Chapter 12 Valuation of Business during Distressed Sale – CS Professional Valuations and Business Modelling Study Material is designed strictly as per the latest syllabus and exam pattern.
Valuation of Business during Distressed Sale – CS Professional Valuations and Business Modelling Study Material
Sound Health Systems Ltd. is operating in the health sector and is having about 40 hospitals – general, specialty and super-specialty- across India. The Balance Sheet of the Company, as reported in its Annual Report, 2008 is given below: (Dec 2009)
Balance Sheet of Sound Health Systems Limited as at 31 st March
Sound Health Systems Ltd. has not been performing well in the past and consequently, has suffered losses during the last few years. However, the management of the company strongly feels that the company can be again put on the path to sound financial health by having proper financial restructuring. Therefore, the following scheme of financial reconstruction is being devised:
(a) Equity shares are to be reduced to ₹ 2 from ₹ 10 fully paid up.
(b) The rate on preference share is to be reduced to 10% and the value thereof reduced to ₹ 50 from ₹ 100 fully paid up.
(c) Lenders have agreed to forego interest payable to them as on March 31, 2008.
(d) Creditors have agreed to forgo 25% of their claims and remaining amount will be converted into equity shares at a rate of ₹ 2 fully paid up but they have to be paid 20% of the amount due as on March 31,2008 in cash immediately.
(e) Unsecured loan lenders will take 10% of the amount as on March 31, 2008 and they have agreed to take the remaining amount after 4 years.
(f) To meet the requirement of working capital of the company and to make payment to creditors and others, it is decided to issue 20 lakh shares of ₹ 2 each at a premium of ₹ 3 totalling ₹ 5 per share. The existing shareholders have decided to subscribe for them and the whole amount will be paid along with the application.
(g) A provision of ₹ 80 lakh is to be made for doubtful debts on debtors.
You are required to show the impact of the said financial restructuring on the balance sheet of the company and also, prepare the new balance sheet assuming that the scheme has been successfully implemented. (15 marks) [CMA Final]
M/s Sound Health Systems Ltd.
Statement showing the Impact of Proposed Financial Reconstruction
|Particulars||ltem(s) on which there will be Impact||Amount of Impact (? in Lakhs)|
|(i) Equity shares are to be reduced to ₹ 2 from ₹ 10 fully paid up.||Share Capital Reserves and Surplus||-19,061.321
|(iii) Lenders have agreed to forego interest payable to them as on March 31, 2008||Interest on Loans Payable Reserves and Surplus||-1000
|(iv) Creditors have agreed to forego 25% of their claims and remaining amount will be converted into equity shares at the rate of ₹ 2 fully paid up but they have to be paid 20% of the amount due as on March 31, 2008 in cash immediately.||Creditors (Paid in Cash)
Cash in Hand and Bank Creditors (Amount foregone)
Reserves & Surplus Creditors
(Issued Equity Shares)
Equity Share Capital
|(v) Unsecured loan lenders will take 10% of the amount as on March 31,2008 and they have agreed to take the remaining amount after 4 years.||Unsecured Loans
Cash in Hand and Bank
|(vi) To meet requirement of the working capital of the company and to make payment to creditors and others it is decided to issue 20 lakhs share of ₹ 2 each at a premium of ₹ 3 totaling₹ 5 per share. The existing share- holders have decided to subscribe for them and the whole amount will be paid along with the application||Equity Shares Capital
Security Premium (Reserves & Surplus)
Cash in Hand and Bank
|(vii) A provision of ₹ 80 lakhs is to be made for doubtful debts on debtors.||Provision for doubtful debts
Reserves & Surplus
Balance Sheet of Sound Health System Ltd. as on 31 st March 2008 (Revised Balance after incorporating necessary impacts of financial restructuring)
- Debit Balance of Profit and Loss Account has been written off by deducting the equivalent amount from ‘Reserve and Surplus.
- Negative Balance in Cash in Hand and at Bank represents the amount of overdraft taken by the company to meet the necessary cash obligations.
Discuss the feature of declining companies.
Features of Declining Companies
At this juncture, it is important to understand the features of ‘Declining Companies’. The characteristics of declining companies are as follows-
1. Stagnant or declining revenues: Perhaps the most telling sign of a company in decline is the inability to increase revenues over extended periods, even when times are good. Flat revenues or revenues that grow at less than the inflation rate is an indicator of operating weakness. It is even more telling if these patterns in revenues apply not only to the , company being analyzed but to the overall sector, thus eliminating the explanation that the revenue weakness is due to poor management (and ’ can thus be fixed by bringing in a new management team).
2. Shrinking or negative margins: The stagnant revenues at declining firms are often accompanied by shrinking operating margins, partly because firms are losing pricing power and partly because they are dropping prices to keep revenues from falling further. This combination results in deteriorating or negative operating income at these firms, with occasional spurts in profits generated by asset sales or one time profits.
3. Asset divestitures: If one of the features of a declining firm is that existing assets are sometimes worth more to others, who intend to put them to different and better uses, it stands to reason that asset divestitures will be more frequent at declining firms than at firms earlier in the life cycle. If the declining firm has substantial debt obligations, the need to divest will become stronger, driven by the desire to avoid default or to pay down debt.
4. Big payouts – dividends and stock buybacks: Declining firms have few or any growth investments that generate value, existing assets that may be generating positive cash flows and asset divestitures that result in cash inflows. If the firm does not have enough debt for distress to be a concern, it stands to reason that declining firms not only pay out large dividends, sometimes exceeding their earnings, but also buy back stock.
5. Financial leverage – the downside: If debt is a double-edged sword, declining firms often are exposed to the wrong edge. With stagnant and declining earnings from existing assets and little potential for earnings growth, it is not surprising that many‘declining firms face debt burdens that are overwhelming.
Discuss the valuation Issues of declining companies.
Valuation Issues of Declining Companies
The issues that we face in valuing declining companies come from their common characteristics. Most of the valuation techniques we use for businesses, whether intrinsic or relative, are built for healthy firms with positive growth and they sometimes break down when a frm is expected to shrink over time or if distress is imminent.
Intrinsic (DCF) Valuation
The intrinsic value of a company is the present value of the expected cash flows of the company over its lifetime. While that principle does not change with declining firms, there are practical problems that can hamper valuations which are discussed as under:
When valuing the existing assets of the firm, we estimate the expected cash flows from these assets and discount them back at a risk-adjusted discount rate. While this is standard valuation practice in most valuations, there are two aspects of declining companies that may throw a twist in the process.
(i) Earning less than cost of capital:
In many declining firms, existing assets, even if profitable, earn less than the cost of capital. The natural consequence is that discounting the cash flows back at the cost of capital yields a value that is less than the capital invested in the firm. From a valuation perspective, this is neither surprising nor unexpected: assets that generate sub-par returns can be value destroying.
(ii) Divestiture effects:
If existing assets earn less than the cost of capital, the logical response is to sell or divest these assets and hope that the best buyer will pay a high price for them. From a valuation perspective, divestitures of assets create discontinuities in past data and make forecasts more difficult to make. To see how divestitures can affect past numbers, consider a firm that divested a significant portion of its assets midway through last year.
Declining firms derive little from growth assets, and the valuation of these assets should therefore not have a significant impact on value. While this is generally true, we have to leave open the possibility that some declining firms are in denial about their status and continue to invest in new assets, as it they had growth potential. If these assets earn less than the cost of capital, the value of adding new assets will be negative and reinvestment will lower the value of the firm.
If the cost of capital is a weighted average of the costs of debt and equity, what is -it about declining firms that makes it difficult to estimate these numbers? First, the large dividends and buybacks that characterize declining firms can have an effect on the overall value of equity and on the debt ratios that we use in the computation. In particular, returning large amounts of cash to stockholders will reduce the market value of equity, through the market price, with dividends, and the number of shares, with stock buybacks. If debt is not repaid proportionately, the debt ratio will increase, which will then affects of costs of debt, equity and capital.
To estimate the terminal value, we first estimate a growth rate that a firm can sustain forever, with the caveat that the growth cannot exceed the growth rate of the economy, with the risk free rate acting as a proxy. We follow up by making reasonable assumptions about what a firm can generate as excess returns in perpetuity and use this number to forecast a reinvestment rate for the firm. We complete the process by estimating a discount rate for the terminal value computation, with the qualifier that the risk parameters used should reflect the fact that the company will be a more stable one.
From Operating Assets to Equity Value per Share While the process of getting from operating assets to equity value per share follows the standard script – add cash and other non-operating assets, subtract debt outstanding and the value of any equity options granted by the firm (either in financing or to management) and divide by the number of shares outstanding – there are two problems that we face, especially with the distressed sub-set of declining firms.
Analysts who fall back on relative valuation as a solution to the problems of valuing declining or distressed firms, using intrinsic valuation, will find themselves confronting the estimation issues that were listed in the earlier sections either explicitly or implicitly when they use multiples and comparables.
(i) Scaling Variable:
All multiples have to be scaled to common variables, which can be broadly categorized into revenues, earnings, book value or sector specific measures. With distressed companies, earnings and book values can become inoperative very quickly, the former because many firms in decline have negative earnings and the latter because repeated losses can drive the book value of equity down and into negative territory.
(ii) Comparable Firms:
There are two possible scenarios that we can face when valuing declining firms. One is when we are valuing a declining firm in a business where the remaining firms are all healthy and growing. Since markets value declining firms very differently from healthy firms, the challenge in this case is working out how much of a discount the declining firm should trade at, relative to the values being attached to healthy firms.
(iii) Incorporating Distress:
While analysts often come up with creative solutions to the first two problems – using multiples of future earnings and controlling for differences in decline, for instance – the presence of distress puts a wild card in the comparison.
Write note on Distress Assets.
Distressed Assets – The Indian Scenario
The Indian banking sector is an exemplar of distressed assets which has been witnessing blow after blow in asset quality management on account of multiple large and small scale projects ran into hurdles along the way, such as, poor evaluation of project, extensive delays in project, poor monitoring and poor accounting leading to cost overruns, which disallowed the borrowers from repayment of their loans. Mostly the public sector banks suffered severe impacts and there was a slowdown in growth of credit.
Therefore, the RBI, following the European Central Bank’s (ECB) tests on supervising the Euro banks after the big financial crisis, came up with certain effective measures to remedy the situation and deal with distressed assets before it’s too late.
Such efficacious methods to lower the stress of distressed assets include lowering the financial stress of the project such as the JLF, the SDR technique (necessitating the banks’ debt-for-equity swap process and change of management in companies), and the 5/25 mechanism (so that loans for long-term projects, such as infrastructure industries and core industrial sectors, are refinanced every 5 years when they have a tenure of 25 years or above).
Further, in order to make an assessment of how effectively the ‘Bad Loan Management Schemes’, drawn up by the bank Boards individually, were working and in order to make sure that the banks were taking proactive measures to clean up balance sheets, the RBI launched an Asset Quality Review (AQR) as a part of the bank’s mandate to improve the banking sector, clean up bad loans and boost the quality of their balance sheets by March 2017.