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 it 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.