WFU Law School
Law & Valuation
4.0 Securities Valuation

4.1.1 Cash Flows (Returns)

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

©2003 Professor Alan R. Palmiter

This page was last updated on: March 30, 2004