SOTE TWAWEZA (Business Valuation)

98
CONCEPTUAL FRAMEWORK OF VALUATION The term 'valuation' implies the task of estimating the worth/value of an asset, a security or a business. The price an investor or a firm (buyer) is willing to pay to purchase a specific asset/ security would be related to this value. Obviously, two different buyers may not have the same valuation for an asset/business as their perception regarding its worth/value may vary; one may perceive the asset/business to be of higher worth (for whatever reason) and hence may be willing to pay a higher price than the other. A seller would consider the negotiated selling price of the asset/business to be greater than the value of the asset/business he is selling. Evidently, there are unavoidable subjective considerations involved in the task and process of valuation. Inter-se, the task of business valuation is more awesome than that of an asset or an individual security. In the case of business valuation, the valuation

description

Solutions to question 1 and 2 of the Business Valuation:Qn 1 (pg 18, 19, 20)Qn 2 (pg 27, 28, 33,)

Transcript of SOTE TWAWEZA (Business Valuation)

Page 1: SOTE TWAWEZA (Business Valuation)

CONCEPTUAL FRAMEWORK OF VALUATION

The term 'valuation' implies the task of estimating the

worth/value of an asset, a security or a business. The

price an investor or a firm (buyer) is willing to pay to

purchase a specific asset/ security would be related to

this value. Obviously, two different buyers may not

have the same valuation for an asset/business as their

perception regarding its worth/value may vary; one may

perceive the asset/business to be of higher worth (for

whatever reason) and hence may be willing to pay a

higher price than the other. A seller would consider the

negotiated selling price of the asset/business to be

greater than the value of the asset/business he is selling.

Evidently, there are unavoidable subjective

considerations involved in the task and process of

valuation. Inter-se, the task of business valuation is

more awesome than that of an asset or an individual

security. In the case of business valuation, the valuation

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is required not only of tangible assets (such as plant and

machinery, land and buildings, office equipments, and

so on) but also of intangible assets (like, goodwill,

brands, patents, trademark and so on) as well as human

resources that run/manage the business. Likewise, there

is an imperative need to take into consideration

recorded liabilities as well as unrecorded/contingent

liabilities so that the buyer is aware of the total sums

payable, subsequent to the purchase of business. Thus,

the valuation process is affected by, subjective

considerations. In order to reduce the element of

subjectivity, to a marked extent, and help the finance

manager to carry out a more credible valuation exercise

in an objective manner, the following concepts of value

are explained in this Section: (i) book value, (ii) market

value, (iii) intrinsic value, (iv) liquidation value, (v)

replacement value, (vi) salvage value, (vii) value of

goodwill and (viii) fair value.

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Book Value

The book value of an asset refers to the amount at

which an asset is shown in the balance sheet of a firm.

Generally, the sum is equal to the initial acquisition cost

of an asset less accumulated depreciation. Accordingly,

this mode of valuation of assets is as per the going

concern principle of accounting. In other words, book

value of an asset shown in balance does not reflect its

current sale value.

Book value of a business refers to total book value of

all valuable assets (excluding fictitious assets, such as

accumulated losses and deferred revenue expenditures,

like advertisement, preliminary expenses, cost of issue

of securities not written off) less all external liabilities

(including preference share capital). It is also referred to

as net worth.

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Market Value

In contrast to book value, market value refers to the

price at which an asset can be sold in the market. The

market value can be applied with respect to tangible

assets only; intangible assets (in isolation), more often

than not, do not have any sale value. Market value of a

business refers to the aggregate market value (as per

stock market quotation) of all equity shares

"outstanding. The market value is relevant to listed

companies only.

Intrinsic/Economic Value

The intrinsic value of an asset is equal to the present

value of incremental future cash inflows likely to accrue

due to the acquisition of the asset, discounted at the

appropriate required rate of return (applicable to the

specific asset intended to be purchased). It represents

the maximum price the buyer would be willing to pay

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for such an asset. The principle of valuation based on

the dis-counted cash flow approach (economic value) is

used in capital budgeting decisions.

In the case of business intended to be purchased, its

valuation is equivalent to the present value of

incremental future cash inflows after taxes, likely to.

accrue to the acquiring firm, discounted at the relevant

risk adjusted discount rate, as applicable to the acquired

business. The economic value indicates the maximum

price at which the business can be acquired.

Liquidation Value

As the name suggests, liquidation value represents the

price at which each individual asset can be sold if

business operations are discontinued in the wake of

liquidation of the firm. In operational terms, the

liquidation value of a business is equal to the sum of (i)

realisable value of assets and (ii) cash and bank

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balances minus the payments required to discharge all

external liabilities. In general, among all measures of

value, the liquidation value of an asset/or business is

likely to be the least.

Replacement Value

The replacement value is the cost of acquiring a new

asset of equal utility and usefulness. It is normally

useful in valuing tangible assets such as office

equipment and furniture and fixtures, which do not

contribute towards the revenue of the business firm.

Salvage Value

Salvage value represents realisable/scrap value on the

disposal of assets after the expiry of their economic

useful life. It may be employed to value assets such as

plant and machinery. Salvage value should be

considered net of removal costs.

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Value of Goodwill

The valuation of goodwill is conceptually the most

difficult. A business firm can be said to have 'real'

goodwill in case it earns a rate of return (ROR) on

invested funds higher than the ROR earned by similar

firms (with the same level of risk). In operational terms,

goodwill results when the firm earns excess ('super')

profits. Defined in this way, the value of goodwill is

equivalent to the present value of super profits (likely to

accrue, say for 'n' number of years in future), the

discount rate being the required rate of return applicable

to such business firms.

The value of goodwill in terms of the present value of

super profits method can serve as a useful benchmark in

terms of the amount of .goodwill the firm would be

willing to pay for the acquired business. In the case of

mergers and acquisition decisions, the value of goodwill

paid is equal to the net difference between the purchase

price paid for the acquired business and the value of

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assets acquired net of liabilities the acquiring firm has

undertaken to pay for.

Fair Value

The concept of 'fair' value draws heavily on the value

concepts discussed above, in particular, book value,

intrinsic value and market value. The fair value is

hybrid in nature and often is the average of these three

values. In India, the concept of fair value has evolved

from case laws (and hence is more statutory in nature)

and is applicable to certain specific transactions, like

payment to minority shareholders.

It may be noted that most of the concepts related to

value are 'stock' based in that they are guided by the

worth of assets at a point of time and not the likely

contribution they can make towards earnings/cash flows

of the business in the future. Ideally, business valuation

should be related to the cash flow generating ability of

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acquired business. The intrinsic value reflects the firm's

capacity to generate cash flows over the long-run and,

hence, seems to be more aptly suited for business

valuation.

In fact, in general, business firms are not acquired with

the intent to sell their assets in the post-acquisition

period. They are to be deployed primarily for generating

more earnings. However, from the conservative point of

view, it will be useful to know the realisable value,

market value, liquidation value and other values, if the

acquiring firm has to resort to liquidation. In brief, the

finance manager will find it useful to know business

valuation from different perspectives. For instance, the

book value may be very relevant form accounting/tax

purposes; the market value may be useful in

determining share exchange ratio and liquidation value

may provide an insight into the maximum loss, if the

business is to be wound up.

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APPROACHES/METHODS OF VALUATION

The various approaches to valuation of business with

focus on equity share valuation are examined in this

Section. These approaches should not be considered as

competing alternatives to the dividend valuation model.

Instead, they should be viewed as providing a range of

values, catering to varied needs, depending on the

circumstances. The major approaches, namely, the (i)

asset based approach to valuation, (ii) earnings based

approach to valuation, (iii) market value based approach

to valuation and (iv) the fair value method to valuation

are described below.

Asset-Based Approach to Valuation

Asset-based approach focuses on determining the value

of net assets from the perspective of equity share

valuation. What should the basis of assets valuation be,

is the central issue of this approach. It should be

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determined whether the assets should be valued at book,

market, replacement or liquidation value. More often

than not, they are (and should be) valued at book value

that is, original acquisition cost minus accumulated

depreciation, as assets are normally acquired with the

intent to be used in business and not for resale. Thus,

the valuation of assets is based on the going concern

concept. Some other value measure may be used

depending on circumstances of the case. For instance, if

the plant and machinery has outlived its economic

useful life (earlier than its initial estimated period), and

is not in use for production, it will be in order to value

the machinery at liquidation value.

Apart from tangible assets, intangible assets, such as

goodwill, patents, trademark, brands, know how, and so

on, also need to be valued satisfactorily. It may be

useful to adopt the super profit method to value some of

these assets.

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To arrive at the net assets value, total external liabilities

(including preference share capital) payable are

deducted from total assets (excluding fictitious assets).

The company's net assets are computed as per Equation

Net assets = Total assets - Total external liabilities

The value of net assets is also known as net worth or

equity/ordinary shareholders funds. Assuming the figure

of net assets to be positive, it implies the value available

to equity shareholders after the payment of all external

liabilities. Net assets per share can be obtained, dividing

net assets by the number of equity shares issued and

outstanding. Thus,

Net assets per share = Net assets/Number of equity

shares issued and outstanding

The value of net assets is contingent upon the measure

of value adopted for the purpose of valuation of assets

and liabilities. In the case of book value, assets and

liabilities are taken at their balance sheet values. In the

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market value measure, assets shown in the balance

sheet are revalued at the current market prices. For the

purpose of valuing assets, and liabilities, it will be

useful for a finance manager/valuer to accord special

attention to the following points:

(i) While valuing tangible assets, such as plant and

machinery, he should consider aspects related to

technological obsolescence and capital improvements

made in the recent years. Depreciation adjustment may

also be needed in case the company is following

unsound depreciation policy in this regard.

(ii) Is the valuation of goodwill satisfactory, given the

amount of profits, capital employed and average rate of

return available on such businesses?

(iii) With respect to current assets, are additional

provisions required for "unrealisability" of debtors?

Likewise, are adjustments required for "unsaleable"

stores and stock?

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(iv) With respect to liabilities, there is a need for careful

examination of 'contingent liabilities', in particular

when there is mention of them in the auditor's report,

with a view to assess what portion of such liabilities

may fructify. Similarly, adjustments may be required on

account of guarantees invoked, income tax, sales tax

and other tax liabilities that may arise.

The net assets valuation based on book value is in

tune with the going concern principle of. accounting. In

contrast, liquidation value measure is guided by the

realisable value available on the winding up/liquidation

of a corporate firm.

Liquidation value is the final net asset value (if

any) per share available to the equity shareholder. The

value is given as per Equation.

Net assets per share = (Liquidation value of assets -

Liquidation expenses - Total external

liabilities)/Number of equity shares issued and

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outstanding.

In the case of liquidation, assets are likely to be sold

through an auction. In general, they are likely to realise

much less than their market values. This apart, sale

proceeds from assets are further dependent on whether

the company has been forced to go into liquidation or

has voluntarily liquidated. In the case of the 'former'

type of liquidation, the realisable value is likely to be

still lower.

The net asset value (NAV) per share will be the lowest

under the liquidation value measure (Example).

(Example Following is the balance sheet of

Hypothetical Company Limited as on March 31, current

year:

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(Rs lakh)

Liabilities Amount Assets Amo

unt

Share capital Fixed

assets

Rs

150

40,000 11%

Preference shares of

Rs 100 each, fully

paid-up

40 Less:

Depreciati

on

30 120

1,20,000 Equity shares

of Rs 100 each, fully

paid-up

120 Current

assets:

Profit and loss account 23 Stocks 100

10% Debentures 20 Debtors 50

Trade creditors 71 Cash and

bank

10 160

Provision for income

tax

8 Preliminar

y

expenses

2

282 282

Additional Information:

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(i) A firm of professional valuers has provided the

following market estimates of its various assets: fixed

assets Rs 130 lakh, stocks Rs 102 lakh, debtors Rs 45

lakh. All other assets are to be taken at their balance

sheet values.

(ii) The company is yet to declare and pay dividend on

preference shares.

(iii) The valuers also estimate the current sale proceeds

of the firm's assets, in the event of its liquidation: fixed

assets Rs 105 lakh, stock Rs 90 lakh, debtors Rs 40

lakh. Besides, the firm is to incur Rs 15 lakh as

liquidation costs.

You are required to compute the net asset value per

share as per book value, market value and liquidation

value bases.

Solution

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Determination of Net Asset Value per Share

(Rs. Lakh)

(i) Book value basis Rs.

120

Fixed assets (net)

Current assets:

Stock 100

Debtors 50

Cash and Bank 10 160

Total assets 280

Less : External liabilities:

10% Debentures 20

Trade Creditors 71

Provision for taxation 8

11% Preference Share capital 40

Dividend on preference shares (0.11 x

Rs. 40 Lakh)

4.4 143.4

Net assets available for equityholders 136.6

Divided by the number of equity

shares (in lakh)

1.2

Net assets value per share (Rs.) 113.83

(ii) Market value basis

Fixed assets (net) 130

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Current assets:

Stock 102

Debtors 45

Cash and Bank 10 157

Total assets 287

Less: External liabilities (as per

details given above)

143.4

Net assets available for equityholders 143.6

Divided by the number of equity

shares (in lakh)

1.2

Net assets value per equity share (Rs.) 119.67

(iii) Liquidation value basis

Fixed assets (net) 105

Current Assets:

Stock 90

Debtors 40

Cash and Bank 10 140

Total assets 245

Less : external liabilities (listed

above);

143.4

Less : Liquidation costs 15.0

Net assets available for equityholders 86.6

Divided by the number of equity 1.2

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shares (in lakh)

Net assets value per equity share (in

Rs.)

72.17

The asset based approach is intuitively appealing in that

it indicates the net assets backing per equity share.

However, the approach ignores the future earnings/cash

flow generating ability of the company's assets. In fact,

the assets acquisition by business firms are not an end

in themselves; they are means to an end. The end is

value maximization and firms acquire assets for the

purpose of creating value. The earning based approach

reckons this perspective.

Earnings Based Approach to Valuation

The earnings approach is essentially guided by the

economic proposition that business valuation should be

related to the firm's potential of future earnings or cash

flow generating capacity. This approach overcomes the

limitation of assets-based approach, which ignores the

firm's prospects of future earnings and ability to

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generate cash in business valuation. Earnings can be

expressed in the sense of accounting as well as financial

management. Accordingly, there are two major variants

of this approach: (i) earnings measure on accounting

basis and (ii) earnings measure on cash flow (financial

management) basis.

Earnings Measure Based on Accounting—

Capitalisation Method As per this method, the earnings

approach of business valuation is based on two major

parameters, that is, the earnings of the firm and the

capatilisation rate applicable to such earnings (given the

level of risk) in the market. Earnings, in the context of

this method, are the normal expected annual profits.

Normally to smoothen out the fluctuations in earnings,

the average of past earnings (say, of the last three to five

years) is computed.

Apart from averaging, there is an explicit need for

making adjustments, to the profits of the past years, in

extraordinary items (which are not likely to occur in the

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future), with a view to arriving at credible future

maintainable profits. The notable examples of

extraordinary/non-recurring items - include profits from

the sale of land, losses due to sale of plant and

machinery, abnormal loss due to major fire, theft or

natural calamities, substantial expenditure incurred on

the voluntury retirement scheme (not to be repeated)

and abnormal results due to strikes and lock-outs of

major competing firm(s). Obviously, their non-

exclusion will cause distortion in determining

sustainable future earnings.

Above all, it will be useful to understand the profile of

the business, focussing on identifying the major growth

and income drivers. Are such drivers likely to continue

in future years? If not, projected profits need to be

discounted. Finally, additional income expected in the

coming years— say, due to launch of a new product—

should also be considered. In brief, the valuer should try

to familiarise himself or herself with all major

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factors/events that had affected the profits of the

business in the past year(s) and are likely to affect them

in the future years too.

Determination of appropriate capitalisation rate is

another major requirement of this approach.

Capitalisation rate, normally expressed in percentages,

refers to the investment sum, that an investor is willing

to make to earn a specified income. For instance, 12.5

per cent capitalisation rate implies that an investor is

prepared to invest Rs 100 to earn an income of Rs 12.5

or an acquiring firm is prepared to invest Rs 100 to buy

the expected profits of Rs 12.5 of another business.

Given the risk return framework of financial decision

making, businesses that exhibit (or are exposed to)

higher business and financial risks obviously warrant a

higher capitalisation factor. Conversely, businesses

carrying a low degree of risk are subject to lower

capitalisation factor. There are a host of factors that

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affect the risk complexion including fluctuation in

sales/earnings, degree of operating leverage, degree of

financial leverage, nature of competition, availability of

substitute products and their prices, pace of change in

technology and the level of governmental regulations.

Thus, there are a number of internal and external factors

associated with a business that can influence the risk

and, hence, the capitalisation factor.

The determination of the capitalisation factor is not an

easy task in practice. A few guidelines/ principles may,

however, be helpful to the valuer in its quantification.

First, the capitalisation factor for a business firm should

be higher than that of a government security (normally

considered riskless). Secondly, the capitalisation factor

should match/hover around the one that is used for

other firms operating in similar type of businesses. In

case the valuer wants to apply different capitalisation

rate, there should be weighty and convincing reasons to

do so. For instance, firms having the potential and

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prospects of achieving abnormal growth rates (for

reasons that are firm specific), vis-a-vis other firms in

the industry, managed by a well known management

team (having a good track record), may have low

capitalisation factor and vice versa.

Having determined the two major inputs, Equation, can

be used to compute the value of business ,VB, (from the

perspective of share owners).

VB = Future maintainable profits / Relevant

capitalisation factor

Example. In the current year, a firm has reported a

profit of Rs 65 lakh, after paying taxes @ 35 per cent.

On close examination, the analyst ascertains that the

current year's income includes: (i) extraordinary income

of Rs 10 lakh and (ii) extraordinary loss of Rs 3 lakh.

Apart from existing operations, which arc-normal in

nature and are likely to continue in the future, the

company expects to launch a new product in the coming

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year.

Revenue and cost estimates in respect of the new

product are as follows: (Rs lakh)

Sales 60

Material Cost 15

Labour Cost (additional) 10

Allocated fixed costs 5

Additional fixed costs 8

From the given information, compute the value of the

business, given that capitalisation rate applicable to

such business in the market is 15 per cent.

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Solution

TABLE 1 Valuation of Business

(Rs lakh)

Profit before tax (Rs. 65 lakh / (1-

0.35)

Rs.

100

Less : Extraordinary income (not

likely to accrue in future)

(10)

Add: extraordinary loss (non-

recurring in nature)

3

Sales Rs. 60

Less: Incremental costs

Material Costs Rs. 15

Labour Costs 10

Fixed costs (additional) 8 33 27

Expected profits before taxes 120

Less: Taxes (0.35) 42

Future maintainable profits after

taxes

78

Relevant capitalization factor 0.15

Value of business (Rs 78 lakh /

0.15)

520

Some useful insights into estimate of capitalisation rate

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can be made by referring to the Price earnings (P/E)

ratio. The reciprocal of the P/E ratio is indicative of the

capitalisation factor employed for the business by the

market. In Example 32.2, the P/E ratio is approximately

6.67 (1/0.15). The product of future maintainable

profits, after taxes, Rs 78 lakh and the P/E multiple of

6.67 times, yield Rs 520 lakh. Given the fact that P/E

ratio is a widely used measure, it is elaborated below.

Price Earnings (P/E) Ratio The P/E ratio (also known as

the P/E multiple) is the method most widely used by

finance managers, investment analysts and equity

shareholders to arrive at the market price of an equity

share. The application of this method primarily requires

the determination of earnings per equity share (EPS).

The EPS is computed as per Equation.

EPS = Net earnings available to equity shareholders

during the period

Number of equity shares outstanding during the period.

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The net earnings/profits are after deducting taxes,

preference dividend, and after adjusting for exceptional

and extraordinary items (related to both incomes and

expenses/losses) and minority interest. Likewise,

appropriate adjustments should be made for new equity

issues or buybacks of equity shares made during the

period to determine the number of equity shares.

The EPS is to be multiplied by the P/E ratio to arrive at

the market price of equity share (MPS).

MPS = EPS x P/E ratio ($2.6)

A high P/E multiple is suggested when the investors are

confident about the company's future

performance/prospects and have high expectations of

future returns; high P/E ratios reflect optimism. On the

contrary, a low P/E multiple is suggested for shares of

firms in which investors have low confidence as well as

expectations of low returns in future years; low P/E

ratios reflect pessimism.

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The P/E ratio may be derived given the MPS and EPS.

P/E ratio = MPS/EPS

The future maintainable earnings/projected future

earnings should also be used to determine UPS. It

makes economic sense in that investors have access to

future earnings only. There is a financial and economic

justification to compute forward or projected P/E ratios

with reference to projected future earnings, apart from

historic P/E ratios. This is all the more true of present

businesses-that operate in a highly turbulent business

environment. Witness in this context, the following: "In

a dynamic business world, a firm's past earnings record

may not be an appropriate guide to its future earnings.

For example, past earnings may have been exceptional

due to a period of rapid growth. This may not be

sustainable in the future.

The P/E ratios should, however, be used with caution as

the published P/E multiples are normally based on the

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published financial statements of corporate enterprises.

Obviously, earnings are not adjusted for extraordinary

items and, therefore, to that extent, may be distorted.

Besides, all financial fundamentals are often ignored in

published data. Finally, they reflect market sentiments,

moods and perceptions. For instance, if investors are

upbeat about retail stocks, the P/E ratios of these stocks

will be higher to reflect this optimism. This can be

viewed as a weakness as well, in particular when

markets make systematic errors in valuing entire sector.

Assuming retail stocks have been overvalued, this error

has to be built into die valuation also.

In spite of these limitations attributed to the P/E ratio, it

is the most widely used measure of valuation.- The

major plausible reasons are: (i) It is intuitively

appealing in that it relates price to earnings, (ii) It is

simple to compute and is conveniently available in

terms of published data. (iii) It can be a proxy for a

number of other characteristics of the. firm, including

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risk and growth.

Example For facts in Example, determine the

market price per equity share (based on future

earnings). Assuming:

(i) The company has 1,00,000 11% Preference shares

of Rs 100 each, fully paid-up.

(ii) The company has 4,00,000 Equity shares of Rs

100 each, fully paid-up.

(iii) P/EE ratio is 8 times.

Solution

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Determination of Market Price of Equity Share

Future maintainable profits after taxes

Less: Preference dividends (1,00,000 x Rs

11)

Earnings available to equity-holders

Divided by number of equity shares

Earnings per share (Rs 67 lakh/4 lakh)

Multiplied by P/E ratio (times)

Market price per share (Rs 16.75 x 8)

Rs.

78,00,000

11,00,000

67,00,000

4,00,000

16.75

8

134

To conclude, the P/E ratios should be used/interpreted

with caution and care. In particular, die investors should

focus on prospective/future P/E ratios, risk and growth

attributes of business and comprehensive company

analysis with a view to have more authentic and

credible valuation.

Earnings Measure on Cash Flow Basis (DCF Approach)

The P/E ratio approach, as a measure of valuation of

equity shareholders wealth, is essentially based on

accounting profits/earnings. Normally, such earnings

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are either of the current year or prospective earnings of

the next year! Tin-single year earnings can be

camouflaged by either recording revenues earlier or by

postponing expenses. Ideally, valuation should be based

on the likely earnings of all the future years. The cash

flow approach is superior to the accounting profit

approach. The discounted cash flow method is also

driven by the firm's cash flow generating ability in

future years.

Discounted cash flow approach is used to evaluate

capital expenditure proposals in terms of their potential

for creating net present value for the firm. The DCF

approach is applied to the entire business, which may

consist of individual capital budgeting projects.

Accordingly, the value of business/firm is equal to the

present value of expected future cash flows (CF) to the

firm, discounted at a rate that reflects the riskiness of

the cash flows (k0). In equation terms:

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To use the DCF approach, accounting earnings (as

shown by the firm's income statement) are to be

converted to cash flow figures as shown in Format 1.

FORMAT Computation of Cash Flows

After tax operating earnings*

Plus: Depreciation

Plus: Other non-cash items (say, amortisation of non-

tangible

asset, such as patents, trade marks, etc and loss on sale

of long-term assets)

* The interest costs are included as a part of the

discount rate (Ko).

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However, analysts/valuers prefer to discount expected

future free cashflows (FCFF) to operating cash flows

(as per Format) for the purpose of firm valuation. The

reason is that firms, in general, are required to make

investments in long-term assets as well as in working

capital to generate/earn future cash flows; hence, the

need for adjusting operating cash flows to free cash

flows.

Format shows computation of operating free cash flows

(OFCF) for the purpose of valuation of a business.

FORMAT 1 Determination of Operating Free Cash

Flows (OFCFF)

After tax operating earnings*

Plus: Depreciation, amortisation and other non-cash

items

Less: Investments in long-term assets

Less: Investments in operating net working capital**

Operating free cash flows (OFCFF)

Page 37: SOTE TWAWEZA (Business Valuation)

*Exclusive of income from (i) marketable securities and

non-operating investments and (ii) extraordinary

incomes or losses.

**Addition is to be made in the event of decrease of net

working capital.

The free cash flow (FCFF) is the legitimate cash flow

for the purpose of business valuation in that it reflects

the cash flows generated by a company's operations for

all the providers (debt and equity) of its 'capital'6. The

FCFF is a more comprehensive term as it includes cash

flows due to after tax non-operating income as well as

adjustments for non-operating assets. Format 3 exhibits

the procedure of determining FCFF.

FORMAT 2 Determination of Free Cash Flows (FCFF)

Operating free cash flows (as per Format 2)

Plus: After tax non-operating income/cash flows

Plus: Decrease (minus increase) in non-operating

Page 38: SOTE TWAWEZA (Business Valuation)

Assets, say marketable securities

Free cash flows to Firm (FCFF)

*Non-operating income (1 - tax rate)

Since the FCFFs are available to all the capital

providers of a corporate enterprise, the discount rate to

be applied to such cash flows should be indicative of

the opportunity cost of the funds made available by

them, weighted by their relative contribution to the total

capital of a corporate enterprise. The opportunity cost is

equivalent to the rate of return the investors expect to

earn on other investments of equivalent risk. The cost to

the firm equals the investors' cost less any tax benefits

received by the company itself (say, tax advantage on

the payment of interest) plus any tax payments required

to be made (say, dividend payment tax).

The value of the firm is given by Equation

Page 39: SOTE TWAWEZA (Business Valuation)

Thus, the value of a firm is the present value of FCFF

through infinity. The equity valuation can be deduced

by subtracting the total external liabilities (debtholders

and preference shareholders) from the value of the firm.

Alternatively, the value of equity can be obtained,

straight way, by discounting future free cash flows

available to equity-holders, (FCFE), after meeting

interest, preference dividends and principal payments,

the discount rate being rate of return required by equity

investors, that is, cost of equity (ke)

Thus, there are varying connotations of FCFF to serve

different needs. However, while the valuation of a firm

and equity use different definitions of FCFF as well as

of discount rates, they provide identical answers as long

Page 40: SOTE TWAWEZA (Business Valuation)

as the same set of assumptions is used in both the

equations. Example 4 illustrates it.

Example 4 Suppose a firm has employed a total capital

of Rs 1,000 lakh (provided equally by 10 per cent debt

and 5 lakh equity shares of Rs 100 each), its cost of

equity is 14 per cent and it is subject to corporate tax

rate of 40 per cent. The projected free cash flows to all

investors of the firm for 5 years are given in the table:

(Rs. Lakh)

Year-end 1 Rs. 300

2 200

3 500

4 150

5 600

Compute (i) valuation of firm and (ii) valuation from

the perspective of equityholders. Assume 10 percent

debt is rapayable at the year-end 5 and interest is paid at

each year-end.

Page 41: SOTE TWAWEZA (Business Valuation)

Solution

(i) Computation of Overall Cost of Capital

Source of capital After tax

cost (%)

Weights Total

cost (%)

Equity 14 0.5 7

Debt 6* 0.5 3

Weighted average cost

of capital (ko)

10

*10% (1-0.4 tax rate) = 6 percent

(ii) Valuation of Firm, Based on Ko

(Rs. Lakh)

Year-end FCFF PV factor

(0.10)

Total present

value

1 Rs.300 0.909 Rs.272.70

2 200 0.826 165.20

3 500 0.751 375.50

4 150 0.683 102.45

5 600 0.621 372.60

Total present value / Valuation of Firm 1288.45

Less : Value of debt 500.00

Value of Equity 788.45

Page 42: SOTE TWAWEZA (Business Valuation)

(iii) Valuation of Equity, Based on Ke

(Rs. Lakh)

Year-

end

FCFF to

all

investor

s

After

tax

payment

to

debthol

ders

FCFE to

equityh

olders

PV

factor

(0.14)

Total

present

value

1 300 30 270 0.877 236.79

2 200 30 170 0.769 130.73

3 500 30 470 0.675 317.25

4 150 30 120 0.592 71.04

5 600 530 70 0.519 36.33*Interest on Rs 500 lakh @ 10% = Rs 50 lakh; Rs 50

lakh (1 - 0.4) = Rs 30 lakh

**Inclusive of debt repayment of Rs 500 lakh at year-

end 5.

Thus, the valuation of equity by both the methods is

virtually the same (Rs 788.45 lakh and Rs 792.14 lakh).

The minor difference of Rs 3.69 lakh can be attributed

Page 43: SOTE TWAWEZA (Business Valuation)

primarily to rounding-off the present value figures.

Total present value of the projected free cash flows to

equityholder can be used to compute free cash flows per

equity share FCFE as per Equation 11.

FCFE per equity share = PV of FCFE to equityholders

Number of equity shares outstanding

In Example 4, FCFE per equity share is =

Rs 792.14 lakh = Rs 158.428

5 lakh

In Example 4, for the sake of simplicity, we have

assumed the life of the corporate firm as 5 years. In

practice, firms have perpetual long-term

existence/indefinite life. Evidently, the indefinite life of

business/corporate firms, in general, is an additional

aspect to be reckoned in a firm's valuation. Ideally, one

approach is to forecast future FCFF for a very long

Page 44: SOTE TWAWEZA (Business Valuation)

period of time, say 30-40 years and ignore all

subsequent year's FCFF. The reason is the discounted

value of such FCFF in such distant years will be

insignificant. However, there are genuine difficulties in

explicitly forecasting decades of performance. In fact, it

is virtually impossible to make reasonably accurate

forecasts of profits/cash flows beyond a certain period

(say 7—10 years) in most of the businesses.

To overcome the problem Copeland et al suggest that

the exercise related to valuation of business can be

segregated into two periods, during and after an explicit

forecast period. The value of a business/firm is:

Present value of cash flows during explicit forecast

period + Present value of cash flows after explicit

forecast period. (12)

What constitutes an ideal explicit forecast period? This

question is not easy to answer. The following guidelines

may be relevant and useful in selecting such a period.

Page 45: SOTE TWAWEZA (Business Valuation)

Whereas in cyclical businesses, the period can

correspond to one full business cycle, in other

businesses, the period can match with the number of

years during which they are likely to perform well. In

operational terms, the period should not be very short,

say 2—3 years, and given the current turbulent dynamic

business world, the period, in general, should not be

very long also, say 10-15 years.

The explicit forecast period is die period in which the

firm grows at a rapid pace; it is said to be at saturation

point at the end of the explicit forecast period, so far as

growth rate is concerned (the economic premise is that

firms, in general cannot sustain abnormal rates of

growth for an indefinite period). The firm is expected to

have attained a steady rate (at the end of explicit

forecast period) and starts growing at a stable growth

rate, which is likely to continue in future years. The

value determined after the explicit forecast period is

referred to as the continuing value. According to

Page 46: SOTE TWAWEZA (Business Valuation)

Copeland et al the continuing value can be estimated as

per Equation 13-

Continuing value = NOPLATT+1 (1-g/ROICI)

k0 - g

Where NOPLATT+1 = The normalised level of net

operating profits less adjusted taxes in the first year

after the explicit forecast period.

g= The expected growth rate in NOPLAT in perpetuity.

ROICI = The expected rate of return on the net new

investment.

The derivation of the formula as per Equation 13 to

compute continuing value is as follows:

Continuing value = FCFFT+1

k0-g (13.1)

Where FCFFT+1 refers to the normalised level of free

Page 47: SOTE TWAWEZA (Business Valuation)

cash flow in the first year after the explicit forecast

period.

Free cash flows (FCFF) can be defined in terms of

NOPLAT and investment rate, IR (that is, the

percentage of NOPLAT reinvested in the business each

year).

FCFF= NOPLAT (1-IR) (13.2)

We know, growth rate, g is the product of return on

invested capital, ROICI and IR, ie,

g=ROICIxIR (13.3)

or IR=g/ROICI (13.4)

Incorporating value of IR in FCFF definition

FCFF= NOPLAT (l-g/ ROICI) (13.5)

Continuing value = NOPLAT(1-g/ ROICI)

k0-g

Page 48: SOTE TWAWEZA (Business Valuation)

Equation 13 is termed as a value driven formula. Since

Equations 13 and 13.1 provide the same answer of

continuing value, it is logistically more convenient to

compute continuing

value based on Equation 13.1.

The major simplifying assumptions made in

determining continuing value are: (i) the firm earns a

constant return on the existing invested capital; (ii) the

firm's NOPLAT grows at a constant rate and it invests

the same proportion of its gross cash flow in business

each year and (iii) the firm earns a constant return on all

new investments.

All the items in equation 13 are self explanatory, except

the term adjusted taxes. Adjusted taxes is the increase in

the estimated tax liability due to the exclusion of the tax

shield provided by interest charges. This is illustrated in

Example 5.

Page 49: SOTE TWAWEZA (Business Valuation)

Example 5 Following is the summarised income

statement of Hypothetical Ltd:

(Rs lakh)

Sales revenues

Less: Cost of goods sold

Less: Administrative expenses

Less: Selling and distribution expenses

Earnings before interest and taxes

(EBIT)

Less: Interest

Earnings before taxes

Less: Taxes (0.40)

Earnings after taxes

Rs 100

42

8

20

30

10

20

8

12

Solution

Page 50: SOTE TWAWEZA (Business Valuation)

Determination of NOPLAT

(Rs lakh)

Net operating profit or EBIT

Less: Taxes as per income statement

Less: Adjusted taxes (interest, Rs 10

lakh x 0.4, tax rate)

Net operating profit less adjusted taxes*

Alternatively, it can be determined as

EBIT less taxes

EBIT

Less: Taxes (0.40 x Rs 30 lakh, EBIT)

NOPLAT

30

8

4

18

30

12

18

Adjusted taxes = (Taxes as per income statement, Rs 8

lakh + Tax shield on interest, ie, Rs 10 lakh x 0.4 = Rs 4

lakh). The rationale for enhancing tax liability is that

the weighted average cost of capital uses the after tax

cost of debt. Advantage of tax savings on interest

should not be counted twice.

According to Copeland, the finn's value is the aggregate

Page 51: SOTE TWAWEZA (Business Valuation)

of (i) the present value (PV) of FCFF during the explicit

forecast period, (ii) PV of continuing value (of

FCFF/NOPLAT) and (iii) value of non-operating assets

(if any) at the end of explicit forecast period (say,

marketable securities).

Among the various variants of the earnings approach,

the DCF approach (that is, free cash flows) seems to be

conceptually superior for business valuation as well as

equity valuation.. The computation of FCFF and

continuing value is illustrated in Example 6.

Example 6 Sagar Industries deals in production and

sales of consumer durables. Its expected sales revenues

for the next 8 years (in Rs million) are given in the

table:

Years Sales Revenue

Page 52: SOTE TWAWEZA (Business Valuation)

1 Rs. 80

2 100

3 150

4 220

5 300

6 260

7 230

8 200

Its condensed balance sheet as on March 31, current

year is as follows: (Rs million)

Liabilities Amount Assets Amount

Equity Funds 120 Current Assets 30

12% Debt 80 Long-Term Assets

(net)

170

200 200

Additional information:

(i) Its variable expenses will amount to 40 per cent of

sales revenue. Fixed cash operating costs are estimated

to be Rs 16 million per year for the first 4 years and at

Rs 20 million for years 5 - 8. In addition, an extensive

advertisement campaign will be launched, requiring

Page 53: SOTE TWAWEZA (Business Valuation)

annual outlays as follows:

(ii) Long-term assets are subject to 15 per cent rate of

depreciation on diminishing balance method,

(iii) The company has' planned the following capital

expenditure (assumed to have been incurred in the

beginning of each year) for the next 8 years,

(iv) Working capital in terms of investment in current

assets are estimated at 20 per cent of sales revenue,

(v) It is expected to have non-operating assets in terms

of investments in marketable securities in the initial

year. The expected after tax non-operating cash flow in

year 1 = Rs 0.5 million.

(vi) Given the tax benefits available to Sagar, the

effective tax rate estimated is 30 per cent.

(vii)The corporate equity capital is estimated at 16 per

cent.

(viii) The free cash flow of the firm are expected to

grow at 5 per cent per annum, after 8 years. Determine

the discounted cash flow (DCF) value of the (i) firm

and (ii) equity.

Page 54: SOTE TWAWEZA (Business Valuation)

(Rs million)

1 Rs. 5

2-3 15

4-6 30

7-8 10

(Rs million)

Year 1 Rs. 5

2 8

3 20

4 25

5 35

6 25

7 15

8 10

Solution

(i) Determination of Weighted Average Cost

of Capital

Source of

Funds

Cost (%) Weights Total (%)

Equity 16 0.6* 9.60

Page 55: SOTE TWAWEZA (Business Valuation)

12% Debt 8.4 0.4** 3.36

12.96 = 13(Rs 120 million/Rs 200 million); *.* (Rs 80

million/Rs,200 million)

(ii) Determination of Depreciation (Years 1 - 8)

(Rs million)

Year Long-term assets at beginning of year

Additions during the year

Total at the year-end

Depreciation @15%

1 Rs.

170.00

Rs 5 Rs.

175.00

Rs. 26.25

2 148.74 8 156.75 23.51

3 133.24 20 153.24 22.99

4 130.25 25 155.25 23.29

5 131.96 35 166.96 25.04

6 141.92 25 166.92 25.04

7 141.88 15 156.88 23.53

8 133.35 10 143.35 21.50

(iii) Determination of Investment [Capital Expenditure

+ Current Assets, (CA)] Required, Years 1-8

(Rs million)

Page 56: SOTE TWAWEZA (Business Valuation)

Year Investment required Existing

investm

ents in

CA

Additio

nal

investm

ents

required

Capital

expendit

ure

CA

(Sales x

0.2)

Total

1 Rs 5 Rs. 16 Rs. 21 30* Nil

2 8 20 28 25** 3

3 20 30 50 20 30

4 25 44 69 30 39

5 35 60 95 44 51

6 25 52 77 60 17

7 15 46 61 52 9

8 10 40 50 46 4*including marketable securities

**Balance of CA in year 1: Rs 30 million - Capital

expenditure incurred in year 1, Rs 5 million

(iv) Determination of Present Value for Explicit Period

Projections (years 1-8)

(Rs million)

Page 57: SOTE TWAWEZA (Business Valuation)

Particulars Years

1

2 3 4 5 6 7 8

A Sales

revenue

80 100 150 220 300 260 230 200

B Less :

Expenses

Variable

Costs

32 40 60 88 120 104 92 80

Fixed cash

operating

costs

16 16 16 16 20 20 20 20

Advertiseme

nt

5 15 15 30 30 30 10 10

Depreciation 26.25 23.51 22.99 23.29 25.04 25.04 23.53 21.50

C EBIT (A-

B)

0.75 5.49 36.01 62.71 104.9

6

80.96 84.47 68.50

D Less:

Taxes (0.30)

0.22 1.65 10.80 18.81 31.49 24.29 25.34 20.55

E NOPAT 0.53 3.84 25.21 43.90 73.47 56.67 59.13 47.95

F Non-

operating

income

0.50 - - - - - - -

Page 58: SOTE TWAWEZA (Business Valuation)

G Gross

cash flow

(E+F+Depre

ciation)

27.28 27.35 48.20 67.19 98.51 81.71 82.66 69.45

H

Less:Invest

ment in

Capital

expenditure

plus current

assets)

- 3 30 39 51 17 9 4

I Free cash

flow (G-H)

27.28 24.35 18.20 28.19 47.51 64.71 73.66 65.45

J PV Factor

(0.13)

0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376

K Total

PV(IxJ)

24.14 19.07 12.61 17.28 25.80 31.06 31.31 24.61

(v) Determination of PV in Respect of Continuing

Value (CV)

CV8 = FCF9/(k0 - g) = Rs 65.45 million (1.05)/(13% -

Page 59: SOTE TWAWEZA (Business Valuation)

5%) = 68.7225 million/8%

= Rs 68.7225/0.08 = Rs. 859.03 million

PV of CV0 = Rs 859.03 million/(1.13)8 = Rs 859.03 x

0.376 = Rs 323 million

(vi) Total Value of the Firm, Based on the DCF

Approach of Free Cash Flows:

(Rs million)

PV of free cash flows during explicit period Rs. 185.88

PV of free cash flows after explicit period (known as

CV) Rs. 323

Total value Rs. 508.88

(vii)Value of Equity:

Total value of firm Rs. 508.88

Less: Value of debt 80.00

Value of equity 428.88

Market Value Based Approach to Valuation

The market value, as reflected in the stock market

quotations, is another method for estimating the value

Page 60: SOTE TWAWEZA (Business Valuation)

of a business. The market value of securities used for

the purpose can be either (i) twelve months average of

the stock exchange prices or (ii) the average of the high

and low values of securities during a year. Alternatively,

some other fair and equitable method of averaging (on

the basis of the number of months/years) can' be

worked out, The justification of market value as an

approximation of the true worth of a firm is derived

from the fact that market quotations by and huge

indicate the consensus of investors as to the firm's

earning potentials and the corresponding risk. The

market value approach is one of the most widely-used

in determining value, in particular of large listed firms.

The major problem with this method is that the market

value of a firm is influenced not only by financial

fundamentals but also by speculative factors. As a

result, this value can change abruptly due to speculative

influences, market sentiments and personal

expectations. Market makers as well as other 'willing

Page 61: SOTE TWAWEZA (Business Valuation)

buyers or sellers' (interested in purchases or sales) can

at times significantly influence these prices. Another

limitation of this approach is that this approach cannot

be applied if the shares are unlisted or are not actively

traded.

Apart from the limited applicability of this method only

to listed corporate enterprises, whose shares/securities

are actively traded, the valuation of a business is not in

tune with the going concern concept. Nevertheless, it

may be/is of immense usefulness in deciding swap

ratios of shares in merger decisions. In fact, the market

prices of the two companies can be the objective of the

decision. Alternatively, a certain percentage of

premium, above the market price may be offered as an

inducement to the shareholders of the acquired

company to convince them to agree to sell their shares

or to make them agree to the merger decisions.

Fair Value Method

Page 62: SOTE TWAWEZA (Business Valuation)

The fair value method is not an independent method of

share valuation like those discussed above. This method

uses the average/weightage average or one or more of

the above methods. Since this method uses the average

concept, its virtue is that it helps in smoothening out

wide variations in estimated valuations as per different

methods. In other words, this approach provides, in a

way, the 'balanced' figure of valuation.

In general, this method has limited application for

business valuation. For instance, this method of

valuation of shares had been used till the early 1990's,

by the erstwhile Controller of Capital Issues (CCI) in

India, for fixing the price of new equity issues. In case

the equity shares were to be issued at a premium, the

amount of premium was based as the CCI guidelines.

To sum up, no one method is appropriate for all

circumstances/situations/requirements. Therefore, it is

important to recognise that the different methods are

Page 63: SOTE TWAWEZA (Business Valuation)

based on different assumptions and depending on the

circumstances, some methods may be more appropriate

than others. For instance, where there is paucity of

information about profits, say (i) in the case of new

companies whose accounts do not serve as a guide to

future profits, (ii) in the case of companies operating at

a loss with no prospects of earning profits in the near

future and (in) in the case of companies having

unreliable statistics of profits owing to factors such as

disruption of business, the net asset method of valuation

seems would be more appropriate. In normal situations,

the DCF (based on free cash flows) method would be

suitable. In the event of wide variations in the

valuations as per these two methods, the fair value

method may be, used. In fact, it is useful for the finance

manager/investor/valuer/analyst to know a range of

values from various perspectives.

OTHER APPROACHES TO VALUE

MEASUREMENT

Page 64: SOTE TWAWEZA (Business Valuation)

In recent years, a number of new

approaches/techniques/methods to measure value (with

focus on shareholders) have been developed and

practised. The two major approaches are market value

added (MVA) and economic value added (EVA). They

are explanied in this Section.

Market Value Added Approach (MVA)

The MVA approach measures the change in the market

value of the firm's equity vis-a-vis equity investment

(consisting of equity share capital and retained profits).

Accordingly,

MVA = Market value of firm's equity - Equity capital

investment/funds (14)

Though the concept of MVA is normally used in the

context of equity investment (and, hence, is of greater

relevance for equity shareholders), it can also be

adapted (like other previous approaches) to measure

Page 65: SOTE TWAWEZA (Business Valuation)

value from the perspective of providers of all invested

funds (i.e., including preference share capital and debt).

MVA = [Total market value of firm's securities - (Equity

shareholders funds

+ Preference share capital + Debentures)] (15)

The MVA approach cannot be used for all types of

firms. It is applicable to only firms whose

market prices are available. In that sense, the method

has limited application. Besides, the value provided by

this approach may exhibit wide fluctuations, depending

on the state of the capital market/stock market in the

country.

Example 7 Suppose, Supreme Industries has an equity

market capitalisation of Rs 3,400 crore. in current year.

Assume further that its equity share capital is Rs 2;000

crore and its retained earnings are Rs 600 crore.

Page 66: SOTE TWAWEZA (Business Valuation)

Determine the MVA and interpret it.

Solution

MVA = (Rs 3,400 core - Rs 2,600 crore) = Rs 800 crore.

The value of Rs 800 crore implies that the management

of Supreme Industries has created wealth/value to the

extent of Rs 800 crore for its equity shareholders. Well

managed companies (engaged in sunrise

businesses),"having good growth prospects, and

perceived so by the investors, have positive MVA.

Investors may be willing to pay more than the net

worth. In contrast, companies relatively less known or

engaged in businesses that do not hold future growth;

potentials may have negative MVA.

Example 8

Suppose, Hypothetical Limited has equity market

capitalisation of Rs 900 crore in the current year. Its

equity share capital and accumulated losses are of Rs

Page 67: SOTE TWAWEZA (Business Valuation)

1,200 crore and Rs 200 crore respectively. Determine

the MVA of the film.

Solution

MVA = (Rs 900 crore - Rs 1,000 crore) = (-Rs 100

crore).

The firm has negative MVA of Rs 100 crore. The

investors discount its value/worth, as it is loss incurring

firm.

The market value added approach reflects market

expectations and is essentially a future-oriented and

forward looking approach. The investors, willing to pay

a different price (other than one suggested by book

value), are guided by the individual company's future

prospects, future growth rates, risk complexion of the

firm, industry to which the firm belongs, required rate

of return and so on.

Economic Value Added (EVA)

The EVA method is based on the past performance of

Page 68: SOTE TWAWEZA (Business Valuation)

the corporate enterprise. The underlying economic

principle in this method is to determine whether the

firm is earning a higher rate of return on the entire

invested funds than the cost of such funds (measured in

terms of the weighted average cost of capital, WACC).

If the answer is positive, the firm's management is

adding to the shareholders value by earning extra for

them. On the contrary, if the WACG is higher than the

corporate earning rate, the firm's operations have eroded

the existing wealth of its equity shareholders. In

operational terms, the method attempts to measure

economic value added (or destroyed) for equity

shareholders, by the firm's operations, in a given year.

Since WACC takes care of the financial costs of all

sources of providers of invested funds in a corporate

enterprise, it is imperative that operating profits after

taxes (and not net profits after taxes) should be

considered to measure EVA. The accounting profits

after taxes, as reported by the income statement, need

Page 69: SOTE TWAWEZA (Business Valuation)

adjustments for interest costs. The profits should be the

net operating profits after taxes and the cost of funds

will be product of the total capital supplied (including

retained earnings) and WACC.

EVA .= [Net Operating profits after taxes - (Total

capital x WACC)] (16)

The computation of EVA is illustrated in Example 9

Example 9 Following is the condensed income

statement of a firm for the current year: (Rs lakh)

Sales revenue

Less: Operating costs

Less: Interest costs

Earnings before taxes

Less: Taxes (0.40)

Earnings after taxes

Rs 500

300

12

188

75.2

112.8The firm's existing capital consists of Rs 150 lakh

equity funds, having 15 per cent cost and of Rs 100 lakh

12 per cent debt. Determine the economic value added

during the year.

Page 70: SOTE TWAWEZA (Business Valuation)

Solution

(i) Determination of Net Operating Profit After Taxes

(Rslakh)

Sales revenue

Less : Operating Costs

Operating profit (EBIT)

Less: Taxes (0.40)

Net operating profit after taxes (NOPAT)*

Rs. 500

300

200

80

120* Alternatively, [EAT, Rs 112.8 lakh + Interest Rs 12

lakh - (Tax savings on interest, Rs 12 lakh x 0.4 = Rs

4.8 lakh)]

Page 71: SOTE TWAWEZA (Business Valuation)

(ii) Determination of WACG

Equity (Rs 150 lakh x 15%)

12% Debt (Rs:100 lakh x 7.2%)*

Total cost

WACC (29.7 lakh/Rs 250 lakh)

= Rs 22.5

lakh

= 7.2

29.7

11.88%*Cost of debt = 12% (1 - 0.4 tax rate) = 7.2 per cent

(iii) Determination of EVA

EVA = NOPAT* - (Total capital x WACC)

Rs 120 lakh-(Rs 250 lakh x 11.88%)

Rs 120 lakh - Rs 29.7 lakh = Rs 90.3 lakh

During the current year, the firm has added an

economic value of Rs 90.3 lakh to the existing wealth

of the equity shareholders. Essentially, the EVA

approach is a modified accounting approach to

determine profits earned after meeting all financial

costs of all the providers of capital. Its major advantage

is that this approach reflects the true profit position of

the firm. What may happen is that the firm may exhibit

Page 72: SOTE TWAWEZA (Business Valuation)

positive profits after taxes (as per the conventional

income statement) ignoring costs of shareholders funds,

giving an impression to the owners as well as outsiders

that the firm's operations are profitable. The profit

picture, in fact, may be illusory. Consider Example 10.

Example 10

For Example 53.8, assuming sales revenues are Rs 330

lakh, compute the earnings after taxes.

Solution

Income Statement (Conventional)

(Rs lakh)

Sales revenue

Less: Operating costs

Less: Interest costs

Earnings before taxes

Less: Taxes (0.40)

Earnings after taxes

Rs 330

300

12

18

7.2

10.8

The firm has registered profits of Rs 10.8 lakh during

Page 73: SOTE TWAWEZA (Business Valuation)

the current year on the equity funds of Rs 150 lakh,

which has financial costs of Rs 22.5 lakh. Therefore, the

firm has, suffered a loss, (of Rsll.7 lakh) as the

opportunity costs of equity funds invested by equity

holders is more than what has been earned by the firm

for them. This point is brought to the fore by the EVA

approach. It is for this reason that the EVA approach is

getting more attention. It is superior to the conventional

approach of determining profits.

Determination of EVA

(Rs. lakh)

(a) Sales revenue

Less : Operating Costs

Operating Profits

Less : taxes (0.4)

Net operating profits after taxes

(b) EVA = Rs. 18 Lakh – (Rs. 29.7 lakh,

already computed above) = -Rs. 11.7

lakh

Rs. 330

300

30

12

18

Example 10 demonstrates that there may be a

Page 74: SOTE TWAWEZA (Business Valuation)

substantial difference between profits determined as per

accounting approach and the EVA approach. Profits

shown ass per the EVA approach are conceptually

realistic than shown by traditional accounting approach.

In no way, the firm can be said to have earned profits

without meeting financial costs of all sources of

finance. The EVA approach is in tune with the basic

financial tenet of cost-benefit analysis; financial

benefits have to be more than financial costs to have

true profits.

Though the MVA and EVA are two different

approaches, the MVA of the firm (in a technical sense)

can be conceived in terms of the present value of all the

EVA profits that the firm is expected to generate in the

future.

Page 75: SOTE TWAWEZA (Business Valuation)

Solved Problems

The following particulars are available in respect of a

corporate:

(i) Capital employed, Rs 500 million.

(ii) Operating profits, after taxes, for last three years

are: Rs 80 million, Rs 100 million, Rs 90 million;

current year's operating profit, after taxes, is Rs 105

million.

(iii) Riskless rate of return, 10 per cent.

(iv) Risk premium relevant to the-business of corporate

firm, 5 per cent.

You are required to compute the value of goodwill,

based on the present value of. the super profits method.

Super profits are to be computed on the basis of the

average profits of 4 years. It is expected that the firm is

likely to earn super profits for the next 5 years only.

Page 76: SOTE TWAWEZA (Business Valuation)

Solution

Determination of goodwill, using super profit method

(Rs million)

Average profits (Rs 80 million + Rs 100

million + Rs 90 million + Rs 105 million

= Rs 375 million)/ 4 years

Rs. 93.75

Less: Normal profits (Rs 500 million x

0.15)

75.00

Super profits 18.75

Multiplied by the PV of .annuity for 5

years at 15 percent

(x) 3.352

PV of super profits/Value of goodwill 62.85

Page 77: SOTE TWAWEZA (Business Valuation)

2. The following is the balance sheet of a corporate

firm as on March 31, current year.

(Rs lakh)

Liabilities Amo

unt

Assets Amou

nt

Share capital (of Rs 100

each fully paid-up)

Reserves and surplus

Sundry creditors and

other liabilities

Rs.

100

40

30

Land and

buildings

Plant and

machinery

Marketable

securities

Stock

Debtors

Cash and bank

balances

Rs. 40

80

10

20

15

5

170 170

Profit before tax for current year-end amount to Rs 64

lakh, including Rs 4 lakh as extraordinary income.

Besides, the firm has earned interest income of Rs 1

lakh in the current year from investments in marketable

Page 78: SOTE TWAWEZA (Business Valuation)

securities. It is not usual for the firm to have excess

cash and invest in marketable securities. However, an

additional amount of Rs 5 lakh per annum, in terms of

advertisement and other expenses, will be required to be

spent for the smooth running of the business in the

years to come.

Market values of land and buildings, and plant and

machinery are estimated at Rs 90 lakh and Rs 100 lakh

respectively. In order to match the revalued figures of

these fixed assets, additional depreciation of Rs 6 lakh

is required to be taken into consideration. Effective

corporate tax rate may be taken at 30 per cent. The

capitalisation rate applicable to businesses of such risks

is 15 per cent.

From the above information, compute the value of

business, value of equity and price per equity/share,

based on the capitalisation method.

Solution

Page 79: SOTE TWAWEZA (Business Valuation)

Valuation of business, value of equity and price per

equity share (capitalisation method)

(Rs lakh)

Profit before tax

Less; Extraordinary income

Less: Interest on marketable securities (not

likely to accrue in future)

Less: Additional expected recurring

expenses

Less: Additional depreciation

Expected earnings before taxes

Less: Taxes (0.30)

Future maintainable profits after taxes

Divided by relevant capitalisation factor

Value of business (Rs 33.60 lakh/0.15)

Value of equity (Rs 224 lakh - Rs 30 lakh

external liabilities)

Price per equity share (Rs 194 lakh/ 1 lakh)

64

4

1

5

6

48

14.40

33.60

0.15

224.00

194.00

194

3 Assume every thing to be the same as contained in

P.32.2: Determine the expected market price of the

Page 80: SOTE TWAWEZA (Business Valuation)

share, given the P/E multiple of (0 8 times and (ii) 5

times, and interpret the result.

Solution

Determination of market price per share (P/E basis)

(Rs lakh)

Future maintainable profits after taxes

(computed in P.2)

Divided by the number of equity shares

issued and outstanding

Earnings per equity share, EPS, (Rs 33.60

lakh/1 lakh)

Multiplied by P/E ratio

(i) Market price per share (Rs 33.60 x 8

times)

Multiplied by P/E ratio

(ii) Market price per share (Rs 33.60 x 5

times)

Rs 33.60

1.00

33.60

8

268.8

5

168

Interpretation

(i) The P/E ratio of 8 times suggests that investors are

confident about the company's future prospects; they

Page 81: SOTE TWAWEZA (Business Valuation)

have high expectations of future returns. It is for this

reasons that they are prepared to pay a higher market

price per equity share than warranted by the

capitalisation method (ie, Rs 194 per share), (ii) In

contrast, the P/E multiple of 5 times suggests that

investors are less optimistic about die company's future

performance. They have low confidence as well as

expectations of low returns in future years and

therefore1 are willing to pay a lower price vis-a-vis the

capitalised price.

P.4 For facts contained in P.2, determine the value of

business as per the net assets method. Assets are to be

valued at market value for this purpose. Value of

goodwill is also to be considered to value assets. Its

value is to be reckoned as an equivalent to the present

value of super profits, which are likely to accrue for 4

years. For the purpose of determining super profits,

normal profits are to be computed with reference to the

year-end value of net assets/capital employed

Page 82: SOTE TWAWEZA (Business Valuation)

(excluding goodwill). Also compute the market value of

equity share as per this approach.

Solution

Determination of valuation of business and net asset

value per share as per the net assets method (assets are

valued at market price)

(Rs lakh)

Land and buildingsPlant and machineryGoodwillMarketable securitiesStockDebtorsCash and bank, balancesTotal, assetsLess: External liabilities Net assets available for equity to shareholders Divided by the number of equity shares issued and outstanding Net assets value per share (Rs 216 lakh/1 lakh)

Rs 90100

61020155

24630

216

1

216Valuation of goodwill

Future, maintable profits after taxes

Less: Normal profit (15% of capital

Rs 33.60

Page 83: SOTE TWAWEZA (Business Valuation)

employed, i.e., 0.15 x Rs 210 lakh*)

Super profits

Multiplied by PV factor at 15% for annuity

of 4 years

Value of goodwill (Rs 2.10 lakh x 2.855)

31.50

2.10

2.855

6.0*(Market value of assets, excluding goodwill, Rs 240

lakh - External liabilities, Rs 30 lakh).

Assume everything to be the same as given in P2.

Determine the fair price of an equity share. The fair

price of an equity share is to be taken as an average of

prices estimated according to the capitalisation method

and the net assets method.

Page 84: SOTE TWAWEZA (Business Valuation)

Solution

Determination of a fair price of an equity share (fair

value method)

Price per equity share (capitalisation

method)

Net assets value per equity share (net assets

method)

Fair value per equity share (Rs 194 + Rs

216)/2

Rs. 194

216

205

P.6 Determine the continuing value of the firm from

the following information: (Rs million)

Cash flow frorn business operations at the end of explicit forecast period (Year 6) Investment required in capital expenditure and current assets during year 6 Expected annual growth rate in free cash flows to the firm, after forecast period (%) Weighted average cost of capital (WACC) (%)Cost of equity capital (%)

Rs. 56

12

8

12

15

Page 85: SOTE TWAWEZA (Business Valuation)

Solution

Determination of PV with respect to continuing value

(CV)

CV6 = FCFF7 = Rs. 44 million * (1.08) = Rs. 47.52 million

WACC-g 12%-8% 4%

CV6= Rs 1,188 million

CV0 = Rs 1,188 million x Present value factor at

12% for 6 years

CV0 = Rs 1,188 million x 0.507

= Rs 602.316 million

*(Gross cash flows Rs 56 million - Investment required

in capital expenditures and current assets Rs 12 million

= Rs 44 million);

P.7 Hypothetical Limited is growing at an above

average rate. It foresees a growth rate of 20 per cent per

annum in free cash flows to equityholders in the next 4

years. It is likely to fall to 12 per cent in the next two

years. After that, the growth rate is expected to stabilise

Page 86: SOTE TWAWEZA (Business Valuation)

at 5 per cent per annum. The amount of free cash flow

(FCFE) per equity share at the beginning of current year

is Rs 10. Find out the maximum price at which an

investor, follower of the free cash approach, will be

prepared to buy the company's shares as on date,

assuming an equity capitalisation rate of 14 per cent.

Solution Maximum price of the equity share will be the

sum of (i) PV of FCFE during 1 - 6 years and 00 PV of

expected market price at the end of year 6, based on a

constant growth rate of 5 per cent.

Page 87: SOTE TWAWEZA (Business Valuation)

(i) Present value of FCFE (years 1 - 6)

Year FCFE per share PV factor

(0.14)

Total PV

1 Rs. 10 (1+0.20)1 =

Rs. 12

0.877 Rs. 10.52

2 10 (1+0.20)2 =

14.40

0.769 11.07

3 10 (1+0.20)3 =

17.28

0.675 11.66

4 10 (1+0.20)4 =

20.74

0.592 12.28

5 20.74 (1+0.12) =

23.23

0.519 12.06

6 23.23 (1+0.12) =

26.02

0.456 11.86

Total PV of FCFE 69.45

Market price of share at year-end 6

= FCFE7 = Rs. 26.02 (1.05)

ke-g 14% - 5%

P6 = Rs. 27.321 = Rs. 303.57

14% - 5%

Page 88: SOTE TWAWEZA (Business Valuation)

(ii) PV of Rs. 303.57 = Rs. 303.57 x 0.456

= Rs. 138.43

Maximum price of share

= Rs 69.45 + Rs 138.43 = Rs 207.88

P.8 The Chemicals and Fertilizer Limited is a growing

company. Its free cash flows for equity holders (FCFE)

have been growing at a rate of 25 per cent in recent

years. This abnormal growth rate is expected to

continue for another 5 years; then these FCFE are likely

to grow at the normal rate of 8 per cent. The required

rate of return on these shares, by the investing

community, is 15 per cent; the firm's weighted average

cost of capital is 12 per cent. The amount of FCFE per

share at the beginning of the current year is Rs 30.

Determine the maximum price an investor should be

willing to pay now it = 0), based on free cash flow

approach. The issue price of share is Rs 500.

Page 89: SOTE TWAWEZA (Business Valuation)

Solution

(i) Present value of FCFE (years 1-5)

Year FCFE per share PV Factor

(0.15)

Total PV

1 Rs 30 (1+0.25)1 =

Rs. 37.50

Rs. 0.870 Rs. 32.62

2 30 (1+0.25)2 = Rs.

46.86

0.756 35.43

3 30 (1+0.25)3 = 58.59 0.658 38.554 30 (1+0.25)4 = 73.23 0.572 41.895 30 (1+0.25)5= 91.56 0.497 45.51

Total PV of FCFE 194.00

Market price of share at year-end 5

= FCFE6 = Rs. 91.56 (1.08) = Rs. 1,412.64

ke-g 15% - 8%

PV at t = 0 = Rs 1,412.64 x 0.497 = Rs 702:08

Investor will be prepared to pay the maximum price at t

= 0 = Rs 194 + Rs 702.08 = Rs 896.08

P.9 The most recent accounts of a corporate firm

Page 90: SOTE TWAWEZA (Business Valuation)

engaged in manufacturing business are summarized

below:.

(Rs million)

Income statement for the current year

ended March 31

Amount

Sales revenue

EBIT

Less: Interest on loan

Earnings before taxes

Less: Corporate taxes (0.35)

Earnings after taxes

Rs 93.5

18.0

1.8

16.2

5.67

10.53

Balance sheet as at March 31, current year

Page 91: SOTE TWAWEZA (Business Valuation)

(Rs million)

Liabilities Amou

nt

Assets Amoun

tEquity share

capital (1 lakh

shares of Rs 100

each)

Reserves and

surplus

10% Loan

Creditors and other

liabilities

10.0

32.5

18.0

18.0

Freehold land

and buildings

(net)

Plant and

machinery (net)

Current assets:

Stock

Debtors

Bank and cash

balance

20.0

29.5

10.0

15.0

4.0

78.5 78.5

Page 92: SOTE TWAWEZA (Business Valuation)

Additional Information:

CO The finance manager of the firm has estimated the

future free cash flows of the company as follows:

Year

1

Rs.

222 233 24.54 26.05 30.06 32.0

Free cash flows in subsequent years, after year 6, are

estimated to grow at 4 per cent. The company's

weighted average cost of capital is 12 per cent.

(ii) The current resale value of the following assets has

been assessed by the professional valuer as follows:

Freehold land and buildings Rs 60 million

Plant and machinery 20

Stock 11

The current resale values of the remaining assets are as

per their book values.

(iii) A similar sized company (which is listed on

Page 93: SOTE TWAWEZA (Business Valuation)

Bombay Stock Exchange) and is engaged in the same

business has a P/E ratio of 7 times.

You are required to compute the value of the firm as

well as value of an equity share on the basis of the

following methods: (i) Net assets method (book value

and market value), (ii) Price-earnings ratio method and

(iii) Free cash flows to the firm.

Solution

Determination of value of firm and value of equity

share (using various methods)

(Rs million)

(i) (a) Net asset method—book value basis:

Freehold land and buildings

Plant and machinery

Stock

Debtors

Bank and cash balances

Total assets

Less: External liabilities

10°/o Loan

Rs. 20.0

29.5

10.0

15.0

4.0

78.5

36.0

Page 94: SOTE TWAWEZA (Business Valuation)

Creditors and other liabilities

Net assets available to equityholders

Divided by number of equity shares outstanding

(lakh)

Net assets backing per share (Rs 42.5 million/ 1

lakh) (Rs)

(b) Market value basis:

Freehold land and buildings

Plant and machinery

Stock

Debtors

Bank and cash balances

Total assets

Less: External liabilities

Net assets at market value

Net assets backing per share (Rs 74 million/1

lakh shares)

(ii) Price-earnings ratio approach

Earnings after taxes (assumed to be normal and

expected to be maintained in future years; no

adjustment is made as there are no extraordinary

items)

42.5

1

425

60

20

11

15

4

110

36

74

740

10.53

Page 95: SOTE TWAWEZA (Business Valuation)

Earnings per share (Rs 10.53 million/1 lakh

shares)

Multiplied by P/E multiple

Market price of equity share (Rs 105.30 x 7

times)

105.30

7

737.10

(iii) Free cash flow basis:

(a) PV of FCFE during explicit forecast period:

(Rs in million)

Year FCFF PV Factor

(0.12)

Total PV

1 Rs. 22 0.893 Rs. 19.6462 23 0.797 18.3313 24.5 0.712 17.4444 26.0 0.636 16.5365 30.0 0.567 17.0106 32.0 0.507 16.225

Total present

value

105.191

(b) PV of FCFF subsequent to explicit forecast period

CV6= Rs. 32 (1.04)= Rs. 33.28 = Rs. 416

0.12 – 0.04 0.08

Page 96: SOTE TWAWEZA (Business Valuation)

PV0 = Rs 416, continuing value x PV factor at 12%

for 6 years

= Rs 416 x 0.507 = Rs 210.912

(c) Total PV of FCFF (Rs 105.191 + Rs 210.912)

= 316.103 million 316.103

Less: External liabilities 36.000 36.00

FCFE available to equityholders 280.103 280.103

MPS (Rs 280.103 million/

1 lakh shares) = Rs 2801.03 280.10

P.10Assume everything to be the same as given in

P.32.9, determine the economic value added during the

current year. Assume the long-term funds shown in the

balance sheet as the total capital employed in the

business.

Page 97: SOTE TWAWEZA (Business Valuation)

Solution

Determination of economic value added (EVA)

(Rs. In million)

Net operating profits before taxes

Less: Corporate taxes (0.35).

Net operating profits after taxes

Less: Cost of capital employed (Rs 60.5

million" x 0.12 WACC)

Economic value added.

Rs 18

6.3*

11.7

7.26

4.44

Alternatively, corporate taxes can be conceived as sum

of (i) taxes as per income statement (Rs 5.67 million

plus (ii) tax savings on interest (Rs 1.8 million x 0.35 =

0.63 million) = Rs 6.3 million "Equity share capital Rs

10 million + Reserves and surplus Rs 32.50 million +

10% loan Rs 18 million- Rs 60.5 million.

P.11 Assume every thing to be the same as given in P9.

Assume further that the equity shares of this company

are currently quoted in the market at Rs 500 per share.

Determine the amount of market value added (MVA).

Page 98: SOTE TWAWEZA (Business Valuation)

Solution

Determination of market value added

A. Market value per equity share

B. Multiplied by number of equity shares

outstanding (lakh)

C. Total market value (A x B) (Rs million)

D. Equity funds (Rs 10 million equity share

capital plus Rs 32.5 million reserves and

surplus)

E. Market value added (Rs 50 million - Rs

42.5 million)

Rs. 500

1

50

42.5

7.5