Chapter 5 Business Valuation Methods – CS Professional Valuations and Business Modelling Study Material is designed strictly as per the latest syllabus and exam pattern.

## Business Valuation Methods – CS Professional Valuations and Business Modelling Study Material

Question 1.

Define:

(iv) DCF technique of valuation of common stock;

(v) Relative Valuation Method; (June 2010, 5 marks each) [CMA Final]

Answer:

(iv) DCF technique of valuation of common stock:

DCF technique uses the time value of money concept. For valuing shares of a firm, three steps are required. The first step is to find the value of operations by discounting all expected future free cash flow at the WACC. The second step is to find the total corporate value by summing the value of operations, the value of non operating asset and the value of growth options. The third step is to find the value of equity by subtracting the value of debt and preferred stock from the total value of the corporations. The last step is to divide the value of equity by the number of shares of common stock.

(v) Relative Valuation Method:

This approach involves valuing a company by comparing it with the valuation of othei1 companies in the same industry. This comparison is done using two approaches:

- Comparison with industry average
- Comparison with comparable companies

The various multiples that are frequently used are:

- P/E Ratio
- Price/Book Value
- Price/sale
- Price/Replacement cost of asset

Relative valuation is not a sound approach for making investment decision, let alone for valuing a target company from the acquisition perspective. However, relative valuation is a very popular approach, right from the retail investors to the fund managers and corporate bigwigs, the reason being that this approach is easy to understand, apply and discuss.

Question 2.

Discuss the major aspects, assumptions and decision rules of the discounted cash flow model. (June 2011, 10 marks) [CMA Final]

Answer:

Major aspects of DCF:

- It weighs the time value of money explicitly while evaluating the costs and benefits of a project.
- Focus is on relevant cash inflows and outflows during the entire life of the project as against income as computed in the accrual accounting sense.

Two Main Variations of DCF

- NPV
- IRR

Assumptions of DCF Model

- Assumed a world of certainty
- The original amount of investment can be looked upon as being either borrowed or loaned at some specified rate of return

Decision rules of DCF Model

- If NPV is greater than 0, accept the project. If NPV is < 0, reject. If NPV = 0, the project may be accepted specially when non-financial considerations are strong enough.
- Rank the projects according to their NPVs and select the project at or above the cut off rate of return.
- Select the project if IRR > cost of capital.

Question 3.

What is ‘Asset-based approach’ towards business valuation? (Dec 2011, 5 marks) [CMA Final]

Answer:

Asset-based approach:

The valuation here is simply the difference between the assets and liabilities taken from the balance sheet, adjusted for certain accounting principles.

Two methods are used here:

The Liquidation Value, which is the sum of estimated sale values of the assets owned by a company.

Replacement Cost:

The current cost of replacing all the assets of a company, However, the asset-based approach is not an alternative to the first three approaches, as this approach itself uses one of the three approaches to determine the values. This approach is commonly used by property and investment companies, to cross check for asset based trading companies such as hotels and property developers, under performing trading companies with strong asset base (market value vs. existing use), and to work outbreak – up valuations.

Assets based approach is not an alternative to the other popular methods of valuation such as:

- Discounted cash flow valuation
- Relative valuation
- Contingent claim valuation

Question 4.

Discuss the major aspects and decision Rules of the Discounted Cash Flow (DCF) Model. (June 2012, 5 marks) [CMA Final]

Answer:

The Discounted Cash Flow (DCF) analysis represents the net present value (NPV) of projected cash flows available to all providers of capital, net of the cash needed. The Present Value of an asset is arrived at by determining the present values of all expected future cash flows from the use of the asset. Mathematically, the discounted cash flow formula is derived from the future value formula for calculating the time value of money and compounding returns.

DPV = \(\frac{C F_1}{(1+r)^1}\) + \(\frac{C_2}{(1+r)^2}\) + …… + \(\frac{C F_n}{(1+r)^n}\)

FV = DPV.(1+i)^{n}

Where

- DPV is the discounted present value of the future cash flow (FY), or FV adjusted for the delay in receipt;
- FV is the nominal value of a cash flow amount in a future period;
- i is the interest rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full;
- d is the discount rate, which is i(1 + i), i.e. the interest rate expressed as a deduction at the beginning of the year instead of an addition at the end of the year,
- n is the time in year before the future cash flow occurs.

Major aspects of DCF (Discounted Cash Flow) Model are:

- It weights the time value of money explicitly while evaluating the Costs and benefits of a Project.
- Focus is on relevant Cash inflows and outflows during the entire life of the project as against income as computed in the accrual accounting sense.
- Two main variations of DCF.

(a) NPV – Net present value is the total of the present value of Cash Flows (DCF) discounted at a given rate (generally the Costs of Capital/ desired rate of return).

(b) IRR – The IRR (Internal Rate of Return) has been defined as “the maximum rate of interest that could be paid for the Capital employed over the life of an investment without loss on the Project.” It is the yield on investment.

Decision Rules of DCF Models:

- If NPV is greater than “O,” accept the project.

If NPV is < O, reject. If NPV = O, the project may be accepted specially when non-financial Considerations are strong enough. - Rank the Projects according to their NPV’s (Net Present Value) and select required project as per ranking.
- In case of IRR all projects where IRR > Cost of capital/required rate of return can be selected.

Question 5.

In valuing a firm should you use marginal or effective tax rate? (Dec 2012, 5 marks) [CMA Final]

Answer:

The most widely reported tax rate in financial statements is the effective tax rate. It is computed as under:

(Taxes due) / Taxable income

The second choice on tax rate is marginal tax rate, which is the tax rate the firm faces on its last rupee of income. The reason for the choice of marginal tax rate lies in the fact that marginal tax rate for most firms remains fairly similar but wide differences in effective tax rates are noted across firms. In valuing a firm, if same tax rate has to be applied to earning of every period, the preferred choice is the marginal tax rate. This makes calculation and analysis comparable across different years of the same firm and across different firms in an industry.

Question 6.

Identify and explain four techniques of relative valuation. (June 2013, 5 marks) (CMA Final)

Answer:

Relative valuation approaches and techniques are based on the premise that the value of any asset can be estimated by analyzing the market prices of similar or comparable assets. In this approach comparable assets are identified and their market value obtained (e.g. from share price listing on stock exchange). These market values are converted into multiples based on revenues or EBITDA or other key numbers. The multiple or adjusted multiple is applied to the asset being valued to obtain its market value. Thus, relative valuation techniques assume that prices have stable and consistent relationships to various firm variables across groups of firms:

- Price – earnings ratio
- Price – cash flow ratio
- Price – book value ratio
- Price sales ratio

1. The Price- earnings ratio: popularly known as P/E ratio is affected by two variables;

(i) Required rate of return on its equity (k)

(ii) Expected growth rate of dividends (g)

\(\frac{p}{E 1}\) – \(\frac{\frac{D 1}{E}}{\mathrm{~K}-\mathrm{g}}\) estimate earnings for the next year, (ii) Estimate P/E ratio and

(iii) multiply expected earning by the expected P/E ratio to get expected price

V = E1 * \(\frac{P}{E}\)

2. Price — cash flow ratio: Cash flows can also be used in this approach are often considered less susceptible to manipulation by management. The steps are similar to using P/E ratio

V – CF1 * \(\frac{\mathrm{P}}{\mathrm{CF}}\)

3. Price — book value ratio: Book values can also be used as a measure of relative value. The steps to obtaining valuation estimates are again similar to using the P/E ratio

V = BV1 * \(\frac{\mathrm{P}}{\mathrm{CF}}\)

4. Price sales ratio: Finally, sales can be used in relation to stock price. There are some drawbacks, in that sales do not necessarily produce profits and positive cash flows. The advantage is that sales are also less susceptible to manipulation. The steps are similar to using the P/E ratio

V = s1 * \(\frac{P}{S}\)

Question 7.

What are the types of companies where management may find difficulties in using Discounted Cash Flow Technique for Valuation? (June 2014, 4 marks) [CMA Final)

Answer:

Limitations of DCF Valuation:

This technique requires a lot of information. The Inputs and information are difficult to estimate. This technique cannot differentiate between over and undervalued stocks. It is difficult to apply this technique in the following scenarios:

(i) Negative earnings firms

For such firms, estimating future cash flows is difficult to do, since there is a strong probability of insolvency and failure. DCF does not work well since under this technique the firm is valued as a going concern which provides positive cash flows to its investors.

(ii) Cyclical firms

For such firms earnings follow cyclical trends. Discounting smooths the cash flows. It is very difficult to predict the timing and duration of the economic situation. The effect of cyclical situation on these firms is neither avoidable nor separable. Therefore, there are economic biases in valuations of these firms.

(iii) Firms with un/under utilized assets

DCF valuation reflects the value of all assets that produce cash flows, if a firm has assets that are un/under utilized that do not produce any cash flows, the values of these assets will not be reflected in the value obtained from discounting expected future cash flows. But, the values of these assets can always be obtained externally, and added on to the value obtained from discounted cash flows valuation.

(iv) Firms with patents or product options

Firms often have unutilized patents or license that do not produce any current cash flows and are not expected to produce cash flows in the near future, but nevertheless, these are valuable. If values of such patents are ignored then value obtained from discounting expected cash flows to the firm will understate the true value of the firm.

(v) Firms in the process of restructuring

Firms in the process of restructuring often sell, acquire other assets, and change their capital structure and sometimes dividend policy. Some of them also change their status from private to public. Each of these changes makes estimating of future cash flows more difficult and affects the riskiness of the firm. Using historical data for such firms can give a misleading picture of the firm’s value.

(vi) Private Firms

The measurement of risk to be used in estimating discount rates is the problem since securities in private firms are not traded, this is not possible. One solution is to look at the riskiness of comparable firms, which are publicly traded. The other is to relate the measure of risk to accounting variables, which are available for the private firm.

Question 8.

The price of the company’s share is ₹ 100 and the value of growth opportunities is ₹ 20. If the company’s capitalization rate is 20%, what is the earnings-price ratio? How much is earnings per share? (Dec 2008, 10 marks) [CMA Final]

Answer:

Let Po stand for Price of company’s share = ₹ 100 (given).

Ke = Capitalization rate = 20%(given)

Vg = Value of growth opportunity = ₹ 20 (given).

The formula connecting Earnings/share, Price of Company’s share, capitalization rate and the value of growth opportunities is, as given below:

Po = EPSI/Ke + Vg., where EPSI stands for Earnings per Share,

Putting the values as are given in the question, we get

100 = EPSI/0.20 + 20

or EPSI/0.20 = 100-20 = 80

or EPSI = 80 × 0.2 = ₹ 16 i.e.. __Earnings per share__ = ₹ 16.

Earning – Price ratio = Earning Per Share /Price of company’s share

= ₹ 16/₹ 100 = 0.16 (Answer).

Question 9.

The following table gives accounting data from the 2008 annual reports of six companies in the IT sector. The market value of equity of five of the firms is also given. From these data, estimate a value for Softech Solutions Ltd. Softech Solutions had a book value of ₹ 1349 millions in 2008.

(June 2009, 15 marks) [CMA Final]

Answer:

** Total value = (R&D assets 3350.4+ other assets 1349)

= ₹ 4,699.4m.(see Note 2 below]

The estimated value of Soft tech Solutions Ltd. by Comparable Companies Approach (Relative Valuation Approach) is taken as the average of all these means

= ₹ (561 1.8 + 4812.2 + 4699.4 + 5077.6) + 4 = ₹ 5050.25 m.

Notes on working:

1. E/P is used rather than PIE because a very high PÆ due to very small earnings can affect the mean (average) considerably. Since Soltech’s Solutions did not have losses, the mean EJP also excludes the loss firms.

2. Research and development (R&D) expenditures are compared to price minus book value. As the R&D asset is not on balance sheets, its missing value is in this difference. The ratio of 10.66 is applied to Softech’s R&D expenditures to yield a valuation for its R&D asset of 3,350.4m which, when added to the book value of the other net assets, gives a valuation of ₹ 4699.4m for Softech.

Question 10.

Every investor in the capital asset pricing model owns a combination of the market portfolio and a riskless asset.

Assume that the standard deviation of the market portfolio is 30% and that the expected return on the portfolio is 15%. What proportion of the following investor’s wealth would you suggest investing ¡n the market portfolio and

what proportion in the riskless asset? (The riskless asset has an expected return of 5%).

(i) an investor who desires a portfolio with no standard deviation;

(ii) an investor who desires a portfolio with a standard deviation of 15%;

(iii) an investor who desires a portfolio with a standard deviation of 30%;

(iv) an investor who desires a portfolio with a standard deviation of 45%;

(v) an investor who desires a portfolio with an expected return of 12%. (June 2009, 5 marks) (CMA Final)

Answer:

(i) Invest everything In the riskless asset.

(ii) Solve 0.15 = w(0.3) to get w ≥ 0.5; invest 50% in each asset.

(iii) Invest everything in the market portfolio.

(iv) Solve 0.45 w (0.3) to get w = 1.5; the investor should borrow 50% of his own outlay at the risk-free rate and invest the borrowing as well as his own outlay in the market portfolio.

(v) Solve w (15) + (1 – w)5 = 12 to get w = 0.7; invest 70% in the market portfolio and the rest in the risk-free asset.

Question 11.

Builders Ltd. a manufacturer of building products, mainly supplies the wholesale trade. li has recently suffered falling demand due to economic recession, and thus has spare capacity. It now perceives an opportunity to produce designer ceramic tiles for the home improvement market. It has already paid ₹ 50 lakh for development expenditure, market research and a feasability study.

The initial analysis reveals scope for selling 1,50,000 boxes per annum over a five-year period at a price of ₹ 200 per box. Estimated operating costs, largely based on experience, are as:

Cost per box of tiles (at today’s prices): ₹

Material çost : 80

Direct labour : 20

Variable overhead : 15

Fixed overhead (allocated) : 15

Distribution etc. : 20

Production can take place in existing facilities although initial re-design and set-up costs would be ₹ 2 crore after allowing for all relevant tax reliefs. Returns from the project would be taxed at 33%.

Builder’s shareholders require a nominal return of 14% per annum after tax, which includes allowance for generally-expected inflation of 5.5% per annum. It can be assumed that all operating cash flows occur at year ends. You are required to:

(a) Assess the financial desirability of this venture in real terms, finding the Net Present Value offered by the project. (June 2009, 7 marks) (CMA Final)

(b) Determine the values of

(i) price (June 2009, 3 marks) (CMA Final)

(ii) volume (3 marks) (CMA Final)

at which the project’s NPV becomes zero.

Answer:

(a) Data given:

- Development cost already paid SOL
- To sell 1,50,000 boxes of tiles per annum for 5 years @ 200 per box
- Cost per box of tiles (at todays prices):

Material and other variable expenses ₹135

Fixed overhead (allocated) ₹ 15 - Initial re-design and set-up costs 2 crore
- Applicable tax rate 33% on income
- Expected general rate of inflation 55% p.a.
- Required nominal rate of return 14%
- All operating cash flows occur at year ends.

Estimated cash flows at current prices are equal to real cash flows. And, real cash flows must be discounted at a real discount rate. But the question provides us with a nominal required rate. This nominal rate must at first be converted to a real discount rate. Using the formula. (1 + nominal rate) (1+ real rate) × (1 + rate of inflation) and putting the given values, we get the real rate = 8% [1.14/1.055].

* Annual post-tax operating cash flow = 1,50,000 × ₹ (200 – 135) × (1 – 0.33) = ₹ 65,32,500.

NPV = ₹ 65,32,000 × 3.993 – ₹ 2,00,00,000 = ₹ 60,82,276.

As the NPV is positive, the project is acceptable.

(b) (i) 0 = 1.5L(P – ₹ 135) (1 – 0.33) (AF_{8%,5}) – ₹ 200L,

where P = the sale-price at which the project will have zero NPV.

By solving the above, we get P = ₹ 185

That is, price can fall to ₹ 185 or by 7.5%.

(ii) Let v be the volume (quantity) of sales, where the project will have zero NPV.

So, we get the equation: NPV = 0 = v(₹200 – ₹ 135)

(1 – 0.33) (AF_{8%,5}),

whence v = 1.15L (approx).

Question 12.

A share of lace value of ₹ 10 presently sells for ₹ 80. It is estimated that it will pay a dividend of 50% at the end of the year. Its beta is 1.2. If risk-free rate of interest is 6% and the expected rate of return on the market portfolio is 16% then what do investors expect the share to sell for at the end of the year? (Assume that CAPM works in the market). (Dec 2009, 6 marks) (CMA Final)

Answer:

Determination of Expected selling Price of Equity share of face value of

₹ 10/-at end of the Year:

Expected Return as per CAPM =6% + (16%-6%) × 1.2 = 18%

Had there been no dividend, the price of the share after one year should be

= ₹ 80 + 18% of ₹ 80 = ₹ 94.40.

Receiving a dividend of ₹ 5 (50% of ₹ 10), the expected price after one year will be = ₹ 94.40 – 5.00 = ₹ 89.40.

Question 13.

The balance sheet of Reliance Industries is shown below. The value of operations as at 31 -12-2008 is ₹ 65.1 Crores and there are 1 Crore shares of common equity. What is the price per share? Balance Sheet as at December 31, 2008 (₹ in Lakhs).

Answer:

Computation of Price per share of Reliance Industries as at 31-12-2008.

Total corporate value = Value of operations + marketable securities

= ₹ 6510 + 470 = ₹ 6,980 Lakhs

Value of equity = Total corporate value – debt – Preferred stock

= ₹ 6,980 – (₹ 650 + ₹ 1,310) – ₹ 330 = ₹ 4,690 Lakhs

Price per share = ₹ 4,690/100 = ₹ 46.90

Question 14.

An analyst prepared balance sheets for the years 2007 and 2006 as follows (₹ in Crores).

The firm reported ₹ 100 Crores in comprehensive income from 2007 and no net financial income or expense?

(a) Calculate the tree cash flow for 2007. (Dec 2009, 5 marks) (CMA Final)

(b) How was the free cash flow utilized? (Dec 2009, 5 marks) (CMA Final)

(c) How can a firm with financial assets and financial liabilities have zero net financial income or expense. (Dec 2009, 5 marks) [CMA Final]

Answer:

(a) Calculation of the free cash flow for 2007:

Use the free cash flow generation equation: C-I = 0I – ΔNOA

As there was no net financial income or expense, operating income (01) equals the comprehensive income of ₹ 100 Crores. The net operating assets for 2007 and 2006 are as follows:

C – I = 0I – NOA

= 100 – 60

= ₹ 40 Crores

(b) Utilization of free cash flow:

Use the free cash flow disposition equation: C – I = NFA -Δ NFI + d

The net dividend (d) = comprehensive income – Δ CSE

= 100 – 160

= – ₹ 60 Crore (a net capital contribution)

The net financial assets for 2007 and 2006 are as follows:

C – I = Δ NFA – NFI + d

= 100 – 0 – 60

= ₹ 40 crores

The firm invested the ₹ 40 Crores of free cash flow in financial assets. In addition, it raised a net ₹ 60 Crores from shareholders which it also invested in financial assets.

(c) Net financial income or expense can be zero if financial income and financial expense exactly offset each other. This firm moved from a net debtor to a net creditor position in 2007 such that the weighted-average net financial income was zero.

Question 15.

A firm has the following summary balance sheet (₹ in Crores):

Net Operating assets : 441

Net Financial Obligations : 52

Common Shareholders’ Equity : 389

The firm is currently earning a return on net operating assets (RNOA) of 14 percent from sales of ₹ 857 Crores and after tax operating income of ₹ 60 Crores. Its required return on operations is 10%. Forecasts indicate that RNOA is likely to continue at the same level in the future with growth in sales of 3 percent per year and growth in net operating assets to support the sales growth of 3 percent per year. Management is considering a plan to introduce new products that are expected to increase the sales growth rate to 4 percent a year and maintain the current profit margin of 7 percent. But the plan will require additional investment in net operating assets that will reduce the firm’s asset turnover to 1.67. What effect will this plan have on the value of the firm? (Dec 2009, 20 marks) [CMA Final]

Answer:

Effect on value of the firm Analysis of Value Added Analysis of Value Added

Pro forma and valuation under the status quo:

0 | 1 | 2 | 3 | ||

Sales | 857 | 883 | 909 | 936 | (grows at 3%) |

Operating income (PM = 7%) | 60 | 61.8 | 63.6 | 65.6 | (grows at 3%) |

Net operating assets | 441 | 454 | 468 | 482 | (grows at 3%) |

PM | 7% | 7% | 7% | 7% | |

ATO | 2 | 2 | 2 | 2 | |

RNOA | 14% | 14% | 14% | 14% | |

ReOI | 17.6 | 18.2 | 18.7 | (grows at 3%) |

Value of operations under the status quo

Value of NOA = 441 + (17.64)/ (1.10-1.03) = 693

0 | 1 | 2 | 3 | ||

Sales | 857 | 891 | 927 | 964 | (grows at 4%) |

Operating income (PM = 7%) | 60 | 62.4 | 64.9 | 67.5 | (grows at 4%) |

Net operating assets | 535 | 556 | 578 | 602 | (grows at 4%) |

PM | 7% | 7% | 7% | 7% | |

ATO | 1.67 | 1.67 | 1.67 | 1.67 | |

RNOA | 11.67% | 11.67% | 11.67% | 11.67% | |

ReOI | 8.93 | 9.29 | 9.66 | (grows at 4%) |

Value of operations under the plan

Value of NOA = 534.8 + (8.93)/ (1.10-1.04) – 684

The plan (marginally) losses value. The additional growth (that generates additional profit margin) is not sufficient to cover the required return on the additional investments in net operating assets.

Question 16.

From the last 5 years annual reports of Queen India Limited, the following information about dividend declared has been collected:

Year | Rate of Dividend |

2004-05 | 10% |

2005-06 | 12% |

2006-07 | 18% |

2007-08 | 22% |

2008-09 | 25% |

The average dividend yield in the industry is estimated to be 8%. If the nominal value of the company’s share is ₹ 10, then determine the value per share of Queen India Limited using the Dividend Yield Method. (Use Weighted Average Method for determining the average dividend rate of the company.) (June 2010, 7 marks) [CMA Final]

Answer:

Weighted Average Rate at Dividend: 20.07%

Value per Share: ₹ 25.08

Question 17.

While evaluating a capital project, a company is considering an option to buy a business from a third party at the cost of ₹ 50 crores. It is expected that in next one year, the value of such business will increase to ₹ 60 crores with probability 70% or decline to ₹ 45 crores with probability of 30%. The company may enter into an agreement with a party to sell the said business at ₹ 48 crores after one year if the company so desires. Assuming that this real option is like a European Call, with the strike price of the underlying real asset is ₹ 48 crores and the risk free interest rate is 9% p.a. Determine the value of this real option. (Dec 2010, 5 marks) [CMA Final]

Answer:

To solve this problem, one can use any approach of the following three:

- No Arbitrage Method
- Hedging Portfolio Method
- Risk Neutral Probability Method

Here, answer is given using Risk Neutral Probability Method:

Let p be the risk neutral probability that the value of the business will increase to ₹ 60 crores and 1 -p will be the risk neutral probability that value of the business will be ₹ 45 crores if it declines.

Then, 50 = [60p + 45 (1 -p)] /1.09 and solving for p we get p

= 0.6333 and 1 -p

= 0.3667.

Using these risk neutral probabilities we get the valuation of the OPTION as – Value of the Real Option = {(60-48) × 0.6333 + 0 ×.3667)/1.09

= ₹ 6.97 crores

Question 18.

Mr. S. K. Sinha had purchased 500 shares of the Company X at the rate of ₹ 60 per share. He held the shares for 2 years and got a dividend of 15% and 20% in the first year, and second year respectively on the face value of ₹ 10 each share. At the end of the second year, the shares are sold at the rate of ₹ 75 per share. Determine the effective rate of return per year which Mr. Sinha has earned on this share. (Dec 2010, 4 marks) [CMA Final]

Answer:

To solve this problem, one can use the following approach:

Time Period | Particulars | Amount |

0 | Purchase 500 Shares @ ₹ 60 each share | ₹ (30,000.00) |

1 | Dividend on 500 shares @ ₹ 1.50 per share | ₹ 750.00 |

3 | Dividend on 500 shares per share + Sale proceeds of 500 shares @ ₹ 75 per share | 38,500.00 |

Assuming that Mr. Sinha is earning r rate of effective return on his equity shares per year, Then from above we get:

-30,000 + [750/(1+r) + [38500/(1+r)^{2}] = 0

Solving the above equation for r we get the value of r = 14.54%.

Hence, the effective rate of return p.a. = 14.54%

Question 19.

Mr. Sudershan Bose is given the task of estimating the weighted average cost of capital (WACC) of the company in which he is working. For that, it s decided that debt/equity ratio is to be estimated on the basis of market values of equity and debt. For that, he has collected necessary information from the Annual Report—2009-10 of the company along with other information that are given below:

Balance Sheet as on March 31^{st}, 2010

Other Information:

(i) Equity Shares of the company are trading in the market at ₹ 60 per share.

(ii) 2 lakhs Share Warrants outstanding confer on its holders the right to buy the shares of the company at ₹ 75 per share. Currently, these share warrants are trading in the market at ₹ 18 per share warrant.

(iii) Unsecured Loans of ₹ 500 lakhs are issued at the current market coupon rate of 9% pa. and hence, its book value is equal to its market price.

(iv) 1 lakh Convertible Debentures are with a coupon of 6%. face value of ₹ 1,000 and remaining time to maturity of 10 years. The straight and plain vanilla valuation of such convertible debentures can be done at a yield of 10% p.a.

You are required to determine the Debt/Equity Ratio of the company based on the above information and by taking the market values of debt and equity. (Dec 2010, 15 marks) (CMA Final)

Answer:

- Number of Equity Share = 100 lakhs
- Market Price of Equity Shares = ₹ 60/Share
- Total Value of Equity Shares = ₹ 6,000 lakhs
- Market Value of Share warrants = ₹ 2 lakhs × ₹ 18/Warrant

= ₹ 36 lakhs

Value of straight bond portion of Convertible Bonds:

=1 lakh debentures × {\(\frac{₹ 1,000 \times 6 \%}{10 \%}\) × [1 .1/(1 +10%)^{10}] + 1,000/(1+10%)^{10})

= 1 lakh × 754.22

= 754.22 lakhs

Therefore, Value of conversion option = (₹ 1,000 – ₹ 754.22) lakhs

= ₹ 245.78 lakhs

Now we obtain:

Total Market Value of Equity = ₹ (6,000 + 36 + 245.78) lakhs

= ₹ 6,281.78 lakhs

Total Value (Market) of Debt = ₹ (754.22 + 500) lakhs (Unsecured Loans)

= ₹ 1254.22 lakhs

Debt Equity Ratio = 1,254.22/ (1,254.22 + 6,281.78)

= 16.64%.

Question 20.

Consider Company A and Company B. Both have recently announced their annual results and as per the reported results, both are having PAT of ₹ 160 lakhs and 40 lakhs equity shares outstanding.

(i) Company A has growth plans in future due to that it is believed that its earnings will increase by 8% every year in perpetuity. Assume that the company is having the required rate of return on equity of 15% a year.

(ii) Company B has growth plans in future due to that it is believed that its earnings will increase by 10% every year in perpetuity. Assume that the company is having the required rate of return on equity of 12% a year.

Assume that both the companies are having a retention ratio of 50% and identical in all other aspects. Calculate P/E Ratios and comment on their relative valuation. (Dec 2010, 7 marks) [CMA Final]

Answer:

Company B has a higher valuation more than three times of Company A due to Following factors:

(a) Expected growth rate of Company B is 10% and is higher than that of Company A-8%

(b) Required rate of return on Equity of Company B is onty 12% and is lower than Company A-15%

(c) PIE Ratio of Company B is 27.50 and is higher than Company A at 7.71.

Question 21.

H Ltd. and Z Ltd. have the same levels of business risk and their market values and earnings are summarized below:

You are required to calculate:

The post tax cost of equity, cost of debt and weighted average cost of capital of both the companies. Assume that the income tax rate on the company is 35% including Education Cess etc. and the additional tax on dividend distribution is 20%. (Dec 2010, 10 marks) [CMA Final]

Answer:

Question 22.

M/s Radha Industries is planning to issue a Bonds series on the following terms- Face value ₹ 100 Terms of maturity 10 years Yearly Coupon Rate.

Years : Rate

1 -4 : 9%

5-8 : 10%

9-10 : 14%

The current market rate of similar bonds is 15% per annum. The company proposes to price the issue in such a manner that it can yield 16% compounded rate of return to the investors. The Company also proposes to redeem the bonds at 5% premium on maturity. You are required to determine the issue price of the bonds :

factor of ₹ 1@ 16% (June 2011, 10 marks) [CMA Final]

Answer:

The issue price of the bonds will be the sum of present value of interest payments during 10 years up to its maturity arid present value of redemption value of bonds, discounted at the rate of planned yield

Question 23.

ABC Limited provides you with following figures:

Particulars : Amount in ₹

Profit before interest and tax : 50,00,000

Less : Interest on debentures @ 12% : 6,00,000

Profit Before Tax : 44,00,000

Income Tax @ 40% : 17,60,000

Profit After Tax : 26,40,000

Number of Equity Shares (₹ 10 each) (Numbers) : 4,00,000

Ruling Price in the market (₹) per share : 66

The company has undistributed reserves of 60,00,000. The company needs ₹ 1,20,00,000 for expansion. This amount will earn the same rate as Return on Capital Employed on existing capital. In view of current boom in the capital markets company management has decided to raise 100% of the total financing requirements externally.

You are informed that a debt equity ratio [(Debt/Debt + Equity)] higher than 35% will push PE ratio down to 8 and raise the interest rate on additional amount borrowed to 14% due to the increased financial risk profile of the company. You are required to ascertain the probable price of the share:

(i) If additional funds are raised as debt; and

(ii) If the amount is raised by issuing equity shares assuming that new shares will be issued at ₹ 60 per share and Price Earnings Ratio will remain unchanged. (June 2011, 10 marks) (CMA Final)

Answer:

Estimated Price of Shares of ABC Ltd.

Case: Equity Financing

The expansion of ₹ 120,00,000 is met by issue of equity shares at ₹ 60/- per share. Additional equity shares issued 2,00,000. Total share capital will become 6,00,000 shares of ₹ 10/- each.

Since debt equity ratio will be (₹ 50,00,000/ ₹ 2,70,00,000) = 18.52% i.e. Less than 35% PE Ratio will remain same 10

Therefore, in case of equity financing the market price will be ₹ 84.

Question 24.

VASUDA Ltd. is a major player in the Textile industry of the country. The Industry is expected to maintain high growth for a period of 5 years after which it is expected to drop down. Currently the company is distributing 40% of its profit as dividend to the shareholders.

The dividend payout ratio of the company is expected to remain at the current level for a period of next 5 years after which it is expected to increase to 55%.

The nét profit margin of the company is currently 8% and is expected to remain at the same level for next 5 years, after which it is expected to decrease to 5.7%.

Currently the company is able to generate sales of ₹ 2.50 for every 1 (one) rupee of assets employed and it is expected to remain the same for the next 5 years and after that the company is expected to generate sales of ₹ 3.50 for every 1 (one) rupee of assets employed.

50% of the assets of the company are financed with equity capital, and it is expected to remain same in future.

At present the risk free rate of return is 7% and market risk premium is 15.50%. The beta of the company is currently 1.2. Current net worth of the company is ₹ 250 lakh and number of shares outstanding is 2 lakh.

Note : The Market is in equilibrium.

You are required to compute:

(i) Price per share of VASUDA Ltd. using Dividend discount model (DDM)

(ii) Price to book value ratio of the share of VASUDA Ltd.

(June 2011, 10 marks)[CMA Final]

Answer:

Calculation of price per share

Calculation of current EPS of Vasuda Ltd.

ROE = PAT/NW

0.40 = PAT/250 Lakh

PAT = 250*0.40 = ₹ 100 lakh.

Number of shares = 2 lakh

EPS = 100/2 = ₹ 50

Calculation of cost of equity

Ke = Rf + B (Rm- Rt) = 7 + 1.20*15.50 = 25.60

Terminal Valué at the end of 5^{th} year = 95.128/(0.256-0.18) = ₹ 1251.68

Question 25.

NABINA UDYOG LTD., a venture capital fund, has specialized in providing bridge finance to young technocrats in biotechnology sector. NABINA UDYOG has received an investment proposal from AKRIT BIOTECH LTD. a Bio-tech firm, to finance its recent project with equity investment of ₹ 15 crore. AKRIT BIOTECH LTD. is an existing profit making organization with a dividend track record of 3 years. The current EPS of the company is 5. The expected growth in EPS for the next year is as follows:

Growth In EPS(%) : Probability

0 : 0.20

25 : 0.30

35 : 0.40

40 : 0.10

NABINA UDYOG reckons that the PIE ratio for this industry will be as follows:

P/E Ratio : Probability

8 : 0.30

10 : 0.40

12 : 0.30

NABINA UDYOG finances every project for 1 year. The company (NABINA UDYOG) invests only in those projects where probability of getting target return of 35% is at least 75%. NABINA UDYOG is expected to dispose of its investment at Industry P/E ratio.

Required:

What should be the price at which NABINA UDYOG LTD. would make the investment? (June 2011, 9 marks) (CMA Final)

Answer:

Nabina Udyog Ltd.

From the table it is seen that the probability of the divestment price being ₹ 50 or less is 0.23. Hence, the probability of divestment puce being ₹ 54 and above is 0.77 which is more than the specified limit 0.75. Hence, the minimum divestment price can be taken ₹ 54

The company should even a target return of 35%

Hence, the purchase price should be

(54 – P)/P = 35% ie. 0.35

54 – P = 0.35P

P = 54/1.35 = 40

The purchase price should be ₹ 40 per share.

Question 26.

S.K. Lab a pharmaceutical company in Western India was expected to have revenues of ₹ 50 lakhs in 2003 and report net income of ₹ 9 lakhs in that year.

The firm had a book value of assets of ₹ 110 lakhs and a book value of equity of ₹ 58 lakhs at the end of 2002. Its market capitalization was ₹ 85 lakhs.

The firm was expected to maintain sales in its niche product, a multivitamin tablet and grow at 5% a year In the long term, primarily by expanding into the generic drug market. The beta of S.K. Lab traded in Mumbai Stock Exchange was 1.25. The return on 10 year GOI bond in India in 2002 was 7% and the risk premium for stocks over bond is assumed to be 3.5%. Do you consider the market price as the fair value of the shares of S.K. Lab? (Dec 2011, 5 marks) (CMA Final)

Answer:

S.K. Lab

Expected net income = ₹ 9 lakhs

Return on equity = 9/58 = 15.52%

Cost of equity = 7% + 1.25 (3.5%) = 11.375%

Price to book value ratio = (0.1552.0.05)/(0.11375-0.05) = 1.65

Estimated Market Value of Equity = BV equity * Price to BV ratio

= 58*165

= 95.70 lakh

Question 27.

Crystal (India) Limited has changed its focus from Profit Maximization” to “Value Maximization” and accordingly, it is changing its whole strategic road map for future. In this exercise, they have to see what divisions are creating value and what are destroying value so that it should divest – from value destroying divisions.

Assume that you have been assigned to estimate the value of one of their divisions – Engineering Division. For that you have been provided the following necessary information:

After 2016-17, it is expected that the cash flows will grow at a growth rate of 8%.

The Company pays tax at the rate of 40% and it has cost of funds of 14%.

Using the Free Cash Flow Valuation Method, you are required to determine the value of the Division.

Answer:

Question 28.

(a) ABC LTD.’s Shares are currently selling at ₹ 13 per share. There are 10,00,000 Shares outstanding. The firm is planning to raise ₹ 20 lakhs to finance a new project to be started soon at Bangalore. You are required to calculate the ex-right price of shares and the value of a right, if:

(i) The firm offers one right share for every two shares held

(ii) The firm offers one right share for every four shares held

(iii) How does the shareholders’ wealth change from (i) to (ii) above? How does right issue increáses shareholders’ wealth? (June 2012, 9 marks) (CMA Final)

(b) The following data are available for a bond:

Face Value : ₹ 1,000

Coupon rate : 16%

Years to Maturity : 6

Redemption Value : ₹ 1,000

Yield to Maturity : 17%

Calculate the current market price of the bond.

PV Factor @ 17% year wise (1 st yr 0.855, 2nd yr 0.730, 3rd yr 0.624, 4^{th} yr. 0.534. 5th yr 0.456, 6th yr 0.390) (6 marks) (CMA Final)

Answer:

(a) Vijey

(i) No. of shares to be issued: 5,00,000

Pre-right = \(\frac{1,30,00,000+20,00,000}{15,00,000}\) = 10

Subscription price = \(\frac{20,00,000}{5,00,000}\) = ₹ 4

Value of right = \(\frac{10-4}{2}\) = 3

(ii) Pre – right = \(\frac{1,30,00,000+20,00,000}{12,50,000}\) = 12

Subscription price = \(\frac{20,00,000}{2,50,000}\) = 8

Value of right = \(\frac{12-8}{4}\) = 1

(iii) Since right issue is constructed in such a way so that shareholders’ Proportionate share will remain unchanged shareholders’ wealth does not change from (i) to (ii).

Right issue increases shareholders’ wealth because the cost of issuing right shares is much lower than the cost of a public Issue.

(b)merger /acquisition is likely to result in synergy providing additional benefits arising out of the M&A.

Alternatively the candidate may attempt by 160 (PV @ 17% yearly cumulative 1 to 6 years) + 1000(PV @ 17% In 6^{th} year)

= 160 (3.589) + 1000 (0.390)

= 574.24 + 390

= 964.24

Question 29.

The directors of HI Value Fund are keen on acquiring the business of G Ltd. They have approached you given your valuation expertise for mergers and acquisitions for help. G Ltd. has an invested capital of ₹ 50 million, Its return on invested capital (ROIC) is 12% and Its weighted average cost of capital (WACC) is 11%. The expected growth rate in G Ltd.’s invested capital will be 20% for the first three years, 12% for the following two years and 8% there after for ever. The forecast of G Ltd’s tree cash flows is given below:

Value G Ltd. under (I) Discounted cash flow method and (ii) present value of economic profit method. Can the consideration paid for the shares exceed the valuation, if so, under what circumstances? (15 marks) (CMA Final)

Answer:

The present value of tree cash flow during the planning period is:

PV(FCF) = \(\frac{-4.00}{1.11}\) + \(\frac{-4.80}{(1.11)^2}\) + \(\frac{-5.76}{(1.11)^3}\) + \(\frac{0}{(1.11)^4}\) + \(\frac{0}{(1.11)^5}\) + \(\frac{4.33}{(1.11)^6}\)

= (-) 9.4 million

The horizon value at the end of six years, applying constant growth model, is

V + 1 = \(\frac{F C F H+1}{W A C C-g}\) = \(\frac{4.68}{.11-.08}\) = 156.0 million

The present value of VH is

= \(\frac{156.0}{(1.11)^6}\)

= 83.4 million

Adding the present value of free cash flow during the planning period and present value of horizon value, gives the enterprise DCF value

v_{o} = -9.4 + 83.4

= 74.0 million.

The present value of Economic profit stream is.

\(\frac{0.50}{1.11}\) + \(\frac{0.60}{(1.11)^2}\) + \(\frac{0.72}{(1.11)^3}\) + \(\frac{0.87}{(1.11)^4}\) + \(\frac{0.97}{(1.11)^5}\) + \(\frac{1.08}{(1.11)^6}\) + \(\frac{1.17}{(0.11-.08)}\) × \(\frac{1}{(1.11)^6}\)

Adding the invested capital to the present value of EP stream given the enterprise value:

V_{0} = 50 + 24

= 74 million.

Thus, the two models lead to identical valuation.

In the case of Mergers and Acquisitions the actual consideration paid for the shares can exceed the valuation of shares under the DCF method and /or under the Present Value of Economic Profit method in situations where the merger /acquisition is likely to result in synergy providing additional benefits arising out of the M&A.

Examples are where the target company has patents or other key facilities/factors like access to resources, raw material, location, markets etc. which can be better utilized by the existing acquirer company, thereby enhancing its profitability. This can also arise where the target company is a key competitor. In such situations the consideration paid can exceed the valuation based on present value using DCF or PV of economic profit.

Question 30.

The following projections for’ T Ltd., have been developed based on internal estimates and market information:

You are required to calculate the enterprise value of T Ltd., using the following assumptions:

(a) Beyond year 5, the free cash flow to the firm will grow at a constant rate of 10 percent per annum

(b) T Ltd.’s unlevered cost of equity is 14%

(c) After year 5, T Ltd. will maintain a debt equity ratio of 4:7

(d) The borrowing rate fo4 T Ltd. will be 12 percent

(e) The tax rate for T Ltd. is 30%

(f) The risk tree rate of return is 8%

(g) The market risk premium is 6% (June 2013, 15 marks) (CMA Final]

Answer:

The present value of the unlevered equity free cash flow (which is the same as the free cash flow to the firm) during the planning period is:

Hence, the enterprise value of the T Ltd. is:

969.0 + 41.9 + 6220.5 = ₹ 7231.4 million

It may be noted that the WACC value of 13.49% used above has been arrived as follows:

1. Given that r_{ue} is 14%, β_{UE}, the unlevered equity beta, was calculated by solving the to following equation:

r_{UE} = Risk – free rate + β_{UE}* market risk premium

14 = 8 + β_{UE}* 6

β_{UE} = 1

2. Given β_{UE} = 1, β_{UE}, the levered equity beta was calculated:

β_{UE} = β_{UE} [1 + (1 – T)\(\frac{D}{E}\)]

= 1[1 + 4/7(1-0.3)]

= 1.4

3. Given β_{UE} = 1.4, r_{LE}, the cost of levered equity was calculated:

r_{LE,} = 8 + 1.4*6 = 16.4%

4. Given r_{LE,} = 16.4%, WACC, the weighted average cost of capital was calculated.

WACC = \(\frac{7}{11}\) * 16.4 + \(\frac{4}{11}\)*12* (1-0.3) = 10.44 + 3.05 = 13.49%

Question 31.

A company is trying to decide whether to Invest in a new project. Two mutually exclusive projects are available, each requiring an investment of ₹ 3,00,000. Project A is expected to generate cash inflows of ₹ 2,00,000 per year in the next two years. It is estimated that the cash inflows associated with project B would either be ₹ 1,80,000 or ₹ 2,20,000 (each with 0.5 probability of occurrence) in the first year. If ₹ 1,80,000 is received in the first year, the cash inflow for the second year is likely to be ₹ 1,50,000 (probability of 0.3) ₹ 1,80,000 (Probability of 0.4) and ₹ 2,00,000 (probability of 0.3).

In case the first year’s cash inflow is ₹ 2,20,000, the second year’s likely cash inflow would be ₹ 1,80,000 and ₹ 2,70,000 (each with 0.3 probability) and ₹ 2,20,000 (Probability 0.4). The firm uses a 14% minimum required rate of return for deciding whether to invest in projects comparable in risk to the ones under consideration.

Required:

(a) Calculate the risk adjusted expected NPV for projects A and B. (June 2013, 10 marks) (CMA Final)

(b) Identify the best and the worst possible outcomes for Project B. (June 2013, 3 marks) (CMA Final)

(c) Which of the projects, if any, would you recommend? Why? (June 2013, 2 marks) (CMA Final)

(The PV of 1 rupee at 14%: year 1: .877, year 2: .769, year 3: .675. year 4: .592 and year 5: .519)

Answer:

(i) Determination of expected NPV of project A

(ii) The worst possible outcome is a CFAT of ₹ 1,80,000 (year 1) and ₹ 1,50,000 (years 2) with the maximum negative NPV as (-) 26,790. The best possible outcome is when NPV is maximum ₹ 1,00,570. It results when CFAT in year 1 is ₹ 2,20,000 followed by ₹ 2,70,000 in year 2.

(iii) The expected NPVs (i.e. 29,200) are the same for both projects. However, from the point of view of risk aversion, project A should be chosen as there is no variability of possible outcomes and associated revenues.

Question 32.

A share, Y, currently sells for ₹ 120. It is expected that in one year it will either rise to ₹ 150 or decline to ₹ 100, with 50% probability of each. A call option is written on Y with the strike price of the underlying of ₹ 125 and the risk free interest rate is 10% p.a. You are required to determine the Option Premium. (Dec 2013, 5 marks) [CMA Final)

Answer:

Method Used: Risk Neutral Probability Method

Using the given probabilities of 50% each, we get value of the Option as,

= [(150 – 125) × 0.5 + (0) × 0.5]/ 1.10

= 12.50/1.10

= ₹ 11.36

Question 33.

Bihari Ltd. is issuing 5% ₹ 25 at par preference shares that would be convertible after three years to equity shares at ₹ 27. If the current market price of equity shares is ₹ 13.25, what is the conversion value and conversion premium?

The convertibles are trading at ₹ 17.75 in the market, Assume expected return as 8%. (June 2014, 6 marks) (CMA Final)

Answer:

Bihari Ltd. is issuing 5% ₹ 25 par preference shares that would be convertible after three years to equity shares at ₹ 27. If the current market price of equity shares is ₹ 13.25, what s the conversion value and conversion premium. The convertibles are trading at ₹ 17.75 in the market.

Assume expected return as 8%.

conversion ratio \(=\frac{\text { Parvalue of conversion security }}{\text { conversion price }}\) = 25/27 = 0.9259

Conversion value = (Conversion ratio) × (Market value per share of the common stock) = (0.9259) × (₹ 13.25) = ₹ 12.27

Now let us find the value as straight preferred stock = 1.25/8 = ₹ 15.63

conversion premium (in absolute terms) = (Market price of the convertible preferred stock) – (Higher of the security value and conversion value)

= 17.75 – ₹ 15.63

= ₹ 2.12.

Question 34.

Following is the information of two companies for the year ended 31st March, 2014:

Assume the market expectation is 18% and 80% of the profits are distributed.

Required-

(i) What is the rate you would pay for the equity shares of each company?

(a) If you are buying a Small lot.

(b) If you are buying controlling interest shares. (June 2014, 3 marks) (CMA Final)

(ii) If you plan to invest only in preference shares which company’s preference shares would you prefer? (June 2014, 3 marks) [CMA Final)

(iii) Would your rates be different for buying small lot, if the company ‘A’ retains 30% and company ‘B’ 10% of the profits. (June 2014, 3 marks) [CMA Final)

Answer:

(i) (a) Buying a small lot of equity shares: if the purpose of valuation is to provide data base to aid a decision of buying a small (non-controlling) position of the equity of the companies dividend capitalisation method is most appropriate. Under thiš method, value of equity shares is given by:

(b) Buying controlling Interest equity shares: If the purpose of valuation is to provide data base to aid a decision of buying controlling interest in the company, EPS capitalisation method is most appropriate. Under this method, value of equity is given by:

(ii) Preference Dividend coverage ratios of both companies are to be compared to make such decision.

Preference dividend coverage ratio is given by:

If we are planning to invest only in preference shares, we would prefer shares of B Company as there is more coverage for preference dividend.

(iii) Yes, the rates will be different for buying a small lot of equity shares, if the company A retains 30% and company B’ 10% of profits.

The new rates will be calculated as follows:

Company A: \(₹ \frac{2.1}{18}\) × 100 = ₹ 11.67

Company B: \(₹ \frac{2.3}{18}\) × 100 = ₹ 13.00

Working Notes:

1. Computation of earning per share and dividend per share (companies distribute 80% of profits)

2. Computation of dividend per share (Company A 30% and Company B 10% of profits)

Question 35.

From the following information and particulars of Salim Ltd. to the year ended 31.03.2014, calculate —

(1) Book Value per share,

(2) Earnings per share,

(3) Dividend yield,

(4) Earning yield,

(5) P/E Ratio and

(6) P/B Ratio.

The information which is available from the Books of Accounts of Salim Ltd.

is as follows:

(All in ₹ lakhs)

Sales — 18.26, Cost of goods sold — 10.25, Administrative expenses – 0.46, selling and distribution expenses — 1 .47, Depreciation — 1.05, Interest on debt — 1.13, Tax provision — 1.08, Proposed dividend — 0.90, Equity share

capital (consisting of 7,000 equity shares of 100 each) 7.00, Reserve & Surplus — 1.15, 8% Debentures — 9.0, 9% Public deposits — 3.4, Trade creditors — 3.28, Outstanding liabilities for expenses 0.23, and Fixed assets

(less accumulated depreciation of 4.6)15.6. Monthly average market price per share during month of March, 2014 was ₹ 247. Industry averages: P/E ratio 10, P/B 1.6, Dividend yield 8%. (June 2014, 6 marks) (CMA Final)

Answer:

Income Statement of Salim Ltd for the year ended 31.03.2014

Computation of the ratios of Salim Ltd:

(i) Book value per share \(=\frac{\text { Shareholders Fund }}{\text { No.of Shares }}\)

\(=\frac{\text { Equity Share Capital }+ \text { Reserve&Surplus }}{\text { No.ofShares }}\) = \(\frac{\text { ₹8.15lakhs }}{7,000}\) = ₹ 116.43

(ii) Earning per share \(=\frac{\text { ProfitafterTax }}{\text { Total No. of shares }}\) = \(=\frac{₹ 2.82 \text { lakhs }}{7,000}\) = ₹ 40.29

(iii) Dividend Yield \(=\frac{\text { DividendPer Shares }}{\text { Market Pricepershare }}\) \(=\frac{₹ 12.86 \mathrm{lakhs}}{₹ 247}\) = 5.21%

(iv) Earning Yield = \(=\frac{\text { Earningper Share }}{\text { MarketPricepershare }}\) = \(\frac{₹ 40.29}{₹ 247}\) = 16.31%

(v) Price: earning Ratio \(=\frac{\text { Market Price per Share }}{\text { Earningper share }}\) = \(\frac{₹ 247}{₹ 40.29}\) = 6.13 or 6 times

(vi) Price: Book Value Ratio \(=\frac{\text { MarketPriceper Share }}{\text { BookValuepershare }}\) = \(\frac{₹ 247}{₹ 116.43}\) = 2.12

Question 36.

The following information is available pertaining to Smart Televisions Ltd. for the financial year ending on 31.03.2014.

Particulars | Amount (₹ in Crores) |

Sales | 250 |

Profit after tax | 40 |

Book value | 100 |

The valuer appointed by the company believes that 50% weightage should be given to the earnings in valuation process. He also believes that equal weightage may be given to sales and book value. He has identified three

firms viz., Alpha Ltd.. Beta Ltd., and Gamma Ltd., which are comparable to the operations of Smart Televisions Ltd.

Particulars | Alpha Ltd. ₹ in Crores | Beta Ltd. ₹ in Crores | Gamma Ltd. ₹ in Crores |

Sales | 190 | 210 | 270 |

Profit after tax | 30 | 44 | 50 |

Book value | 96 | 110 | 128 |

Market value | 230 | 290 | 440 |

Compute the value of Smart Televisions Ltd. using the comparable firms approach. (June 20146 marks) (CMA Final)

Answer:

Valuation multiples for the comparable firms can be calculated as follows:

Particulars | Alpha Ltd. ₹ Crores | Beta Ltd ₹ Crores | Gamma Ltd. ₹ Crores | Average |

Price/Sales Ratio | 1.21 | 1.38 | 1.63 | 1.41 |

Price / Earnings Ratio | 7.67 | 6.59 | 8.80 | 7.69 |

Price / Book value Ratio | 2.40 | 2.64 | 3.44 | 2.83 |

Applying the multiples calculated as above, the value of Smart Televisions Ltd. can be calculated as follows:

Particulars | Average Multiple | Parameter | Value ₹ Crore |

Price/Sales Ratio | 1.41 | 250 | 352.50 |

Price / Earnings Ratio | 7.69 | 40 | 307.60 |

Price / Book value Ratio | 2.83 | 100 | 283.00 |

By applying the weightage to the P/S ratio, P/E ratio and P/BV ratio we get:

[(352.50 × 1) + (307.60 × 2) + (283.00 × 1)/(1 + 2+ 1) = 312.675, i.e.31 2.675 crores is the value.

Working Notes:

Price/Sales Ratio \(=\frac{\text { Market Value }}{\text { Sales }}\)

Price/Earnings Ratio \(=\frac{\text { Market Value }}{\text { Profit after Tax }}\)

Price/Book value ratio \(=\frac{\text { Market Value }}{\text { BookValue }}\)

Question 37.

Dhyan Ltd. has announced issue of warrants on 1 : 1 basis for equity shareholders. The warrants are convertible at an exercise price of ₹ 12. Warrants are detachable and trading at ₹ 7. What is the minimum price of the warrant and what is the warrant premium if the current price of the stock is 16? (Dec 2014, 4 marks) (CMA Final)

Answer:

Minimum Price (Market price of common stock — Exercise price) × (Exercise ratio) = ₹ (16-12) × 1

= ₹ 4

Warrant Premium = Market price of warrant – Minimum price of warrant

= ₹ (7 – 4)

= ₹ 3

Question 38.

ABC Ltd. is engaged in power projects. As part of its diversification plans, the company proposes to put up a windmill to generate electricity. The details of the scheme are as follows:

Particulars |

1. Cost of the windmill, ₹ 300 lakhs |

2. Cost of the land, ₹ 15 lakhs |

3. Subsidy from State Govt, to be received at the end of 1^{st} year of installation ₹ 15 lakh. |

4. Cost of electricity will be ₹ 2.25 per unit in year 1. This will increase by ₹ 0.25 per unit every year till year 7. After that, it will increase every year by ₹ 0.50 per year till year 10. |

5. Maintenance cost will be ₹ 4 lakh in year 1 and the same will increase by ₹ 2 lakh every year. |

6. Estimated life is 10 years |

7. Cost of capital is 15% |

8. Residual value is nil. However, land value will go up to X 60 lakh at the end of year 10. |

9. Depreciation will be 100% of the cost of the windmill in year 1 and the same will be allowed for the tax purpose. |

10. The windmills are expected to work based on wind velocity. The efficiency is expected to be on an average 30%. Gross electricity generated at this level will be 25 lakhs unit per annum; 4% of which will be committed to the State Electricity Board as per the agreement. |

11. Tax rate is 35% |

From the above information you are required to compute the net present value. Ignore tax on capital profit. Use present value up to 2 digit. (Dec 2014, 15 marks) (CMA Final]

Answer:

Determination of NPV of Windmill

Amount in Lakhs

Incremental cash outflows | |

Cost of Land | 15 |

Cost of the windmill | 300 |

Less: Subsidy from State Government (₹ 15 lakhs × 0.87) | 13 |

Total | 302 |

Assuming taxable income from other sources, there will be tax savings of ₹ 87.5 lakhs on negative EAT of ₹ 250 lakhs (₹ 300 lakhs, depreciation — ₹ 50 Lakhs, net savings).

Question 39.

The following is the Balance Sheet of N. Ltd. as on 31^{st} March, 2015:

Further information:

(i) Return on capital employed is 20% in similar businesses.

(ii) Fixed assets are worth 30% more than book value. Stock is overvalued by ₹ 1,00,000. Debtors are to be reduced by ₹ 20,000. Trade investments, which constitute 10% of the total investments are to be valued at 10% below cost.

(iii) Trade investments were purchased on 01-04-2014, 50% of non-trade investments were purchased on 01 -04-2013 and the rest on 01 -04-2012. Non-trade investments yielded 15% return on cost.

(iv) In 2012-2013 new machinery costing ₹ 2,00,000 was purchased but wrongly charged to revenue. This amount should be adjusted taking depreciation at 10% per year on written down value method.

(v) In 2013-2014 furniture with a book value of ₹ 1,00,000 was sold for ₹ 60,000, which was a one time disposal.

(vi) For calculating goodwill two years purchase of super profits based on simple average profits of last four years are to be considered. Profits of last four year are as under:

2011-1012 ₹ 16,00,000, 2012-2013 ₹ 18,00,000, 2013-2014 ₹ 21,00,000, 2014-2015 ₹ 22,00,000.

(vii) Additional depreciation provision at the rate of 10% on the increase in book value of Plant and Machinery alone may be considered for arriving at average profit.

(viii) Preference dividend has been paid till date.

Find out the intrinsic value of the equity share given that Income tax and dividend tax are not to be considered. (June 2015, 15 marks) [CMA Final]

Answer:

Option I

Since the date of purchase of new machinery and put to use is not mentioned in the question. Half year depreciation for 2012-13 is to be considered.

Solution considering the above is given below:

Calculation of Intrinsic value of equity shares of N Ltd.

1. Calculation of Goodwill

(i) Capital employed

Property, Plant and Equipment | ₹ | ₹ |

Building | 24,00,000 | |

Machinery (22,00,000 + 1,53,900) | 23,53,900 | |

Furniture | 10,00,000 | |

Vehicles | 18,00,000 | |

75,53,900 | ||

Add: 30% increase | 22,66,170 | |

98,20,070 | ||

Trade Investment (₹ 16,00,000 × 10% × 90%) | 1,44,000 | |

Debtors (₹ 18,00,000 – ₹ 20,000) | 17,80,000 | |

Stock (₹ 11,00,000 – ₹ 1,00,000) | 10,00,000 | |

Bank Balance | 3,20,000 | 1,30,64,070 |

Less: Outside liabilities | ||

Bank Loan | 12,00,000 | |

Bills payable | 6,00,000 | |

Creditors | 31,00,000 | 49,00,000 |

Capital Employed | 81,64,070 |

(ii) Future maintainable profit

Calculation of average profit | 2011-12 (₹) |
2012-13 (₹) |
2013-14 (₹) |
2014-15 (₹) |

Profit Given | 16,00,000 | 18,00,000 | 21,00,000 | 22,00,000 |

Add: Capital expenditure of machinery charged to revenue | – | 2,00,000 | – | – |

Loss on sale of furniture | – | – | 40,000 | – |

16,00,000 | 20,00,000 | 21,40,000 | 22,00,000 | |

Less: Depreciation on machinery | – | 10,000 | 19,000 | 17,100 |

Income from non-trade investments | – | 1,08,000 | 2,16,000 | 216,000 |

Reduction in value of stock | 1,00,000 | |||

Bad Debts | – | – | – | 20,000 |

Adjusted Profit | 16,00,000 | 18,82,000 | 19,05,000 | 18,46,900 |

₹ | |

Total adjusted profit for four years(2011-2012 to 2014-2015) | 72,33,900 |

Average profit (₹ 72,33,900/4) | 18,08,475 |

Less: Depreciation at 10% on additional value of machinery (22,00,000 + 1,53,900) × 30/100 i.e. ₹ 7,06,170 | 70,617 |

Adjusted average Profit | 17,37,858 |

(iii) Normal Profit

20% on capital employed i.e. 20% on ₹ 81,64,070 ₹ 16,32,814

(iv) Super profit

Expected profit – normal profit

₹ 17,37,858 – ₹ 16,32,814 = ₹ 1,05,044

(v) Goodwill

2 year’s purchase of super profit

₹ 1,05,044 × 2 = ₹ 2,10,088

2. Net assets available to equity shareholders

₹ | ₹ | |

Goodwill as calculated in 1 (v) | 2,10,088 | |

Property, Plant and Equipment | 98,20,070 | |

Trade and Non-trade investments | 15,84,000 | |

Debtors | 17,80,000 | |

Stock | 10,00,000 | |

Bank balance | 3,20,000 | |

1,47,14,158 | ||

Less: Outside liabilities | ||

Bank loan | 12,00,000 | |

Bills payable | 6,00,000 | |

Creditors | 31,00,000 | 49,00,000 |

Preference share capital | 20,00,000 | |

Net assets for equity shareholders | 78,14,158 |

3. Valuation of equity shares

Value of equity share \(=\frac{\text { Net assets available to equity shareholders }}{\text { Number of equity shares }}\)

= \(\frac{₹ 78,14,158}{4,00,000}\)

= ₹ 19.53

Option II

Since the date of purchase of new machinery and put to use is not mentioned in the question. Full year depreciation for 201 2-13 is to be considered.

Solution considering the above is given below:

Calculation of Intrinsic value of equity shares of N Ltd.

1. Calculation of Goodwill

(i) Capital employed

Property, Plant and Equipment | ₹ | ₹ |

Building | 24,00,000 | |

Machinery (₹ 22,00,000 + ₹ 1,45,800) | 23,45,800 | |

Furniture | 10,00,000 | |

Vehicles | 18,00,000 | |

75,45,800 | ||

Add: 30% increase | 22,63,740 | |

98,09,540 | ||

Trade investment (₹ 16,00,000 × 10% × 90%) | 1,44,000 | |

Debtors (₹ 18,00,000 – ₹ 20,000) | 17,80,000 | |

Stock (₹ 11,00,000 – ₹ 1,00,000) | 10,00,000 | |

Bank Balance | 3,20,000 | 1,30,53,540 |

Less: Outside liabilities | ||

Bank Loan | 12,00,000 | |

Bills payable | 6,00,000 | |

Creditors | 31,00,000 | 49,00,000 |

Capital Employed | 81,53,540 |

(ii) Future maintainable profit

Calculation of average profit | 2011-12 (₹) |
2012-13 (₹) |
2013-14 (₹) |
2014-15 (₹) |

Profit given | 16,00,000 | 18,00,000 | 21,00,000 | 22,00,000 |

Add: Capital expenditure of machinery charged to revenue | 2,00,000 | |||

Loss on sale of furniture | 40,000 | |||

16,00,000 | 20,00,000 | 21,40,000 | 22,00,000 | |

Less: Depreciation on machinery | 20,000 | 18,000 | 16,200 | |

Income from n o n – t r a d e investments | 1,08,000 | 2,16,000 | 2,16,000 | |

Reduction in value of stock | 1,00,000 | |||

Bad debts | 20,000 | |||

Adjusted profit | 16,00,000 | 18,72,000 | 19,06,000 | 18,47,800 |

₹ | |

Total adjusted profit for four years (2011 -2012 to 2014-2015) | 72,25,800 |

Average profit (₹ 72,25,800/4) | 18,06,450 |

Less: Depreciation at 10% on additional value of machinery (22,00,000 + 1,45,800) × 30/100 i.e. ₹ 7,03,740 | 70,374 |

Adjusted average profit | 17,36,076 |

(iii) Normal Profit

20% on capital employed i.e. 20% on ₹ 81,53,540 ₹ 16,30,708

(iv) Super profit

Expected profit – normal profit

₹ 17,36,076 – ₹ 16,30,708 = ₹ 1,05,368

(v) Goodwill

2 year’s purchase of super profit

₹ 1,05,368 × 2 = ₹ 2,10,736

2. Net assets available to equity shareholders

3. Valuation of equity shares

Value of equity share \(=\frac{\text { Net assets available to equity shareholders }}{\text { Number of equity shares }}\)

= \(\frac{₹ 78,04,276}{4,00,000}\)

= ₹ 19.51

Question 40.

Futuristic Limited has the following portfolio of investments as on March 31, 2015:

You are required to compute the value of investment for balance sheet purpose assuming that the fall in value of investment Y Limited is temporary and that of Z Limited is permanent as per the relevant accounting standard. (June 2015, 5 marks) (CMA Final)

Answer:

As per AS 13. the Current Investment are valued as thus:

The carrying amount for current investments is the lower of cost and fair value. In respect of investments for which an active market exists, market value generally provides the best evidence of fair value. The valuation of current Investments at lower of cost and fair value provides a prudent method of determining the carrying amount to be stated in the balance sheet.

As per AS 13, the Non-Current (Long Term) Investments are valued as thus:

Long-term investments are usually carried at cost. However, when there is a decline, other than temporary, in the value of a long term investment, the carrying amount is reduced to recognise the decline. Indicators of the value of an investment are obtained by reference to its market value, the investee’s assets and results and the expected cash flows from the investment. The type and extent of the investor’s stake in the investee are also taken into account. Restrictions on distributions by the investee or on disposal by the investor may affect the value

attributed to the investment.

Note 1: Premium paid on acquisition of bond ₹ (1,160-1,000) = ₹ 160.

Amortization per year = ₹ 16 (For 10 years).

Question 41.

Give below is the Balance sheet of Laxmi Ltd. as on 31 -03-201 4:

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:

(i) Profit for the current year ₹ 64 lakhs includes ₹ 4 lakhs extraordinary income and ₹ 1 lakh income from investments of Surplus funds, such Surplus funds are unlikely to recur.

(ii) In subsequent years, additional advertisement expenses of ₹ 5 lakh are expected to be incurred each year.

(ii) Market Value of Land and Buildings & Plant and Machinery has been ascertained at ₹ 96 lakhs and 100 lakhs respectively. This will entail additional depreciation of ₹ 6 lakh each year.

(iv) Effective income tax rate is 30% including all other charges.

(v) The Capitalization rate applicable to similar business is 16%. (Dec 2015, 10 marks) (CMA Final)

Answer:

Net Assets Method:

Assets | ₹ (in lakh) |

Land and Building | 96 |

Plant and Machinery | 100 |

Investments | 10 |

Stocks | 20 |

Debtors | 15 |

Cash at Bank | 5 |

Total Assets | 246 |

Less: Creditors | 30 |

Net Assets | 216 |

Value per Share

Number of shares = 100 lakhs/10 = 10 lakhs

Value per share = Net Assets/No. of shares = ₹ 216 lakhs/10 lakhs = ₹ 21.60

Profit Earning Capacity Method:

Particulars | ₹ (in lakh) |

Profit before tax | 64 |

Less: Extraordinary income | 4 |

Less: Investment income not likely to recur | 1 |

Less: Additional expenses for forthcoming years Advertisement | 5 |

Less: Depreciation on revaluation | 6 |

Expected Earnings Before Taxes | 48 |

Less: Income taxes @30% | 14.4 |

Future Maintainable profits | 33.6 |

Value of Business \(=\frac{\text { FutureMaintainableProfit }}{\text { CapitalizationFactor }}\) = \(\frac{33.6}{0.16}\) = ₹ 210 lakhs.

Subtracting external liabilities we get Net Value of Business. Value of share would be Net Value of Business divided by number of shares = (₹ 210 lakhs – 30 lakhs)/10 lakhs = ₹ 18.00

Computation of Fair Price of Share:

Particulars: ₹

Value as per Net Assets Method : 21.6

Value as per Profit earning capacity (Capitalization) method : 18.0

Fair price = Average of the two = ₹ 19.80 per share

Question 42.

A firm is considering a project for introducing a new product line for which the acceptance in the market is uncertain. The relevant particulars are as follows:

(all amounts are in ₹ Lakhs)

Probability | Estimated Cash Flows | |||

Year 0 | Year 1 | Terminal Value at the end of Year 1 | ||

Investment | -26 | |||

Market Acceptance High | 0.75 | 8 | 26 | |

Market Acceptance Low | 0.25 | 2 | 6 |

The project is not flexible to change according to the market acceptance of the product.

A modified project is also under consideration where after having knowledge about the market acceptance of the product in the first year the firm would enjoy Real Options to expand or to terminate the project. Accordingly, cash flows are modified for inclusion of the Real Option embedded in the modified project as stated below:

The Initial Outlay would increase from 26 to 30 (₹ lakh) and the first year Cash Flow would remain same. However, there would be additional cost for expansion/termination at the end of first year and Terminal Value at the end of the first year would also be different as slated below:

Probability | Options Available at the end of first year | Additional Costs (₹ lakh) | Terminal Value at the end of first year (₹ lakh) | |

Market Acceptance High | 0.75 | Continue as before | 26 | |

Real Option: Expand | -3 | 49 | ||

Market Acceptance High | 0.25 | Continue as before | 6 | |

Real Option: Terminate | -1 | 13 |

The discounting rate to be applied in all cases is 10% per annum. You are required to:

I. Find Expected NPV of the original project and comment on’ its acceptability. (Dec 2015, 3 marks) (CMA Final)

II. Draw a Decision Tree and Expected NPV of the modified project and comment on its acceptability. (Dec 2015, 3 + 6 = 9 marks) (CMA Final)

III. Find Net Value of Real Options embedded in the modified project. (Dec 2015, 3 marks) (CMA Final)

Answer:

#: Since Net TVs for Real Options of Expansion/Termination are greater than TVs for continuation without Real Options, Real Options are exercised to compute Expected NPV of Modified Project.

III. Net Value of Real Option = Expected NPV of Modified Project – Expected NPV of the Original Project = 10-(-1) = 11 (₹ in lakh) |

Question 43.

Hajela Ltd. had earned a Profit after tax of ₹ 48 lakhs for the year just ended. It wants you to ascertain the value of its business, based on the following information:

(1) Tax rate for the year just ended was 36%. Future tax rate is estimated at 34%.

(2) The company’s equity shares are quoted at ₹ 120 at the balance sheet date. The company had an equity capital of ₹ 100 lakhs, divided into shares of ₹ 50 each.

(3) Profit for the year has been calculated after considering the following in the Profit & LOSS account-

- Subsidy ₹ 2,00,000 received from Government towards fulfillment of certain social obligation. The Government has now discontinued this subsidy and hence, this amount will not be received in future.
- Interest ₹ 8,00,000 on term loan. The final installment of this term loan was fully settled in the last year.
- Managerial remuneration ₹ 15,00,000. The shareholders have approved an increase of ₹ 6,00,000 in the overall managerial remuneration from the next year onwards.
- Loss on Sale of fixed assets and investments amounting to ₹ 8,00,000. (Ignore tax effect thereon) (Dec 2015, 10 marks) (CMA Final)

Answer:

I. Computation of Future Maintainable Profits

Particulars | ₹ in lakhs |

Profit after tax for the year just ended | 48,00,000 |

Add: Tax Expense (Tax is 36%, so PAT = 64%. Hence, Tax = 48,00,000 × 36/64) | 27,00,000 |

Profit before tax for the year just ended | 75,00,000 |

Add/(Less): Adjustments in respect of Non-Recurring items | |

Subsidy Income not received in future | (2,00,000) |

Interest on Term Loan not payable in future, hence saved | 8,00,000 |

Additional Managerial Remuneration | (6,00,000) |

Loss on Sale of Fixed Assets and Investments (non-recurring) | 8,00,000 |

Future Maintainable Profits before Tax | 83,00,000 |

Less: Tax Expense at 34% | 28,22,000 |

Future Maintainable Profits after Tax Equity Earnings | 54,78,000 |

2. Computation of Capitalization Rate and Value of Business

Particulars | |

(a) Profit after tax for the year just ended | ₹ 48 Lakhs |

(b) Number of Equity Shares (₹ 100 Lakhs ÷ ₹ 50 per Share) | 2 Lakhs |

(c) Earnings Per Share (EPS) = PAT ÷ Number of Equity Shares = 48/2 | ₹ 24 |

(d) Market Price per Share on Balance Sheet Date | ₹ 120 |

(e) Price Earnings Ratio = MPS ÷ EPS = 120/24 | 5 |

(f) Capitalization Rate = 1 ÷ PE Ratio = 1/5 | 20% |

(g) Value of Business = Future Maintainable Profits ÷ Capitalization Rate = ₹ 54.78 Lakhs ÷ 20% | ₹ 273.90 Lakhs |

Question 44.

Answer the following:

SMITH LTD. has PAT of ₹ 400 lakh with extra ordinary income of ₹ 60 lakh. The cost of capital and the applicable tax rate of the company are 20% and 30% respectively. What is the value of SMITH LTD.? (June 2016, 2 marks) (CMA Final)

Answer:

PAT of extra ordinary income = (1-0.30) × 60 = ₹ 42 lakh

PAT of the company excluding extra ordinary income = (₹ 400 – 42) lakh

= ₹ 358 lakh

So, value of smith Ltd. = (358 ÷ 0.20) = ₹ 1,790 lakh.

Question 45.

For Goal Ltd. the FCFE projected for next 3 yeárs are stated below along with the immediately past year FCFE. You are required to value equity share by DCF approach. From Year 4 FCFE is expected to grow at 3% p.a. Cost of equity is measured at 15% p.a. Number of shares outstanding is 1,00,000.

Past Year | Projected | |||

Year 1 | Year 2 | Year 3 | ||

FCFE (₹ Lakhs) | 160 | 180 | 200 | 220 |

Discounting Factor @ 15% p.a. Year 1 = 0.869565, Year 2 = 0.756144, Year 3 = 0.657516. (June 2016, 8 marks) (CMA Final)

(c) Sun Ltd. has announced issue of warrants on 1:1 basis for its equity shareholders. The warrants are convertible at an exercise price of 12. Warrants are detachable and trading at ₹ 7. What is the minimum price of the warrant and what is the warrant premium it the current price of the stock is 16? (June 2016, 4 marks) [CMA Final)

Answer:

(a) Value of Equity Share of Goal Ltd. by DCF Approach

# past year FCFE is irrelevant for valuation.

* Use the formula based on Gordon. Terminal Value of the firm at the end of year 2 = FCFF/(Ke-G) for the infinite series of FCFFS from year 3 to infinity = 2201(0.15-0.03) = 1833.333.

** PV Of Terminal Value at year 0 = 1833.33/(1 + 0.15)^{2} = 1386.264

Note: The long term growth rate is applicable on the subsequent FCFE and not on the first FCFE of the series. Hence the senes starts with Year 3 FCFE and the PV for the infinite series by application of Gordon formula is obtained at the end of Year 2 (always 1 year before the starting cash flow.)

Alternative solution:

Yr 0 | Yr 1 | Yr 2 | Yr 3 | Yr 4 | |

FCFE (₹ lakh) | 180 | 200 | 220 | 226.6 | |

Discounting Factor | 0.869565 | 0.756144 | 0.657516 | ||

PV of Yr 1 FCFE | 156.52 | ||||

PV of Yr 2 FCFE | 151.23 | ||||

PV of Yr 3 FCFE | 144.6535 | ||||

Terminal Value at the end of Yr 3 | 1888.333 | ||||

PV of Terminal Value | 1241.61 | ||||

Value of Equity EDCF (₹ lakh) | 1694.01 | ||||

Value per share ₹ | 1694.01 |

Note: Terminal Value at end of Year 3 = 226.6 ÷ (0.15-0.03) =1888.333

PV of Terminal Value at year 0 = 1888.333 ÷ (1 + 0.15)^{3} = 1241.61

(c) Sun Ltd.

Minimum Price of warrant = current stock price – exercise price of

warrant = ₹ (16-12) = ₹ 4

Warrant Premium = Trading Price of warrant – minimum price = ₹ (7 – 4) = ₹ 3

Question 46.

Ms. Nisha is an avid investor in fixed income securities. Her portfolio of Bond does not have bonds from AM rated companies. She is considering purchase of an AM rated Bond. Two such bonds of AM rated companies, Bond-A and Bond-B are available in the market that have following features:

Bond-A | Bond-B | |

Face value (₹) | 100 | 100 |

Coupon rate per annum | 15% | 12% |

Periodicity of coupon | Semi-annual | Semi-annual |

Time remaining for maturity | 3 years | 4 years |

Current Market Price (₹) | 110 | 120 |

Her expectation of return from the investment in MA rated bonds is 10% p.a. which is slightly above the yields in the government securities. Ms. Nisha is indifferent to the investment horizon of 3 or 4 years.

Required:

Which of the Bonds should she (Ms. Nisha) buy and why?

[Given: PVIFA (5%, 6 periods) = present value of annuity of ₹ 1 received for 6 periods discounted at the rate of 5% per period = 5.0757, PVF (5%, 6 periods) = present value of ₹ 1 received at the end of 6 periods discounted at the rate of 5% per period = 0.7462.

PVIFA (5%, 8 periods) = present value of annuity of ₹ 1 received for 8 periods discounted at the rate of 5% per period = 6.4632. PVF (5%, 8 periods) = present value of ₹ 1 received at the end of 8 periods discounted at the rate of 5% per period = 0.6768.] (Dec 2016, 6 marks) (CMA Final)

Answer:

Fair value of the bond must be compared with the current market price to make a choice of investment:

Computation of Fair value of Bond A and Bond B

Bond-A | Bond -B |

Face Value = ₹ 100 | Face value = ₹ 100 |

The number of half yearly period = 6 | The number of half yearly period = 8 |

Half yearly interest payment = 7.5% | Half yearly interest payment = 6% |

Discount rate applicable to half yearly period = 5% | Discount rate applicable to half yearly period = 5% |

V = PVIFA (5%, 6 period) × 7.50 + 100 × PVF (5%, 6 periods) | V = PVIFA (5%, 8 periods) × 6 + 100 × PVF (5%, 8 periods) |

= 7.50 × 5.0757 + 100 × 0.7462 | = 6.00 × 6.4632 +100 × 0.6768 |

= ₹ 112.69 | = 38.78 + 67.68 |

Fair Value = ₹ 112.69 | Fair Value = ₹ 106.46 |

Market price: ₹ 110.00 | Market price: ₹ 120.00 |

Decision: Bond A is undervalued by ₹ 2.69 and should therefore, be bought. However, Bond B is overvalued and hence, should not be bought.

Question 47.

Calculate value per share from the following current year data:

Earnings per share : ₹ 50

Capaal Expenditure per share: ₹ 40

Depreciation per share: ₹ 36

Increase in Non-cash working capital per share: ₹ 16

Debt financing ratio : 0.25

FCFF is expected to grow at 4% p.a. The Beta for stock is 1.1, Market return 14% p.a, and Treasury bond interest rate is 8% p.a. (Dec 2016, 6 marks) [CMA Final]

Answer:

Cost of equity = 8 + 1.1 (14 – 8%) = 14.6%

FCFF = EPS – (I-D/E ratio) (Capital expenditure – Depreciation + Increase in non-cash working Capital)

= 50 – 0.75 × (40 – 36 + 16) = 35

Value per share = FCFE × (1 + g)/(Ke – g) = 35 × (1 + 0.04)/(14.6% – 4%)

= 36.4/0.106 = ₹ 343.40

Question 48.

P Ltd. is considering buying the business of Q Ltd., the final accounts of which for the last 3 years ended 31^{st} December is.

Balance Sheet as on 31^{st} December

(Figures in ₹)

Particulars | 2013 | 2014 | 2015 | 2016 |

Fixed Asset (at cost) | 1,00,000 | 1,20,000 | 1,40,000 | 1,80,000 |

Less: Depreciation | 70,000 | 82,000 | 95,000 | 1,09,000 |

30,000 | 38,000 | 45,000 | 71,000 | |

Stock-in-trade | 16,000 | 17,000 | 18,500 | 21,000 |

Sundry Debtors | 21,000 | 24,000 | 26,000 | 28,000 |

Cash in hand and Bank | 32,000 | 11,000 | 28,000 | 13,200 |

Prepaid Expenses | 1,000 | 500 | 2,000 | 1,000 |

Total Assets | 1,00,000 | 90,500 | 1,19,500 | 1,34,200 |

Equity Capital | 50,000 | 50,000 | 70,000 | 70,000 |

Share Premium | — | — | 5,000 | 5,000 |

General Reserve | 16,000 | 24,000 | 26,000 | 42,000 |

Debentures | 20,000 | — | — | — |

Sundry Creditors | 11,000 | 13,000 | 14,000 | 14,000 |

Accrued Expenses | 3,000 | 3,500 | 4,500 | 3,200 |

Total Liabilities | 1,00,000 | 90,500 | 1,19,000 | 1,34,200 |

P Ltd. wishes the offer to be based upon trading cash flows rather than book profits. Trading Cash Flow means Cash received from Debtors less Cash Paid to Creditors and for Business Expenses excluding Depreciatior together with an allowance for average annual expenditure on Fixed Assets of ₹ 15,000 per year.

The actual expenditure on Fixed Assets is to be ignored, as is any cash receipt or payment out on the issue or redemption of Shares or Debentures.

P Ltd. wishes the Trading Cash Flow to be calculated for each of the years 2014, 2015 and 2016 and for these to be combined using weights of 25% for 2014, 35% for 2015 and 40% for 2016 to give an Average Annual Trading Cash Flow, P Ltd. considers that the Average Annual Cash Flow should show a return of 10% on its investment.

You are required to calculate:

(i) Trading Cash Flow for each of the years 2014, 2015 and 2016

(ii) Weighted Average Annual Trading Cash Flow and

(iii) Value of the business (June 2017, 12 marks) (CMA Final)

Answer:

Question 49.

Alpha India Ltd., is trying to buy Beta India Ltd., Beta India Ltd., is a small bio-technology firm that develops products that are licensed to major pharmaceutical firms. The development costs are expected to generate negative cash flows of ₹ 10 lakhs during the first year of the forecast period. Licensing fee is expected to generate positive cash flows of ₹ 5 lakhs, ₹ 10 lakhs, ₹ 15 lakhs and ₹ 20 lakhs during 2-5 years respectively.

Due to the emergence of competitive products, cash flows are expected to grow annually at a modest 5% after the fifth year. The discount rate for the first five years is estimated to be 15% and then drop to 8% beyond the fifth

year. Calculate the value of the firm.

Given: The discount rate @ will be:

Answer:

Year | Cash Flows (₹ In lakhs) | Discount Rate @15% | Present Value (₹ in lakhs) |

1 | (10) | 0.869 | (8.69) |

2 | 5 | 0.756 | 3.78 |

3 | 10 | 0.6575 | 6.575 |

4 | 15 | 0.572 | 8.58 |

5 | 20 | 0.497 | 9.94 |

Total Sum of Present Value = 20.185

Terminal Value_{t} = Cast Flow_{t+1} / r – g_{stable}

Cash Flow_{t+1} = Cash Flow (1+g) = 20 (1+0.05) = 21 Lakhs

Terminal Value = 21/(0.08-0.05) = ₹ 700 Lakhs

Present Value of terminal Value = 700 × 0.497 = ₹ 347.9

Value of the firm = Total Sum of Present Value + Present value of terminal

Value = ₹ 20.185 + ₹ 347.9 = ₹ 368.085.

Question 50.

There is a privately held company XYZ Pvt. Ltd. that is operating into the retail space, and is now scouting for angel investors. The details pertinent to valuing XYZ Pvt. Ltd. are as follows:

The company has achieved break even this year and has an EBITDA of ₹ 90 crore. The beta based on the industry in which it operates is 1.8, and the average debt to equity ratio is hovering at 40:60. The rate of return provided by liquid bonds is 5%. The EV is to be taken at a multiple of 5 on EBITDA.

The accountant has informed that the EBITDA of ₹ 90 crore includes an extraordinary gain of ₹ 10 crore for the year, and a potential write off of preliminary sales promotion costs of ₹ 20 crore are still pending. The internal

assessment of rate of market return for the industry is 11%. The FCFs for the next 3 years are as follows:

(₹ in Crores)

Y1 | Y2 | Y3 | |

Future cash flows | 100 | 120 | 150 |

The cost of debt will be 12%. Assume a tax regime of 30%

What is the potential value to be placed on XYZ Pvt. Ltd.? (June 2018, 12 marks) (CMA Final)

Answer:

The beta is 1.8.

The adjusted EBITDA would be 90 -10 – 20 = ₹ 60 crore

The EV will be multiple of 5 on the 60 obtained above = ₹ 300 crore

The Cost of equity in accordarce with CAPM = R_{f} + β(R_{m} – R_{f})

= 0.05 + 1.8 (0.11 – 0.05) = 0.158 or 15.8%

The WACC = Cost of Equity + Cost of Debt 15.8 (60/100) + 12.0(1 – 0.3)(40/1 00) = 12.84

Finally the future cash flows can be discounted at the WACC obtained above as under-

(₹ in crore)

Y1 | Y2 | Y3 | |

Future Cash flows | 100 | 120 | 150 |

Discount Factor | 0.89 | 0.79 | 0.70 |

PVs of Cash flows | 89 | 95 | 105 |

Value of the Firm | 289 |

Discount factor

Year 1 (100/112.84) = 0.89

Year 2 = (100/112.84)^{2} = 0.79

Year 3= (100/11 2.84)^{3} = 0.70

Question 51.

G. Ltd. has announced issue of warrants on 1:1 basis for its equity shareholders. The current price of the stock 10 and warrants are convertible at an exercise price of ₹ 11.71 per share. Warrants are detachable and are trading at ₹ 3.

(i) What is the minimum price of the warrant? What is the warrant premium? (June 2018, 4 marks) (CMA Final)

(ii) Now had been the current Price 16.375, what is the minimum price and warrant premium? (Consider warrants are tradable at 9.75) (June 2018, 4 marks) (CMA Final)

Answer:

(i) Minimum price = (Market price of common stock – Exercise price) × (Exercise ratio)

= (₹ 10.00 – 11.71) × 1.0

= -1.71 (₹)

Thus, the minimum price on this warrant is considered to be zero, because things simply do not sell for negative prices.

Warrant premium = (Market price of warrant – Minimum price of warrant)

= ₹ 3 – 0 = ₹ 3.

(ii) Minimum price =(Market price of common stock – Exercise price) × (Exercise ratio)

= (₹ 16.375 – 11.71) × 1.0 = 4.665

Warrant premium = (Market price of warrant – Minimum price of warrant)

= ₹ 9.75 – 4.665 = ₹ 5.085

Question 52.

A company has issued a 12% debentures with a maturity of 5 years having face value of ₹ 1,000 and it is listed on the stock exchange. After 2 years of the issue of bonds, the yields in the market have increased to 15%. Someone suggested to the CFO of the company to buy the debentures from the market as they are trading below par.

(i) Do you think that the CFO should accept the suggestion of the person? (June 2018, 2 marks) [CMA Final]

(ii) If yes, then determine the fair value of the debentures at which the company should buy the debentures from the stock market.

Discount factors:

Year ⇒ | 1 | 2 | 3 |

Discounting Factor (12%) | 0.8929 | 0.7972 | 0.7118 |

Discounting Factor (15%) | 0.8696 | 0.7561 | 0.6575 |

Answer:

(i) The CFO should accept the suggestion of the person as the yields in the market have gone up as a result the prices of debentures have fallen below the face value of ₹ 1,000. Since the company will be redeeming debentures at a lower value, the company will get benefit from it.

(ii) If it is decided to redeem the debentures after 2 years when the yield is 15%, then the fair price will be calculated as follows:

Calculation of the Market Price After 2 years

Year | Cash Flows of the Debentures | Discounting Factor (15%) | PV of Cash Flows |

1 | ₹ 120.00 | 0.8696 | ₹ 104.35 |

2 | ₹ 120.00 | 0.7561 | ₹ 90.73 |

3 | ₹ 1,120.00 | 0.6575 | ₹ 736.40 |

Price of Debentures after 2 years when the market yield is 15% | ₹ 931.48 |

Question 53.

Suvo Ltd. plans to expand its operations and estimates the total cost of the expansion to be ₹ 24 crores. The same is proposed to be financed by internal accruals of ₹ 9 crores and the balance through the rights issue. The current share capital of the company is ₹ 2.40 crores. The shares of the company are currently quoting at ₹ 345. The company proposes to price the rights at ₹ 250.

Based on the information

(i) compute the ratio of the rights.

(ii) calculate the value of the rights.

(iii) determine the gain/loss of a shareholder, if he

(a) Exercises his rights in the rights issue

(b) Allows his rights to expire

(c) Sells his rights (Dec 2018, 12 marks) [CMA Final]

Answer:

(i) Total price of the Project = 24 crores

Less : Internal accruals = 9 crores

Size of the proposed right issue = 15 crores

Right issue price = ₹ 250 per share

Number of right shares = 15 Crs. / 250 = 6,00,000

Existing Capital = 24,00,000 shares

Proportion of rights = 6/24 = 1/4

Hence the right ratio is 1 rights share for every 4 shares held.

(ii) Computation of the value of rights :

Value of rights = \(\frac{P_0-S F}{N+R}\) = \(\frac{345-250 \times 1}{4+1}\) = 19

(iii) (A) Gain/Loss to a shareholder If the invests in the rights issue :

The ex-rights price of the share is expected to be = \(\frac{P_0-S R}{N+R}\)

= \(\frac{4 \times 345+250 \times 1}{4+1}\) = ₹ 326

Assume X holds 100 shares

Existing wealth = 100 × 345 = ₹ 34,500

Subscription in rights issue = 25 × 250 = 6,250

Total = 40,750

Expected post-rights market value of his portfolio = 125 @ ₹ 326 = ₹ 40,750

No gain/loss to the shareholder.

(B) Allow the rights to expire :

Existing wealth = ₹ 34,500

Post-rights market value of his holdings = (100 × 326) = ₹ 32,600 Loss in the wealth of shareholder = ₹ 1,900

(C) Sells his rights

Existing wealth = ₹ 34,500

Amount realized by Sale of rights (100 × 19) = 1,900

Post – rights market value of the Holdings (100 × 326) = ₹ 32,600

Gain/Loss is. Nil

Question 54.

Vipul Ventures Limited has entered the phase of maturity in its life cycle and its cash flows (before interest and taxes) are expected to remain constant at the current level of ₹ 550.25 lakh. Presently it is an all equity finance firm.

The cost of equity for Vedika Limited, which resembles Vipul Ventures in terms of its risk-return characteristics, is 15.75 percent. You are expected to find out the value of Vipul Ventures. The tax rate applicable to Vipul Ventures is 38.5% including surcharges and all Cess, if any.

What will be impact on firm’s cost of equity, weighted average cost of capital and its valuation if the firm decides to alter its capital structure to have a 25% debt ratio? The cost of debt for firms with the risk profile similar to Vipul Venture is 10.25 percent. (June 2019, 10 marks) (CMA Final)

Answer:

Value of the firm = Value of equity holders + value to debt holders

Particulars | ₹ in Lakhs |

Cash flow before interest and taxes | 550.25 |

Interest | Nil |

Cash flow before taxes | 550.25 |

Taxes @38.5% | 211.85 |

Cash flow after taxes | 338.40 |

Cost of equity for Vipul ventures (r_{0}) = 0.1575 or 15.75%. The value of the firm is computed at ₹ 2,148.60 lacs:

338.40/0.1575 = ₹ 2,148.60 lakhs (in case of unlevered firm)

The value of levered firm increases by the amount of tax shield generated by debt. The amount of tax shield that is available on debt depends on the tax rate, then the value of Cost of equity in the levered firm is given by = 0.1575 +1/3 × (1- 0.385) × (0.1575 – 0.1025)

= 0.16878 or 16.88%

WACC of levered firm

R_{0} = 3/4 × 0.1688 + 1/4(0.615) × 0.1025

= 0.1423 or 14.23%

Value of firm = 338.4/0.1423 = ₹ 2378 lakhs