Valuation of Finance Receivables

Our professionals at Brookline Valuation Services (“BVS”) were recently involved in the estimation of fair value of Finance Receivables of a Company, which provides consumers an alternative method of paying for services and products. The valuation was done in accordance with the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 825, which requires disclosures about the fair value of all financial instruments.

The primary business of the Company is the extension of credit to consumers through merchants (the “Merchants”) participating in the Company’s program throughout the United States. The Company’s network of Merchants include dental and medical markets, eye care, hearing aids, specialty beds, fitness equipment, and other various services and products. The Company extends credit to customers of Merchants using a system whereby the prospective credit applications are screened on an expedited basis. Based upon the consumer credit rating and underlying Merchant agreement, the Company extends or declines credit to an applicant for use at a Merchant on a nonrecourse or recourse basis. When credit is extended on a recourse basis, the Merchants are typically required to maintain a reserve account with the Company to offset any future losses.

The most appropriate valuation methodology was deemed to be the discounted cash flow analysis. In the first step of the analysis, with the help of BVS professionals, the Company developed a set of projected cash flows that are expected to be collected from finance receivables in place as of the Valuation Date.

The cash flows were examined for:

Analysis of historical and expected delinquency and charge-offs rates;
An analysis of the Company’s finance receivable historical performance and how this compares to their projected performance;
Risk factors facing companies within the industry.

Once a benefit stream was determined, the second step in the income approach was determining the discount rate to be applied to the benefit stream.

How do you determine a discount rate for an asset already in place? The projected cash flows of finance receivables already incorporate the risk of delinquency and charge-offs. The majority of the risk is related to the opportunity cost of not having all the receivables collected today, but rather spread over a five year period.

Ultimately, the methodology used to estimate the discount rate was similar to the methodology of developing rate of returns on individual assets in the Purchase Price Allocation under the ASC 805. In other words, the starting point for the development of the discount rate applicable to finance receivables was the estimation of the discount rate applicable to the cash flows of the enterprise.

The development of the discount rate was based on a variety of factors including perceived similar returns available in the marketplace. The more speculative the benefit stream, the higher the discount rate, and conversely, the more stable the benefit stream, the lower the discount rate.

Eventually, the discount rate applicable to the estimation of Fair Value of Finance Receivables was based on after-tax short term rates, which would have been available to market participants. We gave significant consideration to the mix of debt and equity financing required to fund these Finance Receivables, with the majority of the financing available in the form of debt.

September, 2014

Brookline Valuation Services recently prepared a valuation report that estimated fair values of certain identifiable intangible assets of an acquired company. The valuation was used by the acquirer for financial statement reporting purposes. The key unique feature of this particular transaction was the presence of negative goodwill.

One of the first steps in the allocation process is to ascertain the reasonableness of the purchase price and implied internal rate of return. This involves considering the value of the acquired business as a whole. We have utilized a discounted cash flow methodology for this analysis. Management provided revenue, earnings and cash flow projections.

The business enterprise analysis is essentially a calculation to determine the implied internal rate of return (IRR) from the acquisition. The indication of value, as developed from the cash flow projections provided by management should approximate the purchase price. The discount rate is the implied internal rate of return necessary to equate the cash flow stream to the purchase price. Reconciliation of this rate of return with the weighted average cost of capital (WACC) and weighted average return on the assets (WARA) acquired is an important step in determining the reasonableness of the underlying assumptions and indications of value determined in this report.

The implied IRR was significantly higher than the WACC and WARA. If an IRR is higher, oftentimes there is an indication of a bargain purchase situation. In other words, the purchase price, for the expected cash flows, was lower than what a market participant would likely expect to pay for the Company resulting in the higher implied rate of return on the acquisition.

As a result, the purchase price allocation results in negative goodwill. Goodwill is calculated as the residual difference between the purchase price and the fair value of the tangible and intangible assets acquired and liability assumed. Under ASC 805, negative goodwill is not recorded, but rather, if a bargain purchase is considered, the related gain should be recognized as of the acquisition date.

ASC 805 defines a bargain purchase as a business combination in which the total acquisition-date fair value of the identifiable net assets acquired exceeds the fair value of the consideration transferred plus any non-controlling interest in the acquiree, and it requires the acquirer to recognize that excess in earnings as a gain attributable to the acquirer.

Generally speaking, a bargain purchase is rare. However, for the subject acquisition there were factors that drove down the purchase price, resulting in the bargain purchase and gain recognition.

The seller of the assets had become motivated due to prolonged lapse of time between entering into a plan of divesture the target company and the ultimate sale caused by a previous failed sale transaction with another buyer.

As a result of the unique circumstances surrounding the subject acquisition, and considering the current fair value standard, it appears reasonable a gain would be recognized.

How often do you see bargain purchase especially in the current economic environment?

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Valuation of Finance Receivables

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