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Business Valuation
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BUSINESS VALUTION
Conceptual Framework of Valuation
Other Approaches to Value
Measurement
Approaches/Methods of Valuation
Solved Problems
Mini Case
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CONCEPTUAL FRAMEWORK OF
VALUATION
The term valuation implies the estimated worth of an asset
or a security or a business. The alternative approaches to
value a firm/an asset are:
Book value,
Market value,
Intrinsic value,
Liquidation value,
Replacement value,
Salvage value
Value of Goodwill
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
Intrinsic/Economic Value is the present value of incremental future cash
inflows using an appropriate discount rate.
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 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.
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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.
Fair Value
Fair value is the average of book value, market value and intrinsic 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.
Tata McGraw-Hill Publishing Company Limited, Financial
Management
32 - 8
Approaches/Methods of
Valuation
There are four approaches to valuation of
business (with focus on equity share
valuation):
1) Assets based,
2) Earnings based,
3) Market value based and
4) Fair value method.
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Asset-Based Approach to Valuation
Assets-based method focuses on determining the value of
Net assets = (Total assets Total external obligations) (1)
Net assets per share can be obtained dividing total net assets
by the number of equity shares outstanding. It indicates the
net assets backing per equity share (also known as net worth
per share).
Net assets per share = Net assets / Number of equity shares
issued and outstanding (2)
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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 :
1. 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.
2. With respect to current assets, are additional provisions required for
unrealisability of debtors? Likewise, are adjustments required for
unsaleable stores and stock?
3. With respect to liabilities, there is a need for careful examination of
contingent liabilities, in particular when there is mention of them in the
auditors 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.
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 outstanding. (3)
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Example 1: Following is the balance sheet of Hypothetical Company Limited as on
March 31, current year.
Share capital
40,000 11% Preference shares of
Rs 100 each, fully paid-up
1,20,000 Equity shares of Rs 100
each, fully paid-up
Profit and loss account
10% Debentures
Trade creditors
Provision for income tax


40

120
23
20
71
8
282
Fixed assets
Less: Depreciation
Current assets:
Stocks
Debtors
Cash at bank
Preliminary expenses
Rs 150
30

100
50
10

120



160
2

____
282
Additional Information:
(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 firms 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.
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Solution : Determination of Net Asset Value per Share (Rs lakh)
(i) Book value basis
Fixed assets (net)
Current assets:
Stock
Debtors
Cash and bank
Total assets
Less: External liabilities:
10% Debentures
Trade creditors
Provision for taxation
11% Preference share capital
Dividend on preference shares
(0.11 Rs 40 lakh)
Net assets available for equityholders
Divided by the number of equity shares (in lakh)
Net assets value per share (Rs)



Rs 100
50
10


20
71
8
40

4.4


Rs 120



160
280






143.4
136.6
1.2
113.83
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(ii) Market value basis
Fixed assets (net)
Current assets:
Stock
Debtors
Cash and bank
Total assets
Less: External liabilities (as per details given above):
Net assets available for equityholders
Divided by the number of equity shares (in lakh)
Net assets value per equity share (Rs)



102
45
10
130




157
287
143.4
143.6
1.2
119.67
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(iii) Liquidation value basis
Fixed assets (net)
Current assets:
Stock
Debtors
Cash and bank
Total assets
Less: External liabilities (listed above):
Less: Liquidation costs
Net assets available for equityholders
Divided by the number of equity shares (in lakh)
Net assets value per equity share (in Rs)



90
40
10
105




140
245
143.4
15.0
86.6
1.2
72.17
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Market Value Added (MVA)
The market value added (MVA) approach measures the
change in the value of the firm from the perspective of all
the providers of funds (i.e., shareholders as well as
debentureholders).
MVA = [Total market value of the firms securities (Equity
shareholder funds + Preference share capital +
Debentures)]. (14)
The MVA from the point of view of equity shareholders is =
(Market value of firms equity Equity funds (15)
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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.
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.
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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 1,200 crore and Rs 200 crore respectively. Determine
the MVA of the firm.
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 companys future prospects,
future growth rates, risk complexion of the firm, industry to which the
firm belongs, required rate of return and so on.
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Economic Value Added (EVA)
The EVA method measures economic value added
(or destroyed) for equity-owners by the firms
operations in a given year. 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.
EVA = [Net operating profits after taxes (Total
invested funds WACC)] (16)
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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
112.8
The firms 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.
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(ii) Determination of WACC
Equity (Rs 150 lakh 15%)
12% Debt (Rs 100 lakh 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
Solution: (i) Determination of Net Operating Profit After Taxes
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 0.4 = Rs 4.8 lakh)]
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(iii) Determination of EVA
EVA = NOPAT* (Total capital WACC)
Rs 120 lakh (Rs 250 lakh 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 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 firms
operations are profitable. The profit picture, in fact, may be illusory. Consider
Example 10.
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Example 10 For Example 9, 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 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 Rs 11.7 lakh) as the opportunity
costs of equity funds invested by equityholders 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.
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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 substantial difference between
profits determined as per accounting approach and the EVA approach. Profits
shown as 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.
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Earnings Based Approach to
Valuation
Earnings based method relates the firms value to its potential future
earnings or cash flow generating capacity. Accordingly, there are two
major variants of this approach (i) Earnings measure on accounting basis
and (ii) earnings measure on cash flow basis.
(i) Earnings measure on accounting basis
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.
Value of business (V
B
) = Future maintainable profits Relevant
capitalisation factor (4)
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Example 2:
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 years income includes: (i) extraordinary income of Rs 10 lakh
and (ii) extraordinary loss of Rs 3 lakh. Apart from existing operations,
which are normal in nature and are likely to continue in the future, the
company expects to launch a new product in the coming year.
Revenue and cost estimates in respect of the new product are as follows:
(Rs lakh)
Sales
Material cost
Labour cost (additional)
Allocated fixed costs
Additional fixed costs
Rs 60
15
10
5
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 : Valuation of Business (Rs lakh)
Profit before tax (Rs 65 lakh/(1 0.35)
Less: Extraordinary income (not likely to accrue in future)
Add: Extraordinary loss (non-recurring in nature)
Add: Incremental income expected from the launch of the new
product:
Sales
Less: Incremental costs:
Material costs
Labour costs
Fixed costs (additional)
Expected profits before taxes
Less: Taxes (0.35)
Future maintainable profits after taxes
Relevant capitalisation factor
Value of business (Rs 78 lakh/0.15)







Rs 15
10
8





60



33
Rs 100
(10)
3






27
120
42
78
0.15
520
Some useful insights into estimate of capitalisation rate can be made by
referring to the Price ear-nings (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 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.
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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. (5)
The EPS is to be multiplied by the P/E ratio to arrive at the market price of
equity share (MPS).
MPS= EPS P/E ratio (6)
The P/E ratio may be derived given the MPS and EPS.
P/E ratio = MPS/EPS (7)
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Example 3
For facts in Example 2, 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/E ratio is 8 times.
Solution
Determination of Market Price of Equity Share
Future maintainable profits after taxes
Less: Preference dividends (1,00,000 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 8)
Rs 78,00,000
11,00,000
67,00,000
4,00,000
16.75
8
134
32 - 29
The second method makes use of the discounted cash flow technique to
value the business. According to the DCF approach, the value of
business/firm is equal to the present value of expected future operating
cash flows (CF) to the firm, discounted at a rate that reflects the
riskiness of the cash flows (k0), that is,
Earnings Measure on Cash Flow
Basis (DCF Approach)
The second method makes use of the discounted cash flow
technique to value the business. According to the DCF approach,
the value of business/firm is equal to the present value of
expected future operating cash flows (CF) to the firm, discounted
at a rate that reflects the riskiness of the cash flows (k
0
), that is,
) 8 (

=
+
=
|
|
|
.
|

\
|
1 t
t
0
k 1
t
Firm to CF
0
firm of Value
32 - 30
To use the DCF approach, accounting earnings (as shown by the
firms income statement) are to be converted to cash flow figures as
shown in Format 1.
Format 1: 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 (K
0
).
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Format 2 shows computation of operating free cash flows (OFCF)
for the purpose of valuation of a business.
Format 2: 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)
*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.
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Format 3: 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
Assets, say marketable securities
Free cash flows to Firm (FCFF)
* Non-operating income (1 tax rate)
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 companys operations for all the providers (debt and equity) of its
capital. 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.
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Alternatively, the value of equity can be determined directly by
discounting the free cash flows available to equityholders (FCFE) after
meeting interest, preference dividends and principal payments, the
discount rate being k
e
, that is,
Another variant of cash flow approach is to discount estimated free cash
flows to the firm (FCFF) instead of operating cash flows. The FCFFs are
computed by deducting incremental investments in long-term assets as
well as investment in working capital from operating cash flows. The value
of firm is
( )

= +
=
1 t
t
0
t
0
(9)
k 1
investors all to FCFF
Firm of Value
( )

= +
=
1 t
t
e
t
0
(10)
k 1
ers equityhold to FCFF
Equity of Value
32 - 34
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 give
in the table:
Year-end 1
2
3
4
5
Rs 300 lakh
200
500
150
600
Compute
(i) valuation of firm and (ii) valuation from the perspective of equityholders.
Assume 10 per cent debt is repayable at the year-end 5 and interest is paid at
each year-end.
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(ii) Valuation of Firm, Based on K
0

Year-end FCFF PV factor
(0.10)
Total present
value
1
2
3
4
5
Total present value/valuation of firm
Less value of debt
Value of equity
Rs 300
200
500
150
600
0.909
0.826
0.751
0.683
0.621
Rs 272.70
165.20
375.50
102.45
372.60
1,288.45
500.00
788.45
Solution : (i) Computation of Overall Cost of Capital
Source of capital After tax cost (%) Weights Total cost (%)
Equity
Debt
Weighted average cost of
capital (k
0
)
14
6
*

0.5
0.5
7
3
__
10
* 10% (1 0.4 tax rate) = 6 per cent
32 - 36
(iii) Valuation of Equity, Based on K
e

Year-end FCFF to
all
investors
After tax
payment to
debtholders
FCFE to
equityhold
ers
PV
factor
(0.14)
Total
present
value
1
2
3
4
5
Total present value
Rs 300
200
500
150
600
Rs 30
*

30
30
30
530
**

Rs 270
170
470
120
70
0.877
0.769
0.675
0.592
0.519
Rs 236.79
130.73
317.25
71.04
36.33
792.14
* 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.
32 - 37
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 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 :
158.428 Rs
lakh 5
lakh 792.14 Rs
is share equity per FCFE 4, example In
(11)
g outstandin shares equity of Number
ers equityhold to FCFE of PV
share equity per FCFE
= =
=
32 - 38
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 firms valuation.
Ideally, one approach is to forecast future FCFF for a very long period of time, say
30-40 years and ignore all subsequent years 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 710 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)
(i) PV of cash flows during explicit forecast period
In the context of cyclical businesses, the explicit forecast 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. The firm is said to
have attained a steady state at the end of explicit period. Subsequent to this
period, the firm grows at a steady rate (normal or less than normal) which is likely
to continue in future years.
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(ii) PV of cash flows after explicit forecast period.
The value determined after the explicit forecast period (T + 1) is referred to as
the continuing value. Its value can be determined as per the following
equation:
Where NOPLAT
T+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.
ROIC
I
= 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:
Where FCFF
T+1
refers to the normalised level of free cash flow in the first year
after the explicit forecast period.
( )
(13)
g k
g/ROIC 1 NOPLAT
value Continuing
0
I 1 T

=
+
(13.1)
g k
FCFF
value Continuing
0
1 T

=
+
32 - 40
(ii) PV of cash flows after 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 (1IR) (13.2)
We know, growth rate, g is the product of return on invested capital, ROIC
I
and
IR, ie,
g = ROIC
I
x IR (13.3)
or IR = g/ROIC
I
(13.4)
Incorporating value of IR in FCFF definition
( )
(13.5)
g k
g/ROIC 1 NOPLAT
value Continuing
) g/ROIC (1 NOPLAT FCFF
0
I
I

=
=
32 - 41
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.
1. The major simplifying assumptions made in determining continuing value
are: (i) the firm earns a constant return on the existing invested capital;
2. the firms NOPLAT grows at a constant rate and it invests the same
proportion of its gross cash flow in business each year and
3. 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.
32 - 42
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
Determination of NOPLAT (Rs lakh)
Net operating profit or EBIT
Less: Taxes as per income statement
Less: Adjusted taxes (interest, Rs 10 lakh 0.4, tax rate)
Net operating profit less adjusted taxes*
Alternatively, it can be determined as EBIT less taxes EBIT
Less: Taxes (0.40 Rs 30 lakh, EBIT)
NOPLAT
Rs 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 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.
32 - 43
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
1
2
3
4
5
6
7
8
Rs 80
100
150
220
300
260
230
200
Its condensed balance sheet as on March 31, current year is as follows: (Rs million)
Liabilities Amount Assets Amount
Equity funds
12% Debt
120
80
200
Current assets
Long-term assets (net)
30
170
200
Additional information: (1) 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 annual outlays as follows:
32 - 44
1
2 3
4 6
7 8
Rs 5 million
15
30
10
(2) Long-term assets are subject to 15 per cent rate of depreciation on diminishing balance method.
(3) The company has planned the following capital expenditure (assumed to have been incurred in the
beginning of each year) for the next 8 years.
Year 1
2
3
4
5
6
7
8
Rs 5 million
8
20
25
35
25
15
10
(4) Working capital in terms of investment in current assets are estimated at 20 per cent of sales
revenue.
(5) 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.
(6) Given the tax benefits available to Sagar, the effective tax rate estimated is 30 per cent.
(7) The corporate equity capital is estimated at 16 per cent.
(8) 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.
32 - 45
Solution (i) Determination of Weighted Average Cost of Capital
Source of funds Cost (%) Weights Total (%)
Equity
12% Debt

16
8.4
0.6
*

0.4
**

9.60
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
2
3
4
5
6
7
8
Rs 170.00
148.75
133.24
130.25
131.96
141.92
141.88
133.35
Rs 5
8
20
25
35
25
15
10
Rs 175.00
156.75
153.24
155.25
166.96
166.92
156.88
143.35
Rs 26.25
23.51
22.99
23.29
25.04
25.04
23.53
21.50
32 - 46
(iii) Determination of Investment [Capital Expenditure + Current Assets, (CA)]
Required, Years 1 8 (Rs million)
Year Investment required Existing
investments
in CA
Additional
investments
required
Capital expenditure CA (Sales x
0.2)
Total
1
2
3
4
5
6
7
8
Rs 5
8
20
25
35
25
15
10
Rs 16
20
30
44
60
52
46
40
Rs 21
28
50
69
95
77
61
50
30*
25**
20
30
44
60
52
46
Nil
3
30
39
51
17
9
4
*including marketable securities
**Balance of CA in year 1: Rs 30 million Capital expenditure incurred in year
1, Rs 5 million
32 - 47
(iv) Determination of Present Value for Explicit Period Projections (years 1 8) (Rs million)
Particulars Year 1 2 3 4 5 6 7 8
A Sales revenue
B Less: Expenses
Variable costs
Fixed cash operating costs
Advertisement
Depreciation
C EBIT (A B)
D Less: Taxes (0.30)
E NOPAT
F Non-operating income
G Gross cash flow
(E + F + Depreciation)
H Less: Investment in (capital
expenditure plus current
assets)
I Free cash flow (G H)
J PV factor (0.13)
K Total PV (I J )
Rs 80

32
16
5
26.25
0.75
0.22
0.53
0.50
27.28



27.28
0.885
24.14
Rs 100

40
16
15
23.51
5.49
1.65
3.84

27.35


3
24.35
0.783
19.07
Rs 150

60
16
15
22.99
36.01
10.80
25.21

48.20


30
18.20
0.693
12.61
Rs 220

88
16
30
23.29
62.71
18.81
43.90

67.19


39
28.19
0.613
17.28
Rs 300

120
20
30
25.04
104.96
31.49
73.47

98.51


51
47.51
0.543
25.80
Rs 260

104
20
30
25.04
80.96
24.29
56.67

81.71


17
64.71
0.480
31.06
Rs 230

92
20
10
23.53
84.47
25.34
59.13

82.66


9
73.66
0.425
31.31
Rs 200

80
20
10
21.50
68.50
20.55
47.95

69.45


4
65.45
0.376
24.61
Total present value = Rs 185.88 million
32 - 48
(v) Determination of PV in Respect of Continuing Value (CV)
CV
8
= FCF
9
/(k
0
g) = Rs 65.45 million (1.05)/(13% 5%) = 68.7225 million/8% =
Rs 68.7225/0.08 = Rs 859.03 million
PV of CV
0
= Rs 859.03 million/(1.13)
8
= Rs 859.03 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
PV of free cash flows after explicit period (known as CV)
Total value
Rs 185.88
323
508.88
(vii) Value of Equity: (Rs million)
Total value of firm
Less: Value of debt
Value of equity
Rs 508.88
80.00
428.88
32 - 49
Market Value Based Approach to Valuation
The market value (reflected in the stock market quotations) is the most
widely used approach to determine the value of a business, in
particular of large listed firms. The market value indicates the price the
investors are willing to pay for the firms earning potentials and the
corresponding risk. This method is particularly useful in deciding
swap ratios in the case of merger decisions.
Fair Value Method
Fair value method is not an independent method of share valuation.
The method uses the average/weighted average of two or more of the
above methods. Therefore, such a method helps in smoothening out
wide variations caused by different methods and indicates the
balanced figure of valuation.
32 - 50
SOLVED PROBLEMS
32 - 51
SOLVED PROBLEM 1
The following is the balance sheet of a corporate firm as on March 31, current
year.
(Rs lakh)
Liabilities Amount Assets Amount
Share capital (of Rs 100 each fully
paid-up)
Rs 100 Land and buildings Rs 40
Reserves and surplus 40 Plant and machinery 80
Sundry creditors and other liabilities 30 Marketable securities 10
Stock 20
Debtors 15

____
Cash and bank
balances

5
170 170
32 - 52
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 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.
32 - 53
Solution
Valuation of business, value of equity and price per equity share (capitalisation
method)
(Rs lakh)
Profit before tax 64
Less: Extraordinary income 4
Less: Interest on marketable securities (not likely to accrue in future) 1
Less: Additional expected recurring expenses 5
Less: Additional depreciation 6
Expected earnings before taxes 48
Less: Taxes (0.30) 14.40
Future maintainable profits after taxes 33.60
Divided by relevant capitalisation factor 0.15
Value of business (Rs 33.60 lakh/0.15) 224.00
Value of equity (Rs 224 lakh Rs 30 lakh external liabilities) 194.00
Price per equity share (Rs 194 lakh/ 1 lakh) 194
32 - 54
SOLVED PROBLEM 2
The most recent accounts of a corporate firm engaged in manufacturing
business are summarized below: (Rs million)
Income statement for the current year ended March 31 Amount
Sales revenue Rs 93.5
EBIT 18.0
Less: Interest on loan 1.8
Earnings before taxes 16.2
Less: Corporate taxes (0.35) 5.67
Earnings after taxes 10.53
32 - 55
Balance sheet as at March 31, current year (Rs million)
Liabilities Amount Assets Amoun
Equity share capital (1 lakh
shares of Rs 100 each)
Reserves and surplus
10% Loan
Creditors and other
liabilities

Rs 10.0
32.5
18.0
18.0

____
78.5
Freehold land and buildings
(net)
Plant and machinery (net)
Current assets:
Stock
Debtors
Bank and cash balance

Rs 20.0
29.5

10.0
15.0
4.0
78.5
32 - 56
Additional Information:
(i) The finance manager of the firm has estimated the future free cash flows of
the company as follows:
(Rs million)
Year 1 Rs 22
2 23
3 24.5
4 26.0
5 30.0
6 32.0
Free cash flows in subsequent years, after year 6, are estimated to grow at 4
per cent. The companys weighted average cost of capital is 12 per cent.
32 - 57
(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 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.
32 - 58
Solution
Determination of value of firm and value of equity share (using various
methods)
(Rs million)
(i)(a) Net asset methodbook value basis
Freehold land and buildings
Plant and machinery
Stock
Debtors
Bank and cash balances
Total assets
Less External liabilities
10% Loan
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








Rs 18
18

Rs 20.0
29.5
10.0
15.0
4.0
78.5


36.0
42.5
1
425

60
20
11
15
4
32 - 59
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)
Earnings per share (Rs 10.53 million/1 lakh shares)
Multiplied by P/E multiple
Market price of equity share (Rs 105.30 7 times)








110
36
74
740



10.53
105.30
7
737.10
CONTD.
(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
2
3
4
5
6
Total present value
Rs 22
23
24.5
26.0
30.0
32.0
0.893
0.797
0.712
0.636
0.567
0.507
Rs 19.646
18.331
17.444
16.536
17.010
16.224
105.191
32 - 60
(b) PV of FCFF subsequent to explicit forecast period
CV
6
= [(Rs 32 (1.04) / (0.12 0.04)] = Rs 33.28/0.08 = Rs 416
PV
0
= Rs 416, continuing value PV factor at 12% for 6 years
= Rs 416 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
32 - 61
MINI CASE
32 - 62
Economic Value Added Nova Chemicals Ltd manufactures a wide-range of high-
quality and competitively-priced products including soda ash, sodium bicarbonate,
salt, caustic soda and urea. Its products go into numerous end-use applications in a
variety of industries such as glass, detergents, papers, textiles, agriculture,
photography, pharmaceuticals, food tanning, ryon, pulp, paints, buildings and
construction.
The most recent balance sheet of Nova Chemicals is summarised in Exhibit 1.
EXHIBIT 1 Balance Sheet of Nova Chemicals (Amount Rs Crore)
Liabilities Amount Assets Amount
Borrowings:
15% term loan from banks
14.5% loan from financial
institutions
Debentures@
Others (short-term)
Shareholders equity:
Share capital
Reserves
Deferred tax liability

Rs 91.19

239.95
98.47
336.03

215.16
1,820.18





Rs 765.64


2,035.34
442.03
3,242.91
Fixed Assets:
Net block
Investments
Net current
assets
Miscellaneous

Rs 1,741.45
626.94
871.38
3.14




________
3,242.91
32 - 63
@Details of Debentures:
13% debentures nineteenth series (2007), face value of Rs 50,00,000 each redeemable at
par in three equal yearly instalments commencing September 1, 2007, Rs 46.67 crore.
11.15% secured redeemable non-convertible debentures, face value Rs 1,00,00,000 each
redeemable at par in the ratio of 33:33:34 in three monthly instalments commencing from
January 2010 or earlier at the option of the company, Rs 6.80 crore.
7.18% secured redeemable non-convertible debentures, face value Rs 2,50,00,000 each
redeemable at par in the ratio of 40:20:40 on March 31 2008, 2009 and 2010, Rs 45 crore.
The most recent profit and loss account of Nova Chemicals is summarised in Exhibit 2.
EXHIBIT 2 Profit and Loss Account of Nova Chemicals (Amount in Rs crore)
Income:
Sales and operating income
Investment income
Interest on refund of taxes
Expenditure:
Raw materials, stores, wages and other expenses
Depreciation
Interest (net)

Rs 2,544.15
38.85
38.26

2,084.36
144.15
50.91



Rs 2,621.26



2,279.42
Required Compute the Economic Value Added for Nova Chemicals.
Tata McGraw-Hill Publishing Company Limited, Financial
Management
32 - 64
Solution Economic Value Added = Net operating profit after taxes (NOPAT) - (Weighted
average cost of capital Capital employed)
Weight Average Cost of Capital = Net payments Capital employed (amount outstanding)
Computation of Weighted Average Cost of Capital
Sources of Funds Outstandi
ng
amount
(Rs crore)
Rate (%) Amount
paid
(Rs crore)
Tax
advantage
on debt@
(Rs crore)
Net
amount
paid
(1) (2) (3) (4) (5) (6)
Debt:
13.25% Debentures
11.15% redeemable
debentures
7.18% Debentures
15% term loans from banks
14.5% loan from financial
institutions
Equity:
Total

46.67

6.80
45.00
91.19

239.95
2,035.34
2,464.95

0.13

0.1115
0.0718
0.15

0.145
0.1885**

7.10*

0.758
3.23
13.67

34.79
383.66

2.485

0.265
1.1305
4.78

12.18


4.615

0.4927
2.0995
8.88

22.61
383.66
413.47
Tata McGraw-Hill Publishing Company Limited, Financial
Management
32 - 65
Weighted average cost of capital = (Rs 413.47 Rs 2,464.95) 100 = 16.75%
EVA = Rs 208.3 crore (Rs 413.47 crore Rs 205.17@@ crore)
@Assumed tax rate, 35 per cent
@@Total operating profit (Rs 2,544.15 crore, operating income Rs 2,084.36,
crore, cost of raw materials, stores, wages, other expenses Rs 144.15 crore,
depreciation) = Rs 315.64 crore
Net operating profit after taxes [Rs 315.64 crore Rs 110.47 crore taxes (Rs
315.64 crore 0.35] = Rs 205.17 crore
**Cost of Equity Capital:
Using CAPM approach and assuming the (i) yield on 10-year RBI bonds as the
risk free rate of return of 7.32%, (ii) long term rate of return on BSE-500 Index of
18 per cent (iii) beta of Nova Chemicals from the NSE, 1.08
K
e
= 0.0732 + 1.08 (0.18 - 0.732)
= 0.188544 = 18.85 per cent
Tata McGraw-Hill Publishing Company Limited, Financial
Management
32 - 66
*Interest paid:
PVIFA
2,13
= 2.107
Single instalment = Rs 46.67 2.107 = Rs 22. 15 crore
Total amount payable = 3 Rs 22.15 = Rs 66.45 crore
Interest paid for 5 months = (Rs 66.45 crore 0.13 5) 12 = Rs 3.56
crore
Interest paid for 7 months = (Rs 46.67 crore 0.13 7) 12 = Rs 3.54
crore
Total interest paid (Rs 3.65 crore + Rs 3.54 crore) = Rs 7.10 crore.