CHAPTER 3: LIQUIDATION BASED VALUATION

LIQUIDATION BASED VALUATION 

For most companies, the value generated by assets working together and by human capital applied to
managing those assets makes estimated going - concern value greater than liquidation value. However,
if there will be circumstances that occur which doubts the going-concern ability of a business, using
going-concern value may not be appropriate anymore as the future cash flows will not be realizable
anymore. An alternative approach is the use of liquidation value. 

Liquidation value 

According to the CFA Institute, liquidation value refers to the value of a company if it were dissolved and
its assets are sold individually. Liquidation value represents the net amount that can be gathered if the
business is shut down and its assets are sold piecemeal. In some texts, liquidation value is also known as
net asset value. 

For example, for the case of hotel closes, the assets it owns like beds, chairs, furniture and kitchen
equipment can be sold as part of a package or separately. These assets are priced based on the value it
can fetch if buyers buy these assets separately. If these assets will be sold separately, there is no
guarantee that they can generate future cash flows anymore as it once did when it was used in the
hotel. Hence, their value is significantly reduced to its liquidation value. 

Once a business closes, synergies generated by assets working together or by applying managerial skill
to these assets are lost which reduces firm value. In addition, liquidation value may continue to erode
based on the time frame available for liquidating assets. For example, perishable inventories should be
sold immediately or else it cannot be sold anymore if it gets spoiled. Businesses cannot afford to wait for
potential buyers that are willing to pay higher price. The most appropriate choice is to sell it at a
discount to recover some money from it instead of throwing itt away without recovering any money.
Businesses can wait longer period to sell other assets like building or machineries unless they are other
constraints that will require them to be disposed in a shorter time. 

Circumstances clearly dictates whether it will be appropriate to use liquidation value or going concern
value in a valuation exercise. If a business is profitable or has sustainable growth prospects, these will
normally show future cash flows which will result in firm value that is higher than if the assets are just
separately like in a liquidation. 

However, if liquidation value becomes higher compared against going concern value, this may signal
that a significant business event transpired which makes the liquidation value more appropriate in
valuation exercise. 

Liquidation value is the base price or the floor price for any firm valuation exercise Liquidation value
should not be used to value profitable or growing companies as this approach does not consider growth
prospects of the business Liquidation prices can be difficult to obtain as these are not readily available.
Instead, liquidation value should be used for dying of login companies where liquidation is imminent to
check whether profits can still be realized upon sale of the assets owned. 

A unique callout for liquidation value is if the firm is operating under a proprietorship or a partnership
model. In these two forms of organization profits and cash flows are highly dependent on the skills,
knowledge, ability or network of the owner or partners. As a result, liquidation value should consider
valuing separately the goodwill attributed to these partner-specific qualities as this may not reflect the
true value of the assets which will be sold or transferred. In this scenario where liquidation is the
motive, goodwill will reduce liquidation value. 

Situations to Consider Liquidation Value 

The below list shows circumstances wherein liquidation value will be more appropriate in valuation
exercises: 

 Business Failures 

Business failure is the most common reason why businesses close or liquidate. Early symptoms
of business failure are low or negative returns. Companies which consistently report operating
losses will eventually impact and reduce firm value. If the firm only earns return at a rate lower
than its cost of capital, this might signal business failure. When left unresolved, this may lead to
insolvency or even bankruptcy. 

Insolvency happens when a company cannot pay liabilities as they come due. Insolvent firms
have asset balance which is still greater than liabilities but is having liquidity problems as a result
of depleted cash. Bankruptcy is the most serious type of business failure as this happens when
liabilities become greater than asset balance. As a result, shareholders’ equity becomes negative
balance. This signifies that the firm cannot settle all its liabilities unless the assets can be sold at
a higher price than its book value (which is not often the case). 

Business failures can be driven by different internal factors such as mismanagement, poor
financial evaluation and decisions, failure to execute strategic plans, inadequate cash flow
planning or failure to manage working capital. These external factors that would attribute to
business failure may take the form of, but not limited to the following: 
o severe economic down-turn 
o dynamic consumer preferences 
o material adverse governmental action or regulation
o occurrence of natural disasters or calamities 
o occurrence of pandemic or general health hazards 
Liquidation value can be used for businesses which are closing, are closed, are in bankruptcy, are
in industries that are in irreversible trouble, or going concern firms that isn’t putting its assets to
good use and may be better off closing down and selling the assets. For distressed companies,
the liquidation value conveys relevant information as it is typically the lower bound of the
valuation range. 

 Corporate or Project End of Life 

Most corporations only have finite number of years to operate as stated in their Articles of
Incorporation. This is also similar in the case of projects like joint ventures with finite life. Once
the date arrives and life is not extended, due process takes place to end the life of the
 corporation and start the liquidation process. Non-extension of corporate life may stem from
collective decision of shareholders to stop the operation and realize value from liquidating the
company instead. If corporate end of life is already certain, it is more appropriate to compute
terminal value using liquidation value. 

 Depletion of scarce resources 

In some industries like mining and oil, availability of scarce resources significantly influences firm
value. Oftentimes, these are also industries that are highly regulated by the government.
Government regulation often requires that companies seek approval from the government prior
to commencement of operations. Once the contract with the government expires or scarce
resource become fully depleted and no new site is prepared to support operation, this might
signal potential liquidation and valuation should be based on liquidation value. 

General Principles on Liquidation Value 

Liquidation value is the most conservative valuation approach among all as it considers the realizable
value of the asset if It is sold now based on current conditions. This captures any markdowns (or
markups) that potential buyers negotiate to buy the assets. 

General concepts considered in Iiquidation value are as follows: 

 If the liquidation value is above income approach valuation (based on going-concern principle)
and liquidation comes into consideration liquidation value should be used. 
 If the nature of the business implies limited lifetime (e.g. a quarry, gravel, fixed-term company
etc.), the terminal value must be based on liquidation. All costs necessary to close the
operations (e.g. plant closure costs, disposal costs, rehabilitation casts) should also be factored
in ang deducted to arrive at the liquidation value. 
 Non-operating assets should be valued by liquidation method as the market value is reduced by
costs of sale and taxes. Since they are not Part of the firm’s operating activities, it might be
inappropriate to use the same going concern valuation technique used for business operations,
if such result is higher than net present value of cash-flows from Operating the asset, the
liquidation value should be used. 
 Liquidation valuation must be used if the business continuity is dependent on current
management that will not stay. 

Liquidation value method can also be used as benchmark in making investment decisions, when a
company is profitable with good industry outlook, the liquidation will typically be lower than the
prevailing market price of the share. Share price often reflects growth prospects of the company which
is a consideration that liquidation value does not have. 

For firms that are experiencing decline or industry is consistently declining, prevailing share prices might
be lower than liquidation value. If this happens, the rational decision for the business is to permanently
close the business and liquidate its assets. Some corporate investors tend to look for companies whose
shares exhibit this characteristic. Because liquidation value is higher than market price of share, these
corporate investors buy the shares at prevailing market price and sell the company at the higher
liquidation value. This results in risk-free arbitrage profit for these corporate investors. 
However, if the company can be readily liquidated any time, market price per share should never be
below book value per share if all reported assets in the balance sheet is accurate. 

Types of Liquidation 

Determining the type of liquidation that will occur is important because it will affect the costs connected
with liquidation of the property, including commissions for those facilitating the liquidation (lawyers,
accountants, auditors) and taxes at the end of the transaction. These necessary expenses affect the final
value of the business. 

Assets are sold strategically over an orderly period to attract and generate the most money for the
assets is known to be an orderly liquidation. This liquidation process will expose assets for sale on the
open market, with a reasonable time allowed to find a purchaser, both buyer and seller having
knowledge of the uses and purposes to which the asset is adapted and for which it is capable of being
used, the seller being compelled to sell and the buyer being willing, but not compelled, to buy. 

Liquidation process, at which the asset or assets are sold as quickly as possible, such as at an auction.
This is known as forced liquidation. Liquidation is done immediately especially if creditors have sued or a
bankruptcy is filed. Assets are sold in the market at the soonest time possible which result in lower
prices because of the rush sale. This ultimately drives down liquidation value. 

Calculating Liquidation Value 

The liquidation value considers the present value of the sums that can be obtained through the disposal
(i.e. sale) of the assets of the firm in the most appropriate way, net of the sums set aside for the closure
costs, repayment of the debts and settlement of all liabilities, and net of the tax charges related to the
transaction and the costs of the process of liquidation itself. 

Liquidation value can be further computed on a per share basis by dividing total liquidation value by
outstanding ordinary shares. Liquidation value per share should be considered together with other
quantitative (e.g. current share price, going concern DCF) and qualitative metrics to justify business
decisions to be made. 

Present Value of Sale of Asset Php xxx, xxx

Less: Present Value of Cost for termination and settlement for Liabilities (xxx, xxx) 

Less: Present Value of Tax Charges for the Transactions and Other Liquidation Costs (xxx, xxx)

Liquidation Value Php Xxx, xxx

Calculation for liquidation value at closure date is somewhat like the book Value calculation, except the
value assumes a forced or orderly liquidation Assets instead of book value. Book value should not be
used as liquidation Value. Liquidation value can be obtained based on the potential sales price of the
assets being sold instead of relying on the costs recorded in the books. Liquidation value is far more
realistic as compared to the book Value method. Even if these assets generate lower than expected
return in the present business, liquidation value should be based on the potential earning, Capacity of
the individual asset when sold to the buying party instead of the original capital invested in the assets. 
In practice, the liabilities of the business are deducted from the liquidation Value of the assets at closure
to determine the liquidation value of the business. The overall value of a business that uses this method
should be lower than going-concern value. 

In computing for the present value of a business or property on a liquidation basis, the estimated net
proceeds should be discounted at a rate that reflects the risk involved back to the date of the original
valuation, this is important to ensure that all assumptions are aligned. Liquidation value can be used as
basis for terminal cash flow (instead of going concern terminal cash flow) in a DCF calculation in order to
compute firm value in case there are years that the firm will still be operational prior to liquidation. 

Special consideration should be emphasized for intangible assets like patents and internally developed
software programs which are often unsaleable. When takeover occurs, it is usual that goodwill is
recognized as part of the transaction. Monetary equivalent specific for intangible assets cannot be
reliably and separately measured. Instead, intangible assets are offset against shareholder's equity to
come up with a conservative liquidation value. 

Estimation of liquidation values will be more complex if assets cannot be easily identified or separated;
hence, individual valuation may be impractical. 

Illustrative Example 1 

Pavement Company reported below balances based on its accounting books records. Pavement
Company has 250,000 outstanding shares.

Pavement Company

December 31, 2019

(in ‘000 Philippine Pesos)

Assets

Cash  100,000

Accounts Receivable (A/R) - Net  800,000

Inventories   3,500,000

Prepaid Expenses 100,000

Property, Plant and Equipment (PPE) — Net  4,500,000

Total Assets  9,000,000

Notes Payable Other Liabilities Total Liabilities 

Liabilities

Notes Payable 1,200,000

Other Liabilities 800,000

Total liabilities 2,000,000

Pavement Company is undergoing financial problems and management would like to assess liquidation
value as part of their strategy formulation. If assets will be sold/realized, they will only realize amount
based on below table. 

To computed for the adjusted value of the assets, the current book values should be multiplied by the
assumed realizable value if they are liquidated. Next, the liabilities should be deducted from the asset
adjusted value to arrive at the liquidation value (or net asset value)

Asset Valued At Asset in Php Book Valued Asset Adjusted

Value At Value
Cash 100% Cash 100,000 100% 100,000
A/R – net 85% A/R – net 800,000 85% 680,000
Inventorie 60% Inventories 3,500,000 60% 2,100,000
s
Prepaid 25% Prepaid 100,000 25% 25,000
Expenses Expenses
PPE – net 60% PPE – net 4,500,000 60% 2,700,000
Total Assets 9,000,000 5,605,000

Asset Adjusted Value Php 5,605,000

Less: Total liabilities to be settled 2,000,000

Liquidation Value — Pavement Company Php 3,605,000

Number of Outstanding Shares 250,000

Liquidation Value per Share Php 14.42 

Illustrative Example 2 

Golda Company, which is a company specifically created for a joint venture agreement to extract gold,
will end its corporate life in 3 years. Net Cash Flow expected during the years it still operate is at
Php3,000,000 per year. At the end of its life, Golda estimates to incur Php10,000,000 for closure ang
rehabilitation costs for its mining site and other costs related to the liquidation process. Cost of capital is
set at 10%. Remaining assets by end of the corporate life will be bought by another company for Php
30,000,000 ang remaining debt of Php 4,000,000 will be fully paid off by then. If the Valuation happens
now, compute for the value of Golda Company. 

Since Golda Company will terminate its life after 3 years, it is more appropriate to use liquidation value
as terminal value input to the DCF modal. For the three years prior to the closure, Golda Company will
continue to generate positive Net Cash Flow and this will form part of its value. 

Present Value (PV) of Cash Inflows during Years in Operation 

PV of Annual Net Cash Flow = Net Cash Flow x PV Factor of 10% 

PV of Net Cash Flow (Year 1) = Php 3,000,000 x 0.9091 = Php 2,727,273

PV of Net Cash Flow (Year 2) = Php 3,000,000 x 0.8264 = Php 2,479,339

PV of Net Cash Flow (Year 3) = Php 3,000,000 x 0.7513 = Php 2,253,944 

PV of Cash Inflows during Years in Operation = PV of NCF (Year 1) + PV of NCF (Year 2) + PV of NCF (Year
3) 

PV of Cash Inflows during Years in Operation = Php 2,727,273 + Php2,479,339 + Php 2,253,944 

PV of Cash Inflows during Years in Operation = Php 7,460,556 

Since corporate life ends by Year 3, terminal value will be based on the liquidation value by end of Year
3. 

Present Value of Sale of Asset (Php30,000,000 x 0.7513) Php 22,539,000

Less: Present Value of Cost for termination and settlement for Liabilities 

(Php 10,000,000 x 0.7513) 7,513,000

Less: Present Value of Tax Charges for the Transactions

and Other Liquidation Costs (Php4,000,000 x 0.7513) 3,005,200

Liquidation Value Php 12,020,800 

Cash flows during the remaining operating life and liquidation value by end of Year 3 should be
combined to arrive at the value of Golda Company now. 

Value of Golda Company = PV of Cash Inflows during Years in Operation + Liquidation Value 

Value of Golda Company = Php 7,460,556 + Php 12,021,037 

Value of Golda Company = Php 19,481,593 

Illustrative Example 3 

Droid Company’s balance sheet revealed total assets of Php3 million, total liabilities of Php1 million, and
100,000 shares of outstanding ordinary shares. Upon checking with potential buyers, the assets of Droid
can be sold for Php1.8 million if sold today. Additional Php300,000 will also be incurred to cover
liquidation expenses. How much is the liquidation value of Droid Company per share? 

To compute for the liquidation value in this example, we need to consider how much the company will
receive from the assets if it will sell today. This money will also be used to pay for the remaining
liabilities and liquidation expenses. 

Liquidation Value = Sale of Assets upon Liquidation + Payment for Liabilities - Liquidation Costs 

Liquidation Value = Php 1,800,000 — Php 1,000,000 — Php 300,000

Liquidation Value = Php500,000 

Liquidation Value per Share = Liquidation Value / Number of Outstanding Ordinary Shares 

Liquidation Value per Share = Php 500,000 / 100,000 shares 

Liquidation Value per Share = Php 5.00 per share