Valuation of Cash in Income Approach Valuation
I am having a theoretical argument with a partner at my office regarding the proper valuation of corporate cash holdings. I have argued that theoretically the preferred method for valuing corporate cash holdings in an income approach valuation is to remove the interest income on cash from the cash flow stream, discount the cash flow stream (using non-cash working capital changes), and finally add cash back to the resulting enterprise value. My partner argues that this is "theoretical garbage" and that cash is necessary to operate a business and should not be added back to enterprise value. He argues that I should discount the cash flow stream (presumably with interest income, or at least excluding interest income on excess cash balance) and only to add the value of excess cash to the resulting enterprise value. I understand that theoretically both methods can result in the correct indication of value if performed properly, but my partner believes that my method is theoretically incorrect and substantially overvalues the business. Damodaran you discuss at length in your text book how to value cash in a discounted cash flow methodology and prefer my method over my partners. I showed my partners your text but he has shrugged it off as just wrong and deemed you a proponent for the IRS (although I believe he has you confused with Dr. Bajaj). Do you know of any other papers or text books that discuss the methodology that you propose in your text book? Alternatively, do you any any additional ammunition that I can provide to my partner. We have an issue with cash in an appraisal of a closely held business and the treatment of cash is resulting in significant deviations in vlaue under our market and income base approaches. I suspect that the inconsistencies are related to the treatment of cash (i.e. our income approach is too low when cash is not added back to the resulting enterprise value probably because the cost of capital is too high given that cash represents nearly 50% of the corporations book value). I would appreciation any guidance. Thank you in advance. Valuator
Rigidity (as evidenced by your partner) is never a good trait in someone who does valuation. First, is it possible that some cash is needed for operations? Sure. But as long as that cash is earning a fair market return (such as what you would earn on T.Bills), it is not wasting cash and should be added to enterprise value. And any company that has as much cash as the firm you have in question is clearly holding cash for the sake of holding cash. As for being a proponent of the IRS, I have never done expert witness work and hate paying taxes. I am, however, a proponent of the principle that valuations should be unbiased. Your partner seems intent on adopting practices that will give him a lower value, no matter what the rationale.