BUSINESS VALUATION

Conceptual Framework of Valuation

Estimating the worth of an asset or a security or a business is termed as "valuation". Any investor
would be interested in knowing the value of a business before purchasing a major portion of the
assets or a security. The task of valuation involves not only the estimating the values of the existing
plant and equipment, machinery, furniture & fittings etc., but also of intangible assets like patents,
copyrights, good will etc. The process of valuation would also include any unrecorded contingent
liabilities so that the purchaser is totally aware of the entire business assets and liabilities as on a
particular date. The valuation process is thus influenced and affected by subjective considerations.
The following concepts of valuation are generally used to help the finance manager arrive at a more
accurate valuation, reducing the element of subjectivity to the maximum possible extent.

Book value - Book value is the accounting record value of assets that is shown in the balance sheet.
It is usually the purchase cost of an asset less the accumulated depreciation on it. It may not reflect
the sale value or the fair value of the asset. This valuation is based on the going concern principle of
accounting. It is the total book value of all the assets that are valuable excluding the fictitious assets,
minus the external liabilities. It is otherwise known as the net worth.

Market value - Market value is the value at which an asset or a security of a company can be sold in
the market. Market value can be applied to tangible assets only because intangible assets cannot be
sold generally. The total market value of all the outstanding equity shares as quoted in the stock
market can be referred as the market value of a business. Market value can be ascertained for listed
corporates only.

Intrinsic/Economic value - The present value of all the incremental future cash flows can be termed
as the intrinsic value. The present value is arrived by discounting the incremental cash flows at an
appropriate discount rate. The maximum price at which a business can be acquired is the economic
value.

Liquidation value - This represents the price at which each individual asset can be sold in the event
of liquidation of business. It is valued after subtracting all the external liabilities. The liquidation
value would generally be the least.

Replacement value - It is the cost of purchasing or replacing a new asset which is of equal utility to
the business. It is generally applied to tangible assets like equipment, plant etc.

Salvage value - Salvage value, also called as the scrap or residual value is the sale value of an old
asset after its usage.

Valuation of goodwill - Valuation of goodwill is one of the toughest as goodwill is non-monetary. A

business is said to have a real goodwill if it can earn a higher rate of return on an investment when
compared with its competitor having the same risk. When the firm earns super profits, goodwill
results. It can be valued as the present value of all the future expected super profits for ‘n’ number
of years. It is very useful in merger and acquisition decisions.

Fair value - fair value is based on all of the valuations explained above. Particularly, it is the average
of the market value, book value and the intrinsic value.
Methods/Approaches To Valuation

There are various approaches to the valuation of a business. The major ones are:

1.Asset-based approach to valuation

2.Earnings based approach

3.Measuring on cash Flow Method

Asset - based approach to Valuation

This approach aims at determining the value of net assets. Assets can be valued at their book value,
market value, replacement value or liquidation value and this method determines the basis of assets
valuation.

Net assets = Total assets - Total external liabilities

Net assets per share = Net assets/Number of equity shares issued & outstanding.

Earnings based approach to Valuation

The earnings based approach to valuation is on the proposition that the business valuation should be
based on future earnings or the firm's capacity to generate cash flows. Thus, this approach
eliminates the limitation of the asset based approach which totally ignores the firm's potential to
generate cash flows and earnings. Earnings can be measured on two bases:

Earnings measured by accounting and

EARNINGS MEASURED BY CASH FLOWS.

The value of the firm based on earnings measured by accounting can be expressed as:

Value = ∑∞t = 1 (Cash flows to firm t/ (1+k0) t

Where

ko = appropriate discount factor, t= time (years till infinity)

MARKET VALUE BASED APPROACH TO VALUATION

The market value approach is one of the most widely and frequently used in calculating the value of
a business, especially, the larger listed companies. The market values of the company's securities are
used for this purpose. The market values assigned could be either

a) 12 months average of the prices prevailed in the stock exchange,

b) the average of the low and high security values during a year or

c) any other acceptable fair method of averaging can be used. This method is widely used and is
justifiable because market values reflect the investor's consensus.
A number of few methods have been developed in the recent years to value a business. The two
major approaches are:

Market Value Added approach (MVA)

The MVA approach measures the change in the firm's equity market value as a result of a change in
the equity investment which consists of common stock capital and retained earnings.

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

MVA can also be measured from the point of providers of all invested funds like debt and preference
capital.

MVA = [Total market value of firm's securities - (Equity shareholders' funds + Preference capital +
Debt.

MVA approach cannot be used for all types of companies and can be used only by the firms that's
market prices are available.

Economic Value Added Approach (EVA)

EVA denotes the difference between the total cost of funds and the operating income after taxes. It
is totally based on the past performance of the company. The principle upon which this approach is
based is that whether the firm is earning a higher rate of return on the invested funds, than the costs
of acquiring it. The cost of acquiring the funds is measured by the Weighted Average Cost of Capital
(WACC).

EVA = Net operating profits after taxes - (Total capital x WACC)

If EVA is positive, it implies that the company is adding to the wealth of the shareholders. If the EVA
is negative, it implies that the company has eroded the existing value of the shareholders.

EVA = (ROCE –WACC) X CAPITAL EMPLOYED

ROCE=Return on capital employed

HOW CAN A COMPANY CAN IMPROVE ITS ECONOMIC VALUE ADDED (EVA):

There are two major ways a company can improve its economic value added (EVA):

1) Increase revenues or decrease capital costs. Revenue can be increased by raising prices or selling
additional goods and services. Capital costs can be minimized in several ways, including increasing
economies of scale. It is also possible for a firm to offset capital costs by choosing investments that
earn more than their associated capital charges.

In the EVA formula, a firm's revenue is expressed as being equal to net operating profits after tax
(NOPAT). Capital costs are traditionally estimated using a weighted average cost of .EVA, also known
as economic profit, is the result of subtracting all net capital charges from NOPAT. It is one of the
most popular profitability metrics used by companies and fundamental analysts.
2) If a company wants to improve its EVA by adding to its revenues, it must ensure the marginal
revenue gain is larger than the accompanying marginal costs, including taxes. This makes sense – you
would not spend $150 to earn $100 in revenue. Since revenue generation is usually uncertain, it is
often easier for a company to reduce its net capital costs.

Net capital costs can be lowered by reducing operating expenses, increasing marginal productivity or
both. A company might renegotiate with its creditor to acquire a lower interest rate on debt or call
in preferred shares and reissue them at a lower rate.

Economic value added is sometimes also referred to as shareholder value added (SVA), although
some companies might make different adjustments in their NOPAT and cost of capital calculations.
These are not the same as cash value added (CVA), which is a metric used by value investors to see
how well a company can generate cash flow.

ADVANTAGES OF EVA:

Some outstanding advantages of EVA are:

(i) EVA is a tool which helps to focus managers’ attention on the impact of their decisions in
increasing shareholders’ wealth.

(n) EVA is a good guide for investors; as on the basis of EVA, they can decide whether a particular
company is worth investing money in or not.

(iii) EVA can be used as a basis for valuation of goodwill and shares.

(iv) EVA is a good controlling device in a decentralised enterprise. Management can apply EVA to
find out EVA contribution of each decentralised unit or segment of the company.

(v) EVA linked compensation schemes (for both operatives and managers) can be developed towards
protecting (or rather improving) shareholders’ wealth.

LIMITATIONS OF EVA:

1) Requires numerous adjustments to profit and Capital employed.

2) Does not facilitate comparison between divisions of EVA as EVA is an absolute measure.
3) There are many assumptions made while calculating WACC.
4) Based on historical data but shareholders are interested in future performance.
5) It ignores inflation.
6) It is only shareholder centric and pays less attention to other stakeholders
PRACTICAL PROBLEMS ON EVA /MVA:

1) Calculate EVA from the following Data of Ajanta Ltd for the year ended 31st March 2016:
Debt 30 lakhs
Equity 270 lakhs
Profit after tax before Exceptional Items 145 lakhs
Interest after Tax 0.5 Lakhs
Cost of Debt (after tax) 7.5%
Cost of Equity 15%

2) Victory Ltd provides you with the following information as 31st March 2018

Liabilities Rs(Lakhs) Assets Rs(Lakhs)

Share Capital 1000 Fixed Assets 2250
Reserves and Surplus 1300 current Assets 750
Long Term Debts 200
Creditors 500
3000 3000

Additional Information :
1) Profit before interest and tax Rs 2000 Lakhs .
2) Interest paid Rs 30 Lakhs
3) Tax Rate 30%
4) Risk free Rate 11%
5) Long Term Market Rate 12%
6) Beta (β) = 1.62
Calculate EVA

3) M.K Ltd has given its income statement and Balance sheet :
I) Income statement for the year ended :

Particulars Rs (Lakhs)
Sales 12000
Less :Cost of Production 9000
PBIT 3000
Less :Interest on Loan 20
PBT 2980
Less : Tax @30% 894
EAT 2086
II) Balance sheet as on 31-3-2018 :

Rs Rs
Liabilities (Lakhs) Assets (Lakhs)
Equity share capital (Rs 10 each 400 Land and Building 200
Reserves and Surplus 300 Plant & Machinery 400
10% Bank Loan 200 Debtors 200
Creditors 100 Stock 150
Cash and Bank 50
1000 1000
 a) WACC = 15%
b) Listed Company in BSE
c) P/E Ratio = 6 times
Calculate Value of Business ,EVA and MVA
4) Calculate EVA from the following on March 2017 for Ashoka Ltd
Financial Leverage 1.4 times
Capital Structure :
Equity Capital 170 Lakhs
Reserves and Surplus 130 Lakhs
10% Debentures 400 Lakhs
Cost of Equity 17.5%
Income Tax Rate 30%

5) The account of Sona Ltd :

Income statement for the year ended March 2018:

Particulars Rs (Million)
Sales 95
Less :Cost of goods sold 50.10
General Expenses 6.80
Administrative Expenses 7.80
Selling & distribution Expenses 2.90
Interest on Loan 1.80
EBT 16.60
Less :Tax @ 35% 5.81
EAT 10.79
Balance sheet as on 31-3-2018 :

Liabilities Rs (Million) Assets Rs (Million)

Equity share capital (Rs 10 lakh
shares of Rs.10 each ) 10 Land and Building 20
Reserves and Surplus 31.50 Plant & Machinery 28.50
10% Loan 18.00 Debtors 15.00
Creditors 18.00 Stock 10.00
Cash and Bank 4.00
77.50 77.50

Additional Information :

1) Rate of Return =8%

2) Premium from business =5%
3) Beta =1.27%
4) Equity shares quoted in share market = Rs 50 per share.
5) General expense and R & D expenses Rs. 0.50 Million.
Calculate EVA and MVA

ASSIGNMENT QUESTIONS:
1) Calculate EVA from the following information for the year ended 31st march 2018:
Particulars Rs(crores)
Average Debt 50
Average Equity 2766
Profit after tax before exceptional items 1541
Interest after tax 5
Cost of debt 7.72%
Cost of Equity 16.7%
WACC 16.54%

Ans : EVA Rs. 1080.23 crores

2) From the following information of Nebula Ltd prepare a statement showing computation of
EVA for the year ended 31st March 2018
Income statement for the year ended :

Particulars Rs
Sales 20,00,000
Less :Cost of goods sold 12,00,000
Less :Gross Profit 800000
General Expenses 200000
Administrative Expenses 250000
Selling & distribution Expenses 64000
PBIT 286000
Less :Interest on Loan 36000
PBT 250000
Less :Tax 40% 100000
PAT 150000
Balance sheet as on 31-3-2018 :

Liabilities Rs (Lakhs) Assets Rs (Lakhs)

Equity share capital 240000 Land and Building 600000
Reserves and Surplus 160000 Current Assets:
10% Loan 240000 Stock 120000
Creditors 160000 Debtors 60000
Cash and Bank 20000
800000 800000

Additional Information :

1) General Expenses exclude R and D expenses of Rs 80000 .For EVA computation R and D
expenses are to be taken as investments.
2) Cost of Depreciation include depreciation expense of Rs.60000.
3) The expectation return of shareholders is 12%.
(Ans :NOPAT Rs .251600, Capital Employed Rs 720000 ,WACC Rs 79200 , EVA Rs.172,400 )