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
Write short note on IVS 500.
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.
Write short note on 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.
Write short note on 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.
Discuss the four methodologies are being used for valuation of PSU.
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.
Discuss the four stages of valuation approach.
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
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.
What are the DCF Valuation Fundamentals?
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.