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Page 14
How To Investigate Any Business Opportunity
2. The owner's salary (in excess of an equivalent manager's compensation).
3. Discretionary Benefits paid the owner (such as automobile allowance, travel expenses, personal in-
surance and entertainment).
4. Interest (unless the buyer will be assuming the interest payment).
5. Non-Recurring Expenses (such as non-recurring legal fees).
6. Non-Cash Expenses (such as depreciation and amortization).
7. Equipment Replacements or Additions. (This figure should be deducted from the other numbers since
it represents an expense the buyer will incur in generating future cash flows).
While the future cash flows may be projected out for a number of years, for many small businesses it is
not possible to predict very far into the future before the projections become meaningless. Even with
somewhat larger and more substantial businesses, it is difficult to project cash flows for more than 5
years.
Step #2
Once the future cash flows have been projected, they must be discounted back to their present value.
This is done by selecting a reasonable rate of return or capitalization rate for the buyer's investment. The
selected rate of return varies substantially from one business to the next and is largely a function of risk.
The lower the risk associated with an investment in a business, the lower the rate of return that is re-
quired. The rate of return required is usually in the 20-50% range and, for most businesses, it is in the
30-40% range. The present value of the future cash flows can then be determined by using a financial
calculator or a set of present value tables that are available in most book stores. The following example
demonstrates how the conversion is made with a 40% rate of return.
Year Projected Discount Present
Cash Flow Factor * Value
Year 1 $360 .714 $257
Year 2 $383 .510 $195
Year 3 $397 .364 $145
Year 4 $413 .260 $107
Year 5 $438 .186 $ 81
_____
$785 Total**