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ABFM MODULE - C
Chapter 13: CORPORATE VALUATION
What we will study?
*How to calculate Weighted Average Cost of Capital
(WACC)?
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Weighted Average Cost of Capital (WACC):
The weighted average cost of capital, or WACC, is a marginal
cost, or the cost of raising more capital, that is averaged
across the various sources of capital.
Let rd, rp, and re equal the after-tax cost of debt, the cost of
preference shares, and the cost of equity shares respectively,
and let wd, wp, and we represent the proportion of debt,
preference shares, and equity shares capital in the capital
structure respectively.
The weighted average cost of capital shall be calculated using
the following formula:
WACC = 𝐰𝐝 𝐫𝐝 + 𝐰𝐩 𝐫𝐩 + 𝐰𝐞 𝐫𝐞

This can be explained with the help of the following

illustrations:
Illustration 1:
Source Weight Cost of Capital Weight * Cost

Debt 45% 8% 0.036

Preference Shares 5% 9% 0.0045

Equity Shares 50% 15% 0.075

Weighted Average Cost 0.1155

of Capital
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Illustration 2:
The data in respect of ANC Limited is given:
* Additional Finance Required = Rs. 20,00,000
* Retained earnings = Rs. 4,00,000
* Debt equity ratio 25:75
* Cost of Debt Before Tax
* 10% up to Rs. 2,00,000
* 13% beyond Rs. 2,00,000

* EPS = Rs. 12.

* Dividend Pay-out = 50% of earnings
* Expected growth rate(G) in dividend 10%
* Current Market Price (MP) per Share = Rs. 60
* Company's Tax Rate (Tc) = 30%
* Shareholder's Personal Tax Rate = 20%
Calculate:
A. Post-Tax Average Cost of Additional Debt?
B. Cost of Equity?
C. Cost of Retained Earnings?
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D. Overall Weighted Average (After Tax) Cost of Additional
Finance?
Solution:
* Pattern of Raising Capital = 25(D):75(E)
* Debt = 0.25*Rs. 20,00,000 = Rs. 5,00,000
* Equity = 0.75*Rs. 20,00,000 = Rs. 15,00,000

Equity Fund:
* Retained Earnings = Rs. 4,00,000
* Additional Equity = Rs. 11,00,000
Debt Fund: Total 5 Lac
10% Debt = Rs. 2,00,000
13% Debt = Rs. 3,00,000

Post-Tax Average Cost of Additional Debt:

(𝟏−𝐓𝐜 )
CD = Total Interest *
𝐓𝐨𝐭𝐚𝐥 𝐃𝐞𝐛𝐭
( 𝟏−𝟎.𝟑) 𝟒𝟏,𝟑𝟎𝟎
= [20,000 + 39,000] =( ) =0.0826 * 100%
𝟓,𝟎𝟎,𝟎𝟎𝟎 𝟓,𝟎𝟎,𝟎𝟎𝟎
=8.26%
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𝐏𝐚𝐲𝐨𝐮𝐭
Cost of Equity: 𝐂𝐄 = 𝐄𝐏𝐒 × +G
𝐌𝐏
𝟏𝟐 (𝟓𝟎%)
= +10% = 10% + 10% = 20%
𝟔𝟎

Cost of Retained Earnings: CR = CE (1 – TP)

= 20*(1 – 0.2) = 16%

Weighted Average Cost of Capital (CO):

Amount (Rs.) Cost After Tax% Cost(Rs.)
Equity 11,00,000 20% 2,20,000
Retained earning 4,00,000 16% 64,000
Debt 5,00,000 8.26% 41,300
Total 20,00,000 3,25,300

𝟑,𝟐𝟓,𝟑𝟎𝟎
CO= × 100 = 16.27%
𝟐𝟎,𝟎𝟎,𝟎𝟎𝟎
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ABFM MODULE - C
Chapter 13: CORPORATE VALUATION (PART-I)
What we will study?
*What is Book Value?
*What is Market Value?
*What are the different approaches for corporate
valuation?
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INTRODUCTION:
Corporate valuation is the process of determining the value of
a company entity, and it is most commonly used in the
context of the financial industry.
We need to grasp the idea of value, before even beginning to
discuss valuation approaches.
There are two primary types of value, which are as follows:
Book Value:
Book value can be described as the value of an asset or the
complete business entity as established by the books or the
financials of the company.
Thus, we may say that the book value can be derived from the
Balance Sheet.
Market Value:
This refers to the value that is derived through the analysis of
the market.
The market capitalization of a company, often known as the
number of outstanding shares multiplied by the share price,
defines the market worth of a company.
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The market value is fundamentally an equity value because
equity investors value a company's shares apart from debt
lenders and other investors.
The term "enterprise value", which is synonymous with "firm
value", refers to the value that is placed on a complete
company, including its debts and other commitments.
The significance of enterprise value lies in the fact that it
comes close to approximating the worth of an entity's running
assets, as we will see in the following section.
To be more specific, "Debts and other obligations" can include
short-term debts, long-term debts, the current portion of
long-term debts, capital lease obligations, preferred
securities, non-controlling interests, and other non-operating
liabilities.
To summarise, the formula for determining an enterprise's
value is as follows:
Equity value + short-term debts + long-term debts + the
current portion of long-term debts + capital lease obligations +
preferred securities + non-controlling interests + other non-
operating liabilities (e.g., unallocated pension funds) - (minus)
Cash and cash equivalents.
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As a result of the fact that the fundamental goal of
management is to maximise the value of the firm, managers
require a tool that can estimate the effects that various
strategies will have on the value of the firm.
The model of the business valuation is the instrument in
question.
The primary focus of effective financial management is to
optimise the value creation for shareholders.
If the management cannot increase the value for
shareholders, they are going to hold the management
accountable.
As a result, the top management and all senior managers are
required to have an understanding of what factors into value
and how to quantify it.
In the past, valuation was considered to be a difficult and
highly technical academic subject; but, in today's business
world, it is of utmost relevance to managers.
As a result of increasing globalisation and economic
liberalisation, businesses are placing a greater emphasis on
the capital market; and mergers, acquisitions, and other forms
of corporate reorganisation are becoming increasingly
common; strategic alliances are becoming more prevalent;
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employee stock options are multiplying; and regulatory bodies
are having difficulty determining appropriate tariff levels.
When carrying out these tasks, one of the most important
questions to ask is,
"How should the value of a firm, or a part thereof, be
evaluated?"
The estimation of a company's true worth, in the current
market, is the primary objective of valuation.
It is, therefore, necessary to define "fair market value” and "a
company" in the beginning itself.
The concept of fair market value, as propounded by the
United States Internal Revenue Service (IRS), is accepted the
world over.
Fair market value was defined by IRS as "the price at which
property would change hands between a willing buyer and a
willing seller, when the former is not under any compulsion to
buy and latter is not under any compulsion to sell, both
parties having reasonable knowledge of relevant facts."
When the asset being evaluated is "a corporation" the buyer
and seller are actually selling the claims that each stakeholder
in the firm has on the company as the property that is being
exchanged.
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This covers both equity shares and preference shares as well
as debentures and loans that are currently outstanding.
The International Assets Valuation Standards Committee is
responsible for developing the International Valuation
Standards (IVS), which are intended to be used as the primary
guide for valuation professionals all over the world, in order
to underpin consistency, transparency, and confidence in
valuations.
According to the provisions of IVS 105 Valuation Approaches
and Methods, due consideration must be given to the
valuation approaches that are pertinent and appropriate.

APPROACHES TO CORPORATE VALUATION:

As discussed in IVS 105, the primary methodologies, which are
utilised in valuation, are all founded on the economic
concepts of price equilibrium, anticipation of benefits, or
substitution.
The principal valuation approaches, as per IVS 105, are:
(a) Market approach:
The market approach is a valuation method that determines
the value of a company, an intangible asset, an ownership
stake in a firm, or of securities, by taking into account the
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price of a recent transaction or the price of assets that are
comparable to the one being valued.
When determining the value of an asset, the market approach
takes into account its size, quantity, quality, and other
characteristics, in addition to the values of comparable assets.
This value is then applied to the item under examination.
This method assists in determining the worth of a business by
making a comparison of the business (under valuation) to
other businesses of a comparable nature that have been sold
in more recent times.
(b) Income approach:

When valuing a company, the income approach is utilised to

determine the present or current value of the company's
expected future earnings or cash flows.
The net operating income (NOI) of the company is determined
using this method, and then that figure is divided by the rate
of capitalization.
(c) Cost Approach:
The cost approach, which is also known as the asset-based
approach, is able to extract value by combining the FMV (Fair
Market Value) of the company's net assets.
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This method is also known as the asset-based approach
(assets less its liabilities).
In layman's terms, this methodology has a tendency to
determine the worth of the firm on the basis of the value of
the assets held by the business.
The use of this method is particularly helpful for asset-
intensive businesses, holding corporations, and troubled
entities whose worth is less than their whole net tangible
value."
Each of these methods of valuation contains a variety of
specific application procedures that are distinct from one
another.
When picking ways and methodologies for the valuation of an
asset, the objective is to locate the approach that is most
suitable for the specific conditions at hand.
There is no one approach that is appropriate for use in each
and every scenario.

The following criteria should be considered at the very least,

during the selection process:
(a) The relevant basis of value and premise of value, which are
established by the terms and purpose of the valuation
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assignment, and the appropriate method of determining
value.
(b) The relative advantages and disadvantages of the various
approaches and methodologies that could be used for the
appraisal.
(c) The appropriateness of each way, having regard to the
nature of the asset, as well as the approaches or methods
utilised by players in the relevant market, and the relative
importance of each method.
(d) The accessibility of trustworthy information that is
necessary to implement the approach.
When a valuer has a high degree of confidence in the accuracy
and reliability of a single method, given the facts and
circumstances of the valuation engagement, the valuer is not
required to use more than one method for the valuation of an
asset.
This is especially true when the valuer is valuing a property.
However, valuers should consider the use of multiple
approaches and methods, and more than one valuation
approach or method should be considered and may be used to
arrive at an indication of value.
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Further, the four primary methods that can be utilised for
determining the value of a firm are:
1. Adjusted Book Value Approach.
2. Stock and Debt Approach.
3. Direct Comparison Approach and
4. Discounted Cash Flow Approach.
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ABFM MODULE - C
Chapter 13: CORPORATE VALUATION (PART-II)
What we will study?
*All about adjusted book value approach?
*All about stock and debt approach?
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ADJUSTED BOOK VALUE APPROACH:
Relying just on the data shown in a company's balance sheet,
is the least complicated method for determining the
company's value.
When determining the value of a company, there are two
methods that are functionally equal to using the information
from the balance sheet.
To begin, a direct tally of the book values of investor claims
might be performed, if desired.
Second, the total value of the company's assets can be
determined, and then from that figure, any claims made by
parties other than investors (such as accounts payable and
provisions) can be subtracted.
Let's look at an example to further understand how this
strategy works:
From the following Balance Sheet of Abstract Limited, the
value of the Company can be computed using the various
approaches relating to investor claims and the assets and
liabilities as under:
* Gross Block is the sum of the gross value of each asset as of
the beginning of the financial year.
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Balance sheet of Abstract Limited as on 31/03/2022:
Rs. Crore
LIABILITIES ASSETS

Share Capital 45.00 Fixed Assets (Net) 63.00

Equity 45.00 Gross Block 85.00

Accumulated 22.00
Depreciation

Reserves and Surplus 21.00 Investments 11.50

Secured Loans 24.30 Current Assets, Loans and 41.90

Advances

Term Loans 10.00 Cash and Bank Balances 1.40

Non-Convertible Receivables 25.00

Debentures 14.30

Unsecured Loans 6.50 Inventories 15.00

Bank Overdraft 3.50 Pre-paid expenses 0.50

Inter Corporate Loans 3.00

Current Liabilities and 19.40

Provisions

TOTAL 116.40 116.40

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Valuations based on the Balance Sheet:
INVESTOR CLAIMS APPROACH ASSETS & LIABILITIES
APPROACH
Share Capital 45.00 Total Assets 116.40
Reserves and Surplus 21.00 (Less) Current Liabilities 19.40
and Provision
Secured Loans 24.30
Unsecured loans 6.50
TOTAL 97.00 TOTAL 97.00

The degree of precision that may be achieved, using the book

value approach, is directly proportional to the degree to
which the net book values of the assets accurately represent
their fair market values.
There are three potential causes for a discrepancy between
book prices and market values:
(a) The book value of an asset might become increasingly
disconnected from its actual value as a result of inflation. The
historical cost of the asset is subtracted from the amount of
its depreciation to arrive at its book value. As a result, it does
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not take into account inflation, which is unquestionably one
of the factors that influences market value.
(b) Constant technological advancements render some
essential assets obsolete and render them useless even before
depreciation has taken place.
(c) Organizational capital, which is an extremely important
form of capital, is not shown on the balance sheet. Value is
added to an organization's capital when employees,
customers, and suppliers are brought together in a
relationship that is mutually advantageous and productive for
all parties involved. One of the most essential aspects of
organizational capital is the fact that it cannot be readily
disassociated from the company, in its capacity as a
functioning entity.
Organizational capital is the information/knowledge
embodied in employees. As such, business practices that
facilitate/enhance the knowledge embodied in employees,
such as employee training, empowerment and job design will
enable companies to utilize resources more efficiently, and
garner a competitive advantage.
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STOCK AND DEBT APPROACH:
When a company's securities are traded on a public exchange,
the worth of the company can be determined by simply
adding the current market value of all of its outstanding
securities.
This straightforward method is known as the stock and debt
approach.
The efficiency of the market is the fundamental assumption
that underpins the market-based approach.
This indicates that the price, at which an asset is trading on
the market, is the estimation of its intrinsic worth that is, in all
likelihood, free from prejudice.
Let us take an example of stock and debt approach:
As on the 31st of March, 2022, the Seashore Limited had 15
lakh shares that were still outstanding.
The market value of Seashore Limited's equity was Rs. 7.50
Crore at the end of trading on that day as it was priced at Rs.
50 a share.
Additionally, as of the 31st day of March in 2022, the
Company had an outstanding debt that totaled 15 Crore,
which had a market valuation of Rs. 14.80 Crore.
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If we take the market value of the company's debt and add it
to the marker value of the company's equity, we get a total
value for the company as of the 31st of March, 2022 that
comes out to Rs. 22.30 Crore.
Even while the stock and debt strategy are rather easy to
understand, there is still considerable controversy regarding
the values that should be used when valuing the instruments,
notably the equity shares.
Instead of utilizing the price that existed on the date of the
lien, some appraisers recommend using an average of recent
stock prices, because of the volatility of stock prices (the day
on which the appraiser is attempting to value is called the lien
date).
They contend that a more accurate measure of the company's
genuine underlying value can be obtained by averaging prices
over a period of time rather than looking at the stock's price
at the current moment.
Whether or not it is rational to take the average of things is
dependent on how efficient the stock market is.
If the market is believed to be efficient, which indicates that
prices of securities reflect all of the information that is readily
available to the public, then there is no need for averaging.
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There are two significant ramifications that stem from the
valuation practices involving the efficient market hypothesis:
(a) The stock and debt technique will yield the most reliable
estimate of value in situations in which it may be applied.
(b) The firm's securities have to be valued using the market
price that was obtainable on the date that the lien was
placed. It is not accurate to take an average of prices over a
certain amount of time. The accuracy of the proposal is
harmed as a result.
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ABFM MODULE - C
Chapter 13: CORPORATE VALUATION (PART-III)
What we will study?
*All about Direct Comparison Approach?
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DIRECT COMPARISON APPROACH:
The Direct Comparison Approach is founded on the Principle
of Substitution, which states that a buyer will not pay more
for a given property than the cost of a comparable,
competitive property with the same utility in the open
market, provided there is no delay in making the transaction.
In this method, the analysts look for one or two businesses
that are extremely similar to the company whose value they
are attempting to determine.
Then, they base their estimate on the prices at which the
similar businesses are selling their products or services.
The most important aspect of this analysis is locating these
comparable businesses and determining their current market
prices.
The valuation method involves three steps:
1. Determining the property's highest and best use.
2. Identifying similar properties that have been sold, and
3. Adjusting the comparable sales values.
This method works best with comparable attributes. Best
comparable require minimal tweaking. When the selling price
is converted to a correct unit, the comparison is most
accurate.
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The unit price is adjusted. Always do time adjustments first,
then add all other adjustments to the time adjusted price per
unit to get a completely adjusted price per unit from each
comparator.
Steps involved in the Direct Comparison Approach:
Direct comparison method is very often used for valuation of
real estate.
The various steps of valuation using direct comparison
method are as under:
The first thing that needs to be done is to figure out what the
best possible use of the property is.
This is done to ensure that the property is sold at its highest
possible price, taking into account both the inherent and the
observable qualities of the property in question.
These factors include the maximal productivity, the physical
circumstances, the legal permissibility, and the financial
viability of the enterprise.
In case of valuation of businesses, similar companies are
identified by analysts.
In the second step, the valuer tries to find out the data in
respect of sales that are comparable to the one being
appraised.
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In order to be regarded a comparable sale to the property in
question, the properties that have been sold in the past must
have had the same highest and best use, or at the very least,
one that is substantially close (as if comparing apples to
apples).
It is best to make sure that they are located in the same
geographic area, have a proven track record of sales in the
past, and have comparable amenities.
This will assure the best possible outcome.
The better these comparable are, the more similar they are to
one another.
In case a company is being valued, the analysts evaluate the
price of their own company in relation to the price of
companies in their peer group by utilising a multiple.
Therefore, if a stock is trading at 10 times earnings and the
average price-earnings ratio for the sector is 12, then the
stock is deemed to be inexpensive.
This technique is predicated on the notion that even while
companies within a sector can differ greatly from one
another, the average for the sector is representative of the
type of company that is most common.
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The final stage is to alter the comparable sales values so that
they reflect the qualities of the similar properties that are
greater or inferior to those of the subject property.
When making changes, there are a lot of different elements
that need to be taken into consideration, such as the size,
form, topography, available facilities, and locational qualities
of the comparable transactions.
In the process of valuing a company, analysts will often
attempt to control for differences between different
companies.
This is done in recognition of the fact that there may be
significant differences between the company being valued and
other companies that are included in the comparable firm
group.
In many situations, the control is subject to interpretation.
For example, if a company has a higher expected growth rate
than the average for its industry, it will trade at a higher
multiple of earnings than the average for that industry;
however, the exact amount by which it is trading higher is not
specified.
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Let us take an example of using the direct comparison method
for valuation of real estate:
A 4-bedroom flat was recently sold for Rs. 7 Crore.
A valuer has been engaged for appraising the value of the flat
next to it for mortgage financing.
The flat owner feels that, as the property next door (4-
bedroom flat) has been sold for Rs. 7 Crore, his flat, being a
corner flat with 4 bedrooms, balconies on two sides, Higher
carpet area and more privacy, should be worth more.
As such, the valuer, while using the recently sold house next
door as a comparable property, must also evaluate other
properties that are similar to the flat being appraised and
have been recently sold.
In this scenario, the valuer will first determine the
characteristics of the comparable property, then compare
those features to the characteristics of the subject property,
and then adjust the value of the comparable property so that
it is more comparable to the value of the subject property.
When all of this is finished, the value that has been adjusted
for inflation of the comparable property, should be roughly
equivalent to the value that has been determined for the
property in question.
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The chart that follows illustrates the valuation methodology
for this flat:
The attributes of the various real estate listings can be seen in
the left column.
The comparable property and the necessary adjustments to
the valuation, that are required to make the comparable
property more like the subject property, are listed in the
columns to the right of the subject property.

Property Being Valued Comparable Property

Price - Rs. 7 Crore
Privacy +5% -
Carpet Area + Pro-rate increase -

Balconies +5% -

Add an amount to the value of the similar property, for each

of the subject's characteristics that is superior to that of the
comparable.
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If the subject property lacks a feature that the comparable
property possesses, the value of the subject property should
be decreased.
This is just a simple example between two properties for the
sake of illustration.
However, it is essential to note that in order to compare
characteristics; the appraiser needs to obtain information
from a variety of sources on both the subject property and
comparable properties.
When determining the value that has been changed, the
appraiser will first sum up all of the different changes and
then either add them to or deduct them from the amount that
was paid for the comparable property.
In this particular illustration, the adjustments total an
increased value of more than 10% consequently and because
that amount is added to the comparable sale price of Rs. 7
Crore, this results in an adjusted value of Rs. 7.70 Crore for the
aforementioned property.
In conclusion, the Direct Comparison Approach can be applied
to the property in a speedy and uncomplicated manner by
using this method.
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ABFM MODULE - C
Chapter 13: CORPORATE VALUATION (PART-IV)
What we will study?
*What is Discounted Cash Flow Model?
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DISCOUNTED CASH FLOW APPROACH:
The present value of potential future cash flows can be
calculated using a method known as discounted cash flow, or
DCF, for short.
Obtaining an investment's value, with the use of this strategy,
is possible.
The DCF technique requires one to apply a discount rate to
each periodic cash flow of the company.
The discount rate is determined by that company's cost of
capital.
The total Present Value (PV) of all future cash flows can be
calculated by multiplying this discount by each future cash
flow to arrive at a number that represents the total present
value of all future cash flows.
One can select the alternative that results in the greatest
amount of discounted cash flows by performing the
calculation of discounted cash flows for a number of different
investment choices and then comparing the outcomes of
those calculations.
This idea is helpful for calculating the value of a prospective
acquisition, of a possible investment in an annuity, or of a
purchase of a fixed asset.
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The idea that cash received today is more valuable than cash
received at some point in the future, is the fundamental tenet
upon which discounted cash flow analysis is built.
Paying someone for the privilege of delaying a payment,
which is known as interest income, is the only method to get
someone to agree to the delay in payment.
For example: If a person currently has Rs. 1,00,000 in his
possession and invests it at an interest rate of 10%, then after
one year of using the money he will have earned Rs. 10,000 in
income from the investment.
If, on the other hand, he were to be prevented from accessing
those funds for a period of one year, then he would be
deprived of Rs. 10,000 in interest income.
The value of money over time is demonstrated by the interest
income in this illustration.
The method of arriving at the Present Value (PV) of the firm,
by discounting future cash flows, is a helpful tool for assessing
the value of the firm.
It is also possible to use it to evaluate cash flows of other
similar firms in order to determine which one has the greatest
present value.
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To calculate Present Value (PV) of a firm, we use the following
formula:

The DCF method of valuing a firm is similar to that for

evaluation of a capital project.
However, when valuing a company with the discounted cash
flow methodology, it is necessary to make cash flow
projections over an unspecified amount of time unlike a
project which is presumed to have a definite life.
Also, the basic presumption in a capital project is that it will
not expand during its life-cycle. But a business entity is
anticipated to expand in the future.
This is, without a doubt, a challenging proposition.
In order to accomplish this objective, the value of the
company is typically segmented into two time periods,
namely:
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Value of the firm =

Present value of cash flow during the explicit forecast period + Present
value of cash after the explicit forecast period.

Since it is anticipated that significant change will take place

within the company over the explicit forecast term, which is
typically between 5 and 15 years, a significant amount of
effort is put into the forecasting of its yearly cash flow.
Because it is presumed that the company will have reached a
"stable level" by the time the explicit prediction period is up,
a more straightforward method is used to calculate the
ongoing value of the company.

STEPS INVOLVED IN VALUATION USING DCF APPROACH:

The following steps are involved in the process of evaluating a
company using the discounted cash flow approach:
Step 1. Analyze historical performance to calculate:
A) Operating Invested Capital.
B) Net operating profit less adjusted taxes.
C) Return on Invested Capital.
D) Net Investments.
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Step 2. Calculate Free Cash Flow, using the results of step 1.
Step 3. Calculate the weighted average cost of capital (WACC).
Step 4. Based on calculations of Free Cash Flow (Step 2),
forecast future cash flows for an explicit forecast period.
Calculate PV of free cash flows using WACC.
Step 5. Find the terminal value after the explicit forecast
period and find its PV.
Step 6. Add values in step 4 and 5 plus the value of non-
operating assets, to arrive at the valuation of the firm.
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ABFM MODULE - C
Chapter 13: CORPORATE VALUATION (PART-V)
What we will study?
*Steps in Discounted Cash Flow Model?
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STEP 1: ANALYSIS OF HISTORICAL PERFORMANCE:
The first stage in valuing a firm is to conduct an analysis of the
company's past performance.
If you have a thorough understanding of how the company
has performed in the past, you have a strong basis for
estimating how well it will perform in the future.
Let us look at the following financial statements of Lala
Industries for the last four years, to understand the concept of
historical performance analysis.
Financial Statements of Lala Industries for last four years:

PROFIT AND LOSS ACCOUNT

2018- 19 2019- 20 2020- 21 2021- 22
Net Sales 400 500 600 700

Income from 20 30 35 40
investments
Non-operating Income 15 20 25 30
Total Income 435 550 660 770
Cost of goods sold 300 350 390 430
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Sales and General 40 50 60 70
administration
expenses
Depreciation 15 16 17 18
Interest Expenses 22 25 26 28
Total Cost and 377 441 493 546
expenses
Profit Before Tax 58 109 167 224
Tax Provision 18 39 52 72
Profit After Tax 40 70 115 152
Dividend 21 35 60 80
Retained Earnings 19 35 55 72

BALANCE SHEET
Equity Capital 150 180 180 180
Reserve and Surplus 49 84 139 211
Borrowings 230 250 160 280
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Total 429 514 579 671
Fixed Assets 150 152 157 162
Investments 200 300 350 432
Net Current Assets* 69 62 72 77
Total 419 514 579 671
*Current Assets – Current Liabilities, which do not bear any
interest (like Accounts payable).

Extracting data useful for valuation:

All the data in the financial statements may not be useful for
valuation of the firm.

We need the data which is useful in calculating the following:

A. Operating Invested Capital
B. Net operating profit less adjusted taxes
C. Return on Invested Capital
D. Net Investments
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(a) Operating Invested Capital:
Both operating and non-operating assets can be acquired
using the funds provided by shareholders and lenders.
This capital is referred to as invested capital.
Operating Invested Capital refers to that portion of the
invested capital which is used to acquire only operating
assets.
The operating working capital is also added to it to arrive at
total Operating Invested Capital.
Operating working capital is calculated by subtracting non -
interest bearing current liabilities from operating working
capital assets.
Operating working capital assets are total working capital
assets minus non-operating working capital assets like excess
cash and marketable securities.
Operating Invested Capital:
2018-19 2019-20 2029-21 2021-22

Fixed Assets 150 152 157 162

Net Current Assets* 69 62 72 77

219 214 229 239

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(b) Net operating profit less adjusted taxes (NOPLAT):
NOPLAT = EBIT - Taxes on EBIT
EBIT is the operating income that the company would have
received before taxes if it did not have any debt obligations.
During the process of computing EBIT, interest expenses,
interest income, and revenue or loss from non-operating
activities are not taken into account.

The calculation of NOPLAT for Lala Industries, assuming a

marginal tax rate of 30 percent is given below:

2018- 19 2019- 20 2020- 21 2021- 22

Profit before tax 58 109 167 224

Add:

Interest expense 22 25 26 28

Less:

Interest Loan -20 -30 -35 -40

Non-operating income -15 -20 -25 -30

EBIT 45 84 133 182

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Tax provision from 18 39 52 72
income statement

Add:

Tax shield on interest 6.6 7.5 7.8 8.4

expense

Less:

Tax on interest income -6 -9 -10.5 -12

Tax on Non-operating -4.5 -6 -7.5 -9

income

Total Taxes on EBIT 14.1 31.5 41.8 59.4

NOPLAT 30.9 52.5 91.2 122.6

(c) Return on Invested Capital:

Return on Invested Capital, ROIC, is defined as
𝐍𝐎𝐏𝐋𝐀𝐓
ROIC=
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐢𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐂𝐚𝐩𝐢𝐭𝐚𝐥

Measurement of capital that has been invested often takes

place either at the beginning of the year or as an average of
the starting and ending values for the year.
Always use the same numerator and denominator definitions
when doing the ROIC calculation.
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The following is a calculation of the ROIC for Lala Industries:
2019-20 2020-21 2021-22
NOPLAT (A) 52.5 91.2 122.6
Operating Invested Capital 219 214 229
at the beginning of the year
(B)
Return on Invested capital 23.97% 42.62% 53.54%
(A)/(B)

Net Investment:
The difference between the amount of gross investment and
the amount of depreciation is known as the net investment.
The term "gross investment" refers to the sum of "cumulative
expenditure," which includes expenditure on current as well
as non-current assets."
The term "depreciation” refers to any and all costs that are
not paid in cash.
Alternately, the following formula can be used to determine
the net investment made over the year:
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Net non-current fixed assets at the end of year + Net current
assets at the end of year Minus:
Net non-current fixed assets at the beginning of year + Net
current assets at the beginning of year

Following is a calculation of the net investment for Lala

Industries using the aforementioned method:
2019-20 2020-21 2021-22

Net non-current/fixed assets at the 152 157 162

end of year
Add: Net current assets at the end of 62 72 77
the year

Sub-Total 214 229 239

Less:

Net non-current/fixed assets at the -150 -152 -157

beginning of year
Net current assets at the beginning of -69 -62 -72
the year

TOTAL -5 15 10
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ABFM MODULE - C
Chapter 14: Discounted Cash Flow Valuation (PART-I)
What we will study?
*What is Dividend Discount Model?
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DIVIDEND DISCOUNT MODEL:
The Dividend Discount Model is a quantitative method of
valuing a company's equity shares price based on the
assumption that the fair price of share equals the present
value of the company's future dividends.
Dividend discount models are among of the oldest discounted
cash flow models still used in practice today.
Despite the fact that numerous analysts have moved away
from dividend discount models, on the grounds that these
models produce estimates of value that are far too cautious, a
lot of the key concepts, that come through with dividend
discount models, apply when we look at alternative
discounted cash flow models.
The various dividend discount models used for valuation are
as under:
1- Constant Growth Model (Gordan Growth Model).
2- Zero Growth Model.
3- Two Stage Model.
4- H Model.
5- Three Stage Model.
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Constant Growth Model:
One of the most common assumptions used by dividend
discount models is that the dividend paid out per share would
increase at a rate that is fixed (g).
According to this hypothesis, the value of a share is computed
as follows:
𝐃𝟏 𝐃𝟏 (𝟏 + 𝐠) 𝐃𝟏 (𝟏 + 𝐠)𝐧
𝐏𝟎 = + +⋯ +⋯
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝐧+𝟏
Where,
𝐏𝟎 Is the current fair price of the share or intrinsic value of
share.
D₁ is the expected dividend one year from now.
r is the rate of return required by the investor.
n represents any particular year and can be any number
between 0 and infinity.
Following the use of the formula for the sum of a geometric
progression, the preceding expression can be simplified to:

𝐃𝟏
𝐏𝟎 =
(𝐫 − 𝐠)
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Example:
XYZ Ltd. is expected to pay a dividend of Rs. 3 per share one
year from now.
The dividend payments are expected to grow at 5% p.a.
If an investor needs 12% rate of return on his investment,
what price of the share will be considered to be fair, by him?
Solution:
Applying the formula, given above,
𝐃𝟏 = 3, g = 0.05 and r = 0.12
𝐃𝟏
𝐏𝟎 =
(𝐫 − 𝐠)
𝟑 𝟑
We get 𝐏𝟎 = (𝟎.𝟏𝟐−𝟎.𝟎𝟓) = 𝟎.𝟎𝟕 = Rs. 42.86

The vast majority of stock valuation models are founded on

the idea that dividends will increase over the course of time.
Zero Growth Model:
In the event that we make the assumption that the dividend
per share stays the same from year to year at a value of D, the
formula will look like this:
𝐃
𝐏𝟎 =
𝐫
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Illustration:
XYZ Ltd. is expected to pay a dividend of Rs. 3 per share one
year from now.
The dividend payments are expected to remain constant at Rs.
3 per share.
If an investor needs 12% rate of return on his investment,
what price of the share will be considered to be fair, by him?
Solution:
𝐃𝟏 = 3, g = 0 and r = 0.12
Applying the formula for fair value,
𝐃𝟏
𝐏𝟎 =
(𝐫 − 𝐠)
𝟑 𝟑
𝐏𝟎 = (𝟎.𝟏𝟐−𝟎) = 𝟎.𝟏𝟐 = Rs. 25

Two Stage Model:

The most straightforward modification of the continuous
growth model postulates that the exceptional growth-
whether positive or negative-will last for a set number of
years, after which the usual growth rate will take over and
continue indefinitely.
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The market price of the equity share:

𝐃𝟏 𝐃𝟏 (𝟏+𝐠 𝟏 ) 𝐃𝟏 (𝟏+𝐠 𝟏 )𝟐 𝐃𝟏 (𝟏+𝐠 𝟏 )𝐧−𝟏 𝐏

𝐧
𝐏𝟎 =(𝟏+𝐫) + + ….+ + ⋯ (𝟏+𝐫)
(𝟏+𝐫)𝟐 (𝟏+𝐫)𝟑 (𝟏+𝐫)𝐧 𝐧

where 𝐏𝟎 is the present price of the equity share.

𝐃𝟏 , is the dividend that is anticipated to be paid out one year
from now.

g₁ is the extraordinary growth rate that is valid for n years &

P is the price of the equity share at the end of year n.
It is assumed that the share will be sold at the end of year n at
the price P.
That is why its PV is included in the price 𝐏𝟎 .
The current value of a growing annuity is represented by the
first term on the Right-Hand Side of the following equation:

𝟏+𝐠𝟏 𝐧
𝟏−( ) 𝐏
𝐧
𝟏+𝐫
𝐏𝟎 = 𝐃𝟏 ( ) + (𝟏+𝐫) 𝐧
𝐫−𝐠 𝟏
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Since the two-stage growth model assumes that the growth
rate after n years remains constant, 𝐏𝐧 will be equal to:
𝐃𝐧+𝟏
𝐏𝐧 =
𝐫−𝐠 𝟐

Where 𝐃𝐧+𝟏 the dividend is for year n+ 1 and g₂ is the growth

rate in the second period.
𝐃𝐧+𝟏 , The dividend for year n+1 may be expressed in terms of
the dividend in the first stage.

𝐃𝐧+𝟏 = 𝐃𝟏 (𝟏 + 𝐠 𝟏 )𝐧−𝟏 (𝟏 + 𝐠 𝟐 )

Substituting the above expression, we get

𝟏 + 𝐠𝟏 𝐧
𝟏−( ) 𝐃𝟏 (𝟏 + 𝐠 𝟏 )𝐧−𝟏 (𝟏 + 𝐠 𝟐 ) 𝟏
𝐏𝟎 = 𝐃𝟏 ( 𝟏 + 𝐫 )+( )( )
𝐫 − 𝐠𝟏 𝐫 − 𝐠𝟐 (𝟏+𝐫)𝐧

Illustration: The current dividend on an equity share of PML

Private Limited is Rs. 5.
PML is expected to enjoy an above-normal growth rate of 25%
for a period of 6 years.
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Thereafter, the growth rate will fall and stabilize at 15%.
Equity investors require a return of 20%.
What is the intrinsic value of the equity share of PML?
Solution:
The inputs required for applying the two-stage model are:
g₁ = 25% = 0.25 𝐠 𝟐 = 15% = 0.15
n = 6 years r = 20% = 0.20
𝐃𝟏 = 𝐃𝟎 (1+g₁) = Rs. 5*(1.25) = Rs. 6.25

Plugging these inputs in the two-stage model, we get the

intrinsic value estimate as follows:
𝟏 + 𝐠𝟏 𝐧
𝟏−( ) 𝐃𝟏 (𝟏 + 𝐠 𝟏 )𝐧−𝟏 (𝟏 + 𝐠 𝟐 ) 𝟏
𝐏𝟎 = 𝐃𝟏 ( 𝟏 + 𝐫 )+( )( )
𝐫 − 𝐠𝟏 𝐫 − 𝐠𝟐 (𝟏+𝐫)𝐧

𝟏 − (𝟏. 𝟐𝟓/𝟏. 𝟐𝟎)𝟔 𝟔. 𝟐𝟓(𝟏. 𝟐𝟓)𝟓 (𝟏. 𝟏𝟓) 𝟏

𝐏𝟎 = 𝟔. 𝟐𝟓 ∗ + ∗
(𝟎. 𝟐𝟎 − 𝟎. 𝟐𝟓) (𝟎. 𝟐𝟎 − 𝟎. 𝟏𝟓) 𝟏. 𝟐𝟎𝟔

(𝟏−𝟏.𝟐𝟕𝟖) 𝟔.𝟐𝟓(𝟑.𝟎𝟓𝟐)(𝟏.𝟏𝟓)
𝐏𝟎 = 6.25∗ + (𝟎. 𝟑𝟑𝟒)
−𝟎.𝟎𝟓 𝟎.𝟎𝟓

𝐏𝟎 = 34.6918 + 146.9165 => 𝑷𝟎 = Rs. 181.6083

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ABFM MODULE - C
Chapter 14: Discounted Cash Flow Valuation (PART-II)
What we will study?
*What is H Model?
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H Model:
The H model is another growth model that consists of two
stages.
The H model, as opposed to the traditional two-stage model,
postulates that the exceptional growth rate in the beginning
stage does not remain constant but rather decreases linearly
over time until it achieves a stable rate in the steady stage.
This is in contrast to the conventional two-stage model.
The H model, which was developed by Fuller and Hsia, makes
the assumption that the earnings growth rate starts off at a
high initial rate (𝐠 𝐚 ), and then decreases at a linear rate over
the course of 2H years to a stable growth rate (𝐠 𝐧 ), which is
maintained forever.
This model also assumes that the earnings growth rate will
remain stable forever, after the stability has been achieved.
The equation for H model of valuation is as under:
𝐏𝟎 = 𝐃𝟎 [(𝟏 + 𝐠 𝐧 ) + 𝐇 (𝐠 𝐚 − 𝐠 𝐧 )]
𝐫 − 𝐠𝐧
where r is the rate of return needed by investors,
𝐏𝟎 is the intrinsic value of each share,
𝐃𝟎 is the current dividend per share,
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𝐠 𝐧 is the expected long-term growth rate (n is normal growth
rate),
𝐠 𝐚 is the current growth rate ( a is abnormal growth rate), and

H is the one half of duration during which 𝐠 𝐚 levels out to 𝐠 𝐧.

The above equation can also be written as

𝐃𝟎 (𝟏+𝐠 𝒏 ) 𝐃𝟎 𝐇 (𝐠 𝒂 −𝐠 𝒏 )
𝑷𝟎 = +
𝐫−𝐠 𝐧 𝐫−𝐠 𝐧

The H model can be understood in a straightforward manner

by using the equation that was just presented.
On the right-hand side of the equation, the first term indicates
the value based on the normal growth rate, and
𝐃𝟎 (𝟏 + 𝐠 𝒏 )
𝐫 − 𝐠𝐧
Whereas the second term represents the premium due to the
anomalous growth rate:

𝐃𝟎 𝐇(𝐠𝒂 − 𝐠𝒏 )
(𝐫 − 𝐠 𝐧 )
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ILLUSTRATION:
The equity shares of ABC Private Limited presently generate a
dividend payment of Rupee 1.00 every year.
The growth rate as of right now is 30%.
On the other hand, this will decrease in a linear fashion over
the course of ten years, and then it will level off at ten
percent.
What is the company's intrinsic worth per share, assuming
that investors require a return of 15% on their investment?
The following information is available:
𝐃𝟎 = 1.00
𝐠 𝐚 = 30% = 0.30
H = 5 years
𝐠 𝐧 = 10% = 0.10
r = 15% = 0.15
Putting the above inputs in the H-model, we get the estimated
intrinsic value as follows:

𝐏𝟎 = 𝐃𝟎 [(𝟏 + 𝐠 𝐧 ) + 𝐇 (𝐠 𝐚 − 𝐠 𝐧 )]
𝐫 − 𝐠𝐧
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𝟏[(𝟏.𝟏𝟎)+(𝟎.𝟑𝟎−𝟎.𝟏𝟎)]
𝐏𝟎 = = Rs. 42
𝟎.𝟏𝟓−𝟎.𝟏𝟎

The H model is more realistic than the two-stage model,

which predicts that the growth rate would suddenly slow
down after a given amount of time.
Instead, the H model predicts that the growth rate will
gradually slow down over time.
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ABFM MODULE - C
Chapter 14: Discounted Cash Flow Valuation (PART-III)
What we will study?
*What is Discounted Cash Flow Valuation Model?
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INTRODUCTION:
Even though discounted cash flow valuation is only one of
several ways to approach valuation, and even though the vast
majority of valuations done in the real world are relative
valuations, discounted cash flow valuation serves as the basis
upon which all other valuation techniques are constructed.
In order to accurately do relative valuation, it is necessary for
us to have a fundamental understanding of discounted cash
flow valuation.
It is normal practice to start with a discounted cash flow
valuation before applying option pricing models to the
process of asset appraisal.
That is why understanding the discounted cash flow analysis is
important.
Any person who has a fundamental understanding of this
subject will be able to analyses and apply any of the other
methods.
This approach is grounded in the concept of present value,
which states that the value of any asset is equal to the sum of
the asset's predicted future cash flows, expressed as a present
value.
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The cash flows will be different for each asset, such as
dividends for stocks, coupons (interest) and the face value of
bonds, and cash flows after taxes for real estate projects.
The level of risk associated with the expected cash flows will
determine how the discount rate is calculated; higher rates
will be applied to riskier assets, while lower rates will be
applied to safer projects.
The discounted cash flow valuation method seeks to arrive at
an estimate of an asset's true worth, by basing that estimate
on the asset's underlying characteristics.
What exactly does "intrinsic value” mean?
In the absence of a more precise definition, you can think of it
as the value that would be attached to the company if it were
evaluated by a neutral analyst who not only makes accurate
estimates of the expected cash flows for the company given
the information that is available at the time, but also uses the
appropriate discount rate to value these cash flows.
Even if the task of estimating intrinsic value appears to be
impossible, particularly when valuing young companies with a
great deal of uncertainty about the future, it is still
worthwhile to make the best estimates that you are capable
of and to persevere in attempting to estimate value, because
markets occasionally make errors.
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Even though prices on the market can be different from an
asset's intrinsic value (which can be calculated based on its
fundamentals), you are keeping your fingers crossed that the
two will eventually align.
There are literally many different variations of discounted
cash flow models that can be used.
It is widespread practice at investment banks and consulting
firms, to assert that their valuation models are superior to, or
more complex than, those utilized by their contemporaries in
the industry.

ESTIMATING INPUTS:
For applying the DCF method of valuing a firm or any other
asset, we need the following inputs:
(a) The predicted cash flows in future.
(b) The discount rate that is suitable for the given level of risk
associated with these cash flows.
(c) The estimated cash flow growth rate and
(d) The estimated pattern of growth.

These are discussed, in detail, below:

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Expected Cash Flows:
The dividend is the only source of cash flow that an equity
investor receives from a publicly traded company, at least in
the most literal sense; financial models that use dividends as
cash flows are referred to as dividend discount models.
A broader definition of cash flows to equity would be the cash
flows that are left over after the cash flow claims of nonequity
investors in the firm have been met (interest and principal
payments to debt holders and preferred dividends), as well as
after enough of these cash flows have been reinvested into
the firm to sustain the projected growth in cash flows.
This would be an example of how a broader definition of cash
flows to equity could be used.
This concept is known as the free cash flow to equity (FCFE),
and the types of models that make use of this concept, are
referred to as FCFE discount models.
The total cash flow to all claim holders in the company is what
is referred to as the cash flow to the firm.
One technique to calculate this cash flow is to add the free
cash flows to equity to the cash flows to lenders (debt) and
preferred stockholders.
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Estimating the cash flows prior to payments on debt and
preferred dividends is a much simpler way to reach the same
number.
To do so, take the after-tax operating income and remove the
net investment that is required to maintain growth.
This gives us an estimate of the cash flows.
This cash flow is referred to as the free cash flow to the firm
(FCFF). The models that make use of these cash flows are
referred to as FCFF models.
Discount Rates:
The question "how much money would have to be invested
presently, at a particular rate of return, to yield the
anticipated cash flow, at its future date"?
Can be answered through the process of discounting future
cash flows.
In other words, discounting determines the present value of
future cash flows by using a rate that is the cost of capital that
most accurately reflects the risk and timing of the cash flows.
This rate is called the discount rate.
When doing an evaluation, we begin with the fundamental
idea that the discount rate that is applied to a cash flow
should represent the level of risk associated with that cash
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flow; cash flows with a higher level of risk should have higher
discount rates.
There are two different perspectives on risk.
The first type of risk is known as default risk, and it refers to
the possibility that a person or organization may break a
promise to fulfill some financial obligation, such as paying
interest or the principal that is owed.
When looking at debt, the rate that reflects the possibility of
default is referred to as the cost of debt.
Because interest expenses are deductible from taxable
income, the cost of debt for most companies will be lower
after taxes are taken into account.
The second method to look at risk is to consider how it relates
to the difference between actual returns and expected
returns.
The actual returns on an investment with a high level of risk
may be considerably different from the predicted returns; the
bigger the deviation, the higher the level of risk.
When considering equity, we typically employ risk measures
that are derived from the variation of returns.
However, there are a few fundamental areas in which these
models can reach a consensus, and that will be the topic of
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discussion in this chapter, which will focus on the various
models that make attempts to do this.
The first is that risk in an investment needs to be perceived
through the perspective of the marginal investor in that
investment (the investor who is most likely to be trading), and
it is expected that this marginal investor has a good level of
diversification across a number of other assets.
Therefore, the risk of an investment, specifically the non-
diversifiable or market risk of that investment should be used
to estimate discount rates for that investment.
The second point is that the expected return on any
investment may be calculated by beginning with the return
that would be gained from a risk-free investment and then
adding a premium that is proportional to the degree of
market risk that is associated with the investment in question.
The cost of equity is calculated based on this anticipated
return.
The cost of capital can be determined by taking the average of
the cost of equity, which can be estimated using the method
that was just presented, as well as the cost of borrowing
money after taxes, which is determined by the default risk,
and then weighting the average by the proportions that are
used for each type of funding.
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When evaluating an existing corporation, our contention is
that the weights applied should be determined by the current
market values of the company's debt and equity.
There are some analysts who utilize book value weights, but
doing so goes against a fundamental concept of valuation,
which states that at a fair value, one ought to be indifferent
between purchasing and selling an asset. If you breach this
principle, you are in violation.
Discount rates that are applied in discounted cash flow
valuations ought to be reflective of the risk desks of the cash
flows being valued.
To be more specific, the cost of debt needs to include a
default premium or spread to account for the risk of the debt
going into default, and the cost of stock needs to include a risk
premium to account for the risk of equity.
The challenge in this case is to find out the ways in which we
quantify the risk of defaulting on a loan or losing money on an
investment, and more significantly, how do we determine the
default and equity risk premiums.

(c) Estimating future Growth:

(d) Estimating Growth Patterns: (next video)
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ABFM MODULE - C
Chapter 15: OTHER NON-DCF VALUATION MODELS (PART-I)

What we will study?

*What are different value multiples used in Valuation?
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Determining the Multiples Used in Valuation:
In reality, a variety of different value multiples are utilized.
They can be organized into the following two major groups:
(a) Stock valuation multiples, such as the price-earnings
ratio(P/E ratio), the price-book value ratio(P/B ratio), and the
price sales ratio (P/S ratio), and
(b) Enterprise valuation multiples (EV-EBITDA ratio, EV-FCFF
ratio, EV-book value ratio, and EV-sales ratio).
EBITDA: Earnings Before Interest, Taxes, Depreciation &
Amortization.
FCFF: Free cash flow to firm.
Given that none of the multiples used for valuation are ideal,
it makes the most sense to employ two or three multiples that
provide results that appear to be suitable for the task at hand.
Enterprises are valued using a variety of valuation multiples,
the most common of which are the EV-EBITDA ratio, the EV-
book value ratio, and the EV-sales ratio.

Figuring Out the Valuation Multiples for the Other

Comparable Companies:
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Calculate the valuation multiples for each of the similar
companies by using the observed financial characteristics and
values of the companies being compared.
To illustrate this point, let's imagine that there are two similar
businesses, A and B, and their respective financial data is as
follows:
Company A Company B
Seles 6,000 9,000
EBITDA 1,000 2,000
Book value of Assets 4,000 6,000
Enterprise Value (EV) 3,000 4,500

The valuation multiples for the companies are:

Company A Company B Average
EV-EBITDA 𝐄𝐕 𝟑𝟎𝟎𝟎 2.25 2.625
= = 3
𝐄𝐁𝐈𝐓𝐃𝐀 𝟏𝟎𝟎𝟎

EV-BOOK value 𝐄𝐕 𝟑𝟎𝟎𝟎 0.75 0.75

= = 0.75
𝐁𝐨𝐨𝐤 𝐕𝐚𝐥𝐮𝐞 𝟒𝟎𝟎𝟎

EV-Sales 𝐄𝐕 𝟑𝟎𝟎𝟎 0.5 0.5

= = 0.5
𝐒𝐚𝐥𝐞𝐬 𝟔𝟎𝟎𝟎
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Establishing a Value for the Concerned Business:
It is possible to evaluate the subject company if one considers
the valuation multiples that have been observed for
comparable companies.
You can accomplish this in a straightforward manner by
applying the average multiples of the comparable companies
to the pertinent financial attributes of the subject company.
This will allow you to obtain multiple estimates (as many as
the number of valuation multiples used) of the enterprise
value of the subject company, and you can then take the
arithmetic average of these estimates.
The growth prospects, risk characteristics, and size of the
subject company (the most important drivers of valuation
multiples) should be compared with those of comparable
companies, and after that, a judgmental view of the multiples
that are applicable to it should be taken.
This is a more sophisticated method of doing what needs to
be done.
Illustration:
The following financial information is available for company
M, an unlisted pharmaceutical company, which is being
valued.
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EBITDA: Rs. 500 crore. Book value of assets: Rs. 2000 crore.
Sales: Rs. 5500 crore.
The pharmaceutical businesses E, F, and G have been
identified to be comparable to company M based on an
analysis of a number of other publicly traded pharmaceutical
companies.
The following information regarding the financial health of
these companies is available:
Company E Company F Company G
Sales 1,000 2,000 3,000
EBITDA 400 500 600
Book value of Assets 900 1,000 2,000
Enterprise Value 3,000 4,000 6,000

Company E Company F Company G Avg.

EV-EBITDA 7.5 8 10 12.75
EV-Book Value 3.33 4 3 5.165

EV-Sales 3 2 2 3.5
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The following estimations of Company M's enterprise value
can be derived by applying the average multiples to the
company's financial figures:
EBITDA Basis: EBITDA of M = 500 Cr. (given)
Average EV-EBITDA = 12.75
𝐄𝐕 𝐄𝐕
= 12.75 => 𝟓𝟎𝟎 = 12.75
𝐄𝐁𝐈𝐓𝐃𝐀

EV = 12.75 * 500 = 6375 Cr ₹.

Book Value Basis: Book Value of M = 2,000 Cr. (given)
Average EV-Book Value = 5.165
𝐄𝐕 𝐄𝐕
= 5.165 => = 5.165
𝐁𝐨𝐨𝐤 𝐕𝐚𝐥𝐮𝐞 𝟐𝟎𝟎𝟎

EV = 5.165 * 2000 = 10330 Cr ₹.

Seles Basis:
Sales Value of M = 5,500 Cr. (given)
Average EV-Sales Value = 3.5
𝐄𝐕 𝐄𝐕
= 3.5 => 𝟓𝟓𝟎𝟎 = 3.5
𝐒𝐚𝐥𝐞𝐬 𝐕𝐚𝐥𝐮𝐞

EV = 3.5 * 5500 = 19250 Cr ₹.

A simple arithmetic average of the three estimates of EV is:
𝟔,𝟑𝟕𝟓 +𝟏𝟎,𝟑𝟑𝟎 + 𝟏𝟗,𝟐𝟓𝟎
= Rs. 11,985 crore ₹
𝟑
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ABFM MODULE - C
Chapter 15: OTHER NON-DCF VALUATION MODELS (PART-II)
What we will study?
*What is P/E Multiple?
*What is P/B Multiple?
*What is P/S Multiple?
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EQUITY VALUATION MULTIPLES MODEL:
P/E Multiple:
The price-to-earnings multiple, or P/E multiple, is a popular
valuation statistic that is typically defined as follows:

𝐌𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

P/E multiple = 𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

The denominator of this multiple is the earnings per share

(EPS) for the previous financial year or the EPS for the last 12
months or the expected EPS for the current year or the
expected EPS for the following year.
The numerator of this multiple is the current market price per
share.
One way to express the price-earnings multiple is as follows:
𝐏𝟎
𝐄𝟏
Where Po is the current market price per share and 𝐄𝟏 , is the
expected earnings per share a year from now.

Fundamental Determinants of the P/E Multiple:

From a fundamental point of view:
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(𝟏−𝐛)
𝐏𝟎 /𝐄𝟏 = 𝐫−𝐑𝐎𝐄∗𝐛

Where (1-b) is the dividend payout ratio, r is the cost of

equity, ROE is the return on equity, and b is the plough back
ratio or retention ratio.
𝐃 𝐃
dividend payout ratio (1-b) = 𝐄 𝟎 = 𝐄 𝟏
𝟎 𝟏

g= b * ROE
(𝟏−𝐛)
𝐏𝟎 /𝐄𝟏 = 𝐫−𝐠

Example:
V & S Company's Return on Equity is 20% and its r is 15%.
Company's dividend payout ratio is 0.3 and its retention ratio
0.7.
Solution:
V & S Company's P/E multiple is:
ROE = 20% = 0.20 & r = 15% = 0.15 & (1-b) = 0.3 & b = 0.7
(𝟏−𝐛)
𝐏𝟎 /𝐄𝟏 = 𝐫−𝐑𝐎𝐄∗𝐛
𝟎.𝟑
𝐏𝟎 /𝐄𝟏 = 𝟎.𝟏𝟓−𝟎.𝟐𝟎∗𝟎.𝟕 = 30
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P/B Multiple:
Investment analysts have been using the price to book value
(P/B) multiple for nearly as long as they have been using the
price to earnings (P/E) multiple.
The denominator of the P/E multiple is the earnings per share
(EPS), which is a flow metric derived from the income
statement.
In contrast, the denominator of the P/B multiple, which is
denoted by the letter B and stands for book value per share, is
a stock metric that is derived from the balance sheet.
(𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬 𝐟𝐮𝐧𝐝𝐬−𝐏𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐜𝐚𝐩𝐢𝐭𝐚𝐥)
The book value per share (B) =
𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐨𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞

The Most Important Factors That Determine the P/B Multiple:

When viewed from the most fundamental angle,
𝐏𝟎 𝐑𝐎𝐄(𝟏−𝐛)
= (𝐫−𝐠)
𝐁𝟎

Where ROE is the return on equity, g is the growth rate, (1 - b)

is the dividend payout multiple, and r is the rate of return
required by equity investors.
𝐄𝟏
𝐁𝟎 =
𝐑𝐎𝐄
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Example:
Virtual Limited's ROE is 25% and its r is 18%. Victual’s dividend
payout ratio is 0.5 and its g is 15%.
From a fundamental point of view, Vestal’s P/B multiple is:
ROE = 25% = 0.25 & r= 18% = 0.18 & (1-b) = 0.5 &
g= 15% = 0.15
𝐏𝟎 𝐑𝐎𝐄(𝟏−𝐛)
= (𝐫−𝐠)
𝐁𝟎

𝐏𝟎 𝟎. 𝟐𝟓∗ 𝟎. 𝟓
= = 𝟒. 𝟏𝟕
𝐁𝟎 𝟎. 𝟏𝟖 − 𝟎. 𝟏𝟓

P/S Multiple:
The price-to-sales multiple, sometimes known as the P/S
multiple, is a method of valuation that has garnered a lot of
attention in recent years.
The P/S multiple is determined by dividing the current stock
price of a firm by the revenue per share that the company has
generated over the course of the most recent twelve months.
Alternately, it can be calculated by dividing the company's
current market value of equity capital by its annual sales.
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Basic P/S Determinants:
𝐏𝟎 𝐍𝐏𝐌(𝟏 + 𝐠)(𝟏 − 𝐛)
=
𝐒𝟎 (𝐫 − 𝐠)
Where NPM is the net profit margin ratio, g is the growth rate,
(1 – b) is the dividend pay-out multiple, and r is the rate of
return required by equity investors.
Example:
VLC Limited has a NPM of 10% and a growth rate 14%. VLC
dividend pay-out ratio (1 – b) is 0.4 and its r is 0.19.
From a basic point of view, VLC P/S multiple are:
NPM = 10% = 0.10 & G= 14% = 0.14 & (1-b) = 0.4 &
g= 19% = 0.19
𝐏𝟎 𝐍𝐏𝐌(𝟏+𝐠)(𝟏−𝐛) 𝐏𝟎 𝟎.𝟏𝟎(𝟏.𝟏𝟒) 𝟎.𝟒
= (𝐫−𝐠)
=> = (𝟎.𝟏𝟗−𝟎.𝟏𝟒)
= 𝟎. 𝟗𝟏𝟐
𝐒𝟎 𝐒𝟎

Let us have a look at the equations for P/E multiple, P/B

multiple, and P/S multiple together.
𝐏𝟎 (𝟏−𝐛) (𝟏−𝐛) 𝐏𝟎 𝐑𝐎𝐄(𝟏−𝐛)
= = & =
𝐄𝟏 𝐫−𝐑𝐎𝐄∗ 𝐛 (𝐫−𝐠) 𝐁𝟎 (𝐫−𝐠)

𝐏𝟎 𝐍𝐏𝐌(𝟏+𝐠)(𝟏−𝐛)
= (𝐫−𝐠)
𝐒𝟎
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ABFM MODULE - C
Chapter 15: OTHER NON-DCF VALUATION MODELS
(PART-III)
What we will study?
*What is EV/EBITDA multiple?
*What is EV/EBIT multiple?
*What is EV/FCFF multiple?
*What is EV/BV multiple?
*What is EV/Sales multiple?
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ENTERPRISE VALUE MULTIPLES MODEL:
Enterprise value multiples put the emphasis on the value of
the business itself, in contrast to equity multiples, which place
the emphasis on the value of the equity.
Typically, some measure of earnings, assets, or sales
contributes to the determination of the enterprise value.
The following are some examples of enterprise value
multiples that are regularly used:
* EV/EBITDA multiple
* EV/EBIT multiple
* EV/FCFF multiple
* EV/BV multiple
* EV/Sales multiple

EV to EBITDA Multiple:
The Enterprise Value to Earnings before Interest, Taxes,
Depreciation, and Amortization (EV-EBITDA) multiple is
defined as follows:
𝐄𝐧𝐭𝐞𝐫𝐩𝐫𝐢𝐬𝐞 𝐯𝐚𝐥𝐮𝐞 (𝐄𝐕)
𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐛𝐞𝐟𝐨𝐫𝐞 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭, 𝐓𝐚𝐱𝐞𝐬, 𝐃𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧, 𝐚𝐧𝐝 𝐀𝐦𝐨𝐫𝐭𝐢𝐳𝐚𝐭𝐢𝐨𝐧
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Basic Determinants:
When viewed from the most fundamental angle
𝐄𝐕 (𝐑𝐎𝐈𝐂 − 𝐠) × (𝟏 − 𝐃𝐀) × (𝟏 − 𝐭)
=
𝐄𝐁𝐈𝐓𝐃𝐀 𝐑𝐎𝐈𝐂 × (𝐖𝐀𝐂𝐂 − 𝐠)

Where ROIC stands for return on invested capital, g is for

growth rate, DA stands for depreciation and amortization
charges as a percent of EBITDA, t stands for tax rate, and
WACC stands for weighted average cost of capital.

Example:
JJ Company's ROIC is 20% and its g is 11%. JJ's DA is 9% and its
tax rate is 30%. JJ's WACC is 13%. Calculate JJ's EV/EBITDA?
Solution:
𝐄𝐕 (𝐑𝐎𝐈𝐂 − 𝐠) × (𝟏 − 𝐃𝐀) × (𝟏 − 𝐭)
=
𝐄𝐁𝐈𝐓𝐃𝐀 𝐑𝐎𝐈𝐂 × (𝐖𝐀𝐂𝐂 − 𝐠)

𝐄𝐕 (𝟎.𝟐𝟎−𝟎.𝟏𝟏)×(𝟏−𝟎.𝟎𝟗)×(𝟏−𝟎.𝟑)
= =14.33
𝐄𝐁𝐈𝐓𝐃𝐀 𝟎.𝟐𝟎 ×(𝟎.𝟏𝟑−𝟎.𝟏𝟏)
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EV/EBIT Multiple:
EV/EBIT ratio is defined as:
𝐄𝐧𝐭𝐞𝐫𝐩𝐫𝐢𝐬𝐞 𝐯𝐚𝐥𝐮𝐞 (𝐄𝐕)
𝐄𝐚𝐫𝐧𝐢𝐧𝐠 𝐛𝐞𝐟𝐨𝐫𝐞 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐚𝐧𝐝 𝐭𝐚𝐱𝐞𝐬 (𝐄𝐁𝐈𝐓)

Earnings before interest and taxes are earnings from

operating assets, before taxes.
Basic Determinants:
When viewed from the fundamental angle
𝐄𝐕𝟎 (𝟏 − 𝐭) × (𝟏 − 𝐫𝐞𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐫𝐚𝐭𝐞)
=
𝐄𝐁𝐈𝐓𝟏 𝐖𝐀𝐂𝐂 − 𝐠

Where t is the tax rate, WACC is the weighted average cost of

capital, and g is the growth rate.
Example:
ABC Company has a tax rate of 30% and a reinvestment rate
of 70%. ABC WACC is 15% and growth rate is 12%. Calculate
EV/EBIT?
Solution:
𝐄𝐕𝟎 (𝟏 − 𝐭) × (𝟏 − 𝐫𝐞𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐫𝐚𝐭𝐞)
=
𝐄𝐁𝐈𝐓𝟏 𝐖𝐀𝐂𝐂 − 𝐠

𝐄𝐕 (𝟏 − 𝟎. 𝟑) × (𝟏 − 𝟎. 𝟕)
= =𝟕
𝐄𝐁𝐈𝐓 𝟎. 𝟏𝟓 − 𝟎. 𝟏𝟐
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EV/FCFF Multiple:
The EV/FCFF multiple can be defined as:
𝐄𝐧𝐭𝐞𝐫𝐩𝐫𝐢𝐬𝐞 𝐯𝐚𝐥𝐮𝐞 (𝐄𝐕)
𝐅𝐫𝐞𝐞 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐭𝐨 𝐟𝐢𝐫𝐦 (𝐅𝐂𝐅𝐅)

Basic Determinants:
When viewed from the fundamental angle
𝐄𝐕𝟎 𝟏
=
𝐅𝐂𝐅𝐅𝟏 (𝐖𝐀𝐂𝐂 − 𝐠)
Where WACC is the weighted average cost of capital and g is
the growth rate.
Example:
XYZ Limited's WACC is 16% and its g is 11%.
Calculate EV/FCFF?
Solution:
𝐄𝐕𝟎 𝟏
=
𝐅𝐂𝐅𝐅𝟏 (𝐖𝐀𝐂𝐂 − 𝐠)
𝐄𝐕𝟎 𝟏
= = 20
𝐅𝐂𝐅𝐅𝟏 (𝟎.𝟏𝟔−𝟎.𝟏𝟏)
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EV/BV Multiple:
𝐄𝐧𝐭𝐞𝐫𝐩𝐫𝐢𝐬𝐞 𝐯𝐚𝐥𝐮𝐞 (𝐄𝐕)
EV/BV multiple is defined as: 𝐁𝐨𝐨𝐤 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐚𝐬𝐬𝐞𝐭𝐬 (𝐁𝐕)

Basic Determinants:
When viewed from the fundamental angle
𝐄𝐕 𝐑𝐎𝐈𝐂 − 𝐠
=
𝐁𝐕 𝐖𝐀𝐂𝐂 − 𝐠

Where ROIC is the return on invested capital, g is the growth

rate, and WACC is the weighted average cost of capital.
Example:
Vivek Company has an ROIC of 18% , growth rate of 11% , and
WACC of 13% percent. Calculate EV/BV?
Solution:
𝐄𝐕 𝐑𝐎𝐈𝐂 − 𝐠
=
𝐁𝐕 𝐖𝐀𝐂𝐂 − 𝐠

𝐄𝐕 (𝟎.𝟏𝟖−𝟎.𝟏𝟏)
= = 3.5
𝐁𝐕 (𝟎.𝟏𝟑−𝟎.𝟏𝟏)
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EV/Sales Multiple:
𝐄𝐧𝐭𝐞𝐫𝐩𝐫𝐢𝐬𝐞 𝐯𝐚𝐥𝐮𝐞 (𝐄𝐕)
The definition of EV/Sales multiple is 𝐒𝐚𝐥𝐞𝐬 (𝐒)

Basic Determinants:

𝐄𝐕 [𝐀𝐟𝐭𝐞𝐫 𝐭𝐚𝐱 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐦𝐚𝐫𝐠𝐢𝐧 (𝟏+𝐠)× (𝟏−𝐫𝐞𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐫𝐚𝐭𝐞)]

=
𝐒 (𝐖𝐀𝐂𝐂−𝐠)

where g is the growth rate and WACC is the weighted average

cost of capital.
Example:
Planned Limited's after-tax operating margin is 11% and
growth rate is 9%. Its reinvestment rate is 70% and the WACC
is 14%. Calculate EV/S?
Solution:

𝐄𝐕 [𝐀𝐟𝐭𝐞𝐫 𝐭𝐚𝐱 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐦𝐚𝐫𝐠𝐢𝐧 (𝟏+𝐠)× (𝟏−𝐫𝐞𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐫𝐚𝐭𝐞)]

=
𝐒 (𝐖𝐀𝐂𝐂−𝐠)
𝐄𝐕 [𝟎.𝟏𝟏×(𝟏+𝟎.𝟎𝟗)×(𝟏−𝟎.𝟕𝟎)]
= = 0.72
𝐒 (𝟎.𝟏𝟒−𝟎.𝟎𝟗)
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All formulas:
𝐄𝐕 (𝐑𝐎𝐈𝐂 − 𝐠) × (𝟏 − 𝐃𝐀) × (𝟏 − 𝐭)
=
𝐄𝐁𝐈𝐓𝐃𝐀 𝐑𝐎𝐈𝐂 × (𝐖𝐀𝐂𝐂 − 𝐠)

𝐄𝐕𝟎 (𝟏 − 𝐭) × (𝟏 − 𝐫𝐞𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐫𝐚𝐭𝐞)

=
𝐄𝐁𝐈𝐓𝟏 𝐖𝐀𝐂𝐂 − 𝐠

𝐄𝐕𝟎 𝟏
=
𝐅𝐂𝐅𝐅𝟏 (𝐖𝐀𝐂𝐂 − 𝐠)

𝐄𝐕 𝐑𝐎𝐈𝐂 − 𝐠
=
𝐁𝐕 𝐖𝐀𝐂𝐂 − 𝐠

𝐄𝐕 [𝐀𝐟𝐭𝐞𝐫 𝐭𝐚𝐱 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐦𝐚𝐫𝐠𝐢𝐧 (𝟏+𝐠)× (𝟏−𝐫𝐞𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐫𝐚𝐭𝐞)]

=
𝐒 (𝐖𝐀𝐂𝐂−𝐠)
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ABFM MODULE - C
Chapter 16: Special Cases of Valuation

(PART-I)

What we will study?

*How the valuation of intangible assets is done?
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INTRODUCTION:
In the last few units, we concentrated on Corporate and
Business Valuations and also discussed the various
approaches and methodologies used by Values and Analysts
for the purpose of valuation.
In this unit, we shall be discussing some special cases of
valuation.
INTANGIBLES - BRAND, HUMAN VALUATION etc.:
It is in our nature, as human beings, to make a differentiation
between the assets that are visible to us and the ones that we
cannot see, and we feel somewhat safer and secure about the
items or assets that we can see and feel.
However, the latter category (not visible one) encompasses a
wide range of assets, some of which are: goodwill, a brand
name, devoted employees, technological capabilities, and so
on.
One of the most prominent arguments made against valuation
methods in general and in particular against financial analysts,
is that we give intangible assets very little consideration,
which leads to an undervaluation of those assets.
We can address this concern by taking a comprehensive look
at intangible assets across a range of contexts.
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We start off by taking a look at intangible assets that can
stand on their own and generate cash flows (commercially
developed patents, copyrights, trademarks, and licenses).
These assets have monetary value and are shown in the
balance sheet of the company.
As per Companies Act 2013, the fixed assets are classified as
tangible fixed assets and intangible fixed assets.
For example, the software purchased by a company for its
computer systems is an asset having monetary value but is
intangible in form.
Also, a Spectrum, purchased by a telecom company is an
intangible asset with monetary value.
This type of assets can be more or less accurately valued by
using the traditional discounted cash flow (DCF) models.
Next in line are the intangible assets like a company's brand
name and reputation, which are examples of intangible assets
that collectively generate cash flows for the company that
owns them, but which are far more difficult to single out and
value on their own.
In spite of this, we may contend that the traditional
discounted cash flow valuation techniques are able to
accurately capture their values, and that adding a premium
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for them after using the DCF valuation can be considered as
double counting.
In this unit, we will also examine some of the most enigmatic
intangible assets i.e., those that have the potential to
generate cash flows in the future but do not do so right now.
This group will consist of assets as diverse as undeveloped
patents and due to the fact that there is an option available to
the Company as to their use, there is a big challenge faced by
the Company about the valuation of these intangible assets.
Importance of Intangible Assets:
Over the course of the past quarter of a century, intellectual
capital has developed into the most important category of
assets.
The traditional forms of intellectual property assets, such as
patents, trademarks, and copyrights, are what are meant to
be referred to when using the term "intellectual capital".
The majority of the value of the earliest publicly traded
companies, which emerged as a result of the industrial
revolution, was derived from their physical assets.
These early global corporate giants, which includes companies
like General Motors, Con Edison, Standard Oil, and AT&T etc.
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held land, buildings, and factories that were straightforward
for accountants to measure and value.
In India, we have examples of companies like Tata Steel, TCS,
Infosys, Alembic, Indian Hotels, Godrej and ITC.
The last fifty years have given rise to a new breed of
companies in the world, such as Apple, Coca-Cola, PepsiCo,
Amazon, Microsoft, Intel, Face book, and Pfizer, and Indian
companies like Bharat Biotech, Serum Institute, Wipro,
Flipkart etc.
That derive the majority of their value from intangible assets.
These assets include brand recognition, customer loyalty, and
intellectual property.
Intangible assets might take the form of a company's brand
name (as is the case with PepsiCo, Coca-Cola etc.), patents (as
is the case with Serum Institute, Bharat Biotech, Pfizer etc.), or
technological competence (as is the case with Infosys, Intel
and Microsoft etc.), but they all have certain things in
common.
The first problem is that conventional accounting standards
either grossly underestimate their value or ignore it entirely;
as a result, the balance statements of these companies
provide little indication in this regard.
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The second reason is that these intangible assets contribute
significantly to the market valuations of these organizations;
there is evidence, for instance, that brand name alone may
explain more than half of the value in many consumers'
product companies.
Last but not least, the failure to value these intangible assets
causes a distortion not just in accounting measures of
profitability like return on equity and capital, but also in
market measures of value like P/E ratios and EV/EBITDA
multiples.
Between the years 1975 and 2015, the proportion of market
value attributable to intangible assets rose from 17% to 84%
according to Ocean Tome, a Management Consultancy firm
providing advice focused on matters involving intellectual
property (IP) and other intangible assets.
Intangible assets, according to them accounted for 90% of the
market value of the S&P 500, which indicates that COVID-19
accelerated the trend of increasing IAMV share.
When one looks at the chart below, which illustrates the
market capitalization of the see how the value of intangible
assets has increased over the years.
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VALUE OF ASSETS IN SELECTED GROUP FOR S&P 500
COMPANIES:

*Implied market value of intangibles = Market cap + Book

value of total liabilities - Book value of intangibles.
Given that we derive such a significant portion of the
information that we use in valuation from accounting
statements, one could argue that the valuation of intangible
assets has suffered from many of the same limitations as the
accounting measures.
This is because accounting statements are one of the primary
sources of information that we use in valuation.
In point of fact, the pressure that is being put on accountants
to more accurately reflect the value of intangible assets like
brand name on financial statements has provided an impetus
for valuation analysts to take a closer look at how they have
valued or failed to value the very same assets (brand names).
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ABFM MODULE - C
Chapter 16: Special Cases of Valuation

(PART-II)

What we will study?

*All about independent and cash flow generating Intangible
Assets?
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Independent & Cash-Flow-Generating Intangible Assets:
Those intangible assets that are attached to a particular
product or product line and create cash flows, are the ones
that are the least complicated to evaluate.
These assets typically have finite lifespan, over which the cash
flows have to be estimated, but otherwise, they are not
qualitatively distinct from the many tangible assets that
create cash flows over finite periods of time.
In this part, we will look at a few examples of assets that fit
under this category.
1. Trademarks, Copyrights, and Licenses:
The owner of a trademark, copyright, or license has the sole
authority to manufacture or sell the associated goods or
render the associated service.
As a direct result of this, their value is determined by the cash
flows that can be produced as a result of holding the exclusive
right.
To the extent that there are expenses connected with
production, the value is derived from the additional returns
that are received as a result of possessing the exclusive right.
The value of copyrights and trademarks can be determined in
one of two ways, just like the value of other assets.
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A discounted cash flow valuation of the asset can be obtained
by first estimating the expected cash flows that will result
from owning the asset, then applying a discount rate to these
cash flows that is reflective of the uncertainty associated with
them, and finally taking the present value of this value.
Alternately, we have the option of attempting a relative value,
which is when we apply a multiple to the revenues or income
that we believe can be earned by the copyright or the
trademark.
The multiple is often estimated by taking a look at the prices
at which assets of a comparable nature have been sold in the
past.
2. Franchises:
The owner of a franchise is granted the right to promote and
sell a company's branded good or service under the
franchise's name.
The thousands of Domino's Pizza or McDonald's fast-food
shops located all over the world are two examples of
franchises.
Other examples include the Chain of Delhi Public Schools.
Dealerships for the automobile industry, and even Ola, an
app-based taxi service.
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In either scenario, the individual who buys the franchise,
known as the franchisee, is responsible for paying the
franchisor (McDonald's or Maruti Suzuki), either an initial
charge or an ongoing annual cost in order to operate the
franchise.
In exchange, the individual receives the power of the brand
name, as well as the support of the corporation and
advertising backing.
Approaches for valuation:
It is typically challenging to isolate and put a monetary value
on intangible assets that both garner the most attention and
are considered to have the greatest value.
They do not provide cash flows on their own, but they enable
a firm to charge higher prices for its products, which in turn
produces a greater amount of cash flows for the company.
However, there are three distinct approaches that we can
take in order to arrive at an estimate of the worth of these
intangible assets, despite the fact that it is more difficult to do
so.
The 3 approaches are as under:
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(a) Capital Investment:
The amount of money that a company has put into an asset
over the course of its existence can give us a good idea of how
much that asset is worth on paper.
To do this with a brand name, for example, you would need to
look at advertising expenditures throughout time, capitalize
these expenses, and then look at the balance of these
expenses today that has not yet been amortized.
To capitalize is to record a cost or expense on the balance
sheet for the purposes of delaying full recognition of the
expense. In general, capitalizing expenses is beneficial as
companies acquiring new assets with long-term lifespans can
amortize or depreciate the costs. This process is known as
capitalization.
This method may not match or even come close to the asset's
market value, despite the fact that it is the least subjective of
the three approaches.
However, it follows the pattern that accountants use to
determine the value of other tangible assets that are recorded
in the books.
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(b) Discounted Cash Flow Valuation:
We have the ability to discount the anticipated increase in
cash flows that will be brought to the company as a result of
the intangible asset in question.
This will require isolating the percentage of an organization's
aggregate cash flows that can be attributable to its brand
name or its level of technological expertise and then
discounting back these cash flows at a rate that is appropriate
for the situation.
(c) Relative valuation:
Comparing the market value of a company (with the
intangible asset) to the market value of companies that are
similar but do not have the intangible asset, is one approach
to isolating the effect of an intangible asset such as a brand
name.
This disparity can be traced back to the existence of the
intangible asset.
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ABFM MODULE - C
Chapter 16: Special Cases of Valuation

(PART-III)

What we will study?

*How to do the valuation of companies with low or negative
earnings?
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FIRMS WITH NEGATIVE OR LOW EARNINGS:
In this section, we look at a selection of companies that have
negative earnings or earnings that are abnormally low, and
we investigate the most effective way to evaluate these
companies.
We start by looking into the reasons why companies have
negative earnings in the first place, and then we investigate
the various ways in which valuation needs to be modified to
reflect these fundamental factors.
For companies that are experiencing issues that are only
temporary, such as a strike or the recall of a product, we
contend that the adjustment process can be a straightforward
one.
In this case, we remove from the company's current earnings
the portion of the expenses that is associated with the
temporary problems.
It may be argued that normalized earnings should be used in
valuation for cyclical companies, where negative earnings are
caused by deterioration in the overall economy, and for
commodity companies, where cyclical movements in
commodity prices can affect earnings.
This is because both of these types of companies are
susceptible to fluctuations in earnings.
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The process of valuation is made more difficult for companies
that have long-term strategic or operational problems (such as
obsolete plants, a workforce that is not adequately trained or
poor investments made in the past).
This is because we have to make assumptions about whether
or not the company will be able to outlive its problems and
restructure itself.
Finally, we examine companies that have negative earnings
because they have borrowed an excessive amount of money
and discuss the most effective way to cope with the possibility
that the company would default on its loans.
Valuing Loss Making Firms:
The reasons why a company has negative earnings in the first
place will dictate how we approach the problem of negative
earnings in the company.
In the next section, the various options for dealing with
businesses that have a poor profit history are discussed:
Companies Facing Momentary Challenges:
When earnings are low due to issues that will only last for a
limited time or are just transitory, it is reasonable to
anticipate that earnings will improve in the not-too-distant
future.
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Therefore, the solutions that we come up with will be rather
straightforward, and the majority of them will consist of
replacing the present earnings, which are in the red, with the
normalized profits (which will be positive).
The manner, in which we standardize earnings, will change
according to the specifics of the challenge.
Concerns Unique to the Company:
It is possible for a company to have a bad year in terms of
earnings, but the problems may be unique to the company
and be of a sort that's just temporary.
If the loss can be traced back to a particular occurrence for
example, a strike or a verdict in a legal case-and the financial
records disclose the cost that is linked with the occurrence,
the answer is quite straightforward.
We need to make an estimate of the earnings before these
costs, and we should not just utilize these earnings for
forecasting cash flows but also for computing basics like
return on capital.
When we are making these estimations, it is important to
keep in mind that we should deduct not just the expense but
also any and all tax benefits that were achieved as a result of
the expense, presuming that the expense was tax deductible.
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We will have a more difficult time accomplishing our goal if
the source of the loss is less clear or if the cost of the event
that caused the loss is not broken out from the cost of any
other expenses.
First things first, we need to be sure that the loss is really
transitory and not a sign of more serious issues with the
company in the long run.
The following step is to make an estimate of the typical
earnings of the company.
A comparison of each spending item for the company for the
current year with the same item in prior years, scaled to sales,
is the method that is the quickest, easiest, and most
straightforward way to accomplish this goal.
Any metric that, in comparison to other years, appears to
have an abnormally high value should be normalized (by
taking the average of values from earlier years).
Alternately, we could calculate an operating income to use in
the valuation by applying the operating margin that the
company achieved in previous years to the revenues of the
current year. This would give us an estimate of the operating
income.
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Industry-Wide or Market-Driven Issues:
Earnings at cyclical companies are characterized by their
inherent instability and sensitivity to changes in the status of
the economy.
Earnings at these companies are expected to rise during times
of economic expansion, but they will fall to lower levels when
the economy is in a recession.
The same is true for commodity companies that experience
price cycles, which consist of periods of high prices for the
commodity being frequently followed by periods of low prices
for the product.
In both the circumstances, we can acquire deceptive
estimations of value if we use the current year's results as our
base year earnings.
Companies with Long-Term Issues:
In each and every one of the values that have been discussed
till now, the earnings were either immediately changed to
represent normal levels or very quickly changed to reflect our
expectation that the negative earnings will cease to exist in
the near future.
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However, in some instances, the negative earnings are a
symptom of larger systemic issues that have been present at
the company for a longer period of time.
In these kinds of circumstances, we will be compelled to make
judgments as to whether or not the problem will be solved,
and if it will, as to when this will take place.
This section offers a variety of potential options for businesses
who find themselves in this predicament:
Strategic Issues:
When it comes to the product mixes, they provide the
marketing methods they use, or even the target audiences
they decide to go for, businesses are prone to making
mistakes on occasions.
They frequently find themselves in the position of having
negative or decreased profitability, and in some cases, even
experiencing a permanent loss of market share or even
bankruptcy as a result.
Think on it in light of the following examples:
The Kodak Case: (to be continued)
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ABFM MODULE - C
Chapter 16: Special Cases of Valuation (PART-IV)

What we will study?

*How to do the valuation of companies with low or negative
earnings (continued)?
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The Kodak Case:
Kodak spent over 10 years arguing with Fuji Films, its greatest
competitor, that examining a digital camera image was a usual
procedure and people liked the feel of a printed image.
Kodak felt Americans would always select it over Fuji Films.
Fuji Films and other companies focused on photography and
videographer rather than arguing with Kodak.
Again, Kodak promoted film cameras instead of imitating
competition. It disregarded media and market feedback.
Kodak squandered 10 years by promoting film over digital
cameras. Kodak also lost foreign finance.
Digital photography surpassed traditional film photography,
too. Better image quality and cheaper than film.
A publication said Kodak was falling behind because it ignored
emerging technology.
Kodak's marketing team tried to persuade managers to
change the company's essential ideals.
Kodak's management committee continued to rely on film
cameras, claiming the magazine reporter lacked the
competence to support his allegation.
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Kodak didn't recognize its once-effective strategy was now
hurting it. Technology and market changes derailed the
strategy.
Kodak spent money on modest acquisitions instead of
promoting digital camera sales.
When Kodak eventually figured out digital cameras, it was too
late. Kodak couldn't compete with the big companies at the
time.
In the year 2004, Kodak eventually declared it would end the
sales of classic film cameras. This move made 15,000 workers
(one-fifth of the company's workforce) redundant.
Kodak fell off the S&P 500 index, which ranks the 500 largest
U.S. corporations by stock performance, before 2011.
Kodak stock hit $0.54 per share in September 2011.
The shares fell over 50% that year.
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The IBM Case:

The development of the personal computer industry in the
1980s was a problem for IBM since it threatened the
company's dominant position in the mainframe computer
sector as well as the unprecedented profitability of that
business.
Despite the fact that IBM had the capability to develop an
operating system for personal computers early on in the
process, the company instead chose to cede that business to a
newcomer named Microsoft.
By the year 1989, more than half of IBM's market value had
been erased, and the company's return on equity had fallen
into the single digits.
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The company has since made a comeback but the valuable
lessons learnt remain.
The Case of the Xerox Corporation:
Xerox was so successful in the photocopier market for so
many years that its brand name eventually became
synonymous with the actual product.
During the 1970s and 1980s, competition for the market came
from Asian companies such as Ricoh and Canon that had cost
structures that were less expensive.
Following an early period of losses, Xerox was successful in
recovering a portion of its market share.
Xerox's fortunes, on the other hand, has been steadily
deteriorating since the latter half of the 1990s due to the
impact that technology (in the form of e-mails, faxes, and low-
cost printers) has had.
By the end of the year 2000, many people were beginning to
wonder whether or not Xerox had a bright future.
The failure of senior management at Xerox to notice emerging
technologies that would eventually emplace Xerox's copier
technology precipitated the company's downfall.
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The unfortunate issue is that Xerox invented the majority of
the technology that changed the world, but they failed to
make use of it.
Operating Issues:
Companies which are able to provide their customers with
goods and services in a more timely and cost-effective manner
than their rivals will experience increased profitability and
market value.
But how and why can businesses gradually lose their
competitive edge?
There are several instances in which the causes can be linked
back to a failure to stay up with the times, replace assets, and
keep up with the most recent technologies.
In general, the expenses of producing one metric tons of steel
will be greater for an older steel firm that has factories that
date back several decades, and equipment that was
manufactured in an earlier era, than what is currently used in
the industry.
In other circumstances, the issue may be the price of labor.
A steel company that operates in the United Kingdom is
subject to labor expenses are significantly greater than those
of an equivalent company in Asia.
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The operational margin is the variable that most accurately
evaluates the efficiency of the operating system, and
companies that have problems with their operating systems
typically have margins that are substantially lower than thus
of their competitors.
However, the rate at which the margins will converge will be
determined by a number of factors, including the following:
The Company's Size:
In most cases, the amount of time required to eradicate
inefficiencies is proportional to the size of the company.
If we assume that the costs of operation are the same, then a
company that has revenues of Rs. 1000 crore will need to
reduce its costs by Rs. 50 crores in order to achieve a 5%
improvement in its pre-tax operating margin.
On the other hand, a company that has revenues of Rs. 100
crores will only need to reduce its costs by Rs. 5 crores in
orders to achieve the same goal.
Aspects of the Inefficiency:
There are some inefficiencies that can be corrected
significantly faster than others.
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For instance, a company can swiftly replace ageing machinery
or an inefficient inventory management system, but retraining
an existing workforce will take far more time.
External Limitations:
Contractual constraints, Government restrictions and social
pressure frequently place limitations on the scope and
velocity of change that companies can implement in order to
address inefficiencies in their operations.
For an organization that has more workers than it needs, the
most obvious option may appear to be to lay off a significant
section of the personnel; however, union contracts and the
possibility of receiving unwanted pressure may make
businesses unwilling to take this course of action.

The Quality of Management:

A management team that is willing to embrace changes is one
of the most important ingredients for a successful turnaround.
It is possible that an organization will need to make changes
to its senior management in order to be successful in resolving
the operational issues it is facing.
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ABFM MODULE - C
Chapter 17: MERGER, ACQUISITION & RESTRUCTURING
(PART-I)

What we will study?

*What is Merger and Acquisition?
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INTRODUCTION:
The reorganization of a business is an integral aspect of
modern business operations.
As a result of globalization and the loosening of constraints
and controls, new waves of competition and free trade have
emerged.
This requires a restructuring and reorganization of the
corporate organization in order to produce new synergies to
adapt to the altered market conditions and competitive
environment.
Reorganizational restructuring typically involves significant
organizational changes, such as a shift in business strategies.
Internal restructuring may involve additional investments in
plant and machinery, research and development of goods and
processes, spinning off non-core enterprises, divestiture,
selloffs, demerger, etc.
A form of external restructuring is the sale of non-core
businesses.
External restructuring can also occur through mergers and
acquisitions (M&As), joint venture formation, and strategic
alliances with other companies.
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Corporate re-structuring refers to any modifications made to a
company's assets, financial structure, or ownership structure,
as well as any expansion or contraction of the company's
operations.
Mergers, acquisitions, and takeovers; financial restructuring
and reorganization; divestitures, de-mergers, and spins;
leveraged buyouts; and management buyouts are the most
prevalent types of corporate restructuring.
However, corporate reorganization can take numerous shapes.
Mergers and acquisitions (M&A) is the subject that has
garnered the greatest discussion nowadays.
Mergers and acquisitions are frequent occurrences in
economies that have evolved substantially.
Hundreds of mergers and acquisitions take happen annually in
Japan, the United States, and Europe.
M&A activity is generally seen as typical business strategic
practice worldwide, as also in India.
In India, the business of corporate restructuring, which
includes mergers, acquisitions, and other related activities,
has exploded in the previous decade.
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The market for corporate control has expanded from 2004,
when it was worth around $4.5 billion, hitting a record high of
$13 billion in 2005 and $56.2 billion in 2016.
As their home countries struggled under the weight of a
recession at the time, international investors sought out an
alternate location, preferably one with a rising economy.
This is a result of the adverse macroeconomic climate caused
by the Euro Zone crisis and other internal factors, such as
inflation, the fiscal deficit, and currency depreciation.
According to data collated by Bloomberg and revealed in June,
the second quarter of the year 2022 saw the biggest amount
of mergers and acquisitions activity ever recorded in India,
totaling $82.3 billion in deals that were either in the process
of being done or had already been finalized.
The previous record, which was set in the third quarter of
2019 at $38.1 billion, has been surpassed by more than twice
that amount.
The HDFC Ltd. merger with the HDFC Bank for a total
transaction value of $58.5 billion in April was the driving force
behind the spike in India.
The merger of two software companies, Mind tree Ltd. and
Larsen & Toubro InfoTech Ltd., in an all-stock transaction
valued at $3.3 billion.
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Both companies were controlled by the engineering
conglomerate Larsen & Toubro Ltd.
In everyday conversation, the phrases “mergers,”
“acquisitions” and “takeovers" are frequently used
synonymously with one another. However, there are
distinctions.
Acquisition is the process of one entity buying out another
and absorbing it into itself, as contrast to merger, which refers
to the combination of two separate entities into one.
In the context of Indian law, the term "merger" is more
accurately rendered as "amalgamation."
The amalgamations can be by merger of firms within the
limits of the Companies Act, and acquisition through
takeovers.
The Securities and Exchange Board of India (SEBI) oversees
takeovers, although the Companies Act governs mergers and
acquisitions (M&A) deals.
In cross border transactions, international tax considerations
often arise.
According to Halsburry’s Laws of England, an amalgamation is
described as the combination of two or more pre-existing
businesses, with the shareholders of each amalgamating
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company becoming largely the shareholders in the
amalgamating company.
As a result, the coming together of two or more businesses
into a single entity is known as a merger.
When two or more businesses combine into a single entity,
when one business merges with another, or when one
business is acquired by another, this process is referred to as
"amalgamation."
In the case Inland Steam Navigation Workers Union vs. R.S.
Navigation Company Ltd., it was determined that in the event
of an amalgamation, the rights and liabilities of one company
are merged into those of another company, making the
transferee company vested with all of the rights and liabilities
of the transferor company.
A Take-over occurs when both, the company doing the take-
over and the company being taken-over, are able to continue
operating independently following the completion of the deal.
If the acquisition results in consolidation, it means the legal
dissolution of both of the companies involved and the
creation of a new company into which the prior entities are
combined.
When a merger results in the legal dissolution of only one of
the corporations involved, it is called absorption.
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Lord Swaraj Paul is credited as having initiated the practice of
corporate takeovers in India when he attempted to acquire
Escorts.
The other significant takeovers include Hindujas' Shaw
Wallace's purchase of Ashok Leyland, the Chabbrie Group's
acquisition of Dunlop and Falcon Tyres, the Goenka family's
purchase of Ceat Tyres, and Tata Tea's purchase of
Consolidated Coffee.
The Board for Industrial and Financial Reconstruction (BIFR)
was responsible for coordinating the acquisition of smaller
businesses by industry titans such as ITC, McDowell, Lakshmi
Machine Works, and the Somali Group.
As a result of the rapidly accelerating process of
industrialization taking place in a nation whose primary
economic activity is agriculture, a great number of new
businesses are being established.
There has been a rise in the amount of interaction between
businesses and people from one country and those from other
countries as a result of the new tendencies of globalization,
which have been observed not only in this country but also on
a global scale.
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Given the current state of affairs in the business world, it is
imperative that mergers and acquisitions be supported, both
in the interest of the general public and for the purpose of
promoting industry and trade.
On the other hand, the government is responsible for
protecting the interests of its shareholders, creditors,
investors and employees/workers.
The provisions on "Compromises, Arrangements, and
Amalgamations" are found in Chapter XV (Section 230 to
Section 240) of the Companies Act, 2013.
These provisions cover corporate debt restructuring,
demergers, fast track mergers for small companies/holding
subsidiary companies, cross-border mergers, takeovers,
amalgamation of companies in public interest, and more.
All of these mergers and acquisitions are also governed or
controlled through relevant provisions of the Foreign
Exchange Management Act of 1999, the Income Tax Act of
1961, the Industries (Development and Regulation) Act of
1951, the Competition Act of 2002, and the restrictions
imposed by other relevant Acts including the SEBI Act of 1992,
depending on the circumstances.
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ABFM MODULE - C
Chapter 17: MERGER, ACQUISITION & RESTRUCTURING
(PART-II)

What we will study?

*What are the different types of Mergers?
*What is acquisition?
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TYPES OF TRANSACTIONS:
1. Merger:
A common definition of a merger is the coming together of
two separate businesses into one.
The process of dissolving one or more businesses,
corporations, or proprietorships in order to construct another
company through absorption into it is what is meant by the
phrase "merger".
The combined business would be significantly larger after the
transaction was completed.
The following are some of the most common types of mergers:
Horizontal Merger:
The two businesses that have recently merged are both
operating in the same market sector.
As a result, the newly consolidated company will likely have a
larger market share than its predecessors, and it is possible
that it will move closer to becoming a monopoly or a near
monopoly in order to eliminate competition.
Vertical Merger: This type of merger takes place when two
organizations that have a “buyer-seller” relationship come
together to form a single entity.
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Mergers between Conglomerates:
Mergers of this kind include companies whose lines of
business are completely unconnected to one another.
To put it another way, the acquirer and the target do not
produce the same or rival products, which means that their
respective commercial endeavors are not tied to one another
in either a horizontal or vertical sense (having relationship of
buyer and supplier).
These types of mergers actually involve the consolidation of
several distinct types of enterprises into a single parent
organization.
The utilization of financial resources, the expansion of debt
capacity, and the integration of managerial activities will
continue to be the primary goals of any merger.
Congener Merger:
The acquiring company and the company it is merging with
are connected in some way, whether it is through
fundamental technologies, industrial methods, or market
segments.
The acquirer will benefit from an expansion of their product
range, market participation, or technological capabilities as a
result of the acquired company.
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These mergers represent an outward shift by the acquirer
from its existing business environment to other similar
business activities within the overall structure of the industry
as a whole.
Reverse Merger:
A reverse merger occurs when a smaller, unlisted company
acquires a larger, publicly listed company.
This allows the unlisted company to avoid the lengthy and
complicated process that would be necessary to be followed
in the event that it desired to issue its shares to the public
through an Initial Public Offering.
2. Acquisition:
This term refers to the purchase of a controlling interest in the
share capital of an existing firm by one corporation from
another corporation.
This could happen by:
(i) An arrangement with the person who holds the majority of
the interest.
(ii) The acquisition of fresh shares through a confidential
agreement.
(iii) Acquisition of shares through the open market (open
offer).
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(iv) The acquisition of a portion of a company's share capital
by the payment of cash and the issuing of shares.
(v) Making an offer to buy out the general body of
shareholders in the company.
When one company acquires another, the acquiring firm has
two options:
Either it can combine both businesses into a single entity and
operate as a single entity, or it can continue to run the taken-
over company as an independent entity but with new
management and different policies.
A "merger” refers to the coming together of two separate
businesses on an equal footing.
When a firm is "acquired," it means that it has been bought
out by another corporation, and the acquired company
typically loses its identity.
This method is normally done in a cordial manner.
The sale is referred to as a slump sale if it is completed for a
single sum of money and no specific valuations are assigned to
any of the asset categories included in the transaction.
As a result of a judgment made by the Supreme Court of India,
any capital gains that were realized as a result of slump sales
were not subject to income tax.
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3. Purchase of Division or Plant:
It is possible for one corporation to purchase a division or
factory from another company.
For instance, SRF India acquired CEAT Limited's nylon cord
division in a recent acquisition.
In a typical business acquisition, the acquiring company
purchases the relevant division's assets, assumes
responsibility for the division's liabilities, and makes a
monetary payment of compensation to the selling company.
For instance, Abbott Laboratories paid $3.72 billion to acquire
the pharmaceuticals business of Primal Health Care. Abbott
Laboratories was a competitor of Primal Health Care.
It is important to keep in mind that only a fraction of the
assets and liabilities of one company are taken over by
another firm when a transaction is carried out in this manner.
4. Takeover:
A takeover often comprises the acquisition of a specified
interest in the equity capital of a company (typically between
50 and 100 percent), which grants the acquirer the ability to
exert control over the operations of the company.
For instance, HINDALCO was able to acquire control of INDAL
after purchasing a 54% stake in the company from its
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international parent company, Alcan. INDAL, on the other
hand, was ultimately absorbed into HINDALCO after some
time.
A takeover, in contrast to a merger or the purchase of an
existing division, does not include the transfer of assets and
obligations.
Takeover and acquisition are same, technically.
However, the term takeover generally is used when the
transaction is without the consent of the shareholders of the
target company or, in other words, it is hostile takeover.
Acquisition, on the other hand, refers to an amicable
agreement or consent of the majority shareholders of the
target company.
5. Leveraged Buyout:
A takeover or the purchase of a division can also be referred
to as a leveraged buyout, which differs in that it is mostly
accomplished with the assistance of loan financing.
6. Divestitures:
When compared to divestitures, acquisitions lead to an
increase in control and a larger asset base, while divestitures
result in a smaller asset base and a loss of control.
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The following is a list and brief description of the most typical
types of divestitures:
a) Partial Selloff:
A partial selloff is when one company sells a portion of its
operations, like a facility or a business division, to another
company.
A sale of a business division might be thought of as its inverse
in this context.
b) The Transfer of Ownership:
A sale of equity stake occurs when one investor (or a group of
investors) sells an equity stake to another investor.
This equity stake typically represents a controlling block in the
company.
As an illustration, Alcan has parted ways with HINDALCO by
selling the latter 54 percent of its stock holding in INDAL.
A takeover is essentially what this deal is doing, just in reverse.
c) Demerger:
A demerger is the process by which a corporation transfers
one or more of its business divisions to another company that
is being formed at the same time as the original firm.
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For instance, the Great Eastern Shipping Business split off its
offshore operations and created a new company known as
The Great Offshore Limited to house those operations.
Both the firm whose business division is moved and the
company to which it is transferred are referred to as the
demerged company and the resultant company, respectively.
d) Equity Carve out:
When a parent firm engages in equity carve out, it is selling a
portion of its ownership stake in a wholly owned subsidiary.
It's possible that a strategic investor or the general investing
public will buy the equity.
e) PSU Disinvestment:
Individuals and organizations that are not affiliated with the
government, might acquire ownership stakes in previously
state-owned businesses through a process known as
privatization.
This can either be a partial or complete transfer of ownership.
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ABFM MODULE - C
Chapter 17: MERGER, ACQUISITION & RESTRUCTURING
(PART-III)

What we will study?

*What are the different reasons for Merger?
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REASONS FOR MERGER:
The following list contains the most typical reasons for
mergers and acquisitions (M&A):
1- Synergistic operating economics:
One possible definition of synergy is as follows: V (AB) >V (A) +
V (B).
To put it another way, the total value of two separate
businesses or organizations must be greater than each of their
individual values.
According to Mark L. Sorrowed of Boston Consulting Group,
who wrote "The Synergy Trap", synergy is the increase in
performance of the combined firm over what the two firms
are already expected or required to accomplish as
independent firms.
Synergy is the result of combining the resources of two or
more companies.
This could be due to complementary services, economies of
scale, or both of these factors.
One useful illustration of activities that are complementary is
the possibility that one company may have an effective
production system while another company may have an
effective networking of branches.
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Therefore, the amalgamated enterprises will have a higher
productivity level than their respective predecessors.
Along the same lines as the previous point, one of the reasons
for the benefits of synergy is the economics of huge scale.
The primary reason for this is that production on a larger scale,
results in a lower average cost of production.
This can be seen, for example, in a reduction in overhead costs
brought about by the sharing of central services like
accounting and finances, office executives, top level
management, legal, sales promotion and advertisement, and
so on.
2- Taxation:
It is possible that the provisions of the Income Tax Act that
allow for losses to be offset against other income or carried
forward are yet another compelling argument for the merger
and acquisition.
As result, the amalgamated company will see tax savings as
well as a reduction in its tax liabilities.
In a similar vein, in the event of an acquisition, the target
business's losses will be permitted to be set against the
earnings of the company that is doing the acquiring.
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3- Growth:
A company is able to grow at a faster rate using the mode of
mergers and acquisitions as opposed to the other mode,
which is organic growth.
The reduction in "Time to Market" was the driving force
behind this decision.
The acquiring company avoids delays that would have been
caused by the purchase of a building and site, the
establishment of the plant, and the hiring of people, among
other things.
4- The Consolidation of Production Capabilities and the
Enhancement of Market Power:
The decrease in total number of competitors results in an
increase in marketing power.
In addition, the merging of two or more plants can boost the
output capacity of the overall operation.
5- Economies of Scale:
Due to the increased volume of business conducted by the
combined corporation, some efficiency can be realized when
two or more companies merge into a single entity.
These cost savings are the result of a more intensive
utilization of manufacturing capabilities, distribution
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networks, engineering services, research and development
facilities, data processing systems, and so on and so forth.
In the case of horizontal mergers, where there is the potential
for a more intensive utilization of resources, economies of
scale are at their most obvious and evident.
Vertical mergers typically result in significant benefits, the
most important of which are greater activity coordination,
decreased inventory levels, and increased market power for
the merged firm.
Horizontal merger: When companies that sell similar products
merge together.
Vertical merger: Occurs between companies where one buys
or sells something from or to the company.
Last but not least, even in the case of mergers involving
conglomerates, there is potential for the reduction or
elimination of some overhead expenses.
Are there ever times when economies of scale work against
you?
If the scope of operations and the size of the organization
become excessively large and unmanageable, then the answer
is yes.
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6- Economies of Scope:
A company might broaden the range of its activities by making
use of a certain set of capabilities or assets that it already
owns.
For instance, if Proctor and Gamble (P&G) were to purchase a
consumer product firm that could make use of their well-
respected consumer marketing expertise, they would be able
to reap the benefits of economies of scope.
7- Economies of Vertical Integration:
Vertical integration can lead to cost savings by combining the
resources of multiple enterprises operating at various stages
of a value chain or production process.
A firm that is involved in oil exploration and production, such
as ONGC, and a company that is involved in oil refining and
marketing, such as HPCL, may be able to increase coordination
and control by merging their operations.
8- Complementary Resources:
A merger could make sense for two companies if those
companies' resources are complementary to one another.
For instance, a small company that is developing a
revolutionary product could require the engineering
capabilities and marketing reach of a large company.
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It is possible that the unique product can be successfully
manufactured and marketed if the two companies that
created it decide to merge into one.
As a result, the value of the two companies is increased when
they work together because of the complimentary resources
that the two possess.
9- Utilization of Surplus Funds:
Although a company operating in an established market might
make a lot of cash, it might not have many options for making
lucrative investments.
A company of this nature ought to pay out significant
dividends and even purchase back some of its own shares,
assuming such actions are viable options.
However, the majority of management teams have a
propensity to make more investments, despite the fact that
these expenditures might not be lucrative.
In circumstances like these, a merger with another company
that involves cash compensation is frequently the case that
reflects a more effective utilization of surplus capital.
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10- Managerial Effectiveness:
An increase in management efficiency is one of the potential
benefits that could result from a merger.
It is possible for this to happen if the current management
team, which is not doing well, is replaced with a new
management team that is more effective.
A company that has been plagued by managerial
shortcomings can frequently benefit enormously from the
superior management that is expected to emerge as a sequel
to the merger of the two companies.
11- Industry Consolidation:
The necessity of consolidation has been a key factor in the
formation of mergers across a wide variety of business sectors
all over the world.
Consolidation is required for boosting efficiency whenever
there are an excessive number of players and surplus
capacities.
This has happened (and is continuing to happen) in several
industries all over the world, including but not limited to
banking, telecommunications, pharmaceuticals, cement, steel,
autos, and so on.
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12- Dubious Reasons for Mergers:
There are instances when the desire to diversify, achieve a
cheaper cost of financing, and achieve a greater rate of
earnings growth will lead a company to pursue a merger.
At first glance, these goals appear to be worthy; nonetheless,
it is highly unlikely that they will increase value.
13- Growth in Earnings:
It is indeed pass that a merger will provide the impression
that earnings are growing.
If investors are misled, a price increase could result from this.
An illustration of these phenomena might be provided in the
form of an example.
Imagine that A Limited has purchased B Limited.
The column headings 1 and 2 of the table that follows present
an overview of A Limited and B Limited's respective financial
situations prior to the merger.
The price-earnings ratio for A Limited is set at 20, reflecting
the company's exceptional growth prospects.
On the other hand, B Limited has subpar growth prospects
and is trading at a price-earnings ratio of 10 times its current
price.
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It is not anticipated that the merger will result in the creation
of any new value.
The exchange ratio is set at 1:2, which indicates that one
share of A Limited will be transferred in exchange for two
shares of B Limited.
This ratio was determined based on the market prices that
existed prior to the merger.
After the merger, the financial position of A Limited, assuming
the market is "smart," will be as illustrated in column 3 of the
table that is presented below.
Even when earnings per share go up, the price-earnings ratio
goes down because the market realizes that the growth
prospects of the combined company will not be as bright as
those of A Limited alone.
This causes the price-earnings ratio to reflect a lower value.
Therefore, the price of one share on the market has remained
stable at sixty yen.
Therefore, the market value of the combined firm can be
calculated by adding the market values of the two companies
that merged to form the combined company.
If the market continues to behave in an "inefficient or foolish"
manner, it may consider the 33% increase in earnings per
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share to be reflective of genuine growth. As a result, the price-
earnings ratio will not experience a decline.
The market price per share of A Limited will increase to Rs. 80
as a result of increased earnings per share and a price-
earnings ratio that has remained steady.
As a consequence of this, the overall market worth will rise
from Rs. 9 crores to Rs. 12 crores.
Financial Position of A Limited & B Limited
Particulars A Ltd B Ltd before A Ltd after Merger
before Merger
Merger

Market is Market is
Smart Inefficient

Earnings per 3 3 4 4
share

Price per 60 30 60 80
share

PE Ratio 20 10 15 20

No. of shares 10 lakhs 10 lakhs 15 lakhs 15 lakhs

Total Rs. 30 Lakhs Rs. 30 Lakhs Rs. 60 Lakhs Rs. 60 Lakhs

Earnings

Total Value Rs. 6 crores Rs. 3 crores Rs. 9 crores Rs. 12 crores
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Therefore, if the market is "inefficient," it may be susceptible
to being hypnotized by the allure of earnings growth.
In a market that is inefficient, such an illusion might be
successful for a while.
The false profits are sure to vanish once the market reaches
its optimal level of efficiency.
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ABFM MODULE - C
Chapter 18: DEAL STRUCTURING AND FINANCIAL STRATEGIES
(PART-I)

What we will study?

*What is Deal Structuring?
*What is Negotiation?
*What is Payment and legal consideration?
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Acquisition vehicle: Legal structure created to acquire the
target firm (e.g., corporation, limited liability company, or
partnership).
Post-closing organization: Organization or legal framework
used to manage the combined businesses following the
consummation of the transaction (e.g., corporation, holding
company, or partnership).
Holding Company: holding company is a parent company —
usually a corporation or LLC — that is created to buy and
control the ownership interests of other companies. The
companies that are owned or controlled by a corporation
holding company or an LLC holding company are called its
subsidiaries.
Earn-out is a contractual provision stating that the seller of a
business is to obtain future compensation if the business
achieves certain financial goals.
INTRODUCTION:
As a deal outlines how it will generate value for all the parties
involved in Mergers and acquisitions (M&A) transaction, it is
very important to structure the deal with extreme care.
The process through which it happens is called 'deal
structuring'.
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A well-structured M&A deal takes into account issues which
may arise several years into the future, as also the unforeseen
risks impacting the deal.
Deal structure and financing are closely interwoven, as
establishing a consensus throughout the deal-structuring and
negotiation process is crucial for closing the deals.
This procedure results in an agreement or deal structure
between two parties (the acquirer and the target firms) that
defines their respective rights and responsibilities.
The process includes conversations regarding the implications
of various components of deal structuring for risk
management, the consequences of risk on how agreements
are executed, and the difficulties of financing transactions,
particularly highly leveraged transactions.
A highly leveraged transaction is a bank loan to a company
that has a large amount of debt.
The major aspects of the deal-structuring procedure include
the acquisition vehicle and post-closing organization, the form
of acquisition, the form of payment, and the legal form of the
selling entity, as well as how changes in one area of the deal
frequently have substantial effects on other parts of the
contract.
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Specific strategies for bridging significant price disparities will
also be presented.
Tax issues, such as different forms of taxable and non-taxable
structures and how they affect agreement-making, as well as
new legislation affecting corporate tax inversions, are
extremely crucial.
Equally relevant are the means through which M&A
transactions are financed, the effect of near-zero/negative
interest rates on M&As, and the role played by private equity
firms and hedge funds in financing highly leveraged
agreements.
NEGOTIATIONs:
After it has been decided by management that an acquisition
is the most effective way for the company to put its business
strategy into action, after a target has been chosen, and after
an initial financial analysis has been performed and found to
be satisfactory, it is time to start thinking about how to
properly structure the deal.
An agreement between two parties (the acquirer and the
target firms) specifying their rights and obligations is known
as a deal structure.
The procedure that leads to the formation of this agreement is
referred to as the deal-structuring process.
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The process of deal structuring entails establishing how risk
will be distributed and achieving as many of the major
objectives of both the acquirer and the target as possible.
The extent to which the acquiring company takes on the
liabilities of the target organization is referred to as risk
sharing.
The optimal structure for the business transaction is one that
not only achieves the basic goals of all parties involved while
also laying out each party's rights and responsibilities in a
clear and concise manner.
This structure must also take into account an acceptable
amount of risk.
It is possible that the process may be exceptionally difficult, as
it will include a number of different parties, approvals, types
of payment, and sources of financing.
Choices made in one part of the transaction frequently have
repercussions in other parts.
The process of containing the risk involved with a complicated
transaction is comparable to squeezing one end of a water
balloon, which just causes the contents to migrate to another
location.
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PAYMENT AND LEGAL CONSIDERATIONS:
The overall consideration, which can come in the form of cash,
common stock, or debt, or even a combination of all three of
these things, can be considered the method of payment.
The pay-out might be a one-time lump sum, it could be tied to
how well the target does in the future, or it could be paid out
over an extended period of time.
Both the nature of the thing being bought (whether it be stock
or assets) and the manner in which ownership is transferred
are reflected in the form of acquisition.

Form of Acquisition Vehicle and Post closing Organization:

When deciding on an acquisition vehicle or post-closing
organization it is necessary to take into consideration the
elements listed below:
(a) The cost and level of formality involved in the organization.
(b) The ease with which ownership can be transferred.
(c) The continuous existence of the organization.
(d) Management control.
(e) The convenience of obtaining financial support.
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(f) Ease of assimilation into the system.
(g) The manner in which earnings shall be distributed.
(h) The scope of individual responsibility.
(i) Taxation.
The buyer must consider a variety of factors, including risk,
financing, taxation, and control, depending on the form of the
legal entity being used.
If we choose the right organisation, we may be able to lessen
the impact of potential risks, increase the scope of available
financing options, and reduce the total amount that will be
spent on the acquisition.
Selecting the Appropriate Acquisition Vehicle:
The corporate structure that is most frequently utilized is the
acquisition vehicle, because it provides the majority of the
attributes that buyers want, such as limited liability, flexible
financing, continuity of ownership, and transaction flexibility
(e.g., option to engage in a tax-free deal).
An Employee Stock Ownership Plan (ESOP) structure may be
an easy way for small privately held businesses to transfer the
owner's equity in the company to the employees while
providing significant tax benefits.
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Selecting Suitable Post-closing Organization:
It is possible for the post-closing organization to be identical
to the one selected for the acquisition vehicle.
Structures such as divisional and holding company
arrangements are frequently used after a closing.
Although holding companies are usually corporations, they
are also characterized by a distinctive organizational and
management style within the company.
The goals that the acquirer hopes to accomplish should guide
the selection of the post-closing organization.
The acquiring company may opt for a structure that makes
post-closing integration easier, reduces the risk of the target's
known and unknown liabilities, minimizes taxes, passes
through losses to shelter the owners' tax liabilities, maintains
target independence throughout the duration of an earn-out,
preserves unique target characteristics, or maintains the tax-
free status of the deal.
Because it allows for the greatest amount of control, the
corporate or divisional structure is frequently chosen when
the acquirer plans to immediately integrate the target after
the transaction has been finalized.
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Because of the distributed ownership in joint ventures and
partnerships, decision making may be slowed down or made
more controversial.
It is more likely that implementation will depend on tight
cooperation and creating consensus, both of which may slow
down efforts at speedy integration of the company that was
bought.
It is possible that realizing synergies will take longer than it
would if managerial control were centered more within the
parent company.
When the target company has large liabilities, an earn-out is
required, if the target company is a foreign corporation, or the
acquirer is a financial investor, a holding company structure
may be preferable as the acquisition vehicle.
It is possible that the parent will be able to isolate specific
obligations that exist within the subsidiary, and then the
parent will be able to push the subsidiary into bankruptcy
without putting the parent in jeopardy.
It may be possible to reduce the amount of disruption caused
by cultural differences by running the target company in a
manner that is distinct from the rest of the acquirer's
operations when the target company is an international
business.
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ABFM MODULE - C
Chapter 18: DEAL STRUCTURING AND FINANCIAL STRATEGIES
(PART-II)

What we will study?

*What are the different types of payment consideration for
merger and acquisition?
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Different Types of Payment Consideration:
The following is a list of the various types of payment that are
accepted, as well as the situations under which one form may
be favored over another:
(a) Cash:
Cash may be used by acquirers if the target company has a
considerable borrowing capacity, a high credit rating, cheap
shares, and the desire to preserve control of the company
after the acquisition.
Surprisingly, there is very little of a correlation between the
magnitude of an acquirer's cash balances and the possibility
that it would make a cash offer in a takeover situation.
In point of fact, acquirers who have larger cash holdings are
typically more inclined to make stock offers rather than cash
offers as compared to acquirers who have smaller cash
holdings.
This seeming oddity may be the result of the target's
preference for the acquirer's stock due to the target's
perception of the acquirer's company's prospects for growth
or for a tax-free transaction.
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When a company has a high credit rating and relatively low
borrowing costs, it is more likely that a cash transaction will
be financed by borrowing rather than being paid for in cash.
Highly leveraged acquirers are less likely to offer agreements
that consist entirely of cash and are more likely to pay less
cash in mixed payment offers that include both cash and stock.
It's possible that undervalued shares will lead to a significant
reduction in the acquirer's existing shareholder base.
If the issuance of voting stock to acquire the target poses a
threat to the bidder's dominant shareholder's ability to
exercise voting control, the bidder may choose to pay for the
target with cash rather than shares.
(b) Non-cash:
Because of the necessity to comply with the rules that are
now in place regarding securities, the use of stock is a more
involved process than the usage of cash.
It is possible that the acquirer will prefer to pay for the
acquisition with its own shares if it is deemed that the target
company is overvalued, the acquirer has limited borrowing
capacity, and surplus cash balances.
When it is anticipated that the integration of the target
company will take a significant period of time, acquirer's stock
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may be utilized as the principal form of payment instead of
cash in order to reduce the total amount of debt that will be
necessary to finish the takeover.
The acquirer is in a position to finance unplanned cash outlays
throughout the integration period and to explore investment
possibilities that may present themselves if they are able to
maintain their ability to borrow money.
Companies whose actual leverage is higher than their desired
leverage are more likely to make acquisitions using a form of
payment other than cash.
This is because actual leverage is higher than desired leverage.
In addition, acquirer's stock may be a beneficial type of
payment in situations where it is difficult to value the target
company, such as when the target has intangible assets that
are difficult to value, new product entrants, or high R&D
expenditures.
If a seller desires to take part in any appreciation of the stock
it receives from an acquirer and accepts acquirer's stock in
exchange for those shares, the seller may have less motivation
to negotiate an overpriced acquisition price.
Real estate, rights to intellectual property, royalties, earn outs,
and contingent payments are some more examples of non-
cash sources of payment.
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(c) Mix of Cash and Stock:
It is possible that providing target shareholders with a number
of different payment choices will motivate more of them to
participate in tender offers.
If a target company's shareholders are unsure about the
prospective appreciation of the acquirer's shares, they may
prefer a transaction that includes a combination of cash and
acquirer stock.
Some people might prefer a combination of cash and stock,
particularly if they need the cash to pay taxes that are owed
on the sale of their shares of the company.
In addition, acquirers who are either unable to borrow money
to finance an all-cash offer or hesitant to take on the dilution
that comes with an all-stock offer may opt to make an offer to
the target company that is a combination of cash and shares.
Because acquirers have the ability to issue fewer shares, they
may feel more compelled to sell their shares if they consider
the price they paid for them was excessive.
The term "overvaluation" refers to the situation in which the
current share price of the acquirer is higher than the
company's intrinsic value.
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(d) Convertible Securities:
Even after conducting all of the necessary due diligence, an
acquirer and a target frequently have insufficient information
about one another.
Both the acquirer and the shareholders of the target company
are concerned about whether or not the offer price accurately
reflects the value of their shares.
The acquirer is anxious about paying too much for the target
company.
Because target shareholders wishing to participate in any
future appreciation are less likely to withhold vital
information when using acquirer's stock as the major source
of payment, this problem may be partially mitigated by using
acquirer's stock as the primary form of payment.
However, this does not solve the problem of whether or not
the purchase price is fair to the shareholders of the target
company.
When both the buyer and the target lack vital knowledge
about one another, convertible securities have the potential
to alleviate the concerns of both parties.
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People who are interested in bidding but think their shares
are worth less than they should be hesitant to use stock so
they don't dilute the ownership of their existing shareholders.
It is possible for such bidders to offer convertible debt as a
kind of payment in order to indicate their belief.
Target shareholders may find such offers appealing because
they provide a floor equal to the value of the debt at maturity
plus accumulated interest payments and the potential for
participating in future share appreciation.
Additionally, such offers floor equal to the value of the debt at
maturity plus accumulated interest.
On the other hand, potential buyers, who think the price of
their shares is too high, are more likely to make an offer of
stock rather than cash or convertible instruments.
If it is doubtful that the convertible securities will be
converted into equity because of the limited share price
appreciation of the bidder's stock, then the instruments will
continue to function as debt and the company will be subject
to a significant amount of leverage.
There is evidence from real-world situations to suggest that
making use of convertible securities, when both the buyer and
the seller are lacking information, can be beneficial to both
parties.
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ABFM MODULE - C
Chapter 18: DEAL STRUCTURING AND FINANCIAL STRATEGIES
(PART-III)

What we will study?

*All about tax and accounting consideration in Merger and
Acquisition?
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TAX AND ACCOUNTING CONSIDERATIONS:
Accounting concerns address the influence on future earnings
of the combined firms that will be caused by the requirements
for financial reporting.
Tax considerations involve the establishment of tax structures
to ascertain whether or not a transaction will result in taxable
income for the shareholders of the selling company.
The tax ramifications of the selling entity's legal structure
should not be ignored.
The core economics of the sale should always be the decisive
factor, with any tax benefits serving to reinforce a purchasing
decision.
Although taxes are a significant consideration, this aspect
should never override the core economic aspects.
The influence of accounting concerns on the structure of a
deal can be more subtle at times, but it nonetheless poses a
threat to the profitability of the acquirer both now and in the
future.
Alternative Tax Structures:
In case of acquisition, tax implications are typically less crucial
for the buyer than they are for the seller.
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Buyers are primarily concerned with assessing the basis of the
assets they are acquiring and avoiding accountability for any
tax issues that may exist with the target organization.
The tax basis is the level at which an asset can be depreciated
and also determines the future taxable gains that will be
realized by the buyer in the event that such assets are sold in
the future.
On the other hand, the seller is typically worried about how
the transaction might be structured to postpone the payment
of any taxes that are owed.
Taxable Transactions:
A transaction is considered taxable to the shareholders of the
target company if it involves the majority of the consideration
being in the form of cash, debt, or something other than
equity.
A cash purchase of target assets, a cash purchase of target
shares, or a statutory cash merger or consolidation, are all
examples of transactions that are subject to taxation.
Statutory cash mergers and consolidations most typically
include direct cash mergers as well as triangular forward and
reverse cash mergers.
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A forward triangular merger is the acquisition of a company
by a subsidiary of the purchasing company. The target
company is then merged into the shell company completely.
A reverse triangular merger is when the shell company is
merged into the target company.
Taxable Mergers:
In a direct statutory cash merger (i.e., the form of payment is
cash), the acquirer and target boards come to a negotiated
settlement, and both firms, with certain exceptions, are
required to receive approval from their respective
shareholders.
In a direct statutory stock merger (i.e., the form of payment is
stock), the acquirer and target boards reach a negotiated
settlement, and either the target is merged into the acquirer
or the acquirer is merged into the target, and at that point,
only one of them is left standing.
All assets and liabilities, both on and off the balance sheet, are
immediately transferred to the company that is left standing.
The use of so-called triangular mergers is a common tactic
adopted by acquirers who wish to shield themselves from the
liabilities of their targets.
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In these types of transactions, the target company is either
merged into the acquirer's operating or shell acquisition
subsidiary, with the subsidiary continuing to exist (this type of
transaction is known as a forward triangular cash merger), or
the acquirer's subsidiary is merged into the target company,
with the target company continuing to exist (called a reverse
triangular cash merger).
The following topic of discussion will be the repercussions of
these deals on taxes:
Taxable Cash Purchase of Target Assets:
The target company's tax cost or basis in the acquired assets is
increased, or "stepped up" to its fair market value (FMV),
which is equal to the purchase price (less any assumed
liabilities) paid by the acquirer.
This occurs when a transaction involves the cash purchase of
target assets and the buyer assumes none, some, or all of the
target company's liabilities.
The combined companies will have a lower tax liability in the
current year as a result of the additional depreciation that will
be taken in subsequent years.
The difference between the asset's fair market value (FMV)
and its net book value (NBV) is the amount that the target
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company recognizes as an immediate gain or loss on assets
that are sold (i.e., book value less accumulated depreciation).
There is a possibility that the shareholders of the target will
be subject to double taxation: first, when the firm pays taxes
on any gains, and then again when the proceeds from the sale
are paid to the shareholders either in the form of a dividend
or a distribution following the liquidation of the corporation.
If a buyer purchases a significant enough portions of the
target company's assets to force it to discontinue operations,
then the target company may be forced into liquidation.
In most cases, the buyer will be required to jack up the
purchase price in order to compensate the owners of the
target firm for any potential tax obligation they may suffer.
Taxable Cash Purchase of Target Stock:
In order to prevent the target company's shareholders from
being subject to double taxation on gains, taxable
transactions - that is, transactions that include something
other than acquirer stock- require the purchase of the target
company's voting stock.
When a company buys an asset, they are required to pay tax
on any gain that the company made from selling the asset, as
well as another tax if the company pays any of the after-tax
earnings to shareholders.
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Due to the fact that the transaction takes place between the
acquirer and the shareholders of the target company, taxable
stock purchases do not result in a double taxation.
On the other hand, shareholders of the target company can
make a profit or a loss through the sale of their stock.
Tax-Free Transactions:
When the primary form of payment for an acquisition is
acquirer stock, the transaction is exempt from taxation.
Transactions may be subject to partial taxation if the
shareholders of the target company receive something other
than the acquirer's stock in exchange for their shares.
This non-equity consideration, often known as boot, is
typically subject to the same taxation as regular income.
There is no automatic increase in the value of newly acquired
assets to their Fair Market Value, if the transaction does not
trigger any taxes.
To be exempt from paying taxes, a transaction needs to fulfill
the requirements of the step-transaction theory, which
requires that it maintain continuity of ownership interests,
continuity of business enterprise, and a legitimate business
objective.
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Target shareholders are required to own a significant portion
of the value of the combined firms in order to provide
evidence of the continuity of ownership interests.
This necessitates the majority of the purchase price being
comprised of acquirer stock.
To demonstrate a long-term commitment to the target, the
acquirer must show that they will continue to operate a large
amount of the target's "historic business assets" in a business
in order to meet the requirements of "continuity of
commercial enterprise."
In most cases, this indicates that an acquirer is required to
purchase "substantially all" of the target company's assets.
In addition, the transaction must serve a legitimate
commercial goal, such as increasing the acquiring
corporation's profits to their full potential, rather than serving
the sole aim of evading taxes.
Last but not least, according to the step-transaction concept,
the transaction in question is not allowed to be a component
of a wider scheme that would have otherwise constituted a
taxable agreement.
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ABFM MODULE - C
Chapter 18: DEAL STRUCTURING AND FINANCIAL STRATEGIES
(PART-IV)

What we will study?

*What are the tax relief and benefits in case of amalgamation
in India?
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TAX RELIEFS & BENEFITS IN CASE OF AMALGAMATION IN
INDIA:
If an amalgamation takes place within the meaning of section
2(1B) of the Income Tax Act, 1961, the following tax reliefs
and benefits shall be available:
(a) Tax Relief to the Amalgamating Company:
(i) Exemption from Capital Gains Tax [Sec. 47(Vi)]:
Under section 47(vi) of the Income-tax Act, capital gain arising
from the transfer of assets by the amalgamating companies to
the Indian Amalgamated Company is exempt from tax as such
transfer will not be regarded as a transfer for the purpose of
Capital Gain.
The two conditions that must be satisfied, are:
a) The scheme of amalgamation satisfies the conditions of
Section 2(1B) and
b) The amalgamated company is an Indian Company.
(ii) Allotment of Shares In Amalgamated Company To The
Shareholders Of Amalgamating Company [Section 47(Vii)&
49(2)]:
Any transfer by a shareholder in a scheme of amalgamation of
shares held by him in the amalgamating company shall not be
regarded as transfer if
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a) Transfer is made in consideration of allotment to him of
shares in the amalgamated company; and
b) Amalgamated company is an Indian company.
Section 49(2)-provides that in above case the Cost of Shares of
the amalgamating company shall be the Cost of Shares to the
amalgamated company.
(b) Tax Relief to the Shareholders of The Amalgamating
Company:
Exemption from Capital Gains Tax [Sec 47(vii)]:
Under section 47(vii) of the Income-tax Act, capital gains
arising from the transfer of shares by a shareholder of the
amalgamating companies are exempt from tax as such
transactions will not be regarded as a transfer for capital gain
purpose, if:
a) The transfer is made in consideration of the allotment to
him of shares in the amalgamated company; and
b) Amalgamated company is an Indian company.
Note: 'Transferor company' means the company which is
merging also known as amalgamating company in case of
amalgamation and 'transferee company' is the company
which is formed after merger or amalgamation also known as
amalgamated company in case of amalgamation.
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(c) Tax Relief to the Amalgamated Company:
A) Carry Forward and Set Off of Accumulated loss and
unabsorbed depreciation of the amalgamating company [Sec.
72A]:
Section 72A of the Income Tax Act, 1961 deals with the
mergers of the sick companies with healthy companies and to
take advantage of the carry forward of accumulated losses
and unabsorbed depreciation of the amalgamating company.
But the benefits under this section with respect to
unabsorbed depreciation and carry forward losses are
available only if the followings conditions are fulfilled:
There should be an amalgamation of:
(a) A company owning an industrial undertaking (Note 1) or
ship or a hotel with another company.
(b) A banking company referred in section 5(c) of the Banking
Regulation Act, 1949 with a specified bank (Note 2), or
(c) One or more Public Sector Company or companies engaged
in the business of operation of aircraft with one or more
public sector company or companies engaged in similar
business.
Note 1. The term 'Industrial Undertaking' shall mean any
undertaking engaged in:
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(i) The manufacture or processing of goods, or
(ii) The manufacture of computer software, or
(iii) The business of generation or distribution of electricity or
any other form of power, or
(iv) Mining, or
(v) The construction of ships, aircrafts or rail systems, or
(vi) The business of providing telecommunication services,
whether basic or cellular, including radio paging, domestic
satellite service, and network of trucking, broadband network
and internet services.
Note 2.
(i) Specified bank means the State Bank of India constituted
under the State Bank of India Act, 1955 or
(ii) A subsidiary bank as defined in the State Bank of India
(Subsidiary Bank) Act, 1959 or
(iii) A corresponding new bank constituted under section 3 of
the Banking Companies (Acquisition and Transfer of
Undertaking) Act, 1980.

B) The amalgamated company should be an Indian Company.

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C) The amalgamating company should be engaged in the
business, in which the accumulated loss occurred or
depreciation remains unabsorbed, for 3 years or more.
D) The amalgamating company should hold continuously as on
the date of amalgamation at least three-fourth of the book
value of the fixed assets held by it two years prior to the date
of amalgamation.
E) The amalgamated company holds continuously for a
minimum period of five years from the date of amalgamation
at least three-fourths in the book value of fixed assets of the
amalgamating company acquired in a scheme of
amalgamation.
F) The amalgamated company continues the business of the
amalgamating company for a minimum period of five years
from the date of amalgamation.
G) The amalgamated company fulfils such other conditions as
may be prescribed to ensure the revival of the business of the
amalgamating company or to ensure that the amalgamation is
for genuine business purpose.
H) The amalgamated company, which has acquired an
industrial undertaking of the amalgamating company by way
of amalgamation, shall achieve the level of production of at
least 50% of the installed capacity of the said undertaking
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before end of four years from the date of amalgamation and
continue to maintain the said minimum level of production till
the end of five years from the date of amalgamation.
The Central Government may relax above condition in desired
situations.
I) The amalgamated company shall electronically furnish to
the Assessing Officer (AO), a certificate in Form 62 duly
verified by an accountant, with reference to the books of
account and other documents showing particulars of
production along with the return of income for the AY
relevant to FY falling within a period of five years from the
date of amalgamation.
The requirements of furnishing Form 62 will arise for the first
time only when amalgamated company fulfils conditions of
achieving level of production of 50% of installed capacity of
undertaking of amalgamating company within four years
period.

Consequences When Above Conditions Are Satisfied:

If the above conditions are satisfied then accumulated
business loss and unabsorbed depreciation of the
amalgamating company shall be deemed to be business loss.
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Consequences When Above Mentioned Conditions Are Not
Satisfied:
After Adjusting Business Loss/ Depreciation - In case the
above specified conditions are not fulfilled then that part of
brought forward loss and unabsorbed depreciation which has
been set off by amalgamated company shall be treated as
income of the amalgamated company for the year in which
failure to fulfill above conditions occurred.

Availability of MAT credit:

Section 115JB of the ITA levies MAT (Minimum Alternate Tax)
on a company if the amount of income-tax payable under
general provisions of the ITA is less than 15% of the
company's 'book profits'.
In such case, the ‘book profits' computed are deemed to be
the total income of the company and income-tax is levied
thereon at 15%.
However, the excess of MAT paid over normal tax liability for
the year is permitted to be carried forward under Section
115JAA of the ITA for set-off in future years in which normal
tax liability exceeds MAT liability ("MAT Credit").
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There is no express provision in Section 115JAA which allows
an amalgamated/ resulting company to carry forward and
claim MAT Credit which was available to the amalgamating /
demerged company.
Capital Gains Taxes:
If the shares qualify as capital assets under Section 2(14) of
the ITA, the gains arising upon transfer of the shares would
attract capital gains tax liability.
As per Section 45, capital gains tax must be assessed at the
time of transfer of the capital asset, and not necessarily at the
time when consideration is received by the transferor or on
the date of the agreement to transfer.
In other words, a taxpayer is required to pay capital gains tax
with respect to the year his right to receive payment accrues,
even if such payment is deferred in whole or in part.
Tax issues in Domestic M&A:
Tax issues arise in domestic M&A transactions when the
conditions stipulated under the ITA are not fulfilled or the tax
authorities allege that such conditions are not fulfilled.
Courts have interpreted the exemptions provided under
section 47 of the ITA in relation to amalgamation and
demerger in such cases.
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These issues typically cover the following cases:
(a) Allotment of securities or payment of cash consideration
to shareholders of amalgamating company.
(b) Part consideration paid directly to shareholders of
demerged company.
(c) Availability of MAT credit.
(d) Merger of Limited Liability Partnership into a company.

Tax Issues in Cross Border M&A:

In cross-border transactions, tax concerns emerge when two
countries seek to tax the same income or the same legal entity,
resulting in double taxation of the money.
Most countries recognize that double taxation acts as a
disincentive for cross-border trade and activity; consequently,
in order to promote cooperation, trade, and investment,
countries enter bilateral Double Taxation Avoidance
Agreements (DTAAs) to limit their taxing rights voluntarily
through self-restraint, thereby avoiding overlapping tax claims.
The availability of DTAA benefits and the ultimate tax liability
frequently drive or impede cross-border transactions.
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Particularly in the Indian setting, where the tax administration
is viewed as aggressive and the laws are ambiguous, any
protection granted by a country with which India has a DTAA
is crucial.
For a buyer, it is essential to determine whether a tax
withholding duty exists when making a payment to a seller.
India is undergoing a transformation of its current investment
climate.
Foreign Direct Investments ("FDI") from Mauritius, Singapore,
and Cyprus accounted for more than fifty percent of all FDI in
India.
India appears to be altering the status quo and limiting
investors' access to tax benefits by amending its DTAAS with
each of these countries.
Moreover, worldwide concern over treaty violations is
growing.
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ABFM MODULE - C
Chapter 18: DEAL STRUCTURING AND FINANCIAL STRATEGIES
(PART-V)

What we will study?

*All about financial reporting of Business Combination?
*All about Deal Financing?
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FINANCIAL REPORTING OF BUSINESS COMBINATIONS:
An entity shall account for each business combination by
applying the acquisition method.
Applying the acquisition method requires:
(a) Identifying the acquirer.
(b) Determining the acquisition date.
(c) Recognizing and measuring the identifiable assets acquired,
the liabilities assumed and any non-controlling interest in the
acquiree and
(d) Recognizing and measuring goodwill or a gain from a
bargain purchase.
Each of the above steps is explained in detail in IND AS 103
Business Combination.
Under Generally Accepted Accounting Principles (I-GAAP),
shares acquired by the buyer would be recorded at cost and
continued to be done so in subsequent years as well.
However, under Indian Accounting Standard (Ind-AS) method
of accounting, investments will be recorded at fair value,
unless the buyer opts to record its investments in its
subsidiaries and associates at cost.
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In a share acquisition, no intangible assets are recognized in
the standalone books of the target company.
However, if the share acquisition results in acquisition of
control over the target company, the assets and liabilities of
the target company may be recorded at their acquisition-date
fair values in the consolidated financial statements and the
excess of asset over liabilities may be recorded as Goodwill in
the consolidated financial statements.
The purchase method must be used to account for business
combinations by a company that maintains its financial
statements in accordance with International Financial
Reporting Standards (IFRS) or Generally Accepted Accounting
Principles (GAAP) (also called the acquisition method).
According to the purchase method of accounting, the
purchase price or acquisition cost is calculated, assigned first
to tangible net assets and then to intangible net assets using a
cost-allocation strategy, and then recorded on the books of
the purchasing business.
Acquired assets less assumed liabilities are referred to as net
assets (or net acquired assets).
Any difference between the purchase price and the acquired
net assets' fair market value is recorded as goodwill.
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Goodwill is an asset that represents potential future financial
gains from acquired assets that were not specifically
recognized.
Acquirer must record assets, liabilities, and any non-
controlling interest in the target at their fair value as of the
acquisition date in accordance with current accounting rules.
Instead of the announcement or signing date, the purchase
date typically coincides with the closing date.

Recognizing Acquired Net Assets and Goodwill at Fair Value:

Current accounting standards mandate recording 100% of the
assets bought and liabilities assumed, even if the acquirer
buys less than 100% of the target, in order to facilitate
comparisons across various transactions.
As a result, regardless of whether 51%, 100%, or any other
proportion of the target is bought, the target's business is
recognized in its entirety.
As a result, the buyer must account for the goodwill
attributable to both it and the non-controlling interest.
This is because the component of the target that was not
bought (i.e., the non-controlling, or minority stake) is also
recognised.
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Non-controlling/minority interest is shown separately from
the parent's equity in the equity account of the consolidated
balance sheet.
Additionally, the consolidated income statement should
include the revenues, expenses, gains, losses, net income or
loss, and other income related to the non-controlling interest.
The value of the 49.9% non-controlling, or minority, interest in
shareholders' equity must be recorded if, for instance, Firm A
purchases 50.1% of Firm B, indicating its effective control over
the latter.
In this case, Firm A must also add 100% of the assets and
liabilities of Firm B that it has acquired and assumed to its
own assets and liabilities.
This recognizes that Firm A is in charge of managing all the
acquired assets and assumed liabilities and sees the non-
controlling stake as merely another type of stock.
Similar to Firm A, Firm B's income statement is added to the
consolidated firms' retained earnings and contains 100% of
Firm B's earnings less the portion attributed to the 49.9%
minority owner.
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DEAL FINANCING:
M&A deals are frequently financed using cash, stock, debt, or
a combination of all three.
For instance, the $17.7 billion (including assumed debt)
acquisition of US cable operator Cablevision by French
telecommunications giant Altice, in late 2015, was financed by
a combination of bank financing, cash on hand, and new
equity offerings.
The choice of financing source or sources is influenced by a
number of variables, such as the state of the capital markets,
the liquidity and creditworthiness of the target and acquiring
companies, the combined borrowing capacity of the target
and acquiring companies, the size of the transaction, and the
target shareholders' preference for cash or acquirer shares.
The choice to buy might be made independently of the
financing structure of the deal.
An acquirer can draw different kinds of investors by
decoupling these choices (or clientele).
In the case of mergers and acquisitions, a company may issue
shares prior to a bid in order to acquire money to finance a
cash purchase of a target.
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The company is able to draw investors by clearly indicating
that the issue's goal is to finance future acquisitions.
These investors think that acquisitions are a better use of the
proceeds than operating capital, creating liquidity, or
reinvested back into the company.
As a result, the acquirer returns on the acquisition's
announcement date can be larger than they would be if the
acquirer's investor composition were less favourable to the
firm making acquisitions.
Further, if the acquirer can time the issuance of shares to
periods when they are highly valued by investors and use the
proceeds to buy another company in the same industry when
firms in the industry are seen as being undervalued, the value
of the deal to the acquirer could be enhanced, at least in the
short run.
The particulars of the contract will ultimately determine what
source of cash, or combination of sources, are used and when
they are used.
The various financing options, available to an acquirer are:
1. Issue of equity and/or preference shares.
2. Internal accruals.
3. Long Term loans from banks or other lenders.
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4. Issue of convertible/non-convertible debentures or other
types of domestic or foreign debt instruments.
The potential for debt to boost earnings per share and returns
on equity are two factors that contribute to the desirability of
long-term debt.
The cost of the debt after taxes is also relatively modest.
But, an excessive amount of debt can make the possibility of
default more likely.
The capacity of a company to finance unanticipated
investment opportunities, as they come up, can be hindered
when it has an excessive amount of leverage.
Since the late 1970s, there has been a significant rise in the
proportion of businesses operating with little to no leverage
in the United States.
This trend can be traced back to the beginning of the 1980s.
The percentage of businesses that have no debt has climbed
from about 7% in 1977 to approximately 20% in 2010.
The percentage of businesses that have debt that is less than
5% of their total capital has increased from approximately
14% in 1977 to approximately 35% in 2010.
Why?
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It would appear that companies place a higher value on the
flexibility that low leverage provides in terms of funding
desirable but unexpected investment possibilities than they
do on the tax benefits that are associated with debt.
Despite this, merging companies, the cash flows of which are
relatively uncorrelated with one another, have a tendency to
increase their leverage after the completion of the deal.
This is because more stable total cash flows make it easier for
the combined firms to pay interest and principal on the
incremental debt.
In the event of liquidation, long-term debt issues might be
categorized as either senior or junior.
When it comes to a company's earnings and assets, senior
debt has a greater priority claim than junior debt does.
Another way to categorise unsecured debt is according to
whether or not it is subordinated to other forms of debt.
Because they are not secured by anything other than the
overall creditworthiness of the borrower, subordinated
debentures are typically ranked lower than other forms of
debt, such as bank loans.
This is due to the fact that subordinated debentures are
unsecured.
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Convertible bonds are a type of debt that can be converted
into shares of stock in the issuing firm at a predefined ratio
(i.e. a particular number of shares for each bond).
They often have a coupon rate that is not particularly high.
The ability to convert the bond into common stock at a
significant discount from the company's market value is the
primary form of compensation that is provided to the buyer of
the bond.
When bondholders convert their bonds into new shares, it will
have the effect of diluting the earnings of current
shareholders as well as their ownership of the company.
The degree to which one debt issue is subordinate to another
relies on the constraints that are placed on the company by an
agreement known as an indenture.
An indenture is a contract that is made between the
corporation that issues the long-term debt instruments and
the lenders.
The indenture provides specifics regarding the form of the
offering, the manner in which the main obligation must be
repaid, as well as the affirmative and negative covenants that
are relevant to the long-term debt offering.
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Credit-rating agencies assign a numerical value to each debt
issue based on how high of a risk it poses in comparison to
other debt issues.
The rating agencies take into account a variety of factors,
including the consistency of a company's earnings, interest
coverage ratios, debt as a percentage of total capital, the
degree of subordination, and the company's historical
performance in meeting the requirements of its debt service
obligations.