Business Valuation

Joel N. Morse, Ph.D.

Financial Economist

November 6, 2010

Mr. xxx xxx xxx Washington, DC 20036

Dear Mr. xxxxx:

RE: Valuation of The Legacy Hotel and Meeting Center (hereafter referred to as Legacy), a hotel owned by Congressional Hotel Corporation (hereafter referred to as CHC), Debtor-in-Possession//

BACKGROUND

You have asked me to estimate the value of The Legacy Hotel and Meeting Center in the context of a bankruptcy proceeding (U.S. District Court for the District of Maryland (Greenbelt Division), Case No. 09-17901-PM, Chapter 11. This letter, and the attachments below, is my response to your request.

I am a tenured full professor of finance at the University of Baltimore, which is a unit of the University System of Maryland. The opinions expressed here are my own only, and do not represent my employer in any way.

I have done this type of analysis a number of times in the past. This present report uses the same methodology that I have used in my prior work, for both Plaintiff and for Defense. My methodology is consistent with the principles of business valuation that I teach in the MBA Program at the Merrick School of Business, University of Baltimore. The University of Baltimore is fully accredited by AACSB and by the Middle States Association on Higher Education. These principles arise from the received literature in financial economics. As such, they are consistent with, and indeed form the intellectual origins of the standards known as USPAP (Uniform Standards of Professional Appraisal Practice. In particular, my report that follows is consistent with, in my opinion, the business valuation Standards 9 and 10 of USPAP.

I have reviewed following information:

1. Exhibit 2 To Disclosure Statement, Document 127-2, Filed 10/02/09 (2 pages)

2. Exhibit 2 to Amended Disclosure Statement, Document 152-2, filed 01/08/10 (2 pages)

3. Second Amended Disclosure Statement, Document 193, Filed 07/01/10

4. Voluntary Petition for Bankruptcy, Document 1, Filed 05/03/09 (20 pages)

5. Expedited Application for Order Authorizing Debtor's Counsel to retain TS Worldwide

6. Deed and Assessment of Landlord's Interest in Ground Lease

Debtor's Amended Plan of reorganization

7. MDC's Objection to Debtor's Disclosure Statement

8. Legacy-Rockville, financials ending October, 2009 and YTD FY 2009

9. Self-contained Appraisal Report--Worldwide

10. Monthly Operating reports, May,2009-May,2010

11. Liquidation Analysis, filed 08/04/10

12. Debtor's Third Amended (Redlined) Plan of Reorganization

Citizens' Bank-Terms and Conditions

13. Various documents of lesser importance (to me) concerning construction loans, ground lease and assignment of ground lease

14. Various industry publications, resulting in a separate background piece (provided below)

15. Data on peer groups or comparables (publicly traded) companies from Morningstar-Ibbotson Associates, Inc. 2010 Cost of Capital Yearbook; Audit Analytics, Inc.; and Morningstar Direct (an institutional portfolio manager software application)

16. Congressional Hotel's Answers to First ATI's, including a new set, in fact the fourth set, of financial forecasts, filed 11/01/10

Of all the materials reviewed, the first three, as well as Items 15 and 16, were the most important. In my analysis below, I will refer to four documents (Items 1,2, 3 and 16) as Financial Projections 1,2,3 and 4. I consider the components of item 15 as my Valuation Metrics.

SUMMARY OF MY EVALUATION

In Table 1 below, I summarize my work:

Using the original data from all four filings, the valuation approach called capitalization of earnings (also known as discounted cash flow analysis, or DCF) shows a range, over the four filings (dates appear in my table) of $1,089,237-$1,724,508.

Correcting what I believe is an error in the original data from all four filings, the capitalization of earnings shows a range, over the four filings (dates appear in my table) of $3,119,231--$4,156,467.

In business valuation, which I view as a subset, or sub-discipline within my field of financial economics, it is customary to prepare valuations with alternative methodologies, to serve as a robustness check. Thus, again using the original and the corrected data, and applying a price/earnings multiple method as well as a price/sales methodology, I obtain a range of $610,500-$7,352,691.

Of the three methods, I feel that the capitalization of earnings method is most accurate and useful in the instant context.

MY GENERAL METHODOLOGY FOR VALUING PRIVATE COMPANIES

(note-this general set of comments is usually only applied in part for my actual valuation assignments, due to variation in the factual predicate of various cases)

The value of a company depends on so many different aspects that it is hard to specify, as a general theory, a particular method of valuation. However, one can state that a vital role is often assigned to key considerations such as:

Information on company, competitors and industry: How is the business performing in absolute terms and relative to competitors? In which state is the industry – growth or decline?

Analysis of historical financial statements: What do the financial ratios reveal? Are there any irregularities? How was the growth pattern over the last several years?

Future business prospects and scenarios: How does the future look?

Purpose: Use a valuation technique that is appropriate for the purpose of the appraisal, or use several techniques and weight them.

Similarly, IRS Revenue Ruling 59-60 specifies several factors which should be included in the valuation of a closely-held business:

The background and the history of the business since its foundation;

the economic outlook in general and the industry’s

situation in particular; the company’s book value and the financial condition;

the earnings capacity of the company; the dividend-paying capacity, if any;

whether the enterprise has goodwill or other intangible assets;

the reason for the sale of the stocks and the size of the block to be valued;

the market price of comparably, publicly traded companies.

Certain definitions are commonly used in valuation:

Fair market value is the cash or cash-equivalent price at which an asset would change hands between a willing buyer and a willing seller, both having the means to complete the transaction and neither acting under duress. The job of the valuation professional in most situations is to estimate fair market value. Next, I outline several approaches to completing this task.

Net asset value

The first of three popular methods of valuation is the “balance sheet approach”. It is one of the quickest and straightforward ways to appraise a business, though it often produces the lowest value compared to the two following methods, because for most firms, assets are stated net of accumulated depreciation.

A company's book value is attained by simply subtracting the firm's total liabilities from its total assets. Some appraisers believe that adjusting assets and liabilities to their fair market value leads to a more accurate valuation. This variation is called "adjusted book value" formula.

The net asset value approach is often utilized as verification, rather than as a primary approach to valuing a business. It is very useful to value companies for which replacement costs or liquidation value can easily be estimated.

The net asset value method represents only a snapshot at one point in time and disregards the company’s financial history, future, and qualitative analysis of its ability to generate sustainable earnings. It is especially inappropriate for companies whose value is strongly determined by intangibles such as good will, branding, management expertise, and market share, which are not evaluated in traditional balance sheets. Finally, the method's lack of sophistication ignores so many valuation factors that book value may be considered as part of a business appraisal but is normally given little weight.

Discounted cash flow model (DCF)

The value of a firm is the present value of expected cash flows generated by its assets, discounted back to "time zero" at a cost of capital that reflects the costs of financing the assets. The idea is that the current value of a company can be derived by looking at its ability to generate future returns to investors' capital, makes the discounted cash flow (DCF) model one of the most widely used valuation approaches. The following figure offers a sense of the DCF process.

(the remainder of page blank to allow proper formatting of the figure that follows)

1

2

3

Figure 1: Discounted Cash Flow Valuation (courtesy of Aswath Damodaran, New York University)

Market comparables (also known as guideline companies)

The last method of valuation to be detailed in this paper is the “market comparables approach”. In this case, private companies are compared to similar public companies and their market values. For example, if a comparable public company’s stock price trades at 15 times its current earnings, then the same ratio might be applicable to determine the value of the private company. However, private companies are usually valued at a significant discount for the lack of marketability or possibly minority interests.

The search for a group of comparable companies, a so called “peer group”, should consider non-financial factors, such as companies with similar products, acting in the same markets or industries; and financial factors, i.e. companies with a similar size in revenues, EBITDA, cash flows, and financial ratios.

While the number of firms suitable to be included in the peer group may be limited, there are many different ratios that can be drawn for them for valuation purposes. Generally, these ratios can be grouped into the categories of liquidity ratios, leverage ratios, activity ratios, and profitability ratios. They include:

Earnings multiples (Price/Earnings, Price/EBIT, Price/EBITDA);

Revenue multiples (Price/sales ratio); and

Book value multiples (Price/Book ratio).

Earnings multiples are probably the most commonly used ratios, while revenue multiples provide a much more useful way of valuation especially for companies with negative earnings. On the other side, book value multiples have to be applied very carefully when it comes to valuing service or technology businesses.

From this we can draw the conclusion that the advantages of using a market comparables approach lies in its versatility: It can be used not only for private companies, but also for companies with negative earnings or companies without an extended business history. Additionally, peer group calculations are relatively easy to complete and can be updated quickly.

However, there are some problems associated with comparables:

The general difficulty in finding suitable comparables;

The changes in the price of publicly traded stock, which expose private companies to market fluctuations; and

The lack of real data on buys and sells for comparables that are not publicly listed.

The market comparables approach is very useful in valuing companies. In fact, this method is pervasive in valuation practice.

PEER GROUPS FOR ESTABLISHING VALUATION METRICS FOR THE LEGACY HOTEL AND MEETING CENTER

 To estimate market-appropriate valuation metrics, I initially created two peer groups, or guideline companies[footnoteRef:1]. The first was obtained from Audit Analytics, Inc., a widely used and well-respected database used by financial analysts, auditors and accounting researchers. The second was obtained from Morningstar, Inc. Morningstar, which is now merged with Ibbottson Associates, is the world's leading source of historical asset class rate of return information. Via a component of the Morningstar service, Morningstar Direct, a highly vetted, standardized and verified corporate information database, I created a database of comparables from the hotel industry. [1: In practice, the term comparables is also used.]

My use of these two peer groups was qualitative, not quantitative. I used both peer groups to familiarize myself with the names of companies in this space, and to guide myself to their websites and possibly industry news sources. I also used these as guides to look further into the financial data of each company, to obtain a sense of growth rates, profit margins, REVPAR (a key metric, "revenue per available room"), and to help me understand quotes from industry people that I ran into when I did the research for my background piece (APPENDIX A).

I also relied on a third peer group. Again relying on the highly regarded Morningstar, I chose the highly processed and standardized data on SIC codes (a system of industry codes) from Morningstar's Ibbotson Cost of Capital 2010 Yearbook (updated data was obtained directly from Morningstar, dated June 30,2010. The SIC code for hotels and motels is 7011.

SIC code 7011 consists of 14 companies. The largest company in the group is Marriott International, and the smallest is Full House Resorts, Inc.

VALUATION OF LEGACY

Note that I have conducted industry studies, and performed lost profit calculations on a number of occasions. Recently, for example, in the matter of Mervis Diamond Corporation v Congressional Hotel Corporation (Circuit Court for Montgomery, Maryland; Case No. 259919-V), Judge Rubin’s decision noted that my lost profits analysis was one of the most cogently presented he had ever observed. An analysis of profits is, naturally, a key step in business valuation. However, in this case, I was asked to rely on the filings of CHC in this bankruptcy matter.

I performed an analysis in this case based on three methods: capitalization of earnings or discounted cash flow methodology (DCF), price/earnings multiples, and price/sales multiples.

I reduced the value of these results by 35%, to recognize that there is a lack of marketability and liquidity of the entity (Legacy) that I am valuing. This discount, or “haircut” as it is known in the valuation literature, is a standard step in the valuation of private equity[footnoteRef:2]. I have not separately valued the implications of majority or minority positions, but if asked, I may comment on this topic. [2: The "haircut" is standard, although there are some differences of opinion on the amount.]

These results are shown in the summary at the top of this report. A six page set of tables appears in this report, just after the narrative. it contains detailed labeled calculations that resulted from my work.

I have conducted my valuation of Legacy using the following metrics from Morningstar:

Price/earnings multiple=11.04, further adjusted downward due to Legacy's small size with respect to the guideline, or comparable companies.

Price/sales multiple=1.48

Discounted cash flow analysis[footnoteRef:3] (DCF) rate used=17% [3: In my discounted cash flow analyses, "DCF" in Table 1 above, I have assumed that after 2015, income will grow at 5.00% in nominal terms, for 25 years. Unlike Worldwide, I have not assumed a terminal, or cash-out value. If one adds 25 years to 2010,2011,2012,2013,2014 and 2015 (six years),the total is 31 years. This well within the "remaining life" estimate of 36 years provided by Worldwide on page 11-21, Figure 11-6. Further, since the expenses of bankruptcy that were introduced as of the 7/1/10 filing are not likely to be relevant to the income of the post-bankruptcy Legacy Hotel, for 7/1/10 and 11/10. I replaced the original figures with the $313,751 from the 1/8/10 filing. In addition, so that all filings have the same set of years estimated, I inserted the 2014 net income figures into 2015. I assumed no growth, even though the basic series from CHC do exhibit healthy growth.]

In my opinion, these are the premier sources of relative valuation available. Historically, they arose from the pioneering first-in-class and best-of-breed studies of asset class returns conducted by professor Roger Ibbotson of Yale University several decades ago.

I used the subset of this data for the smallest composite, since Legacy is small.

Above, I refer to a correction that I made to the original filed data. These four filings have a line item called either "New $13 million (sic) loan: Principal/Interest" on the 10/2/09 filing, and "Bank loan Prin/Interest over 25 years" on the three subsequent filings. However, it is not appropriate to include repayment of principal as a cost in an income statement. rather, this component of debt service is usually placed on the balance sheet[footnoteRef:4], where as principal is repaid, indebtedness decreases. [4: No balance sheet was provide in the filings.]

To isolate interest from principal for a proper income statement, I conducted a series of calculations which are detailed, but standard in my field. The result was that in my opinion, $451,253 was added to income for the first two filings, and $593,462 was added to income for the last two filings. Naturally, this increased my valuation estimates. I have provided valuations based on both the original, unadjusted filings, as well as on the adjusted filings. Note that for conservatism, I made no such adjustment on the years in the filings. Only when looking forward to discount future earnings did I utilize my adjustments just described.

I make special note of the discount rate that I used, 17%. It is worth noting because although it is derived from Morningstar as applicable to small hotels, it is also precisely the equity rate of discount recommended, and indeed used by Worldwide, CHC's consultant, in the "Self-contained Appraisal Report." It is further worth noting that Worldwide, in that report, has already opined on the going-concern value of Legacy. The report's terminology is slightly different from mine. The term used is "Value of Equity Component." This appears on page 9-40. Worldwide's value is $4,974,000. In my opinion, this analysis is equivalent to the work I have conducted herein. In other words, this estimate from Worldwide appears to be an arms-length, going concern value.

Worldwide's report did not overtly discuss an adjustment, as I did, for bifurcating principal and interest, in the context of assessing the value of the equity component. However, they did make an assumption of debt service costs in the course of their earnings estimates which appear in several parts of their report (for example, on page 9-40). On page 9-40, debt service is assumed to be $893,000 per year. From page 9-35, we know that Worldwide is assuming a debt-to-loan ratio of 65%, and an assumed interest rate of 8.5%.

If, after the bankruptcy is discharged, the hotel were to be financed exactly as CHC's four filings assume, then the figures on the first panel (ORIGINAL DATA) of my TABLE 1 are relevant. If I am correct in asserting that CHC erroneously includes repayment of principle as a charge against earnings, then the figures in my next panel of TABLE 1 are relevant (MY MODIFICATION OF LOAN (PRIN/INTEREST). However, if the hotel emerges financed entirely by equity, then debt service costs would be zero.

In that case, if I assume that all CHC's revenue and costs estimates remain unchanged except for debt service, then the Legacy Hotel values that arise from a capitalization of earnings approach rise significantly, at least doubling. This statement is based on earnings figures provided by CHC, and simply adding back in all debt service costs as provided by CHC in the filings. The resulting income figures are not dissimilar from what Worldwide offers[footnoteRef:5] in its discussion of direct capitalization costs on page 9-45. [5: Figure 9-35 estimates "2013/2014 Stabilized net Income" at $1,761,000 per year.]

A final note is appropriate on the subject of taxes. Neither I, nor Worldwide nor the filings referred to income taxes, although all incorporate, or recognize property and franchise taxes. Taxes will not immediately be relevant, as it appears that Legacy may have some tax-loss carry-forwards. In addition, the current high level of indebtedness provides a significant tax deduction for interest paid on the current loan of $14,000,000.[footnoteRef:6] The tax rate may also depend on whether Legacy is consolidated or not into the tax computations/financial statements of a prospective owner, in turn whose tax bracket may be difficult to ascertain at this time. The effect of taxes would be to lower valuations. [6: The filed income estimates refer to this as $13 million, but I believe that the debtor's Third Amended plan states the larger figure. ]

CLOSING REMARKS

In the future, if facts or documents are provided to me for comment and analysis, I may amend my report.

I am ready to answer further questions, if asked.

Sincerely,

Joel N. Morse

Seven detailed calculations pages

EXHIBIT A-Hotel industry background

Four filings--Income Statements 10/2/09, 1/8/2010, 7/1/10 and 11/1/10 from CHC.

SIC code 7011 Sheet from Morningstar

My CV

REFERENCE LIST FOR BUSINESS VALUATION

Zukin, James H. (1990) Financial Valuation, Maxwell Macmillan Publishing Company.

Pratt, Shannon. (1989) Valuing a Business, Business One, Irwin.

Damodaran, Professor A., professorial home page at New York University.

Dickie, Robert B. (2006) Financial Statement Analysis, Second Edition, American Bar Association.

END OF DOCUMENT

230 Stony Run Lane, #2F • Baltimore, MD 21210

410-235-8094 • 410-235-6884 FAX

[email protected]

https://sites.google.com/site/jnmorsepages/home