudulent trades. It is now Monday September 22nd, This Year and management has determined that the mark-to-market

237


positions result in Nitrogen Corporation Inc. owing C$1.9 billion to various counterparties which must be settled by Wednesday September 24th, This Year as per the standard ISDA (International Swap Dealer Association) contract signed between the various trading counterparties and Nitrogen Corporation Inc. which requires all trades to be settled within three business days. The company clearly does not have the suffi cient short term funds/liquidity to pay off its debts as a result of fraudulent derivative trades in the required time frame. If Nitrogen Corporation Inc. is unable to come up with the required funds for the ISDA contracts it will default, causing a cross-default on its long term bond indentures which bear interest on a variable basis at the cost of funds. The same level of bonds that were outstanding on September 1st, Last Year was outstanding during the entire course of fi scal year ending August 31st, This Year. The average cost of funds for the company’s bonds was 5% over the year ending August 31st, This Year and for the last four years as well. Current cost of funds is 5%. Given the weak conditions in the current credit market, the company faces a serious risk of bankruptcy if it defaults on its long term bond indentures. Even if the company could win the backing of its institutional bond holders, opportunistic hedge fund managers would certainly insist on pushing the company into bankruptcy. Management is very concerned about the current situation.

Understandably so, management has decided to keep the actions of the rogue trader as quiet as possible. To protect itself from pending bankruptcy, management has decided to issue equity for Nitrogen Corporation Inc., as a result of the situation. The company will conduct an auction with three large investment banks to determine who will underwrite the deal. Auction bids are to be due and available to be accessed by noon EST on Tuesday September 23rd, This Year. The auction is a “winner take all” situation — the highest bid will underwrite the deal entirely and take the price risk of reselling Nitrogen Corporation Inc.’s shares on the open market once it’s possible to do so. Nitrogen Corporation Inc. has specifi cally noted that they will consider bids based on price only, as terms and conditions of the deal are not to be negotiated. The winner of the auction will also be required to maintain its new ownership in Nitrogen Corporation Inc. for a period of one year. Nitrogen Corporation Inc. will be providing a work fee of C$1 million to each investment bank to consider the situation. Assume management can undertake the equity issue/auction without the consent of existing shareholders.

You are Ace Valtura, CBV in training, working with internationally renowned PJ GanMor’s in its Toronto, offi ce. Daniel Crook, Chief Investment Offi cer, has asked you to submit PJ GanMor’s auction bid for Nitrogen Corporation Inc. Before you leave his offi ce, Daniel, who is a legend in the investment industry with over 30 years of experience, makes the following comment to you:

We are counting on you to work long hours on this one, kiss the spouse and kids goodbye for a couple of days Ace! I smell blood here and money to be made! I don’t care if we win the auction but we must make a juicy profi t if we do! Make sure you let me know what a Fair Market Value (per share) would be for this company and what we should actually bid (per share) in the auction considering there are two other parties to bid against!

In assessing the situation you are able to quickly pull together the following: • Financial statement information (Exhibit A2.1) • Nitrogen Corporation Inc.’s stock trading information (Exhibit A2.2)


238

• Industry transactions (Exhibit A2.3) • Comparable market trading information as at period ending August 31st, This Year (Exhibit

A2.4)

Required: 1. Address Daniel Crook’s concerns. Discuss any valuation issues raised including your

pro-posed fair market value (per share) and bid price (per share) along with valuation calculations for Nitrogen Corporation Inc’s shares. Please ensure your discussion of valuation issues covers all information included in the appendices of this question.

2. Daniel Crook, being a CBV, and given the expediency required in this matter, has asked you to only cover the introduction of a valuation report (i.e. the CICBV Standards found online under Resources > Professional Practice > Practice Standards > “Valuation Reports — Report Disclosure Standards and Recommendations” section 10 under Standard No. 110) when completing the required in “1” above.

3. Given a recent bankruptcy of one of PJ GanMor’s recent investments, PJ GanMor’s internal auditors are in reviewing transactions undertaken by the entity in the last twelve months. Daniel Crook would like you to separately discuss the type of valuation reports that can be issued under CICBV standards and what distinguishes these reports apart.

EXHIBIT A2.1: FINANCIAL STATEMENT INFORMATION

CAD $000’s 9th Last

Year 8th Last

Year 7th Last

Year 6th Last

Year 5th Last

Year 4th Last

Year 3rd last

Year 2nd Last

Year Last Year This Year

Revenues 1,231,400 1,641,600 2,067,800 2,910,000 2,479,500 1,481,200 1,231,400 1,641,600 2,067,800 2,910,000

Cost of sales 689,584 820,800 951,188 1,047,600 1,190,160 740,600 689,584 820,800 951,188 1,047,600

Gross profi t 541,816 820,800 1,116,612 1,862,400 1,289,340 740,600 541,816 820,800 1,116,612 1,862,400

Sales and marketing 246,280 328,320 413,560 582,000 495,900 296,240 246,280 328,320 413,560 582,000

General and adminis-trative 123,140 164,160 206,780 291,000 247,950 148,120 123,140 164,160 206,780 291,000

Depreciation 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000

Interest expense 185,000 170,000 155,000 140,000 125,000 110,000 95,000 80,000 65,000 50,000

Total expenses 579,420 687,480 800,340 1,038,000 893,850 579,360 489,420 597,480 710,340 948,000

Net income (37,604) 133,320 316,272 824,400 395,490 161,240 52,396 223,320 406,272 914,400

Company volume (tonne)

Nitrogen 14,100 14,400 14,700 15,000 14,250 13,800 14,100 14,400 14,700 15,000

Potash 940 960 980 1,000 950 920 940 960 980 1,000

Phosphate 3,760 3,840 3,920 4,000 3,800 3,680 3,760 3,840 3,920 4,000

Total 18,800 19,200 19,600 20,000 19,000 18,400 18,800 19,200 19,600 20,000

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C$000’s 9th Last

Year 8th Last

Year 7th Last

Year 6th Last

Year 5th Last

Year 4th Last

Year 3rd last

Year 2nd Last


Company and industry

Pricing per tonne

Nitrogen 50 70 90 130 115 65 50 70 90 130

Potash 160 180 200 240 225 175 160 180 200 240

Phosphate 100 120 140 180 165 115 100 120 140 180

Average pricing 66 86 106 146 131 81 66 86 106 146

Revenues by product

Nitrogen 705,000 1,008,000 1,323,000 1,950,000 1,638,750 897,000 705,000 1,008,000 1,323,000 1,950,000

Potash 150,400 172,800 196,000 240,000 213,750 161,000 150,400 172,800 196,000 240,000

Phosphate 376,000 460,800 548,800 720,000 627,000 423,200 376,000 460,800 548,800 720,000

Total 1,231,400 1,641,600 2,067,800 2,910,000 2,479,500 1,481,200 1,231,400 1,641,600 2,067,800 2,910,000

% Revenues by product

Nitrogen 57% 61% 64% 67% 66% 60% 57% 61% 64% 67%

Potash 12% 11% 9% 8% 9% 11% 12% 11% 9% 8%

Phosphate 31% 28% 27% 25% 25% 29% 31% 28% 27% 25%

Total 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

Summary Balance Sheet August 31st This Year (CAD $000’s)Cash 400,000 Accounts receivable 200,000 Inventory 600,000 Prepaid assets 100,000 Fixed assets 3,000,000 Intangibles 150,000 Deferred taxes 50,000

4,500,000Liabilities 1,000,000 Equity & retained earnings 3,500,000

4,500,000

Note: Please ignore and do not provide comments on how the company achieved changes in its capital structure (i.e. changes in debt and equity) from year to year in the chart above.


240

EXHIBIT A2.2: NITROGEN CORPORATION INC.’S STOCK TRADING INFORMATION

Year Ended August 31st 4th Last Year3rd last

Year2nd Last


Trading price — close $12.00 $11.11 $15.00 $20.00 $26.67

Average daily volume 5 million 4.5 million 4 million 3.5 million 3 million

Shares outstanding 500 million 450 million 400 million 350 million 300 millionCall options (6 months) $1.00 $0.90 $0.80 $0.70 $0.30Call options (18 months) $2.00 $1.80 $1.60 $1.40 $0.60Put options (6 months) $0.20 $0.30 $0.30 $0.40 $1.00Put options (18 months) $0.40 $0.60 $0.60 $0.80 $2.00

The call and put options represent exchange traded options on the common stock of Nitrogen Corporation Inc. Call and put options for 12 months of duration are presently not available. The exercise price for the option is equal to the closing price of the common shares at the end of period shown above.

Please ignore and do not provide comments on how the company achieved changes in its capital structure (i.e. changes in debt and equity) from year to year in the chart above.

EXHIBIT A2.3: INDUSTRY TRANSACTIONS

Transaction Date Seller/Acquirer

Description of Seller's Busi-ness

Seller's Revenues

in Millions

Enterprise Value

in Millions

EBITDA in Millions

(last 12 months)

EBITDA in Millions

(average last 5 years)

Form of

Consideration

3rd last year Dec

ABC Fertilizer/Big Fertilizer

Nitrogen Producer

10,000.0 30,000.0 2,500.0 1,500 Cash

This year Aug Right Fertilizer/Mega Nitrogen

Nitrogen Producer

400.0 1,000.0 125.0 80.0 Cash

This year Aug Fast Growth Products/Tri-Fertilizer

Potash Producer

6,400.0 16,000.0 2,000.0 1,280.0 Cash

This year July Quick Release Fertilizer/Phosphate Inc.

Phosphate 4,200.0 8,400.0 840.0 560.0 Cash

This year Jun Nugrew In-dustries/Hope Nitrogen Inc.

Nitrogen Producer

1,000.0 1,500.0 350.0 200.0 Shares

This year Apr 123 Fertilizer/Small Fertilizer

70% Nitrogen 20% Potash 10% Phosphate

2,700.0 5,400.0 360.0 300.0 Cash

This year May YYZ Products/NY Fertilizer

60% Nitrogen 10% Potash 30% Phosphate

400.0 1,200 240 150 Cash

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EXHIBIT A2.4: COMPARABLE MARKET TRADING INFORMATION ENDING AUGUST 31ST, THIS YEAR

Location Company Name

Description of Business

Revenues in Mil-lions

Enterprise Value in Mil-

lions

EBITDA in Millions (last

12 months)

EBITDA in Millions (aver-

age last 5 years)

Canada Tri-Fertilizer Potash Producer 19,200.0 36,000.0 6,000.0 3,840.0Canada Phosphate Inc. Phosphate 12,600.0 18,900.0 2,520.0 1,680.0Canada Hope Nitrogen Nitrogen Producer 3,000.0 15,750.0 1,050.0 600.0Mexico Small Fertilizer 70% Nitrogen

20% Potash10% Phosphate

8,100.0 12,150.0 1,080.0 900.0

U.S. NY Fertilizer 60% Nitrogen 10% Potash 30% Phosphate

1,200.0 2,700.0 720.0 450.0

U.S. Big Fertilizer Nitrogen Producer 30,000.0 67,500.0 7,500.0 4,500.0U.S. Mega Nitrogen Nitrogen Producer 1,200.0 2,250.0 375.0 240.0

Question 2.3Assume today’s date is September 20 of This Year. Based in Halifax, Cold Storage is a national provider of cold storage services to various grocery chains and restaurants. Cold Storage will pick up and store pallets of fruits, vegetables, meat and poultry for customers in one of its many physically secure fi reproof facilities. Pallets can be easily retrieved at a customer’s request and dropped off at their place of business within 24 hours of notice.

Cold Storage generates revenues by charging customers a monthly fee based on the number of pallets that a customer occupies in its warehouses. Additional fees are charged for picking up and dropping off pallets at a customer’s premises.

Andrew Rudy started Cold Storage 15 years ago. On September 30 four years ago, Gassmann Industries provided fi nancing to Cold Storage in order to repay all outstanding indebtedness. A shareholder’s agreement has never existed in respect of Cold Storage.

Currently, there are six million Class A Common Shares of Cold Storage outstanding, all of which are owned by Andrew. There are authorized Class B Common Shares; however, no Class B Common Shares have been issued. In return for providing $15 million of fi nancing on September 30 four years ago, Gassmann Industries received 15,000 convertible preferred shares of Cold Storage. Each convertible preferred share has a face value of $1,000 and is entitled to receive a 10% annual cumulative dividend in the form of identical additional convertible preferred shares with the same face value per share (i.e., after year one, the 15,000 initial convertible preferred shares would be entitled to a 1,500 convertible preferred share dividend; after year two, a $1,650 convertible preferred share divided would be paid).

On September 30 of This Year, Gassmann Industries has the option of either: • Converting all of its convertible preferred shares (including those received as share

dividends) into two million newly issued Class A Common Shares.


242

OR • Requiring Cold Storage to redeem all of its convertible preferred shares (including those

received as dividends) for their face value of $1,000 per share.

If Cold Storage is unable to redeem shares in the second scenario above, Gassmann Industries may achieve liquidity by selling the entire business of Cold Storage to a third party purchaser and compel Andrew to sell his common shares in order to eff ect such a transaction.

Exhibit A2.5, provides a summary of Cold Storage’s results for the fi scal years ended December 31.

EXHIBIT A2.5: COLD STORAGE ($CAD) Cold Storage

Dec 314th Last Year

Dec 313rd last Year

Dec 312nd Last Year

Dec 31Last Year

Revenue ($000s) 17,500 18,200 17,300 17,400EBITDA ($000s) 5,000 5,100 5,205 5,305Net income ($000s) 1,070 1,115 980 1,020Number of pallets ($000s) 440 460 435 460

As at August 31 of This Year, Cold Storage had no outstanding indebtedness and had approximately $1M of excess cash on its balance sheet. The only securities outstanding were Andrew’s common shares and Gassmann Industries’ convertible preferred shares.

There is only one “pure play” publicly-traded cold storage company in North America. It is named Freeze It and is listed on the NASDAQ.

EXHIBIT A2.6: FREEZE IT INFORMATION AVAILABLE AS OF AUGUST 31 Freeze It

Number of common shares outstanding 10 MillionShare price USD $28.00Total debt USD $20 MillionTotal cash USD $5 MillionEBITDA USD $20 MillionNumber of pallets 4,775,000

Listed on the Toronto Stock Exchange, Gassmann Industries is a Vancouver-based publicly-traded holding company with investments in several companies such as Cold Storage. Michael, the major shareholder and CEO of Gassmann Industries, has contacted you, a CBV, to provide him with an estimate of value for Gassmann Industries’ investment in Cold Storage. Since Michael is not familiar with business valuation, he has asked you to detail the approach, the reasoning

243


behind the choice of approach, and the calculations in arriving at an estimate of FMV. Michael is considering selling his convertible preferred shares to Eng Real Estate Investment Trust for $23M.

In light of the above, Michael comes to you, CBV, to prepare the valuation estimate (not a formal report) of Cold Storage.

Required: 1. Prepare the valuation estimate requested by Michael. Determine the value of Gasmann

Industries investment in Cold Storage. Make sure your answer includes items in the “Introduction” of a CICBV Estimate Valuation Report.

2. Discuss whether Michael should sell his convertible preferred shares to Eng Real Estate Investment Trust.


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Assignment 3Question 3.1Health Pro Outfi tters Ltd. currently manufactures a complete line of fi tness equipment, including treadmills, stationary bicycles, and home gyms. However, Health Pro would like to concentrate solely on electronic fi tness equipment, and is looking at selling the operating assets associated with its home gym division to Fitness Distributors Inc.

The purchase and sale agreement currently specifi es the following allocation of proceeds, with respect to these assets:

Purchase Price $ Original Cost $Land 100,000 30,000Building 2,500,000 3,000,000Manufacturing equipment 4,000,000 5,000,000Vehicles 30,000 70,000Goodwill 400,000 100,000 Total 7,030,000 8,200,000

In its last tax return prior to the sale, Health Pro reported the following balances of Undepreciated Capital cost at end of year:Class 1 — Building (4% CCA rate) 8,000,000Class 10 — Vehicles (30% CCA rate) 50,000Class 43 — Manufacturing equipment (30% CCA rate) 3,200,000

These UCC balances comprise assets for all of Health Pro, including those retained in the treadmill and stationary bicycle division. However, the only Class 10 assets in the group are the assets being sold in the home gym division.

The cumulative eligible capital account has a balance of $24,000. This balance arose as a result of legal and incorporation fees of $100,000, $75,000 of which were set up as CEC expenses many years ago.

Required:1. Calculate the after tax cash proceeds on the sale to Health Pro Outfi tters as a result of the

sale. Assume a combined federal and provincial corporate tax rate of 35% on business income and 40% on investment income.

2. The controller of Fitness Distributors has asked you to compute the tax shield related to the assets acquired, assuming a 10% discount rate.

245


Question 3.2Jane Junno is 25 years old. She was born and raised in Ottawa. During her undergraduate university studies in Ottawa, she met Al Gaiter, from Los Angeles, who was a foreign student at the same university. Upon graduation, Al stayed in Ottawa to study law, while Jane decided to use her computer science degree to open her own business called Jane’s E-Commerce Inc. (“JEC”) which provides e-commerce consulting services.

Thanks to the Internet boom, JEC was quite successful during Al’s four years in law school.

After completing his law degree, Al obtained a high paying position at a very prestigious law fi rm in San Francisco. Not wanting to be apart from each other, the college sweethearts were married and decided to move to San Francisco.

Although Al has already moved to San Francisco, Jane continues to live in Ottawa until she decides what to do with her business. Al and Jane take turns visiting each other every other weekend.

Jane has received two off ers to sell her business (Exhibit A3.1). Under the assumption that she must accept one of the off ers, Jane would like to know which off er is preferable. Jane has asked you to assume that the sale of the JEC would occur before Jane’s departure from Canada.

Jane would also like to know what other options might be available to her.

Required: Prepare a summary of the options available to Jane.

EXHIBIT A3.1: OPTIONS AVAILABLE TO JANE

Off er #1Sell the assets of JEC, for $1.3 million, and separately sell the customer list for $500,000.

Off er #2Sell the shares of JEC for $1.4 million.


246

EXHIBIT A3.2: JEC COMPARATIVE STATEMENT OF EARNINGS

Year Ended December 31 Year 1 Year 2 Year 3 Year 4

Revenues

Hosting fees 240,000 520,000 640,000 720,000 Development fees 160,000 400,000 480,000 440,000 E-commerce consulting — 160,000 400,000 380,000 400,000 1,080,000 1,520,000 1,540,000 Cost of Sales Programmers’ salary 60,000 240,000 300,000 300,000 Connection fees 30,000 70,000 70,000 80,000

Gross Profi t 310,000 770,000 1,150,000 1,160,000

Expenses Management salaries 100,000 180,000 240,000 300,000 Rent & occupancy 96,000 120,000 120,000 144,000 Telecommunications 10,000 20,000 30,000 40,000 Insurance and taxes 40,000 50,000 60,000 60,000 Depreciation 40,000 92,000 68,000 54,000 Interest & bank charges 10,000 10,000 10,000 10,000

296,000 472,000 528,000 608,000

Earnings before taxes 14,000 298,000 622,000 552,000 Income taxes 4,000 92,000 186,000 166,000Net earnings 10,000 206,000 436,000 386,000 Retained earnings beginning of year — — 146,000 482,000 Dividends 10,000 60,000 100,000 150,000Retained earnings end of year — 146,000 482,000 718,000

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EXHIBIT A3.3: JEC SUMMARY OF BALANCE SHEETS

Year Ended December 31 Year 1 Year 2 Year 3 Year 4

Assets Cash 10,000 54,000 164,000 196,000 Accounts receivable 150,000 250,000 450,000 650,000 Prepaid expenses 20,000 30,000 40,000 44,000 Capital assets 420,000 328,000 260,000 206,000

600,000 662,000 914,000 1,096,000 Liabilities and shareholder’s equity Accounts payable 74,000 80,000 100,000 114,000 Income taxes payable 4,000 92,000 186,000 166,000 Current portion of long term debt 48,000 48,000 48,000 48,000 Long term debt 192,000 144,000 96,000 48,000 Shareholder loan payable 280,000 150,000 — — Capital stock 2,000 2,000 2,000 2,000 Retained earnings 146,000 482,000 718,000

600,000 662,000 914,000 1,096,000

EXHIBIT A3.4: ADDITIONAL INFORMATION

JEC’s customers are geographically located as follows:• Canada – 55%• United States – 40%• International – 5%

JEC’s accounts receivable includes $60,000 from one customer, which is unlikely to be collected. A provision in the amount of $20,000 had already been taken for this customer.

JEC’s capital asset information:• Market value $500,000• UCC $214,000• Cost $460,000• Depreciation and CCA 20%

JEC has no balance in its capital dividend account and RDTOH account.

JEC pays tax at the following rates:• Active business income 30%• Investment income 40%

Jane is in a personal income tax bracket of 45% (combined federal and provincial).


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Question 3.3As at December 31, last year, Black Tiger Shrimp restaurants entered into negotiation with the Sqwid family to purchase all the issued and outstanding shares of Long Tom’s Seafood restaurants, a privately-owned chain of 21 restaurants in the provinces of New Brunswick, Prince Edward Island, Nova Scotia and Newfoundland. The parties are willing to transact; however, the price remains the fi nal issue under negotiation. The diff erence in position on price stems from diff ering growth assumptions for the business. While Mr. Sqwid foresees the demographic trend of people dining out increasing, and projects annualized growth for his business of 15%, Black Tiger Shrimp believes that the prevailing growth trend of 5% is more realistic. Black Tiger Shrimp has proposed that, in order to get the deal done, Black Tiger Shrimp will pay Mr. Sqwid an initial amount equal to the net tangible asset value of Long Tom’s Seafood business. In addition, Black Tiger Shrimp will pay 75% of Long Tom’s Seafood’s free cash fl ow for the next fi ve years, which is over and above the growth rate expected by Black Tiger Shrimp. If Mr. Sqwid’s expectation for the annual rate of growth is achieved, the total consideration for the shares will be $50 million. After accepting the off er, Mr. Sqwid stated: “I really won this negotiation. I settled at the price I wanted and I also get to defer a portion of the taxes over the next fi ve years in addition to utilizing my qualifi ed small business corporation exemption on the shares I own in Long Tom’s Seafood.”

Required: Discuss the relevant issues in the case and respond to Mr. Sqwid’s remarks.

249


Question 3.4Provided below is some information on Astral Media Inc.’s (Astral) publicly-traded Class A and Class B common shares on the Toronto Stock Exchange:

EXHIBIT A3.5: ASTRA MEDIA COMMON SHARES - CLASS A AND B

• Astral has outstanding 65,000 Special shares, 51,714,927 Class A non-voting shares and 3,240,622 Class B subordinate voting shares. Both Class A and B have an unlimited number of authorized shares. (Please note that this stock graph is not a current stock graph of this company).

• The average daily volume of the Class A shares and Class B shares for the last 90 days (as per the chart above) were 1,000,000 and 10,000 respectively.

• Class A shares are non-voting while Class B shares are voting. In addition, the Special shares have 10 votes per share.

• Class B voting shares may receive a dividend at a semi-annual rate of up to $0.05 per share only after the Class A non-voting shares have been paid a dividend at an annual rate of $0.05 per share.

• Class A shares are entitled to a vote per share in certain situations related to a take-over bid.

• Each Class B share is exchangeable for a Class A share on a one-for-one basis.

Astra MediaCommon Shares – Class A and B

Daily Closing Price – TSXJanuary This Year

$34.00

$33.00

$32.00

$31.00

$30.00

$29.00

$28.00

$27.00

Astral Class AAstral Class B


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• Class A shares provide a 5% non-cumulative dividend and are convertible on the basis of two Class B shares for each special share.

• Abergreen Holdings Inc., owns 47% of the outstanding Class B shares and 100% of the outstanding Special Shares. Abergreen Holdings Inc. is controlled by the Greenberg family.

• You review other dual class shares on the Toronto Stock Exchange and note that several companies on the Exchange such as Rogers Communications, Bombardier, Extendicare and Canadian Tire have similar situations as above.

Required: Justify and discuss the small diff erence of the stock trading price between the Class A and Class B shares of Astral Media Inc., when the shares clearly have diff erent voting rights. Given their share characteristics, why do Class A and Class B of Astral’s not trade at a wider diff erence?

Question 3.5On September 2 of This Year, ABC Ltd., which trades on the Toronto Stock Exchange (20,000,000 common shares issued and outstanding) was taken over by XYZ Ltd. at $12.00 a share, which represents a 100% premium over its last trading price (see ABC’s stock trading information below). You understand from studies on takeover premiums that the average takeover price is 20% to 30%.

EXHIBIT A3.6: STOCK TRADING INFORMATION

ABC Ltd. Stock Trading Information for This Year (C$)

Month Ending High Share

Price Low Share

Price Closing Share

Price Total Monthly

Volume

March 30 6.75 4.00 5.25 500,000

April 30 5.50 4.50 5.50 450,000

May 31 5.25 4.25 4.25 500,000

June 30 6.00 4.75 5.90 550,000

July 31 6.50 4.00 5.90 450,000

August 31 6.00 4.25 6.00 550,000

September 1 6.00

Required: Describe the possible reasons why the price XYZ Ltd paid is much higher than the trading price range of ABC Ltd., as well as the average takeover premium indicated on studies regarding takeover premiums. (Hint: discuss the possible components that may make up the 100% premium).

251


Question 3.6Assume today’s date is October 1 of this year. Levon Rudan owns the Ontario-based Rover Pet Foods, which has 30 stores. Levon wants to retire immediately to pursue his dream of sailing around the world. He has received an off er for his business from PetChoice Foods, as summarized in the chart below:

Summary of PetChoice’s Draft Letter of Intent for Rover Pet Foods:

Off er

To purchase all the assets of Rover Pet Foods, to operate its business including inventory, fi xed assets, customer lists, customer contracts and corporate names. PetChoice does not intend to assume any liabilities of Rover Pet Foods.

Price

$9 million

Consideration

600,000 common shares of PetChoice Foods valued at $15 a share.

Escrow

Consistent with regulatory requirements, the common shares of PetChoice Foods received as consideration will be held in escrow for a period of three years before they may be sold.

Conditions of Off er

Off er is subject to due diligence by PetChoice Foods, negotiation of fi nal legal agreements and satisfaction of all legal and regulatory requirements.

You have previously conducted an en bloc valuation of Rover Pet Foods’ common shares and have arrived at a value of $9 million that is still valid.

PetChoice Foods is the largest pet store company in Canada with operations across Canada. The company’s common shares have been publicly listed on the Toronto Stock Exchange for six years.

PetChoice was founded 20 years ago and has built its operations primarily through acquisitions. Its strategy involves acquiring leading independent food companies in large centres and then building these regional operations by integrating small acquisitions in each market area.

PetChoice plans to expand its operations to include every major center across Canada. The Canadian investment community has mixed views on PetChoice’s prospects. Many investment analysts have commented that they are not comfortable with the company’s level of management depth and are doubtful as to whether they will be able to achieve their growth plan. PetChoice’s share price has traded in a wide range since its initial public off ering


252

PetChoice’s public fl oat of common shares is relatively small. The company’s founders and management team currently own 6 million shares, while another 4 million shares are mainly held by former owners of pet stores purchased by PetChoice. The PetChoice shares owned by the former storeowners are being held in escrow, subject to regulatory requirements. It is anticipated that approximately 2.5 million of these shares will come out of escrow and be freely tradable beginning January 1 of next year.

Exhibit A3.7 provides some of PetChoice’s share price and share volume history. Closing share price of PetChoice was $15.00 a share as at the end of September 30 of this year.

EXHIBIT A3.7: PETCHOICE’S SHARE PRICE AND VOLUME HISTORY ($CAD)

YearLow Share

PriceHigh Share

PriceTotal Share

Volume

Total Outstanding

Share4th last year 4.00 9.00 200,000 5,000,0003rd last year 5.00 10.00 300,000 6,000,0002nd last year 6.50 11.50 400,000 6,500,000Last year 4.00 10.00 335,000 7,500,000This year Q1 6.00 10.00 105,000 8,500,000This year Q2 9.00 13.00 75,000 9,500,000This year Q3 10.30 15.00 91,000 10,000,000

Exhibit A3.8, demonstrates PetChoice’s recent historic results, with a company year-end on December 31.

EXHIBIT A3.8: PETCHOICE’S RECENT HISTORIC RESULTS ($CAD)

PetChoice’s Results

Item 3rd Last Year 2nd Last Year Last Year

Revenue 25,000 50,000 80,000

EBITDA 2,500 6,000 6,500

Net income 1,000 1,500 2,000

Capital expenditures 500 800 1,100

Debt 4,000 7,000 10,000

Current assets 1,100 2,000 2,900

Average number of stores 90 170 325

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You have determined correctly that an appropriate multiple to value PetChoice is 10x to 12x EBITDA.

Required: Assist Levon in evaluating PetChoice’s off er for his Rover Pet Foods business. Make sure your answer includes items in the “Introduction” of a CICBV Estimate Valuation Report.

Question 3.7ABC Recording Company is owned by the following individuals with their respective percentage ownership in each class as at December 31st of Last Year.

EXHIBIT A3.9: ABC RECORDING COMPANY’S CLASS PERCENTAGE OWNERSHIP

Class A Class BConvertible

Preferred Shares

Paula Cowell 30% 100%

Simon Seacrest 68%

Ryan Jackson 100%

Randy Abdul 2%

Paula and Randy always agree with one another and generally oppose Simon’s voting on shareholder matters.

Share Information

Class A Common Shares Non-voting, cumulative dividends, paying at the average Bank of Canada prime rate outstanding during the calendar year on December 31st of each year, and can be redeemed at par value per share ($2.00 a share). A total of 50 million of these shares are outstanding.

Class B Common Shares Voting with 1 vote per share and a par value of C$3.00 per share, a total of 100 million of these shares are outstanding.

Convertible Preferred Shares Non-voting, convertible into newly issued Class B Common Shares of ABC Recording Company on a 1 to 1 basis. A total of 3 million of these shares are outstanding. Each preferred share can be redeemed by the owner for their face value of C$15.00 per share. These preferred shares carry a cumulative dividend paying at the average Bank of Canada prime rate outstanding during the calendar year on December 31st of each year.

Other Information You have conducted your valuation of the company and correctly determine the following for the valuation of ABC Recording Company as at December 31st of Last Year:

• The company is to be valued using a maintainable earnings approach


254

• The maintainable EBITDA of the company is C$162.5 million • The capitalization rate is 12.5% • The average Bank of Canada prime rate was 5% during the last calendar year• You learn through review of ABC Recording Company’s fi nancial statements, amongst

other fi nancial statement items, that ABC Recording Company had as at the valuation date the following:

- C$50 million in accounts payable

- C$60 million in accounts receivable

- C$70 million in goodwill

- C$80 million in prepaid expenses

- C$90 million in short term debt

- C$100 million in future taxes

- C$110 million in long-term debt

- C$120 million in deferred revenue

Required: You are Roger Daughtry, CBV. Based on the above information, the existing owners have asked you to provide a value for each of their ownership interests as at the valuation date, in each class of share, with discussion of supporting rationale.

255

ASSIGNMENT SOLUTIONS

Assignment 1 SolutionsLevel II - Intermediate Business Valuation

256

Assignment 1 Solutions

Solution 1.1

Situation #1This organization has many of the elements of a joint venture, including the following:

• It has been defi ned by a contractual relationship between the 2 parties• It involves the participation of two or more persons• Both parties have a joint property interest in the apartment• There is mutual control over the management of the apartment• There has been a contribution of money from each of the parties• The question is silent on the existence of a partnership agreement• A joint venture usually involves a single undertaking which is the case here (the apartment

building)

In this case, the leasing revenue represents property income. Because a joint venture is not recognized as an entity under the Act, this property income will be taxed in the hands of each of the venturers. The rate applicable to this income will depend on each of their marginal personal tax rates. As we know, they both have income from other sources, so it appears that the rental income will therefore be taxed at the top marginal rate.

Situation #2Marko Ltd. is not a Canadian-controlled private corporation (CCPC) as it is controlled by a combination of a Canadian public company and a non-resident. It is also not a private corporation as it is controlled by a public company. Nor is it a public company as its shares are not traded on a stock exchange. This type of corporation would be classifi ed as “other.” Although it is earning income from an active business, it is not eligible for the small business deduction if it is not a CCPC and therefore, its combined federal and provincial tax rate in the province of Quebec, is 26.9% (as of 2014).

Situation #3Quantum is a CCPC. However, because its income is strictly investment income and not derived from an active business, is not eligible for the small business deduction. The dividend income earned from its investment in Cooper constitutes a portfolio investment. As such, the dividend income will be subject to Part IV tax at a rate of 33 1/3%. This tax will be refundable on the basis of $1 for every $3 of dividends subsequently paid to Mr. & Mrs. Jones.

The dividend income earned from Quality Holdings would not be subject to Part IV tax, as Quality Holdings would be considered connected to Quantum. The dividend received from Quality would be included in income for Part 1 tax purposes, but would be eligible for a deduction pursuant to subsection 112 of the Income Tax Act. The result, then, is that this dividend income will not be taxable.

257


The interest income earned from Purity would be investment income to Quantum. It would be subject to tax at the top corporate rates; additionally, Quantum would have to pay a refundable tax on this income. The combined federal and provincial rate on the investment income for Alberta would be 40%, plus the 6 2/3 refundable tax, for a combined overall rate of 46 ²⁄3%. The refundable tax will be refundable on the basis of $1 for every $3 of dividends subsequently paid to Mr. & Mrs. Jones. The capital gains income earned from Purity would also be investment income to Quantum, however the taxable amount would only be 50% of the gain allocated from the fund. Similar to interest income, the applicable rate on this income would be 40% of the taxable capital gain.

Solution 1.2Lee Enterprises could be considered to be a “personal services business” because Mr. Lee performs the services and is a specifi ed shareholder of the corporation. However, there is an exception from this defi nition if Lee Enterprises is associated with each of the payor companies. In this case they are associated; therefore, Lee Enterprises is not a “personal services business” (and since it is not a “personal services business, it will be eligible for the small business deduction). However, Lee Enterprises will have to share the small business deduction with all of the operating companies since they are associated.

Solution 1.3

1.3 (A)Net profi t before taxes (in ‘000’s) $7,000 Non-capital losses (5,000) SRED claim (2,000) Taxable income -0- Taxes payable Nil Carryover balances: Non-capital losses (5,000 – 5,000) Nil SRED carryover (13,000 – 2,000) 11,000 ITC’s (2,500 – 0) 2,500

Comments: While Microtech has the choice of claiming either its unused SRED deductions or its non-capital losses, because the losses are subject to expiry it would be prudent to claim the non-capital losses fi rst.

1.3 (B)While Johnson does not exercise de jure control over Microtech in the previous years (i.e., it owns less than 50% of the shares that permit them to elect the majority of directors) the test for association looks to “controlled directly, indirectly or in any manner whatever.” As such, the implications of de facto control must be considered. In this case, because a unanimous shareholder agreement is in


258

place, the terms and provisions of that agreement would have to be reviewed carefully to ensure there are no provisions in that agreement which would result in de facto control by Johnson.

More importantly, the association rules will also look to the options and rights that exist in any of the contracts or agreements of the shareholders. In particular, the original purchase agreement provides Johnson with the right to acquire 100% of the remaining shares of Microtech. Subsection 256(1.4) of the Act specifi es that “for the purpose of determining whether a corporation is associated with another corporation” and “where a person…has a right at any time under a contract, in equity or otherwise, either immediately or in the future and either absolutely or contingently” to acquire the shares of the corporation, then that person will be deemed to own such shares.

As such, because the purchase agreement provides Johnson the right to acquire the additional 51% of the Microtech shares in the future, even though that right is contingent upon certain events, they will be deemed to own 100% of Microtech’s shares at the time the purchase and sale agreement becomes eff ective.

Consequently, Johnson and Microtech would be considered associated corporations for the current taxation year.

1.3 (C)As a result of the asset transfer, and the subsequent issue of common shares of Microtech, Johnson became owner of 55% of the voting common shares of Microtech, consequentially diluting the other shareholders. As a result of this transaction, with Johnson now owning more than 50% of the shares that permit them to elect the majority of directors, there will be an acquisition of control of Microtech as at February 28 of this year.

The implications of a change in control are fi rstly that a deemed year-end will occur on February 28 of the current year. Because of this short taxation year, the expiry date for the ITCs will be accelerated. Although the previous non-capital loss carryovers of the corporation will have been utilized prior to the change in control, there may be implications for Microtech regarding the unused SRED claims, and ITC’s and the restrictions on carryover rules of subsection 37(6.1) and 127(9.1) and (9.2) must be reviewed. In particular, since the television division may be considered a line of business dissimilar from the home product division, the SRED claims and ITCs may not be available to shelter the income as Mr. Corbett expects.

In addition, the value of the Microtech assets will have to be reviewed prior to the change in control to determine whether there are any unrealized losses that will have to be crystallized upon the change in control (e.g., FMV of capital or depreciable property is less than original cost or UCC, respectively). If such is the case, Microtech will have to write-down the value of the property and take the capital loss or terminal loss as the case may be. To the extent there are terminal losses, this will result in a new non-capital loss that will be subject to the restrictions in subsection 111(5). The capital losses will not be eligible for carryforward, however an election to “bump” the cost of other appreciated capital property may be available pursuant to subsection 111(4) of the Act. This would eff ectively result in a deemed capital gain to Microtech, but such gain could be off set by the deemed capital loss on the change in control.

259


Some students may identify that a change in control may have occurred on March 1 of the previous year because of the optional right to acquire additional shares as specifi ed in the purchase and sale agreement. This isn’t necessarily the wrong answer as subsection 256(8) will deem such right to be exercised if it can reasonably be regarded that one of the main reasons for the right is to avoid a change in control and the application of subsection 111, 37 or 127 to the losses, SRED claims or ITCs respectively. The impact of this right being exercised would be that Johnson would be deemed to own 100% of the voting shares of Microtech at March 1, of the previous year, such that control will be deemed to be acquired upon the execution of the purchase and sale agreement. While this changes the timing of the actual acquisition of control, it would not change the related implications.

Solution 1.4The income tax issues that should be examined when adopting a going concern approach include:

• The selection of the appropriate tax rate to apply to the estimated maintainable earnings/cash fl ow. If the small business deduction had been claimed, will the purchaser be entitled to the small business deduction?

• Available loss carry forwards should be considered with regard given to the restriction on the utilization of the losses on an acquisition of control

• The selection of the appropriate tax rate and the computation of taxable income on the realization of redundant assets and the subsequent withdrawal of the surplus

• The value of any tax pools available for utilization in the future • The eff ect of investment tax credits on CCA claims• The tax shield on the existing asset base and the capital reinvestment• The income taxes factored into the discounted cash fl ow formula are on a cash basis and

the future tax aspects are included in determining the residual value • Potential tax liabilities that may exist re: bonuses, etc. • The level of taxable income expected to utilize CCA claims, investment tax credits, scientifi c

research and development incentives

Solution 1.5Defi ne arm’s length principle as the result that would arise if the two parties to the transaction had dealt at arm’s length.

Defi ne FMV as the highest price paid, in an open and unrestricted market, between fully informed parties dealing at arm’s length, under no compulsion to act, expressed in terms of money or money’s worth.

Diff erences• FMV is a range of dollar values. Arms-length price is often determined based on an

accounting ratios such as gross margin, operating margin, or net cost plus and not a specifi c range of dollar values.


260

• FMV assumes no market restriction; arm’s length standard does not have that requirement.• FMV assumes the highest price paid; arm’s length could be the lowest price paid, and

arm’s length principle does not consider compulsion to act. If a company entered a transaction out of desperation, the transaction could still prevail under arm’s length terms and conditions.

• Both defi nitions consider parties acting at arm’s length.

Solution 1.6As companies become more and more global, and intercompany sales and purchases across jurisdictions increase, there are implications for valuation. Tax Authorities are generally only concerned with the company that is transacting above the range. That is, showing a sale to a related company at less than an arm’s length price, or showing a purchase from an arm’s length company at greater than an arm’s length price. Tax authorities do not, as a matter of practice, downward adjust a taxpayer’s income.

Therefore, should the transaction not be at arm’s length, there is a risk that either the domestic company or the foreign related company will have their income adjusted by the relevant taxing authority.

Clearly, an adjustment to income will aff ect the fair market value of the enterprise being examined.

Companies might take a reserve for transfer pricing on their fi nancial statements to allow for potential changes in transfer prices upon audit in the future. These reserves provide guidance on the level of risk of a transaction, what transactions might be missing from the fi nancial statements, and insight into the transfer pricing policies of the company.

Questions that may indicate the level of risk associated with the transfer pricing policies include:• Has the tested party been in a loss position for an extended period of time?• Is one of the parties to the transaction in an off shore tax haven?• Are the returns earned by the tested party unusually high or low?

Solution 1.7

• Acquisition of control on September 1, 2013• Immediately before Sept 1, 2013 there is a deemed year end• Deemed year end will accelerate the expiry of the losses• Loss on assets will need to be recognized on acquisition of control• Calculate non capital loss on inventory at $3,000• Calculate non capital loss on A/R at $3,000• Calculate terminal loss on equipment at $18,000• Calculate capital loss on marketable securities at $16,000

261


• Calculate recapture on goodwill at $4,000• Net capital losses can be carried back 3 years. However there are loss balances for 2010,

2011 that have not been applied so it appears this is not possible• Net capital losses will expire on an acquisition of control (marketable securities)• Non capital losses can be used subject to three conditions:

1. Business that gave rise to the losses must be carried on continually after the acquisi-tion of control

2. Business must be carried on for profi t3. Losses can only be applied to gains from same or similar business

• SRED expenditure will be reduced to nil but will be reinstated to the extent that the same or similar business earns income after the acquisition of control

Solution 1.8Areas that should be considered include:

Transfer pricingAn incorrect price can transfer profi ts to a related non-resident corporation and, if identifi ed during an audit, may result in a reassessment.

Income vs. Capital treatment (characterization of a transaction)If current deductions are taken for items that may be considered capital in nature, a tax liability may exist.

Interest deductibilityFor interest to be deductible it must be on money borrowed to earn income. It may also be capitalized in cases such as construction, and is subject to thin capitalization rules.

Unrealized gainsIf assets that are going to be divested in the near future, or have inherent gains, a tax liability will result.

ReservesOnly specifi c reserves are deductible for tax. If other reserves are included, a tax liability may result.

High risk transactionsReorganizations, sales, lease back transactions, unusual related party transactions are often targeted when an audit occurs, so due diligence should ensure they have been recorded appropriately.


262

Assignment 2 Solutions

Solution 2.1In the situation given, the land is redundant to the operations of the company and can be withdrawn before the sale of the company. Therefore, the value of the land should be net of the tax on withdrawal. If the land or proceeds from sale of the land were retained in a corporation, personal tax could be deferred. If the land was sold and proceeds distributed immediately, personal taxes should be considered.FMV 310,000 ACB 165,000 Gain 145,000 Taxable gain at 50% 72,500 Tax at 52% 37,700 Refundable tax ($72,500 x 26.67%) (19,335) Net corporate tax 18,365

Solution 2.2

2.2 (1) and 2.2 (2)A full Calculation Valuation Report was not requested in this particular report, only an introduction of a Calculation Report was requested (so only 10.1 of standard 110) and as such the response below does not include a calculation report in its entirety.

Private and Confi dential

Today’s Date

Mr. Daniel Crook PJ GanMor Address

Attention: Mr. Daniel Crook

Dear Mr. Daniel Crook

Re: Proposed Auction for Nitrogen Corporation Inc.’s (“Nitrogen”) Shares

You have requested a Calculation Report of the fair market value of Nitrogen’s common shares which are publicly traded on the Toronto Stock Exchange as at September 23 of This Year (“the Valuation Date”). Fair market value is defi ned as being the highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms’ length in an open and unrestricted

263


market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

I understand you have requested a calculation valuation report (“the Report”) to assist you in preparing an auction bid for a new share issue of Nitrogen’s shares to take place on Tuesday September 23rd of This Year. Given that my report is a Calculation Valuation Report it is therefore limited in scope and due diligence procedures regarding key information and assumptions.

Please note that in preparation of my report my fees are based on hours spent and not contingent on the outcome of any events.

In my preparation of this report I have been independent and objective at all times. My report has been prepared in conformity with all CICBV Practice Standards. I have no fi nancial interest in Nitrogen or in the outcome of any transactions that may occur as a result of this valuation.

Sincerely,

Ace Valtura

The rogue trader situation at Nitrogen has caused the company to owe $1.9 billion through fraudulent trades. The current situation puts into the question whether or not Nitrogen is a going concern. Determination of whether or not the company is a going concern will decide whether or not a going concern or a liquidation approach will be used to value the company.

The following arguments support the use of a going concern approach:

1. Nitrogen has been profi table in the past and/or is expected to be profi table in the future. 2. The rogue trader’s loss is signifi cantly less than Nitrogen’s equity value based on its stock

market price.3. The $1.9 billion loss/amount owing represents approximately two years of Nitrogen’s

EBITDA.4. Nitrogen’s current debt levels represent approximately one year’s worth of EBITDA.

The following arguments support the use of a liquidation approach:

1. Nitrogen lacks the liquidity to pay the $1.9 billion in fraudulent trades based on cash on hand.

2. Nitrogen faces the risk of bankruptcy since non-payment of the derivative trades will cause a default on the bond indentures.

3. The current credit markets are poor and Nitrogen may not be able to obtain the necessary fi nancing.

4. Nitrogen’s current investors may lose faith with the company due to the rogue trader and may view the trader’s loss as systemic rather than a one-time item.

After review of the situation, we have decided to value Nitrogen based on a going concern approach, given that the company can comfortably undertake an approximate 3x debt/EBITDA level that has resulted from the $1.9 billion loss created by the rogue trader. The fact that Nitrogen


264

does not have the current liquidity to pay for the loss is a function of timing as opposed to the company being over levered.

We developed our off er price of $10.17 a share from an analysis of the current stock price in the next section below. This analysis was supported by a review of the intrinsic value of the company using the capitalized earnings approach.

Current Stock Price Analysis This analysis results in an off er of $10.17 per share based on the following table.

265


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Est

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e gi

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the

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s co

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e oc

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nce.

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l pro

fi tab

ility

20%

(4

.07)

PJ

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Mor

wan

ts to

ear

n a

heal

thy

profi

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ompe

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d si

tuat

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limits

the

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Mor

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arn

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. Dis

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requ

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Cal

cula

ted


266

Given the off er price above, we have determined from the table below that PJ GanMor would own approximately 25% to 38% of the company based on the minimum and maximum level of fi nancing that would be required by Nitrogen.

Determine # of Shares to be Issued at Off er Price and% Ownership for Minority Interest Consideration

MIN MAX Item Amount/% Amount/% Marks/discussionLoss created by rogue trader 1,900,000,000 1,900,000,000 Undrawn credit facility (500,000,000) Lower or no amount could be

argued Cash on hand (400,000,000) Lower or no amount could be

argued Requirement 1,000,000,000 1,900,000,000 CalculatedOff er price 10.17 10.17 Noted aboveShares to be issued 98,328,417 186,823,992 Calculated aboveCurrent shares outstanding 300,000,000 300,000,000 GivenNew shares o/s 398,328,417 486,823,992 Calculated aboveOwnership interest % 24.7% 38.4% Note 1

Note 1 Shareholding results in an ability to stop a 100% takeover. Given it is a large shareholding, a minority discount is likely smaller than would be for other minority shareholders. We would need to determine if the winning bid would be the largest shareholding.

Capitalized Earnings Approach We chose to use the capitalized earnings method in determining the intrinsic value of Nitrogen (rather than various going concern valuation methods) because we believe Nitrogen’s net income after taxes is not signifi cantly diff erent than net cash fl ows since depreciation expense has been consistently $25,000,000 per annum. As well, the results are cyclical and, as such, a maintainable earnings approach makes sense in this situation.

In determination of the maintainable earnings level, we considered the following:

1. Earnings are cyclical. As such, a weighting to the later years is not considered representative of future periods.

2. It would appear that the sales cycle is six years given the past results.

Given the above, we have taken the last fi ve years as an earnings cycle and the average maintainable EBITDA level over that period was $464,349,000

A revenue multiple could be applied to Nitrogen, however, revenue multiples do not account for possible diff erences in the cost structure and/or cash fl ow generating capabilities of diff erent companies within an industry and, as such, have not been used.

In determination of a multiple to apply against maintainable EBITDA of Nitrogen, we considered the following positive and negative factors as noted in the following table:

267


Positive factors Negative factors- In business for 75 years- Great reputation in industry- Industry performing strongly- Company has produced record results as of late- Operating at capacity- Flush with cash- Banks recently renewed lines- Strong cash fl ow

- Industry very cyclical- Nitrogen most volatile of all fertilizer types (NIC mostly produces Nitrogen)- Natural gas prices are rising- Industry has reached cyclical peak- New fertilizer plants will commence production over next couple of years- U.S. market poised for recession

As well, in consideration of a multiple to apply against maintainable EBITDA, we reviewed precedent transactions and public market comparable information. To start this analysis, we have prepared a table below to assist our review:

CAD $000’s 4th Last

Year3rd last

Year2nd Last

Year Last Year This YearDebt $2,200,000 $1,900,000 $1,600,000 $1,300,000 $1,000,000EBITDA 296,240 172,396 328,320 496,272 989,400Debt 2,200,000 1,900,000 1,600,000 1,300,000 1,000,000Equity 6,000,000 5,000,000 6,000,000 7,000,000 8,000,000Enterprise value 8,200,000 6,900,000 7,600,000 8,300,000 9,000,000Shares outstanding (millions) 500 450 400 350 300Share price 12.00 11.10 15.00 20.00 26.67EV/Revenue 5.54 5.60 4.63 4.01 3.09EV/EBITDA 27.68 40.02 23.15 16.72 9.10Average EBITDA last 5 years 531,144 499,960 466,369 367,744 456,526EV/Avg last 5 EBITDA 15.44 13.80 16.30 22.57 19.71Average EBITDA $464,349


268

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EBIT

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in M

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st 1

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in M

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d la

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269


The precedent transactions method involves applying the observed multiples (such as price to revenue and price to EBITDA) from recent transactions, involving companies whose operations are similar to Nitrogen, to Nitrogen’s operating results.

Caution should be taken when interpreting values based on transactions due to the fundamental diff erences between Nitrogen and each of the companies listed in the chart above. These diff erences include company size (ABC, Right Fertilizer), markets served, products off ered (Quick Release, Fast Growth), etc. In the absence of direct involvement with any of these transactions, it is not possible to determine the extent to which the price paid was infl uenced by factors such as:

1. Perceived synergies that may have caused the multiples paid to be infl ated.2. Negotiating abilities of buyer/seller that could infl ate or defl ate multiples paid.3. Form of consideration paid which could infl ate or defl ate multiples paid.

In review of specifi c transactions, the following comments are made on each:

ABC Fertilizer

• Larger than Nitrogen (in terms of EBITDA and/or revenue) - Therefore Nitrogen likely deserves lower multiple

• Does not sell potash and phosphate like Nitrogen - Therefore reducing comparability somewhat

- But does sell nitrogen which is large part of Nitrogen’s business

• Transaction is dated (3 Years) - Therefore transaction is not a good comparable

Right Fertilizer

• Smaller than Nitrogen (in terms of EBITDA and/or revenue) - Therefore Nitrogen likely deserves higher multiple


- But does sell nitrogen which is a large part of Nitrogen’s business

Fast Growth Products


• Only sells potash (no nitrogen) - Therefore transaction is likely not a good comparable

- Potash is a small part of Nitrogen’s business

Quick Release Fertilizer

• Larger than Nitrogen in terms of revenue


270

• Smaller than Nitrogen in terms of EBITDA - Therefore likely no and/or minimal adjustment for size in terms of multiple for

Nitrogen

• Only sells phosphate - Therefore transaction is likely not a good comparable

- Phosphate is a small part of Nitrogen’s business

Nugrew Industries

• Smaller than Nitrogen (in terms of EBITDA and revenue) - Therefore Nitrogen likely deserves higher multiple

• Only sells nitrogen (no potash, no phosphate) - Therefore reducing comparability somewhat


• Transaction is for shares and not cash - Therefore form of consideration is diff erent

- Which likely lowers the multiple

- Therefore transaction is (likely) not comparable

123 Fertilizer

• Similar in size to Nitrogen in terms of revenue • Smaller in size to Nitrogen in terms of EBITDA

- Therefore Nitrogen likely deserves higher multiple

• Sells similar products as Nitrogen - Therefore likely a good comparable

YYZ Products

• Smaller in size to Nitrogen in terms of revenue and EBITDA - Therefore Nitrogen likely deserves higher multiple


271


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ic M

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para

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tiple

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of S

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s in

Milli

ons

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rpris

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lue

in

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ons

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DA

in M

illion

s (la

st 1

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onth

s)

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in M

illion

s (a

vera

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last

5

year

s)

Form

of

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side

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r’s

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enue

s in

Milli

ons

EBIT

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in M

illion

s (la

st 1

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in

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(ave

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272

The comparable public companies methodology involves applying public equity market multiples (such as price to revenue and price to EBITDA) of public companies whose operations are similar to those of Nitrogen, to Nitrogen’s operating results.

Caution should be observed when interpreting values based on public market comparables because of the fundamental diff erences between Nitrogen and each of the companies listed in the chart above. These diff erences include company size, markets served, products off ered, etc. As well, public equity market prices are sometimes sporadic and may not refl ect the Fair Market Value of the underlying comparables. While a control premium is typically applied to multiples to arrive at a control value, no adjustment has been made in this case for a premium, since we are measuring a minority interest stock value.

While some of the multiples are for companies outside of Canada (unlike Nitrogen), such diff erences in geography are assumed away in this analysis of multiples.

In review of specifi c publicly trading companies, the following comments are made on each:

Tri Fertilizer


• Only sells potash (no nitrogen) - Therefore transaction is likely not a good comparable

- Potash is a small part of Nitrogen’s business

Phosphate Inc.


• Only sells phosphate (no nitrogen) - Therefore transaction is likely not a good comparable

- Phosphate is a small part of Nitrogen’s business

Hope Nitrogen

• Similar to Nitrogen (in terms of EBITDA and revenue) - Therefore Nitrogen likely deserves similar multiple

• Only sells nitrogen (no potash, no phosphate) - Therefore reducing comparability somewhat


Small Fertilizer

• Larger in size to Nitrogen in terms of EBITDA and revenue (average last 5 years) - However less profi table than Nitrogen in terms of EBITDA margin

273


- Therefore Nitrogen likely deserves higher multiple


NY Fertilizer

• Smaller in size to Nitrogen in terms of revenue • Similar in size to Nitrogen in terms of EBITDA (average last 5 years)

- Therefore Nitrogen likely deserves lower multiple


Big Fertilizer




Mega Nitrogen

• Smaller than Nitrogen (in terms of EBITDA and/or revenue) - Therefore Nitrogen likely deserves higher multiple



Intrinsic Value Calculation Although we have considered all the multiple information, we have determined that the most relevant piece of information relates to the 123 Fertilizer transaction with an EV/EBITDA multiple of 18 (based on the 5-year average) given that it appears most comparable. In our analysis below, we have chosen a multiple that is higher than what was indicated in the 123 Fertilizer transaction, because Nitrogen has similar revenue levels but much higher EBITDA and EBITDA margin levels. We selected multiples that were approximately 20% to 40% higher. Further, since the 123 Fertilizer transaction represents a control position, we have used a 20% minority discount based on our experience with going-private transactions in this industry (note that in a valuation report, a more detailed explanation of both the multiple selection and the minority discount would likely be required). While the 123 Fertilizer transaction might include synergies, we have no way of knowing whether synergies exist and, for purposes of our analysis, we have assumed synergies did not exist in this transaction.


274

High Low6 year average EBITDA of Nitrogen 471,353,000 471,353,000 As discussed

aboveEnterprise/EBITDA multiple 22 25 As discussed

aboveEstimated enterprise value 10,369,766,000 11,783,825,000Less actual debt ( This year’s interest expense of 50M1 / Interest rate of 5% (current cost of funds))

(1,000,000,000) (1,000,000,000)

Add Cash 400,000,000 400,000,000Control equity value 9,769,766,000 11,183,825,000Minority discount 20% (1,953,953,200) (2,236,765,000) As discussed

aboveMinority share value 7,815,812,800 8,947,060,000

Note 1: See Appendix I to the Questions

The above analysis of intrinsic value of the shares supports the current trading price of the shares given the current trading minority share value (of $8,001,000,000) falls within the minority share value range above. As such, no adjustment is necessary to (market capitalization) to arrive at our bid price of $10.17 per share.

The Enterprise/EBITDA multiple is determined based on the comparable companies. 123 Fertilizer was determined to be most comparable but the multiple was adjusted since the earnings of the subject company were better than 123 Fertilizer. These are subjective determinations and the actual amount will vary but the justifi cation for the adjustments are important. If based on your research two of the companies are comparable, you could use an average of the multiples, as long as your choices can be justifi ed.

$50 million is the interest expense per the income statement and it is divided by the rate of interest to approximate the value of the debt.

Refer to: Module 3 for help with the blockage adjustments and minority and control positions for the adjustments on A2-11. The amounts/adjustments are based on judgement and the justifi cation is important.]

Many diff erent multiples could have been chosen here based on the data provided, as multiples vary widely. The choice (or quantum) of the multiple is less important in an exam scenario than providing reasonable support for why that selection was made. If the minority share value above was signifi cantly diff erent than the current market capitalization an adjustment would be necessary to arrive at a bid price for the shares.

2.2 (3)The three types of Valuation Reports that can be issued under CICBV standards are as follows:

1. Comprehensive Valuation Report 2. Estimate Valuation Report 3. Calculation Valuation Report

275


These three reports are distinguished by the following:

1. Scope of review 2. Amount of disclosure provided or level of detail 3. Level of assurance

Briefl y:

1. A Comprehensive Valuation Report off ers the highest level of assurance, contains a conclusion that is based on a comprehensive review and analysis of the business, its industry and all relevant factors.

2. An Estimate Valuation Report contains a conclusion that is based on a limited review and generally refl ects a less detailed valuation report.

3. A Calculation Valuation Report contains a conclusion based on minimal review and analysis and little or no corroboration or relevant information.

Solution 2.3

2.3 (1)Private and Confi dential

Today’s Date

Mr. Michael Gassmann Industries Address

Attention: Mr. Michael

Dear Mr. Michael

Re: The Estimate Valuation Report for Gassman Industries business interest in Cold Storage as at September 20, This Year.

You have requested our estimate of the fair market value of Gassman Industries’ (“Gassman”) convertible preferred share interest in Cold Storage (“the Company”) as at September 20, This Year (“the Valuation Date”). Fair market value is defi ned as the highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms’ length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

We understand you have requested our Estimate Valuation Report (“the Report”) to assist you in evaluating a purchase off er made by Eng Real Estate for your interest in the Company.

The defi nition of fair market value contemplates the concept of “highest price.” As such, I performed an analysis of the alternatives with respect to Gassmann Industries’ ownership in Cold Storage in order to determine the “highest price.” Specifi cally, we have:


276

1. Estimated the fair market value of Gassman’s interest in Cold Storage as at December 31, Last Year under the assumption that Gassman converts their preferred shares into common shares.

2. Calculated the fair market value of Gassman’s preferred shares, with accrued dividends, under the assumption that they are not converted to common shares but rather redeemed.

Method 1: Valuation Of Cold Storage If Preferred Shares Were Converted To Common Shares

ApproachA going concern approach to value Cold Storage is appropriate as Safe Storage has exhibited positive EBITDA and net income historically, with no indications that such positive returns will not continue into the future.

We used a capitalized EBITDA methodology. This methodology is appropriate in this situation given the historic relative consistency of earnings levels. We selected a range of future maintainable EBITDA based on analysis of historic EBITDA levels. Reliance on historical results as a predictor of future results is appropriate in this particular case as this type of business is not likely to be subject to cyclical or other signifi cant fl uctuations. Again, this is evidenced by the historic consistency of EBITDA levels. The number of cubic feet of boxes has also remained consistent historically.

EBITDA MultipleWe reviewed various valuation multiples and metrics with respect to Freeze-It, which is a somewhat comparable public company. The calculated multiples are indicated on schedules below. The comparability of Freeze-It to Cold Storage is limited by the following factors:

1. Freeze-It is publicly traded and therefore has increased liquidity, greater transparency of fi nancial and operational results, and increased access to additional capital.

2. Freeze-It is a signifi cantly larger than Cold Storage (both in terms of available storage space and revenue).

3. Since Freeze-It is publicly traded, the implied enterprise value and market capitalization amounts refl ect a minority discounted valuation.

We also considered current economic indicators and conditions. Based on the calculation of value multiples as set out in a schedule below, and the factors discussed above, we selected a range of EBITDA multiples of 10 to 12.

277


LOW HIGHEBITDA Range 5,200 5,400 Based on historical EBITDA with more weighting on later

years given these are considered more representative of future results and the fact that the historical EBITDA trend

has been risingEBITDA Multiple 12 10 Based on Market EV/EBITDA Multiple of 14.75 below

adjusted for size, geography, etc.

Enterprise Value 62,400 54,000Add: Redundant Cash 1,000 1,000 Considered redundant to business operationsLess: Debt 0 0 Assumed to be zero since no debt discussedEquity Value 63,400 55,000Ownership 25% 25%pro rata ownership 15,850 13,750less: minority discount (15%) (2,378)

(2,063)

To further account for lack of control, liquidity and other

factorsFMV of ownership if converted to C/S 13,473 11,688Midpoint (rounded) 12,600

When reviewing multiples obtained from the public markets and using them to derive a value of a private company, students should consider the diff erence between public and private companies as outlined in the course notes.

After consideration of a minority discount of 15% to refl ect Gassman’s non-controlling interest in Cold Storage whereby he would 1) own only 25% upon conversion, thereby lacking control of the company, and 2) be unable to block special resolutions (as noted in chart below), we estimated that the fair market value of Gassman’s ownership share in Cold Storage as at December 31, Last Year ranges between $11.7 million to $13.5 million (if he were to convert his preferred shares to common shares). Please note that the minority discount of 15% is lower than what would normally be applied to a shareholding of similar size, in a company with a similar profi le. However, the 14.75x multiple was derived from a publicly-traded company’s share price. Such share price (and accordingly, the 14.75x multiple) inherently refl ects a minority interest discount. Therefore, the 15% discount refl ects the additional risk not captured by the minority interest discount inherent in the public company share price and multiple.

Freeze It (Comparable Analysis)Common shares outstanding 10,000,000 Share price (based on August 31 stock price on the assumption there has not been a major change since that date to the current valuation date. In practice, the stock price as at the valuation date would be used to determine market multiples).

$28

Market capitalization 280,000,000Total debt 20,000,000 Cash (considered redundant to the business) (5,000,000) Enterprise value 295,000,000 EBITDA 20,000,000 EV/EBITDA 14.75


278

Typically in practice, more than one comparable would be used to determine market multiples to assess value. At least four to fi ve appropriate multiples should be considered.

If one had stated on the examination that they didn’t apply a minority discount to the value of Cold Storage because the public company multiple of Freeze already includes a minority discount, marks would be awarded. If this comment is not included, marks would be missed because there is no evidence of realization that public company multiples have embedded minority discounts. Alternatively, one could have grossed up the publicly company multiple (i.e., 14.75x) to eliminate the inherent minority interest discount, and then deducted a larger minority interest discount (i.e., larger than 15%).

In this particular answer the author decided to provide an additional minority discount over and above what is already imbedded in the public company multiple due to additional risk. Although there is nothing in the question that indicates an additional minority discount is required, this comment would also receive full marks on an examination question.

Public company shares are more liquid than private companies. This increases their multiples. However, public company shares traded on the stock market are usually minority interests. This decreases their multiples. Sometimes, solutions to questions will state that the liquidity and minority positions of public company multiples are not considered as they essentially cancel each other out.

Method 2:

Valuation of Preferred Shares Gassman has the option to redeem the preferred shares as at September 30, This Year. As indicated in the schedule below, if this option is selected, the preferred shares have a redemption value ranging between approximately $17.6 million to $19.8 million. This is signifi cantly higher than the calculated value of the Gassman’s ownership in Cold Storage under a conversion scenario with mid-point of approximately $12.6 million. The comparison is valid to the extent that the Fair Market Value of Cold Storage as at December 31 Last Year is not signifi cantly diff erent than the fair market value of Cold Storage as at September 30, This Year. A review of the Cold Storage valuation as at December 31, Last Year should be completed as at September 30, This Year to ensure that the September 30, This Year is still appropriate for comparative purposes.

It is unlikely that Cold Storage has the cash resources to redeem Gassman’s preferred shares immediately. A review of a current Cold Storage balance sheet, and an analysis of credit facilities would have to be undertaken prior to defi nitive comments in this regard. Even if Cold Storage does not currently have the cash resources to redeem the shares, other options may be considered in order for Gassman to realize the redemption value of the preferred shares, as follows:

1. Gassman could cause Cold Storage to be sold to a third party in order to create liquidity. 2. Instead of immediate cash, Gassman could accept a note from Cold Storage. Cold Storage

could pay out the redemption of the preferred shares over a period of, say, fi ve years. Time value of money and other risk factors would have to be considered under this scenario, with Gassman compensated accordingly.

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3. Cold Storage could enter into a borrowing arrangement with a fi nancial institution to fi nance the share redemption

Preferred Shares Held at Valuation Date# of Shares Dividend Cumulative

Sep-30 four years ago (when shares were received) 0 0 15,000Sep-30 three years ago 15,000 1,500 16,500Sep-30 two years ago 16,500 1,650 18,150Sep-30 one year ago 18,150 1,815 19,965Sep-30 this year (i.e., held at valuation date) 19,965 1,997 21,962

High Low

Redemption price per share $1,000 $1,000

Redemption value $21,962,000 $21,962,000

Less liquidity discount 10% 20%

Redemption amount $19,765,800 $17,569,600

This table should not be confused with a time value of money analysis since we are trying to determine the amount of preferred shares at the valuation date, which is 21,962 shares.

Conclusion I have concluded that Gassman’s interest in Cold Storage should be valued based on the redemption value of the preferred shares (as opposed to the value if the preferred shares were converted to common shares) as this represents the highest price between the two methods above. I have applied a discount of between 10% and 20% to refl ect the costs involved in collecting the liquidation value of the preferred shares from Gassman.

2.3 (2)Given the valuation in part one whereby the preferred share redemption yielded the highest value of the two methods at a maximum of $19.8 million, the off er from Eng Real Estate Investment Trust of $23 million should be accepted, given that it is higher and the type of consideration is in the form of cash which is preferable in this case. (The stated value in the preferred share redemption, before any discounts for liquidity, was approximately only $22 million).


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Assignment 3 SolutionsSolution 3.1

3.1 (1)

Note Proceeds CostUCC of the

classBusiness

Income

Taxable Capital

gain CDA RDTOH1 Land 100,000 30,000 35,000 35,000 9,3342 Building 2,500,000 3,000,000 8,000,0003 Vehicles 30,000 70,000 50,000 (20,000)4 Manufacturing

Equipment4,00,000 5,000,000 3,200,000 800,000

5 Goodwill 400,000 100,000 24,000 201,000 150,0007,030,000 981,000 35,000

Tax rates 30% 40%Less: taxes 308,300 294,300 14,000After tax pro-ceeds

6,721,700

1. Non-depreciable property: Proceeds 100,000 Cost 30,000 Gain 70,000

Taxable Capital Gain 35,000Capital Dividend Account 35,000

2. Depreciable property :

Class 1 Proceeds 2,500,000 Cost 3,000,000

Proceeds of $2.5 million are to be credited to the UCC pool, reducing the pool to $5.5 million (i.e. $8 million less $2.5 million). Because the pool is still positive and there are still remaining assets in the class, there are no immediate tax consequences.

3. Class 10 Proceeds 30,000Cost 70,000Residual 20,000

Proceeds of $30,000 are to be credited to the UCC pool, reducing the pool to $20,000 (i.e. $50,000 less $30,000). Although the pool is still positive, there are no remaining assets in the class. The remaining $20,000 balance can therefore be deducted in the current tax year as a terminal loss.

4. Class 43 Proceeds 4,000,000Cost 5,000,000

Proceeds of $4 million will be credited to the UCC pool, creating a negative balance in the pool of $800,000 (i.e. $3.2 million less $4 million). This negative balance represents recapture and must be included in income in the year of sale.

281


5. Cumulative Eligible Property (goodwill)Transaction Value CEC Multiplier CEC Pool Value Notes

Proceeds 400,000 75% 300,000Cost 100,000 75% 75,000UCC 24,000

Recapture $ 51,000 A

Capital Gain 300,00050% rule applied 50%Taxable CG $ 150,000 B

Note: For taxes owing calculation, Taxable capital gain on goodwill is taxed at business income rates.

Total business income $ 201,000

Alternative Capital Gain CalculationProceeds 300,000Less: cost 75,000Capital gain 225,00050% rule applied 50%

112,500Grossed up (1/0.75)

75%

$ 150,000 150,000 BTotal business income $ 201,000

Proceeds 400,000Cost 100,00

Proceeds of $400,000 x 75% will result in a $300,000 credit to the CEC pool.

The CEC balance is $24,000. This will give rise to a negative balance of $276,000. The tax treatment of this balance will be calculated as follows:

NOTE A: Recapture of prior year CEC (($100,000 X 75%) – $24,000) = $51,000

NOTE B: Excess proceeds over cost treated as capital gain $300,000 x 50% = $150,000

(alternatively = $276,000 – $51,000 x 2/3)


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3.1 (2)The tax shield represented by the assets acquired is as follows:

Depreciable Property

Class 1 (2,500,000 x 35% x 4%)/(10%+4%) x ((1+(0.5x.10))/(1+.10)) = $238,636

Class 10 (30,000 x 35% x 30%)/(10%+30%) x ((1+(0.5x.10))/(1+.10)) = $7,517

Class 43 (4,000,000 x 35% x 30%)/(10% + 30%) x ((1+(0.5x.10))/(1+.10)) = $1,002,273

Cumulative Eligible Capital property (400,000 x ¾ x 35% x 7%)/(10% + 7%) = $43,235

Solution 3.1

Private & Confi dential

Jane Junno, President Jane’s E-Commerce Inc. Ottawa, Ontario

Dear Ms. Junno,

Re: Analysis of off ers for JEC

Introduction

Pursuant to your request, we have analyzed the two off ers you have received for the sale of JEC, and provided you with recommendations and general comments.

We have not valued the company since you indicated that you must accept one of the off ers.

Should we be asked to provide our view on value, additional work is required. Rather, we have analyzed the two off ers in order to recommend which of the two is preferable. In addition, we have outlined what other alternatives may be available to you as well, as other qualitative factors to be considered in making your decision. Please note that this memorandum is a preliminary calculation of value for internal fi le purposes for which a report to the client will be based. It is not a valuation report prepared in accordance with CICBV standards.

283


Analysis of Off ers

Off er #1 — Sale of Assets As indicated by our analysis in the attached schedule, off er #1 would yield net cash (after taxes) of approximately $1 million.

The proceeds of $1.8 million for off er #1 are $50,000 less than the market value of the assets being sold. Therefore, we assumed that there would be $50,000 of transaction costs

• In selling the assets under Off er #1, you could make a Section 22 election for JEC’s accounts receivable in order to avoid potential adverse tax consequences on the sale of accounts receivable. Specifi cally, as Section 22 election permits the purchaser to take a reserve or write-off the receivables purchased. The loss to the seller is treated as a business loss deductible against any type of income — if s. 22 is not used, the loss is treated as a capital loss and only 1/2 is deductible and is only deductible against taxable capital gains.

• The customer list being sold would be treated the same way as goodwill (or cumulative eligible capital for tax purposes) in that half the gain is taxed as active business income and the other half not being taxed would be added to JEC’s capital dividend account.

• A sale of assets would be better for the buyer as a result of the ability to ‘bump-up’ the value of the assets to fair market value and benefi t from the capital cost allowance in future years.

Off er #2 — Sale of Shares As indicated by our analysis in the attached schedule, off er #2 would yield net cash (after all taxes) of $1,265,450.

We have considered that JEC is a Qualifi ed Small Business Corporation based on the following:

• All the assets are used in an active business in Canada (as per balance sheet). Therefore, the business meets requirements of 90% rule.

• More than 50% of assets were used in an active business in Canada during the past 24 months (as per balance sheet). Therefore, the company meets the requirements of 50% rule.

• You have owned the shares of JEC since its inception. Therefore, the shares meet the 24-month holding period test.

• Customers from outside of Canada comprise 45% of sales (less than 50%). Therefore, active business is being carried on in Canada.

• The sale would take place prior to your departure to the US. Therefore, at the time you will still be a Canadian resident. Therefore, this meets the requirement that the shares be owned by a Canadian resident.

Therefore, your shares qualify for the capital gain exemption. We have assumed that you had not yet used the capital gain exemption.


284

A sale of shares would be simpler and easier to complete; only one transaction would be required with one party. As opposed to a sale of assets where, following the sale of assets, you would have to pay the liabilities and wind-up the corporation. Other factors to consider are:

• A sale of shares would avoid taxes on the recaptured capital cost allowance. • A sale of shares would transfer all liabilities (known and unknown) to the new owner.

Conclusion Based on our analysis, Off er #2, sale of shares, is the better off er to accept.

Other Alternatives You may want to consider moving the business with you to the U.S. for the following reasons:

• Based on the nature of your business it is a service that can be provided remotely and very easily moved to the U.S.

• 40% of JEC’s customers are in the U.S. • This will provide you with a source of income and an occupation after you move. Otherwise

you will have to look for a job or start a business from scratch.

If you consider this alternative there would be a deemed disposition of your business at Fair Market Value at the date of departure (i.e. the date you move to the U.S.). You would have to pay taxes on that gain. We recommend a valuation be done to justify the value being used for the deemed disposition.

In order to minimize the taxes under this alternative, you may consider creating a holding company into which you can transfer your shares of JEC (also known as a rollover). This would allow you to use the $800,000 capital gain exemption. This would have to be done prior to your departure to the US.

If you would like to discuss the content of our report further do not hesitate to contact the undersigned.

Respectfully yours,

CBV

285


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286

When the assets of the company are sold, there may be goodwill that has been developed by the company (as opposed to being purchased). When it is sold, 3/4 of the proceeds are deducted from the CEC account. If there has been no previous CEC balance, this will create a negative amount. This negative amount is treated in the same manner as the capital gain (50% inclusion rate). However the Income Tax Act requires it be included in business income. This is covered in Canadian Tax Principles in the chapter on Sale of an Incorporated Business in the section on goodwill, subsection Sale of Assets as a going concern.

Analysis of Off er 2:Proceeds from sale of shares $1,400,000 AACB/PUC of shares 2,000 Capital gain 1,398,000 Less: capital gain exemption 800,000 598,000 Taxable capital gain at 50% 299,000 Taxes at 45% 134,550 B Net cash retained (A - B) 1,265,450 Notes:

All assets are used in active business. Therefore, this transaction meets 90% rule. It also meets the 50% rule for 24 months prior to the sale, based on the prior year’s balance sheets. More than 50% of the active business in Canada, as foreign customers total only 45%. The sale is taking place prior to departure. Therefore, the company is Canadian owned. Therefore, this transaction meets the requirements for a QSBC qualifi ed capital gain exemption.

Solution 3.3

Note to File:

Re: Notes for discussion regarding purchase of Long Tom’s Seafood Restaurants

Issues to address with Mr. Sqwid:

• The proposed payment structure is eff ectively an earnout - Earn-outs are a simple concept, but diffi cult to defi ne (e.g. what is cash fl ow) and

implement. They also open up the potential for dispute and interpretation. Consider: compound growth, cumulative vs annual earnings etc., and accordingly earn-outs are diffi cult to enforce.

• The deal leaves a considerable amount of consideration in the hands of the purchaser to be paid at a later date which makes the risk of recovery of an issue/considerable risk still being assumed by the vendor

• The deferral results in value being provided to the vendor of an amount, less than the gross amount due to the time value of money issues, i.e. payments now are worth more than payments later (regardless of collection risk)

287


• The earnout is over fi ve years, which meets income tax bulletin requirements on this issue regarding capital vs. Income. There might be some concern over tax classifi cation (i.e. income or capital), however, in this case, an earn-out is essential to establish goodwill.

• He did not win. He now only receives the tangible asset backing whereas the remaining goodwill portion is contingent on the future operations of the company (continued assumption of risk). The risk is the same as if he continued to operate the business himself, despite no longer having any control over its performance.

• Capital gain reserve can be claimed. Reserve is only allowed for fi ve years. The amount of the capital gain which must be included in income in each year is the greater of: (a) 20% of the capital gain; and (b) (capital gain X amount payable after the end of the year)/total proceeds of disposition.

• Capital gain exemption allowed for QSBC shares. Note: Earn outs and the taxation of earn outs are no longer covered in this course. There are a number of diff erent earn outs

and they can be taxed diff erently depending on the type. CRA has two Interpretation Bulletins that cover the taxation of earn outs. They can be found at the following links.

http://www.cra-arc.gc.ca/E/pub/tp/it426r/README.html

http://www.cra-arc.gc.ca/E/pub/tp/it462/README.html

Solution 3.4The following factors must be considered when considering diff erences in stock trading prices between the two diff erent classes of shares of Astral Media Inc:

Major Considerations: • Studies of diff erences between voting and non-voting shares of public companies have

not provided consistent results. Some studies have found to have minimal diff erences in valuation.

• The value impact of voting rights with respect to Class B over that of Class A is minimized because

- Public stock market investors cannot infl uence decisions of a company regardless of whether or not they have voting rights (given that they have a small minority shareholding in a company). The company is already under control (i.e. greater than 50% when the Class B and special shares voting rights are considered together) by the major shareholder Aberdeen Holdings Inc. once all share classes and conversion features are considered.

- Class B is illiquid and Class A is liquid

Class A shares are generally liquid (2% outstanding traded per day) thereby increases value.

Class B shares are generally illiquid (0.3% outstanding traded per day) thereby detracts from value.


288

Minor Considerations: • Class B shares have better dividend rate (assuming dividends on Class A are already

paid) which increases their value.• Class A shares have priority over Class B with respect to dividends which increases their

value.• Notes that fl oor value of Class B is value of Class A given 1 to1 redemption provision.

Solution 3.5The reasons why XYZ Ltd. paid a 100% takeover premium for ABC Ltd. — versus that of stock studies that indicate that a 20% to 30% takeover premium — are as follows:

1. The 20% to 30% premium average is just that, an average. The range of premiums should be considered as opposed to the average. The range of premiums may in fact be greater than 100% at the top end.

2. The 20% to 30% average premium generally represents only the minority share value that is absent when takeover occurs as control is sought by the acquiror and as such control pricing occurs.

3. Given that the company is likely rumoured to be a takeover target, the takeover off er likely includes a special purchaser premium that is probably not the case in the 20% to 30% average premium. XYZ Ltd. is likely trying to fend off other special purchaser bids with its off er.

4. ABC Ltd. is infl uenced by stock market prices and, as such, is generally not representative of the intrinsic value of stock under review and stock market prices generally under value a stock, which may aff ect ABC Ltd. to a greater degree than the average company on the stock market.

5. ABC Ltd. is infl uenced by stock market prices and as such the occurrence of a) poor frequency of trading; b) poor dealer interest; and 3) poor public awareness may aff ect ABC Ltd. to a greater degree than the average company on the stock market.

6. ABC Ltd.’s stock suff ers from poor liquidity and likely has poorer liquidity than the average company on the stock market. The stock price is depressed due to low trading activity since ABC Ltd. has low monthly volumes in relation to its total outstanding shares. Over the last six months, ABC Ltd’s average trading volume is 500,000 shares a month which when compared to the 20,000,000 total outstanding shares only 2.5% is traded per month on average. For XYZ Ltd. to buy 100% of ABC Ltd. based on normal trading volumes it would take 40 months to make the purchase. In order to XYZ Ltd. to purchase ABC Ltd. it would eff ectively have to buy liquidity to make the purchase of ABC Ltd.

7. Further to the above, the low liquidity indicates that there is perhaps a large portion of shares held by a signifi cant shareholder or group of shareholders. This would indicate that the public fl oat is very low and therefore would trade at a higher than average minority discount

289


From the above items, #6 is the most important and discussion of this factor would garner a signifi cant number of marks. The #6 point relates to the topic of blockage premium, albeit from the purchase of the shares as opposed to the sale. The table in the question showing the stock trading information deserves considerable attention.

Solution 3.6A full Estimate Valuation Report was not requested in this particular report, only an introduction of

an Estimate Valuation Report was requested (so only 10.1 of standard 110) and as such the response below does not include an Estimate Valuation Report in its entirety.

PetChoice Foods Off er

Private and Confi dential

Today’s Date

Mr. Levon Rudan Rover Pet Foods Address

Attention: Mr. Levon Rudan

Dear Mr. Levon Rudan

Re: Assessment of PetChoice Foods Off er For Rover Pet Foods

You have requested our Estimate Valuation Report of the fair market value of the PetChoice Foods consideration (i.e., common shares publicly traded on the Toronto Stock Exchange) for Rover Pet Foods as at October 1 of This Year (“the Valuation Date”).

Fair market value is defi ned as being the highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

We understand you have requested our Estimate Valuation Report (“the Report”) to assist you in evaluating a purchase off er made by PetChoice Foods for your interest in the Rover Pet Foods.

An Estimate Valuation Report is a report that concludes on the value of shares, assets or an interest in a business that is based on a limited review and analysis of the relevant information and is communicated in a less detailed valuation report that provides a lower level of assurance than a Comprehensive Valuation Report.

The Report was prepared by the fi rm’s valuators on an independent and objective basis. The compensation of the fi rm or the persons responsible for preparing the report is not contingent on an action or event resulting from the use of the Estimate Valuation Report. Further, the Report has


290

been prepared in conformity with the Practice Standards of the Canadian Institute of Chartered Business Valuators (“CICBV”).

The off er from PetChoice Foods would not be an acquisition but a merger since you would be taking PetChoice Foods shares back. Therefore, you need to consider whether or not you are comfortable with the investment aspects of PetChoice Foods such as management, business and the expected returns from this investment since you would be a shareholder.

We believe that the PetChoice Foods off er likely does not meet your objectives since it is a share deal (not cash) and it would appear that given your stated objective is to sail around the world, you likely need cash to do so.

In addition, the PetChoice Foods shares are illiquid as:

1. The shares are escrowed for three years as per the off er. 2. The share price has been erratic on a historical basis with the high price in a particular

year essentially double from the low price in that same year. 3. The shares have very low trading volumes (total share volume Last Year was 335,000 for

the entire year).

Therefore, given the circumstances, the shares cannot be converted to cash quickly.

You should consider renegotiating the deal to include some signifi cant cash component given your stated objective of retiring to sail around the world, as well as to minimize the market volatility on your proceeds given the low level of liquidity in this off er. You need to consider your own cash needs in future periods to determine the extent of cash required in this particular off er. Another alternative may be to explore whether a bank would be willing to lend you money against the escrowed shares; however, this may be unlikely given the current lending environment.

Furthermore, if you accept the share consideration, the share price may be adversely impacted when the other former owners’ shares come out of escrow. As noted by the information provided, there are approximately 2.5 million of these escrowed shares that will come out of escrow and be freely tradable beginning January 1 of Next Year which when compared to the 10 million shares outstanding would represent a signifi cant increase to the outstanding share base of 25%.

The evaluation of the PetChoice Foods off er requires a valuation of the intrinsic value of PetChoice Foods’ shares since the consideration is in shares. That is, a valuation may highlight the future risk of a drop in share price (i.e., off ered share price may be temporarily overvaluing PetChoice Foods and thus giving less consideration than would be expected).

In addition, the public share price is not likely indicative of the underlying value since shares are illiquid, the company is small cap, and the share price trading range is wide. The value of the PetChoice Foods off er is $9 million given the $15 share price and the 600,000 shares being off ered as consideration, which coincidentally matches the $9 million valuation previously conducted for Rover Pet Foods. We have assumed for the purposes of this report that the valuation of Rover Pet Foods has remained unchanged since the last time we determined its value.

291


Valuation of PetChoice Foods Shares A going concern method was used to value the intrinsic value of PetChoice Foods’ shares versus that of a liquidation method given the company’s past profi table history and expectation that the business will be profi table in the future. There are several going concern methods of valuation available for PetChoice Foods such as:

a. EBITDA multiple. b. Net income multiple. c. Revenue multiple. d. Maintainable cash fl ow multiple (EBITDA less maintenance capex). e. Discounted cash fl ow. f. Value per machine (rule of thumb).

We have selected an EBITDA multiple approach as this fi gure better refl ects operating cash fl ow, absent specifi c fi nancing considerations. In this regard, EBITDA is likely a better indicator of a price that may be obtainable in the open market. As a note, there is not enough information to determine whether or not capital expenditures are equivalent to depreciation expense to justify using other approaches. As such, an EBITDA multiple approach appears to the most justifi ed in this situation.

We used a multiple of EBITDA using a maintainable EBITDA range of $6 million to $7.5 million and an EBITDA multiple range of 10x to 12x to account for PetChoice’s larger size and presence in the market place (albeit the appropriate multiple was provided in the question). In this particular case it was assumed that the multiples chosen for EBITDA did not refl ect growth considerations and, as such, growth considerations could be refl ected in the maintainable earnings level. The maintainable EBITDA level was selected based on the growing trend in EBITDA over the last couple of years with more weighting to the latter years given these years are considered more representative of future results.The $6 million in EBITDA was based on:

• The 2nd Last Year of results.• The $7.5 million of EBITDA on continued projected growth in EBITDA from the Last Year

of $6.5 million. • The fact that the purchase of Rover Pet Foods will add to the EBITDA level of PetChoice

-albeit the EBITDA level for Rover has not been provided).

The results of our valuation are shown in the table below.

LOW (000’s) HIGH (000’s)Maintainable EBITDA $6,000 $7,500Multiple 12 10Capitalized value 72,000 75,000Debt (10,000) (10,000)Equity value 62,000 65,000Shares outstanding 10,600 10,600Value per share $5.85 $6.13


292

As shown in the schedule above, we have estimated the intrinsic share value of PetChoice Foods consideration (before any discounts relating to illiquidity or blockage) to be in the range of $5.85 to $6.13 per share, with a mid-point of $6 per share without adjustment for minority discount (as would be the case for publicly traded shares which already have a minority discount embedded in the stock price). As compared to the $15.00 per share as per the latest trading price — which does consider minority discounts — the PetChoice Foods value appears very high based on our calculated value per share. Therefore, even without adjusting for minority discounts, the value of the consideration based on the calculated value would be approximately $3.6 million given the 600,000 in shares you will receive, instead of the $9 million value we previously determined for the Rover Pet Food business. The shares outstanding for PetChoice were determined by the 10 million existing shares plus the 600,000 shares to be issued as a result of the purchase of your holdings.

Alternatively, we have estimated that the value of the PetChoice Foods share consideration using the last closing share price reduced by a restriction discount (for the escrow period) and marketability (blockage) discount as per the table below. The blockage and restriction discounts are based on our experience and knowledge of the market place, the extent of shares off ered and the variability in the company’s stock price.

LOW (000’s) HIGH (000’s)Closing share price $15.00 $15.00Restriction (illiquidity) 40% 30%Subtotal 9.00 10.50Blockage discount 20% 10%FMV $7.20 $9.45

As a note, the illiquidity discount is fairly high in this case due to the negative analyst forecasts.Again, the resulting value is likely well below the value of Rover Pet Foods. You should as well consider renegotiating to improve the value of the off er or perhaps actively market the business to achieve a higher price.

Other Issues We also point out that 1) the off er from PetChoice Foods is for assets (versus shares) which is less advantageous to you from a tax point of view as the assets may have a signifi cant latent tax liability; 2) the off er from PetChoice food does not allow you the ability to shelter income through the $500,000 QSBC Capital Gains Exemption; 3) PetChoice Foods may be a motivated buyer since it may not have signifi cant operations in Ontario; and 4) PetChoice Foods may not be willing to pay as much as other purchasers since it has no synergies with Rover Pet Foods.

Sincerely,

Ace Valtura

Valuations R USNote: Generally, an illiquidity discount refl ects the fact that you usually cannot sell private company shares immediately

because there is no organized market for such an asset. In this question, there is an illiquidity discount due to the escrow period. Once the shares can be freely traded, there is a blockage discount since one cannot sell the block of shares on the open market that quickly.

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Solution 3.7

Note to File:

Re: Valuation of ownership interests of ABC Recording Company

In order to calculate the value for each ownership interest as at the valuation date, we need to consider the value of Paula’s position before, and after, the convertible preferred shares are converted to determine whether or not she would convert (as it impacts the value of each individuals shareholding). As such, we have provided the analysis below in tabular format as well as a discussion that can be reviewed with the client.

Maintainable EBITDA $162,500,000Cap rate 12.5% (therefore multiplier of 8) 8Enterprise value 1,300,000,000 Less: debt (short term of $90M and long term of $110M) (200,000,000)Equity value ($1,100,000,000)

Converted versus Redemption If Converted If RedeemedEquity value $1,100,000,000 $1,100,000,000Less: preferred shares redemption amount 0 (45,000,000)Equity distributable to class A and class B common shares 1,100,000,000 1,055,000,000Less: value to class A (50M shares redeemable at $2/share)

(100,000,000) (100,000,000)

Therefore, total value of class B common shares 1,000,000,000 955,000,000Divided by shares outstanding (currently 100M shares + 3m if converted)

103,000,000 100,000,000

Per share pro rate value of class B common shares (diluted either way)

$ 9.71 $ 9.55

Redeem-able at $2 per share

Class AClass A # of shares Class B

Class B # of shares

Redeem-able at

$15 per share

Class CClass C # of shares

Paula (act as a group with Randy) — jointly own 32% of class B

30% 30,000,000 100% 3,000,000

Simon 68% 68,000,000 Ryan 100% 50,000,000 Randy (act as a group with Paula) — jointly own 32% of class B

2% 2,000,000

50,000,000 100,000,000 3,000,000

If converted (class B equity = $1,000,000,000) If redeemed (class B equity = $955,000,00)

Simon Paula Randy Simon Paula Randy

Ownership interest 66.0% 32.0% 2.0% 68% 30% 2%

Prorata portion of equity 660,194,175 320,388,350 20,000,000 649,400,000 286,500,000 19,100,000

Minority discount zero 20% 30% zero 30% 40%

Value of class B 660,194,175 256,310,680 14,000,000 649,400,000 200,550,000 11,460,000

Increase if converted 10,794,175 55,760,680 2,540,000

Loss of redemption proceeds (45,000,000)

Net benefi t to Paula for converting 10,760,680


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Note: In calculating equity value from enterprise value, only short term and long term debt is deducted. If any other items were included in the calculation of equity value from enterprise value no partial marks are typically awarded since this concept was considered a core concept of enterprise value. As well, students tend to provide a TAB analysis. The question should be read carefully as a full balance sheet was not provided. Finally, many students discuss the liquidity of the company in relation to the redemption of the preferred shares. Students should consider the question at hand as well as the data provided. In this case, given the fact that equity value of the company is $1.1 billion, and the preferred shares have a value of $45 million, the company could easily obtain the liquidity to redeem the preferred shares. There is not enough information on the balance sheet of the company to determine the liquidity of the company.

Minority Discounts In consideration of the various minority discounts, the following was considered for each individual:

Simon Seacrest • Lack of minority discount is reasonable as Simon owns over 50% of the company (whether

or not the preferred shares are converted to common).

Paula Cowell • 25% to 35% discount is considered reasonable if the preferred shares are not converted

given the following: - Can block a 100% takeover bid as owns more than 10% of the shares (owns 30% of

Class B)

- Has dissent rights

- Cannot block special resolutions as owns less than 33.3% assuming CCPC (owns 30% of Class B)

- Paula with her 30.0% ownership when combined with Randy’s 2.0% would have 32% which is not enough to block special resolutions as a group since 33.3% is required assuming CCPC

• 15% to 25% discount (i.e., lower) if the preferred shares are converted given - Paula with her 32.04% ownership when combined with Randy’s 1.94% would have

33.98% which is enough to block special resolutions as a group since they would have more than 33.3% assuming CCPC

Randy Abdul • 35% to 45% discount is considered reasonable if the preferred shares are not converted

given the following: - Cannot block a 100% takeover bid as owns less than 10% of the shares (owns 2% of

Class B)

- Has dissent rights

- Has nuisance value

- Cannot block special resolutions as owns less than 33.3% assuming CCPC (owns 30% of Class B)

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- Randy with his 2% ownership when combined with Paula’s 30.0% would have 32% which is not enough to block special resolutions as a group since 33.3% is required assuming CCPC

• 25% to 35% discount (i.e., lower ) if the preferred shares are converted given - Randy with his 1.94% ownership when combined with Paula’s 32.04% would have

33.98% which is enough to block special resolutions as a group since they would have more than 33.3% assuming CCPC

Conversion of Paula’s Convertible Preferred Shares

CONVERSION OF PAULA’S CONVERTIBLE PREFERRED SHARES As noted above, Paula’s minority discount on her Class B shares would be considerably smaller if she would convert her preferred shares into Class B common shares than if she would not convert, given she could act with Randy as a group to stop a special resolution by Simon.

As such, as per the above table, Paula would expect to receive greater proceeds of $256.3 million for all of her shares if she would convert the convertible preferred shares into Class B than if she would not convert her convertible preferred shares (in which case she would receive only $245.6 million). As such, the preferred shares would be converted, and the values of each individual’s shareholding are shown on the left portion of the chart above.

296

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IndexLevel II - Intermediate Business Valuation

Exhibit, Example and MQE IndexModule 1 ............................................................................................................... 1

Exhibit 1.1: Calculating an Existing Tax Shield ....................................................................6Exhibit 1.2: Calculating a Tax Shield on Additions — CCA Half-year Rule Applies ..........6Example 1.1 Redundant Asset Calculation ............................................................................7

Example 1.2 Tax Calculation on a Liquidation of a Corporation .........................................9

Example 1.2A ..........................................................................................................................9

Example 1.2B ........................................................................................................................10

Exhibit 1.3: %’s on Eligible and Non-Eligible Dividends ....................................................20Example 1.3: Positive Undepreciated Capital Cost (UCC) Balance .................................27

Example 1.3A ........................................................................................................................27

Example 1.3B ........................................................................................................................27

Example 1.4: Negative Undepreciated Capital Cost (UCC) Balance .................................28

Example 1.4A ........................................................................................................................28

Example 1.4B ........................................................................................................................28

Example 1.4C ........................................................................................................................28

Exhibit 1.4 Rules governing the application of unutilized losses .....................................30Example 1.5: Impact of Transfer Pricing on a Valuation (Distribution Rights using

Maintainable Earnings) .......................................................................................................38

Example 1.5A ........................................................................................................................38

Example 1.5B .......................................................................................................................38

Example 1.6: Multiple Transactions......................................................................................39

Example 1.7: Impact of Transfer Pricing on a Valuation ....................................................40

MQE Question 1.1 ...................................................................................................................43

MQE Question Table 1.1A .....................................................................................................43

MQE Question Table 1.1B .....................................................................................................44

MQE Question Table 1.1C .....................................................................................................44

MQE Question Table 1.1D .....................................................................................................45

MQE Question Table 1.1E .....................................................................................................45


298

MQE Question Table 1.1F .....................................................................................................45

Module 2 ............................................................................................................. 49Exhibit 2.1: Analysis of Trading Volumes across three companies ..................................58Exhibit 2.2: Enterprise Value ...............................................................................................60Exhibit 2.3: Analysis of Multiples .........................................................................................64Exhibit 2.4: Diff erences in Purchase of Shares between Private / Public .......................64Exhibit 2.5: Public Company Multiples ................................................................................68

Exhibit 2.5A ...........................................................................................................................69

Exhibit 2.5B ...........................................................................................................................70

Exhibit 2.5C ...........................................................................................................................70

MQE Question 2.1 ..................................................................................................................71

MQE Question Table 2.1 .......................................................................................................73

MQE Answer 2.2: “Adam Forestry Corporation” ................................................................76

MQE Answer 2.3: “Market Based Method using Transaction Multiples” .........................84

MQE Answer 2.4: “Merger/Acquisition” .............................................................................85

Exhibit 2.6: Optimal Level for Ratios ...................................................................................88Exhibit 2.7: Is the business a going concern? ....................................................................91Exhibit 2.8: Steps for Calculating Liquidation Value ..........................................................93Example 2.2: Liquidation Approach — MBC Investment Holding Company ...................94

Example 2.2A .......................................................................................................................94

Example 2.2B........................................................................................................................95

Example 2.3 Liquidation Value — Plastic Moulders Ltd.....................................................99

Example 2.3A ........................................................................................................................99

Exhibit 2.10 — The Adjusted Net Book Value Method ......................................................102Exhibit 2.11 — Calculating Tax Shield — Full CCA Available in Year: ............................103Exhibit 2.12 — Calculating Tax Shield — CCA Half-year Rule Applies: ..........................104Example 2.4: Tax Shield Calculations ................................................................................104

Example 2.5: Adjusted Book Value Approach — ABV Company ....................................105

Example 2.5A ......................................................................................................................105

Example 2.5B......................................................................................................................106

Example 2.6: Adjusted Book Value Approach — ML Lodging Inc. .................................106

Example 2.6A ......................................................................................................................107

Example 2.6B ......................................................................................................................107

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Example 2.7: Tangible Asset Backing ................................................................................109

Example 2.7A ......................................................................................................................109

Example 2.7B ...................................................................................................................... 110

Module 3 ............................................................................................................115Example 3.1: Wireless Inc. .................................................................................................. 119

Example 3.2: Corporation with Two Non-Depreciable Capital Properties .....................123

Exhibit 3.1: Acquisition of Control - Illustration of Impact on Certain Assets...............124MQE Question 3.1 ................................................................................................................126

MQE Question 3.2 ................................................................................................................127

MQE Question Table 3.2A ..................................................................................................129

MQE Question Table 3.2B ..................................................................................................129

MQE Question Table 3.2C ..................................................................................................129

Example 3.3: Sale of Assets versus Shares .....................................................................138

Example 3.3A ......................................................................................................................138

Example 3.3B......................................................................................................................139

Example 3.3C .....................................................................................................................139

Example 3.3D .....................................................................................................................139

Example 3.3E .....................................................................................................................140

Example 3.3F ......................................................................................................................140

Example 3.3G .....................................................................................................................140

MQE Question 3.3 ................................................................................................................142




MQE Question Table 3.3D ..................................................................................................144

MQE Question Table 3.3E ..................................................................................................145

MQE Question Table 3.3F ..................................................................................................145

Example 3.4: Applicability of Discounts on Specifi c Share Classes ..............................172

Exhibit 3.3: The yield approach ..........................................................................................173Example 3.5: Yield Approach .............................................................................................173

Example 3.6: Considerations in Assessing Appropriate Discounts ...............................178

Exhibit 3.4: High-Level Considerations in assessing an appropriate discount range for minority shareholdings ....................................................................................................179Exhibit 3.4A .........................................................................................................................179


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Exhibit 3.4B .........................................................................................................................179

Exhibit 3.4C .........................................................................................................................179

Exhibit 3.4D .........................................................................................................................180

Exhibit 3.4E .........................................................................................................................180

Exhibit 3.4F .........................................................................................................................180

Exhibit 3.4G ........................................................................................................................180

Example 3.7 — Blockage Discount Considerations ........................................................189

Exhibit 3.5: Calculating % Discount — Restriction Period ..............................................193MQE Question 3.4 ................................................................................................................197




MQE Question 3.5 ................................................................................................................205

Exhibit 3.7 : Levels of Value ................................................................................................208Exhibit 3.9: Levels of value associated with Valuation Approaches ..............................209Example 3.8: Death of a Shareholder .................................................................................214

MQE Question 3.6: “Tottles R US” .....................................................................................224


Assignment Questions .................................................................................. 231Exhibit A1.1: Fly By Night Inc., Financial Information ......................................................235Exhibit A2.1: Financial Statement Information .................................................................238Exhibit A2.2: Nitrogen Corporation Inc.’s stock trading information .............................240Exhibit A2.3: Industry Transactions ..................................................................................240Exhibit A2.4: Comparable market trading information ending August 31st, This Year 241Exhibit A2.5: Cold Storage ($CAD) .....................................................................................242Exhibit A2.6: Freeze It Information available as of August 31 ........................................242Exhibit A3.1: Options Available to Jane .............................................................................245Exhibit A3.2: JEC Comparative Statement of Earnings ..................................................246Exhibit A3.3: JEC Summary of Balance Sheets ................................................................247Exhibit A3.4: Additional Information ..................................................................................247Exhibit A3.5: Astra Media Common Shares - Class A and B ...........................................249Exhibit A3.6: Stock Trading Information............................................................................250Exhibit A3.7: PetChoice’s Share Price and Volume History ($CAD) ...............................252

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Exhibit A3.8: PetChoice’s Recent Historic Results ($CAD) .............................................252Exhibit A3.9: ABC Recording Company’s class percentage ownership ........................253

Assignment Solutions ..................................................................................... 255

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