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.