ELEC2 - Module 3 - Liquidation Value Method

CHAPTER 3
LIQUIDATION VALUE
METHOD
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Department of Accountancy – MGT7A-Financial Management

LEARNING OUTCOME
• Define liquidation value.

• Enumerate the types of liquidation
• Compute the liquidation value
Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Source: Valuation Concepts and Methodologies
By: Marvin V. Lascano, Herbert C. Baron and Andrew Timothy L. Cachero
LEARNING CONTENTS
• Liquidation Value
• Situations to Consider Liquidation Value
• General Principles on Liquidation Value
• Types of Liquidation
• Calculating Liquidation Value

LIQUIDATION VALUE
• Liquidation value refers to the value of a company if it

were dissolved and its assets are sold individually. (CFA
Institute)
• 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

LIQUIDATION VALUE
• Once the 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.

LIQUIDATION VALUE
• Circumstances clearly dictates whether it will be

appropriate to use liquidation value or going concern value
in 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
• Liquidation value is the base price or the floor price for

any firm valuation exercise.
• Liquidation value should not be used to value profitable
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 or
losing companies where liquidation is imminent to check
whether profits can still be realized upon sale of the assets
owned.

SITUATIONS TO CONSIDER LIQUIDATION VALUE
• a. Business Failures – low or negative returns are signs

of business failures that is why it is the common or
usual reason why a certain business closes or
liquidates.
Types of Business Failures
1. Insolvency, when a company cannot pay liabilities
as they become due.
2. Bankruptcy, when liabilities become greater than
an asset balance.

• Factors causing Business Failures

• Internal Factors – can come from mismanagement,
poor financial evaluation and decisions, failure to
execute strategic plans, inadequate cash flow
planning or failure to manage working capital.
• External Factors – are severe economic downturn,
occurrence of natural calamities or pandemic,
changing customer preferences, and adverse
governmental regulations.

b. Corporate/Project End of Life – normally, corporations

have stated their finite life in their Articles of
Incorporation. If there will be no extension on the
corporate life, the terminal value may be computed using
liquidation value.
c. Depletion of Scarce Resources – this is most applicable to
mining and oil where availability of scarce resources
influences the value of the firm. Liquidation happens in
this business when the permits or contracts with the
government expire and the operation will no longer be
allowed to execute.
GENERAL PRINCIPLES ON LIQUIDATION VALUE
• Liquidation value is the most conservative approach

among all as it is 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 liquidation value

• 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.
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 costs) should also be factored in and deducted to
arrive at the liquidation value.
General Concepts considered in liquidation value

• Non-operating assets should be valued by liquidation method
as the market value reduced by costs of sales 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 value must be used if the business continuity is
dependent on current management that will not stay.
TYPES OF LIQUIDATION
Orderly liquidation – assets are sold strategically over an
orderly period to attract and generate the most money
for the assets
• Liquidation process will expose assets for sale on the
open market with a reasonable time allowed to find a
purchaser, both the buyer and seller having knowledge
of the uses and purposes to which 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.
TYPES OF LIQUIDATION
Forced liquidation – assets are sold as quickly as
possible, such as at an auction.
• Liquidation is done immediately especially if creditors
have sued or bankruptcy is filed.
• Assets are sold in the market at the soonest time
possible which result in lower prices because of the
rush sale.
• Ultimately drives down the liquidation value.

CALCULATING LIQUIDATION VALUE
• Liquidation value considers the present value of the sums
that can be obtained through the disposal 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.
• It can also be computed on a per share basis by dividing total
liquidation value by outstanding ordinary shares and be
considered together with other quantitative and qualitative
metrics to justify business decisions to be made
Present Value of Sale of Asset Pxxx.xx

Less: Present Value of Cost for
termination for Liabilities xxx.xx
Less: Present Value of Tax Charges for
the Transactions and other
Liquidation Costs xxx.xx
Liquidation Value P xxx.xx

• Calculation for liquidation value at closure date is
somewhat like the book value calculation, except the
value assumes a forced or orderly liquidation of 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
• 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.
• The present value of a business or property on a liquidation
basis is computed as: the estimated net proceeds should be
discounted at a rate reflects the risk involved back to the
date of the original valuation.
• Liquidation value can be used as basis for terminal cash flow
in 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 takeovers occurs, it is usual that goodwill is
recognized as part of the transactions.
• Monetary equivalent specific for intangible assets
cannot be reliably and separately measured.
• Instead, intangible assets are offset against
shareholders’ equity to come up with conservative
liquidation value.
ILLUSTRATION 1
Pearl Company below balances based on its accounting books records. Pearl company
has 250,000 outstanding shares’
Pearl Company
December 31, 2020
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
Liabilities
Notes Payable 1,200,000
Other Liabilities 800,000
Total Liabilities 2,000,000
ILLUSTRATION 1
Pearl 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 the table on the next slide.
To compute for the adjusted value of the assets, the current
book value 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).

ILLUSTRATION 1
Asset
Book Adjusted
Asset Valued At Asset Value Valued At Value
Cash 100% Cash 100,000 100% 100,000
A/R - Net 85% A/R – Net 800,000 85% 680,000
inventories 60% Inventories 3,500,000 60% 2,100,000
Prepaid Prepaid
Expenses 25% Expenses 100,000 25% 25,000
PPE - Net 60% PPE – Net 4,500,000 60% 2,700,000
Total assets 9,000,000 5,605,000
Asset Adjusted Value P5,605,000

Less: Total liabilities to be settled 2,000,000
Liquidation value - Pearl Company 3,605,000
Number of Outstanding shares 250,000
Liquidation value per share 14.42
ILLUSTRATION 2
Golden Company, which is a company specifically created for a
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 P3,000,000 per year. At the end of its life.
Golden estimates to incur P10,000,000 for closure and
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 P30,000,000 and remaining debt of
P4,000,000 will be fully paid off by then. If the valuation
happens now, compute for the value of Golden Company.

ILLUSTRATION 2
Since Golden Company will terminate its life after 3
years, it is more appropriate to use liquidation value
as terminal value input to the DCF model. For the
three years prior to the closure, Golden Company will
continue to generate positive Net Cash Flow and this
will form part of its value.

ILLUSTRATION 2
Present Value (PV) of Cash Inflows during Years in Operation
Formula: PV factor of 1 = (1 +i)-n
PV Of annual Net Cash flow = Net Cash Flow X PV Factor of 10%
PV of Net Cash Flow (year 1) = P3,000,000 x 0.909091 = P2,727,273
PV of Cash inflow 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 = P2,727,273 + P2,479,338
+ P2,253,945
PV of Cash Inflows during Years in Operations = P7,460,556

ILLUSTRATION 2
Since corporate life ends by Year 3, terminal value will be
based on the liquidation value by end of Year 3.
Formula: PV factor of 1 = (1 +i)-n
Present Value of Sale Asset (P30,000,000 x
0.751315) P22,539,450
Less: Present Value of Cost for termination
and settlement for Liabilities
(P10,000,000 x 0.751315) 7,513,150
Less: Present Value of Tax charges for the
Transactions and other Liquidation Costs
(P4,000,000 x 0.751315) 3,005,260
Liquidation Value P12,021,040
ILLUSTRATION 2
Cash flows during the remaining operating life and
liquidation value by end of year 3 should be combined
to arrive at the value of Golden Company now.
Value of Golden Company = PV of Cash Inflows during
years in Operation + Liquidation Value
Value of Golden Company = P7,460,556 + P12,021,040
Value of Golden company = P19,481,596

ILLUSTRATION 3
Diamond Company’s statement of financial position revealed
total assets of P3 million, total liabilities of P1 million, and
100,000 shares of outstanding ordinary shares. Upon
checking with potential buyers, the assets of Diamond can be
sold for P1.8 million if sold today. Additional P300,000 will
also be incurred to cover liquidation expenses. How much is
the liquidation value of Diamond 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.
ILLUSTRATION 3
Liquidation Value = Sale of Assets upon Liquidation – Payment
for Liabilities – Liquidation costs
Liquidation Value = P1,800,000 – P1,000,000 – P300,000
Liquidation Value = P500,000
Liquidation Value per Share = Liquidation Value / Number of
Outstanding Ordinary shares
Liquidation Value per share = P500,000 / 100,000
Liquidation Value per share = P5.00 per share

THANK YOU
STAY SAFE
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Department of Accountancy – ELEC2

ELEC2 - Module 3 - Liquidation Value Method

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CHAPTER 3

This Photo by Unknown Author is licensed under CC BY-SA

Department of Accountancy – MGT7A-Financial Management

• Define liquidation value.

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Liquidation value refers to the value of a company if it

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Once the business closes, synergies generated by

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Circumstances clearly dictates whether it will be

• Liquidation value is the base price or the floor price for

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• a. Business Failures – low or negative returns are signs

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Factors causing Business Failures

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

b. Corporate/Project End of Life – normally, corporations

• Liquidation value is the most conservative approach

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

General Concepts considered in liquidation value

General Concepts considered in liquidation value

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Present Value of Sale of Asset Pxxx.xx

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Asset Adjusted Value P5,605,000

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

This Photo by Unknown Author is licensed under CC BY-SA

Department of Accountancy – ELEC2

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