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Advanced Accounting concepts
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Value Based Management
Creating value for shareholders is accepted as acorporate objective in todays times
Many VBM approaches have been developed tomeasure and create value. These are synergiesof various disciplines
Finance DCF and shareholder value maximisationBusiness strategy Value creation through exploitation of
business oppurtunitiesAccounting Structure of financial statements with modificationsOrganisational Behaviour - Incentive plans for creating value
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Principal methods ofVBM
1.Free cash flow Mckinsey and Alcar
2.EVA / MVA Stern Stewart
3.Cash flow return on investment / Cash value added
( CFROI /CVA ) BCG
Common threads
1. Value of any company = PV of future cash flows
2. Firms should use value metrics and employ themacross all management functions
3. A well designed incentive structure will motivateemployees to create shareholder value.
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Economic Value AddedEVA
EVA as a concept was developed byStern Stewart & Co. EVA is the surplusover and above the cost of capital.
A company which gives a return morethan the cost of capital creates wealthor adds shareholder value whereas a
company earning a return less than thecost of capital destroys value.
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EVA = PAT cost of equity
= PAT cost of equity rate * equity capital
EVA = Capital * ( return on capital cost of
capital )
EVA = NOPAT cost of capital
(PAT + INT(1-t)) (Capital * WACC)
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Illustration
Net sales 300
COGS 258PBIT 42
Interest 12
PBT 30
Tax @30% 9
P AT 21
Cost of equity = 18%Cost of debt = 12%
Debt Equity ratio = 1
Equity = 100 , Debt = 100
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Components of EVA
NOPAT
Cost of capital
Capital employed
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Value creating strategies using EVA
Capital = 10000, NOPAT =2000, c = 15%, r=20%
EVA = 10000* ( 20-15) = 500
I. Improvement of operating performance to 2250
II . Profitable investment of 10000 at a return of 18%
III. Withdrawal of unproductive capital of 1000 therebyreducing return by 50.
IV. Reduction in cost of capital by altering capitalstructure.
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EVA and firm valuation
Firm value = economic book value ofassets +PV of EVA associated with it.
Ideally firm value using EVA will be moreor less similar to firm value using DCF
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Global Ltd. is interested in acquiring the food
division of Regional Ltd. They have forecastedthe free cash flow on the basis of followingassumptions :
1. Growth rates in assets, revenues and profitsafter tax will be 20% for the first 3 years,12% for the next 3 years and 8% thereafter.
2. The ratio ofPAT to net assets would be 0.12
3. The oppurtunity cost of capital is 11%
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1 2 3 4 5 6
Asset value 50.00 60.00 72.00 86.40 96.77 108.38
NOP AT 6.00 7.20 8.64 10.37 11.61 13.00
Net Invt. 10.00 12.00 14.40 10.37 11.61 8.67
FCF (4.00) (4.80) (5.76) nil nil 4.33
Terminal value 4.33 ( 1+0.8) =156
0.11 -0.08
PV ( FCF+TV) = (9.39 ) + 83.46 = 74.07
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EVA projection
1 2 3 4 5 6
Op. capital 50.00 60.00 72.00 86.40 96.77 108.38
NOP AT 6.00 7.20 8.64 10.37 11.61 13.00
Cost of capital 11% 11% 11% 11% 11% 11%
Capital charge 5.50 6.60 7.92 9.50 10.64 11.92
EV A 0.50 0.60 0.72 0.87 0.97 1.08
TV 1.08 * 1.08 = 1.17 = 39
0.11-0.08 0.03Firm value = 50 + PV ( EVA + TV )
= 50 + 24.05 = 74.05
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Mergers and Acquisitions
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Economic rationale of a merger is that thevalue of the combined entity will be more
than that of individual entities.
Realistic reasons in favour of mergers
1. Strategic benefit
2. Economies of scale
3. Economies of scope4. Economies of vertical integration
5. Complementary resources
6. Tax shields
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Mechanics of a mergerI. Legal Procedure Sec 391-394 of the
Companies Act 1956
Examination of object clause Intimation to stock exchanges Approval of draft amalgamation proposal by the
Boards Application to High courts Notice to shareholders and creditors
Meetings of shareholders and creditors Passing of High court orders Filing the order with Registrar Transfer of assets and liabilities Issue of shares and debentures
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II . Tax aspects
Tax concessions are available to amalgamated company only ifthe amalgamating company is a Indian company.
Following deductions remaining unabsorbed by theamalgamating company will be allowed to the amalgamated
company.
Capital expenditure on scientific research
Expenditure on acquisition of patents / knowhow etc.
Expenditure for obtaining license to operate telecom servicesAmortisation of preliminary expenses
Carry forward of losses and unabsorbed depreciation
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Accounting for amalgamations AS -14
Pooling method - merger
Purchase method - acquisition
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Illustration
Beta Ltd. has agreed to merge with Alpha Ltd.The swap ratio of 3:5 has been fixed. The facevalue per share of both companies is Rs.10/-.The assets & liabilities of Beta Ltd. are
revalued as :
Net fixed assets 3200
Investments 400Current assets 2900
Current liabilities 1600
Loan funds 2400
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Before merger After merger
Pooling Purchase
Liabilities A Ltd. B Ltd. Alpha Ltd. Alpha
Ltd.Share capital 4000 1000 4600 4600
Capital reserve - - 4001900
Share premium 2000 500 2500 2000
G. Reserve 6000 1500 7500 6000
Loan funds 4000 2500 6500 6400
C.Liab & Prov. 2000 1500 3500 3600
18000 7000 25000 24500
AssetsNet fixed assets 7000 3000 10000 10200
Investments 3000 500 3500 3400
Current assets 7000 3000 10000 9900
Misc. expenses 1000 500 1500 1000
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Exchange ratio in a merger
Basis
Book value per shareEarnings per share
Dividend discounted value per share
Discounted cash flow value per share
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Book value per share
If BV per share of acquiring company is Rs.25and that of target company is Rs.15, theexchange ratio will be 15/25 = 3/5
for every 5 shares in target company 3 shares inacquiring company.
Drawback of this method Book values do not reflect economic
values
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Earnings per share : If the EPS of the target companyis Rs. 5.00 and the EPS of acquiring company is Rs.5exchange ratio = 2/5
Drawbacks of this method
This method is based on current earning per share. It
fails to take into account :
The growth rate of the companies Improvement in earnings due to merger Risks associated with the earnings of the two companies.
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Market price per share
The exchange ratio is based on the relative marketprice of the shares of the company.
If the shares of the company are actively traded thenthe market prices indicate current earnings, growthprospects and risks. If the shares are not activelytraded market price may not be a realistic indicator
Share prices may be manipulated by vested interests.
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Dividend discounted value per share
The dividend discounted value is the presentvalue of expected dividends
This method is useful only if the dividendstreams can be predicted with reasonablesurety
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Discounted cash flow value per share
DCF value per share
= Firm value by DCF method debt value
Number of equity shares
This method is useful if the companiesbusiness plans and cash flow projections areavailable for 5 10 years.
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