Essentials of Entrepreneurship & Small Business Mgmt., 7e (Scarborough)
Chapter 7 Buying an Existing Business
1) The due diligence process of analyzing and evaluating an existing business:
A) may be just as time consuming as the development of a comprehensive business plan for a
start-up.
B) helps to determine if the company will generate sufficient cash to pay for itself and leave you
with a suitable rate of return on your investment.
C) helps to determine what the company’s potential for success is.
D) All of the above
2) When done correctly, the due diligence process will:
A) reveal both the positive and negative aspects of an existing business.
B) be time consuming and expensive.
C) most often result in the purchase of the business.
D) rarely prove to be beneficial.
3) Advantages to buying an existing business that you do not have with a startup include:
A) greater access to venture capital.
B) the opportunity to participate in a national advertising campaign.
C) inventory is in place and trade credit is established.
D) easy implementation of innovations and changes from past policies.
4) Which of the following is a potential disadvantage of purchasing an existing business?
A) The employees inherited with the business may not be suitable.
B) The previous owner may have created ill will among the company’s customers.
C) Equipment and facilities may be obsolete or inefficient.
D) All of the above
5) When evaluating the assets of an existing business, the inventory:
A) is always current and salable.
B) usually appreciates over time, making the business a bargain.
C) should be judged on the basis of its market value, not its book value.
D) is usually stated honestly and does not need an independent audit.
6) An entrepreneur who is considering purchasing a business is analyzing a company’s accounts
receivable. The following table summarizes her findings.
Age of Accounts Amount Probability of Collection
0 – 30 days $12,000 .96
31 – 60 days $ 4,000 .87
61 – 90 days $ 2,500 .71
91 – 120 days $ 1,400 .65
121 + days $ 800 .24
How much should this potential buyer be willing to pay for these accounts receivable?
A) Nothing ; a buyer should never purchase existing accounts receivable.
B) $20,700
C) $17,877
D) Not enough information given to determine
7) The first step an entrepreneur should take when buying an existing business is to:
A) explore financing options.
B) prepare a list of potential candidates.
C) analyze his or her skills, abilities, and interests in an honest self-audit.
D) contact existing business owners in the area and ask if their companies are for sale.
8) When acquiring a business, the buyer should:
A) conduct a self-analysis of skills, abilities, and interests.
B) prepare a list of potential candidates.
C) investigate potential candidates and carefully evaluate them.
D) All of the above
9) Which of the following statements concerning financing the purchase of an existing business
is true?
A) It is usually more difficult than securing financing for a start-up business.
B) Usually, the business seller is not a good source of financing.
C) The buyer should be able to make the payments on the loans out of the company’s cash flow.
D) All of the above
10) Which of the following statements concerning financing the purchase of an existing business
is not true?
A) The business seller usually is a good candidate for a source of financing.
B) The deal should allow the buyer to make the loan payment out of the company’s cash flow.
C) The buyer should wait until late in the purchase process to arrange financing to avoid
processing fees in case the deal falls through.
D) All of the above
11) Perhaps the ideal source of financing the purchase of an existing business is:
A) a venture capitalist.
B) the Small Business Administration.
C) the seller of the business.
D) an insurance company.
12) To ensure a smooth transition when buying an existing business, a buyer should:
A) communicate with employees to reduce their uncertainty and anxiety.
B) be honest with existing employees about upcoming changes and plans for the company’s
future.
C) consider asking the seller to stay on and serve as a consultant until the transition is complete.
D) All of the above
13) The most common reasons owners of small- and medium-sized businesses give for selling
their businesses are:
A) need for money and low return on investment.
B) boredom and burnout.
C) low return on investment and burnout.
D) greater opportunities working for someone else and low return on investment.
14) Important factors to investigate regarding the business to be purchased include:
A) assessing the physical assets of the business.
B) reviewing accounts receivable and business records.
C) reviewing contractual arrangements and assessing intangible assets.
D) All of the above
15) Laurette has entered into a contract with Jackson to purchase his retail music shop. Jackson’s
lease on the existing building (which is in an excellent location) has five years remaining. If
Laurette wants the lease to be part of the business sale:
A) she should include a clause in the sales contract in which Jackson agrees to assign to her his
rights and obligations under that lease.
B) she should notify the landlord of Jackson’s assignment of the lease agreement to her.
C) A and B are correct.
D) None of the above. Because Jackson does not actually own the building, he can transfer no
rights to it to Laurette.
16) Generally, a seller of an existing business can assign any contractual right to the buyer
unless:
A) the contract specifically prohibits the assignment.
B) the contract is personal in nature.
C) A and B are correct.
D) None of the above. Business sellers typically cannot assign any contractual rights to buyers.
17) During the acquisition process, the potential buyer usually must sign a ________, which is
an agreement to keep all conversations and information secret and legally binds the buyer from
telling anyone any information the seller shares with her.
A) covenant not to compete
B) nondisclosure document
C) letter of intent
D) purchase agreement
18) Which of the following is required for the covenant not to compete to be enforceable?
A) Part of a business sale and reasonable in scope
B) Approved by a court of law and reasonable in scope
C) The assistance of an attorney and approved by a court of law
D) The registration of the due-on-sale agreement
19) Sources of potential legal liabilities for the buyer of an existing business include all but
which of the following?
A) Problems with the physical premises, such as hazardous materials
B) Product liability claims
C) Labor problems and disputes
D) Errors and omissions
20) A toy manufacturer is sued based on the claim of injuries caused by a product it makes. This
is an example of a:
A) product liability lawsuit.
B) promissory estoppel lawsuit.
C) restrictive covenant lawsuit.
D) contingent liability lawsuit.
21) When evaluating the financial position of a business he or she is considering buying, an
entrepreneur should examine:
A) its income statements and balance sheets from the past three to five years.
B) its income tax returns for the past three to five years.
C) the owner’s compensation and that of relatives.
D) All of the above
22) In a business sale, a letter of intent:
A) states that the buyer and the seller have reached a sufficient meeting of the minds to justify
the time and expense of negotiating a final agreement.
B) should contain a clause calling for “good faith negotiations” between the parties.
C) addresses such issues as price, payment terms, a deadline for closing the deal, and others.
D) All of the above
23) During the acquisition process, the buyer and the seller sign a ________, which spells out the
parties’ final deal and represents the details of the agreement that are the result of the negotiation
process.
A) covenant not to compete
B) nondisclosure document
C) letter of intent
D) purchase agreement
24) Which of the following statements about valuing a business is true?
A) The balance sheet technique is the best way to value a business.
B) Business valuation is partly art and partly science.
C) Buyers should rely on the seller’s industry expertise and years of experience to determine
what his company is worth.
D) Business valuation processes are consistently misleading regarding the future earning
potential of a business.
25) The main reason a buyer purchases an existing business is for:
A) its future income and profits for earning potential.
B) its customer base and access to those customers.
C) its tangible assets and the ability to liquidate those assets.
D) its goodwill.
26) A method of valuing a business based on the value of the company’s net worth is the:
A) balance sheet technique.
B) adjusted balance sheet technique.
C) earnings approach.
D) opportunity cost technique.
27) A valuation method that is more realistic than the balance sheet technique, because it adjusts
book value to reflect actual market value, is the:
A) excess earnings method.
B) market approach.
C) capitalization method.
D) adjusted balance sheet method.
28) Which of the following valuation methods does not consider the future income-earning
potential of a business?
A) Balance sheet technique
B) Excess-earnings method
C) Discounted future earnings approach
D) Market approach
29) When valuing inventory for a business sale, the most common methods used are:
A) first-in-first-out (FIFO) and last–in-first-out (LIFO).
B) first-in-first-out (FIFO) and average costing.
C) cost of last purchase and replacement value of inventory.
D) cost of last purchase and average costing.
30) Business valuations based on balance sheet methods suffer certain disadvantages, including:
A) they are extremely complex and are difficult to calculate.
B) they do not consider the future earning potential of the business.
C) they fail to take into account what is usually the largest asset a company owns: inventory.
D) All of the above
Use the following information to answer the question(s) below.
Baubles and Bells, a small business, is up for sale. The book value of its assets is $397,650, and
its liabilities have a book value of $148,500. After adjusting for market value, total assets are
worth $386,475, and total liabilities are $153,600. The business is considered to be a “normal
risk” venture. The new owner (if he buys) plans to draw a salary of $28,000. Estimated earnings
for the upcoming year are $88,400. Complete net earnings estimates for the next five years are:
Pessimistic Most Likely Optimistic
Year 1 $82,000 $88,400 $90,500
Year 2 $85,000 $90,000 $93,000
Year 3 $88,000 $92,500 $95,500
Year 4 $91,000 $95,000 $97,000
Year 5 $94,000 $97,000 $98,500
31) Using the adjusted balance sheet technique, what is the business worth?
A) $397,650
B) $386,475
C) $249,150
D) $232,875
32) The valuation approach that considers the value of goodwill is the:
A) balance sheet technique.
B) excess earnings method.
C) discounted future earnings approach.
D) market approach.
33) Under the excess earnings method, what is the “extra earning power” of the business?
A) $86,219
B) $2,181
C) $11,175
D) Cannot be determined from the information given
34) Using the excess earnings method, what is the company’s “goodwill”?
A) $6,543
B) $33,525
C) $15,267
D) Cannot be determined from the information given
35) Which of the following is considered an opportunity cost of buying an existing business?
A) The salary that could be earned working for someone else and the owner’s investment in the
business
B) Dividends
C) The market value of tangible assets
D) The salary that the business has paid to previous owners
36) The amount the seller of a business receives for “goodwill” is taxed as:
A) a long-term capital gain.
B) regular income.
C) superlative income.
D) None of the above
37) The capitalized earnings approach determines the value of a business by capitalizing its
expected profits using:
A) the interest rate that could be earned on a similar risk investment.
B) the prime interest rate.
C) the normal rate of return.
D) the prevailing return of inflation.
38) If a business buyer estimates that 20 percent is a reasonable rate of return for an existing
business expected to produce a profit of $27,000, its capitalized value would be:
A) $5,400.
B) $32,400.
C) $135,000.
D) $540,000.
39) In the earnings methods of business valuation, the rate of return associated with a “normal
risk” business is:
A) 15 percent.
B) 25 percent.
C) 35 percent.
D) 50 percent.
40) Which method of business valuation relies on three forecasts of future earnings: optimistic,
pessimistic, and most likely?
A) Balance sheet technique
B) Excess-earnings method
C) Discounted future earnings
D) Market approach
41) The ________ approach to valuing a business assumes that a dollar earned in the future is
worth less than that same dollar is today.
A) balance sheet
B) capitalized earnings
C) adjusted balance sheet
D) discounted future earnings
42) Which of the following valuation techniques is best suited for determining the value of
service businesses?
A) Discounted future earnings approach
B) Balance sheet technique
C) Adjusted balance sheet technique
D) Excess earnings approach
43) The ________ approach to valuing a business uses the price-earnings ratios of similar
businesses to establish the value of a company.
A) balance sheet
B) capitalized earnings
C) discounted future earnings
D) market
44) Which of the following is a disadvantage of the market approach to valuing a business?
A) Necessary comparisons between publicly traded and privately owned companies
B) Unrepresentative earnings estimates
C) Difficulty in finding similar companies for comparison
D) All of the above
45) Which of the following is a drawback of the market approach of evaluation?
A) It does not consider current earnings.
B) It may underrepresent earnings.
C) Its reliability depends on the forecasts of future earnings.
D) It overemphasizes the value of goodwill.
46) You are considering purchasing Babcock Office Supply. You estimate that the company’s
earnings next year will be $67,400. You have found three similar companies whose stock is
publicly traded. Their P/E ratios are 6.8, 7.4, and 7.1. Using the market approach, you estimate
Babcock Office Supply to be worth:
A) $478,540.
B) $9,493.
C) $67,400.
D) $498,760.
47) A company’s P/E ratio is:
A) the price of one share of its common stock divided by its earnings per share.
B) its profits per share divided by its equity per share.
C) its profits per share divided by its excess cash flow per share.
D) None of the above
48) Some business brokers differentiate between the types of buyers: ________ buyers see
buying a business as a way to generate income and ________ buyers view the purchase as part of
a larger picture to offer a long-term advantage.
A) strategic; financial
B) financial; strategic
C) strategic; optimistic
D) financial; passive
49) This type of business sale is best for those entrepreneurs who want to step down and turn
over the control of the company to the new buyer as soon as possible.
A) Straight business sale
B) Earn-out
C) Sale of controlling interest
D) Employee stock ownership plan – ESOP
50) Which of the following strategies would not be suitable for an entrepreneur who wants to
surrender control of the company gradually?
A) Forming a family limited partnership
B) Restructuring the company
C) Straight business sale
D) Using a two-step sale
51) Mitchell Schlimer, founder of the Let’s Talk Business Network, a support community for
entrepreneurs, says that, initially, about ________ percent of small business owners who sell
their companies to larger businesses remain with the acquiring company.
A) 40
B) 50
C) 70
D) 90
52) ________ gives owners the security of a sales contract but permits them to stay at the “helm”
for several years.
A) Earn-out
B) A controlled sale
C) Company restructuring
D) An ESOP
53) A(n) ________ allows owners to “cash out” by selling their companies to their employees as
gradually or as quickly as they choose.
A) two-step sale
B) controlled sale
C) company restructuring
D) ESOP
54) An ESOP:
A) allows an owner to transfer all or part of his company to the employees as gradually or as
quickly as he chooses.
B) works best in companies where pre-tax profits exceed $100,000.
C) is not beneficial to companies with fewer than 15 to 20 employees.
D) All of the above
55) To avoid a stalled deal, a buyer should:
A) take a hard line and never give an inch.
B) understand that they may not be able to get what they really want.
C) go into the negotiation with a list of objectives ranked in order of priority.
D) be firm, focused, and unbending.
56) The process of investigating the details of a company that is for sale to determine the
strengths, weaknesses, opportunities and threats facing it is known as the:
A) hidden market process.
B) due diligence process.
C) skimming process.
D) business assessment process.
57) The due diligence process in analyzing and evaluating an existing business can be just as
time consuming as the development of a comprehensive business plan for a start-up.
58) With an existing business, the new owner can depend on employees to help him make money
while he is learning the business.
59) For a new owner of an existing business, physical facilities and equipment costs are very
similar to what would have been spent on a startup with all new facilities and equipment.
60) When buying a business, an entrepreneur can usually purchase equipment and fixtures at
prices well below their book value.
61) A principal advantage of buying an existing business is the purchaser’s ability to rely on the
previous owner’s experience.
62) An entrepreneur should never purchase a business that is losing money.
63) A new owner of an existing business can generally introduce change and innovation almost
as easily as if the company were a new business because employees and customers expect
change in business practice when there is a change in ownership.
64) Accounts receivable are rarely worth face value and should be “aged” when evaluating a
company’s assets.
65) The reason an entrepreneur should conduct a self-audit of his or her skills, abilities, and
interests is to help focus on those businesses that will best “fit.”
66) The business acquisition process should begin with the search for potential companies to
acquire.
67) The hidden market of companies -those companies that might be for sale and are not
advertised-is one of the richest sources of top quality businesses to purchase.
68) Financing the purchase of an existing business usually is easier than financing the startup of
a new one.
69) When evaluating a business as a potential candidate for purchase, an entrepreneur should
determine the real reason the current owner wants to sell.
70) The most common reasons that owners of small businesses give for selling are the intensity
of competition and an inability to raise sufficient cash to continue to grow.
71) Before purchasing an existing business, an entrepreneur should analyze both its existing and
its potential customers.
72) If a business has a lien against any of its assets at the time of the sale, the buyer must assume
them and is financially responsible for them.
73) A creditor’s claim against an asset is referred to as lien.
74) A prospective buyer should have an attorney thoroughly investigate all of the assets for sale
in a business and their lien status before buying any business.
75) One way for a business buyer to avoid being surprised by liens against the assets purchased
is to include a clause in the sales contract stating that any liability not shown on the balance sheet
at the time of the sale remains the responsibility of the seller.
76) A due-on-sale clause is a loan contract provision that prohibits a seller from assigning a loan
arrangement to the buyer and instead, the buyer is required to finance the remaining loan balance
at prevailing interest rates .
77) When a buyer purchases an existing business, she may “inherit” liability for damages and
injuries caused by products the company has manufactured or sold in the past.
78) A due-on-sale clause allows an entrepreneur buying a business to “assume” the seller’s loan
(usually at a lower interest rate).
79) A due-on-sale clause requires a buyer to pay the full amount of the remaining balance on a
loan or to finance the balance at prevailing interest rates.
80) A due-on-sale clause in a loan contract prohibits the buyer of a business from assuming a
seller’s loan even though it may carry a lower interest rate.
81) If the corporation, rather than the business seller, signs a restrictive covenant, the seller may
not be bound by its terms.
82) A restrictive covenant prohibits the seller of an existing business from opening a competitive
business within a specific time period and geographic area of the existing one.