Small Business Valuation with Use of Cash Flow Stochastic Modeling

Abstract

Enterprise can be described with vector of financial characteristics e.g. revenue, net profit, net working capital, depreciation, debt etc. Vector evolution can be modeled with use of system of recurrent equations. These equations can be combined in three groups: equations of the income statement, equations of sources and uses of funds and balance equations. System parameters can be obtained using financial performance analysis. Cash flow can be calculated using vector components. Discounted cash flow method is used for business valuation. In real systems there is an uncertainty in all parameters. This uncertainty can be modeled utilizing stochastic approach. Monte Carlo simulation can be adopted to forecast cash flow distribution and to predict the risks caused by uncertainty. We show that once simulation model is set up, it is a simple matter to analyze the principal sources of uncertainty in the cash flows and to see how much this uncertainty could be reduced by improving the forecasts of sales or costs. Practical realization of this approach is discussed in the paper. Finally, we demonstrate how changes in model parameters influence cash flows.