CS Professional

CS Professional Drafting, Pleadings and Appearances Study Material

CS Professional Drafting, Pleadings and Appearances Study Material Important Questions Notes Pdf

CS Professional Drafting, Pleadings and Appearances Notes Study Material Important Questions

CS Professional Drafting, Pleadings and Appearances Study Material Important Questions Notes

CS Professional Drafting, Pleadings and Appearances Syllabus

CS Professional Drafting Pleadings and Appearances Syllabus

CS Professional Drafting Pleadings and Appearances Chapter Wise Weightage

CS Professional Drafting Pleadings and Appearances Chapter Wise Weightage

Professional Programme Module 1 – Paper 3
Drafting, Pleadings and Appearances (Max Marks 100)
Syllabus

Objective
To provide expert knowledge of drafting, documentation and advocacy techniques.

Detailed Contents
1. Judicial & Administrative framework: Procedure; Jurisdiction and Review; Revisions; Reference; Appellate forum.

2. General Principles of Drafting and Relevant Substantive Rules: Drafting, Concept, General Principles and relevant substantive rules thereof; Drafting in simple language, nuances of drafting, common errors and its consequences like litigation, liability. Drafting policies, codes of conduct, guidance note, waivers, releases, disclaimers, Basic Components of Deeds, Endorsements and Supplemental Deeds, Aids to Clarity and Accuracy, Legal Requirements and Implications; Supreme Court Rules, and other guiding principles for drafting.

3. Secretarial Practices & Drafting: Principles relating to Drafting of various resolutions; Drafting of notices & Explanatory Statements; Preparation of Agendas for meetings; Drafting and recording of minutes.

4. Drafting and Conveyancing Relating to Various Deeds and Agreements: Conveyancing in General, Object of Conveyancing- Drafting of Conveyancing agreements, wills, encumbrances, and gift deeds.

5. Drafting of Agreements, Documents and Deeds: Drafting of various Commercial Agreements, Guarantees, Counter Guarantees, Bank Guarantees, Outsourcing Agreements, Service Agreements, E-Contracts, Legal License, IPR Agreements; General and Special Power of Attorney; Pre-incorporation Contracts; Share Purchase Agreement; Shareholders Agreements and Other Agreements under the Companies Act, 2013; Drafting of Memorandum of Association and Articles of Associations; Drafting of Provisions for Entrenchment of Specified Provision of Articles; Joint Venture and Foreign Collaboration Agreement, Nondisclosure Agreements ; Drafting of Limited Liability Partnership Agreement, Drafting of Bye Laws for Societies; Drafting Replies to Regulatory Show Cause Notices; Review of critical business documents and press releases; Responding to proxy Advisory Reports, Drafting Response to Media Reports; Drafting and review of crisis communications, presenting complex legal subjects to simple business oriented language.

6. Pleadings: Pleadings in General; Object of Pleadings; Fundamental Rules of Pleadings; Civil: Plaint Structure; Description of Parties; Written Statements, Interlocutory Applications, Original Petition, Affidavit, Execution Petition and Memorandum of Appeal and Revision, Petition under Articles 226 and 32 of Constitution of India, Special Leave Petition; Criminal: Complaints, Criminal Miscellaneous Petition, Bail Application and Memorandum of Appeal and Revision; Drafting of Affidavit in Evidence; Arguments on Preliminary Submissions; Arguments on Merits; Legal Pleadings and Written Submissions, Application, Petitions, Revision Petitions, Notice of Motion, Witness, Improper Admission, Rejection, Appeal, Review, Suits, Undertakings, Indemnity Bonds, Writs, Legal Notices, Response to Legal Notices.

7. Art of Writing Opinions: Understanding facts of the case; the case for opinion writing, Application of relevant Legal Provisions to the facts; Research on relevant case Laws; Discussion and Opinion writing.

8. Appearances & Art of Advocacy: Requisites for entering appearances; Appearing before Tribunals/ Quasi-judicial Bodies such as NCLT/ NCLAT/ / CCI/ TRAI/ Tax Authorities and Appellate Tribunals/ and authorities such as ROC/ RD/ RBI/ ED/Stock Exchange/ SEBI/ RERA; Art of advocacy.
Case laws, Case studies & Practical Aspects

CS Professional Study Material

CS Professional Corporate Funding and Listings in Stock Exchange ICSI Study Material

CS Professional Corporate Funding and Listings in Stock Exchange ICSI Study Material Important Questions Notes Pdf

CS Professional Corporate Funding and Listing in Stock Exchanges Notes Study Material Important Questions

CS Professional Corporate Funding and Listing in Stock Exchange ICSI Study Material Notes

CS Professional Corporate Funding and Listing in Stock Exchanges Syllabus

CS Professional Corporate Funding and Listings in Stock Exchange Syllabus

CS Professional Corporate Funding and Listing in Stock Exchanges Chapter Wise Weightage

CS Professional Corporate Funding and Listing in Stock Exchanges Chapter Wise Weightage

Professional Programme Module 3
Paper 7 Corporate Funding & Listings in Stock Exchanges (Max. Marks 100)
Syllabus

Objective
Part I: To provide practical knowledge of finance available to corporates at their various stages of the journey, their suitability, pros and cons, process, compliances, etc.
Part II: To acquire knowledge of legal & procedural aspects of various types of listing, eligibility criteria, documentation, compliances, etc.

Detailed Contents
Part I: Corporate Funding (60 Marks)

1. Indian Equity – Public Funding: Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009; Initial Public Offer (IPO)/ Further Public Offer (FPO); Preferential Allotment; Private Placement; Qualified Institutional Placement; Institutional Private Placement; Rights Issue; Fast Track Issue; Real Estate Investment Trust (REIT); Infrastructure Investment Trust (InvIT).
2. Indian Equity – Private Funding: Venture Capital; Alternative Investment Fund; Angel Funds; Seed Funding; Private Equity.
3. Indian Equity – Non Fund based: Bonus issue; Sweat Equity, ESOP.
4. Debt Funding – Indian Fund Based: Debentures, Bonds; Masala Bonds; Bank Finance; Project Finance including machinery or equipment loan against property, Loan against shares; Working Capital Finance- Overdrafts, Cash Credits, Bill Discounting, Factoring, etc. Islamic Banking.

5. Debt Funding – Indian Non Fund Based: Letter of Credit; Bank Guarantee; Stand by Letter of Credit, etc.
6. Foreign Funding – Instruments & Institutions: External Commercial Borrowing (ECB); American Depository Receipt (ADR)/Global Depository Receipt (GDR); Foreign Currency Convertible Bonds (FCCB); Foreign Currency Exchangeable Bonds (FCEB); International Finance Corporation (IFC), Asian Development Bank (ADB), International Monetary Fund (IMF).
7. Other Borrowings Tools: Inter-corporate Loans; Commercial Paper etc.; Deposits under the Companies Act; Customer Advances/Deposits.
8. Non-Convertible Instruments- Non-Convertible Redeemable Preference Shares (NCRPs) etc.
9. Securitization.

Part II: Listing (40 Marks)

10. Listing–Indian Stock Exchanges: Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015; Equity Listing (SME, ITP, Main); Debt Listing; Post listing disclosures.
11. International Listing: Applicability of Listing Regulations, Singapore Stock Exchange; Luxembourg Stock Exchange; NASDAQ-NGSM, NCM, NGM; London Stock Exchange-Main, AIM; U S Securities and Exchange Commission.
12. Various Procedural requirements for the issue of securities and Listing.
13. Preparing a Company for an IPO and Governance requirements after that, Appraising the Board and other organizational functions regarding the Post IPO/Listing Governance changes.
14. Documentation & Compliances.
Case Studies and Practical Aspects

CS Professional Study Material

CS Professional Governance, Risk Management, Compliances and Ethics Study Material

CS Professional Governance, Risk Management, Compliances and Ethics Study Material Important Questions Notes Pdf

CS Professional Governance Risk Management Compliances and Ethics Notes Study Material Important Questions

CS Professional Governance, Risk Management, Compliances and Ethics Study Material Notes

CS Professional Governance, Risk Management, Compliances and Ethics Syllabus

CS Professional Governance, Risk Management, Compliances and Ethics Syllabus

CS Professional Governance Risk Management Compliances and Ethics Chapter Wise Weightage

PROFESSIONAL PROGRAMME Module 1 – Paper 1
GOVERNANCE, RISK MANAGEMENT, COMPLIANCES AND ETHICS (100 Marks)
SYLLABUS

Objective:
Part-I: To develop skills of high order so as to provide thorough knowledge and insight into the corporate governance framework, best governance practices.
Part–II: To develop skills of high order so as to provide thorough knowledge and insight into the spectrum of risks faced by businesses.
Part-III: To develop the ability to devise and implement adequate and effective systems to ensure compliance of all applicable laws.
Part-IV: To acquire knowledge of ethics in business and framework for corporate sustainability reporting.

Detailed Contents
Part I: Governance (50 Marks)

1. Conceptual Framework of Corporate Governance: Introduction, Need and Scope, Evolution of Corporate Governance, Management vs. Ownership, Majority vs Minority, Corporate Governance codes in major jurisdictions, Sarbanes Oxley Act, US Securities and Exchange Commission; OECD Principles of Corporate Governance; Developments in India, Corporate Governance in Indian Ethos, Corporate Governance –Contemporary Developments.
2. Legislative Framework of Corporate Governance in India: Listed Companies, Unlisted Companies, PSUs, Banks and Insurance Companies.
3. Board Effectiveness: Composition and Structure, Duties and Liabilities, Evolution of Jurisprudence, Diversity in Board Room, Women Director, Nominee Directors; Selection and Appointment Process, Independent Directors: expectations, liabilities and their role, code of conduct, responsibilities and effectiveness.
4. Board Processes through Secretarial Standards.
5. Board Committees: Composition & Terms of Reference, Roles and Responsibilities.

6. Corporate Policies & Disclosures: Various policies and disclosures to be made as per regulatory requirements / voluntarily made as part of good governance.
7. Directors’ Training, Development and familiarisation.
8. Performance Evaluation of Board and Management: Evaluation of the performance of the Board as a whole, individual director (including independent directors and Chairperson), various Committees of the Board and of the management.
9. Role of promoter/controlling shareholder, redressal against Oppression and Mismanagement.
10. Monitoring of group entities and subsidiaries.

11. Accounting and Audit related issues.
12. Related Party Transactions.
13. Vigil Mechanism/Whistle blower.
14. Corporate Governance and Shareholders’ Rights.
15. Corporate Governance and other Stakeholders: Employees, Customers, Lenders, Vendors, Government and Regulators, Society, etc.

16. Governance and Compliance Risk: Governance/Compliance failure and their impact on business, reputation and fund raising.
17. Corporate Governance Forums.
18. Parameters of Better Governed Companies: ICSI National Award for Excellence in Corporate Governance.
19. Dealing with Investor Associations, Proxy Services Firms and Institutional Investors.
20. Family Enterprise and Corporate Governance.
Case Laws, Case Studies & Practical Aspects.

Part II: Risk Management (20 Marks)

21. Risk Identification, Mitigation and Audit: Risk Identification, Risk Analysis, Risk Measurement, Risk Mitigation, Risk Elimination, Risk Management Committee, Clarification and Investigation, Role of Internal Audit, Risk Audit, Risk Related Disclosures.
Case Studies & Practical Aspects.

Part III: Compliances (20 Marks)

22. Compliance Management: Essentials of successful compliance program, Significance of Compliance, devising proper systems to ensure compliance, ensuring adequacy and effectiveness of compliance system, internal compliance reporting mechanisms, use of technology for compliance management.
23. Internal Control: Nature, Scope and Elements, Techniques of Internal Control System, Steps for Internal Control, Efficacy of internal controls and its review.
24. Reporting: Integrated Reporting, Non-financial Reporting, Corporate Sustainability Reporting, Board Reporting, Annual Report, Other Reports under LODR, PIT, SAST Regulations.
25. Website Management: Meeting through Video Conferencing.
Case Studies & Practical Aspects

Part IV: Ethics & Sustainability (10 Marks)

26. Ethics & Business: Ethics, Business Ethics, Organization Structure and Ethics, Addressing Ethical Dilemmas, Code of Ethics, Indian Ethos, Designing Code of Conduct, Policies, Fair practices and frameworks.
27. Sustainability: Corporate Social Responsibility, Corporate Sustainability Reporting Framework, Legal Framework, Conventions, Treaties on Environmental and Social Aspects, Triple Bottom Line, Principle of Absolute Liability – Case Studies, Contemporary Developments, Indian Ethos.
28. Models / Approaches to measure Business Sustainability: Altman Z-Score Model, Risk Adjusted Return on Capital, Economic Value Added (EVA), Market Value Added (MVA), Sustainable Value Added Approach.
29. Indian and contemporary Laws relating to Anti-bribery: Prevention of corruption Act,1988, Central Vigilance Commission Act, 2003, Lokpal & Lokayukta Act, 2013, Foreign Corrupt Practices Act, 1977, Unlawful Activities (Prevention) Act, 1967 & Delhi Special Police Establishment Act, 1946; ICSI Anti Bribery Code.
Case Studies & Practical Aspects

CS Professional Study Material

Business Valuation Methods – CS Professional Study Material

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:

  1. Comparison with industry average
  2. Comparison with comparable companies

The various multiples that are frequently used are:

  1. P/E Ratio
  2. Price/Book Value
  3. Price/sale
  4. 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:

  1. It weighs the time value of money explicitly while evaluating the costs and benefits of a project.
  2. 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

  1. NPV
  2. IRR

Assumptions of DCF Model

  1. Assumed a world of certainty
  2. 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

  1. 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.
  2. Rank the projects according to their NPVs and select the project at or above the cut off rate of return.
  3. Select the project if IRR > cost of capital.

Business Valuation Methods - CS Professional Study Material

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:

  1. Discounted cash flow valuation
  2. Relative valuation
  3. 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:

  1. It weights the time value of money explicitly while evaluating the Costs and benefits of a Project.
  2. 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.
  3. 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:

  1. 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.
  2. Rank the Projects according to their NPV’s (Net Present Value) and select required project as per ranking.
  3. 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:

  1. Price – earnings ratio
  2. Price – cash flow ratio
  3. Price – book value ratio
  4. 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 * \(\frac{P}{S}\)

Business Valuation Methods - CS Professional Study Material

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.
Business Valuation Methods - CS Professional Study Material 1
(June 2009, 15 marks) [CMA Final]
Answer:
Business Valuation Methods - CS Professional Study Material 2
Business Valuation Methods - CS Professional Study Material 3
** 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.

Business Valuation Methods - CS Professional Study Material

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:

  1. Development cost already paid SOL
  2. To sell 1,50,000 boxes of tiles per annum for 5 years @ 200 per box
  3. Cost per box of tiles (at todays prices):
    Material and other variable expenses ₹135
    Fixed overhead (allocated) ₹ 15
  4. Initial re-design and set-up costs 2 crore
  5.  Applicable tax rate 33% on income
  6. Expected general rate of inflation 55% p.a.
  7. Required nominal rate of return 14%
  8. 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) (AF8%,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) (AF8%,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).
Business Valuation Methods - CS Professional Study Material 4
Business Valuation Methods - CS Professional Study Material 5
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).
Business Valuation Methods - CS Professional Study Material 6
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:
Business Valuation Methods - CS Professional Study Material 7
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:
Business Valuation Methods - CS Professional Study Material 8
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:
Business Valuation Methods - CS Professional Study Material 9
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%

Business Valuation Methods - CS Professional Study Material

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 31st, 2010
Business Valuation Methods - CS Professional Study Material 10

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:
Business Valuation Methods - CS Professional Study Material 11
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:
Business Valuation Methods - CS Professional Study Material 12
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:
Business Valuation Methods - CS Professional Study Material 13

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 :
Business Valuation Methods - CS Professional Study Material 14
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
Business Valuation Methods - CS Professional Study Material 15
Business Valuation Methods - CS Professional Study Material 16

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.
Business Valuation Methods - CS Professional Study Material 17
Business Valuation Methods - CS Professional Study Material 18
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.
Business Valuation Methods - CS Professional Study Material 19
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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.
Business Valuation Methods - CS Professional Study Material 21
(June 2011, 10 marks)[CMA Final]
Answer:
Business Valuation Methods - CS Professional Study Material 22
Calculation of price per share
Business Valuation Methods - CS Professional Study Material 23
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 5th year = 95.128/(0.256-0.18) = ₹ 1251.68

Business Valuation Methods - CS Professional Study Material

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.
Business Valuation Methods - CS Professional Study Material 24
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:
Business Valuation Methods - CS Professional Study Material 25
Business Valuation Methods - CS Professional Study Material 26
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.
Business Valuation Methods - CS Professional Study Material 61
Answer:
Business Valuation Methods - CS Professional Study Material 27
Business Valuation Methods - CS Professional Study Material 28

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, 4th 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.
Business Valuation Methods - CS Professional Study Material 29
Alternatively the candidate may attempt by 160 (PV @ 17% yearly cumulative 1 to 6 years) + 1000(PV @ 17% In 6th 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:
Business Valuation Methods - CS Professional Study Material 30
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
vo = -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:
V0 = 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.

Business Valuation Methods - CS Professional Study Material

Question 30.
The following projections for’ T Ltd., have been developed based on internal estimates and market information:
Business Valuation Methods - CS Professional Study Material 31
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:
Business Valuation Methods - CS Professional Study Material 32
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 rue is 14%, βUE, the unlevered equity beta, was calculated by solving the to following equation:
rUE = Risk – free rate + βUE* market risk premium
14 = 8 + βUE* 6
βUE = 1
2. Given βUE = 1, βUE, the levered equity beta was calculated:
βUE = βUE [1 + (1 – T)\(\frac{D}{E}\)]
= 1[1 + 4/7(1-0.3)]
= 1.4
3. Given βUE = 1.4, rLE, the cost of levered equity was calculated:
rLE, = 8 + 1.4*6 = 16.4%
4. Given rLE, = 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
Business Valuation Methods - CS Professional Study Material 33

(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:
Business Valuation Methods - CS Professional Study Material 34
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:
Business Valuation Methods - CS Professional Study Material 35

(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:
Business Valuation Methods - CS Professional Study Material 36

(ii) Preference Dividend coverage ratios of both companies are to be compared to make such decision.
Preference dividend coverage ratio is given by:
Business Valuation Methods - CS Professional Study Material 37

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)
Business Valuation Methods - CS Professional Study Material 38

2. Computation of dividend per share (Company A 30% and Company B 10% of profits)
Business Valuation Methods - CS Professional Study Material 39

Business Valuation Methods - CS Professional Study Material

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
Business Valuation Methods - CS Professional Study Material 40
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 1st 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

Business Valuation Methods - CS Professional Study Material 41
Business Valuation Methods - CS Professional Study Material 42

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 31st March, 2015:
Business Valuation Methods - CS Professional Study Material 43
Business Valuation Methods - CS Professional Study Material 44

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
Business Valuation Methods - CS Professional Study Material 58
Business Valuation Methods - CS Professional Study Material 59

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:
Business Valuation Methods - CS Professional Study Material 45
Business Valuation Methods - CS Professional Study Material 46
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:
Business Valuation Methods - CS Professional Study Material 47
Business Valuation Methods - CS Professional Study Material 48
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).

Business Valuation Methods - CS Professional Study Material

Question 41.
Give below is the Balance sheet of Laxmi Ltd. as on 31 -03-201 4:
Business Valuation Methods - CS Professional Study Material 49
Business Valuation Methods - CS Professional Study Material 50
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:
Business Valuation Methods - CS Professional Study Material 51
Business Valuation Methods - CS Professional Study Material 52
#: 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

Business Valuation Methods - CS Professional Study Material

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
Business Valuation Methods - CS Professional Study Material 53
# 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

Business Valuation Methods - CS Professional Study Material

Question 48.
P Ltd. is considering buying the business of Q Ltd., the final accounts of which for the last 3 years ended 31st December is.
Business Valuation Methods - CS Professional Study Material 54
Business Valuation Methods - CS Professional Study Material 55

Balance Sheet as on 31st 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:
Business Valuation Methods - CS Professional Study Material 56
Business Valuation Methods - CS Professional Study Material 57

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:
Business Valuation Methods - CS Professional Study Material 60
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 Valuet = Cast Flowt+1 / r – gstable
Cash Flowt+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 = Rf + β(Rm – Rf)
= 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

Business Valuation Methods - CS Professional Study Material

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 (r0) = 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
R0 = 3/4 × 0.1688 + 1/4(0.615) × 0.1025
= 0.1423 or 14.23%
Value of firm = 338.4/0.1423 = ₹ 2378 lakhs

Valuation during Mergers & Acquisitions – CS Professional Study Material

Chapter 10 Valuation during Mergers & Acquisitions  – CS Professional Valuations and Business Modelling Study Material is designed strictly as per the latest syllabus and exam pattern.

Valuation during Mergers & Acquisitions – CS Professional Valuations and Business Modelling Study Material

Question 1.
Write a short note on the following:
Hostile Takeover Bids (June 2016, 4 marks) [CMA Final]
Answer:
Hostile Takeover Bids: The acquiring firm, without the knowledge and consent of the management of the target firm, may unilaterally pursue the efforts to gain a controlling interest in the target firm, by purchasing shares of the latter firm at the stock exchanges. Such case of merger/acquisition is popularity known as ‘raid’.

The Caparo group of the U.K. made a hostile takeover bids to takeover DCM Ltd. and Escorts Ltd. Similarly, some other NRI’s have also made hostile bids to takeover some other Indian companies. The new takeover code, as announced by SEBI deals with the hostile bids. Space to write important points for revision

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 2.
Write short notes on the following:
(a) Shareholder Value Analysis
(b) Valuing Synergy (Dec 2016, 4 × 2 = 8 marks) [CMA Final]
Answer:
(a) Shareholder Value Analysis:
Shareholder Value Analysis (SVA) focuses on the creation of economic value for shareholders, as measured by share price performance and flow of funds.

Shareholders Value is used to link management strategy and decision to the creating of value for shareholders.

Value Drivers: Factors or Value Drivers which influence the Shareholder’s Value are identified.

Example: Growth in Sales, Profit Margin, Capital Investments Decisions, etc.

Management Responsibilities: Management should pay attention to value drivers, while taking investment and finance decisions.
Benefit
(a) SVA helps the management to concentrate on activities which create value to the shareholders rather than on short-term profitability.
(b) SVA and EVA together helps to strengthen the competitive position at the firm, by focusing on wealth creation.
(c) They provide an objective and consistent framework of evaluation and decision making across all functions, departments and units of the Company.

Valuation during Mergers & Acquisitions - CS Professional Study Material

(b) Synergy:

  • The most general definition of synergy is a whole that is greater than the sum of its parts. In the context of takeovers, the additional value from synergy can come from a variety of sources, either operational or financial.
  • The key to the existence of synergy is that the target firm controls a specialized resource that becomes more valuable when combined with bidding firm’s resources.
  • The specialized resource will vary depending on the type of merger. In case of horizontal merger (it occurs when two firms in the same line of business merge), the synergy must come from some form of economies of scale, which reduces costs, or from increased market power, which increases profit margin and sales.
  • Valuing synergy requires assumptions about future cash flows and growth.
  • The lack of precision in the process does not mean that an unbiased estimate of value cannot be made.
  • Thus, we maintain that synergy can be valued by answering two fundamental questions:
    1. What form is the synergy expected to take? Will it reduce costs as a percentage of sales and increase profit margins? Will it increase future growth?
    2. When can the synergy be expected to start affecting cash flows instantaneously.
      • Once these questions are answered, the value of synergy can be estimated using an extension of discounted cash-flow techniques.
      • First, the firms involved in the merger are valued independently by discounting expected cash flows to each firm at the weighted average cost of capital for that firm.
      • Second, the value of the combined firm, with no synergy, is obtained by adding the values obtained for each firm in the first step.
      • Third, the effects of synergy are built into the expected growth rates and cash flows, and the combined firms revalued with synergy.
      • The difference between the values of the combined firm with synergy and the value of the combined firm without synergy provides a value for synergy.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 3.
(a) Why do many mergers fail? (June 2009) (5 marks) [CMA Final]
(b) What factors are considered for selection of a target in a business acquisition strategy? (5 marks) [CMA Final]
Answer:
(a) Major reasons why mergers fail:

  1. Lack of fit due to difference in management styles or corporate structures.
  2. Lack of commercial fit.
  3. Paying too much.
  4. Cheap purchases turning out to be costly in terms of resources required to turn around the acquired company.
  5. Lack of community of goals.
  6. Failure to integrate effectively.

(b) Factors to be considered for selecting a target:

  1. The target fits well with the acquisition objective.
  2. The target has growth potential but faces some solvable managerial problems.
  3. The market value of the target is lower than the acquirer’s.
  4. The target does not have too many ongoing litigations with substantial financial impact.
  5. The target’s market-to-book value ratio is less than one.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 4.
Explain the relationship of synergy with Strategic realignment in the context of Merger. (June 2010, 5 marks) [CMA Final]
Answer:
Synergy is the term used to describe a situation where different entities co-operate and the value created is greater than the sum of its parts. The most fundamental of all reasons for mergers is the ‘Synergy’ argument, which serves as the basis of strategic realignment.

Separate Companies “pre-merger values”: Accordingly under Synergy, the combined value of a firm is much greater than the value of individual firms. The phenomenon of synergy arises due to economies of scale of operation. Besides, the combined mega features such as enhanced managerial capabilities, creativity innovativeness, R&D and market coverage capacity expand beyond simple arithmetic. Due to the complementary nature of the resources and skills, a widened horizon of opportunities is also responsible for “Synergy” on a merger situation.

For example, Madura Bank had a very big network compared to ICICI Bank. Bank of Madura had one of the lowest costs of deposit and capital Adequacy Ratio was very high. ICICI had latest technology to be implemented and subsidiaries overseas but had no significant network in India. So ICICI and Madura Bank came together and there was a dramatic improvement post merger due to synergy.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 5.
Discuss the causes of horizontal and vertical mergers. (June 2011, 5 marks) [CMA Final]
Answer:
The causes of mergers of two firms in the same industry Horizontal Mergers:

  1. Economies of scale
  2. Increased monopoly and bargaining power
  3. Complementary nature of product and services
  4. Management opportunity
  5. Acquisition of new products and brands

Vertical Mergers:

  1. Value chain management
  2. Technological and other economies
  3. Tax benefit
  4. Better control on the supply side

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 6.
Explain the various methods of payment in case of mergers and amalgamations. (June 2011, 3 marks) [CMA Final]
Answer:
METHODS OF PAYMENT IN MERGERS & AMALGAMATIONS
The different methods of payment in mergers and acquisitions are given below:
Cash :
Where one company purchases the shares or assets of another for cash, the shareholders of the latter company cease to have any interest in the combined business. The shareholders of the selling company get the specified sum on the disposal of their shares. The disadvantage is that they may be liable to capital gains tax.

Loan Stock :
In this case, the shareholders of the selling company exchange their equity investment for a fixed interest investment in the other company. The advantage is that any liability to capital gains tax will be deferred until the disposal of the loan stock. The advantage to the shareholders increases with higher residual income accruing to them. In addition, interest on the loan stock is deductible for company tax purposes.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Ordinary Shares :
A share for share exchange is often the method used in combinations involving large companies. Here the shareholder merely exchanges his shares in one company for shares in another company, the advantage is that the shareholders of the selling company continue to have an interest in the combined businesses and will not be subject to capital gains tax on the exchange. However, the value of the security, which he receives, is not certain but will depend upon market reaction to the combination.

Convertible Loan Stock :
The issue of convertible loan Stock is sometimes used in connection with business combinations. In such a case, the shareholders in one company exchange their shares for convertible loan stock in another company. The selling shareholder exchanges an equity investment for a fixed interest security which is convertible into an equity investment at some time in the future if he so desires.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 7.
What is partial Sell off? (Dec 2011, 4 marks) [CMA Final]
Answer:

  • A partial sell off means Slump sale is transfer of one or more business undertakings for a lump sum consideration, without assigning individual values to the each assets and liabilities to be transferred. It is not sale of assets which on its own cannot produce sustainable revenue.
  • Under Indian Income tax Act, 1961, “slump sale” means the transfer of one or more undertakings as a result of the sale for a lump sum consideration without values being assigned to the individual assets and liabilities in such sales.
  • Therefore transferor is not required to assign value to each “assets and liabilities” of “business undertaking” to be transferred.
  • In other words, the sale of a business unit or plant of one firm to another. It involves the purchase of a business unit or plant of one firm by another.
  • It is the mirror image of a purchase of a business unit or plant. From the seller’s perspective, it is form of contraction; from the buyer’s point of view, it is a form of expansion.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 8.
What are the defensive strategies available to a company in case of hostile takeover ? (Dec 2011, 5 marks)
Answer:
Valuation during Mergers & Acquisitions - CS Professional Study Material 1

Question 9.
(a) Why do many mergers fail? (June 2012) (5 marks) [CMA Final]
(b) Discuss Synergy with reference to merger. (5 marks) [CMA Final]
Answer:
(b) Synergy:

  • Synergy results from complementary activities.
  • For example one firm may have a substantial amount of financial resources while the other has profitable investment opportunities.
  • Likewise one firm may have a strong research and development team whereas the other may have a very efficiently organized production department.
  • Similarly one firm may have well established brands of its products but lacks marketing organization and another firm may have a very strong marketing organization.
  • The merged business unit in all these cases will be more efficient than the individual firms. And hence the combined value of the merged firms is likely to be greater than the sum of the individual entities (units).
  • Symbolically; Combined value = Stand alone value of acquiring firm Va + Stand alone value of acquired target firm Vt +Value of synergy ∆Vat
  • Normally the value of synergy is positive and this constitutes the rationale for the merger.
  • In valuing synergy costs attached with acquisitions should also be taken into account.
  • These costs primarily consist of costs of integration and payment made for the acquisition of the target firm in excess of its value Vt.
  • Therefore the net gain from the merger is equal to the difference between the value of synergy and costs.
    Net gain = Value of synergy ∆ Vat – costs.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 10.
What do you mean by reverse merger? (Dec 2012, 5 marks) [CMA Final]
Answer:
A Reverse Merger is a transaction whereby the private company shareholders may gain’control of a public company by merging it in with their private company. The private company shareholders receive a substantial majority of the shares qf the public company (normally 85% to 90% or more) and the control of the board of directors. When a healthy company merges with a sick or a small company it is called reverse merger.

Following are some of the reverse merger:
1. The Transferee Company is a sick company and has carried forward losses and Transferor Company is profit making company. If Transferor Company merges With sick transferee company, it gets advantages of setting off carry forward losses without any additions. If sick company merges with a healthy company, many restrictions are applicable for allowing set off of the accumulated losses.

2. If Transferee Company is a listed company and transferor, non-listed company merges With the listed company; it gets advantages of listed company without fQllowing strict norms of listing of stock exchanges. In such cases, it is provided that on the date of merger, name of Transferee Company will be changed to that of Transferor Company. Thus, outside people even may not know that the transferee company with which they are dealing after merger is not the same as the earlier one.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 11.
What is value chain analysis? (Dec 2012, 5 marks) [CMA Final]
Answer:
Value Chain Analysis is a useful tool for working out how you can create the greatest possible value for your customers. In business, we’re paid to take raw inputs, and to “add value” to them by turning them into something of worth to other people. This is easy to see in manufacturing, where the manufacturer “adds value” by taking a raw material of little use to the end-user (for example, wopd pulp) and converting it into something that people are prepared to pay money for (e.g. paper).

Value chain analysis is relevant for most business, but particularly useful: A vertically integrated business is engaged in all the activity required for converting raw material from sourcing to converting into and selling the finished goods to the ultimate consumers including after sales service. Value chain analysis helps in identifying company is doing well, where the company needs to improve and what the company can outsource profitably.

Activity susceptible to technological change. Technological changes can disintegrate value chains, permitting companies to specialize in to narrow set of activities.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 12.
(a) Discuss the amalgamation in the nature of merger as per Accounting Standard, AS-14. (Dec 2013) (6 marks) [CMA Final]
(b) What are the factors that favour external growth and diversification through mergers and acquisitions? (4 marks) [CMA Final]
Answer:
(a) Amalgamation in the nature of merger: As per AS -14, an amalgamation is called in the nature of merger if it satisfies all the following condition:
(i) All the assets and liabilities of the transferor company should become, after amalgamation the assets and liabilities of the other company.

(ii) Shareholders holding not less than 90% of the face value of the equity shares of the transferor company (other than the equity share already held therein, immediately before the amalgamation, by the transferee company or its subsidiaries or their nominees) become equity shareholders of the transferee company by virtue of the amalgamation.

(iii) The consideration for the amalgamation receivable by those equity shareholders of the transferor company who agree to become equity shareholders of the transferee company is discharged by the transferee company wholly by the issue of equity shares in the transferee company, except that cash may be paid in respect of any fractional shares.

(iv) The business of the transferor company is intended to be carried on, after the amalgamation by the transferee company.

(v) No adjustment is intended to be made in the book value of the assets and liabilities of the transferor company when they are incorporated in the financial statements of the transferee company except to ensure uniformity of accounting policies.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Amalgamation in the nature of merger is an organic unification of two or more entities or undertaking or fusion of one with another. It is defined as an amalgamation which satisfies the above conditions. As per Income Tax Act 1961, merger is defined as amalgamation with the following three conditions to be satisfied.
(i) All the properties of amalgamating company(s) should vest with the amalgamated company after amalgamation.

(ii) All the liabilities of the amalgamating company(s) should vest with the amalgamated company after amalgamation.

(iii) Shareholders holding not less than 75% in value or voting power in amalgamating company (s) should become shareholders of amalgamated companies after amalgamation. Amalgamation does not mean acquisition of a company by purchasing its property and resulting in its winding up. According to Income tax Act, exchange of shares with 90% of shareholders of amalgamating company is required.

(b) Factors that favour external growth and diversification through Mergers and Acquisitions

  1. Some goals and objectives may be achieved more speedily through an external acquisition.
  2. The cost of building an organization internally may exceed cost of an acquisition.
  3. There may be fewer risks, lower costs or shorter time requirements involved in achieving an economically feasible market share by the external route.
  4. The firm may not be utilizing their assets or arrangement as effectively as they could be utilized by the acquiring firm.
  5. The firm may be able to use securities in obtaining other companies, where as it might not be able to finance the acquisition of equivalent assets and capabilities internally.
  6. There may be tax advantages.
  7. There may be opportunities to complement capabilities of other firms.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 13.
The Balance Sheets of A Ltd. and B Ltd., separately are given to you. B Ltd. ¡s a legal subsidiary of A Ltd.
Valuation during Mergers & Acquisitions - CS Professional Study Material 2
A Ltd. holds 90% of 20 million shares of B Ltd. (face value Re.1), A Ltd. has 100 million shares. Market price of A Ltd. shares as on December 31,2007 is ₹ 70 and that of B Ltd. ₹ 18.

It was decided that B Ltd. will acquire A Ltd., by issuing its equity shares. For this purpose the plant equipment of A Ltd. were valued at ₹ 644 million and investments in B Ltd., which are 18 million shares, valued at market price. How many shares of B Ltd. should be issued to acquire A Ltd. without any acquisition of goodwill? (Dec 2008, 15 marks) [CMA Final]
Answer:
B Ltd. may issue shares to the extent fair value of the net assets of A Ltd. including its own shares held by A Ltd.

By this it will effectively buy-back its 18 million shares from A Ltd. through Business Acquisition.

Fair Value of Assets acquired ₹ in million
Plant, Equipment etc., 644
Investment in subsidiaries 324
Inventories 200
Debtors 100
Cash 20
Total 1,288
Less: Liabilities acquired
8% Debentures 300
Sundry Creditors 60
Deferred Tax Liability 100
Total 460
Net Assets acquired 828
Consideration paid 828
No. of shares issued = 828/18 46 million shares.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 14.
Consider two firms that operate independently and have following characteristics:
Valuation during Mergers & Acquisitions - CS Professional Study Material 3
Both firms are in steady state with capital spending offset by depreciation. Both firms have an effective tax rate of 40% and are financed only by equity. Consider the following two scenarios:

Scenario-1: Assume that combining the two firms will create economies of scale that will reduce the COGS to 50% of Revenue.

Scenario-ll: Assume that as a consequence of the merger, the combined firm is expected to increase its future growth to 7% while GOGS will be 60%.

It is given that Scenario I & II are mutually exclusive.
You are required to:
(a) Compute the values of both the firms as separate entities.
(b) Compute the value of both the firms together if there were absolutely no synergy at all from the merger.
(c) Compute the value of cost of capital and the expected growth rate.
(d) Compute the value of synergy in (i) Scenario I & (ii) Scenario II. (June 2009, 3 + 2 + 2 + 4 + 4 = 15 marks) [CMA Final]
Answer:
(a) Value of Ganga Ltd. = FCFF(1 + g)/(Ke – g) = EBIT(1 – t)(1 + 0.05) /(0.08 – 0.05)
= 2500(1 – 0.4)(1 + 0.05)/0.03
= ₹ 52,500L.
Value of Yamuna Ltd. = 1200(1 – 0.4)(1 + 0.07)/(0.09 – 0.07) = ₹ 38,520L.

(b) Value of both firms without synergy = ₹ 52.500L + ₹ 38,520L = ₹ 91020L

(c) Cost of capital 8% × 52,500/91,020 + 9% × 38,520/91,020 = 8.42%
Expected growth = .05 × 52,500/91,020 +.07 × 38,520/91,020 = 5.84%

(d) Claculation of Value of Synergy:
Valuation during Mergers & Acquisitions - CS Professional Study Material 4

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 15.
Perfect Precision Limited has adopted a strategy of inorganic growth and as a consequence, it is always on the look out for a soft vjj target to be acquired. Recently, the company has identified Exact Precision Limited as a target company and the concerned team is working on this acquisition. Some of the financial data collected by the team is given below:

Perfect Precision Limited Exact Precision Limited
Earnings per Share (EPS) ₹ 7.50 ₹ 5.00
Market Price per Share (MPS) ₹ 80.00 ₹ 35.00
Number of Shares (in Crores) 100 25

It is expected that there may be a synergy gain of 5%. Assume that you are one of the members of the concerned team and are requested to determine the exchange ratio it Perfect Precision Limited wants to have post-merger earnings per share of ₹ 6 (June 2010, 8 marks) [CMA Final)
Answer:

Perfect Precision Limited Exact Precision Limited
Earnings Per Share (EPS) ₹ 7.50 ₹ 5.00
Market Price Per Share (MPS) ₹ 80.00 ₹ 35.00
Number of Shares (in crores) 100 25
Total Earnings of Perfect Precision Limited ₹ 750.00
Total Earnings of Exact Precision Limited ₹ 125.00
Total ₹ 875.00
Synergy Gain @ 5% ₹ 43.75
Total Earnings of the Combined Entity ₹ 918.75
Desired. Post-Merger EPS ₹? 6.00
No. of Shares of Perfect Precision Limited post­merger 153.125
Therefore, new shares are to be issued 53.125
Hence, exchange ratio will be 2.125

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 16.
Two firms ANKIT LTD., and SMITH LTD., operate independently and had the following financial statements:
(Amount in ₹ Lakhs)

Particulars ANKIT LTD. SMITH LTD.
Revenues 4400 3000
Cost of Goods Sold 3850 2670
EBIT 550 330
Expected Growth Rate 5% 6%
Cost of Equity 10% 12%
Cost of Debt (pre-tax) 9% 9%
Debt Equity Ratio 1 : 2 2 : 3

Both firms are in a steady state and working capital requirements for both firms are Nil. Both firms have tax rate of 35%. Combining the two firms will create economies of scale in the form of shared distribution and advertising costs which will increase its future growth to 7% and reduce the cost of goods sold to 85% of revenues.

Requirements:
(i) Estimate the value of both firms as separate entities
(ii) Estimate the value of combined firm with no synergy effect
(iii) Estimate the value of combined firm with synergy effect
(iv) Compute the value of synergy (June 2010, 3 + 2 + 3 + 2 = 10 marks) [CMA Final]
Answer:
(i) Value of Ankit Ltd.:
FCFF (1 + g)/Kc – g)
= [EBIT(1 – t) × 1.05]/(0.0862 – 0.05)
= (550 × 0.65 × 1.05)/0.0362
= ₹ 10,369.48 lakh

Valuation during Mergers & Acquisitions - CS Professional Study Material

Cost of Capital:
[2 × 0.10 + 1 × (1 – 0.35) × 0.09] / 3 = 8.62%

Value of Smith Ltd.:
FCFF(1 + g)/(Kc – g)
= [EBIT(1 – t) × (1 + g)]/(Kc – g)
= (330 × 0.65 × 1.06)/(0.0954 – 0.06)
= ₹ 6,422.88 lakh

Cost of Capital :
[3 × 0.12 + 2 × (1 – 0.35) × 0.09] / 5 = 9.54%

(ii) Value of combined firm with no synergy:
(10369.48 + 6422.88) = ₹ 16,792.36 lakh

(iii) Value of combined firm with synergy effect:
Valuation during Mergers & Acquisitions - CS Professional Study Material 5
Cost of Capital for combined firm:
(0.0862 × 10369.48 × 0.0954 × 6422.88)/16792.36
= 0.08972 i.e. 8.97% (WACC)
Expected Growth = 7%
4″Value of combined firm with synergy:
[1110 × (1 – t) × 1.07]/(Kc – g)
= (1110 × 0.65 × 1.07)/(0.0897 – 0.07)
= ₹ 39188.07 lakh

(iv) Value of Synergy:
[Value of combined firm with Synergy – Value of combined firm without Synergy
(39,188.07 – 16,792.36) = ₹ 22,395.71 lakh]

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 17.
As the General Manager (Finance) of ZENITH LTD. you are investigating the acquisition of STARLIGHT LTD. The following tacts are given:

ZENITH LTD. STARLIGHT LTD.
Earning per Share ₹ 6.75 ₹ 2.50
Dividend per Share ₹ 3.25 ₹ 1.00
Price per Share ₹ 48 ₹ 15
Number of Shares 60,00,000 20,00,000

Investor currently expected the dividends and earnings of Starlight Ltd. to grow at a steady rate of 7%. After acquisition, this growth rate would increase to 8% without any additional investment.

Required:
(i) What is the benefit of the acquisition?
(ii) What is the cost of the acquisition to ZENITH LTD. if it pays.
(a) 7 17 per share compensation(cash) to Starlight Ltd., and (b) Offer one share for every 3 shares of Starlight Ltd.? (June 2010, 4 + 3 + 4 =11 marks) [CMA Final]
Answer:
(i) Rate of Return (Ke) required by the investors of Starlight Ltd:
Ke = D1/P1 + g = 1/15 + 0.07 = 0.1367 i.e. 13.67%
If g – 8% then Pst = (1.00 × 1.08) / (0.1367 – 0.08) = ₹ 19.0476
Benefit of Acquisition = (Price of Starlight with Merger – Price of Starlight without Merger) × Ns
= (19.0476 -15) × 20,00,000]
= ₹ 80,95,200

Valuation during Mergers & Acquisitions - CS Professional Study Material

(ii) Cost of Acquisition to Zenith Ltd.
(a) If it pays ₹ 17 cash compensation
= Cash Compensation – PVs
= (17 × 20,00,000) – (15 × 20,00,000)
= ₹ 40 lakh

(b) if Zenith Ltd. offers one share for every three shares of Starlight, then the share of Starlight (a) in the combined entity will be:
(∝) = [(1/3) × 20,00,000]/[60,00,000 + (1/3) × 20,00,000]
= 6,66,667/66,66,667
= 0.10
Pvzs = PVz + PVs + Synergy (Benefit Merger)
= 2880 + 300 + 80.95
= ₹ 3260.95 lakh
Cost of Acquisition to Zenith Ltd. given the exchange ratio:
= (∝) × PVzs – PVs
= 0.10 × 3260.95 – 300
= ₹ 26.95 lakh

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 18.
AKASH LTD. wants to take over VASTAN LTD. and the financial details are as follows:
(Amount in ₹ lakhs)

AKASH LTD. VASTAN LTD.
Preference Share Capital 20
Equity Share Capital (₹10 at par) 100 50
Share Premium 2
Profit & Loss Account 10% Debentures 38 4
15 5
Total 173 61
Property, Plant and Equipment 122 35
Current Assets 51 26
Total 173 61
Profit after Tax & Preference Dividend 24 15
Market Price ₹ 24 ₹ 27

Valuation during Mergers & Acquisitions - CS Professional Study Material

Requirements:
(a) What should be the share exchange ratio to be offered to the shareholders of VASTAN LTD. based on:
(i) Net Asset Value;
(ii) EPS, and
(iii) Market Price;
(b) Which should be preferred from the point Of AKASH LTD.? (June 2010, 5 + 4 + 4 + 2 = 15 marks) [CMA Final]
Answer:
(a) (i) Share exchange ratio based on Net Asset Value:

(Amount in ₹ Lakh) Akash Ltd. Vastan Ltd.
Total Assets 173 61
Liabilities (15) (5)
Preference Share Capital (20)  —
Net Assets for equity Shareholders 138 56
No. of Equity Shares (lakhs) 10 5
Worth per share ₹ 13.80 ₹ 11.20
Ratio of Net Asset Value per share 1.00 0.812

For 5 Iakh shares of Vastan Ltd., Akash Ltd. will have to issue (5 × 0.812)
= 4.060 lakh shares

Valuation during Mergers & Acquisitions - CS Professional Study Material

(ii) Share exchange ratio based on EPS:

(Amount in ₹ Lakh) Akash Ltd. Vastan Ltd.
Earnings 24 15
Shares outstanding (nos. Lakhs) 10 5
EPS ₹ 2.40 ₹ 3.00
Ratio of EPS 1.00 1.25

For 5 lakh shares of Vastan Ltd.. Akash Ltd. will have to issue (5 × 1.25)
= 6.250 lakh shares

(iii) Share exchanqe ratio based on Market Price:

Akash Ltd. Vastan Ltd.
Market Price ₹ 24 ₹ 27
Ratio 1.000 1.125

For 5 lakh shares of Vastan Ltd., Akash Ltd. will have to issue (5 × 1.125) = 5.625 lakh shares

(b) From the point of view of Akash Ltd., the shares exchange ratio based on Net Asset Value may be preferred as in this case number of shares to be issued is the least 4.060 lakh shares.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 19.
Company-Aggressive has decided to takeover Company-Soft Target and merge it with itself. In this respect, you have been provided the following information:
Valuation during Mergers & Acquisitions - CS Professional Study Material 6
It is decided that the exchange ratio would be based on the market prices of these two companies and there would not be any cash payment, all settlement would be by issuing equity shares of Company-Aggressive to the shareholders of Company-Soft Target.

You are required to determine the following:
(i) What will be the EPS of both the companies after the merger?
(ii) What will be the change in the EPS of each company due to the merger?
(iii) Assuming that Relative Valuation Method based on P/E Multiple is an appropriate method for determining the price of the equity share of Company-Aggressive and its P/E should be 15 after the merger, what will be the market price of the equity share of Company-Aggressive after the merger?
(iv) What will be the market capitalization of Company-Aggressive after the merger?
(v) What will be the gains accruing to the shareholders of both the companies after the merger?
(vi) Will the decision of Company-Aggressive to acquire Company-Soft Target and merge it in itself be a value creating decision? (Dec 2010, 4+2+4+2+2+1=15 marks) [CMA Final]
Answer:

  • Since the market price of both companies are same, the Exchange Ratio will be 1:1
  • New Shares to be issued to the shareholders of Company – Soft Target: 22,00,000
  • Total Shares of Company-Aggressive (22,00,000 + 40,00,000) : 62,00,000
  • Assuming no synergy gains, the Total Profit of the Company – Aggressive after merger will be (₹ 77,00,000 + 1,00,00,000) : ₹ 17,700,000

Valuation during Mergers & Acquisitions - CS Professional Study Material

Therefore, New EPS of Company – Aggressive after the merger is: ₹ 2.85
(i) Old EPS (before merger):
Company – Soft Target (77,00,000/22,00,000) : ₹ 3.50
Company – Aggressive (1,00,00,000/40,00,000): ₹ 2.50

(ii) Decrease in the EPS – Company -Soft Target (₹ 3.50 – 2.85): ₹ 0.65
Increase in the EPS – Company – Aggressive (₹ 2.85 – 2.50) ₹ 0.35

(iii) Market Price of the Equity Share of Company – Aggressive after merger based on the P/E of 15 is (15 × 2.85): ₹ 42.82 [(1,77,00,000 ÷ 62,00,000) × 15 = ₹ 42.82]

(iv) Market Capitalization of Company – Aggressive after merger (₹ 42.82 × 62,00,000): ₹ 26,55,00,000 or, [1,77,00,000 × 15] = ₹ 26,55,00,000

(v) Market Capitalization of both companies (before merger):
Company – Soft Target (₹ 40 × 22,00,000): ₹ 88,000,000
Company – Aggressive (₹ 40 × 40,00,000): ₹ 160,000,000
Total Market Capitalization: ₹ 248,000,000
Total Gains to shareholders of both the companies (₹ 26,55,00,000 – 24,80,00,000): ₹ 17,500,000

(vi) Since the market capitalization of the companies after the merger has gone up, it shows that the decision to merger has created value for shareholders.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 20.
Soft-Tech International Limited has identified a target company, Sunshine India Ltd. and asked Value Search Consultant Pvt. Limited to provide necessary valuation of the business of the target company. The target company identified is from Karnataka and is located in Mysore. On the basis of the past financial records, Value Search Consultant Pvt. Limited has projected necessary financials for the company for the next five years which are given below:

PROFIT AND LOSS ACCOUNT OF SUNSHINE INDIA LIMITED FOR THE YEAR ENDING ON 31ST MARCH (₹ crores)
Valuation during Mergers & Acquisitions - CS Professional Study Material 7
The Cost of capital for the company is estimated to be 16%. Assuming that the free cash flows of the target company will grow at a constant rate of 12% forever after 2015, you are required to determine the value of the business based on the free cash flows. (Dec 2010, 15 marks) [CMA Final]
Answer:
Valuation during Mergers & Acquisitions - CS Professional Study Material 8

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 21.
A Company-X is contemplating the purchase of another Company-Y. Company-X is having 6 lakhs shares outstanding having a current market price of ₹ 50 per share, while Company-Y has 4 lakhs shares outstanding having a current market price of ₹ 25 per share. The Earning Per Share (EPS) of Company-X is ₹ 4 while that of the Company-Y is ₹ 2.25 per share. Company-X in consultation with Company-Y is considering the following two alternative ways to determining the exchange ratio:

(i) In proportion of their relative EPS.
(ii) In proportion of their current market prices.

Suggest which alternative way Company-X should use to determine the exchange ratio so that after the merger increase in the EPS of Company-X is higher. (Dec 2010, 8 marks) (CMA Final)
Answer:
Valuation during Mergers & Acquisitions - CS Professional Study Material 9
Since EPS s higher ¡p case the exchange ratio is determined on the basis of market prices, Coripany-X should go for the same.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 22.
Google Ltd. wants to acquire Froogle Ltd. and has offered a swap ratio of 1 : 2 (0.5) shares of Google Ltd. for every oneshare of Froogle Ltd. Following Information is provided :
Valuation during Mergers & Acquisitions - CS Professional Study Material 10
Require:
(i) The number of equity shares to be issued by Google Ltd. for acquisition of Froogle Ltd.
(ii) What is the EPS of Google Ltd. after acquisition ?
(iii) What is the expected market price per share of Google Ltd. after the acquisition, assuming Its P/E multiple remains unchanged ?
(iv) Determine the market value of the merged firm. (June 2011, 12 marks) [CMA Final]
Answer:
(i) The number of shares to be issued by Google Ltd. 1,80,000*0.5
= 90,000 shares

(ii) EPS of Google Ltd. after acquisition
Total earning (1 8,00.000 + 3,60.000) = ₹ 21,60,000
No. of shares (6,00,000 + 90,000) = 6,90,000
EPS = 21 ,60,000 / 6,90,000 = ₹ 3.13

(iii) New Market price of Google Ltd. (PIE remaining unchanged)
Present PIE Ratio of Google Ltd. 10 times
Expected EPS after merger ₹ 3.13
Expected market price (3.13*10) = ₹ 31.30

(iv) Market value of merged firm
Total No. of shares 6,90,000
Expected market price ₹ 31.30
Total Value (6,90.000*31.30) ₹ 2,15,97,000

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 23.
Dominating Limited is planning to acquire Weak Limited and it is expected that the deal would be finalized after one year. The management of Dominating Limited is trying to get an estimate of share prices of Weak Limited after one year.

Assume that the company contacts you and provides the following necessary information:

  • Beta of Weak Limited = 1.25
  • Expected Return on the Market Index = 16.50%
  • Risk Free Rate = 8%
  • Expected Dividend Payment by the end of the year by Weak Limited = ₹ 5 per share on a face value of ₹ 10 each.
  • Share price of Weak Limited at present = ₹ 70

You are required to determine the expected price of Weak Limited after one year. (Dec 2011, 6 marks) [CMA Final]
Answer:
Cost of Equity as per CAPM = 8% + (16.50 – 8)*1.25
= 18.625%
Price after One Year = Price at Present × (1 + cost of equity) – Divided Payment
= 70 × (1 +18.625%) – 5 = 78.04

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 24.
Solid Limited is in the Pharmaceutical Industry and has a business strategy of growing inorganically. For this purpose, it is contemplating to acquire Fluid Limited which has a strong hold in cardiac segment. Solid Limited has 30 crores shares outstanding which are trading on an average price of ₹ 300 while Fluid Limited has outstanding shares 20 crores and are selling at an average price of ₹ 195 per share. The EPS are ₹ 12 and ₹ 6 for Solid Limited and Fluid Limited respectively. Recently, the management of both the companies had a meeting wherein number of alternative proposals were considered for exchange of shares. They are –

(i) Exchange Ratio should be in proportion to the relative EPS of two companies.
(ii) Exchange Ratio should be in proportion to the relative Prices of two companies.
(iii) Exchange Ratio should be 3 shares of Solid Limited for every 5 shares of Fluid Limited.

You are required to estimate EPS and Market Price assuming the P/E of Solid Limited after merger will remain unchanged, under each of the three options. (Dec 2011, 6 marks) [CMA Final]
Answer:
Valuation during Mergers & Acquisitions - CS Professional Study Material 11

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 25.
A Ltd. Plans to acquire B Ltd. The following information is available:
Valuation during Mergers & Acquisitions - CS Professional Study Material 12
(i) What is the maximum exchange ratio acceptable to the shareholders of A Ltd. if the PE ratio of the combined entity is 12 and there is no synergy gain.
(ii) What is the exchange ratio acceptable to the shareholders of B Ltd. if the PE ratio is 1]1 and there is synergy benefit of 5%?
(iii) Assuming that there is no synergy gain, at what level of PE multiple will the lines indicating earnings ratio 1 and earnings ratio 2 intersect? (Dec 2011, 4 + 4 + 3 = 11 marks) [CMA Final]
Answer:
(i) Maximum exchange ratio from the point of the shareholder of A Ltd.
ER1 = -S1/S + PE12(E12)/P1S2
= -20 million/1 Omillion + 12*70million/30*10 million
= 0.80

(ii) Exchange ratio from the point of the shareholder of B Ltd.
ER2 = P2S1/(P12)(E12) – P2S2
= 20*20 million/11 *(70million*1,05)-20*10 million
= 400million/ 808.5-200
= 0.657

(iii) Assuming that there is no synergy gain, the lines ER and ER will intersect at the weighted average of the two price-earnings multiples, wherein the weights correspond to the respective earnings of the two firms:
PE12 = 50/70PE1 + 20/70PE2
= 50/70*12 + 20/70*10
= 11.43

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 26.
Fair Ltd. is considering takeover of White Ltd. and Black Ltd. The financial data for the three company are as follows:
Valuation during Mergers & Acquisitions - CS Professional Study Material 13
You are required to calculate:
(i) Price Earning Ratios
(ii) Earning per share of Fair Ltd. after acquisition of White Ltd. and Black Ltd. separately.
(iii) Will you recommend the merger of either/both of the companies? Justify your answer. (Dec 2011, 10 marks) (CMA Final)
Answer:
(i) Calculation of PIE Ratio
Valuation during Mergers & Acquisitions - CS Professional Study Material 14

(iii) EPS of Fair Ltd. after acquisition with Black Ltd. is higher than EPS of Fair Ltd. itself as well as EPS if Fair Ltd. acquires White Ltd. Hence, merger with only Black Ltd. suggested increasing the value to shareholder of Fair Ltd.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 27.
X Ltd. is investigating the acquisition of Y Ltd. Y Ltd.’s balance sheet is given below: –
Y Ltd: Balance Sheet (₹ in crore)

10% Cumulative preference shares 100
Ordinary share capital (30 crore shares @ ₹ 10 per share) 300
Reserves & Surplus 150
14% Debentures 80
Current Liabilities 100
Total 730
Property, Plant and Equipment 275
Investments 50
Current Assets
Stock 190
Book debts 150
Cash & Bank 65 405
Total 730

Valuation during Mergers & Acquisitions - CS Professional Study Material

X Ltd. proposed to offer the following to Y Ltd.
(a) 10% cumulative preference shares of ₹ 100 crore In X Ltd. for paying 10% cumulative preference capital of Y Ltd.
(b) 12% convertible debentures of ₹ 84 crore in X Ltd. to redeem 14% debentures of Y Ltd.
(c) One ordinary share of X Ltd. for every three shares held by Y Ltd.’s shareholders, the market price being ₹ 42 for X Ltd’s shares and ₹ 20 for Y Ltd.’s shares.

After acquisition, X Ltd. is expected to dispose of Y Ltd.’s stock for ₹ 150 crore, book debts for ₹ 102 crore and investments for ₹ 55 crore. It would pay entire current liabilities. What ¡s the cost of acquisition to X Ltd.? If X Ltd.’s required rate of return is 20% how much should be the annual after-tax cash flows from Y Ltd.’s acquisition assuming a time horizon of 8 years and a zero salvage value? Would your answer change if there is a salvage value of ₹ 30 crore alter 8 years?

Given, Present Value of ₹ 1 discounted © 20% cumulative for 1 to 8 years = 3.837 and Present Value of ₹ 1 in 8th year discounted @ 20% = 0.233. (June 2012, 15 marks) (CMA Final)
Answer:
Cost of Acquisition

Crore
10% Cumulative Preference share 100
12% Convertible debentures 84
Ordinary share capital ₹ (30/3 × 42) 420
Payment of current liabilities 100
Gross payment (A) 704
Less: realization from Investment 55
Stock 150
Book debts 102
Cash & Bank (B) 65 372
Net Cost              (A-B) 332

Valuation during Mergers & Acquisitions - CS Professional Study Material

Computation of annual after – tax cash flows.
332 = A × PVAF (0.208)
332 = A × 3.837 or A = ₹ 86.53 crore (Annual Cash Flows)
Computation of annual after – tax cash flows with salvage value.
332 = A × PVAF (0.208) + 30 × PVF (0.208)
332 = 3.837 A + 0.233 × 30
332 = 3.837 A + 6.99
A = ₹ 84.70 crores (Annual cash flows with salvage value of ₹ 30 crore after 8 years.)

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 28.
The following is provided in relation to VASUDA LTD. and MASH IT LTD. (June 2012)

VASUDA LTD. MASHIT LTD.
Market Price per Share ₹ 60 ₹ 20
No. of Shares 6,00,000 2,00,000
Market Value of the Firm ₹ 360 lakhs ₹ 40 lakhs

Firm Vasuda Ltd. iintends to acquire firm Mashit Ltd. The market price per share of Mashit Litd. has increased by ₹ 4 because of rumours that Mashit Ltd. might get a favourable merger offer. Vasuda Ltd. assumes that by combining the two firms it will save in costs by ₹ 20 lakh. Vasuda Ltd. has two options:

(i) Pay ₹ 70 lakhs cash for Mashit Ltd.
(ii) Offer 125000 Shares of Vasuda Ltd. instead of ₹ 70 lakh to the shareholders of Mashit Ltd.

You are required to calculate:
(a) The cost of the cash offer if Mashit Ltd.’s market price reflects, only its value as a separate entity. (2 marks) [CMA Final]
(b) Cost of cash offer if Mashit Ltd.’s market price reflects, the value of the merger announcement. (2 marks) [CMA Final]
(c) Apparent cost of the stock offer. (3 marks) [CMA Final]
(d) True cost of the stock offer. (3 marks) [CMA Final]
Answer:
(a) Cost of the Cash offer if Mashit Ltd’s Market price reflects only its value as a Separate entity:
Cost: = Cash Paid – PVM
= 70,00,000 – 40,00,000 = ₹ 30,00,000.

Valuation during Mergers & Acquisitions - CS Professional Study Material

(b) Mashit Ltd’s Share price risen by ₹ 4 because of rumours that Mashit might get a favorable merger offer, means that the market price is over stated by 4 × 2,00,000 = ₹ 8,00,000.
Hence the true value of Mashit Ltd. in PVM is only:
(40,00,000 – 8,00,000) = ₹ 32,00,000
In this Case, Cost = Cash Paid – PVM = (70,00,000 – 32,00,000)
= ₹ 38,00,000

(c) Cost of Stock Offer: N × PVM – PVM
Vasuda offers 1,25,000 Shares instead of ₹ 70 Lakh in Cash. Vasuda Ltd’s Share price before the deal is announced was ₹ 60. If Mashit Ltd is worth ₹ 40 Lakh stand alone (disregarding rumours) the Cost of the Merger will be:
Apparent Cost = (1,25,000 × 60 – 40,00,000)
= 75,00,000 – 40,00,000 = ₹ 35,00,000.

(d) The new firm will have 6,00,000 + 1,25,000 = 7,25,000 Shares.
PVM = Gain + (PVv + PVM)
= 20,00,000 + (3,60,00,000 + 40,00,000)
= ₹ 4,20,00,000.
New Share Price = (4,20,00,000) ÷ 7,25,000 = ₹ 57.93
True Cost = (1,25,000 × 57.93 – 40,00,000)
= (72,41,250 – 40,00,000) = ₹ 32,41,250

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 29.
The following information is provided in relation to the acquiring Company MARKET LTD. and the Target Company TRITON LTD. (June 2012)

MARKET LTD. TRITON LTD.
Earning after Tax (?) 2,000 lakh 400 lakh
Number of shares outstanding 200 lakh 100 lakh
P/E Ratio 10 5

Required:
(a) What is the Swap Ratio in terms of current market prices? (4 marks) [CMA Final]
(b) What is the EPS of Market Ltd. after acquisition? (3 marks) [CMA Final]
(c) What is the expected Market Price per Share of Market Ltd. after acquisition assuming that P/E ratio of Market Ltd. remain unchanged? (2 marks) [CMA Final]
(d) Determine the Market value of the Merged Company. (2 marks) [CMA Final]
(e) Calculate Gain/Loss for shareholders of the two erstwhile independent companies after acquisition. (4 marks) [CMA Final]
Answer:
(a)

MARKET LTD. TRITON LTD.
Earning After Tax 2,000 Lakh 400 Lakh
Number of Shares (Outstanding) 200 Lakh 100 Lakh
P / E Ratio 10 5
EPS 10 (2,000/200) 4(400/100)
Market Price = P/E × EPS ₹ 100 ₹ 20

Valuation during Mergers & Acquisitions - CS Professional Study Material

Therefore, swap ratio in terms of Market prices
MPS of target Company / MPS of acquiring company. (20 ÷ 100) = 0.20
i.e. 1 Share of Market Ltd for every 5 shares of Triton Ltd.

(b) We have a general formula given by:
EPSMT = \(\frac{\left(E_M+E_T\right)}{\left(S_M+S_T\left(E R_{M W}\right)\right.}\)
Therefore, EPS of MARKET LTD after acquisition
= \(\frac{2400}{220}\) = ₹ 10.91

(c) Expected Market Price per Share of Market Ltd with the same P/E of 10 will be
= EPS × P/E
= ₹ 10.91 × 10
= ₹ 109.10

(d) Market value of the Merged company:
= Total number of outstanding shares × market price
= (200 + 20) Lakh × ₹ 109.10
= ₹ 24,002 Lakh

Valuation during Mergers & Acquisitions - CS Professional Study Material

(e) Calculation of Gain / Loss Accuring to the Share holders of both Companies

Total Market Ltd. Triton Ltd
Number of shares after acquisition 220 Lakh 200 Lakh 20 Lakh
Market Price after acquisition ₹ 109.10 ₹ 109.10 ₹ 109.10
Total Market Value after acquisition Existing Market Value ₹ 24,002 Lakh
₹ 22,000 Lakh
₹ 21,820 Lakh
₹ 20,000 Lakh
₹ 2,182 Lakh
₹ 2,000 Lakh
Gain to Shareholders: ₹ 2,002 Lakh ₹ 1,820 Lakh ₹ 182 Lakh

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 30.
The following information has been extracted from the Annual Report 201 1-12 of ABC Limited:
Balance Sheet of ABC Limited as at 31st March, 2012
Valuation during Mergers & Acquisitions - CS Professional Study Material 15
Current Assets :
Valuation during Mergers & Acquisitions - CS Professional Study Material 16
Note: Profit on Sale on Non-current Assets (included in other Income above) being exceptional items. : 313.58
Tax expense is 30% of the profit.

The directors of XYZ Ltd. are considering a take over of ABC Ltd. As the consultant of XYZ Ltd., you are required to determine the value of a share of ABC Limited on the basis of the Profit-Earning Capacity (Capitalization) Method by considering the following additional information:
(i) The face value of the share is ₹ 10.
(ii) Profit on Sale on Non-current Assets is an exceptional item of the profit and it is expected that in future no such profits are likely to occur.
(iii) In subsequent years, additional expenses on advertisements of ₹ 25 crores and on depreciation of ₹ 50 crores each year are expected to be incurred.
(iv) The Capitalization rate on the similar business is 10.50%.
(v) All other items of the above financial statements are expected to remain same in the future. (Dec 2012, 10 marks) [CMA Final]
Answer:
Valuation during Mergers & Acquisitions - CS Professional Study Material 17

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 31.
Frontier Company Limited (FCL) is in negotiation for taking over Back Moving Company Limited (BMCL). The management of FCL is seeing strong strategic fit in taking over BMCL provided it is a profitable proposition. Mr. Guha, GM (Finance) has been asked to look into the viability of the probable takeover of BMCL. He has collected the following necessary information.

Summarized Balance Sheet of Back Moving Company Limited (BMCL) as on March 31,2012
Valuation during Mergers & Acquisitions - CS Professional Study Material 18
Proposed Purchase Consideration:

  • 10.50% Debentures of FCL for redeeming 10% Debentures of BMCL- ₹ 44 crores.
  • 11% Convertible Preference Shares of FCL for the payment of Preference Shareholders of BMCL – ₹ 100 crores.
  • 12.50 crores of Equity Shares of FCL would be issued to the shareholders of BMCL at the prevailing market price of ₹ 20 each.
  • FCL would meet all dissolution expenses of ₹ 0.50 crores.

The management of FCL would dispose any asset and liability which may not be required after takeover:

  • Investments : ₹ 150 crores
  • Debtors : ₹ 15 crores
  • Inventories : ₹ 9.75 crores
  • Payment of Current Liabilities : ₹ 25 crores
  • All intangible assets will be written off

Valuation during Mergers & Acquisitions - CS Professional Study Material

The management of FCL would like to run the taken over company, BMCL, for next 7 years and after that, it would discontinue with it. It is expected that for the next 7 years, the taken over company would generate the following yearly operating cash flows after tax:

1 2 3 4 5 6 7
Operating Cash Flows After Tax (₹ In crores) 70 75 85 90 100 125 140

It is estimated that the terminal cash flows of BMCL would be ₹ 5 the end of 7th year.

If the cost of capital of FCL is 16%, then you are required to find out whether the decision to takeover BMCL at the terms and conditions mentioned above will be a profitable decision : (June 2013, 15 marks) [CMA Final]

Year 1 2 3 4 5 6 7
Discounting Factor @ 16% 0.8621 0.7432 0.6407 0.5523 0.4761 0.4104 0.3538

Answer:
Valuation during Mergers & Acquisitions - CS Professional Study Material 19

Year Cash Flow (in ₹ crores) Discounting factor Present Value
1. 70 0.8621 60.34
2. 75 0.7432 55.74
3. 85 0.6407 54.46
4. 90 0.5523 49.71
5. 100 0.4761 47.61
6. 125 0.4104 51.31
7. 140 0.3538 49.54
7. 50 0.3538 17.69
Total = 386.39

Since the present value of the future cash flows is more than the cost of acquisition. it will be a profitable proposition to take over the said company, BMCL.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 32.
Acquiring Ltd. is in the business of making bicycles. The Company operates from North India. To diversify its operations Acquiring Ltd. has identified Target Tyres Ltd., a South India based company, as a potential takeover candidate. After due diligence, the following information is available: (Dec 2013, 15 marks) [CMA Final]
(i) Cash Flow Forecasts (₹ in Lakhs)
Valuation during Mergers & Acquisitions - CS Professional Study Material 20
Valuation during Mergers & Acquisitions - CS Professional Study Material 21
Valuation during Mergers & Acquisitions - CS Professional Study Material 22

(iii) Talks for the takeover have crystallized on the following:
(a) Acquiring Ltd. will not be able to use Machinery worth ₹ 175 lakhs which will be disposed off by them subsequent to take over. The expected realization will be ₹ 150 lakhs.
(b) The inventories and receivables are agreed for take over at value of ₹ 400 and ₹ 700 lakhs respectively, which is the price they will realize on disposal.
(c) The liabilities of Target Tyres Ltd. will be discharged in full on take over along with an employee settlement of ₹ 120 lakhs for the employees who are not interested in continuing under the new management.
(d) Acquiring Ltd. will invest a sum of ₹ 250 lakhs for upgrading the Plant of Target Tyres Ltd. on take over. A further sum of ₹ 250 lakhs will also be incurred in the second year to revamp the machine shop floor of Target Tyres Ltd.
(e) The anticipated cash flows of the combined business post take over are as follows: (₹ in lakhs)

Year 1 2 3 4 5 6 7 8 9 10
Cash Flows 900 1,200 1,800 2,200 3,000 4,000 4,800 5,000 7,000 10,000

The management of Target Ltd. is not ready to accept its present standalone value as consideration for the takeover. Acquiring Ltd. wishes to know upto what extent they can quote higher price, without suffering any loss in value post merger.

Valuation during Mergers & Acquisitions - CS Professional Study Material

You are required to advice the management the upper limit price which they can pay per share of Target Tyres Ltd., if a discount factor of 15% is considered appropriate.
Use the following Discount Factor Table:

Year 1 2 3 4 5 6 7 8 9 10
Discount Factor at 15% 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323 0.3759 0.3269 0.2843 0.2472

Answer:
(a) Computation of Operational Synergy expected to arise out of merger (₹ in lakhs):
Valuation during Mergers & Acquisitions - CS Professional Study Material 23

(b) Valuation of Target Tyres Ltd. (₹ in Iakhs)
Valuation during Mergers & Acquisitions - CS Professional Study Material 24
Total Valuation with Merger ₹ 5,325.81

Valuation during Mergers & Acquisitions - CS Professional Study Material

(c)

Total valuation with merger ₹ 5,325.81
Add: Cash to be collected on the disposal of assets 150
Machinery 400
Inventories 700 1,250
Less: Liabilities to be discharged on the takeover
Long term Borrowings 565
Bank Loan 78.50
Trade Payables 163.5
Other Current Liabilities 47.25
Employee Settlement 120
Investment to made on takeover 250
Present value of the investment to be made at the end of year 2[250*0.7561 ] 189.03 1,413.28
Maximum amount to be quoted 5,162.53

Total shares of Target Ltd.= 10 lakhs. Upper limit price per share to be quoted is ₹ 516.25 .

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 33.
Consider two firms that operate independently and have the following financial characteristics: (June 2014)
(₹ in millions)

Firm A Firm B
Revenues 8000 4000
Cost of goods sold 6000 2400
EBIT 2000 1600
Expected growth rate 4% 6%
Cost of capital 9% 10%

Both firms are in steady state wiih capital spending offset by depreciation. Both firms have an effective tax rate of 50% and are financed only by equity.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Scenario I
Assume that the combining of the two firms will create economies of scale that will reduce the cost of goods sold to 65%.
Scenario II
Assume that as a consequence of the merger the combined firm is expected to increase its future growth to 6% while cost of goods sold remains at 70% and does not come down to 65%.

Scenario I and Scenario II are mutually exclusive.

You are required to:
(i) Compute the value of both the firms as separate entities. (3 marks) [CMA Final]
(ii) Compute the value of both the firms together if there were absolutely no synergy at all from the merger (Scenario III). (1 mark) [CMA Final]
(iii) Compute the cost of capital and the expected growth rate for the combined entity. (2 marks) [CMA Final]
(iv) Compute the value of synergy in Scenario I and Scenario II. (3 marks) [CMA Final]
Answer:
(i) Value of the firms before the merger:
Calculation of free cash flow to each of the firm
Free cash flow to Firm A = EBIT (1 – tax rate)
= 2,000(1 – 0.50)
= 1,000
Free cash flow to Firm B = EBIT (1 – tax rate)
= 1,600 (1 – 0.50)
= 800
Value of the two firms independently:
Value of Firm A = [1,000 (1.04)] / (0.09 – 0.04)
= 20,800
Value of Firm B = [800 (1.06)] / (0.10 – 0.06)
= 21,200

Valuation during Mergers & Acquisitions - CS Professional Study Material

(ii) In the absence of synergy the combined firm value is:
Combined Firm Value with no synergy
= 20,800 + 21,200 = 42,000

(iii) On Combining the two firm the cost of goods sold is reduced from 70% to 65% of revenues. The revenue of the combined firms
= 8,000 + 4,000 = 12,000
= 0.65 × 12,000 = 7,800
Weighted average cost of capital for the combined firm
= 9% [20,800/42,000] + 10% [21,200/42,000]
= 0.0446 + 0.0505 = 0.0951
= 9.50% approximately
Weighted average expected growth rate for the combined firm
= 4% [20,800/42,000] + 6% [21,200/42,000]
= 0.0198 + 0.0303 = 0.0501
= 5% approximately

(iv) Value of Synergy
Scenario I
Revenues – ₹ 12,000 million
COGS (65%) – ₹ 7,800 million
EBIT – ₹ 4,200 million
PAT – ₹ 2,100 million
Cost of Capital – 9.504%
g (growth rate) – 5.01 %
Value = \(\frac{2,100(1.0501)}{0.09504-0.0501}\) = ₹ 49,070.09 million
Value of synergy = ₹ (49,070.09 – 42,000)million = ₹ 7,070.09 million

Valuation during Mergers & Acquisitions - CS Professional Study Material

Scenario II
Revenues – ₹ 12,000 million
COGS (70%) – ₹ 8,400 million
EBIT – ₹ 3,600 million
PAT – ₹ 1,800 million
Cost of Capital – 9.504%
g (growth rate) – 6% (5% for combination without synergy)
Value = \(\frac{1,800(1.06)}{(0.09504-0.06)}\) = ₹ 54, 452.06 million
Synergy Value = ₹ (54,452.06 – 42,000) million = ₹ 12,452.06 million

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 34.
Healthy Ltd. is planning to takeover Dull Ltd. and merged it with itself. The following information has been taken from the books of both the companies: (Dec 2014)

Balance Sheet as on March 31, 2014 (₹ in crores)

Equity and Liabilities: Healthy Ltd. Dull Ltd.
Equity Share Capital 4,000.00 2,200.00
Reserves and Surpius 5,250.00 3,250.00
Shareholders’ Funds 9,250.00 5,450.00
Non-Current Liabilities:
Long Term Debt 3,000.00 1,375.00
Deferred Tax Liabilities (Net) 670.00 450.00
Current Liabilities 2,060.00 13,640.00
Total Liabilities 14,980.00 8,615.00
Assets
Non-Current Assets:
Property, Plant and Equipment 9,745.00 4,310.00
Investments 1,650.00 900.00
Current Assets 3,585.00 3,405.00
Total Assets 14,980.00 8,615.00

Valuation during Mergers & Acquisitions - CS Professional Study Material

Profit and Loss Account for the year ending on March 31, 2014 (₹ in crores)

Particulars Healthy Ltd. Dull Ltd.
Income:

Net Revenue Other Income

Total Income

30,150.00

460.00

12,529.00

900.00

30,610.00 13,429.00
Less: Expenses

Total Operating Expenses Operating Profit

20,135.00 6,214.00
10,475.00 7,215.00
Less: Interest 375.00 171.88
Profit Before Tax 10,100.00 7,043.12
Less: (Tax @ 30%) 3,030.00 2,112.93
Profit After Tax 7,070.00 4,930.19
Price/Earning Ratio 21.80 15.25
Notes:

Valuation during Mergers & Acquisitions - CS Professional Study Material

Notes:

  • Face value of both companies shares is lo.
  • There will not be any synergy gain after merger of the companies.
  • The management of Healthy Ltd. believes that the PIE Ratio of the merged entity will be 22.50.

The management wants to determine the exchange ratio or swap ratio for the said merger in such a manner that the market price per share of the merged entity is maximum. Therefore, you are required to determine a suitable exchange ratio or swap ratio based on Book Value per share or EPS or Markt Price per share so that the market price per share of the merged entity is maximum. (10 marks) (CMA Final)
Answer:
Valuation during Mergers & Acquisitions - CS Professional Study Material 25

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 35.
Frontier Company Limited (FCL) is in negotiation for taking over Back Moving Company Limited (BMCL). The management of FCL is seeing strong strategic fit in taking over BMCL provided it is a profitable proposition. Mr. Guha, GM (Finance) has been asked to look into the viability of the probable takeover of BMCL. He has collected the following necessary information. (Dec 2014, 15 marks) [CMA Final]

Summarized Balance Sheet of Back Moving Company Limited (BMCL) as on March 31, 2014.
Valuation during Mergers & Acquisitions - CS Professional Study Material 26
Proposed Purchase Consideration:

  • 10.50% Debentures of FCL for redeeming 10% Debentures of BMCL – ₹ 44 crore.
  • 11% Convertible Preference Shares of FCL for the payment of Preference Shareholders of BMCL – ₹100 crore.
  • 12.50 crores of Equity Shares of FCL would be issued to the shareholders of BMCL at the prevailing market price of ₹ 20 each. . FCL would meet all dissolution expenses of ₹ 0.50 crores.

The management of FCL would dispose any asset and liability which may not be required after takeover:

  • Investments – ₹ 150 crores
  • Debtors – ₹ 15 crores
  • Inventories – ₹ 9.75 crores
  • Payment of Current Liabilities – ₹ 25 crores
  • All intangible assets will be written off

Valuation during Mergers & Acquisitions - CS Professional Study Material

The management of FCL would like to run the taken over company, BMCL, for next 7 years and after that, it would discontinue with it. It is expected that for the next 7 years, the taken over company would generate the following yearly operating cash flows after tax.

1 2 3 4 5 6 7
Operating Cash Flows After Tax (₹ in crores) 70 75 85 90 100 125 140

It is estimated that the terminal cash flows of BMCL would be ₹ 50 crores at the end of 7th year.

If the cost of capital of FCL is 16%, then you are required to find out whether the decision to takeover BMCL at the terms and conditions mentioned above will be a profitable decision ?

Year 1 2 3 4 5 6 7
Discounting Factor @ 16% 0.862 0.7432 0.641 0.552 0.476 0.41 0.3538

Answer:
Valuation during Mergers & Acquisitions - CS Professional Study Material 27
Since the present Value of the future cash flows is more than the cost of acquisition, it will be a profitable proposition to take over the said company, BMCL

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 36.
The bidding company B Ltd. is contemplating a merger with the target company, T Ltd. so as to form the merged B Ltd. under two distinct situations X and Y. You are provided with the following information about the proposed merger: (June 2015)

Company B Ltd. T Ltd.
EAT'(₹ lakh) 40 12.5
No. of Equity Shares (in lakh) 5 2
P/E ratio 12.5 20

Situation X:
There is no synergy in earnings, but PIE of merged B Ltd. will stand at 15. Merger is based on market value of shares.
Situation Y:
Post merger PIE stands at that of stand-alone S Ltd., but earnings of the merged entity rises by 20% over the aggregate earnings of B Ltd. and T Ltd. Swap ratios 1.3 for every share of T Ltd.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Find for both the situations X and Y:
(i) Post merger EPS. (3 marks) (CMA Final)
(ii) Post merger market value per share. (2 marks) (CMA Final)
(iii) Synergy due to merger. (2 marks) (CMA Final)
(iv) Gain/’oss for merger to shareholders of B Ltd. and T Ltd. (a) in value of share holdings and (b) in earnings available to them. (4+4= 8 marks) (CMA Final)
Answer:
Valuation during Mergers & Acquisitions - CS Professional Study Material 28
@ MC = EAT × PIE = 52.5 × 15 = 787.50 & 63 × 12.5 = 787.50
# (125/1 00) × 2 = 2.5 for × and 1.3 × 2 =2.6 torY
$ (52.5/7.5) = 7 for X and (63/7.6) = 8.29 for Y
Valuation during Mergers & Acquisitions - CS Professional Study Material 29
**(0667 × 52.5) = 35 (rounded off) for B and (0.333 × 52.5) = 17.5 (rounded off) for T under X;
(0.6579 × 63) = 41.45 (rounded off) for B and (0.3421 × 63) = 21.55 (rounded off) for T under Y.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 37.
M Limited wants to takeover N Limited and their Summarized Balance Sheet as on March 31. 2015 are give below: (Dec 2015)
Valuation during Mergers & Acquisitions - CS Professional Study Material 30
I. Using the above information, what should be the share exchange ratio
to be offered to the shareholders of N Limited by M Limited based on:
(i) Net Worth .
(ii) Earnings Per Share (EPS)
(iii) Market Price
II. Suggest which one out of the above basis should be preferred by N Limited?
III. Assuming that there are no synergy gains, then determine the EPS after merger if the exchange ratio is one as suggested in (II) above. (9+2+4= 15 marks) (CMA Final)
Answer:
(i)
Valuation during Mergers & Acquisitions - CS Professional Study Material 31
Exchange Ratio is 2.00:1.56; or 2.00/1.56 = 1.282
It means is (17.50 × 1.282 = 22.435) crores shares of M Limited will be issued to the shareholders of N Limited.

M Limited N Limited
Market Price Per Share ₹ 75.00 ₹ 45.00

Exchange Ratio is 45:75; or 45/75 = 0.60.
It means is (17.50 × 0.60 = 10.50) crores shares of M Limited will be issued to the shareholders of N Limited.

Valuation during Mergers & Acquisitions - CS Professional Study Material

(ii) Since the shareholders of N Limited are getting maximum number of shares -26 crores when the Exchange Ratio is fixed as per the Book Value or Net Worth, Shareholders of N Limited will prefer fixing of the Exchange Ratio as per Net Worth.

(iii)

Total PAT after Merger (78 + 35)

Total No. of Shares assuming that Exchange Ratio is determined as per Book Value (50 + 26)

₹ 113.00

76

 

EPS after Merger will be ₹ 1.49

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 38.
Answer the following:
If value of B Ltd. is ₹ 50 lakhs, T Ltd. is ₹ 20 lakhs, and on merger their combined value is ₹ 94 lakhs and B Ltd. receives premium on merger ₹ 13 lakhs, then what is the synergy gain? (June 2016, 2 marks) [CMA Final]
Answer:
Synergy gain = Combined Value – Value of merging companies
= ₹ [94 – (50 + 20)] lakhs = ₹ 24 lakhs.

Question 39.
A Limited and B Limited are in negotiations in which A Limited has expressed the desire to acquire B Limited and it is decided that A Limited will acquire B Limited. For this, purpose, the following information has been extracted from the books of both the companies for F.Y. 2015-16. (June 2016)
Valuation during Mergers & Acquisitions - CS Professional Study Material 32
Valuation during Mergers & Acquisitions - CS Professional Study Material 33

In a joint meeting of the directors of both companies, the following decisions are taken:
(i) The swap ratio will bedecided by considering the following parameters
with the weights as given below:
(a) Book Value – 25%
(b) Market Price – 40%
(c) EPS – 25%
(d) Net Profit Ratio – 10%

Valuation during Mergers & Acquisitions - CS Professional Study Material

(ii) All assets and liabilities will be taken over by A Limited at book values.
(iii) The combined profit will increase by 10% due to synergy gains arising because of higher scale of operations.
(iv) It is expected that the market will look this decision of A Limited as ‘a value creator’ decision and consequently, it is expected that A Limited’s PIE Ratio will increase by 10% from Its existing level after the acquisition of B Limited.

Given the above information, you are required to compute assuming that the acquisition will be completed as per the terms given.
(a) The Swap Ratio
(b) Book Value per share of A Limited after acquisition
(c) Earnings per share of A Limited after acquisition
(d) Market Price of A Limited’s share after acquisition (7+3+3+3 = 16 marks) (CMA Final)
Answer:
Valuation during Mergers & Acquisitions - CS Professional Study Material 34

(i) It means that the Swap Ratio is – 0.712 shares of A Limited for every share of B Limited.
Therefore, total no. of shares to be issues by A Limited (20 × 0.712) – 14.24

Net Worth of A Limited after acquisition:
Share Capital (30 +14.24) × 10 – ₹ 442.40
Reserves and Surplus (3210 +1 356) – ₹ 4,566.00
Net Worth of A Limited after acquisition – ₹ 5,008.40
Book Value per Share – ₹ 113.21

(ii) Net Profit of A Limited after acquisition
Considering 10% synergy gain
=(312 + 175) × 1.1 = ₹ 535.70

(iii) EPS – 12.11
PIE ratio of A Limited before acquisition (175 ÷1 0.40) = 16.83
New PiE Ratio of A Limited after acquisition (10% synergy impact) – 18.51

(iv) Therefore, Market Price (18.51 × 12.11) – 224.16
* Note: Capital Reserve of ₹ 57.60 lakhs arising on takeover of all assets and liabilities by A Ltd. at book value is not considered as it is not a part of distributable surplus. If the same is included Net worth is ₹ 5,066 lakhs & book value is ₹ 114.51.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 40.
(a) The following information is provided in relation to the acquiring firm M Ltd. and the target firm P Ltd.:
Valuation during Mergers & Acquisitions - CS Professional Study Material 35

Required:
(i) What is the swap ratio in terms of current market price?
(ii) What is the EPS of M Ltd. after acquisition?
(iii) What is the expected market price per share of M Ltd. after acquisition assuming that P/E ratio of M Ltd. remains unchanged?
(iv) Determine the market value of the merged firm. (Dec 2016, 12 marks) [CMA Final]

(b) A Ltd. is planning to acquire T Ltd. and the following information is provided in relation to the acquisition about both the companies:
Valuation during Mergers & Acquisitions - CS Professional Study Material 36
Required:
(i) What will be the swap ratio if it is to be determined on the basis of market prices? (2 marks) [CMA Final]
(ii) Assuming that the swap ratio is on the basis of market price, what will be the market value of A Ltd. after acquisition if the merged entity is expected to have a P/E ratio of 20? (2 marks) [CMA Final]
Answer:
(a)

Particulars M Ltd. P Ltd.
Earnings after tax (₹) 200 lakhs 40 lakhs
Number of shares outstanding 20 lakhs 10 lakhs
P/E Ratio 10 5
ESP 10 4
Market price (?) 100 20

(i) Swap ratio in terms of market prices: 20/100 = 0.20
(ii) EPS of M Ltd. after acquisition: (200 + 40)/(20 +.2 × 10) = 240/22 or say ₹ 10.91
(iii) Expected market price per share of M Ltd. with the same P/E ratio of 10 will be: 10.91 × 10 = ₹ 109.10
(iv) Market value of merged firm:
Total number of outstanding shares × market price
= ₹ 2,400.2 lakhs.

Valuation during Mergers & Acquisitions - CS Professional Study Material

(b)
Valuation during Mergers & Acquisitions - CS Professional Study Material 37

Question 41.
(a) The following information is provided related to the acquiring firm, Sun Ltd. and the target firm Moon Ltd.

Particulars Sun Ltd. Moon Ltd.
Profits after Tax ₹ 2,000 Lakh ₹ 4,000 Lakh
Number of Shares outstanding 200 Lakh 1,000 Lakh
P/E Ratio (times) 10 5

Required:
(i) What is the swap ratio based on the current market prices?
(ii) What is the EPS of Sun Ltd., after the acquisition? (June 2017 10 marks) (CMA Final)

(b) X Ltd. is considering a takeover of Y Ltd. The particulars of the two companies are given below:

Particulars X Ltd. Y Ltd.
Earnings after Tax (EAT) in ₹ 20,00,000 10,00,000
Equity Shares (Nos.) 10,00,000 10,00,000
EPS 2 1
P/E Ratio (times) 10 5

Valuation during Mergers & Acquisitions - CS Professional Study Material

Required:
(i) What is the market value of each company before merger?

(ii) Assuming that the management of X Ltd. estimates that the shareholders of Y Ltd. will accept an offer of one share of X Ltd. for four shares of Y Ltd. If there are no synergic effects, what is the market value of the Post-merger X Ltd.? Are the shareholders of X Ltd. better off than they were before the merger?

(iii) Due to synergic effects, the management of X Ltd. estimates that the earnings will increase by 20%. What is the new Post-merger EPS and the Price per Share? Will the shareholders be better-ott or worse-off? (10 marks) (CMA Final)
Answer:
(a) EPS before acquisition
Sun Ltd., = ₹ 2,000 / Lakhs = ₹ 10.
Moon Ltd., = ₹ 4,000 Lakhs / 1,000 Lakhs = ₹ 4.
Market Price of shares before acquisition
Sun Ltd.,= ₹ 10 × 10 = ₹ 100.
Moon Ltd., = ₹ 4 × 5 = 20.

(i) Swap ratio based on current market price:
= ₹ 20/₹ 100 = 0.2 i.e. 1 share of Sun Ltd., for 5 shares of Moon Ltd.,
No. of shares to be issued = 1,000 Lakhs × 0.20 Lakh = 200 Lakhs.

(ii) EPS after acqulsetions:
(₹ 2,000 Lakhs + ₹ 4,000 Lakhs) / (₹ 200 Lakhs + ₹ 200 Lakhs)
= ₹ 6,000Lakhs/ ₹ 400Lakhs = ₹ 15.

Valuation during Mergers & Acquisitions - CS Professional Study Material

(b)
(i) Market Value of Companies before merger:
Valuation during Mergers & Acquisitions - CS Professional Study Material 38
Thus, the shareholders of both the companies have gained from the merger.

(iii) Post-merger Earnings:
Increase in earnings by 20%
New earnings: ₹ 30,00,000 × 120% = ₹ 36,00,000
No. of Equity Shares = ₹ 12,50,000
EPS = ₹ 36,00,000/12,50,000 = ₹ 2.88
PIE Ratio = 10
Market Price/Share = ₹ 2.88 × 10
= 28.80
Therefore, shareholders will be better-off.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 42.
R. Ltd. is intending to acquire S Ltd. (by merger) and the following information are available in respect of both the companies:

Particulars R Ltd. S Ltd.
Total Current Earnings (₹) 2,50,000 90,000
No. of Outstanding Shares 50,000 30,000
Market Price per Share (₹) 21 14

(i) What is the present EPS of both the companies?
(ii) If the proposed merger takes place, what would be the new earnings per share for R Ltd. (assuming the merger takes place by exchange of Equity Shares and the Exchange Ratio ¡s based on the Current Market Price)? Assume no synergy impact. (June 2017, 10 marks)
Answer:
(I) EPS = Total earnings /No. of Equity shares
EPSR Ltd. = ₹ 2,50,000150,000 = ₹ 5.
EPSS Ltd. = ₹ 90,000/30,000 = ₹ 3.

(ii) No. of shares S Ltd., shareholders will get in R Ltd., based on market prices of shares ¡s as follows:
Exchange Ratio= 14121 = 2/3 i.e., for every 3 shares of S Ltd.,
2 Shares of R Ltd., Total No. of shares of R Ltd., issued = (14/21) × 30,000 = 20.000 shares.
Total number of shares of R Ltd., after merger 50,000 + 20000 = 70,000.
Total earning of R Ltd., after merger = ₹ 2,50,000 + ₹ 90,000 = ₹ 3,40,000 (No synergy given)
The new EPS of R Ltd., after merger = ₹ 3,40,000/70,000 = ₹ 4.86.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 43.
A Ltd., is considering the acquisition of B Ltd., with stock. Relevant financial information is given below:

Particulars A Ltd. B Ltd.
Present earnings (₹) 7.5 Lakhs 2.5 Lakhs
Equity (no. of shares) 4.0 Lakhs 2.0 Lakhs
EPS (₹) 1.875 1.25
P/E ratio 10 5

Answer the following questions:
(i) What is the market price of each company?
(ii) What is the market Capitalization of each company?
(iii) If the P/E of A Ltd., changes to 7.5, what is the market price of A Ltd.?
(iv) Does market value of A Ltd., change?
(v) What would be the exchange ratio based on Market Price? (Take the revised price of A Ltd.) (Dec 2017, 2 × 5 = 10 marks)
Answer:
(i) P/E = Market Price/EPS.
Therefore, we have, Market Price = P/E × EPS A Ltd.’s
Market Price = 10 × 1.875 = ₹ 18.75
B Ltd.’s Market Price = 5 × 1.25 = ₹ 6.25.

(ii) Market Capitalization (Same as market value or in short referred to as market cap) = Number of outstanding shares × market price
A Ltd.’s Market cap = 4.0 lakhs × ₹ 18.75 = ₹ 75 Lakhs
B Ltd.’s Market cap = 2.0 Lakhs × ₹ 6.25 = ₹ 12.5 Lakhs

(iii) If the P/E of A Ltd., changes to 7.5, then the market price is given by
= 7.5 × ₹ 1.875 = ₹ 14.0625

(iv) Yes. The market value decreases, i.e., = A Ltd.’s market value = 4.0 Lakhs × ₹ 14.0625 = ₹ 56.25 Lakhs

(v) General Formula for exchange ratio = MPS of Target Firm / MPS of acquiring Firm = 6.25/14.0625 = 0.44.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 44.
The shareholders of A Co. Ltd., have voted in favour of a buyout offer from B Co. Ltd. Information about each firm is given here below. Moreover, A Co. Ltd.’s shareholders will receive one share of B Co. Ltd. Stock for every three shares they hold in A Co. Ltd.

Particulars A Co. Ltd. B Co. Ltd.
Present earnings (₹) 6.75 3.00
EPS (₹) 3.97 5.00
Number of share (Lakhs) 1.70 0.60
P/E ratio 20 5

(i) What will the EPS of Co. Ltd., will be after the merger? What will the PE ratio if the NPV of the acquisition is zero?
(ii) What must B Co. Ltd. feel would be the value of the synergy between these firms? (Dec 2017, 10 marks) [CMA Final]
Answer:
(i) The EPS of the combined company will be the sum of the earnings of both companies divided by the shares in the combined company. Since the stock offer is one share of the acquiring firm for three shares of the target firm, new shares in the acquiring firm will increase by one-third (Exchange ratio = 1/3)
So, the new EPS will be = (₹ 3,00,000 + 6,75,000) / [1,70,000 + (1/3)(60,000)]
= (9,75,000/1,90,000)
= ₹ 5.132.
The market price of B Co. will remain unchanged if it is a zero NPV acquisition. Using the P/E ratio, we find the current market price of B Co. stock, which is = P/E × EPS = 20 × (6.75 lakhs /1.70 lakhs) = 20 × (3.97) = ₹ 79.40

Valuation during Mergers & Acquisitions - CS Professional Study Material

(ii) If the acquisition has a zero NPV, the stock price should remain unchanged. Therefore, the new P/E will be = P/E = ₹ 79.40 / ₹ 5.132 = 15.47.

(iii) If the NPV of the acquisition is zero, it would mean that B Co. would pay just the market value of A Co. i.e., Number of shares x market price of A Co. i.e.,
= 60,000 × 25 (MPS = P/E × EPS = 5×5 =25)
The market value received by B Co. = ₹ 15,00,000.
The cost of the acquisition is the number of shares offered times the share price, so the cost is = (1/3) (60,000) (₹ 79.40) = ₹ 15,88,000.
The difference is synergy i.e., ₹ 88,000.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 45.
Q Ltd. wants to acquire R Ltd. and has offered a swap ratio of 1: 2 (0.5 shares for every one share of R Ltd.).
Following information is provided:

Particulars Q Ltd. R Ltd.
Profit after tax (₹) 18,00,000 3,60,000
Equity shares outstanding (Nos.) 6,00,000 1,80,000
EPS (₹) 3 2
P/E Ratio 10 times 7 times
Market price per share (₹) 30 14

Required:
(i) The number of equity shares to be issued by Q Ltd., for acquisition of R Ltd.
(ii) What is the EPS of Q Ltd., after the acquisition?
(iii) Determine the equivalent earnings per share of R Ltd.
(iv) What is the expected market price per share of Q Ltd., after the acquisition, assuming its P/E multiple remains unchanged?
(v) Determine the market value of the merged firm. (Dec 2017, 2 × 5 = 10 marks) [CMA Final]
Answer:
(i) The Number of Shares to be issued by Q Ltd.:
The Exchange ratio is 0.5
So, the new shares = 1,80,000 × 0.5 = 90,000 shares.

(ii) EPS of Q Ltd., after acquisition:

Total Earnings = ₹ (18,00,000 + 3,60,000) ₹ 21,60,000
No. of Shares (6,00,000 + 90,000) 6,90,000
EPS (₹ 21,60,000) / 6,90,000 ₹ 3.13

Valuation during Mergers & Acquisitions - CS Professional Study Material

(iii) Equivalent EPS of R Ltd.,

No. of Shares 0.5
EPS (₹) 3.13
Equivalent (3.13 × 0.5) (₹) 1.57

(iv) New Market Price of O Ltd., (P/E remaining unchanged):

Present P/E Ratio of Q Ltd., 10 times
Expected EPS after merger (₹) 3.13
Expected Market Price (3.13 × 10) (₹) 1.57

(v) Market Value of merged firm:

Total number of Shares 6,90,000
Expected Market Price (₹) 31.30
Total Value (6,90,000 × 31.30) (₹) 2,15,97,000

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 46.
Vodafone Ltd. is considering a merger with Idea Ltd. The data below are in the hands of both Board of Directors. The issue at hand is how many shares of Vodafone Ltd. should be exchanged for Idea Ltd. Both boards are considering three possibilities 20000, 25000 and 30000 shares. You are required to construct a table demonstrating the potential impact of each scheme on each set of shareholders. (June 2018, 10 marks)

Vodafone Ltd. Idea Ltd. Combined Post merger Firms ‘A’
1 Current earnings per year (₹) 2,00,000 1,00,000 3,50,000
2 Shares outstanding 50,000 10,000 ?
3 Earnings per share (₹) (1 ÷ 2 4 10 ?
4 Price per share (₹) 40 100 . ?
5 Price-earning ratio [4 ÷ 3] 10 10 10
6 Value of firm (₹) 20,00,000 10,000,00 35,00,000
7 Expected annual growth rate in earnings in foreseeable future 0 0 0

Answer:
The following table demonstrates the potential impact of the three possible schemes, on each set of shareholders:
Valuation during Mergers & Acquisitions - CS Professional Study Material 39
The total synergy gain is ₹ 5,00,000. In the three options both sets of shareholders are benefitted differently. Thus, Idea shareholders benefit maximum if they receive 30,000 shares of Vodafone. They do not benefit at all if they receive only 20,000 shares. The deal is likely to be settled at ₹ 25,000 shares.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 47.
Pure Drugs Limited is in the Pharmaceutical Industry and has a business strategy of growing inorganically. It is contemplating to acquire Solid Drugs Limited which has a strong hold in cardiac segment. Pure Drugs Limited has 30 crore shares outstanding which are trading on an average price of ₹ 300 while Solid Drugs Limited has outstanding shares 20 crore and are selling at an average price of ₹ 200 per share. The EPS are of ₹ 12 and ₹ 6 for Pure Drugs Limited and Solid Drugs Limited respectively. Recently, the management of both the companies had a meeting wherein number of alternative proposals was considered for exchange of shares. They are-

(i) Exchange Ratio should be in proportion to the relative EPS of two companies.
(ii) Exchange Ratio should be in proportion to the relative share prices of two companies.
(iii) Exchange Ratio should be 3 shares of Pure Drugs Limited for every 5 shares of Solid Drugs Limited.

You are required to estimate EPS and Market Price under the three options, assuming the P/E of Pure Drugs Limited after merger will remain unchanged. Assume that there will not be any synergy gains due the said merger. (June 2018, 4 + 4 = 8 marks) [CMA Final]
Answer:

Pure Drugs Limited Solid Drugs Limited
EPS (₹) 12 6
No. of Outstanding Shares (in crores) 30 20
Net Profit (in ₹ crores) 360 120
Net Profit (in ₹ crores) after Acquisition 480
Price of Share 300 200
P/E Ratio 25.00 33.33

Valuation during Mergers & Acquisitions - CS Professional Study Material

Alternative – I (Basis-EPS) Alternative – II (Basis-Prices) Alternative – III (Basis-3 shares for 5 shares)
Exchange Ratio (No. of Shares of Pure Drugs Limited for each share of Solid Drugs Limited) 0.50 0.67 0.60
New Shares to be issued (in Crores) 10 13.40 12
Total No. of Shares after Acquisition (in crores) 40 (30 + 10) 43. 40 (30 + 13.40) 42 (30+12)
EPS (in ₹) after Acquisition Given ₹ 480 crores of Profit Acquisition 12.00 11.06 11.43
Given the P/E Ratio of 25, the Share Price of Pure Drugs Limited will be – (in ₹) 300.00 276.50 285.71

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 48.
Hard Company Limited is planning to acquire Soft Company Limited and merge it with the Company. The following financial information has been extracted from the respective Annual Reports of 2018 of these companies:
Valuation during Mergers & Acquisitions - CS Professional Study Material 40
Required:
(i) What is the market price of each company’s share before merger?

(ii) Assuming that the management of Hard Company Limited (HCL) estimates that the shareholders of Soft Company Limited (SCL) will accept an offer of one share of HCL for four shares of SCL. If there are no synergic effects and post-merger Price/Earnings Ratio remains unchanged, then what will be the market price of the post-merger HCL share?

(iii) Will the shareholders of HCL be better or worse off than they were before the merger?

(iv) Due to synergic effects, the management of HCL estimates that the earnings will increase by 20%. In such a case, what will be the new post-merger EPS and price per share if the new Price/Earnings Ratio of HCL will be 15? Will the shareholders be better off or worse off than before the merger? (Dec 2018, 20 marks)
Answer:
(i)
Valuation during Mergers & Acquisitions - CS Professional Study Material 41

(ii)
Valuation during Mergers & Acquisitions - CS Professional Study Material 42

Valuation during Mergers & Acquisitions - CS Professional Study Material

(iii) After merger the price of HCL share has increased from ₹ 96.00 to ₹ 99.17. It shows that the HCL shareholders will be benefited from the merger.

(iv)
Valuation during Mergers & Acquisitions - CS Professional Study Material 43

(v) After merger and having synergic gains, the price of HCL share has increased from ₹ 96.00 to ₹ 124.80. It shows that the HCL shareholders will be benefitted from the merger.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 49.
You are the Director of Ram & Company. One of the projects you are considering is the acquisition of Shyam & Company. Shyam, the owner of Shyam & Company, is willing to consider selling his company to Ram & Company if he is offered an all-cash purchase price of ₹ 5 million. The project estimates that the purchase of Shyam & Company will generate the following profit after-tax cash flow:
Year – Cash Flow (in ₹)
1 – 10,00,000
2 – 15,00,000
3 – 20,00,000
4 – 25,00,000
5 – 30,00,000
If you decide to go ahead with this acquisition, it will be funded with Ram’s standard mix of debt and equity at the firm’s weighted average (after-tax) cost of capital of 9 per cent. Ram’s tax rate is 30 per cent. Should you recommend acquiring Shyam & Company to your CEO? PVF @ 9 per cent is: (Dec 2018, 12 marks)

Year 1 2 3 4 5
PVF 0.917 0.842 0.772 0.708 0.650

Answer:

Year Cash Flow (₹) PVF (at 9%) PV of cash flow
1 10,00,000 .917 9,17,000
2 15,00,000 .842 12,63,000
3 20,00,000 .772 15,44,000
4 25,00,000 .708 17,70,000
5 30,00,000 .650 19,50,000
Total value of the project ₹ 74,44,000 (total of PV cash flow

Since the value of Shyam and Company is ₹ 74,44,000 a figure greater than minimum desired amount of ₹ 50 lakhs to be paid to Shyam and Company, Ram and Company can consider buying Shyam and Company.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 50.
A Private Limited Company has already in the business of manufacture and sale of imitation jewellery, is planning to take over the business of a similar Company (Target Company). Before take over the Management has approached you as Valuation consultant, to suggest on future profitability and valuation. Following information is obtained from the existing Management:

(i) The Target Company is doing business in 2 Segments i.e., wholesale and Retail. In Retail Segment there are two categories of products – budget and premium.

(ii) In the Retail Segment, the estimated Annual sale in the next financial period for the budget category is ₹ 200 Lakh and premium category is ₹ 100 Lakh. The sales for budget category is expected to grow by 20% year on year. Premium category is expected to grow 10% year on year.

(iii) In the Wholesale Segment-Company is having Annual orders for ₹ 200 Lakh. (Credit period allowed to Debtors is 2 months).The demand in this segment is expected to grow by 25% year on year.

(iv) Raw materials form 35% of the sale value for budget category and the Wholesale Segment, while they form 45% for the premium category. Creditors give one month credit for raw material purchased.

(v) The variable processing cost is 25% of the sale value for budget category and 15% of the sale value for premium category while it is 25% of the sale value in the case of Wholesale Segment.

Valuation during Mergers & Acquisitions - CS Professional Study Material

(vi) Fixed costs are expected as follows: Rent ₹ 3,00,000 per month for processing and storage unit and ₹ 15,000 per month each for Ten showrooms. In third year 10% addition is expected for rent and thereafter there will be no change in rent for next 3 years. Administration overheads are expected at 10% of Sales for next 3 years. Rent of storage unit is to be apportioned between budget, premium and wholesale in their respective sales ratio and Rent for showroom is to be apportioned only to budget and premium categories in their respective sales ratio.

(vii) 10% of raw material requirements for all categories/segments are to be maintained as inventory.

(viii) The Equity Capital of the Company is ₹ 100 Lakh (10,00,000 Equity shares of ₹ 10 each ) and the Company has a Term loan of ₹ 200 Lakh which is to be repaid in next 5 years with an interest of 10%, per annum (Interest is to be apportioned between budget, premium and wholesale in their respective sales ratio). Further, the Company has overdraft facility which carries an interest of 12% per annum, which will be availed in case of negative cash flows. (Interest on overdraft also to be apportioned between budget, premium and wholesale in their respective sales ratio).

(ix) The Company has the policy of maintaining minimum Bank Balance of ₹ 25 Lakh.

(x) The investment in plant and machinery is ₹ 200 Lakh and 15% per annum Depreciation is charged on straight line basis. Depreciation is to be apportioned between budget, premium and wholesale in their respective sales ratio.

(xi) Company has Furniture, Fittings, Computers and other assets of ₹ 100 Lakh and it is depreciated at 10% per annum on straight line basis. Depreciation is to be apportioned between budget, premium and wholesale in their respective sales ratio.

Valuation during Mergers & Acquisitions - CS Professional Study Material

(xii) Tax rate to be assumed at 25%.
(xiii) Discount Rate can be considered as 10% (Discount factors are as below):

Year 1 Year 2 Year 3
0.9091 0.8264 0.7513

(xiv) The risk free rate of return is 6% and the Market risk premium is 9%. Industry Beta is 1.125. Beginning period debt and equity value can be considered for Debt Equity Ratio (Overdraft can be ignored; for debt equity ratio). Growth to perpetuity can be assumed at 3%.

Based on the above information on Target Company, answer the following questions:
(a) Prepare projected Income Statement for 3 years (Category-wise and total)
(b) (i) Prepare projected Balance Sheets for 3 years and also calculate (ii) cost of Eauity using CAPM model and (iii) Weighted Average Cost of Capital (WACC).
(c) Find out (i) Free Cash Flows to the Firm (FCFF) and (ii) Free Cash Flows to Equity (FCFE) (iii) Find out which category has highest EBITDA/Sales Ratio and PAT/Sales Ratio over the 3 years.
(d) (i) The Management would like to know the expected Value of the Target Company and the share price it can offer to buy the Company, (ii) What are the type of companies where management may find difficulties in using Discounted cash Flow Technique for Valuation? (June 2019, 10 marks each)
Answer:
(a)
Valuation during Mergers & Acquisitions - CS Professional Study Material 44
Year 3
Valuation during Mergers & Acquisitions - CS Professional Study Material 45

Valuation during Mergers & Acquisitions - CS Professional Study Material

(b) (i) Projected Balance Sheet for 3 Years
Valuation during Mergers & Acquisitions - CS Professional Study Material 46

(b) (ii) Cost of Equity using Capital Asset Pricing Model (CAPM)
E(Ri) = R1 + βi [E(RM) – R1]
E(Ri) = Expected return on Security
R1 = Risk free Rate
E(RM) – Expected return on Market [E(RM) – Rf] = Market Risk Premium
Bi = Beta
E(Ri) = 6 + 1.125 × 9 = 16.125
Therefore, Cost of Equity = 16.125%

(b)(iii)
Weighted Average Cost of Capital = WACC
WACC = WErE + WDrD(1 – T) + Wprp
Debt Equity Ratio is 2:1
So, 1/3 × 16.125 + 2/3 × 10 (1 – 0.25)
= 5.375 + 5.000
= 10.375%

Valuation during Mergers & Acquisitions - CS Professional Study Material

(c) (i) Free Cash Flows to the Firm
Valuation during Mergers & Acquisitions - CS Professional Study Material 47

(c) (ii) Free Cash Flows to Equity
Valuation during Mergers & Acquisitions - CS Professional Study Material 48

(c) (iii)
Valuation during Mergers & Acquisitions - CS Professional Study Material 49

(d) (i)
Valuation during Mergers & Acquisitions - CS Professional Study Material 50

(d) (ii) Types of companies where we may find difficulties in using discounted cash flow valuation are:
(a) Private firm which is being managed by few individuals, the success of the firm largely depends on the skills of the people controlling the same. It would be difficult to separate the individuals and the firm.

The other employees may not be contributing intellectually so much to the success of the firm. A biotechnology firm, with no current product or sales, but with several promising product patents in the pipeline. Difficulty may be in estimating the future sales, profits and in turn near term cash flows.

Valuation during Mergers & Acquisitions - CS Professional Study Material

(b) A cyclical firm, during recession. The subsequent impact could be adverse / worsening debt / equity ratios and ROI may also be affected which may create problems.

(c) A troubled firm, which is in the process of restructuring, where it is selling some of its assets and changing its financial mix. Using the historical data for earnings growth and cash flows of the firm may not give true picture and may lead to error/uncertainty in the valuation.

(d) A firm which owns a lot of valuable land which is currently unutilized. It would be very difficult to estimate the future earning from the same, which may lead to under valuation or overvaluation of the firm.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 51.
“Combined Value = Stand alone value of acquiring firm (Va) + Stand alone value of acquired target firm (Vt) + Value of Synergy ∆Vat” -Discuss this equation with reference to Synergy benefits in Merger of Companies. (June 2019, 5 marks)
Answer:
Synergy results from complementary activities. For example, one firm may have a substantial amount of financial resources while the other has profitabfe investment opportunities. Likewise, one firm may have a strong research and development team whereas the other may have a very efficiently organized production department.

Similarly, one firm may have well established brands of its products but lacks marketing organization and another firm may have a very strong marketing organization. The merged business unit in all these cases will be more efficient than the individual firms and hence, the combined value of the merged firms is likely to be grater than the sum of the individual entities (units) due to synergy created which enhances the operational efficiency and more business value.

Accordingly, the combined value of the firm is calculated using the following formulae:
Combined Value = Standalone value of acquiring firm (Va) + Standalone value of acquired target firm (Vt) + Value of synergy ∆Vat.

Normally, the value of synergy is positive and this constitutes the rational for the merger. In valuing synergy, costs attached with acquisitions should also be taken into account. These costs primarily consist of costs of integration and payment made for the acquisition of the target firm, in excess of its value, Vt.

Therefore, the net gain from the merger is equal to the difference between the value of synergy and costs.
Net gain = Value of synergy ∆Vat – Costs.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 52.
(a) Two firm X and Y operating in the cement industry. Both the firms are planning for a merger. Firm X is worth ₹ 200 lakh and Y is worth ₹ 50 lakh. On merging, the two would allow cost savings with a present value of ₹ 25 lakh. Assume that Y is bought by X for a cash of ₹ 65 lakh. Estimate:
(i) The value of the combined firm
(ii) The cost of the merger for firm
(iii) The NPV to Y’s shareholders
(iv) The NPV to X’s shareholders (June 2019, 10 marks) [CMA Final]
Answer:
(a) (i) Let the value of the combined firm be presented as PVXY and the value of the two separate firms can be represented as PVX and PVY Gain the difference between the value of the combined firm and the sum of the values of two individual firms. It given as:
Gain = PVXY – (PVX + PVY)
PX = ₹ 200 lakhs, PY = ₹ 50 lakhs and
Gain = ₹ 25 lakhs
Gain = PVXY (PVX + PVY)
25 = PVXY – (200 + 50)
(Value of the combined firm) PVXY = ₹ 275 lakhs

(ii) Cost of the Merger, for firm X = Cash paid – PVY
= ₹ (65 – 50) lakhs = ₹ 15 lakhs

(iii) NPV to Y‘s shareholders = The gain of Y‘s shareholders is the cost firm X i.e. ₹ 15 lakhs. This means, of the ₹ 25 lakhs gain, firm Y has contributed ₹ 15 lakhs.

(iv) NPV to X‘s shareholders = Overall gain from the merger less Cost to acquire Y = ₹ (25 – 15) lakhs = ₹ 10 lakhs.

Valuation during Mergers & Acquisitions - CS Professional Study Material

(b) Deepika Ltd. is a highly successful company and wishes to expand by acquiring other firms. Its expected high growth in earnings and dividends is reflected in its price-earning (P/E) ratio of 17. The Board of Directors of Deepika Ltd. has been advised that if it were to takeover firm with a lower P/E ratio than its own, using a share-for-share exchange, it could increase its reported earnings per share.

Alia Ltd. has been suggested as a possible target for takeover, which has a P/E ratio of 10 and 10,00,000 shares in issued with a share price of ₹ 15 each. Deepika Ltd. has 50,00,000 shares in issue with a share price of ₹ 12 each.

Calculate the change in earnings per share of Deepika Ltd., if it acquire Alia Ltd. shares for ₹ 15 per share, assume that the price of Deepika Ltd. shares remains constant. (10 marks)
Answer:
Valuation during Mergers & Acquisitions - CS Professional Study Material 51
Total earnings after takeover = ₹ 35,30,000 + ₹ 15,00,000 = ₹ 50,30,000
Number of shares offered by Deepika Ltd. to Alia Ltd.,
= 10,00,000 × 15/12 = 12,50,000 shares
EPS of combined entity = \(\frac{₹ 50,30,000}{50,00,000+12,50,000}\) = 0.8048
Increase in earnings per share = 0.8048 – 0.7060 = ₹ 0.0988.

Note: Current P/E of Deepika Ltd. = 17
Price offered to Alia Ltd. = 15
Implied P/E ratio = Price offered ÷ EPS of Alia Ltd. = 15 ÷ 1.5 = 10
This P/E is less than P/E of Deepika Ltd.
Therefore such a deal would result in a higher EPS after acquisition.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 53.
Rachna Limited is considering a takeover of Mona Limited. The particulars of two companies are given below:

Particulars Rachna Limited Mona Limited
Earnings after tax (₹) 20,00,000 10,00,000
Equity shares (Number) 10,00,000 10,00,000
Earnings per share 2 1
Price earnings ratio (times) 10 5

You are required to give following:
(i) What is the market value of each company before merger?
(ii) Assuming that the management of Rachna Limited estimates that the shareholders of Mona Limited will accept an offer of one share of Rachna Limited for four shares of Mona Limited. What is the market value of the post-merger effect on Rachna Limited? Are the shareholders of Rachna Limited better or worse off than they were before the merger?
(iii) Due to synergic effects, the management of Rachna Limited estimates
that the earnings will increase by 25%. What will be the market price per share? (June 2019, 10 marks) [CMA Final]
Answer:
(i) Market value of companies before merger:

Particulars Rachna Limited Mona Limited
EPS (₹) 2 1
P/E ratio 10 5
Market price per share (₹) 20 5
Number of equity shares 10,00,000 10,00,000
Total market value (₹) 2,00,000 50,00,000

Valuation during Mergers & Acquisitions - CS Professional Study Material

(ii) Post merger effect of Rachna limited:

Particulars
Post merger earnings (20 lakhs +10 lakhs) (₹) 30,00,000
Equity. shares (exchange ratio 1 : 4) (10 lakhs + 10/4
lakhs)
12,50,000
EPS (₹) 2.4
P/E ratio 10
Market price per share (₹)  (2.4 × 10) 24
Total market value (₹) 3,00,00,000

Gains from merger for Rachna Limited

Particulars
Post merger market value of the firm 300,00,000
Less: Pre-merger market value
Rachna Limited ₹ 200,00,000
Mona Limited ₹ 50,00,000 250,00,000
Gains 50,00,000

Valuation during Mergers & Acquisitions - CS Professional Study Material

Apportioment of gains between shareholders: (₹)

Particulars Rachna Limited Mona Limited
Post merger market value
10,00,000 × 24 2,40,00,000
2,50,000 × 24 60,00,000
Less: pre merged market value 2,00,00,000 50,00,000
Gains 40,00,000 10,00,000

Conclusion: Shareholders of Rachna Limited will be better off than before the merger situation.

(iii) Post merger earnings:
Increase in earnings by 25 percent.
New earnings ₹ 30,00,000 × 125 percent
= ₹ 37,50,000
Number of equity shares = 12,50,000
Earnings Per Share (EPS) = ₹ 37,50,000/12,50,000
= ₹ 3
P/E ratio = 10
Market price per share = ₹ 3 × 10 = ₹ 30.

Valuation during Mergers & Acquisitions - CS Professional Study Material

Question 54.
Sanju Limited is studying the possible acquisition of Manju Ltd. by way of merger.
The following data is available:
Valuation during Mergers & Acquisitions - CS Professional Study Material 52
If the merger goes through and the exchange ratio is based on current market prices, what is the new EPS for Sanju Ltd.? (Dec 2019, 5 marks)

Steps to Establish the Business Worth – CS Professional Study Material

Chapter 6 Steps to Establish the Business Worth – CS Professional Valuations and Business Modelling Study Material is designed strictly as per the latest syllabus and exam pattern.

Steps to Establish the Business Worth – CS Professional Valuations and Business Modelling Study Material

Question 1.
Explain the steps to establish the business worth of a company?
Answer:
Steps to Establish Business Worth
Business valuation is a process that follows a number of key steps starting with the definition of the task at hand and leading to the business value conclusion. The five steps are:

  1. Planning and preparation
  2. Adjusting the financial statements
  3. Choosing the business valuation methods
  4. Applying the selected valuation methods
  5. Reaching the business value conclusion

Step 1: Planning and Preparation
A successful business takes planning in a disciplined manner as effective business valuation; effective business valuation requires organisation of significant facts and focusing on business related matters in detail. The two key starting points toward establishing your business worth are:

  • determining why you need business valuation
  • assembling all the required information

It may seem surprising at first that the valuation results are influenced by need for a business valuation. Business valuation is a process of measuring business worth and this process depends on two key elements: how you measure business value and under what circumstances.

In formal terms, these elements are known as the standard of value and the premise of value. Business value depends on how and why it’s measured.

Step 2: Adjusting the Historical Financial Statements Business valuation is largely an economic analysis exercise. Not surprisingly, the company’s financial information provides key inputs into the process. The two main financial statements you need for business valuation are the income statement and the balance sheet. To do a proper job of valuing a small business, you should have 3-5 years of historic income statements and balance sheets available.

Many small business owners manage their businesses to reduce taxable income. Yet when it comes to valuing the business, an accurate demonstration of the full business earning potential is essential.

Since business owners have considerable discretion in how they use the business assets as well as what income and expenses they recognize, the company’s historical financial statements may need to be recast or adjusted. The idea is to construct an accurate relationship between the required business assets, expenses and the levels of business income these assets are capable of producing. In general, both the balance sheet and the income statement require recasting in order to generate inputs for use in business valuation. Here are the most common adjustments:

  • Recasting the Income Statement.
  • Recasting the Balance Sheet

Step 3: Choosing the Business Valuation Methods
Once your data is prepared, it is time to choose the business valuation procedures. Since there are a number of well-established methods to determine business value, it is a good idea to use several of them to cross-check your results.

All known business valuation methods fall under one or more of these t fundamental approaches:

  • Asset approach
  • Market approach
  • Income approach

Step 4: Number Crunching: Applying the Selected Business Valuation Methods
With the relevant data assembled and your choices of the business valuation methods made, calculating your business value should produce accurate and easily justifiable results.

One reason to use several business valuation methods is to cross-check your assumptions. For example, if one business valuation method produces surprisingly different results, you could review the inputs and consider if anything has been overlooked.

Business valuation software tools must assist business people with making critical decisions, while performing routine calculations automatically. Here are the key elements that set apart quality business valuation software products:

1. Ease of use
Business valuation software that makes your life easier integrates a number of tools and resources into one easy-to-use package. You should have ready access to the tools you need and help on how to use them.

2. Power
Business valuation software should support a number of standard business valuation methods. Your tools must help you focus on the “big picture” of measuring your business worth – handling all the math details for you.
business valuation using a number of methods under the market, income, and asset business valuation approaches. No one method is better than another.

3. Flexibility
You can do your business valuation using a number of methods under the market, income, and asset business valuation approaches. No one method is better than another.

4. Extensive help system
If you are new to business valuation, understanding the right terms and concepts is very important. To save you time, your business valuation software Help System should provide you with a quick reference to the term definitions, explanations and examples of the tools.
The system should act as your Information Center by offering suggestions on how to calculate and interpret your business valuation results.

5. Accuracy of business valuation calculations
Needless to say, the credibility of your business appraisal relies upon the accuracy of your results. Business valuation software should offer you a choice of well-designed, standard business valuation methods.

6. Security of critical business data and your computer systems Business valuation involves analysis of sensitive business data. Your business valuation software should safeguard privacy and security of this data and support its communication to the right people.

7. Cost of ownership
State-of-the-art business valuation software should help you measure your business value – without breaking the bank.

Modern technologies, such as Open Source, help make your business valuation software far more powerful and cost-effective when compared to older proprietary systems.

Step 5: Reaching the Business Value Conclusion Finally, with the results from the selected valuation methods available, you can make the decision of what the business is worth. This is called the business value synthesis. Since no one valuation method provides the definitive answer, you may decide to use several results from the various methods to form your opinion of what the business is worth.

Step 6: Number Crunching: Applying the Selected Business Valuation Methods
How can we find Terminal Value?
Terminal value is found either by using the relative valuation or the DCF method. Tata Steel had used DCF method to calculate the Terminal Value. The perpetual growth method of calculating a terminal value formula is the preferred method among academics as it has the mathematical theory behind it. This method assumes the business will continue to generate Free Cash Flow (FCF) at a normalized state forever (perpetuity). The formula for calculating the terminal value is:
The formula for calculating the terminal value is:
TV = (FCFn × (1 + g)) / (WACC – g)
Where:
TV = terminal value
FCF = free cash flow
g = perpetual growth rate of FCF
WACC = weighted average cost of capital

Step 7: Reaching the Business Value Conclusion Analysts value a company for various reasons. They value a company to determine if its stock is undervalued or not. Acquiring companies value target companies to determine the acquisition premium that can be paid to the shareholders of the target companies.

Valuation of stocks or companies is a useful exercise for primarily three types of people.

  1. It helps medium to long term investors in deciding whether a stock is properly priced in the market.
  2. Valuation of the target company is a necessary input for the acquiring company, irrespective of whether the merger is financed with cash or stock.
  3. Valuation Techniques can help us assess the impact of any corporate decision like corporate restructuring, share buyback, etc., on the stock price of the company.
    This proves to be a useful tool for corporate finance executives in the company and valuation consultants.

Steps to Establish the Business Worth - CS Professional Study Material

Question 2.
Explain the methods of Business Valuation?
Answer:
Asset Approach
Under the asset approach you adopt the view of a business as a set of assets and liabilities. The balance sheet elements serve as building blocks to create the picture of business value. A finance professor would tell you that the asset approach is based on the economic principle of substitution.

Choosing the asset based business valuation methods
Determining the value of an asset-rich company may justify the cost and complexity of the asset-based valuation methods, such as the asset accumulation method. In addition to valuing the individual business assets and liabilities, the method can be helpful when allocating the business purchase price across the individual business assets, as part of the asset purchase agreement.
However, the method requires considerable skill in individual asset and liability valuation which often makes its application costly and time consuming.
Business Value = Assets + Business Goodwill

Market Approach
Under the market approach, you look for signs from the real market place to figure out what a business is worth. The market is a competitive place, so the economic principle of competition applies:

What are other businesses worth that are similar to my business?
Key uses of market-based business valuation
Determining your business value by such market comparisons is especially useful in these situations:

  1. To set an asking price or offer price for a business acquisition.
  2. To defend your business valuation in a legal controversy or before the tax authorities.
  3. To justify your business value in a dispute such as partner disagreements or buyout.

Business fair market value estimation
Market comparisons are an excellent way to estimate the very important fair market value of a business. This is by far the most common measure of business value – and is the de-facto standard used in most business valuations.

Valuation Multiples: business value calculation
You can use a number of valuation multiples to estimate your business fair market value. All such multiples are statistically derived ratios that relate the potential business selling price to some measure of its financial performance. Using the valuation multiples derived from comparable business sales, you can determine what your business is worth based on its recent revenues, net income, discretionary cash flow, EBITDA, total assets or book value, among others.

The Income Based Business Valuation
Income based business valuation methods determine business worth based on the business earning power. Business valuation experts widely consider these methods to be the most accurate. All income-based business valuation methods rely on either discounting or capitalization of some measure of business earnings.

The discounting methods, such as the Discounted Cash Flow, produce very accurate results by letting you specify the details of the expected business income stream over time. The Discounted Cash Flow method is an excellent choice for valuing a young or rapidly growing company whose earnings vary considerably.

Alternatively, the so-called direct capitalization methods, such as the ValueAdder Multiple of Discretionary Earnings, determine your business worth based on the business earnings and a carefully constructed capitalization rate. The Multiple of Discretionary Earnings method is an outstanding choice for valuing small established companies with consistent earnings and growth rates.

The income valuation approach helps you to figure what kind of money the business is likely to bring as well as to assess the risk.

Business valuation by income capitalization
The capitalization valuation method is essentially the result of dividing the expected business earnings by what is known as the capitalization rate. The idea is that the business value is defined by business earnings and the / capitalization rate is used to relate the two.

For example, if the capitalization rate is 33%, then the business is worth f about 3 times its annual earnings. An alternative is a capitalization factor that is used to multiply the income. Either way, the result is what the business value is today.

The capitalization method works really well for businesses with steady, predictable earnings. Nothing like a cash cow business to cut you a handsome paycheck every month.

Valuation of a business by discounting its cash flow
In the discounting valuation method, first, you forecast the business income some time into the future, usually a number of years. Next, you figure out the discount rate which captures the risk of getting this income on time and in full measure.

Finally, you estimate what the business is likely to be worth at the end of your forecast period. If you expect the company to keep running, there is some residual value, also known as the terminal value. Discounting the forecast earnings and the terminal value together gives you the present value of the business, or what it is worth today.

Steps to Establish the Business Worth - CS Professional Study Material

Question 3.
How can the company find the terminal value and what is the usage of terminal value?
Answer:
Terminal value is found either by using the relative valuation or the DCF method. Tata Steel had used DCF method to calculate the Terminal Value. The perpetual growth method of calculating a terminal value formula is the preferred method among academics as it has the mathematical theory behind it. This method assumes the business will continue to generate Free Cash Flow (FCF) at a normalized state forever (perpetuity). The formula for calculating the terminal value is:

The formula for calculating the terminal value is:
TV = (FCFn × (1 + g)) / (WACC – g)
Where:
TV = terminal value
FCF = free cash flow
g = perpetual growth rate of FCF
WACC = weighted average cost of capital

Valuation of Tangibles – CS Professional Study Material

Chapter 7 Valuation of Tangibles  – CS Professional Valuations and Business Modelling Study Material is designed strictly as per the latest syllabus and exam pattern.

Valuation of Tangibles – CS Professional Valuations and Business Modelling Study Material

Question 1.
What do you understand by free cash flows? (Dec 2011, 5 marks) [CMA Final]
Answer:
Free Cash Flow:
Free cash flow is the post-tax cash flow generated from operations of the company after providing for increase in investments in fixed capital and increase is net working capital required for operations of the firm. Thus it is the cash available for distribution to shareholders (by way of dividend and buyback of shares) and lender (by way of interest payment and debt repayment).

Free cash Flow = Net income (+) Depreciation (+/-) Non Cash item (-) changes in working capital (-) capital expenditure (+) new debt issue – repayment of debt (-) Preference dividends.

Valuation of Tangibles - CS Professional Study Materialr

Question 2.
ABC Co. Ltd. an engineering company, is considering the purchase of a new machine for its immediate expansion program. There are three possible machines at the same cost, which are suitable for the purpose; the details of these are given with estimated cost and sale values.

ITEMS Machine A (₹) Machine B (₹) Machine C (₹)
Capital cost 3,00,000 3,00,000 3,00,000
Sales (at stand. Prices) 5,00,000 4,00,000 4,50,000
Net cost of production:
Direct material 40,000 50,000 48,000
Direct Labour 50,000 30,000 36,000
Factory Overheads 60,000 50,000 58,000
Administration costs 20,000 10,000 15,000
Selling & District costs 10,000 10,000 10,000

The economic life of machine 1 is 2 years, while it is 3 years for other two machines, after which the scrap value of ₹ 40,000, ₹ 25,000 and ₹ 30,000 respectively. Sales are expected to be at the rates shown for each year during the life time of machines. The cost relates to the annual expenditure resulting from each machine. Average tax rate is 45%. Payables and receivables are settled promptly. Return on capital to be on an uniform basis of 8% p.a.

Valuation of Tangibles - CS Professional Study Materialr

You are required to value the proposals and show which machine would be the most profitable investments on the basis of net cash flows. (State the assumptions, if any, made in arriving at the answer) (Dec 2008, 15 marks) [CMA Final]
Answer:

Item Machine A (₹) Machine B (₹) Machine C (₹)
Capital Cost 3,00,000 3,00,000 3,00,000
Sales 5,00,000 4,00,000 4,50,000
Cost of Production 1,50,000 1,30,000 1,42,000
Administration Cost 20,000 10,000 15,000
Selling and Distribution Cost 10,000 10,000 10,000
Total Cost 1,80,000 1,50,000 1,67,000
PBDI (Sales-Cost) 3,20,000 2,50,000 2,83,000
Depreciation: Cost less Scrap value/life 1,30,000 91,667 90,000
Interest on borrowings 24,000 24,000 24,000
PBT 1,66,000 1,34,333 1,69,000
Taxation @ 45% 74,700 60,451 76,050
Profit after tax 91,300 73,882 92,950
Add Depreciation + Interest 1,54,000 1,15,667 1,14,000
Net Cash Flow 2,45,300 1,89,549 2,06,950
No. of years for cost recovery 1.21 years 1.58 years 1.45 years

The following are the assumptions made while arriving at the answer :

  • Factory overheads do not include depreciation.
  • Interest will have to be paid on borrowings for machine purchased during the life of the machine.
  • No borrowings have been made for working capital.

Valuation of Tangibles - CS Professional Study Materialr

Question 3.
Das Ltd. is having a Machine carrying amount of which is ₹ 100 lakhs as on 31.03.2013. Its balance useful life is 5 years and residual value at the end of 5 years is ₹ 5 lakhs. Estimated future cash flows from the Machine for the next 5 years are:

Years Estimated cash flows (₹ in lakhs)
2014 52
2015 34
2016 32
2017 28
2018 32

Valuation of Tangibles - CS Professional Study Materialr

Compute “Value in use” for plant if the discount rate is 15% and also compute the recoverable amount if net selling price of the machine as on 31.12.2013 is ₹ 55 lakhs. (Dec 2018, 8 marks) [CMA Final]
Answer:
Present value of the future cash flow

Year Estimated cash flows (₹ in lakhs) Discount @ 15% DCF
2014 52 0.870 45.24
2015 34 0.756 25.704
2016 32 0.658 21.056
2017 28 0.572 16.016
2018 32 0.497 15.904
Total 123.92

Present Value of residual price on 31.03.2018 : ₹ 5 × 0.497 = ₹ 2.485 (₹ in lakhs)

Present Value of estimated cash flow by use of an asset and residual value, which is called “Value in use”.
Value in use is (₹ 123.92 + ₹ 2.485) = ₹ 126.405 lakhs
Recoverable Amount = Net Selling Price (₹ 55 Lakhs) or Value in Use (₹ 126.405 Lakhs), whichever is higher.
Hence, Recoverable Amount = Value in Use = ₹ 126.405 Lakhs

Valuation of Tangibles - CS Professional Study Materialr

Question 4.
Autumn Spring Limited has FCFF of ₹ 2.0 billion and FCFE of ₹ 1.5 billion. Autumn Spring’s WACC is 11 percent, and its required rate of return for equity is 13 percent. FCFF is expected to grow forever at 7 percent, and FCFE is expected to grow forever at 7.5 percent. Autumn Spring has debt outstanding of ₹ 20 billion.

  1. What is the total value of Autumn Spring’s equity using the FCFF valuation approach?
  2. What is the total value of Autumn Spring’s equity using the FCFE valuation approach? (Dec 2019, 5 marks)

Question 5.
Discuss different terms related to value.
Answer:
The below are a few forms of Values that could be estimated depending upon the specifc situation / purpose at hand:
(i) Book Value: An asset’s book value is equal to its carrying value on the balance sheet, and companies calculate it netting the asset against its accumulated depreciation. Book value is also the net asset value of a company calculated as total assets minus intangible assets (patents, goodwill) and liabilities. For the initial outlay of an investment, book value may be net or gross of expenses such as trading costs, sales taxes, service charges and so on.

Valuation of Tangibles - CS Professional Study Materialr

(ii) Salvage Value: Salvage value is the estimated resale value of an asset at the end of its useful life. Salvage value is subtracted from the cost of a fixed asset to determine the amount of the asset cost that will be depreciated. Thus, salvage value is used as a component of the depreciation calculation.

(iii) Original Cost: Original cost is the total price associated with the purchase of an asset. The original cost of an asset takes into consideration all of the items that can be attributed to its purchase and to putting the asset to use. These costs include the purchase price and such factors as commissions, transportation, appraisals, warranties and installation and testing. Original cost can be used to value an asset type, including equipment, real estate and security instruments.

(iv) Written Down Value: Written-down value is the value of an asset after accounting for depreciation or amortization. It is calculated by subtracting accumulated depreciation or amortization from the asset’s original value, and it reflects the asset’s present worth from an accounting perspective.

(v) Replacement Value: Replacement cost or value is the cost to replace an asset of a company at the same or equal value, where the asset to be replaced could be a building, investment securities, accounts receivable or liens. The replacement cost can change, depending on changes in market value of the asset and any other costs required to prepare the as$et for use. Accountants use depreciation to expense the cost of the asset over its useful life.

(vi) Fair Value: Fair value is the sale price agreed upon by a willing buyer and seller, assuming both parties enters the transaction freely and knowledgeably. Many investments have a fair value determined by a market where the security is traded. Fair value also represents the value of a company’s assets and liabilities when a subsidiary company’s financial statements are consolidated with a parent company.

Valuation of Tangibles - CS Professional Study Materialr

(vii) Net Realisable Value: The net realizable value (NRV) of an asset is the money a seller expects to receive for the sale of an asset after deducting the costs of selling or disposing of the asset.

(viii) Market Value: Market value refers to the current or most recently-quoted price for a market-traded security. It can also refer to the most probable price an asset, like a house, would fetch on the open market.

The market value of an asset is determined by fluctuations in supply and demand. It should be noted that market value represents what someone is willing to pay for an asset – not the value it is offered for or intrinsically worth.

(ix) Economic Value: Economic value is the maximum amount a consumer is willing to pay for an item in a free market economy. Alternatively, it is the amount of time an individual will sacrifice waiting to obtain a government rationed good in a socialist economy.

In contrast, market value represents the minimum amount a consumer will pay. Economic value, thus, often exceeds market value. The economic value of a good or service is determined by the preferences of a given population and the trade offs its members make given their resources. Economic value is also directly correlated to the value that any given market places on an item.

(x) Residual Value: In accounting, the residual value is an estimated amount that a company can acquire when they dispose of an asset at the end of its useful life. In order to find an asset’s residual value, you must also deduct the estimated costs of disposing the asset.

The residual value of an asset is usually estimated as its fair market value, as determined by agreement or appraisal.

Valuation of Tangibles - CS Professional Study Materialr

Question 6.
Mention steps in DCF approach.
Answer:
Steps in the DCF Approach
The use of a DCF approach for tangible assets, especially properties, is intuitively appealing. The general steps to a DCF analysis are as follows:

  • Projection of income from existing assets and properties
  • Make assumptions about contract renewals
  • Make assumptions about operating expenses
  • Estimate the working capital infusions required
  • Estimate the capital expenditures required
  • Select appropriate discount rate to find PV of cash flows

Valuation of Tangibles - CS Professional Study Materialr

Question 7.
Discuss advantages and disadvantages of Income approach.
Answer:
Advantages & Disadvantages of applying the Income Approach
We have seen that there are many ways of applying the income approach, ranging from a relatively simple application of a cap rate with direct capitalization to a more advanced DCF analysis that involves projecting cash flows over a holding period and then forecasting the stable cash flows to perpetuity.

The advantages of the more complex DCF approach are:

  1. It captures the cash flows that investors actually care about.
  2. It takes cognizance of the fact that money changes value over time.
  3. This approach does not depend on current transactions from comparable sales as long as we feel that we can select an appropriate discount rate

The disadvantages of the DCF approach are:

  1. Detailed information is needed for building up the forecasts
  2. Selecting an appropriate discount rate is critical, as is arriving at an appropriate terminal value. Small variations in assumptions can have a significant impact on the value
  3. There could be a lot of assumptions and if there is a change in any of these assumptions (independent variables), that could have a significant impact on the estimated value of the Asset (Dependant Variable)

Valuation of Tangibles - CS Professional Study Materialr

Question 8.
Discuss advantages and disadvantages of Cost and Sales Comparison approaches.
Answer:
Advantages & Disadvantages of Cost and Sales Comparison Approaches
The cost approach to valuation is sometimes said to set an upper limit on the value. It is assumed that an investor would never pay more than the cost to buy land and develop a comparable building. This assumption may be somewhat of an overstatement because it can take time and effort to develop another building and find tenants. Furthermore, there may not be the demand for another building of the same type in the market.

That said, one would question a value that is much higher than implied by the cost approach. The main disadvantage of the cost approach is that it can be difficult to estimate the depreciation for a property that is older and/or has much obsolescence. So, the cost approach will be most reliable for newer properties that have a relatively modern design in a stable market.

The sales comparison approach relies on a reasonable number of comparable sales to be able to gauge what investors are expected to be willing to pay for the subject property. When the market is active, the sales comparison approach can be quite reliable.

Valuation of Tangibles - CS Professional Study Materialr

But when the market is weak, there tends to be fewer transactions, which makes it difficult to find comparable properties at a location reasonably close to the subject property. Even in an active market, there may be limited comparable sales for some properties, such as regional malls or special purpose properties.

Finally, the sales comparison approach assumes the investors who are buying properties are behaving rationally. That is, it assumes that the prices paid by investors in the current market are representative of market values. However, the investment value to a particular investor may result in that investor being willing to pay a price in excess of market value.

Also, there are times when investors in general are overly exuberant and there is a “bubble” in prices being paid for properties. This raises the question of whether these prices still represent “market value” because it seems likely that prices will eventually fall back to a more normal level. It is often argued that the appraiser’s job is to measure what investors are willing to pay whether they think it is rational Or not because market value is a most probable selling price.

Valuation of Intangibles – CS Professional Study Material

Chapter 8 Valuation of Intangibles  – CS Professional Valuations and Business Modelling Study Material is designed strictly as per the latest syllabus and exam pattern.

Valuation of Intangibles – CS Professional Valuations and Business Modelling Study Material

Question 1.
State under what conditions/assumptions the following statements are true (state only one important condition/assumption for each):
A Company can show Goodwill in its Balance Sheet. (June 2019, 5 marks)
Answer:
A company can show Goodwill in its Balance Sheet.

It must be noted that a company cannot show its own goodwill in its own balance sheet; however, it buys / acquires goodwill from someone, then goodwill can be shown in the balance sheet. As per AS 26, the self-generated goodwill / own goodwill / internally generated goodwill are termed as unidentified intangible assets whose cost cannot be measured reliably. So they are not recognized in books / financial statements.

Valuation of Intangibles - CS Professional Study Material

Question 2.
Why do Companies want to measure intellectual capital and what are the pitfalls in valuation of such assets. (June 2019, 5 marks)
Answer:
There a number of reasons why firms want to measure intellectual capital and the predominant reasons have been for strategic or internal management purposes. Specifically, the reasons include:
(i) Alignment of intellectual capital resources with strategic vision. To support the implementation of a specific via a general upgrading of the work with the companies’ human resources (support and maintain a strategy concerning the composition of staff as regards seniority, professional qualifications, and age. Through the description of the staff profile, measuring, discussion and adjustment become possible).

(ii) To support or maintain various parties’ awareness of the company.

(iii) To help bridge the present and the past (stimulates the decentralized development of the need for constant development and attention towards change).

(iv) To ensure that stock prices valued fairly, by making several competencies visible to current and potential customers.

Valuation of Intangibles - CS Professional Study Material

(v) To make the company appear to the employees as a name providing an identity for the employees and visualizing the company in the public. Knowledge of employees and customers will stimulate the development of a set of policies to increase customer satisfaction and customer loyalty.

(vi) Assessing effectiveness of a firm’s intellectual capital utilization- Allocate resources between various business units. Extract full value from acquisition and joint ventures.

(vii) Determine the most effective management incentive structures.

Pitfalls in Valuation of Intellectual Capital – The first problem with intangibles starts with identifying them unlike physical assets, intangible assets have no specific lifetime and are not marketable in the conventional sense, meaning no market exists where they can be sold and priced readily.

This not only increases the likelihood of information asymmetry where the same asset will be priced differently by people with different levels of information, but also of the risk of not being able to sell the asset. Moreover, the absence of intangible assets from the Balance Sheets leads to misleading profitability metrics and hence the decisions based on these metrics are flawed.

For example, the absence of intangible assets will understate the total assets in the Balance Sheet, so ratios like Return on Asset and Return on Equity will be overstated. In the opposite case, if intangible assets are priced without any standardized method, there may be a tendency to overprice these intangible assets, leading to understated profitability ratios. In both cases, the investors are not getting the proper picture of a company’s financial situation.

Valuation of Intangibles - CS Professional Study Material

Alternate Answer:
Intellectual capital (IC) is increasingly recognized as an important strategic asset for sustainable corporate competitive advantages. Intellectual capital is one of the most important intangible assets in the firm. Empirical evidences suggest that intellectual capital has direct effect in the firm’s value and performance. Companies may want to measure intellectual capital for internal and external reasons.

Internal Reasons
First, measuring intellectual capital can help an organization formulate business strategy. By identifying and developing its intellectual capital, an organization may gain a competitive advantage.

Second, measuring intellectual capital may lead to the development of key performance indicators that will help evaluate the execution of strategy. Intellectual capital even if measured properly, has little value unless it can be linked to the firm’s strategy.

Third intellectual capital may be measured to assist in evaluating mergers and acquisitions, particularly to determine the prices paid by the acquiring firms.

Fourth, using nonfinancial measures of intellectual capital can be linked to an organization’s incentive and compensation plan.

Valuation of Intangibles - CS Professional Study Material

External Reasons
To communicate to external stakeholders what intellectual property the firm owns. Improving external reporting of intellectual capital can:

  1. Close the gap between book vrlue and market value,
  2. Provide improved information about the “real value” of the organization,
  3. Reduce information asymmetry,
  4. Increase the ability to raise capital by providing a valuation on intangibles, and
  5. Enhance an organization’s reputation.

Valuation Guidance Resources in India – CS Professional Study Material

Chapter 4 Valuation Guidance Resources in India – CS Professional Valuations and Business Modelling Study Material is designed strictly as per the latest syllabus and exam pattern.

Valuation Guidance Resources in India – CS Professional Valuations and Business Modelling Study Material

Question 1.
Write short note on IVS 500.
Answer:
Financial Instruments (IVS 500) : In case of IVS 500, several respondents pointed out that the term “financial instruments” encompasses a wide variety of instruments including derivatives, contingent instruments, hybrid instruments, fixed income, and structured products. However, they noted that the standard primarily defined financial instruments in terms of equity instruments. The Board agreed that the term “financial instruments” is broad and encompasses a wide range of instruments. While they did not believe IVS 500 could accurately present an exhaustive list of financial instruments, they agreed that the existing description of what constitutes a financial instrument was too limited and expanded upon it accordingly.

Question 2.
Write short note on Income method.
Answer:
Income method
The income method is used in those markets where buyers are acquiring the right to enjoy future benefits from the asset and where those benefits can be readily expressed in monetary terms. Typically in investment markets, buyers are looking for future income, future value growth or a combination thereof. The income method is used in the bond market, equity share market and real estate market, or where it is possible to assess the relationship between price paid by buyers and the expected income to be derived from ownership. In its simplest form, the relationship is expressed as a multiplier or a yield rate, but becomes more complex where there is a variable income expected and where that income may be time constrained.

The income is the total of all the income streams from the property adjusted for any average annual expenses that are to be paid by the owner of the property and are not recoverable through a service charge. (Consideration must be given to the actual rent paid and to the market rent. Such comparison might indicate an under-rented, overrented or market-rented property.

Income capitalisation requires two inputs: income and multiplier or yield. In some markets it is the gross income that is capitalised, but the preferred approach is to capitalise the net operating income (NOI) before taxation. The basis on which tenants occupy property varies from state to state, and sometimes between property types and from one property to another. It is important to identify who is responsible for:

  • building repairs and maintenance;
  • building insurances (where applicable) for fire, flood and other losses;
  • annual operating expenses for heating, lighting, cleaning, etc.;
  • availability and price of parking slots;
  • annual taxes payable on the building (this excludes ownership taxes such as wealth taxes); and
  • management expenses in the collection of rent and management of the space for the tenants.

This approach requires consideration of whether some or all of these costs are recoverable from the occupying tenants by means of additional annual charges, sometimes referred to as service charges.
In most states a range of occupation agreements or leases can exist under which the various operating costs can be any of the following:

  • total responsibility of the tenant(s);
  • total responsibility of the owner (landlord);
  • payable by the owner, but totally or partially recoverable from the tenant(s); or
  • partly the owner’s responsibility and liability, and partly that of the tenant(s).

Analysis of sale prices in the various income earning sectors of the real estate market must also be on the basis of net income if a net income capitalisation process is to be adopted. Income analysis and capitalisation in this form is only possible where there are comparable sales of similar properties, and where no specific allowance is needed for capital recovery because the ownership title under analysis and valuation is capable of being viewed as one in perpetuity. For this, recovery of capital is assumed to be possible (as with equity shares) through a resale of the property.

International Valuation Standards Overview - CS Professional Study Material

Question 3.
Write short note on cost method.
Answer:
Cost Method
The cost approach is based on the supposition that no one would pay more or accept less for an existing property than the amount it would cost to buy an equivalent property, in terms of size and location, plus the cost of constructing an equivalent building at present. Where used for properties that are not new, the cost figure will be written down for age or obsolescence. The cost in such cases will be based on the cost of a simple substitute rather than that of replicating the actual building.

In other situations, over-improvement can mean that cost will considerably exceed Market Value. For example, a hotel with 5,000 rooms on a holiday island with typical inflow of only 1,000 tourists a day will be of low value compared to its cost. This method also ignores the possible loss of income that may result in constructing a property with similar utility, which often leads to value exceeding cost to replace.
The cost approach is usually referred to as the depreciated replacement cost (DRC) method when used in the context of financial reporting. The cost approach requires the valuer to consider three elements:

  • the cost or value of an equivalent parcel of land;
  • the cost of constructing a replica, a simple substitute building or a modem equivalent building; and
  • an allowance for depreciation

The value of the land does not usually depreciate and may be assessed using normal Market Value approaches, the best method being direct sales comparison of similar land being bought and sold for similar purposes.
The gross replacement cost (GRC) of the buildings is calculated using current cost figures to which the following related costs are added:

  • site works;
  • architect’s fees;
  • building permit costs; and
  • finance (interest) charges on bank borrowing to cover the costs.

If the existing building can be replaced with a modern equivalent building at a lower cost, then the modern equivalent cost figure is used.

The GRC has to be adjusted to reflect the hypothetical buyer’s perception of the likely difference in utility between the replica new build, or modern equivalent, and the actual building(s) on the site. IVS recognise the need to account for physical deterioration, functional or technical obsolescence, and economic or external obsolescence. A major factor at present may be depreciation arising from new buildings requiring lower carbon footprints.

Application of Cost Approach
The cost approach is used in many states as a valuation method of last resort, only to be used when it is impossible to find market evidence. The calculation is of the DRC and the resultant figure can be used only for certain classes of asset for the purpose of compliance with the International Financial Reporting Standards (IFRS) or other reporting standards. As it is not based on market evidence the final sum should be expressed as a non-market valuation.

Question 4.
Discuss the four methodologies are being used for valuation of PSU.
Answer:
A brief discussion on the aforesaid methods is as under:
(a) Discounted Cash Flow (DCF) Method: The Discounted Cash Flow (DCF) methodology expresses the present value of a business as a function of its future cash earnings capacity. This methodology works on the premise that the value of a business is measured in terms of future cash flow streams, discounted to the present time at an appropriate discount rate.

(b) Balance Sheet Method: The Balance Sheet or the Net Asset Value (NAV) methodology values a business on the basis of the value of its underlying assets. This is relevant where the value of the business is fairly represented by its underlying assets. The NAV method is normally used to determine the minimum price a seller would be willing to accept and, thus serves to establish the floor for the value of the business.

(c) Transaction / Market Multiple Method: This method takes into account the traded or transaction value of comparable companies in the industry and benchmarks it against certain parameters, like earnings, sales, etc. Two of such commonly used parameters are: Earnings before Interest, Taxes, Depreciation & Amortisations (EBITDA) and Sales.

(d) Asset Valuation Method: The asset valuation methodology essentially estimates the cost of replacing the tangible assets of the business. The replacement cost takes into account the market value of various assets or the expenditure required to create the infrastructure exactly similar to that of a company being valued. Since the replacement methodology assumes the value of business as if we were setting a new business, this methodology may not be relevant in a going concern.

Question 5.
Discuss the four stages of valuation approach.
Answer:
The valuation approach: There are four stages in this method:
Stage 1: assess the best scheme of development for the land;
Stage 2: assess the value of the assumed development on completion;
Stage 3: assess all the costs of completing the assumed development scheme; and
Stage 4: estimate residual land value

Stage 1: Assess the best scheme of development for the land
For the first stage of this method, the valuer establishes the development or redevelopment/ refurbishment potential within the market for that parcel of real estate in that location. The method is used to assess value on a ‘what if’ basis. This means that the resultant figure is dependent upon all necessary permissions, licences and other authorisations being obtained to undertake the scheme. Any calculations on this basis must be qualified fully with all the assumptions that have been made.

Stage 2: Assess the value of the assumed development on completion
The value of the completed development is the Market Value of the proposed development assessed on the special assumption that the development is complete as at the date of valuation in the market conditions prevailing at that date. This is widely referred to as the gross development value (GDV). The GDV is calculated using the comparative or income approach. The comparative method is used for developments of apartments and houses. Where the scheme is of a commercial nature and the space created is likely to be leased, then GDV is estimated using the income approach.

Stage 3: Assess all the costs of completing the assumed development scheme
In this stage, the valuer assess all the development costs, including an amount for normal profit and for the finance costs and interest charges on the capital (money) needed to fund the whole of the scheme. The costs can be broken down into three categories: pre-construction, construction and post-construction.

  • costs of all permissions, licences to build and other costs that may have to be met before construction can begin;
  • survey costs, including site measurements, environmental and archaeological surveys, and soil/subsoil investigations to determine load bearing; and
  • site clearance expenses, including demolition and the cost of contamination cleaning of the site
    Construction costs are scheme-specific, but would normally include:
  • build costs assessed by a qualified cost estimator or quantity surveyor (there may be state-specific .sums that might offset some costs of development, such as capital allowances or subsidies);
  • fees and expenses of all professional advisers, such as architects, project managers, civil engineers, cost estimators, electrical engineers;
  • any highway, utility connection costs or area improvement costs that are a requirement of the building consents;
  • costs relating to the securing of the capital to undertake the development and the likely interest charges on borrowed money; and
  • non-recoverable charges, such as value added tax (VAT/TVA) or building taxes.

An allowance is to be made to reflect the opportunity CQst of the principal, even if the developer is funding the project internally. This is done on the assumption that the completed fully let and income-producing development is to be sold, or long-term finance is to be obtained on its transfer to the developer’s investment portfolio. This allowance is also included where the development is to be owner-occupied.

The developer’s normal profit margin is also always to be accounted for in the construction costs. It is normally assessed as a percentage of total construction cost or as a percentage of the GDV. The typical percentage and basis of assessment will be known within a given market.
Post-construction costs could include:

  • marketing costs and associated fees
  • landscaping.

Stage 4: Estimate residual land value
The costs are added together and deducted from NDV to arrive at a gross residual value, which may have to be further adjusted to assess the net residual value. This adjustment reflects any costs that may be incurred on the acquisition of the land, or the land and existing buildings. These costs include any land sale tax and associated legal and title transfer fees. In addition, the residual must allow for the cost of interest payments on money borrowed to purchase the site. This latter allowance is usually made by finding the PV of the gross residual value at the interest rate used for the finance charges for the total estimated period of the development.

International Valuation Standards Overview - CS Professional Study Material

Question 6.
What are the DCF Valuation Fundamentals?
Answer:
Discounted Cash Flow Method
The discounted cash flow (DCF) method is frequently preferred to income capitalisation. DCF is a standard tool for investment analysis and is used in all investment markets. When valuing property, valuers are seeking to mirror market behaviour, hence the argument that if buyers base their decision to purchase an asset using DCF, then DCF should be used to estimate Market Value.

The DCF method can be used to assess Market Value. When used for this purpose, all the variables used in the calculation must be based on market evidence. If any of the variables, such as the discount rate or the rental growth rate, are instead based on a client’s data or requirement, then the result of the calculation is not the Market Value, but the worth or investment value to that client on those specific assumptions. In such case the valuer is recommended to state this in the report.

The valuation approach: A DCF valuation differs from market capitalisation in the following ways:

Income is specified over a given time period, or projection period, to provide a statement of cash inflows over that time period on an annual, quarterly or monthly basis. The time period rarely exceeds 10 years.

The cash flow will normally incorporate an adjustment for income growth. Whereas capitalisation reflects growth in the capitalisation rate, a DCF will specify a growth in income (rent) based on market assumptions.

The cash flow will include all normal expenditures, including any non-recoverable operating expenses such as repairs, property insurances, management costs and capital expenditures (e.g. anticipated renewal and replacement costs over the projected period for building elements, fixtures, fittings, plant). If there is a separate service charge then cash outflows will be minimal.

A market-based assessment of the resale price of the property at the end of the cash flow must be included. In some circumstances this can be negative, as with extractive industries when the land may have to be returned to the pre-extraction agricultural activity.

The cash flow will identify the net cash flow per period.

The discount rate used to assess the PV of the net cash flow will be specified. For a Market Value DCF, the discount rate must be based on market assumptions. Where growth has been included in the cash flow, the valuer must not use a market-based capitalisation rate as the discount rate.

DCF can be used for Market Value estimates of both income-producing and development properties, in place of the residual method. It can also be used in place of the profits method for Market Value estimates of business properties where the business is normally bought and sold as a single entity, such as hotel properties. However, its use for Market Value purposes must be distinguished from its use as an analytical tool to assess NPV or internal rate of return to be achieved from a property-based investment opportunity.

Accounting for Share based Payment (IND AS 102) – CS Professional Study Material

Chapter 9 Accounting for Share based Payment (IND AS 102) – CS Professional Valuations and Business Modelling Study Material is designed strictly as per the latest syllabus and exam pattern.

Accounting for Share based Payment (IND AS 102) – CS Professional Valuations and Business Modelling Study Material

Question 1.
Softex Ltd. announced a Stock Appreciation Right (SAR) on 01 -04-07 for each of its employees. The scheme gives the employees the right to claim cash payment equivalent to an excess of market price of company shares on exercise date over the exercise price of ₹ 125 per share in respect of 100 shares, subject to a condition of continuous employment of 3 years. The SAR is exercisable after 31-03-2010 but before 30-06-10.

The fair value of SAR was ₹ 21 in 2007-08, ₹ 23 in 2008-09 and ₹ 24 in 2009-10. In 2007-08 the company estimated that 2% of its employees shall leave the company annually. This was revised to 3% in 2008-09. Actually 15 employees left the company in 2007-08,10 left in 2008-09 and 8 left in 2009- 10. The SAR therefore actually vested in 492 employees on 30-06-2010; when SAR was exercised the intrinsic value was ₹ 25 per share.

Show the provision for SAR account by fair value method. Is this provision a liability or equity ? (Nov 2010, 16 marks) [CA Final]
Answer:
Provision of SARs Account in the books of Softex Ltd.
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 1
Note: The Provision for Stock Appreciation Rights (SARs) is a liability. Therefore SARs are settled through cash payment equivalent to an excess of market price of company’s shares over the exercise price on exercise date.

Working Notes:
Year 2007-08
Number of employees to whom SARs were announced (492 + 15 + 10 + 8) = 525 employees
Number of SARs expected to vest = (525 × 0.98 × 0.98 × 0.98) × 100 = 49,413
* SARs expected to lies years 2007-08 and 2008-09.
It can also be worked out by rounding off the number of employees.
Fair value of SARs = 49,413 SARs × 21 = 10,37,673
Vesting period = 3 years
Value of SARs recognised as expense in year 2007 – 08 = 10,37,673 / 3 years = 3,45,891.

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Question 2.
2011 – Nov [1] {C} (c)
On 1st April, 2010, A company offered 100 shares to each of its 500 employees at ₹ 50 per share. The employees are given a month to decide whether or not to accept the offer. The shares issued under the plan (EPP) shall be subject to lock-in on transfers for three years from grant date. The market price of shares of the company on the grant date is ₹ 60 per share. Due to post-vesting restrictions on transfer, the fair value of shares issued under the plan is estimated at ₹ 56 per share.

On 30th April, 2010, 400 employees accepted the offer and paid ₹ 50 per share purchased. Nominal value of each share is ₹ 10.
Record the issue of shares in the book of the company under the aforesaid plan. (5 marks) [CA Final]
Answer:
Fair value of an EPP = ₹ 56 – ₹ 50 = ₹ 6
Number of shares issued = 400 employees × 100shares/employee = 40,000 shares
Fair value of EPP which will be recognized as expenses in the year 2010-11 = 40,000
Shares × ₹ 6 = ₹ 2,40,000
Vesting period = 1 month
Expenses recognized in 2010-11 = ₹ 2,40,000
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 2

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Question 3.
Answer the following :
Goodluck Limited grants 180 share options to each of its 690 employees. Each grant containing condition on the employees working for Goodluck Ltd. over the next 4 years. Goodluck Ltd. has November 2, 2012 estimated that the fair value option is ₹ 15. Goodluck Ltd. also estimated that 30% of employees will leave during four year period and hence forfeit their rights to the share option. If the above expectations are correct, what amount of expenses to be recognised during vesting period? (Nov 2012, 4 marks) [CA Final]
Answer:
Expense to be recognized during 4 years’ vesting period

Year Calculation Expenses for the period ₹ Cumulative expenses ₹
1 690 employees × 180 options × 70% × ₹ 15 × 1/4 3,26,025 3,26,025
2 [690 employees × 180 options × 70% × ₹ 15 × 2/4 years]- ₹ 3,26,025 3,26,025 6,52,050
3 [690 employees × 180 options × 70% × ₹ 15 × 3/4 years] – ₹ 6,52,050 3,26,025 9,78,075
4 [690 employees × 180 options × 70% × ₹ 15 × 4/4 yearsl – ₹ 9,78,075 3,26,025 13,04,100

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Question 4.
On 1st April, 2012, A company offered 100 shares to each of its employees at ₹ 40 per share. The employees are given a month to decide whether or not to accept the offer. The shares issued under this plan will be subject to each in transfer for throe years from the grant date. The market price on the grant date is ₹ 50 per share. However the fair value of shares issued under this plan is estimated at ₹ 48 per share. On 30-04-2012, 400 employees accepted the offer and paid ₹ 40 per share. Nominal value of each share is ₹ 10.

Record the issue of shares in the books of the company under the aforesaid plan. (May 2013, 4 marks) [CA Final]
Answer:
Journal Entries
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 3

Note:

  • Guidance Note on “Employee Share Based Payments” states that if the shares granted vest immediately, the employee is not required to complete a specified period of service before becoming unconditionally entitled to those instruments.
  • In such a case, the enterprise presumes the services rendered by the employee as consideration received for the instruments granted.
  • Accordingly, in this case, because there is no vesting period the enterprise should recognise the expense of ₹ 3.20,000 immediately.

Working Note:
Fair value of an Employee Share Purchase Plan (EPP) = ₹ 48 – ₹ 40 = ₹ 8
Number of shares issued 400 employees × 100 share per employee = 40,000 shares
Fair value of EPP which wifl be recognized as expense in the year 2012-13
= 40,000 shares × ₹ 8 = ₹ 3,20,000

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Question 5.
Kush Ltd. announced a Share Based Payment Plan for its employees who have completed 3 years of continuous service, on 1st of April, 2010. The plan is subject to a 3 year vesting period. The following information is supplied to you in this regard :
(i) The eligible employees can either have the option to claim the difference between the exercise price of ₹ 144 per share and the market price in respect of the share on vesting date in respect of 5,000 shares or such employees are entitled to subscribe to 6,000 shares at the exercise price.
(ii) Any shares subscribed to by the employees shall carry a 3 year lock in restriction. All shares carry face Value of ₹ 10.
(iii) The Current Fair Value of the shares at (ii) above is ₹ 60 and that in respect of freely tradeable shares is higher by 20%.
(iv) The Fair Value of the shares not subjected to lock in restriction at the end of each year increases by a given % from its preceding value as under:
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 4

You are required to draw up the following accounts under both options:
(i) Employee Compensation Account
(ii) Provision for Liability Component Account
(iii) ESOP Outstanding Account (Nov 2013, 10 marks) [CA Final]
Answer:
Working Notes:
1. Computation of Fair Values
Fair value of shares subject to lock in as on 1st April, 2010 : ₹ 60.00
% of increase in fair value of shares not subjected to Lock in : 20%
Fair Value as on 1st April, 2010 of Shares not subjected to lock in (60 + 20%) : ₹ 72.00
% increase over previous value in respect of Fair Value on 31.03.2011 : 6%

Fair value of shares not subjected to lock in restriction on 31.03.2011(72 + 6%) : ₹ 76.32
% increase over previous value in respect of Fair Value on 31.03.2011 : 10%

Fair Value of Shares not subjected to lock in restriction on 31.03.2012(76.32 + 10%) : ₹ 83.95
@ increase over previous value in respect of Fair Value on 31.03.2012 : 15%

Fair Value of Shares not subjected to Lock in restriction on 31.03.2013(83.95 + 15%) ₹ 96.54

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

2. Expense to be recognized in respect of Equity Component
Fair Value under Equity Settlement Option (6,000 × ₹ 60/-) : 3,60,000
Less: Fair Value under Cash Settlement (Liability Component) option (5,000 × ₹ 72) : 3,60,000
Equity Component : Nil
Expenses to be recognized each year for Equity Component : Nil

3. Expenses to be recognized for Liability Component
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 5
Employee Compensation Account
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 6

If Employee opts for Cash Settlement
Provision for Liability Component Account

Year Particulars Year Particulars
2013-14 To Bank (5000 × ₹ 96.54) 4,82,700 2013-14 By Balance b/d 4,82,700

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

If Employee opts for Equity Settlement
Provision for Liability Component Account

Year Particulars Year Particulars
2013-14 To ESOP outstanding A/c 4,82,700 2013-14 By Balance b/d 4,82,700

ESOP Outstanding Account
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 7

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Question 6.
Quittle Ltd. announced a Stock Appreciation Rights (SAR) Scheme to its employees on 1st April, 2011. The salient features of the scheme is given below :

  1. The scheme will be applicable to employees who have completed three years of continuous service with the company .
  2. Each eligible employee can claim cash payment amounting to the excess of Market Price of the company’s shares on exercise date over exercise price in respect of 60 (sixty) shares.
  3. The exercise price is fixed at ₹ 75 per share.
  4. The option to exercise the SAR is open from 1st April, 2014 for 45 days and the same vested on 975 employees.
  5. The intrinsic value of the company’s share on date of closing (15th May, 2014) was ₹ 30 per share.
  6. The fair value of the SAR was ₹ 20 in 2011-12; ₹ 25 in 2012-13 and ₹ 27 in 2013-14.
  7. In 2011 -12 the expected rate of employee attrition was 5% which rate was doubled in the next year.
  8. Actual attrition year wise was as under:
    2011- 12 35 employees of which 5 had served the company for less than 3 years.
    2012- 13 30 employees of which 20 employees served for more than 3 years.
    2013- 14 20 employees of which 5 employees served for less than 3 years.

You are required to show the Provision for Stock Appreciation Rights Account by Fair Value Method. (May 2014, 8 marks) [CA Final]
Answer:
Provision for SAR’s Account
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 8

Working Notes :
1. No. of eligible employees = 975 + 35 – 5 + 20 + 20 – 5 = 1,040
2. Expenses to be recognized each year:

2011-12 2012-13 2013-14
No. of SARS to Vest 1040 × 0.95 × 0.95 × 0.95 × 60 = 53,500 1040 – (35-5) × 0.90 × 0.90 × 60 = 49,086 1040 – (35 -5 ) – 20 – (20 – 5) × 60 = 58,500
Fair Value of SAR 20 25 27
Total Fair Value Expenses to be recognized each year 10,70,000
10,70,000 × 1/3
= 3,56,667
12,27,150
12,27,150 × 2/3 – 3,56,667
= 4,61,433
15,79,500
15,79,500 – (3,56,667 + 4,61,433)
= 7,61,400

3. Expenses to be recognized in the year 2014-15.
Total intrinsic Value of SARs less expense recognized till date.
= (975 × 60 ×30) – 15,79,500 = 1,75,500

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Question 7.
Virtual Limited granted on 1st April, 2011, 1,00,000 Employees’ Stock Options at ₹ 40, when the market price was ₹ 60/-. These options will vest at the end of year 1, if the earning of Virtual Limited is more than 15% or it will vest at the end of the year 2, if the average earning of two years is more than 12% or lastly it will vest at the end of third year, if the average earning of 3 years will be 9% or more. 6000 unvested options lapsed on 31st March, 2012. 5500 unvested options lapsed on 31st March, 2013 and finally 3000 unvested options lapsed on 31st March, 2014.
The earnings of Virtual Limited was as follows:
Year ended on – Earning in %
31.3.2012 – 13%
31.3.2013 – 9%
31.3.2014 – 7%
Employees exercised for 85,000 stock options which vested in them at the first opportunity and the balance options were lapsed. Pass necessary journal entries and show the necessary working. (Nov 2014, 12 marks)
Answer:
Journal Entries
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 9
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 10

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Working Note :
Statement showing compensation expenses to be recognised
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 11

Question 8.
A company announced a Stock Appreciation Right (SAR) on 01/04/2011 for each of its 600 employees. The scheme gives the employees the right to claim cash payment equivalent to excess on market price of company’s shares, on exercise date, over the exercise price ₹ 130 per share in respect of 100 shares, subject to the condition of continuous employment of 3 years. The SAR is exercisable after 31/03/14 but before 30/06/14.

Particulars 2011-12 2012-13 2013-14
Fair value of SAR 25 28 32
Actual no. of employees left 25 15 10
Company estimation for left employee 3% 5%

On 30/06/2014 when SAR was exercised, the intrinsic value per share was ₹ 35 per share. Show Provision for SAR account by fair value method. (Nov 2015, 8 marks) (CA Final]
Answer:
Note: The solution given below is by rounding off the number of employees and then the number of SARs has been calculated.
Provision of SARs A/c (For 2011-12)
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 12
Provision of SARs A/c (For 2014-15)
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 13

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Working Notes:
Year 2011-12
Number of employees to whom SARs were announced = 600 employees
Total number of employees after three years, on the basis of the estimation in 2011-12
= [(600 – 25) × .97 × .97) = 541 employees (approx.)
Total estimated SARs, to be vested at the end of the vesting period
= 541 employees × 100 SARs = 54,100 SARs
Fair value of SARs = 54,100 SARs × ₹ 25 = ₹ 13,52,500
Vesting period = 3 years
Value of SARs to be recognized as an expense in 2011-12 = ₹ 13,52,500/3
years = ₹ 4,50,833

Year 201 2-13
Total number of employees after three years, on the basis of the estimation
in 2012-13 = [(600 – 25 – 15) × 0.95] = 532 employees
Total estimated SARs, to be vested at the end of the vesting period
= 532 employees × 100 SARs = 53,200 SARs
Fair value of SARs = 53,200 SARs × ₹ 28 = ₹ 14,89,600
Vesting period = 3 years and No. of years expired = 2 years
Cumulative value of SARs to recognize as expense = 14,89,600/3 × 2 = ₹ 9,93,067
Value of SARs to be recognized as an expense in 201 2-13 = ₹ 9,93,067 – ₹ 4,50,833 = ₹ 5,42,234

Year 2013-14
Fair value of SARs = ₹ 32
SARs actually vested = (600 – 25 – 15-10) employees × 100 SARs
= 550 employees × 100 = 55,000 SARs
Fair value = 55,000 SARs × 32 = ₹ 17,60,000
Cumulative value to be recognized = ₹ 17,60,000
Value of SARs to be recognized as an expense = ₹ 17,60,000 – ₹ 9,93,067 = ₹ 7,66,933

Year 2014-15
Cash payment of SARs = 55,000 SARs × ₹ 35 = ₹ 19,25,000
Value of SARs to be recognized as an expense in 2014-15 = ₹ 19,25,000 – ₹ 17,60,000 = ₹ 1.65,000

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Question 9.
On 1st April, 2015, Krishna Limited offered 50 shares to each of its 1000 employees at ₹50 per share. The employees are given a month time to decide whether or not to accept the offer. The shares issued under the plan (ESPP) shall be subject to lock-in transfer for three years from grant date.

Other information:
(1) The market price of shares of the company on the grant date is ₹ 60 per share.
(2) Due to post vesting restrictions on transfer, the fair value of shares issued under the plan is estimated at ₹ 56 per share.
(3) On 30th April, 2015,800 employees accepted the offer and paid ₹ 50 per share purchased.
(4) The nominal value of each share is ₹ 10 each.
You are required to record the issue of shares in the books of the company under aforesaid plan. (May 2016, 4 marks) [CA Final]
Answer:
Fair Value of ESPP = (800 × 50) × (56 – 50)
= 2,40,000
Vesting Period = one month
Expenses recognised = 2,40,000
30th April, 2015:
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 14

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Question 10.
At the beginning of year 1, an enterprise grants 300 options to each of its 1,000 employees. The contractual life of option granted is 6 years. Other relevant information is as follows:
Vesting Period – 3 years
Exercise Period – 3 years
Expected Life – 5 years
Exercise Price – ₹ 50
Market Price – ₹ 50
Expected forteitúres per year – 3%

The option granted vest according to a graded schedule of 25% at the end of the year 1,25% at the end of the year 2, and the remaining 50% at the end of the year 3.

You are required to calculated total compensation expenses for the options expected to vest and cost and cumulative cost to be recognised at the end of all the 3 years assuming that expected forfeiture rate does not change during the vesting period when,
(i) The fair value of these options, computed based on their respective expected lives, are ₹ 10, ₹ 13, ₹ 15 per options, respectively.
(ii) The intrinsic value of the options at the grant date is ₹ 6 per options. (Nov 2016, 10 marks) [CA Final]
Answer:
(i) Based on Fair Value Method.
1. Since the options granted have a graded vesting schedule, the enterprise segregates the total plan into different groups, depending upon the vesting dates and treats each of these groups as a separate plan.
2. The enterprise determines the number of options expected to vest under each group as below:
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 15
3. Total compensation expense for the options expected to vest is determined as follows:

Vesting Date (Year-end) Expected Vesting (No. of Options) Fair Value per Option (₹) Compensation Expense (₹)
1 72,750 10 7,27,500
2 70,568 13 9,17,384
3 1,36,901 15 20,53,515
2,80,219 36,98,399

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

4. Compensation expense, determined as above, is recognised over the respective vesting periods. Total compensation expense of ₹ 36,98,399, determined at the grant date, is attributed to the years 1, 2 and 3 as below:
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 16
(ii) Based on Intrinsic Value Method
In case of intrinsic value method, total compensation expense for the options expected to vest would be:

Vesting Date (End of year) Expected Vesting (No. of Options) Value per Option (₹) Compensation Expense (₹)
1 72,750 6 4,36,500
2 70,568 6 4,23,408
3 1,36,901 6 8,21,406
2,80,219 16,81,314

The compensation expense of ₹ 16,81.314. determined at the grant date, would be attributed to the years 1, 2 and 3 as below:
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 17

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Question 11.
ABC Limited issued 20,000 Share Appreciation Rights (SARs) that vest immediately to its employees on 1st April 2015. The SARs will be settled in cash. At that date it is estimated using an option pricing model, that the fair value of a SAR is ₹ 95. SAR can be exercised any time up to 31st March 2018. At the end of period on 31st March 2016 it is expected that 95% of total employees will exercise thé option, 92%, of total employees will exercise the option at the end of next year and finally 89% will be vested only at the end of the 3rd year. Fair values at the end of each period have been given below:

Fair value of SAR
31st March 2016 110
31st March 2017 107
31st March 2018 112

Discuss the applicability of Cash Settled Share based payments under the relevant md AS and pass the journal entries. (May 2018, 10 marks) (CA Final)
Answer:
Calculation of expenses recognised during the year on account of change in fall value of SARs
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 18
Journal Entries
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 19

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Question 12.
Beetel Holding Inc. grants 100 shares to each of its 300 employees on 1st January, 2015. The employees should remain in service during the vesting period. The shares will vest at the end of the

First year if the company’s earnings increase by 13%
Second year if the company’s earnings increased by more than 21 % over the two-year period.
Third year if the entity’s earning increased by more than 23% over the three-year period
The fair value per share at the grant date is ₹ 125.

In 2015, earnings increased by 9% and 20 employees left the organization. The company expects that earnings will continue at a similar rate in 2016 and expects that the shares will vest at the end of the year 2016. The company also expects that additional 30 employees will leave the organization in the year 2016 and that 250 employees will receive their shares at the end of the year 2016.

At the end of 2016, company’s earnings increased by 19%. Therefore, the shares did not vest. Only 20 employees left the organization during 2016. Company believes that additional 25 employees will leave in 2017 and earnings will further increase so that the performance target will be achieved in 2017.

At the end of the year 2017, only 22 employees have left the organization. Assume that the company’s earnings increased to desired level and the performance target has been met.

Determine the expense for each year and pass appropriate journal entries. (May 2019, 8 marks) [CA Final]
Answer:
Since the earnings of the entity is non-market related, hence It will not be considered in fair value calculation of the shares given. However, the same will be considered while calculating number of shares to be vested.

Workings:
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 20

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Note: 1
Expense for 2015 = No. of employees × shares per employee × Fair value
of share × Proportionate vesting period
= 250 × 100 × 125 × 34
= 15,62,500

Note: 2
Expenses for 2015 = (No. of employees × shares per employee × Fair value of share x Proportionate vesting period) – Expense recognised in year 2015
= (235 × 100 ( 125 × 2/3) – 15,62,500
= 3,95,833

Note: 3
Expenses for 2017 = (No. of employees × shares per employee × Fair Value of share × Proportionate vesting period) – Expense recognised in year 2015 and 2016
= (238 × 100 × 125 × 3/3) – (15,62,500 + 3,95,833)
= 10.16,667

Accounting for Share based Payment (IND AS 102) - CS Professional Study Material

Journal Entries
Accounting for Share based Payment (IND AS 102) - CS Professional Study Material 21

Valuation of Various Magnitudes of Business Organizations – CS Professional Study Material

Chapter 11 Valuation of Various Magnitudes of Business Organizations – CS Professional Valuations and Business Modelling Study Material is designed strictly as per the latest syllabus and exam pattern.

Valuation of Various Magnitudes of Business Organizations – CS Professional Valuations and Business Modelling Study Material

Question 1.
Define each of the following terms
Investment Timing Options; (Dec 2009, 5 marks) [CMA Final]
Answer:
Investment timing option
Investment timing options give companies the option to delay a project rather than implement it immediately. This option to wait allows a company to reduce the uncertainty of market conditions before it decides to implement the project. Capacity options allow a company to change the capacity of their output in response to changing market conditions.

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Question 2.
What is Valuation Multiple? Give examples of any four multiples. (June 2015, 4 marks) [CMA Final]
Answer:
Valuation Multiple:
A valuation multiple is the ratio of firm value or equity value to some aspect of the firm’s economic activity, such as cash flow, sales, or EBITDA. The table below lists the most common multiples used to value firms, together with the terminology that is used to describe the multiple.

Multiples Used in Finance

Quantity X Multiple Terminology = Value
Cash Flow X Firm Value/Cash Flow of Firm “Cash flow multiple” =’ Value of Firm
EBITDA X Firm Value/EBITDA of Firm “EBITDA multiple” = Value of Firm
Sales X Firm Value/Sales Value of Firm “Sales multiple”= Value of Firm
Customers X Firm Value /Customers “Customer multiple”= Value of Firm
Earnings X Price per Share /Earnings “Price-earnings ratio” = Share Price

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Question 3.
Aneez Biotech Private Limited is a start-up Venture in Biotech field and expects a Private Equity investment shortly from a Venture Capital investor, lathis scenario the Company has approached you to value its business. As a Valuation Consultant, list out various methods of Valuation of these types of entities and explain a method suitable for Aneez Biotech Private Limited. (Dec 2019, 5 marks)

Question 4.
Following information is available in respect of XYZ Ltd. which is expected to grow at a higher rate for four years after which growth rate will stabilize at a lower level: (June 2014, 10 marks) [CMA Final]
Base year information:
Revenues : ₹ 2,000 crores
EBIT : ₹ 300 crores
Capital expenditure : ₹ 280 crores
Depreciation : ₹ 200 crores

Information for high growth and stable growth period is as follows:

High Growth Stable Growth
Growth in Revenue & EBIT 20% 10%
Growth in capital expenditure and depreciation 20% Capital expenditure is offset by depreciation
Risk free rate 10% 9%
Equity beta 1.15 1
Market risk premium 6% 5%
Pre-tax cost of debt 13% 12.86%
Debt equity ratio 1:1 2:3

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

For all time, working capital is 25% of revenue and corporate tax rate is 30%. What is the value of the firm? Use rate of discounting @ 13%.

Year 1 2 3 4
P.V. Factor @ 13% 0.885 0.783 0.693 0.613

Answer:
High growth phase:
ke = 0.10 + 1.15 × 0.06 = 0.169 or 16.9%.
kd = 0.13 × (1 – 0.3) = 0.091 or 9.1%.
Cost of capital = 0.5 × 0.169 + 0.5 × 0.091 = 0.13 or 13%.

Stable growth phase:
ke = 0.09 + 1.0 × 0.05 = 0.14 or 14%
kd = 0.1286 × (1 – 0.3) = 0.09 or 9%.
Cost of capital = 0.6 × 0.14 + 0.4 × 0.09 = 0.12 or 12%.
Determination of forecasted Free Cash Flow of the Firm (FCFF)
Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material 1

Present value (PV) of FCFF during the explicit forecast period is:
Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material 2
PV of the terminal, value is: \(\frac{375.32}{0.12-0.10}\) × \(\frac{1}{(1.13)^4}\) = ₹ 18.766 Crores × 0.613
= ₹ 11,504 Crores.
The value of the firm is: ₹ 217.38 Crores + ₹ 11,504 Crores = 11,721 Crores.

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Question 5.
Calculate the expected rate of return of the security from the following information: (Dec 2016)
(i) Beta of a security is 0.5; Expected rate of return On portfolio is 15% p.a.; Risk free rate of return is 6% p.a. (3 marks) [CMA Final]
(ii) If another security has an expected rate of return of 18% p.a.; what would be its Beta? (3 marks) [CMA Final]
Answer:
(i) Calculation of expected rate of return of the security:
= 6 + 0.5 (15 – 6)
= 6 + 4.5
= 10.5%

(ii) Calculation of Bjeta of another security whose expected rate of return is 18%
18 = 6 + Beta (15 – 6)
Beta 9 = 18 – 6
Beta = 12/9
= 1.33

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Question 6.
A Registered Valuer has been asked to determine the combined level of valuation discounts for a small equity interest in a private company. The Valuer concluded that an appropriate control premium is 15 percent. A discount for lack of Marketability was estimated at 25 percent. Given these factors, what is the combined discount? (June 2019, 5 marks)
Answer:
The valuation of a small equity interest in a private company would typically be calculated on a basis that it reflects the lack of control and lack of marketability of the interest. The control premium of 15 percent must first be used to provide an indication of a discount for lack of control (DLOC). A lack of control discount can be calculated using the formula Lack of control discount = 1 – [1 / (1 + Control Premium)]

In this case, a lack of control discount of approximately 13 percent is calculated as 1 – [1/(1 + 15%)]. The discount for lack of marketability (DLOM) was specified. Valuation discounts are applied sequentially and are not added.

A combined discount of approximately 35 percent is calculated as 1 – (1 – 13%) × (1 – 25%) = 0.348 or 34.8%.

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Question 7.
Discuss the valuation methods for micro, small and medium enterprise.
Answer:
Valuation Methods for micro, small and medium sized enterprises
Analysts use various approaches for valuing MSMEs ranging from simple to the sophisticated. There are three approaches to valuation, in general terms. The discounted cash flow valuation, relative valuation and contingent claim valuation. Distinct features of SMEs have an impact on the choice of the valuation approach. The following approaches are generally followed to determine the value of the SMEs business depending on the nature of operations:

  • The DCF method,
  • The relative valuation method,
  • Asset based method and
  • The mixed method.

Discounted Cash Flow (DCF) method
A small business is valued using all the methods but the Discounted Cash Flow method gives the best picture of the business. DCF method is the most popular method as it arrives at nearly accurate valuation. In this method, the value of the future cash flows of the business is reduced to present.

It also takes inflation into account while calculating the valuation of the business. This method gives a better picture of company’s value at present, and is more relatable for the investors, as well as, the business owners. Most of the companies, however, go for a combination of two or more methods for estimating the enterprise value.

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Comparable Transaction Valuation
Size has consequences for the level of risk and, hence, comparable transaction valuation method of relative valuation approach is also used for small enterprises. Small size naturally increases risk levels and in estimating required rates of return for small and private companies risk premiums for small size will often be incorporated. This method is usually used when the valuation is accepted by the valuer for sale.

Under this method, peer group is compared on similar standards. Similar companies are decided based on industry they belong to as well as the market capitalization for the purpose of valuation. The companies are then assessed on common multiples such as EV/EBITDA, PE ratio, PEG ratio and so on. For fair valuation, the company should be evaluated on more than one standard to ascertain the current and the potential value of the company.

However, this approach has its own set of drawbacks when the historical data of the company is not available. Therefore, this approach is not used solely, but in combination with other approaches. Comparable Transaction Valuation is often used along with Discounted Cash Flow to present fair value of business.

Asset based Approach
Asset based approach is another approach to valuation of SMEs. The valuation here is simply the difference between assets and liabilities taken from the’balance sheet, adjusted for certain accounting principles. Fair market value of assets is arrived to get enterprise value. Patents, goodwill, bad debts, etc. are valued at their book value along with adjustments for inventory undervaluation to arrive at the fair value of the assets.

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

This approach is generally used to assess 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).

Asset Based valuation can be done using three methods. They are Economic Book Value Calculation, Liquidation Value Calculation, and Valuation at Replacement Cost. The valuation of the enterprise is done as per the values arrived from any of the three methods as under:

  • Economic Book Value: The accounting book values of the assets are adjusted to their current market value.
  • Liquidation Value method: At estimated sale value of assets at liquidation less the cost of liquidation.
  • Valuation at Replacement Cost: The cost incurred to get the same assets from scratch is used for valuing assets.

However, the asset-based approach is not an alternative to the above approaches, as this approach itself uses one of the three methods to determine the values. In determining which of these approaches to use, the valuer must exercise discretion as each technique has advantages as well as drawbacks. It is normally considered advisable to employ more than one technique, which must be reconciled with each other before arriving at a value conclusion.

Mixed method (particularly, Anglo-Saxon method with limited capitalization of goodwill): In general, mixed methods mediate between income-based methods and assets-based methods, as the value of an enterprise mostly s. depends on the attitude to produce earnings.

SMEs are shaped by their entrepreneurs and that strongly affect the future perspectives of profit. Therefore, in case of changes in the decision-making owner, perspectives of profit will considerably change, as they particularly depend on the entrepreneur. Thus, it is reasonable to assume that goodwill has a limited duration, in case of changes in ownership arrangement. The method is suitable to define the value of small and medium-sized enterprises and theoretically correct for the specific purpose.

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Question 8.
Discuss the valuation methods for start up.
Answer:
Valuation of Startups
Startup means an entity, incorporated or registered in India:

  • Upto a period of seven years from the date of incorporation/registration or upto ten years in case of Startups in Biotechnology sector
  • As a private limited company or registered as a partnership firm or a limited liability partnership
  • With an annual turnover not exceeding ₹ 25 crore for any of the fnancial years since incorporation/ registration
  • Working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation

Features of startups:
The following are some of the key characteristics of start-up companies:

  • No past history, operations have not reached the stage of commercial production.
  • No or negligible revenue with operational losses.
  • Limited promoter’s capital infused and high dependence on external sources of funds.
  • Illiquid investments.

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Methods of Valuation
The following are the valuation methods of start-ups as per Indian Valuation Standards Issued by ICAI applicable for the valuation reports issued on or after 1st July, 2018:

  • Income approach
  • Cost approach
  • Venture Capital (VC) method
  • First Chicago Method
  • Adjusted discounted cash flow method
  • Rule of thumb

Income approach : It is a valuation approach that converts maintainable or future amounts (e.g., cash flows or income and expenses) to a single current (i.e., discounted or capitalized) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts.

This approach involves discounting future amounts (cash flows/income/cost savings) to a single present value. The valuer may consider using other valuation approaches instead of income approach or in combination with income approach whenthere is signifcant uncertainty on the amount and timing of income/future cash flows of the start-up companies;

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Cost approach: It is a valuation approach that reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost). A valuer applies cost approach in case income approach cannot be used. The valuer may also consider using other valuation approaches in combination with cost approach, when the asset has not yet started generating income / cash flows (directly or indirectly);

The following are some of the generally acceptable methods of valuation of start- ups:
Venture Capital (VC) method: Venture Capitalist Method is one of the globally acceptable methodologies in estimating the value of start-ups .In this method the valuation of the start-up is done from the venture capitalist point of view. It indicates the value of pre-money ventures by following the process that VCs go through, where they exit an investment within three to seven years. It estimates the expected exit price of a similar mature business venture and discounts it back to present value considering the risks involved.

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Question 9.
Discuss the valuation of small companies.
Answer:
Valuation of Small Companies
Small companies are private in nature and financially less transparent than their publicly traded peers. Though often smaller in size these small private companies have a major importance in the world’s economy. These businesses have noticeably more risk than larger ones.

Size contributes to the discount in the valuation since it replicates the industry. These private company’s owners do not publicly issue shares of their company, instead they keep ownership and associated transactions at low-key.

Valuation of such closely-held private companies can be costly and difficult due to non-availability of exact financial information. Small private companies may be good acquisition targets for larger competitors and publicly-traded counterparts. There are different methodologies and financial tools to evaluate a small private company.

When it comes to small businesses which are private in nature, the following three techniques are most commonly used:

  • Comparable Company Trading Multiple Analysis, (also known as “peer group analysis”
  • Precedent/Comparable Transaction Analysis, and
  • Discounted Cash Flow (“DCF”) Analysis.

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Question 10.
Discuss the valuation of various magnitude of business.
Answer:
Discounted Cash Flow valuation
The method involves forecasting future cash flows and discounting the same to the present point of time using a cost of capital that replicates the firm’s capital structure and business risk. It relates the value of an asset to the present value of expected future cash flows on that asset.

There are several methods of DCF valuation:
Enterprise DCF model: The method values the entire business, with both assets in place (investments already made) and growth assets (investments yet to be made).The cash flows before debt payments and after reinvestment needs are called free cash flows to the frm (FCFFs).

The discount rate that reflects the composite cost of financing from all sources of capital is called the cost of capital (WACC). WACC-based models work best when a company maintains a relatively stable debt-to-value ratio. If a company’s debt-to-value ratio is expected to change, WACC-based models can still yield accurate results but are more difficult to apply.

Value of the firm = Present value of cash flow during an explicit forecast period + Present value of cash flow after the explicit forecast period

Equity DCF model:
The method values the equity stake in the business and is known as equity valuation. The cash flows before debt payments and after re-investment needs are called free cash flows to the equity (FCFs). The discount rate reflects only the cost of equity financing.

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Free cash flow to equity (FCFE)
Another model known as the free cash flow equity model involves forecasting the free cash flow to equity (FCFE). It represents a model where potential or future dividends are discounted rather than actual dividends.

The FCFE model can be used to evaluate publicly traded firms and assumes that there is strong corporate governance system is in practice in the company.Similar to dividend discount model, there are variations in the FCFE model that revolve around assumptions about future growth and reinvestment needs.

Growth Models
Gordon growth model values stock in a stable-growth firm that pays out the shareholders in the form of dividends. The usage of the model is limited to the frms that are growing at a stable rate and at a rate comparable to or lower than the growth rate in the economy. The stable growth rate cannot be more than 0.25 percent to 0.5 percent above the economy growth rate. If the gap between the stable growth rate and growth rate in the economy becomes larger, than using a two -stage or three-stage model to capture the ‘supernormal’ or ‘above average’ growth would be more appropriate.

A two-stage dividend discount model is based on two clearly defined growth stages-high growth and stable growth. It is used when the expected earnings growth rate of the company is superior to the growth rate of the economy. The model is used to value the companies which maintain high growth for a specific time period and the sources of such high growth tend to disappear after some time. The value of a sector or a market can also be estimated using this model.

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Three-Stage dividend discount model is the combination of the features of the two-stage model and the H-model. The model adopts an initial phase of constant high growth, a second phase of declining growth and a third phase of stable low growth that lasts forever. No restrictions on the payout ratio are imposed by the model. The model is suitable for banking companies characterized by high growth initially, followed by declining growth due to competition and lastly maintains a stable low growth because of its nature of business and ownership, specifically the public sector banks in India.

Adjusted present value (APV) model: In case, where a company’s debt-to-value ratio is expected to change adjusted present value (APV) is used as alternative to WACC-based models to get accurate value. APV specifically forecasts and values any cash flows associated with capital structure separately, rather than inserting their value in the cost of capital. Enterprise Value – Value of the unlevered Value of the financing side effects equity free cash flow + Enterprise Value = Current invested capital +Present value of the future economic profit stream

The equity free cash flow of the unlevered firm is same as the free cash flow to the firm. It is discounted at the cost of unlevered equity. For computing the present value the borrowing rate of the firm is used.

Economic profit model: Because of its close link to economic theory and competitive strategy, the discounted economic-profit valuation model is attaining the popularity. Economic profit shows whether a company is earning its cost of capital and how its financial performance is anticipated to change over time. The two models enterprise DCF model and economic profit model yield identical results and have different but complementary benefits. Creating both enterprise DCF and economic-profit models when valuing a company results in accurate value.

Enterprise Value = Current Invested capital + Present value of the future economic stream.
Economic Profit = Invested Capital (ROIC – WACC) .Where ROIC = Return on Invested Capital

Economic profit highlights whether a company is earning its cost of capital and how its financial performance is expected to change over time. The two models enterprise DCF model and economic profit model yield identical results and have different but complementary benefits. It is recommended to create both enterprise DCF and economic-profit models when valuing’ a company.

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Question 11.
Explore the valuation of a bank using equity discounted cash flow method.
Answer:
Valuation of Banks
Financial Institutions like banks and insurance companies are among the most challenging companies to value, particularly for outside analysts as they do not have some crucial information such as asset-liability mismatch about these companies. Further, as these institutions are highly levered, their valuations are remarkably sensitive to small changes in key drivers. Their operations cannot be valued separately from interest income and interest expense, as they are the main components of their income statements.

In valuation of the banks, the focus has to be not on profit growth, but on stability. Therefore, for financial companies which are highly levered, the equity cash flow approach is more appropriate. The equity DCF approach does not tell us how and where a Bank creates value in its operations. Is the bank creating or destroying value when receiving the percentage of interest i.e., for example assume that 6.5 percent on its loans or when paying. 4.3 percent on deposits.

When valuing banks and other financial institutions, where capital structure is an inseparable part of operations, capital cash flow and equity cash flow, valuation models are used.

Discounted cash flow approach
Business valuation models of financial institutions are largely based on discounted cash flow approach (DCF model)and assume some growth stages, which is typical for different growth rates of cash flow or resources for owners. A bank’s cash flows tend to be highly volatile and connected to macroeconomic factors. This makes forecasting cash flows very challenging and prone to mistake. Hence,the calculation of FCFE in banks and financial institutions can be implemented in two basic ways:

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Method 1: FCFE = net income – growth of capital + other income The growth of financial institutions should be followed by an adequate increase in its capital. If the growth is not accompanied by an adequate increase in the capital, it may lead to failure of financial institutions due to lack of solvency. Growth in FCFE lowers the capital, as it means that the bank is introduced into the banking business of profits that would otherwise be paid to owners as dividends.

The Residual Income Valuation Method
An alternative bank valuation model is used based on discounted residual income. Residual Income (Rl) is the difference between operating profits after taxes and the cost of equity capital employed. The latter equals the previous year’s total equity multiplied by the cost of equity according to CAPM.

Second, the terminal value of the bank in perpetuity is estimated by dividing the residual income of the year following the analytical period y with the cost of equity. The two methods theoretically show that both Equity Cash Flow Method and Residual Income (RI) Method produce equivalent equity bank values.

Valuation of Various Magnitudes of Business Organizations - CS Professional Study Material

Question 12.
What is the purpose of valuation?
Answer:
Purpose of Valuation
Value is wanted to be known in a commercial context for the purpose of a transaction of ‘buy or sell’ or to know the ‘worth’ of a possession. Valuations of businesses, business ownership interests may be performed for a wide variety of purposes including the following(as listed by ICAI):

(a) Valuation of financial transactions such as acquisitions, mergers, leveraged buyouts, initial public offerings, employee stock ownership plans (ESOPs) and other share-based plans, partner and shareholder buy-ins or buy-outs, and stock redemptions;

(b) Valuation for dispute resolution and/ or litigation/pending litigation relating to matters such as marital dissolution, bankruptcy, contractual disputes, owner disputes, dissenting shareholder and minority ownership oppression cases, employment disputes, etc;

(c) Valuation for compliance oriented engagements, for example:

  1. Financial reporting; and
  2. Tax matters such as corporate reorganizations, purchase price allocations etc.

(d) Valuation for other purposes like the valuation for planning, internal use by the owners etc;
(e) Valuation under Insolvency and Bankruptcy Code.
(f) Valuation for the stake to be divested by public sector undertakings (PSUs).