FINAL GROUP - IV PAPER - 18 BUSINESS VALUATION MANAGEMENT The Institute of Cost and Works Accountants of India 12, SUDDER STREET, KOLKATA - 700 016 First Edition : January 2008 Revised Edition : March 2009 Published by: Directorate of Studies The Institute of Cost and Works Accountants of India 12, SUDDER STREET, KOLKATA - 700 016 Printed at : Repro India Limited, 50/2, TTC MIDC Industrial Area, Mahape, Navi Mumbai - 400 710, India Copyright of these Study Notes in reserved by the Institute of Cost and Works Accountants of India and prior permission from the Institute is necessary for reproduction of the whole or any part thereof. BUSINESS VALUATION MANAGEMENT A Note to the Student: Business Valuation Management is a fascinating subject, as it, foremost, provides (and also warrants) the most comprehensive analysis of a business model. It perforce enjoins upon the business valuer to delve into the depths of the business that is being valued and come to grips with the macro and micro, technical and ! nancial, the short and longer term aspects of the business. This book attempts to provide the following to you: • An easy introduction to the concept of business valuation • A complete overview of the existing business valuation models • An understanding of the importance of various assumptions underlying the valuation models • An easy-to-understand explanation of various business valuation techniques, with their pros and cons • A discussion on valuation of assets and liabilities, whether tangible or intangible, apparent or contingent. • Application of the concepts in real-life situations, with many examples. The design and structure of the book are such that the book can provide vital insights into the key issues in business valuation, suitably enhanced with many scholastic articles that can not only provide the depth, but also bring out the complexities involved in business valuation. In writing the book, we have relied upon not only our knowledge and experience, but also the extensive work done worldwide by several pioneers and experts, as can be seen from the reference materials appended to the book, but also from the bibliography. We owe them, as well as their institutions and publishers, a debt of gratitude. Business valuation is a complex exercise and no single volume or course can attempt to cover the subject in its entirety. Fortunately for the keen learner, there is a great deal of literature available on the (constantly expanding) subject. This is an introductory course on business valuation, and therefore, the student is well advised to look at this as a beginning of a long and exciting journey and not an end. Bon Voyage and Happy Learning! CONTENTS Page No. Study Note - 1 Chapter -1 Concept of Value 2 Chapter -2 Principles & Techniques of Valuation 9 Chapter -3 Discounted Cash Flow Valuation 15 Chapter -4 Relative Valuation 19 Chapter -5 Contingent Claim Valuation 24 Chapter -6 Asset Valuation 26 Chapter -7 Related Concepts in Business Valuation 30 Illustration on Valuation 32 Model - 1, Question 40 Study Note - 2 41 Chapter -1 Business Strategy 42 Chapter -2 Basic Concepts in Mergers and Acquisitions 47 Chapter -3 Theories of Mergers and Acquisitions 50 Chapter -4 Valuation of Mergers and Acquisitions 55 Chapter -5 The Merger Process 94 Chapter -6 Major Challenges to Success of Mergers 97 Chapter -7 Restructuring and Financial Engineering 103 Chapter -8 Take-Over Defenses 117 Model - 2, Question 121 Page No. Study Note - 3 123 Chapter -1 Forms of Intellectual Property and Methods of Valuation 124 Chapter -2 Valuation of Fixed Assets 147 Chapter -3 Valuation of Inventories 155 Chapter -4 Valuation of Investments 157 Chapter -5 Valuation of Shares 160 Chapter -6 Valuation of Intangibles 174 Chapter -7 Human Resource Accounting 200 Chapter -8 Valuation of Goodwill Patents and Copyrights 208 Chapter -9 Valuation of Brands 213 Chapter -10 Valuation of Real Estate 234 Chapter -11 Valuation of Liabilities 239 Model - 3, Question 243 AT&T/SBC Merger 245 Valuation of Hard-to-price Assets 249 Brand Valuation 253 Brand Valuation-Interbrand Approach 265 Growth in FCFE Versus Growth in FCFF 269 Reporting on Environmental Liabilities 277 Valuation of Intellectual Property 283 Valuing cyclical companies 287 What are your Employees worth 292 STUDY NOTE - 1 Valuation Basics Business Valuation Management Chapter 1 CONCEPT OF VALUE CHAPTER CONTENTS 1. An understanding of ‘Value’ 2. The nature and scope of Valuation 3. Objectives of Valuation 4. Importance of Business Valuation 5. Misconceptions about Valuation “A thing is worth whatever the buyer will pay for it”. – Publilius Syrus. 1.1 What is Value? 1.1.1 Value is the ‘worth’ of a thing. It can also be defined as ‘a bundle of benefits’ expected from it. It can be tangible or intangible. 1.1.2 Value is defined as: a. The worth, desirability, or utility of a thing, or the qualities on which these depend b. Worth as estimated c. The amount for which a thing can be exchanged in the market d. Purchasing power e. Estimate the value of, appraise (professionally) 1.1.3 Valuation is defined as: • Estimation (esp. by professional valuer) of a thing’s worth • Worth so estimated • Price set on a thing 1.2 How is Value different from cost and price? 1.2.1 Cost is defined as ‘resources sacrificed to produce or obtain a thing, (a product or service). 1.2.2 Price is what is charged by a seller or provider of product or service. Many a time, it is a function of market forces. 1.2.3 Oscar Wilde said, “A cynic is one who knows the price of everything and the value of nothing”. 1.3 Different connotations of Value: 1.3.1 Value, like ‘utility’, has different connotations in different contexts, and may vary from person, place and time. It can range from a precise figure to something bordering on sentimental or emotional, or even the absurd. 2 Valuation Basics 1.3.2 Value is also different from ‘Values’, which refers to one’s principles or standards. 1.4 What has Value? 1.4.1 Everything under the sun has value. There is nothing in God’s creation that does not have value. This applies to all physical things. If something has not been assigned any value, it can only be said that its value or utility has not yet been explored or discovered yet. 1.4.2 A case in point is the element called Gadolinium. It was considered a useless rare earth element by the chemists, till hundred years later when magnetic resonance imaging (MRI) was invented and the use of Gadolinium was found in MRI as the perfect contrast material. This only goes to show that no material can be perceived to be useless, i.e., without any value. 1.4.3 In a philosophical context, ‘Values’ have ‘Value’, as they guide a person through life and provide the moorings or anchorage in the sea of life. Refer Swami Dayanand Saraswathi’s “The Value of Values”. 1.5 Why Value? 1.5.1 Value is sought to be known in a commercial context on the eve of a transaction of ‘buy or sell’ or to know the ‘worth’ of a possession. 1.6 Who wants to Value? 1.6.1 The following entities may require valuation to be carried out: 1. A buyer or a seller 2. A lender 3. An intermediary like an agent, a broker 4. Regulatory authorities such as tax authorities, revenue authorities 5. General public 1.6.2 Global/corporate investors have become highly demanding and are extremely focused on maximizing corporate value. The list of investors includes high net worth individuals, pension and hedge funds, and investment companies. They no longer remain passive investors but are keen followers of a company’s strategies and actions aimed at maximizing and protecting the value of their investments. 1.7 When to Value? 1.7.1 Valuation is done for “numerous purposes, including transactions, financings, taxation planning and compliance, intergenerational wealth transfer, ownership transition, financial accounting, bankruptcy, management information, and planning and litigation support”, as listed by AICPA. 1.7.2 We see that the corporate world has increasingly become more dynamic, and sometimes volatile. Globalization, enhanced IT capabilities, the all pervasive role of the media, and growing awareness of investors have rendered the situation quite complex. Mergers, acquisitions, disinvestment and corporate takeovers have become the order of the day across the globe, and are a regular feature today. 3 Business Valuation Management 1.7.3 Understanding the factors that determine the value of any business will pay tangible dividends by focusing the management on ways to increase the firm’s short and long - run profitability. 1.7.4 Investors in shares and companies seeking to make acquisitions need to know how much a company is worth and how much to pay for their investment. We need to determine ‘Value’ mainly on the following occasions: 1. Portfolio Management/transactions: A transaction of sale or purchase, i.e., whenever an investment or disinvestment is made. Transaction appraisals include acquisitions, mergers, leveraged buy-outs, initial public offerings, ESOPs, buy-sell agreements, sales of interest, going public, going private, and many other engagements. Mergers and Acquisition: Valuation becomes important for both the parties – for the acquirer to decide on a fair market value of the target organization and for the target organization to arrive at a reasonable for itself to enable acceptance or rejection of the offer being made. 2. Corporate Finance: The desire to know intrinsic worth and enhance value is important, as financial management itself is defined as “maximization of corporate value”. A proper valuation will help in linking the value of a firm to its financial decisions such as capital structure, financing mix, dividend policy, recapitalization and so on.