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TABLE OF CONTENTS
INTRODUCTION ............................................................................................................................................................ 3
CAPITAL BUDGETING ............................................................................................................................................... 3
IMPORTANCE OF CAPITAL BUDGETING ............................................................................................................... 3
THE CAPITAL BUDGETING PROCESS ..................................................................................................................... 3
BASIC PRINCIPLES OF CAPITAL BUDGETING ........................................................................................................ 4
A FEW BASIC CONCEPTS IN CAPITAL BUDGETING ................................................................................................... 5
SUNK COST ........................................................................................................................................................... 5
OPPORTUNITY COST............................................................................................................................................. 5
DISCOUNT RATE/TIME VALUE OF MONEY ........................................................................................................... 6
CANNIBALIZATION ............................................................................................................................................... 6
INCREMENTAL CASH FLOWS ................................................................................................................................ 7
PROJECT VALUATION METHODS: ............................................................................................................................ 7
PAYBACK PERIOD ................................................................................................................................................. 7
PROFITABILITY INDEX ........................................................................................................................................... 8
AVERAGE ACCOUNTING RATE OF RETURN (AAR) ................................................................................................ 9
NET PRESENT VALUE (NPV) .................................................................................................................................. 9
INTERNAL RATE OF RETURN (IRR) ...................................................................................................................... 10
COMPARISON BETWEEN NPV AND IRR.............................................................................................................. 11
WHY MERGERS & ACQUISITIONS? ......................................................................................................................... 13
M&A DEFINITIONS ................................................................................................................................................. 14
METHODS OF VALUATION ..................................................................................................................................... 14
REPLACEMENT COST .......................................................................................................................................... 15
MARKET PRICE BASED ........................................................................................................................................ 15
BOOK VALUE BASED ........................................................................................................................................... 15
CASH FLOW BASED............................................................................................................................................. 15
VALUE OF A FIRM ................................................................................................................................................... 17
RETURN ON ASSETS ........................................................................................................................................... 17
MODIGLIANI MILLER THEOREMS ....................................................................................................................... 17
WEIGHTED AVERAGE COST OF CAPITAL ............................................................................................................ 18
COST OF DEBT .................................................................................................................................................... 19
COST OF EQUITY................................................................................................................................................. 19
CAPITAL BUDGETING
Capital budgeting entails making decisions to invest present funds in long-term projects in order to earn
future returns.
IMPORTANCE OF CAPITAL BUDGETING
Firstly, the capital resources available to a firm are limited, and the success of a firm largely depends
on how well it uses the limited resources available to it. Capital Budgeting helps a manager to select
the most profitable avenues for the investment of the scarce resources of the company.
Secondly, Capital budgeting is usually used in evaluating Capital projects, which are Long-term
investment projects requiring relatively large sums to acquire, develop, improve, and/or maintain a
capital asset (such as land, buildings, dykes, roads). The outlays on these projects can be so big that
the future of corporations may be decided by capital budgeting decisions. Reversal of capital
budgetingdecisions cannot be done at a low cost; hence mistakes in the selection of capital projects
can be very costly.
Thirdly, many other corporate decisions also have scope for the application of capital budgeting
principles, as adopted for the specific case. Examples of such areas of application are investments in
working capital, mergers and acquisitions, leasing and bond refunding.
Fourthly, the valuation principles in capital budgeting are quite similar to those used in portfolio
management and security analysis. Thus, the diverse use of capital budgeting methods extends to
these areas also.
Fourthly, the focus of capital budgeting is on ultimately maximizing shareholder value. Thus, correct
capital budgeting decisions have payoffs for a number of stakeholders in the company.
THE CAPITAL BUDGETING PROCESS
We will try to understand this process while using an example. Suppose a firm XYZ & Co. has enough funds and
now has decided to invest in Capital projects. The process it will follow is:
Step One: Generating Ideas- Generation of investment ideas can be from anywhere. All levels of the
organization- from the top to the bottom, from departments to functional areas- can contribute by
generating fresh investment ideas. Ideas can also be generated from outside the company. In our
example, the firm can increase its existing production capacity, expand its product line by setting up
an additional factory, invest in some other business, etc.
Step Two: Analyzing Individual Proposals- In the next step XYZ & Co. would gather adequate,
reliable information in order to first forecast future cash flows from each proposed project and then
evaluate their profitability. In this stage, the non-profitable proposals are screened away and the
remaining are moved on to next stage
Step Three: Planning the Capital Budget- Next, the profitable proposals are organized after taking
into account two key considerations:
o The match between the proposal and the companys overall strategic objectives,
o The duration and timing of the project.
Since companies have various financial and other resource constraints, the proposals usually have to
be scheduled on a priority-basis.
Suppose XYZ & Co. identifies two potential profitable investments as investing in a different business
and expanding its existing production facility. The option of investing in a different business is
forecasted to generate a better profitability, but the money would be locked in for a long period and
one of the companys goals is to become a market leader in its existing market. In such a situation,
the option of expanding its existing production facility would be ranked highest and undertaken first.
Step Four: Monitoring and Post-auditing- Post-auditing capital projects are as important as selecting
and implementing them. Firstly, it serves to monitor the analysis and forecasts that the capital
budgeting process is based on. Overly optimistic forecasts can be detected and such systematic
errors rectified. Secondly, the negative deviation between actual performance and expectations can
be corrected by taking adequate measures, wherever possible, which in turn improves business
operations. Lastly, sound ideas for future investments may be evolved during post-auditing current
investments.
BASIC PRINCIPLES OF CAPITAL BUDGETING
1. Cash flows are the basis for decisions. Accounting concepts, such as net income, are not the basis
for decisions.
2. Timing of cash flows is crucial due to the fact that provided money can earn interest, any amount of
money is worth more the sooner it is received.
3. Cash flows are based on opportunity costs. Here we consider what the increase in cash flows is due
to the investment, with respect to the cash flows without the investment.
4. Cash flows are adjusted for tax payments, i.e. after-tax cash flows are taken.
5. Financing costs are not accounted for: A company can finance its Capital projects from various
sources. The major sources are Debt and Equity. Each of these different sources has a cost of raising
and using the funds associated with them. However, while evaluating capital projects, we do not take
them into account. Instead, the operating cash flows are focused on and the costs of debt (and other
capital) are reflected in the discount rate (explained below)
6. Cash flows are recorded only when they actually occur and not when work is undertaken or a
liability is incurred.
PRINCIPLE: Todays decisions should be based on current and future cash flows and should not
be affected by prior or sunk costs.
OPPORTUNITY COST
Opportunity cost is the cost of any activity measured in terms of the best alternative forgone. It is the
sacrifice related to the second best choice available to someone who has picked among several mutually
exclusive choices. In capital budgeting, the opportunity cost of capital or the discount rate is the expected
rate of return that is foregone by investing in the project chosen rather than investing in the next-best
alternative.
EXAMPLES:
Suppose that a company already owns a building that could be used for a new project instead of
buying a new building. If the companys managers decide to use this building, the company would
not incur the cash outlay of $12 million that would be required to buy a new building. Would this
mean that the $12 million expenditure should be excluded from the analysis, which would obviously
raise the expected NPV? The answer is that we should exclude the cash flows related to the new
building, but we should include the opportunity cost associated with the new building as a cash cost.
For instance, if the building had a market value of $14 million, then the company would be giving up
$14 million if it uses the building for the project. Therefore, the $14 million that would be foregone
as an opportunity cost should be charged to the project.
If an old machine is replaced with a new one, what is the opportunity cost? The opportunity cost
here is the cash flows that the old machine would generate.
If $20 million is invested, what is the opportunity cost? The $20 million itself is the opportunity cost
here since it could have been invested elsewhere.
PRINCIPLE: The opportunity cost of capital for an investment project is the expected rate of
return demanded by investors in common stocks or other securities subject to comparable risks as the project.
DISCOUNT RATE/TIME VALUE OF MONEY
Discount rate is the interest rate used to calculate the present value of future cash flows. It essentially flows
from the concept of time value of money, which says that, other things being equal, due to its potential
earning power, a given sum of money has higher worth now than it would be in future. The discount rate
takes into account the time value of money and the risk or uncertainty associated with future cash flows.
The discount rate applicable to a capital project depends on many factors such as the riskiness of the project,
the weighted average cost of capital of a firm, etc.
EXAMPLE: For e.g., An instrument which returns Rs. 100 each at end of next two years would have a
present value of 173.55 when the discount rate is 10%
=
100
100
+
= 173.55
(1 + 0.1)
(1 + 0.1)2
PRINCIPLE: Money available now is worth more than the same amount available in the future.
This is taken into account while measuring the value of future cash flows of the firm.
CANNIBALIZATION
Cannibalization takes place when an investment results in one part of a company taking away customers and
sales from another part. An externality is defined as the effect that an investment has on other things
besides the investment itself and cannibalization is one such externality. The lost cash flows due to
cannibalization should be charged to the new project. However, it often turns out that if the company would
not have produced the new product, some other company would have and hence, the old cash flows would
have been lost anyway. In this case, no charge should be assessed against the new project. All this makes
determining the cannibalization effect difficult, because it requires estimates of changes in sales and costs,
and also of the timing when those changes will occur.
EXAMPLE: Apples introduction of the iPod Nano caused some people who were planning to purchase a
regular iPod to switch to a Nano. The Nano project generates positive cash flows, but it also reduces some of
the companys current cash flows. This is a manifestation of the cannibalization effect because the new
business eats into the companys existing business.
PRINCIPLE: Cannibalization can be important, so its potential effects should be considered and
any significant lost cash flows due to it should be charged to the new project.
PRINCIPLE: The value of a project depends on all the additional/incremental cash flows that
follow from project acceptance and hence, incremental cash flows provide a sound basis for capital
budgeting.
Investment
Cash Inflow
$4,000
$1,000
2,000
2,000
1,000
500
3,000
2,000
2,000
Beginning
Unrecovered
Investment
Investment
Cash Inflow
Ending
Unrecovered
Investment
(1) + (2) - (3)
$4,000
$1,000
$3,000
3,000
3,000
3,000
2,000
1,000
1,000
1,000
2,000
2,000
500
1,500
1,500
3,000
2,000
2,000
2,000
By the middle of the sixth year, sufficient cash inflows will have been realized to recover the entire
investment of $6,000 ($4,000 + $2,000).
The drawbacks of the payback period are apparent. Since the cash flows are not discounted at the projects
required rate of return, the payback period ignores the time value of money and the risk of the project.
Additionally, the payback period ignores cash flows after the payback period is reached. Thus this method
provides a good measure of payback and not of profitability. But its simplicity and easy calculation make it
useful as an indicator of project liquidity. Thus a project with a two-year payback may be more liquid than a
project with a longer payback.
The discounted payback period partially addresses the shortcomings in the payback period method. It takes
the cumulative discounted cash flows from the project into consideration while calculating the number of
years it takes to recover the original investment. Thus, it takes the time value of money and risk of the
project into account, but this method also ignores the cash flows that occur after the discounted payback
period is reached. For a project with negative NPV, there will not be any discounted payback period since it
never recovers its original investment. The discounted payback period must be greater than the payback
period without discounting.
PROFITABILITY INDEX
The profitability index (PI) is the present value of a projects future cash flows divided by the initial cash
outlay. It can be expressed as:
=
= 1 +
Thus, it can be seen that PI is closely related to NPV. The PI is the ratio of the PV of future cash flows to the
initial investment, whereas the NPV is the difference between the PV of future cash flows and the initial
PI > 1
Do not invest if
PI < 1
EXAMPLE: In the example discussed for NPV and IRR above, the company had an outlay of $70 million, a
present value of future cash flows of $70.2274 million, and an NPV of $0.2274 million.
The Profitability Index = 70.2274/70 = 1.0032
Because the Profitability Index > 1, this investment is profitable.
Thus the PI indicates nothing but the value received when we invest one unit of currency. Although the PI not
used as often as the NPV and IRR, it is sometimes considered better for Capital Rationing; because unlike
NPV, it takes the size of the project also in account. Therefore it is a useful tool for ranking projects because
it allows you to quantify the amount of value created per unit of investment.
AVERAGE ACCOUNTING RATE OF RETURN (AAR)
The average accounting rate of return (AAR) can be defined through the following formula:
AAR = Average net income/ Average book value
EXAMPLE: Suppose a company has an average net income of $20000 each year during a five-year period
from an asset. The initial book value of the asset is $250000, depreciating by $50000 per year until the final
book value is 0. The average book value for this asset is (250000 0)/2 = 125000. The average accounting
rate of return is
AAR = 20000/125000 = 16%
The advantages of the AAR are that it is simple to compute and understand. But, the AAR suffers from some
important conceptual limitations in that it uses accounting concepts like net income instead of cash flows.
The time value of money is also ignored. This is no specific rule or cut-off number in ARR that can be applied
to distinguish between profitable and unprofitable investments. Thus sound methods like NPV and IRR
should be used over ARR, wherever possible.
The above-mentionedmetrics usually provide a simplistic measure to evaluate a project and their merit is in
their ease of calculation. The most comprehensive and often used measures of judging the profitability of a
project are the net present value (NPV) and internal rate of return (IRR).
NET PRESENT VALUE (NPV)
For a project with a single initial investment outlay, the net present value (NPV) is the present value of
the future after-tax cash inflows discounted at the relevant discount rateminus the investment outlay,
=
=1
0
(1 + )
where
Ct = the net cash receipt at the end of year t
Io = the initial investment outlay
r = the discount rate/the required minimum rate of return on the investment
n = the project/investment's duration in years.
EXAMPLE: Suppose a company is considering an investment of $70 million in a capital project that will
return after-tax cash flows of $20 million per year for the next three years plus another $30 million in
year 4. The required rate of return is 10 percent.
Here, the NPV would be
NPV= 20/1.1 + 20/1.1^2 +20/1.1^3 + 30/1.1^4 70
= 70.2274 70 = $0.2274 million.
Thus the investors wealth is expected to increase by a net of $0.2274 million. This indicates the decision
rule for NPV:
Invest if
NPV > 0
Do not invest if
NPV < 0
Positive NPV investments increase investor wealth whereas negative NPV investments decrease it. Many
investments have cash outflows that occur not only at time zero, but also at future dates. In this case, all
cash outflows are taken as negative inflows and discounted at the required rate of return just as in the
case of positive cash inflows at different points of time.
INTERNAL RATE OF RETURN (IRR)
For a project with one initial investment outlay, the IRR is the discount rate that makes the present value
of the expected incremental after-tax cash inflows equal to the investment outlay. In other words, it is
that discount rate that will cause the net present value of a project to be equal to zero or
Where
CF = the cash flow generated in the specific period (the last period being n)
r = the IRR
In the above example given for NPV, the IRR is the discount rate that solves the following equation:
20
20
20
20
+
+
+
(1 + )1 (1 + )2 (1 + )3 (1 + )4
Algebraically, this equation would be very difficult to solve. Normally, trial and error method is resorted
to, systematically plugging various discount rates until one, the IRR, satisfies the equation. But financial
calculators and spreadsheet software have routines that calculate IRR easily, so the trial and error
method can be avoided. The IRR is 10.14 percent here.
The decision rule for the IRR is to invest if the IRR exceeds the required rate of return for a project:
Invest if
IRR > r
Do not invest if
IRR < r
In the above example, since the IRR of 10.14 percent exceeds the projects required rate of return of 10
percent, the company should invest.
However there are several shortcomings with the IRR,
First, there is an implicit assumption while calculating IRR that interim positive cash flows are reinvested
at the same rate of return as that of the project that generated them. This is usually an unrealistic
scenario and a more likely situation is that the funds will be reinvested at a rate closer to the firm's cost
of capital. The IRR therefore often gives an unduly optimistic picture of the projects under study.
E.g. if you invest Rs. 100 today to receive Rs. 10 at the end of first year and Rs. 110 at the end of second
year, your IRR on this investment is 10%. However, if you are able to reinvest the Rs. 10 received at the
end of 1st year at only 3%, then the total amount you receive at the end of 2 years is 110 + 10*1.03 = Rs.
120.3. This implies an annual return of 9.7% (which is less than the IRR).
Sometimes the cash flows during the project lifetime are negative (i.e. the project operates at a loss or
the company needs to contribute more capital). This is known as a "non-normal cash flow", and such
cash flows will give multiple IRRs or No IRRs, which leads to confusion and ambiguity.
M&A DEFINITIONS
Mergers: When one (smaller) company is absorbed by another (bigger) company and the smaller
company ceases to exist.
Acquisitions: When one defined segment of a company, assets of or the entire company is acquired
by another it is termed an acquisition. Example: Abbott India acquiring the domestic formulations
business of Piramal Healthcare solutions.
Reverse Mergers: Similar to a merger but the bigger company ceases to exist as it acquires the
smaller companys name. Usually done when the smaller company has a more well-known brand
name. Example: ICICI Bank reverse merger back in 2001.
Consolidations: A consolidation is similar to a merger except that both companies lose their previous
legal existence and form a new legal entity. Example: The Indian telecom tower sector has seen a
wave of consolidations this past year as smaller players look to exit the market owing to lack of scale
and efficiency.
METHODS OF VALUATION
A very important part of any M&A is valuation of a firm. When you go to buy a second hand car, you try to
estimate its value using factors like age, miles driven, price of similar second-hand cars etc. and then based
on this estimate you negotiate a price with the dealer. Similarly when you set out to acquire a firm, you need
to figure out its value and it is based on that estimate that you quote a price at which youll purchase that
firm. There are several methods for valuation and depending on the industry different methods are the goldstandard when it comes to valuing companies. In this section we will look at some of the most common
methods, discuss what is right and wrong about them and in which sector they are used the most.
=
+
+ +
+
1
2
(1 + )
(1 + )
(1 + )
(1 + )
Where FCFi represents Free cash flow to firm (see definition below) in period i, and H is the horizon. PVH is
the expected value of firm after period H, the horizon chosen for valuation.
Valuation horizons are used because it would be impractical and error prone to try and calculate cash flows
till infinity. PVH is effectively an estimate of discounted cash flows from year H+1 onwards. It can be
calculated in many ways, some of which are constant growth method, based on P/E ratio etc.
This cash flow is also called the Free Cash Flow for the Firm (FCFF) and is available to all the security holders
of the organization including equity and debt holders alike (hence interest not subtracted from FCFF). Since
debt holders also have a claim on the cash flow described above, we can further find out cash flow available
to equity holders called Free Cash Flow to Equity (FCFE). FCFE additionally takes into consideration
repayment of debt as well as new debt capital raised by the firm. It is given by:
FCFE = FCFF + New debt Debt Repayment Preferred Dividends- Interest*(1-t)
Example: Following are the details for a firm: Net Income = $2,176 Million, Capital Expenditures = $494
Million, Depreciation = $ 480 Million, Change in Non-Cash Working Capital = $ 35 Million.
FCFE = 2176 + 480 494 35
FCFE = $2127 million
(Source: Damodaran)
FCFF It is a measure of companys profitability (net cash generated) after taking into consideration
its expenses, taxes and investments.
A positive value of FCFF suggests that company generated sufficient cash to cover its expenses and
investment activities, while a negative value of FCFF indicates otherwise. If FCFF is negative, the
investors should investigate the actual reasons for the same to unearth any bigger problem in the
company.
FCFE It measures the amount of cash that can be paid to equity shareholders after accounting for
expenses, tax, investments and debt repayments.
FCFE has become increasingly popular of late owing to doubts over the effectiveness of the Dividend
Discount Model.
Now, that we know what is the surplus cash available to the equity holders, the question arises as to what
does firm do with this cash? There are two options for the firm, either to invest further in the business or to
pay out the cash to equity holders in the form of dividends. Dividend is basically the portion of earnings of
Example: Consider a firm that has EPS of $2.5 and pays out $0.5 as dividend Then payout ratio = 0.5/2.5 = 0.2
The dividends are of particular interests to shareholders since that is the only way they get paid back for the
equity capital invested in the firm (except liquidation). Thus, dividends are instrumental in finding the value
of equity shares of a firm as we will see later.
So far, we have discussed about the cash flows available to firm and the equity holders. If, however, we want
get a better idea of the kind of returns shareholders are getting, we use another measure called residual
value or Economic Value Added (EVA)
VALUE OF A FIRM
We take a look at how the financing policy of a firm (how much should be debt or equity?) affects the valuation of
a firm.
RETURN ON ASSETS
The source of a firms value is the cash-flows which its assets can generate. These assets are financed by a
mixture of debt and equity. The value of a firm depends on its cash-flow generating real assets (like
machines, patents etc.) The value of a firms debt and equity is equal to the value of the firm. So a question
which arises is: can we produce any changes in the value of a firm by merely changing its debt to equity
mixture? How does the expected return on equity of the firm change if we, say, increase the debt and reduce
the equity? Modigliani & Miller have tried to answer these questions (under certain assumptions) below:
MODIGLIANI MILLER THEOREMS
Modigliani and Miller said that under the assumptions of perfect and frictionless markets (described below),
no transaction costs, no default risk, no taxation, both firms and investors can borrow at the same rD interest
rate; the value of a firm is same regardless of its financing decision i.e. firm value is independent of D/E
ratio. In simple terms, the value of a firm depends on its current and future earning potential and risk of its
Where, D is the market value of the Debt, E is the market value of the Equity, and rD and rE are the cost of
debt and equity respectively.
WEIGHTED AVERAGE COST OF CAPITAL
In the absence of taxes, ra is also the Weighted Average Cost of Capital (WACC). With the presence of tax,
however, the interest paid by the firm on its debt is tax deductible and thus the after tax cost of debt
becomes rD*(1-T) and thus for the firm, the weighted average cost of capital comes out to be
WACC = + (1 ) +
a = D *(D/D+E) + E*(E/D+E)
Now, when D/E ratio changes, since ra does not depend on financing decision of the firm (MM), a remains
unchanged. Thus, for the original D/E ratio and using original E, calculate the a. This is called unlevering the
.
Equity for new leverage ratio can then be calculated as
= + ( )
This process is called relevering the . Once we have the new equity , we can calculate the new cost of
equity (using CAPM) and then calculate the new WACC.
INTEREST TAX SHIELD
If the return on debt is rD and the market value of debt is D then:
Interest Payment I = rD*D
P0 = DIV1/(r-g)
And why do the dividends grow? That is because the firms do not pay out all of the earnings as dividends.
Some of the earnings are reinvested into the business and earn incremental income leading to growth in
dividends as well. Recall, that the ratio of earnings paid out as dividends is called the payout ratio = DIV/EPS
(where EPS is earnings per share).
Thus, 1- DIV/EPS represents the fraction of income reinvested in the business. This is called the plowback
ratio. The ploughed back capital would earn a return equal to the Return on Equity earned by the company
and thus if the payout ratio stays constant, the income and hence the dividend would grow at:
g = plowback ratio * ROE
0 =
1
2
+
+ +
+
1
2
(1 + )
(1 + )
(1 + )
(1 + )
Where DIVi represents dividend in ith period and PH is the expected price of stock at the end of period H.
Usually H is chosen to be the time when the firms growth is expected to stabilise.
Example: Consider a firm that has an EPS of Rs. 10 and a payout ratio of 0.5. Furthermore, the ROE is 15%,
and discount rate is 10%Then, g = 0.5*0.15 = 0.075;P = Price of share = 10*0.5/(.1-0.075) = Rs. 200
MULTIPLES BASED
Multiple It measures a specific aspect of the companys financial health. It is calculated by dividing one financial
metric by another. Numerator is generally greater than the denominator. For Example: P/E, the price per share to
earnings per share (EPS) ratio, is a multiple that measures how much the investors value the companys stock
relative to its earnings. If P/E =15, then investors are ready to pay a multiple of 15 times the current EPS of the
company.
Multiples approach - A valuation method which states that when firms are comparable, then the value of one
firm can be used to find the value of another similar firm.
Trading VS Transactional Multiples
o
o
Both are examples of Relative Valuation, whose aim is to calculate the value of a given asset
in line with the current market values of similar assets.
Analysis of trading multiples factors both a companys current trading price and the current
trading prices of its competitors to arrive at a valuation that is in line with valuation multiples
of comparable public traded companies. Common Multiples used for trading analysis are
P/E, EV/EBITDA.
Transactional Multiples relies on transactions of similar firms in the market to obtain the
valuation of the desired firm. It requires data actual prices and multiples, for acquisition of
similar firms in the market. Data can often be hard to get as most acquisitions are done in
private. Secondly, it is hard to describe similar firms. Thirdly, data should not be very old,
as they would reflect different market conditions.
Advantages
It can be undertaken quicker and is more efficient than DCF valuation.
The intuitive nature of relative valuation is attractive to prospective investors than the
technical nature of DCF.
Disadvantages
For some companies, it is difficult to find true value because of low trading pattern and
small market capitalization.
Also, volatile market sentiments may lead to stock prices that are not true reflection of a
companys intrinsic value.
Financial
Here we will see both price and enterprise multiples.
EV/S
Enterprise Value-to-Sales is a better alternative to Price-to-Sales ratio because not all
sales are attributed to the equity investors. Also in a debt financed company, P/S is
not meaningful because share price does not take into account debt situation of the
firm.
Non-Financial
Besides the set of financial ratios discussed above there are certain industry-specific ratios that are
non-financial in nature and are useful places to start valuation. Ideally one would want to use nonfinancial ratios to triangulate the valuation rather than using it as a primary measure.
o
Retail Companies
Same stores sales
Sales per square meter
Service Sectors
Revenues per employee
Net income per employee
Hotel/ Hospitals
Average daily rate
Occupancy rate
Financial Firms
Current Account Savings Account
Net Interest Margins
Monetary reserves
FINANCING
THE PECKING ORDER THEORY OF FINANCE
As per the Pecking Order Theory of Finance, a firm prefers to utilize internal sources of funding i.e. retained
earnings over external sources of funding. Further, in the latter case, a firm would prefer to issue debt over
equity. The theory is based on the idea that information asymmetry between a firms managers and
shareholders and transaction costs incurred in raising funds from external sources influence the firms choice
of capital structure.
Consider a firm which needs funds for a project. It can raise debt or equity or use internal accruals. If the
firms prospects are more positive as compared to its current market valuation, it would prefer to issue debt
rather than issuing equity as it is undervalued. On the contrary, another firm which has poorer prospects vis-vis its current market valuation would prefer to issue equity over debt to avoid worsening its financial
position.
However, there is information asymmetry between investors who are external to the firm and the managers
who run the business. Consequently, investors tend to draw inferences from the actions of the managers.
Rational investors would conclude that an equity issuing firm has an overvalued share price and debt issuing
firms have an undervalued one. Hence, the share price of an equity issuing firm would fall. To avoid this fate,
the manager of the firm with poorer prospects would issue debt as well. Therefore, while raising external
financing a firm irrespective of its prospects would prefer issuing debt to issuing equity. However, both
Instrument
Debt
Senior Secured Debt
Senior Unsecured Debt
Subordinated Debt
Mezzanine Debt
Preferred Stock
Ordinary Shares
Actual Listing
Step 1
Processing of
Applications by
Registrar
SEBI Approves
Draft Offer
Prospectus
Price Fixed
based on bids
Submit
Prospectus to
Stock Exchange
Distribution of
RHP & Forms to
Investors
Steps in IPO process