Going Concern Valuation

From Open Risk Manual

Definition

Going Concern Valuation of a Non-Performing Loan refers to the collection of valuation methodologies where operational cashflows from the debtor (obligor, borrower) continue and hence available collateral is only conditionally exercised[1]

The approach is suitable when future operating cash flows of the debtor are material and can be reliably estimated. Normally, Financial Statements are prepared on the assumption that the Reporting Entity is a going concern and will continue in operation for the foreseeable future. This means that the entity has neither the intention nor the need to enter Liquidation or to cease operating under its Business Model.

In general a Going Concern Valuation contains a Gone Concern Valuation as a special case where liquidation is certain.

Methodology

A Going Concern Valuation of NPL is conceptually similar to a Performing Loan valuation with a significant difference: Collateral may be exercised to the extent it does not influence operating cash flows (e.g. premises pledged as collateral cannot be exercised without impacting cash flows; stock or commodities pledged under asset based lending products cannot be sold without significantly impacting operations of business etc.).

Steady-state cash flow approach

This is essentially a corporate valuation approach that involves:

  • Estimate sustainable (steady-state) one-period operating cash flows of the debtor or group.
  • Convert to present value by multiplying operational cash flows by a multiple to arrive at the sustainable level of debt for the bank.
  • Add any discounted recoveries from sales of collateral that is independent of operating cash flows.


The present value of cash flows to the significant bank for exposure i (Cash Flow Value0,i) is derived as follows:

  • First, estimate the __present value of cash flows of the debtor__ by forecasting a one-period sustainable (steady-state) cash flow (CFS) and applying a multiple (M).
  • Then, allocate the present value of cash flows of the debtor to liabilties based on the effective seniority of each exposure.

Estimation Of The Present Value Of Cash Flows Of The Debtor

  • The present value of cash flow to the debtor is defined as PV Operating Cash Flows (Debtor) = CFS * M.
  • One-Period Sustainable Cash Flows (CFS) are defined as follows: CFS = EBITDA + Cash Flow adjustment + Sustainability adjustment


The following general principles apply when forecasting CFS:

  • Forecasting CFS on a going concern basis;
  • Estimating CFS based on the Financial Statements of the debtor;
  • Latest information is regarded as the best basis for forecasting EBITDA. Accounts from 2012 are acceptable. If no current information is available and cannot be retrieved by the significant bank within a timely manner, the CFS is expected to be zero.
  • The information of last management accounts and audited accounts should be used (where management accounts are available).

Guidance for forecasting: EBITDA


Deriving EBITDA


-

Revenues

Cost of sales

-

Distribution costs

-

Administrative expenses excl. depreciation/amortisation

-

Payroll taxes

+/-

Other gains/losses

=

EBITDA


Guidance for forecasting: cash flow adjustment


Estimating the Cashflow adjustment

-

Income tax expense

-

Owner’s remuneration/“essential dividends”

-

Required capital expenditure (CAPEX)

=

Cash flow adjustment


  • Income tax expense is defined as Profit Before Income Tax * Effective Income Tax Rate.
  • Effective Income Tax Rate is forecasted in line with typical income tax rates in the jurisdiction and the NCA bank team’s experience.
  • Profit Before Income Tax is defined as EBITDA - Net interest expense - Depreciation. Both net interest expense and depreciation will be constant as per 2013/2012 figures unless there are significant one-off effects (e.g. large depreciation of tangible assets due to technology change).
  • One must deduct Owner’s //remuneration/“Essential dividends”// from cash flows. Examples are where the owner(s) of the firm require(s) a minimum payout to make a living, or where the controlling shareholder depends on parts of the dividends to avoid default.
  • One must also deduct the minimum annual CAPEX required to maintain the cash flows of the operation.

References

  1. AQR Manual