ABSTRACT The area of corporate finances, management and strategy dealing with purchasing and/or joining with other companies. Sangapu Pranathi CA FINAL SFM
MERGERS & ACQUISITIONS
Consolidation of Companies or Assets
0 | P a g e
Contents Mergers ...... 3 Distinguish between Acquisition/Takeover and Amalgamation ...... 5 Types of Mergers ...... 5 Types of Takeover Strategies ...... 7 Friendly and Hostile takeover ...... 7 Various Anti-Takeover Strategies (or) Defending against Takeover Bid ...... 9 Corporate Restructuring ...... 10 Mode of Consideration ...... 10 Computation of Minimum Exchange Ratio and Maximum Exchange Ratio ...... 11 Financial Evaluation of Merger Proposal...... 11 Gains from Mergers or Synergy Effect ...... 12 Valuation Techniques of Mergers and Acquisitions ...... 13 Discounted Cash Flow/Free Cash Flow Method...... 13 Cost to Create Method ...... 14 Capitalized Earnings Method ...... 14 Chop-Shop Method ...... 14 Market based Valuation of Target Firm ...... 14 If Target Firm is a Listed Company ...... 15 If Target Firm is not a Listed Company ...... 15 Asset based Valuation of Target Firm...... 15 Book Value ...... 15 Net Adjusted Asset Value or Economic Book Value...... 15 Liquidation Value ...... 15 Valuation of Intangible Assets of Target Firm ...... 16 Economic Value Added ...... 17 Demerger ...... 17 Financial Restructuring ...... 18 Restructuring by bringing about changes in Corporate Controls ...... 19 Leveraged Buy-Outs ...... 19 Management Buy-Outs ...... 19 Shareholder Value Analysis ...... 20 Sustainable Growth Rate ...... 21 Illustrations ...... 23 Example 1 ...... 23
1 | P a g e
Example: 2 ...... 24 Example: 3 ...... 25 Example: 4 ...... 27 Example: 5 ...... 29 Example: 6 ...... 29 Example: 7 ...... 32 Example: 8 ...... 34 Example: 9 ...... 36 Example: 10 ...... 37 Example: 11 ...... 38 Example: 12 ...... 39 Example: 13 ...... 40 Example: 14 ...... 42 Example: 15 ...... 46 Example: 16 ...... 48 Example: 17 ...... 48 Example: 18 ...... 50 Example: 19 ...... 51 Example: 20 ...... 52
2 | P a g e
Mergers 1. Mergers mean Unification of two entities into one. In India, in legal sense, Merger is known as “Amalgamation” 2. Amalgamations and Absorptions are the basic forms of Merger. 3. If two or more Companies, combine together and forms a new company to take-over the running business of existing companies is known as Amalgamation. 4. In this case, Existing firms will liquidate then Business and New Firms will continue with the Assets and liabilities of the existing firms. 5. If one firm takes over the Assets and Liabilities of another firm, it is a case of Absorption. 6. In this case the acquiring firm will be continued as going concern and the business of Target Company will be liquidated. 7. A Merger results in the legal dissolution of one of the companies, and a Consolidation dissolves both the companies and creates a new company, into which previous entities are merged. 8. Acquisition involves one entity buying out another and absorbing the same. 9. An Acquisition is when both the acquiring companies are still left standing as separate entities at the end of transaction. 10. It refers to purchase of ownership rights or any other assets by one company in another company. The acquiring company and target company will be continued as going concerns
3 | P a g e
Reasons for Mergers and Acquisitions:
1) Synergy Effect The combined value of two entities is generally more than the sum of their individual values. This additional value creation is called Synergy Effect. 2) Desire for Quick Growth Organic Growth can happen only step-by-step, and takes a longer period of time. On the other hand, inorganic growth, that is growth by acquisitions, helps a company to grow faster and quicker, the reason being the shortening of ‘Time to Market’ 3) Reduction in Business Risk through Diversification Merger between two unrelated companies would lead to reduction in Business Risk. It will increase the market value due to reduction in Discount Rate or Required Rate of Return. Generally, greater the combination of statistically independent or negatively correlated income streams of Merged Companies, there will be higher reduction in the Business Risk, in comparison to Companies having income streams which are positively correlated to each other. 4) Taxation Provisions of Set off and carry-forward of losses as per Income Tax Act can also be a reason for M&A, since there will be a tax saving or reduction in tax liability of the Merged Firm. Tax Saving is one of the main reasons for “Reverse Merger” Also in case of acquisition, the losses of the Target Company will be allowed to be set off against the profits of the Acquiring Company. 5) Other Reasons a. Consolidation of Production Resources b. Increased Market power and Market Share c. Entry into new markets d. Better access to funds and Cash Flow Management
4 | P a g e
Distinguish between Acquisition/Takeover and Amalgamation Acquisition/Take over Amalgamation SEBI is the primary governing law Companies Act 1956 is the governing law It involves gaining control over the assets of the It involves direct control over the assets of the company by holding controlling interest in the target company by absorbing the company Target Company Takeover does not liquidate the Target Company Selling Companies will be liquidated pursuant to Amalgamation Assets and Liabilities of the Target Company are Assets and Liabilities of the Selling Companies are not transferred to the Acquiring Company transferred to the Acquiring Company Court Approval for acquisition is not required, if Scheme of Amalgamation or arrangement requires the transfer of business is to be accomplished High Court’s Order without allotting shares in the transferee company to the shareholders of the transferor company
Types of Mergers 1. Horizontal Merger It is a Merger when the companies which have merged are in the same industry, i.e. producing either same or competing products. Advantages - 1. High Market Share for new consolidated Company 2. Moving closer to being a monopoly, economies of Scale 3. Optimum Size 4. Curbing off Competition 5. Usage of unutilized capacity.
5 | P a g e
2. Vertical Merger When two companies having “Buyer-Seller” relationship (or potential buyer-seller relationship) come together. Advantages – 1. Improved co-ordination of activities 2. lower inventory levels 3. higher market power of the combined entity 4. Lower costs and eliminating avoidable Sales Tax and /or Excise Duty.
3. Conglomerate Merger It involves two companies that merge are in different fields altogether, i.e. unrelated type of business operations. The business activities of the Acquirer and the Target are not related to each other horizontally or vertically. There are no important common factors between the Acquirer and the Target Companies in Production, Marketing, R&D and Technology. Advantages – 1. Unification of Different kinds of businesses under one flagship Company 2. Utilization of financial Resource 3. Enlarged debt capacity and enlarged debt capacity and synergy of managerial functions.
4. Congeneric Merger In these mergers, the Acquirer and the Target Companies are related through basic technologies, production processes or markets. The Acquired Company represents an extension of product-line, market participants or technologies of the Acquirer. These Mergers represent an outward movement by the Acquirer from its current business scenario, to other related business activities within the overarching industry structure.
5. Reverse Merger Takeover of Big or Profits making Company by Small or Loss making Company. Reverse Merger happens when, in order to avail benefit of carry forward of losses which are available according to tax law only to the Company which had incurred them, the profit making company (Target Company/Big Company) is merged with Companies having Accumulated Losses (Acquirer or Small Company).
6 | P a g e
It can also be described as acquisition of a public company by a private company so that the private company can bypass the lengthy and complex process of going public.
Features – (a) In a Reverse Merger, a smaller company gains control over larger one. (b) The entire undertaking of the healthy and prosperous company is merged and vested in the Sick Company which is non-viable and whose net worth has eroded. (c) Reverse takeover is also applicable to the purchase of a Listed Company by an United Company with control passing to the Shareholders and Management of the Unlisted Company. This is known as a Back Door Listing. (d) A Reverse Takeover may take place by way of a Pure Equity Acquisition, also called as Share Swap. Conditions to be satisfied – (a) Assets of the Transferor Company are greater than the Transferee Company (b) Equity Capital to be issued by the Transferee Comp any pursuant to the acquisition exceeds its Original Issued Capital. (c) There is a change in the Transferee Company, through the introduction of a minority holder or group of holders.
Types of Takeover Strategies 1. Street Sweep – A technique where the Acquiring Company accumulates larger number of shares in a Target Company before making an Open Offer. The Advantage is that the Target Company is left with no option but to agree to the proposal of the Acquirer for Takeover. 2. Bear Hug – When the Acquirer Company threatens the Target Company to make an Open Offer, the Board of Directors of the Target Company agrees to a settlement with the acquirer for Change of Control. 3. Strategic Alliance – this involves Disarming the Acquirer by offering a Partnership rather than Buyout. The Acquirer should assert control from within, and takeover the target company. 4. Brand Power – this refers to entering into an alliance with powerful brands to displace the Target’s brands, and as a result, buyout the weakened company.
Friendly and Hostile takeover Friendly Takeover The owners of both the firms agree to the terms of takeover strategy One firm acquires the other firm and both the firm agreed to such takeover Hostile Takeover A takeover opposed by Target Company’s Board of Directors Acquiring Company offers the Target Company’s Shareholders Cash in exchange for their Shares
7 | P a g e
If the acquiring corporation obtains enough shares, it can approve a merger resolution or, alternatively, simply operate the corporation as its subsidiary by replacing its directors and officers with its own appointees and direct corporate affairs in this manner.
8 | P a g e
Various Anti-Takeover Strategies (or) Defending against Takeover Bid Actions by managers to resist having their firm taken over by other companies 1. Crown Jewel Defence An act by Board of Directors of Target Company sells off the most valuable Assets of the company to make the company less attractive to the acquirer 2. Poison Pill To dilute the Target Company Stock in the Company so much that bidder never manages to achieve an important part of the company without the consensus of the board. 3. Poison Put The company issue bonds which will encourage the holder of the bonds to cash in at higher prices which will result in Target Company being less attractive 4. Greenmail It involves Repurchasing a block of shares by the Target Company which is held by a Single shareholder or group of shareholders at a premium over the stock Price in return for an agreement. In this agreement it is stated that the bidder will no longer be able to buy shares for a period more than 5 Years. 5. White Knight Here the Target Company approaches a Friendly Company which can acquire majority of shares of Target Company. The main intention of White Knight is to ensure that the management of the Target Company is not diluted. 6. White squire It is a Variation of White Knight. Instead of Acquiring Major Stake, here the acquiring company acquires a minor stake that is enough to hinder the hostile bidder from acquiring majority stake 7. Golden Parachutes An agreement between a company and an employee (usually upper executive) specifying that the employee will receive certain significant benefits if employment is terminated. This will discourage the bidders and hostile takeover can be avoided. 8. Pac-man Defence The target company itself makes a counter bid for the Acquirer Company and let the Acquirer Company defence itself which will call off the proposal of takeover.
9 | P a g e
Corporate Restructuring Corporate Restructuring and reorganization seeks to create new synergies and shift in corporate strategies, to face the competitive environment and changed market conditions. It Covers – 1. Expansion or Contraction of a Firm’s operations 2. Changes in Assets 3. Changes in Financial or Ownership structure 4. Changes in Financial or Ownership structure It can be done internally or externally. ● Internally in the form of new Investments, Hiving off of non-core businesses, divestment, demerger etc. ● Externally in the form of Mergers and Acquisitions, by forming Joint-Ventures, having strategic alliances with other firms.
Mode of Consideration The acquiring company has to decide about the mode of consideration to be payable to target company. The Purchase Consideration is discharged in Cash Mode or in the form of Shares. 1. Cash Mode It leads to sale of shares by Members of Target Company and attracts Capital Gains Tax. There is No dilution of control as far as the members of acquiring company are considered. It will affect the liquidity position of acquiring company. It is certain to receive fixed amount per share. The members of Target Company will prefer the cash mode. 2. Share Exchange Mode There is dilution of control It is not a sale and does not attract Capital Gain Tax. The members of the Target Company will be continued as the members of the Acquiring Company as a Result, the Earnings per Share of Acquiring Company will be diluted in the future. Appropriate Mode of Discharge of Compensation Situation Compensation
Acquiring Firm’s Stock is overvalued relative to the Target Company’s Stock Stock
Taxability in the hands of Shareholders of Target Firm Cash
High Risks associated with the stock of Target Firm Cash
Basis of Share Exchange of Share Exchange Ratio – It can be defined as Number of shares to be offered by the acquiring company to the members of the Target Company. For Example, 3:4 share exchange gains can be defined as acquiring company will issue “3” New Shares for every “4” existing shares held in Target Company.
10 | P a g e
Share Exchange Ratio based on – 푁퐴푉 푝푒푟 푠ℎ푎푟푒 표푓 푇푎푟푔푒푡 퐶표푚푝푎푛푦 1. NAV per Share – 푁퐴푉 푝푒푟 푠ℎ푎푟푒 표푓 퐴푐푞푢𝑖푟𝑖푛푔 퐶표푚푝푎푛푦 푀푃푆 표푓 푇푎푟푔푒푡 퐶표푚푝푎푛푦 2. MPS – 푀푃푆 표푓 퐴푐푞푢𝑖푟𝑖푛푔 퐶표푚푝푎푛푦 퐸푃푆 표푓 푇푎푟푔푒푡 퐶표푚푝푎푛푦 3. EPS - 퐸푃푆 표푓 퐴푐푞푢𝑖푟𝑖푛푔 퐶표푚푝푎푛푦
Computation of Minimum Exchange Ratio and Maximum Exchange Ratio (푉 + 퐺 ) × 푆 퐸푥푐ℎ푎푛푔푒 푅푎푡𝑖표 = 푆 푆 퐵 (푉퐵 + 퐺퐵) × 푆푆 Where,
Vs = Value of Selling Company before Merger
VB = Value of Buying Company before Merger
Gs = Share of Selling Company in the Gain on Value due to Merger
GB = Share of Buying Company in the Gain on Value due to Merger
Ss = Shares outstanding in Selling Company before Merger
SB = Shares outstanding in Buying Company before Merger
(푉푆+0)×푆퐵 Minimum Exchange Ratio = (푉퐵+퐺퐵)×푆푆
(푉푆+퐺푆)×푆퐵 Maximum Exchange Ratio = (푉퐵+0)×푆푆
Financial Evaluation of Merger Proposal Financial Evaluation of a Merger Proposal involves computing NPV of the Merger for each firm. A + B = AB Cash and Synergy in Value
VAB = VA +VB + Synergy – Cash
NPV of A = VAB - VA
NPV of B = Cash – VB
Maximum Amount that A can pay is VB + Synergy
Minimum Price that B wants is VB True Cost of Acquisition to A = NPV to B Stock and Synergy in Value
VAB = VA +VB + Synergy PAB = VAB
NA+ r. NB NPV to any firm = (Post merger price – premerger price)* no. of shares
NPV to A = (PAB - PA)* NA
NPV to B = (r.PAB – PB)*NB
11 | P a g e
Cash Deal and Synergy in Earning NPV of the merger to each firm-
PATAB = PATA + PATB + Synergy Assuming P/E ratio remaining the same
VAB= (P/E Ratio *PATAB) - cash
NPVA= VAB –VA
NPV B= Cash –VB ● Stock Deal and Synergy in Earnings NPV of the merger to each firm- VAB= (P/E Ratio* PATAB) PAB = VAB NA+ r. NB NPVA = (PAB – PA) NA NPVB = (r. PAB – PB) * NB NOTATION VA = Value of firm A VB = Value of firm B VAB = Value of a firm A + Value of a firm B Synergy = VAB - (VA + VB) PAB = Share price of A and B
Gains from Mergers or Synergy Effect Synergy may be defined as
VAB > VA + VB Combined Values of Two Firms will be more than the individual values. Synergy represents increase in performance of the Combined Firm, over and above what the two Firms are already expected or required to accomplish as Independent Firms. Reasons – (a) Complimentary Activities - One Company having a good networking of Branches and Sales Centres, and the other company having efficient production system. Thus, the merged company will be more efficient than individual companies. (b) Economies of Scale – “Real” Economies of Scale arises reduction in factor input per unit of output “Pecuniary” economies of scale arise paying lower prices for factor inputs for bulk transactions. Thus, large scale production results in lower average cost of production and consequent Synergy Effect. Computation – 1. Combined Value = Value of Acquirer + Stand Alone Value of Target + Value of Synergy 2. Cost of Acquisition (or) Transaction Cost = Premium Price paid over Market Value plus Other Costs of Integration. 3. Net Gain in Acquisition = Value of Synergy minus Transaction Cost. Subsequent Value Creation – 1. Even if a merger is non-synergistic at the time of acquisition, operating improvements can lead to value creation in due course. 2. Better post-merger integration could lead to higher returns and value creation by cutting down costs, improving revenues and operating profit margins, cash flow position, etc. Cost of Merger (or) True Cost of Acquisition (or) Premium (or) Good will (or) Transaction Cost It is the excess consideration paid by Acquiring Company to take over the Current Market Value of Target Company. Consideration offered to Target Company – Current MV of Target Company
12 | P a g e
Valuation Techniques of Mergers and Acquisitions Discounted Cash Flow/Free Cash Flow Method Merger proposed is treated as Investment Decision. It can be evaluated by any of the Capital Budgeting Techniques (NPV, IRR, PI etc.). But NPV is the most common Technique used for evaluation of Merger Proposals. It takes into consideration the future earnings of the business. The value of the business depends on projected future revenues and costs, expected Capital Outflows, number of years of projection, Discounting Rate and Terminal Value of Business.
Procedure – 1. Compute Present Value of Cash Outflows (or) Cost of Acquisition 2. Compute Operating Cash Flows after Tax Particulars Amount
Sales XXX
Less Cost XXX
Earnings Before Interest and Tax XXX
Less Interest XXX
Earnings Before Tax XXX
Less Tax XXX
Earnings after Tax XXX
Add Depreciation XXX
Cash Flow After Tax XXX
Less Increase in Capital Expenditure XXX
Increase In Working Capital XXX
Free Cash Flows after Tax XXX
3. Terminal Cash Flows 4. NPV is difference between PV of Cash Inflows (PV of Operating Cash Flows and PV of Terminal Cash flows) and PV Cash Outflows. 5. Discounting factor being WACC of the Acquiring Company. Assumptions involved 1. Terminal Value is Growing Perpetuity Cash flows are assumed to grow at a constant rate after the forecast period. The acquirer will not make any operating improvements or change the capital structure. 퐶퐹 × (1 + 푔) 푇푒푟푚𝑖푛푎푙 푣푎푙푢푒 = 푡 (푘 − 푔)
Where, CFt is Cash flow in the last year, g is Constant Growth rate and k is Discount Rate 2. Terminal Value is a Stable Perpetuity There is no growth in the Total Capital after the forecast period, i.e. either no capital expenditure or Capital Expenditure exactly equals Depreciation Expense
13 | P a g e
퐶퐹 푇푒푟푚𝑖푛푎푙 푉푎푙푢푒 = 푡 푘
Where, CFt is Cash flow in the last year and k is discount rate 3. Terminal Value is a Multiple Book Value Terminal Value is taken as an appropriate multiple of the book value. Forecast Book Value and Market Value are interrelated in the same manner as current M/B Ratio 푇푒푟푚𝑖푛푎푙 푉푎푙푢푒 = 퐵푉푡 × 퐶푢푟푟푒푛푡 푀 ⋰ 퐵 푅푎푡𝑖표
BVt is Book Value in the last year and 푀푎푟푘푒푡 푣푎푙푢푒 표푓 퐶푎푝𝑖푡푎푙 (퐸 + 퐷) 푀 ⋰ 퐵 푅푎푡𝑖표 = 퐵표표푘 푉푎푙푢푒 표푓 퐶푎푝𝑖푡푎푙 (퐸 + 퐷)
4. Terminal Value is a Multiple of Earnings Terminal Value is taken as an appropriate multiple of the projected Net Operating Profits (NOPAT). The current PE Ratio will continue after the forecast period. 푇푒푟푚𝑖푛푎푙 푉푎푙푢푒 = 푁푂푃퐴푇푡 × 퐶푢푟푟푒푛푡 푃퐸 푅푎푡𝑖표
Where, NOPAT1, is NOPAT in the last year and 푀푎푟푘푒푡 푃푟𝑖푐푒 푝푒푟 푆ℎ푎푟푒 푃퐸 푅푎푡𝑖표 = 퐸푎푟푛𝑖푛푔푠 푝푒푟 푆ℎ푎푟푒 Cost to Create Method Value of Business is Cost of Creating the Business from Scratch + Reasonable Margin This method is suitable in cases like Build-Operate-Transfer Deals. Capitalized Earnings Method 퐴푣푒푟푎푔푒 푁푒푡 푃푟표푓𝑖푡푠 표푓 푇푎푟푔푒푡 퐹𝑖푟푚 푉푎푙푢푒 표푓 퐵푢푠𝑖푛푒푠푠 = 푅푒푞푢𝑖푟푒푑 푅푎푡푒 표푓 푅푒푡푢푟푛 (퐶푎푝𝑖푡푎푙𝑖푧푎푡𝑖표푛 푅푎푡푒)
Net profits of the Target Firm may either be current year profits or Average Profits of Specified years. Capitalization rate refers to the Return on Investments expected by an Investor, from the new entity. Chop-Shop Method This approach seeks to identify Multi-Industry Companies that are undervalued and would have more value if separated from each other. Under this approach an attempt is made to buy assets below their replacement value. Procedure – 1. Identify the Total Segments of the Company 2. Identify Total Assets, Total Sales, Total Profits in each segment 3. Obtain Standard Ratios with respect to Sales, total assets and profits (Capital TO Ratio, Assets TO Ratio, ROCE – Operating Profit Ratio) 푉푎푙푢푒 표푓 푡ℎ푒 푐표푚푝푎푛푦 푉푎푙푢푒 푏푎푠푒푑 표푛 퐴푠푠푒푡푠 + 푉푎푙푢푒 푏푎푠푒푑 표푛 푆푎푙푒푠 + 푉푎푙푢푒 푏푎푠푒푑 표푛 푃푟표푓𝑖푡푠 = 3 Market based Valuation of Target Firm Market based Valuation of Target firm is similar to Capitalized Earnings Method; however the Capitalization Rate is based on Market Rates.
14 | P a g e
If Target Firm is a Listed Company Net Profits and Capitalization Rate are taken based on Earnings and Market Capitalization Rate of similar type of companies. If Target Firm is not a Listed Company 퐹푢푛푑푎푚푒푛푡푎푙푠 퐹𝑖푛푎푛푐𝑖푎푙 푉푎푟𝑖푎푏푙푒 표푓 푇푎푟푔푒푡 퐹𝑖푟푚 푉푎푙푢푒 표푓 퐵푢푠𝑖푛푒푠푠 = 퐴푝푝푟표푝푟𝑖푎푡푒 푀푎푟푘푒푡 퐶푎푝𝑖푡푎푙𝑖푧푎푡𝑖표푛 푅푎푡푒
(Or)
(Fundamental Financial Variable of Target Firm) × (Appropriate Market Value Multiple)
Fundamental Financial Variable of Target Company may either be Earnings, Book Value or revenue of the Target Company Market Multiples/ Capitalization Rate of comparable Listed Companies are taken as base, and adjusted for differences/variations due to Target Firm’s growth, size, business model, geographical spread, risk patterns etc. vis-à-vis as those of comparable companies. Market Multiples or Capitalization Rate may either be Market Capitalizations to Sales, PE ratio, etc. Asset based Valuation of Target Firm Value of Business = Value of Assets less Value of Liabilities Book Value This method considers the Book Value (Balance Sheet Value) of all Assets and Liabilities. It does not take into account, the effect of current market prices/realizable values thereof. Assets are taken at Historical Cost Liabilities are taken at Balance Sheet Amounts Net Adjusted Asset Value or Economic Book Value 1. Value of Going Concern business is computed by adjusting the value of all its assets and liabilities to the Fair Market Value. This method allows for valuation of Goodwill, Inventories, Real Estate, Intangibles, and other assets at their current market value. 2. Assets are taken at Current Market Value or Fair Market Value 3. Assets are taken at Fair Market Value, i.e. amount required to settle them in due course. Liquidation Value 1. If the Business is not to be acquired on Going Concern basis, the Liquidation Value (i.e. realization from sale of assets and settlement of liabilities) is considered for the purpose of valuation. 2. Liquidation Value of a company is equal to what remains after all assets have been sold and all liabilities have been paid. 3. Value of Business using this method should be lower than a valuation reached using the book value or adjusted asset value method. 4. This is considered to be a better floor price than book value of a company, because if a company drops significantly below this price, then a Corporate Raider can buy enough stock to take control of it, and then liquidate it for a riskless profit. However, the company’s Stock Price would have to be low enough to cover the costs of liquidation, and the uncertainty in what the assets would actually sell for in the market place. 5. Assets are taken at the price they would fetch on sale, i.e. NRV 6. Liabilities are taken at the actual amount required to settle them immediately
15 | P a g e
Valuation of Intangible Assets of Target Firm 1. Market based Valuation Value is based on Market Values of similar Intangible Assets 2. Cost based Valuation Either “Cost to Create” or “Cost to replace” method can be used Assumes that there is some relationship between cost and value Ignores Time Value of Money and Capital Maintenance Concept 3. Income based Valuation, i.e. Estimates of Past and Present Economic Benefits This may be further sub-classified into – a. Capitalization of Historical Profits Method b. Gross Profit Differential Method c. Excess Profits Method d. Relief from Royalty Method a. Capitalization of Historical Profits Method Value of Intangible Assets = Maintainable Historical Profitability of the Asset × Appropriate Multiple The appropriate multiple is determined, after assessing the relative strengths of the Intangible Asset, in the light of factors like leadership, stability, and market share, and internationality, trend of profitability, marketing, and advertising support and protection. This method has major short comings, associated with Historical Earning Capability. The method pays little regard to the future. b. Gross Profit Differential Method This method is often associated with Trademark and Brand Valuation. This method look at the differences in Sale Prices, adjusted for differences in Marketing Costs. That is the difference between the Margin of Branded and Patented Product and an unbranded or generic product. This result is used to determine appropriate Cash-Flows and Value of Intangible Asset. However, finding generic equivalents for a patent and identifiable price differences is more difficult than for a Retail Brand. c. Excess Profits Method This method looks at the current value of the Net Tangible Assets employed as the benchmark for an estimated rate of return. This is used to calculate the profits that are required to induce Investors to invest into those Net Tangible Assets. Any return over and above those profits required in order to induce investment is considered to be the Excess Return attributable to the Intangible Assets While theoretically relying up on Future Economic Benefits from the use of the asset, the method has difficulty in adjusting to alternative uses of the asset. ● Relief from Royalty Method This method considers what the Purchaser could afford, or would be willing to pay, for a license of similar Intangible Assets. The Royalty Stream is then capitalized, to reflect the risk and return relationship of investing in that Intangible Asset.
16 | P a g e
Economic Value Added It is the Surplus generated by an entity after meeting an equitable change towards the providers of Capital. In other words it is the returns earned by Company in excess of minimum expected return of the shareholders. Particulars Amount
EBIT (Operating Income) XXX
Less: Taxes XXX
EAT (Net Operating Profits after Tax) XXX
Less: Cost of Capital Employed XXX
Economic Value Added XXX
Cost of Capital Employed = WACC x Capital Employed EVA can be increased by – 1. Improving the Operating Profits by efficient operation, without employing additional capital 2. Investing in new projects which give higher returns than cost of their financing 3. Liquidating Unproductive capital (Buy-back of shares, redemption of Debentures etc) Benefits – 1. It helps in measuring business 2. It helps to Equate Managerial incentives with Shareholder’s interest 3. It helps to improve Financial and Business literacy throughout the firm
Demerger It is a form of Corporate Restructuring, an Undertaking transferred or sold to another entity. Even after Demerger, the existing company continues to exist, as only part of the entity is sold or transferred. Reasons – 1. Need to pay attention to core areas of Business 2. Downsizing of the firm, in case if it is too big 3. Selling off of loss making divisions, in order to Optimize the Profits 4. Window of Opportunity, possibility to sell at a attractive price 5. Lack of adequate capital to continue the project 6. Need for immediate cash Methods – 1. Sell off A Sale of an Asset, division, factory, product line, subsidiary, by one entity to another entity for a Purchase Consideration payable in Cash or in other form of Securities 2. Spin Off No Change in Ownership Part of Business is separated and created as a separate firm Existing Shareholders get proportionate ownership in newly formed entity Management is spun-off
17 | P a g e
Reasons – To create separate identity To avoid takeover attempt by a Predator, by making firm unattractive to him To Create separate regulated and unregulated lines of business 3. Split Up Breaking up of entire business into series of spin offs Parent firm no longer legally exists Only newly created small entities with Separate Legal entity exists They are logically more convenient and manageable It is likely to enhance shareholders value and bring efficiency and effectiveness 4. Carve Out Similar to Spin-Off Some shares of new company are sold in the market by making public offer So there is inflow of Cash The existing company may sell their majority or minority share depending up on whether they want to control management or not. 5. Sale of Divisions The seller company is demerging its business where as the buyer company is acquiring a business.
Financial Restructuring 1. It is also called as Internal Re-construction. 2. Internal Changes made by Management, in the Assets and Liabilities of a Company, with the consent of its shareholders. 3. It leads to significant changes in the Financial Obligations and Capital Structure of the entity, leading to a change in the Financing Pattern, Ownership and Control and payment of various financial charges. 4. It is suitable for entities which have suffered sizeable losses over a period of time. 5. It is suitable to firms which have potential and promise for better financial performance in future years. 6. It gives a fresh start to the firms. It aims at re-defining the financial position of the corporate firm, by way of – 1. Seeking re-financing 2. Reduction or waiver in the claims of various stakeholders 3. Revaluation of Assets and Liabilities 4. Using the profit accruing on account of appreciation of assets and waiver of liabilities, to write off Accumulated Losses and Fictitious Assets.
Who sacrifices – What? ● Equity Shareholders – Change in Rights, Reduction in Face Value of Shares, etc. ● Preference Shareholders – foregoing arrears in Cumulative dividend, reduction in face value of shares, etc. ● Debenture holders, Lenders and Creditors – waiving a part of the sum payable to them, acceptance of new securities with lower coupon rates, conversion of debt into equity, conversion of their dues into equity shares to avert pressure of payment, acceptance of certain assets in full or part settlement etc.
18 | P a g e
Restructuring by bringing about changes in Corporate Controls This can be done in any of the following ways – 1. Delisting or Going Private A situation where in a Listed Company is converted into a Private Company by buying back all the outstanding shares from the markets 2. Equity Buyback The Company buys back its own shares back from the market. This results in reduction in Equity capital of the company. It also strengthens the Promoter’s Position by increasing his stake in the Equity of the Company. 3. Re-structuring of existing business It involves downsizing and closing some unprofitable departments, reduction in number of personnel, etc. 4. Buy-outs and Buy-ins Buy-Outs are divided into Leveraged Buyouts and Management Buy-Outs. Leveraged Buy-Outs It is Acquisition or Takeover of the company, in which acquisition is substantially financed through Debt. Debts may constitute around 80% of the Value of Acquisition Such debts is obtained on the basis of the Company’s Future Earnings A large part of Debt is secured by Firm’s Assets and the Lenders take a portion of Firm’s Equity It involves settlement of Cash to Sellers (Purchase Consideration is not in the form of Shares) Management Buy-Outs When Managers buy their company from its Owners it is called Management Buy-Outs When? o When the management of the Company is threatened with the sale of the Business to third parties o When the Management of the Company is frustrated with the Slow Growth of the Company They step in and acquire the Business from its Owners, and run the business by and for themselves. Buy-Out by Current Management The current management of the company buys out the Company or Division of the Company from its owners This generally happens when the owners loose interest in the company or due to accumulated losses. Buy-Out by Private Equity Participant – Buy-In An active Private Equity Participant may go after weak managements and buy-out their stake PEP brings in its own management team to manage the business takeover That management team takes a stake in the Equity Capital of the Company while coming in, so it is called as Management Buy-In.
19 | P a g e
Shareholder Value Analysis It focuses on creation on Economic value for shareholders. It is measured by Share Price Performance and Flow of Funds It is used a way of linking management strategy and decisions to the creation of value for the shareholders. Managerial decisions include – Investment decision, Business decisions and Financing Decisions. These decisions have impact on the creation of value to shareholders.
Shareholders Value = NOPAT – Cost of Capital In order to understand value creation in a company it is necessary to locate and understand where the value is created – which means identification of Value Drivers of the business. A thorough understanding of the value drivers and their effect on the company’s future cash flows will help in managerial decision making to create value for shareholders. Value Drivers include – Growth in Sales, Profit margin, Capital investment decisions etc. Benefits – 1. It helps management to concentrate on activities which create value to shareholders rather than on short-term profitability. 2. SVA and EVA helps in strengthening the competitive position of the firm, by focusing o wealth creation.
20 | P a g e
Sustainable Growth Rate It is the maximum growth rate that can be achieved in sales without exhausting the Operating Cash Flows.
Objectives – To maintain target capital structure without losing new Equity Maintain target dividend payment ratio Increase sales as rapidly as market conditions allow
Variables – ✓ Net Profit Margins on new and existing revenues ✓ Asset Turnover Ratio ✓ Assets to beginning of the period Equity Ratio ✓ Retention Ratio – Earnings retained in the business
Variants – Incremental Growth strategy, Profit Strategy and Pause Strategy are the other variants of Stable or Sustainable Growth Strategy
Analysis – If a Firm has actual growth rates less than the SGR, the Management’s Principle objective is – ✓ To find out productive uses of cash flows that exist in excess of their needs ✓ To enhance their actual growth rates through acquisition of rapidly growing firms
Computation of Sustainable Growth Rate – Assumptions – 1. Assets of the Firm will increase proportional to Sales 2. Net Profit is a constant proportion of Sales 3. Dividend Pay-out Ratio and the Debt Equity Ratio of the Firm are given 4. Firm will not raise external Equity Capital 5. Addition to Assets = Addition to Retained Earnings + Addition to Borrowings
Computation – a) Sustainable Growth Rate (g) = ROE x (1-Dividend Payout Ratio) 퐸푎푟푛𝑖푛푔푠 푎푓푡푒푟 푇푎푥 Where 푅푂퐸 = (this is used in Gordon Model in Dividend Decisions – It recognizes 푁푒푡 푊표푟푡ℎ growth relating to Equity) 퐼푛푐푟푒푎푠푒 𝑖푛 퐴푠푠푒푡푠 b) Sustainable Growth Rate (g) = 퐴푠푠푒푡푠 푎푡 푡ℎ푒 푏푒푔𝑖푛𝑖푛푔 표푓 푡ℎ푒 푦푒푎푟 퐼푛푐푟푒푎푠푒 𝑖푛 퐴푠푠푒푡푠 = (퐴푠푠푒푡푠 푎푡 푡ℎ푒 푌푒푎푟 퐸푛푑 − 퐼푛푐푟푒푎푠푒 𝑖푛 퐴푠푠푒푡푠)
푁푒푡 푀푎푟푔𝑖푛 × 푅푒푡푒푛푡𝑖표푛 푅푎푡𝑖표 × 퐿푒푣푒푟푎푔푒 = 퐴푠푠푒푡 푡표 푆푎푙푒푠 − [푁푒푡 푀푎푟푔𝑖푛 × 푅푒푡푒푛푡𝑖표푛 푅푎푡𝑖표 × 퐿푒푣푒푟푎푔푒]
21 | P a g e
퐷 푃 × 푆0 × 푏(1 + ) 푆푢푠푡푎𝑖푛푎푏푙푒 퐺푟푤표푡ℎ 푅푎푡푒 = 퐸 퐷 퐴 − 푃 × 푆 × 푏(푎 + ) 0 퐸 Where, P is Net Profit Margin on Sales
S0 is Sales for the Previous Year A is Total Net Assets at the end of the Period [Capital Employed] b is Retention Ratio = (1-Dividend Pay-out Ratio) D/E is Debt Equity Ratio
Here it is assumed that Debt Component also grows at SGR and this formula cannot be considered for all Equity Firm.
22 | P a g e
Illustrations Example 1 A Ltd wants to acquire T Ltd and has offered a Swap ratio of 1:2 (0.5 shares for every one share of T Ltd). Following information is provided – Particulars A Ltd T Ltd
Profit After Tax Rs. 1800000 Rs. 360000
Equity Shares Outstanding 600000 180000
Earnings per Share Rs. 3 Rs. 2
PE Ratio 10 times 7 Times
Market Price per share Rs. 30 Rs. 14
Required – a) Number of Equity Shares to be issued by A ltd, for acquisition of T Ltd b) What is the EPS of A Ltd after the Acquisition c) Determine the Equivalent Earnings Per share of T Ltd d) What is the expected Market price per share of A Ltd, after the acquisition, assuming its PE multiple remains unchanged? Also determine the Market Value of the Merged Firm. Solution a) Number of shares to be issued by A Ltd to T Ltd Existing number of shares of T Ltd 180000
Number of shares issued by A Ltd as a result of Merger = 180000/2 90000
Existing number of shares in A Ltd 600000 Shares
Shares issued to Shareholders of T Ltd as a result of Merger 90000 Shares
Total Number of Shares of A Ltd 690000 Shares
b) Computation of Value of A Ltd Post Merger Particulars Amount
Profit after Tax of A Ltd 1800000
Profit after Tax of T Ltd 360000
Profit after tax of Merged Entities 2160000
Total number of shares of A Ltd 690000 shares
2160000 Earnings per Share of A Ltd (Post-Merger) = Rs. 3.13 per Share 690000 PE Multiple of A Ltd 10 Times
MPS of A Ltd (Post-Merger) = PE Multiple x EPS = 10x3.13 Rs. 31.3 per share
Market Value of A Ltd Post-Merger (690000x31.3) Rs. 216 Lakhs
23 | P a g e
c) Equivalent EPS of T Ltd = EPS of Merged Entity x Swap Ratio = Rs. 3.13x0.50 = Rs. 1.565 Therefore, a Shareholder holding one share in T Ltd, will have an EPS of Rs. 1.57 in Merged Entity. Example: 2 XYZ Ltd is considering merger with ABC Ltd. XYZ Ltd’s Shares are currently traded at Rs. 20. It has 250000 Shares outstanding and its Earnings after Tax amount to Rs. 500000. ABC Ltd has 125000 shares outstanding; its current Market price is Rs. 10 and it’s EAT is Rs. 125000. The Merger will be effected by means of a stock swap (exchange). ABC ltd has agreed to a plan under which XYZ Ltd will offer the current market value of ABC Ltd’s Share – a) What is the Pre-Merger Earnings per Share (EPS) and P/E Ratios of both the companies? b) If ABC Ltd’s PE Ratio is 6.4, what is its Current Market Price? What is the Exchange Ratio? What will be the XYZ Ltd’s Post-Merger EPS? c) What should be the Exchange Ratio, if XYZ Ltd’s Pre-merger EPS are to be same? Solution a) Pre-Merger EPS and PR Multiples for XYZ Ltd and ABC Ltd Particulars XYZ Ltd ABC Ltd
Earnings after Tax Rs. 500000 Rs. 125000
Number of Shares 250000 Shares 125000 Shares
Current market price Rs. 20 Rs. 10
Earnings per share = EAT/Number of Shares Rs. 2 Re. 1
PE Multiple = MPS/EPS 10 Times 10 Times
b) If PE Ratio of ABC Ltd is 6.4, then Current Market Price of ABC Ltd = PE Multiple x EPS = 6.4x1 = Rs. 6.4 푀푃푆 표푓 푆푒푙푙𝑖푛푔 퐶표푚푝푎푛푦 6.4 MPS based Exchange ratio = = = 푀푃푆 표푓 퐵푢푦𝑖푛푔 퐶표푚푝푎푛푦 20 0.32 푠ℎ푎푟푒푠 표푓 푋푌푍 퐿푡푑 푓표푟 푒푣푒푟푦 푠ℎ푎푟푒 ℎ푒푙푑 𝑖푛 퐴퐵퐶 퐿푡푑. Number of shares to be issued to ABC Ltd = (Existing number of shares) x (Swap ratio) = 125000 shares x 0.32 = 40000 shares 푇표푡푎푙 퐸퐴푇 (푃표푠푡−푀푒푟푔푒푟) 500000+125000 XYZ Ltd’s Post Merger EPS = = 푇표푡푎푙 푁푢푚푏푒푟 표푓 푆ℎ푎푟푒푠 (푝표푠푡 푀푒푟푔푒푟) 250000+40000 625000 = 푅푠. 2.16 290000 퐸푃푆 푂퐹 푆퐸퐿퐿퐼푁퐺 퐶푂푀퐴푃푁푌 1 c) EPS based Exchange Ratio – = = 퐸푃푆 푂퐹 퐵푈푌퐼푁퐺 퐶푂푀푃퐴푁푌 2 0.5 푆ℎ푎푟푒푠 푓표푟 푒푣푒푟푦 표푛푒 푠ℎ푎푟푒 ℎ푒푙푑 𝑖푛 퐴퐵퐶 퐿푡푑. Total Number of Shares in ABC Ltd = 125000 shares Number of shares issued to ABC Ltd as a result of Merger = 125000x0.5 = 62500 shares of XYZ Ltd 푇표푡푎푙 퐸퐴푇 (푃표푠푡−푀푒푟푔푒푟) 500000+125000 XYZ Post merger EPS = = = 푇표푡푎푙 푁푢푚푏푒푟 표푓 푆ℎ푎푟푒푠 (푝표푠푡 푀푒푟푔푒푟) 250000+62500 625000 = 푅푠. 2 푝푒푟 푠ℎ푎푟푒 312500
24 | P a g e
Example: 3 The Share capital of the companies X and Y consist of 75000 shares of Rs. 100 each and 25000 shares of Rs. 100 each respectively. Company X plans to make an acquisition of Y Ltd by exchange of 4 shares for every 5 shares in Y ltd. The Cost of Equity for X, Y and Combined XY Ltd are 15%, 16% and 14% respectively. The Cash Flows (EBIT x (1-t) + Depreciation) are likely to be as follows for a period of 5 Years. The Terminal year Cash Flows are likely to grow by 5% annually from Year 6 in each case – [Rs. In Lakhs] Years 1 2 3 4 5
X Ltd 15 16 17 18 19
Y Ltd 4 5 6 7 8
XY Ltd 20 22 24 26 28
a) Evaluate the proposal and give your comments on the scheme of merger b) If the shares swap exchange ratio is changed to 4.5 shares of X Ltd for every 5 Shares of Y Ltd, whether the merger scheme is viable. If so, allocate merger gain between the two companies again. Solution Computation of value of Companies
X Ltd Y Ltd XY Ltd
Disc. Disc. Disc. Particulars Year PVF @ Cash PVF @ Cash PVF @ Cash Cash Cash Cash 15% Flow 16% Flow 14% Flow Flow Flow Flow
Annual 1 0.870 15 13.05 0.862 4 3.45 0.877 20 17.54 Cash 2 0.756 16 12.10 0.743 5 3.72 0.769 22 16.93 Flows 3 0.658 17 11.19 0.641 6 3.84 0.675 24 16.20
4 0.572 18 10.30 0.552 7 3.87 0.592 26 15.39
5 0.497 19 9.44 0.476 8 3.81 0.519 28 14.54
Terminal 5 0.497 199.5 99.15 0.476 CF 76.36 36.35 0.519 326.67 169.54
155.23 55.04 250.12
Computation of Terminal Values: 퐶 × (1 + 푔) 푇푒푟푚𝑖푛푎푙 푉푎푙푢푒 = 퐾푒 − 푔
19(1.05) Terminal Value for X Ltd = = 199.5 0.15−0.05
8(1.05) Terminal Value of Y Ltd = = 76.36 0.16−0.05
25 | P a g e
28(1.05) Terminal Value of XY Ltd = = 326.67 0.14−0.05
Computation of Gain on Merger: Particulars Amount
Value of Merged Entity – XY Ltd 250.12
Less: Value of X Ltd before Merger (155.23)
Less: Value of Y Ltd before Merger (55.04)
Gain on merger 39.85
Computation of Minimum Exchange Ratio and Maximum Exchange Ratio (푉 + 퐺 ) × 푆 퐸푥푐ℎ푎푛푔푒 푅푎푡𝑖표 = 푆 푆 퐵 (푉퐵 + 퐺퐵) × 푆푆 Where,
Vs = Value of Selling Company before Merger
VB = Value of Buying Company before Merger
Gs = Share of Selling Company in the Gain on Value due to Merger
GB = Share of Buying Company in the Gain on Value due to Merger
Ss = Shares outstanding in Selling Company before Merger
SB = Shares outstanding in Buying Company before Merger (55.04+0)75 4128 Minimum Exchange Ratio = = = 0.846 (155.23+39.85)25 4877
(55.04+39.85)75 7116.75 Maximum Exchange Ratio = = = 1.834 (155.23+0)25 3880.75
Evaluation of Exchange Ratio Exchange ratio Comments 4 Shares for 5 Held = 4/5 = This is lower than the minimum exchange ratio of 0.846. 0.8 So value of shareholders of Y Ltd will erode after merger. Therefore, Y Ltd will not accept this exchange ratio
4.5 Shares for 5 Held = 4.5/5 This is higher than the minimum exchange ratio of 0.846 and lower = 0.9 than the maximum exchange ratio of 1.834. Hence, shareholders of both the Companies will have share in the gain on merger. So, this exchange ratio may be acceptable to both the companies.
26 | P a g e
Example: 4 RIL is considering a takeover of Sunflower Industries Ltd (SIL). The particulars of the two companies are given below – RIL SIL
Earnings after Tax (EAT) 2000000 1000000
Equity Shares Outstanding 1000000 1000000
Earnings per Share (EPS) 2 1
PE Ratio 10 5
Required – 1. What is the Market Value of each Company before Merger? 2. Assume that the Management of RIL estimates that the Shareholders of SIL will accept an offer of one share of RIL for four shares of SIL. If there are no synergic effects, what is the Market Value of the Post-Merger RIL? What is the New Price per Share? Are the Shareholders of RIL better or worse off than they were before the merger? 3. Due to Synergic effects, the Management of RIL estimates that the earnings will increase by 20%. What is the new post-merger EPS and price per share? Will the Shareholders be better off or worse off before the merger? Solution 1. Market Value of each firm before merger: Particulars RIL SIL
푀푃푆 PE Ratio = 10 5 퐸푃푆 EPS 2 1
MPS = PE Ratio X EPS 20 5
Number of Shares 1000000 1000000
Market Value 200 Lakhs 50 Lakhs
2. Merger Offer – Shareholders of SIL will get one share of RIL for every four shares of SIL. Total Number of Shares in SIL 1000000
Number of shares offered by RIL as a result of Merger = 1000000/4 250000 shares
Existing number of Shares in RIL 1000000
Shares issued to SIL as a result of Merger 250000
Total Number of Shares of RIL 1250000 Shares
Market Value of RIL – Post Merger – No Synergy Benefit Particulars Amount
Earnings of RIL post-merger (RIL 20L and SIL 10L) 3000000
Number of Shares Outstanding – Post merger (10L+2.5L) 1250000
27 | P a g e
EPS of RIL Post Merger = (30L/12.5L) 2.40
PE Multiple 10
MPS = PE Multiple X EPS = 10X2.4 24
Market Value of RIL Post Merger = 24X1250000 300 Lakhs
Computation of Gain or Loss to Shareholders – Without Synergy Benefits
For Shareholders of RIL SIL Number of Shares (Post Merger) 1000000 250000 MPS 24 24 Market Value after Merger 240 Lakhs 60 Lakhs Less: Market Value Before Merger (200 Lakhs) (50 Lakhs) Gain to Shareholders 40 Lakhs 10 Lakhs Shareholders will be better off in terms of wealth due to Merger, in case of No Synergy Benefits. 3. Market Value of RIL – Post Merger with 20% Synergy Benefits Particulars Amount
Earnings of RIL post-merger [(RIL 20L and SIL 10L)+20% there on] 3600000
Number of Shares Outstanding – Post merger (10L+2.5L) 1250000
EPS of RIL Post Merger = (36L/12.5L) 2.88
PE Multiple 10
MPS = PE Multiple X EPS = 10X2.88 28.8
Market Value of RIL Post Merger = 28.8X1250000 360Lakhs
Computation of Gain or Loss to Shareholders For Shareholders of RIL SIL
Number of Shares (Post Merger) 1000000 250000
MPS 28.8 28.8
Market Value after Merger 288 Lakhs 72 Lakhs
Less: Market Value Before Merger (200 Lakhs) (50 Lakhs)
Gain to Shareholders 88 Lakhs 22 Lakhs
Shareholders will be better off in terms of wealth due to Merger, in case of 20% Synergy Benefits.
28 | P a g e
Example: 5 ABC Company is considering acquisition of XYZ Ltd, which has 1.5 crores Shares outstanding and issued. The Market Price per share is Rs.400 at present. ABC’s average cost of capital is 12%. Available information from XYZ indicates its expected cash accruals for the next three years as follows: Year 1 – Rs. 250 Crores, Year 2 – RS. 300 Crores, Year 3 - Rs. 400 Crores. Calculate the range of valuation that ABC has to consider. (PV Factors @ 12% for 1, 2, and 3 years respectively: 0.893, 0.797, 0.712) Solution: Computation of Present Value of Future Cash Inflows (in Crores) Year Cash Inflow PVF @ 12% PV Cash Inflows
1 250 0.893 223
2 300 0.797 239
3 400 0.712 285
Value of Business = PV Cash Inflows 747
Assumptions: ● Project has useful life of only three years ● Project does not have any Terminal Cash Flows
Computation of Market Capitalization Particulars Amount
Value of Business Rs. 747 Crores
Number of Shares Outstanding 1.5 Crores
747 Value per Share = Rs. 498 per Share 1.5 Market Price per share Rs. 400 per Share
Market Capitalization = 400x1.5 Rs. 600 Crores
Range of Valuation that the company has to consider is Rs. 600 Crores to Rs. 747 Crores that is range between Market Capitalization and value determined based on Expected Cash Flows. Range of Valuation that the Company can consider is Rs. 400 per Share to Rs. 498 per Share Example: 6 BRS Inc deals in Computer and IT hardware and peripherals. The Expected Revenue for the next 8 Years is as follows: Years 1 2 3 4 5 6 7 8
Sales 8 10 15 22 30 26 23 20 (millions)
Summarized Financial Position is as follows – Liabilities Amount Assets Amount
29 | P a g e
Equity Stocks 12 Fixed Assets (Net) 17
12% Bonds 8 Current Assets 3
20 20
Additional Information: 1. Its Variable expenses is 40% of Sales Revenue and Fixed Operating Expenses (Cash) are estimated as follows: Period 1-4 Years 5-8 Years
Amount (millions) 1.6 2
2. An additional advertisement and sales promotion campaign shall be launched requiring expenditure as follows: Period 1 Year 2-3 Years 4-6 Years 7-8 Years
Amount (Millions) 0.50 1.50 3 1
3. The details as to Capital Expenditures are as follows: Period 1 2 3 4 5 6 7 8
Amount 0.50 0.80 2 2.5 3.5 2.5 1.5 1 (Million)
4. Fixed Assets are subject to depreciation at 15% as per WDV Method 5. Investment in Working Capital is estimated to be 20% of Revenue 6. Applicable tax rate for the company is 30% 7. Cost of Equity is Estimated to be 16% 8. The free cash flow of the firm is expected to grow at 5% per annum after 8 years. From the above information you are required to determine value of the firm and value of Equity.
Solution: Calculation of Weighted Average Cost of Capital Sources of Funds Cost (%) Weights Weighted Cost ( Cost x Weights)
Equity Stock 16 12/20 = 0.60 9.60
12% Bonds (After Tax) 12(1-0.3) = 8.40 8/20 = 0.40 3.36
12.96
Schedule of Depreciation: Opening Balance Additions Total Depreciation @ 15% Closing Balance
17.00 0.5 17.50 2.63 14.88
14.88 0.8 15.68 2.35 13.32
13.32 2 15.32 2.30 13.03
13.03 2.5 15.53 2.33 13.20
30 | P a g e
13.20 3.5 16.70 2.50 14.19
14.19 2.5 16.69 2.50 14.19
14.19 1.5 15.69 2.35 13.33
13.33 1 14.33 2.15 12.18
Calculation of Investment: Addition Capital Capital Total Required Addition Sales = 20% of Existing Investment Expenditure Investment Investment (1) Revenue (5) = Opn – (3) + (Op 6) (3) (4) = (2)+(3) (6) = (4)-(5) (2) 8.00 1.6 0.50 2.10 3 0.00 10.00 2 0.80 2.80 2.50 0.30 15.00 3 2.00 5.00 2.00 3.00 22.00 4.4 2.50 6.90 3.00 3.90 30.00 6 3.50 9.50 4.40 5.10 26.00 5.2 2.50 7.70 6.00 1.70 23.00 4.6 1.50 6.10 5.20 0.90 20.00 4 1.00 5.00 4.60 0.40
Determination of Present Value Cash Inflows Years Particulars 1 2 3 4 5 6 7 8 Revenue (Sales) 8.00 10.00 15.00 22.00 30.00 26.00 23.00 20.00 Variable Costs (40% Less 3.20 4.00 6.00 8.80 12.00 10.40 9.20 8.00 of Rev) Cash Operating 1.60 1.60 1.60 1.60 2.00 2.00 2.00 2.00 Expenses Advertisement Cost 0.50 1.50 1.50 3.00 3.00 3.00 1.00 1.00 Depreciation 2.63 2.35 2.30 2.33 2.50 2.50 2.35 2.15 EBIT 0.07 0.55 3.60 6.27 10.50 8.10 8.45 6.85 Taxes @ 30% 0.02 0.17 1.08 1.88 3.15 2.43 2.54 2.06 Operating Profit After Tax 0.05 0.39 2.52 4.39 7.35 5.67 5.92 4.80 Add Depreciation 2.63 2.35 2.30 2.33 2.50 2.50 2.35 2.15 Gross Cash Flows 2.68 2.74 4.82 6.72 9.85 8.17 8.27 6.95 Additional Less 0.00 0.30 3.00 3.90 5.10 1.70 0.90 0.40 Investment Free Cash Flows 2.68 2.44 1.82 2.82 4.75 6.47 7.37 6.55 WACC - 13% 0.8850 0.7831 0.6931 0.6133 0.5428 0.4803 0.4251 0.3762 Discounted Free Cash Flows 2.37 1.91 1.26 1.73 2.58 3.11 3.13 2.46 Here Interest is not deducted because Discounted Cash Flows are treated as Total Value. If the discounted cash flows are treated as Value of Equity, then we have to deduct Interest. Total Present Value of Discounted Cash Flows = Rs. 18.549 Millions. 퐹퐶퐹 6.55(1.05) Terminal Cash Flows = 9 = = 푅푠. 85.84 푀𝑖푙푙𝑖표푛푠 퐾푒−푔 0.13−0.05 PV of Terminal Cash Flows = Rs. 85.84x0.3762 = Rs. 32.2749 Millions. Value of Equity
31 | P a g e
Particulars Amount
Present Value Cash Flows 18.549
PV of Terminal Cash Flows 32.2749
Total value of Firm 50.824
Less: Value of Debt 8
Value of Equity 42.824
Example: 7 XY Ltd which is specialized in manufacturing garments is planning for expansion to handle a new contract which it expects to obtain. An Investment Bank has approached the company and asked whether the Company had considered Venture Capital financing. The company has borrowed Rs. 100Lakhs on which interest is paid at 10% per annum. The company shares are unquoted and it has decided to take your advice in regard to the calculation of value of the Company to obtain the new contract, the chance for which is 60%. Turnover for the following year is dependent to some extent on the outcome of the Year 1.
Following are the estimated Turnovers and probabilities: Year 1 Year 2
Turnover Probability Turnover Probability
2000 0.6 2500 0.7
3000 0.3
1500 0.3 2000 0.5
1800 0.5
1200 0.1 1500 0.6
1200 0.4
Operating Costs inclusive of Depreciation are expected to be 40% and 35% of Turnover respectively for the years 1 and 2. Tax is to be paid at 30%. It is assumed that the profits after interest and taxes are Free Cash Flows. Growth in earnings is expected to be 40% for the years 3, 4, and 5 which will fall to 10% each year after that. Industry average Cost of Equity is 15%. Solution: Computation of Expected Cash Flows for Year 1 Cash Flows Probability Expected Cash Flows
2000 0.6 1200
1500 0.3 450
32 | P a g e
1200 0.1 120
Expected Cash Flows 1770
Less Operating Cost 40% of Turnover (708)
Less Interest on Term Loan of 100Lakhs @ 10% (10)
Operating Profits Before Taxes 1052
Less Taxes at 30% (316)
Operating Profits after Tax 736
Computation of Expected Cash Flows for Year 2 Expected Cash Flows Probability in Year 1 Probability in Year 2 Combined Probability Cash Flow 2500 0.6 0.7 0.42 1050 3000 0.6 0.3 0.18 540 2000 0.3 0.5 0.15 300 1800 0.3 0.5 0.15 270 1500 0.1 0.6 0.06 90 1200 0.1 0.4 0.04 48 Expected Cash Inflow for Year 2 2298 Less Operating Cost at 35% of Turnover (804) Less Interest on Term Loan of 100Lakhs @ 10% (10) Operating Profits Before Taxes 1484 Less Taxes at 30% (445) Operating Profits after Tax 1039
Computation of Value of Equity Disc. Cash Nature Years Cash Flows PVF @ 15% Flows Operating Cash Flows after Tax 1 736 0.870 640 2 1039 0.756 786 3 1455 0.658 956 4 2036 0.572 1164 5 2851 0.497 1417 Terminal Value 5 62722 0.497 31184 Value of Company 36148
퐹퐶퐹퐹5(1+푔) 2851(1.10) Terminal Value = = = 푅푠. 62722 퐾0−푔 0.15−0.10 Value of Firm = Value of Equity + Value of Debt = Rs. 36148 + Rs. 100 = Rs. 36,248.
33 | P a g e
Example: 8 Given below is the balance sheet of S ltd as on 31.03.20XX – Liabilities Amoun Assets Amount t Share Capital: Shares of Rs. 10 each 100 Land and Buildings 40 Reserves and Surplus 40 Plant and machinery 80 Creditors 30 Investments 10 Stock 20 Debtors 15 Cash and Bank 5 170 170 You are required to work out the Value of the Company’s Shares on the basis of Net Assets Method and Profit Earning Capacity (Capitalization) method, and arrive at the Fair Price of the Shares, by considering the following information – 1. Profit of the current year Rs. 64Lakhs includes Rs. 4Lakhs extraordinary income and Rs. 1Lakh Income from Investments of Surplus funds are unlikely to recur. 2. In subsequent Years, additional Advertisement Expenses of Rs. 5Lakhs are expected to be incurred each year. 3. Market Value of Land and Building and Plant and Machinery have been ascertained at Rs. 96Lakhs and Rs. 100Lakhs respectively. This will entail additional Depreciation of Rs. 6Lakhs each year. 4. Effective Income Tax is 30% 5. The Capitalization rate applicable to similar business is 15% Solution: Computation of Net Assets Value per Share Particulars Amount Land and Buildings 96 + Plant and Machinery Revalue Amounts of 100 196 Book Value Amounts of Investments 10 + Stock 20 + Debtors 15 45 Cash and Bank 5 Total Assets 246 Less: Sundry Creditors -30 Net Asset Value of Company 216 Number of Equity Shares Outstanding 10Lakhs Net Asset Value per Share 216/10 21.6 In the absence of information on computing Goodwill on the Net Asset Value is not considered in the above computations.
Value per Share under Earnings Capitalization Method 1. Assuming Additional Depreciation are not Tax Deductible Particulars Amount Amount
Profit for Current Year 64
Less Extraordinary Income 4
Income from Surplus funds 1
34 | P a g e
Additional Advertisement Expenditure 5
Adjusted Profit before Tax 54
Less Tax @ 30% 16.2
Less Depreciation 6
Future Maintainable Earnings for Valuation Purposes 31.8
2. Assuming Additional Depreciation is Tax Deductible Particulars Amount Amount
Adjusted Profit before Tax 54
Less Depreciation 6
Adjusted Profit before Tax 48
Less Tax @ 30% 14.40
Future Maintainable Earnings for Valuation Purposes 33.60
Value per Share Particulars Amount Amount
Whether additional depreciation allowed for Tax purposes No Yes
Future Maintainable Profits after Tax 31.8 33.6
Value of Equity = FMP/15% 212 224
Add: Investments out of Surplus Funds as at Valuation Date 10 10
Total Value of Equity 222 234
Value per Share = Value of Equity/10Lakh Shares 22.2 23.4
Here FMP do not include Value of Investments, as we did not include Income from Investments while calculating FMP. Computation of Fair Value per Share Whether additional depreciation allowed for Tax purposes No Yes
Net asset Value per Share 21.6 21.6
Earnings Capitalization Value per Share 22.2 23.4
Fair Value = Average of NAV and ECV = (NAV+ECV)/2 21.9 22.5
35 | P a g e
Example: 9 X Ltd reported a profit of Rs. 65 Lakhs after 35% Tax. An Analysis of the accounts revealed that the Income included Extra-Ordinary Items Rs. 10Lakhs and an Extra-Ordinary Loss of Rs. 3Lakhs. The existing operations, except for the extra-ordinary items, are expected to continue in the failure. In addition, the results of the launch of a new product are expected to be as follows – (Rs. Lakhs) Sales 60 Labour Costs 10
Material costs 15 Fixed Costs 8
You are required to 1. Compute the Value of Business, given that the capitalization rate is 15% 2. Determine the Market Price per share with X Ltd' s Share Capital being comprised of 100000 11% Preference Shares of Rs. 100 each and 4000000 Equity Shares of Rs. 10 each, and PE Ratio being 8 times. Solution Computation of Value of Business Particulars Amount Earnings after Tax 65 Add Tax @ 35% (65x35%)/65% 35 Earnings before tax 100 Less Extra-Ordinary Income (10) Add Extra-Ordinary Loss 3 Additional Income from New Launch (60-15-10-8) 27 Future Expected Earnings before Tax 120 Less Tax @ 35% 42 Future Expected Earnings after Tax 78 Less Preference Dividend520s (11% of 100 Lakhs) (11) Equity earnings 67 Value of Whole Business (assuming overall Capitalization rate = 15% = 520 78Lakhs/15% Assuming Equity Expectations = 15% Value of Equity = (67/15%) 446.67 Value of Preference Capital 100 546.67
Value of Market Price per Equity Share Based on Equity No. Of equity Earnings PE Multiple Market Price per earnings shares per Share Eq Share
Projected Earnings 67 40 1.675 8 13.4
Past Years Earnings 65-11 = 54 40 1.35 8 10.8
36 | P a g e
Example: 10 Using Chop-Shop approach (or Break-up Value Approach), assign a value for Cranberry Limited whose stock is currently trading at a total Market Price of €4 Million. For Cranberry Ltd. the accounting data set forth three business segments, Consumer Wholesale, Retail and General Centers. Data for the Firms three segments are as follows Segment Operating Business Segment Segment Sales Segment Assets Income
Wholesale €225000 €600000 €75000
Retail €720000 €500000 €150000
General €2500000 €4000000 €700000
Industry data for “Pure-Play” Firms have been compiled and are summarized as follows – Capitalization/Operati Business Segment Capitalization/Sales Capitalization/Assets ng Income
Wholesale 0.85 0.70 9
Retail 1.20 0.70 8
General 0.80 0.70 4
Solution Particulars Wholesale Retail General Total
Segment Sale based valuation (225000x0.85) (720000x1.2) (2500000x0.8) 3055250
191250 864000 2000000
Segment Asset based Valuation (600000x0.70) (500000x0.70) (4000000x0.70) 3570000
420000 350000 2800000
Segment Operating Income (75000x9) (150000x8) (700000x4) 4675000 based Valuation 675000 1200000 2800000
3055250+3570000+4675000 Average = = €3766750 3
3766750+4000000 Break-Up Value =Average of Book Value and Market Value = = €3883375 2
37 | P a g e
Example: 11 Calculate Economic Value Added (EVA) from the following – Financial Leverage 1.4 Times
Capital Structure Equity Capital – Rs. 170Lakhs, Reserves and Surplus – Rs. 130Lakhs,
10% Debentures – Rs. 400 Lakhs
Cost of Equity 17.5%
Tax rate 30%
Solution 1. Computation of WACC Particulars Percentage Amount Proportion WACC
(1) (2)` (3) (4) (5)-(2)X(4)
Equity Capital 17.5% 300 lakhs (170+130) 300/700 7.5%
Debt 10%(1-0.30) = 7% 400 lakhs 400/700 4%
Total WACC 11.5%
2. Computation of Operating Profits after Tax (OPAT) 푃퐵퐼푇 Financial Leverage = 푃퐵푇 푃퐵퐼푇 1.4 = 푃퐵퐼푇 − 퐼푛푡푒푟푒푠푡 푃퐵퐼푇 1.4 = 푃퐵퐼푇 − 40 1.4(푃퐵퐼푇 − 40) = 푃퐵퐼푇 1.4 푃퐵퐼푇 − 56 = 푃퐵퐼푇 0.4푃퐵퐼푇 = 56
PBIT = 56/0.4 = Rs. 140 lakhs OPAT = PBIT (I-Tax) OPAT = 140 (1-0.30) = Rs. 98 Lakhs 3. EVA = OPAT – (WACC x Capital Employed) EVA = 98 – ((11.5%x700 lakhs) EVA = 98-80.5 EVA = 17.5 lakhs
38 | P a g e
Example: 12 The Following information is given for 3 Companies that are identical except for their Capital Structure Particulars Orange Grape Apple
Total Invested capital 1,00,000 1,00,000 1,00,000 Debt to Assets Ratio 0.8 0.5 0.2 Shares Outstanding 6,100 8,300 10,000 Pre Tax Cost of Debt 16% 13% 15% Cost of Equity 26% 22% 20% Operating income (EBIT) 25,000 25,000 25,000 Net Income 8,970 12,350 14,950 The Tax Rate is Uniform 35% in all Cases (a) Compute WACC for Each Company (b) Compute EVA for Each Company (c) Based on EVA, which company would be considered for Best Investment? Give Reasons (d) If the Industry PE Ratio is 11, Estimate the Price for Share of each Company (e) Calculate the Estimated Market Capitalization for each of the Companies
Solution - Computation of Weighted Average Cost of Capital Particulars Orange Grape Apple
Capital Employed (Debt + Equity) 1,00,000 1,00,000 1,00,000
Debt to Assets Ratio (Wd) 0.80 0.50 0.20
Equity (We) 1-Wd 0.20 0.50 0.80
Post Tax Cost of Debt 16(1-0.35) = 10.40% 13(1-0.35) = 8.45% 15(1-0.35) = 9.75%
Cost of Equity (Ke) 26% 22% 20%
Weighted Average Cost of (0.8x10.4) + (0.2x26) (0.5x8.45%) + (0.2x9.75%) Capital (Kd x Wd) + (Ke x We) = 13.52% (0.5x22%) = 15.23% + (0.8x20%) = 17.95%
Computation of Economic Value Added Particulars Orange Grape Apple
Operating Income (EBIT) 25,000 25,000 25,000 Less Taxes @ 35% (8,750) (8,750) (8,750)
Operating Profit After Taxes 16,250 16,250 16,250 Less WACC x CE (13,520) (15,225) (17,950) (1,00,000 x 13.52%) (1,00,000 x (1,00,000 x 15.23%) 17.95%)
39 | P a g e
Economic Value Added 2,730 1,025 (1,700) Choice based on EVA - Orange is preferable, as it has the Maximum Economic Value Added i.e. it earns more than what is required to Service the providers of Finance. The Entire EVA will contribute to Value of Equity Shareholders. Computation of Share Price per Share or Market Capitalization Particulars Orange Grape Apple
Net Income 8970 12350 14950
No. of Equity Shares 6100 8300 10000
Earnings Per Share 1.470 1.488 1.495
PE Multiple 11 11 11
MPS = EPS x PE 16.17 16.37 16.45
Equity Market Capitalization (PE x 98,670 1,35,850 1,64,450 Net Income)
Example: 13 The following information relating to Fortune India Ltd, having two divisions, viz, Pharma Division and Fast Moving Consumer Goods Division (FMCG Division). Paid Up Share Capital of Fortune India Lts. Is consisting of 3000 Lakhs Equity Shares of Rs. 1 each. Fortune India Ltd decided to demerge Pharma Division as Fortune Pharma Ltd. Details of Fortune India Ltd as on 31st March XXXX and Fortune Pharma Ltd as n 1st April XXX are – Particulars Fortune Pharma ltd Fortune India ltd
Outside Liabilities
Secured Loans 400 Lakhs 3000 Lakhs
Unsecured Loans 2400 Lakhs 800 Lakhs
Current Liabilities and Provisions 1300 Lakhs 21200 Lakhs
Assets
Fixed Assets 7740 Lakhs 20400 Lakhs
Investments 7600 Lakhs 12300 Lakhs
Current Assets 8800 Lakhs 30200 Lakhs
Loans and Advances 900 Lakhs 7300 Lakhs
Deferred Tax/Misc. Expenses 60 Lakhs (200) lakhs
The Board of Directors of the company has decided to issue necessary Equity Shares of Fortune Pharma Limited of Rs. 1 each, without any consideration to the shareholders of Fortune India Ltd. For that, following points are to be considered –
40 | P a g e
● Transfer of Assets and liabilities at Book Values ● Estimated Profit for next year is Rs. 11400 Lakhs for Fortune India ltd and Rs. 1470 Lakhs for Fortune Pharma Ltd. ● Estimated Market Price of Fortune Pharma Ltd is Rs. 24.5 per share ● Average PE ratio of FMCG sector is 42 and Pharma Sector is 25, which is to be expected for both the Companies. Required – a) Calculate the ratio in which shares of Fortune Pharma are to be issued to the shareholders of Fortune India Ltd. b) Calculate the Expected Market Price of Fortune India Ltd c) Calculate the Book Value per Share of both the companies immediately after Demerger.
Solution Summary as to how to solve this problem – 1. Shares to be issued to Pharma Ltd – by using EAT and EPS 2. MPS of Fortune India can be calculated with the help of Earnings of Fortune India Ltd, Average PE Ratio and number of Shares. 3. NAV of Fortune India, Fortune Pharma and Fast Moving Goods Division
1. Computation of Shares to be issued – Particulars Amount
Estimated Profit of Fortune Pharma Ltd (Equity Rs. 1470 Lakhs Earnings)
Expected EPS = MPS/PE Multiple = 24.5/25 Rs. 0.98 per share
Number of Shares = Earnings/Expected EPS = 1470/0.98 1500 Lakhs Shares
Therefore number of shares to be issued to 1500 lakhs Shareholders of Fortune Pharma Ltd
2. Expected Market Price of Fortune India Ltd Particulars Amount
Estimated Profit for the Year Rs. 11400 Lakhs
Number of Equity Shares Outstanding 3000 lakh shares
Earnings per Share(11400/3000) Rs. 3.80 per Share
Average PE Ratio 42
Market Price Per share Rs 159.60
3. Computation of Net Worth (Shareholders Funds) Particulars Fortune India Ltd Fortune Pharma Fortune (Consolidated) Ltd India Ltd (FMCG)
41 | P a g e
(1) (2) (3) (4) = (2)- (3)
Assets
Fixed Assets 20400 7740 12660
Investments 12300 7600 4700
Current Assets 30200 8800 21400
Loans and Advances 7300 900 6400
Deferred Tax/Misc. Expenses (200) 60 (260)
Total 70000 25100 44900
Outside Liabilities
Secured Loans 3000 400 2600
Unsecured Loans 800 2400 (1600)
Current Liabilities and Provisions 21200 1300 19900
Total 25000 4100 20900
Net worth [A] – [B] 45000 21000 24000
Number of Shares Outstanding 1500 3000
Book Value per share 14 8
Example: 14 The following is the balance sheet of GFC Ltd as on 31st March 20XX – Particulars Amount Particulars Amount
Equity Shares of Rs. 100 Each 600 Land and Buildings 200
14% Preference Shares of Rs. 100 each 200 Plant and Machinery 300
13% Debentures 200 Furniture and Fixtures 50
Deb Interests Accrued & Payable 26 Inventory 150
Loan from Bank 74 Sundry Debtors 70
Trade Creditors 340 Cash at Bank 130
Preliminary Expenses 10
Cost of issue of Debentures 5
Profit and Loss Account 525
Total 1440 Total 1440
42 | P a g e
The company did not perform well and has suffered sizable losses during the last few years. However, it is felt that the company could be nursed back to health by proper Financial Restructuring. Consequently, the following scheme of reconstruction has been drawn up: a. Equity Shares are to be reduced to Rs. 25 per Share, fully paid. b. Preference shares are to be reduced (with coupon rate of 10%) to equal number of shares of Rs. 50 each, fully paid up. c. Debentures holders have agreed to forego the accrued interest due to them. In the future, the rate of interest on Debentures is to be reduced to 9%. d. Trade creditors will forego 25% of the amount due to them. e. The Company issues 6 lakh Equity Shares at Rs. 25 each and the entire sum was fully subscribed to promoters. f. Land and Buildings was to be revalued at Rs. 450 Lakhs, Plant and Machinery was to be written down by 120 Lakhs and a provision of Rs. 15 lakhs had to be made for Bad and Doubtful Debts. Required – 1. Show impact of Financial Restructuring on the Company’s Activities 2. Prepare a Fresh Balance Sheet after reconstruction is completed on the basis of the above proposals. Solution 1. Reconstruction Account (Workings are done in the end) Particulars Amount Particulars Amount
To Plant and Machinery A/c 120 By Equity Share Capital Account 450
To Preliminary Expenses 10 By 14% Pref. Share Capital A/c 100
To Cost of Issue of Debentures 5 By Accrued Interest on Debentures 26
To Profit and Loss Account 525 By Trade Creditors 85
To Provision for Bad Debts A/c 15 By Land and Buildings 250
To Capital Reserve A/c 236
Total 911 Total 911
2. Balance Sheet of GFC Ltd as on 31st March 20XX after Reconstruction
PARTICULARS NOTE AMOUNT Equity and Liabilities Shareholders’ Funds a) Share Capital 1 400 b) Reserves and Surplus 236 Non-Current Liabilities a) Long Term Borrowings 2 274 Current Liabilities a) Trade Payables - Sundry Creditors (Rs. 340 – Rs. 85 lakhs) 255 Total 1165 Assets Non-Current Assets 680 Fixed Assets 3
43 | P a g e
Current Assets 150 a) Inventories 55 b) Trade Receivables – Sundry Debtors (70-15) 280 c) Cash and Cash Equivalents (130+150) Total 1165
Note 1 – Share Capital Particulars Amount
Issued, Subscribed and Paid up : 12 Equity Shares of Rs. 25 each fully paid up 300
2 Lakh 10% Preference Shares of Rs. 50 each 100
Total 400
Note 2 – Long Term Borrowings Particulars Amount
9% Debentures (Secured) 200
Loan from Bank (Secured) 74
Total 274
Note 3 – Tangible Assets Particulars Amount
Land and Buildings (200 + 250) 450
Plant and Machinery (300-120) 180
Furniture and Fixtures 50
Total 680
3. Impact on Financial Restructuring a. On Capital Base Equity Capital has been reduced, and due to additional Equity Shares issued to Promoters, their stake in the Company has been increased b. On Debt Base The base of Fixed Cost Funds has reduced, and also the cost of such funds is also reduced. This contributes to a better Equity Earnings c. Re-statement of Assets Re-statement of Assets to their Fair Value will help in knowing in the true return on investment, and would help compare with the benchmark industry data. d. Infusion of Capital Infusion of Capital by Promoters, coupled with lower cost of funds, will result in increased amount available for capital expansion. This would further result in increased earnings due to increased business.
44 | P a g e
Journal Entries in the books of GFC Ltd Particulars Debit Credit Equity Share Capital Account (Rs. 100) Dr 600 To Equity Share Capital Account (Rs. 25) 150 To Capital Reduction Account 450 (Being Equity Shares of Rs. 100 each has been reduced to Equity shares of Rs. 25 each) 14% Preference Share Capital Account Dr 200 To 10% Preference Share Capital Account 100 To Capital Reduction Account 100 (Being 14% Preference Shares of Rs. 100 has been reduced to 10% Preference Shares of Rs. 50 each) 13% Debentures Account Dr 200 To 9% Debentures Account 200 (Being Debentures has been reduced from 13% to 9%) Debenture Interest Accrued and Payable Account Dr 26 To Capital Reduction Account 26 (Being Debenture Holders agreed to forego the accrued interest due to them) Trade Creditors Account Dr 85 To Capital Reduction Account 85 (Being Trade Creditors agreed to forego 25% of the amount due to them) (340x25%) Bank Account Dr 150 To Equity Share Capital Account 150 (Being the Company has issued 6 Lakh Equity Shares of Rs 25 each, which were fully subscribed by Promoters) Land and Buildings Account Dr 250 To Capital Reduction Account 250 (Being Upward Revaluation of Land and Buildings to Rs. 450 Lakhs from Rs. 200 Lakhs) Capital Reduction Account Dr 675 To Plant and Machinery 120 To Provision for Bad and Doubtful Debts 15 To Preliminary Expenses 10 To Cost of Issue of Debentures 5 To Profit and Loss and Account 525 (Being Downward revaluation in Plant and Machinery and provision for bad debts has to be created) Capital Reduction Account Dr 236 To Capital Reserve Account 236 (Being balancing figure of Capital Reduction Account was transferred to Capital Reserve Account)
45 | P a g e
Example: 15 Personal Computer Division of Distress Limited, a Computer Hardware Manufacturing Company has stated facing Financial Difficulties for the Last Two to three Years. The Management of the Division headed by Mr. Smith is interested in a Buyout. However to make this Buyout successful there is an urgent need to attract Substantial Funds from Venture Capitalists Ven Cap an European Venture Capitalist firm has shown its interest to Finance the proposed buyout. Distress Limited intrested to sell the Division for 180 Crores and Mr. Smith is of Opinion that an additional amount of 85 Crores shall be required to make the division viable. The expected Financing pattern shall be as follows - Source Mode Amount (crores)
Management Equity Shares of Rs. 10 Each 60
VenCap VC Equity Shares of Rs. 10 Each 22.5 9% Debentures with attached Warrant of 100 Each 22.5 8% Loan 160
Total 265
The Warrants can be exercised any time after 4 Years from now for 10 Equity shares @ 120 per share. The Loan is repayable in one go at the end of 8th Year. The Debentures are repayable in equal Annual Instalment consisting of both Principal and Interest amount over a period of 6 Years Mr. Smith is of View that the Proposed Dividend shall not be kept more than 12.5% of distributable profit for the firs. The forecasted EBIT after the proposed Buyout is as follows - Year 1 2 3 4
EBIT (Crores) 48 57 68 82 Applicable Tax Rate is 35% and it is expected that it shall remain unchanged at least for 5-6 Years. In order to attract VenCap, Mr Smith stated that Book Value of Equity shall increase by 20% during above 4 Years. Although VenCap has shown their Interest in Investment but are doubtful about the Projections of Growth in the Value as per Projections of Mr. Smith. Further VenCap also demanded that warrants should be convertible in 18 Shares instead of 10 Shares as proposed by Mr. Smith. You are required to determine whether or not the book value of equity is expected to grow by 20% per year. Further if you have been appointed by Mr. Smith as advisor then whether you would suggest to accept the Demand of VenCap of 18 shares instead of 10 or not. Solution Calculation of Interest and Principal Payments on 9% Debentures Annual Interest = (22.50Cr/4.486) = 5.0156 Cr [PVAF (9%, 6Y)=4.486] (in Crores) Year Balance Outstanding Interest Instalment Principal Balance Repayment
1 22.5 2.025 5.0156 2.9906 19.5094
2 19.5094 1.756 5.0156 3.2596 16.2498
46 | P a g e
3 16.2498 1.462 5.0156 3.5536 12.6962
4 12.6962 1.143 5.0156 3.8726 8.8236
Statement showing Book value of Equity (in Crores) Particulars Year 1 Year 2 Year 3 Year 4
EBIT 48 57 68 82
Interest on 9% 2.025 1.756 1.462 1.143 Debentures
Interest on 8% 12.8 12.8 12.8 12.8 Loan
EBT 33.1750 42.4440 53.7380 68.0570
Tax @ 35% 11.611 14.855 18.8080 23.8200
EAT 21.5640 27.5890 34.9300 44.2370
DIV @ 12.5% of 2.6955 3.4490 4.3660 5.5300 EAT
Retention 18.8685 24.14 30.5640 38.7070
Balance b/f Nil 18.8685 43.0085 73.5725
Balance c/f 18.8685 43.0085 73.5725 38.7070
Share Capital 82.5000 82.5000 82.5000 82.5000
Book Value of 101.3685 125.5085 156.0725 194.7795 Equity
In the Beginning of Year 1 Equity was Rs. 82.5 Crores which has been grown to Rs. 194.7795 in the span of 4 Years. In such a case Compounded Growth rate shall be as follows (194.7795/82.5)% = 23.96% This growth rate is slightly higher than 20% as projected by Mr. Smith
Viability of Increasing the Number of Underlying Shares in a Warrant If the Condition of VenCap for 18 Shares is accepted the Expected Shareholding after 4 Years shall be as follows - Number of Shares held by Management 6 Crores
No. of Shares held by VenCap at the Starting stage 2.25 Crores
No. of Shares obtained by exercising the Warrant 0.225 Cr deb x 18 4.05 Crores Shares
47 | P a g e
Total Holdings by VenCap 6.3 Crores
Thus it is likely that Mr. Smith may not accept this condition of VenCap as this may result in losing their majority ownership and control to VenCap, Mr. Smith may accept their condition if Management has further opportunity to increase their Ownership through Other Forms.
Example: 16 Company A has Net Operating Profits of Rs. 15 Crores. Applicable Tax Rate is 35%. The Company’s Capital amounts to Rs. 6 Crores. Solution - Shareholders Value Added = (NOPAT - Cost of Capital) = [15(1-0.35) - 6] = Rs. 3.75 Crores Company A’s SVA is Rs. 3.75 Crores Example: 17 Following are the financial data of the Platinum Limited for a year - (lakhs) Equity Shares 100 Effective Tax Rate 30%
8% Debentures 150 Operating Margin 10%
10% Bonds 50 Required Rate of Return of 15% Investors
Reserves and Surplus 200 Dividend pay-out Ratio 20%
Total Assets 500 Current market Price of Rs. 13 Share
Assets Turnover Ratio 1.1 You are required to – (a) Draw Income Statement for the year (b) Calculate Sustainable Growth Rate (c) Calculate Fair Price of the company’s Share using Dividend Discount Model (d) Draw your Opinion in the Company’s Share at Current Price
48 | P a g e
Solution (a) Income Statement – Particulars Amount
Sales = Total Assets x Asset TO Ratio = 500 x 1.1 Times 550
Operating Profit = Sales x Operating Margin = 550x10% 55
Less: Interest Expense (150x8%) + (50x10%) 17
Operating Profit After Tax, But before Interest 38
Less: Tax at 30% 11.40
Equity Earnings 26.60
Less: Dividend = Equity Earnings x Payout Ratio of 20% 5.32
Retained Earnings 21.28
(b) Sustainable Growth Rate Factors –
Sales for Last Year (S0) = 550 Net Profit Margin (P) = 26.60/550 = 4.83% Retention Ratio (b) = 1-0.20 = 80% Debt Equity Ratio (D/E) = 200/300 = 0.67 Total Assets = 500 퐷 푃 × 푆0 × 푏(1 + ) 푆푢푠푡푎𝑖푛푎푏푙푒 퐺푟표푤푡ℎ 푅푎푡푒 = 퐸 퐷 퐴 − [푃 × 푆 × 푏(푎 + )] 0 퐸 0.0483 × 550 × 0.80(1 + 0.67) 35.49 푆퐺푅 = = = 7.64% 500 − [0.0483 × 550 × 0.80(1 + 0.67)] 500 − 35.49
Alternatively, SGR = ROE x (1 – Dividend Pay-out Ratio) = 8.87% x 0.80 = 7.10% Where ROE = 26.60/300 = 8.87%
(c) Fair Price of Company’s Share using Dividend Discount Model (Gordon’s Model) 퐷𝑖푣𝑖푑푒푛푑푠 532000 퐷 = = 5.32 0 100000 푆ℎ푎푟푒푠
퐷1 퐷0(1 + 푔) 5.32(1 + 0.0710) 푉푎푙푢푒 푝푒푟 푆ℎ푎푟푒 = 푃0 = = = 퐾푒 − 푔 퐾푒 − 푔 0.15 − 0.0710 = 푅푠. 72.12
Since Growth Rate of Earnings is considered, Gordon’s Constant Pay-out Model is most appropriate. Also, Growth Rate for Gordon’s Model = SGR as per 2nd alternative above i.e., 7.10%, based on Return on Equity, since, Gordon’s Dividend Discount Model considers an All-Equity Firm, where as in 1st Alternative SGR, Debt Component of Capital is also considered.
49 | P a g e
Since the Current Market Price of Rs. 13 is less than Fair Value Rs. 72.12, it is worthwhile to invest in the Company’s Shares at present. Example: 18 ABC (India) Ltd., a market leader in printing industry, is planning to diversify into defense equipment businesses that have recently been partially opened up by the GOI for private sector. In the meanwhile, the CEO of the company wants to get his company valued by a Leading consultants, as he is not satisfied with the current market price of his scrip.
He approached consultant with a request to take up valuation of his company with the following data for the year ended 2009:
Share Price 66 per share Outstanding Debt 1934 Lakhs Number of Outstanding Debts 75 Lakhs Net Income (PAT) 17.2 Lakhs EBIT 245 Lakhs Interest Expenses 218.125 Lakhs Capital Expenditure 234.4 Lakhs Depreciation 234.4 Lakhs Working Capital 44 Lakhs Growth Rate 8% (from 2010 to 2014) Growth Rate 6% (beyond 2014) Free Cash Flow 240.336 Lakhs (Year 2014 onwards) The capital expenditure is expected to be equally offset by depreciation in future and the debt is expected to decline by 30% in 2014.
Required: Estimate the value of the company and ascertain whether the ruling market price is undervalued as felt by the CEO based on the foregoing data. Assume that the cost of equity is 16%, and 30% of debt repayment is made in the year 2014.
Answer: Computation of Tax Rate:
Particulars Amount (Lakhs) EBIT 245.000 Less Interest 218.125 PBT 26.875 PAT 17.200 Tax Paid 9.675 Tax Rate = 9.675/26.875 36%
Computation for Increase in Working Capital:
Particulars Amount (Lakhs) Working Capital (2009) 44 Increase in 2010 = 44 x 0.08 3.52 It will continue to increase @ 8% per annum
50 | P a g e
Weighted Average Cost of Capital:
Particulars Amount (Lakhs) Present Debt 1934 Interest Cost = 218.125/1934 11.28% Equity Capital = 75 Lakhs x 66 4950 4950 1934 KC = × 16% + × 11.28(1 − 0.36) = 11.51 + 2.028 = 13.54 1934+4950 1934+4950
As Capital Expenditure and depreciation are equal, they will not influence the free cash flows of the company.
Computation of Free Cash Flows up to 2012 (In Lakhs) 2010 2011 2012 2013 2014 Year Amount Amount Amount Amount Amount EBIT (1-t) 169.344 182.890 197.520 213.320 230.39 Increase in Working Capital 3.520 3.800 4.100 4.430 4.780 Debt Repayment (1934 x 0.30) - - - - 580.200 Free Cash Flows 165.824 179.090 193.410 208.890 (354.590) PVF @ 13.54% 0.8807 0.7757 0.6832 0.6017 0.5300 PV of Free Cash Flow @ 13.54% 146.040 138.920 132.140 125.690 (187.930) Present Value of Free Cash Flows up to 2014 = Rs. 354.86 Lakhs
Cost of Capital [2014 Onwards] Debt = 0.7 x Rs. 1934 = Rs. 1353.80 Lakhs Equity = Rs. 4950 Lakhs 4950 1353.80 KC = × 16% + × 11.28 (1 − 0.36) = 12.56 + 1.55% = 14.11% 4950+1353.80 4950+1353.80
Continuing Value: 240.336 1 × ( )5 = 푅푠. 1570.556 퐿푎푘ℎ푠 0.1411 − 0.06 1.1354 Value of the Firm = PV of Free Cash Flows up to 2014 + continuing value = Rs. 354.86 Lakhs + Rs. 1570.556 Lakhs = Rs. 1925.416 Lakhs Value per Share = [Value of Firm – Value of Debt]/Number of Shares = [Rs. 1925.416 Lakhs – 1353.80 Lakhs]/75 Lakhs = Rs. 7.622 < Rs. 66 (Present Market Value) Therefore, the share price is overvalued in the market. Example: 19 Herbal Gyan is a small but profitable producer of beauty cosmetics using the plant Aloe Vera. This is not a high-tech business, but Herbal’s earnings have averaged around Rs. 12 Lakh after tax, largely on the strength of its patented beauty cream for removing the pimples.
51 | P a g e
The patent has eight years to run, and Herbal has been offered Rs. 40 Lakhs for the patent rights. Herbal’s assets include Rs. 20 Lakhs of working capital and Rs. 80 Lakhs of property, plant, and equipment. The Patent is not shown on Herbal’s books. Suppose Herbal’s cost of capital is 15 percent. What is its Economic Value Added (EVA)?
EVA = Income Earned – [Cost of Capital x Total Investment]
Total Investments: Particulars Amount (Lakhs) Working Capital 20 Property, Plant and Equipment 80 Patent Rights 40 Total 140
Cost of Capital = 15%
EVA = 12 Lakhs – [0.15 x 140 Lakhs] = Rs. 12 Lakhs – 21 Lakhs = (Rs. 9 Lakhs)
Thus Herbal Gyan has a negative EVA of Rs. 9 Lakhs Example: 20 The following data pertains to XYZ Inc. engaged in software consultancy business as on 31 December 2010. ($ Millions) Income from Consultancy 935.00 EBIT 180.00 Less: Interest on Loan 18.00 EBT 162.00 Tax @ 35% 56.70 105.30
Balance Sheet:
Particulars Amount Particulars Amount Equity Stock (10 Million shares @ Land and Buildings 200 $10 each) 100 Computers and Soft wares 295 Reserves and Surplus 325 Current Assets: Loans 180 Debtors = 150 Current Liabilities 180 Bank = 100 Cash = 40 290 785 785
With the above information and following assumption you are required to compute –
1. Economic value Added 2. Market Value Added
Assuming that:
1. WACC is 12% 2. The share of company currently quoted at $ 50 each
52 | P a g e
Determination of Economic Value Added [EVA]
Particulars Amount EBIT 180 Less Taxes @ 35% 63 Net Operating Profit after Tax 117 Less Cost of Capital Employed [W No 1] 72.60 Economic Value Added 44.40
Amount (Million) Market Value of Equity Stock [W No 2] 500 Equity Fund [W No 3] 425 Market Value Added 75
Working Notes:
1. Total Capital Employed Equity Stock $ 100 Million Reserve and Surplus $ 325 Million Loan $ 180 Million $ 605 Million
2. Working Note 2 Markey Price per Equity Share [A] $ 50 No. of Equity Share Outstanding [B] 10 Million Market Value of Equity Stock [A x B] $ 500 Million
3. Working Note 3 Equity Fund $ 100 Million Equity Stock $ 325 Million Reserves and Surplus $ 425 Million
53 | P a g e