| An investment's value depends on the
cash flow (or cash flows) that you anticipate it
will provide over the period of ownership. To have
value, the investment need not provide constant
returns. Intermittent cash flows, a single cash
payment and even declining cash flows have value.
The timing of cash flows is relevant, given the
time value of money. Cash flows that will begin
at some point in the future have less value than
the same cash flows beginning now. Sometimes even
experts forget this, as the side case reveals.
Estimating cash flows involves predicting the
future, still an inexact science. What will be
the revenues, expenses and returns of a business?
How will the economy perform? Often valuation
experts employed in a dispute will arrive at far
different estimates. As the Tax Court explains:
The differences among the expert valuations
in this case demonstrate the caution that is
necessary in weighing expert valuations that
zealously attempt "to infuse a talismanic
precision into an issue, which should frankly
be recognized as inherently imprecise,"
while ignoring relevant facts concerning the
property to be valued.
Estate of Hall v. CIR, 92 T.C. 312, 338 (1989)
quoting Messing v. Commissioner, 48 T.C. 502,
512 (1967). |
Example
Estate
of William J. Desmond, v. IRS
T.C. Memo 1999-76 (U.S. Tax Court 1999).
Desmond dies owning 81.93% of
Deft Inc., a closely-held business that manufactures
and sells industrial coating materials. His
estate's executor values his interest in Deft
on the estate tax return at $6,160,576. The
IRS concludes this understates the value of
Desmond's interest, and the executor challenges
the IRS in Tax Court. How should the court value
an equity interest in a closely-held business?
Answer:
One method is the discounted flow
method. Relying on figures presented by the
executor's expert, the court first determines
expected future Deft cash flows:
|
Year |
Projected
cash flows ($000) |
1992 |
1,162 |
1993 |
1,290 |
1994 |
1,432 |
1995 |
1,589 |
1996 |
1,764 |
1997 and thereafter |
1,740 |
|
4.0 Securities Valuation