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
What do you understand by free cash flows? (Dec 2011, 5 marks) [CMA Final]
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.
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 (₹)|
|Sales (at stand. Prices)||5,00,000||4,00,000||4,50,000|
|Net cost of production:|
|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.
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]
|Item||Machine A (₹)||Machine B (₹)||Machine C (₹)|
|Cost of Production||1,50,000||1,30,000||1,42,000|
|Selling and Distribution Cost||10,000||10,000||10,000|
|Depreciation: Cost less Scrap value/life||1,30,000||91,667||90,000|
|Interest on borrowings||24,000||24,000||24,000|
|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.
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)|
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]
Present value of the future cash flow
|Year||Estimated cash flows (₹ in lakhs)||Discount @ 15%||DCF|
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
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.
- What is the total value of Autumn Spring’s equity using the FCFF valuation approach?
- What is the total value of Autumn Spring’s equity using the FCFE valuation approach? (Dec 2019, 5 marks)
Discuss different terms related to value.
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.
(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.
(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.
Mention steps in DCF approach.
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
Discuss advantages and disadvantages of Income approach.
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:
- It captures the cash flows that investors actually care about.
- It takes cognizance of the fact that money changes value over time.
- 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:
- Detailed information is needed for building up the forecasts
- 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
- 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)
Discuss advantages and disadvantages of Cost and Sales Comparison approaches.
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.
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.