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1 1
OVERVIEW OF VALUATION
Unit Structure :
1.0 Objectives
1.1 Introduction
1.2 Understanding Financial Goals and Strategy
1.3 Shareholder Value Creation (SCV)
1.4 Market Value Added (MVA)
1.5 Market -to-Book Value (M/BV)
1.6 Economic Value Added (EVA)
1.7 Financial Strategy for Capital Structure
1.8 Leverage effect and Shareholders’ Risk
1.9 Summary
1.10 Unit End Questions
1.11 Suggested Readings
1.0 OBJECTIVES
The main purpose of this chapter is –
To discuss financial goals and strategy
To understand sharehol der value creation
To analyse the market value added
To discuss Market -to-Book Value
To understand Economic Value Added
1.1 INTRODUCTION
Every business requires a better and strategic financial planning so that all
the components can be utilised in right d irection. Management needs a
smart financial planner that can groom the business in natural way. Many
often it has been seen that either business owner or any person in
management has capability to plan some financial strategies but in the
absence of same, companies hire professional services in this regard.
Existing assets, utilisation pattern, quantum of production, investment in
creating infrastructure, outsourcing of some of the expensive works are
few points where financial planner put their main focus . Main aim of any
company is to achieve maximum benefit by investing minimum capital munotes.in
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2 and efforts. Though, this is theoretical but as far as practical approaches
are concerned, business owner needs a special kind of planning that can
give comprehensive supp ort to keep erecting business pillar.
1.2 UNDERSTANDING FINANCIAL GOALS AND
STRATEGY
Normally, all business organizations consider their financial goal on
prime level. This is the base of every business that complete financial
scheduling has been done keep ing in some unforeseen incidents. In
business, this is quite common to have some drops (in any way) and to
handle any unexpected situation they need sufficient liquidity. This
achievement can only be done if some goals and strategies are planned.
Being a business owner you should understand that all the business
planning should be done well in advance and before starting of business.
Conduction of meetings with management - Conduct several sittings with
your management board and discuss each and every aspect related to your
business. Even smallest expenditure should also be taken into
consideration. Your attention should be on achieving fiscal benefit so
that your call in market can be matured at any time. Remember if you
have made better planning, only the n you will be able to maintain flow in
business otherwise cut throat competition and co -businessmen’s strategies
will cost you a lot. Before starting of a business, maintain a healthier
relationship with various service providers. Every service provider is
having some of the opportunities for you. You should consider that you
are depending on him until you procure the same services at your end.
For example, transportation is such an important support service that is
needed by every businessman. To have the same with you, a huge
investment will need. It is better to procure the same from support services
providers. Maintain a strategy that gradually you will own some of the
services in phased manner in certain time frame. In this way, you will
work better. Your first financial goal is to minimize credit.
Maintain relations with banks and money lending agencies - Before you
start your business; you must liaise with some money lenders of official
financial agencies and intimate them regarding your needs. On p erusal
of your property and ascertaining better and adequate guarantees, they
will provide you a better amount. This amount needs to be repaid in some
pre-decided time. Every business organization must follow the bank’s
guidelines on this issue and make some strategies so that credit can be
returned on time as well as some profit is maintained to re -invest. These
strategies are not to be disclosed to other business organization to maintain
the smooth functioning in market. It is quite possible that other business
houses are also getting financial help from the same agency but assume
this activity only as a part of business.
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3 1.3 SHAREHOLDER VALUE CREATION (SCV)
Every shareholder is provided with some benefit in proportion of his
contribution. Apart fro m the above, capital investment of shareholder is
also returned by the business organisation after some time. The separation
or taking back the invested capital is depending on mutual agreement
between shareholder and business house. This amount is other t han
routine profit amount. The value provided to shareholder is the result of
strategically planning made by business house. Though, this is not only
the business owner’s responsibility to invest the value of shareholder but
every shareholder should unders tand the circumstances. It may be that
market is not getting desired pace and, in this scenario, investing money
would not be beneficial.
Shareholder value creation, also known as shareholder value maximization
(SVM), refers to the notion that the primar y objective of a corporation is
to maximize the wealth of its shareholders. This concept holds that the
ultimate goal of corporate management is to increase the company's stock
price, which is seen as a direct reflection of the value being created for
shareholders.
In practice, this means that corporate management should focus on
maximizing profits, improving operational efficiency, and making
strategic investments that will increase the company's long -term growth
potential. This can involve prioritizing sh ort-term gains over other goals,
such as environmental sustainability or community development, if they
are seen as detracting from the ultimate goal of maximizing shareholder
value.
It's important to note that the concept of shareholder value creation has
been criticized by some, who argue that it can lead to a narrow focus on
financial performance at the expense of other important considerations,
such as employee well -being, customer satisfaction, and ethical business
practices.
1.4 MARKET VALUE ADDED (MV A)
In normal manner, market value added is a simple term. This is only a
difference in existing market value and contribution made by all the
investors. In more simple manner, this is only difference in the wealth
accrued as a result of business and money invested. This additional profit
is divided into all the involved shareholders. This is market value added
or (MVA). All the markets are having different nature. Sale of produced
goods may be different in every market but certain values are adopted in
every market that is added to the products. But have you ever thought that
what market value adds to an amount. All the investors provide monetary
support to a business organization and they need a return of their amount
with certain increase. This increase is normally considered on two ways.
First, the percentage of benefit is added and second one is the market
price of each commodity and services being produced by the business
owner. Some of the cash flow is used with discount and some as non- munotes.in
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4 discounted. Though, increase and decrease of the amount is based on the
market circumstances. In case there is a positive role of supporting
circumstances, some value well be added to you investment but in case the
conditions are not in favor, definitely your investment will be getting no
gains. This difference should be understood by every investor.
Normally, every business house decides this percentage by applying a
simple method. Total capital invested is reduced from the current market
value and accurate MVA comes out. This amount is adjusted in between
the shareholders according to their proportion. From various examples
you can understand the real situation. The investment of business house
as well as by investors makes a grand capital and all addition of wealth
adde d on this amount is only due to the increase in market.
Market Value Added (MVA) is a financial metric that measures the
difference between a company's market value and its capital employed. It
is a measure of how much value a company has generated for its
shareholders beyond what they have invested in the company. MVA is
calculated as the difference between the market capitalization of a
company (i.e., the total value of all its outstanding shares) and the total
amount of capital employed by the company (i .e., the sum of equity and
debt).
For example, if a company has a market capitalization of 100 million
and has employed 80 million in capital, its MVA would be 20 million.
This means that the company has generated 20 million in value for its
shareholders beyond what they have invested in the company.
MVA is often used as a performance metric to evaluate a company's
ability to create value for its shareholders. A positive MVA indicates that
the company has created value for its shareholders, while a negative MVA
suggests that the company has destroyed value for its shareholders.
It's important to note that MVA is a dynamic metric that can change over
time, reflecting changes in the company's market value and capital
employed. As a result, it is not a static measure of a company's
performance and should be evaluated in conjunction with other fin ancial
metrics.
MVA = Market Value of Shares – Book Value of Shareholders’
Equity
Example:
As an example, consider Company Ajay whose shareholders’
equity amounts to $15,00,000. The company owns 10,000 preferred shares
and 200,000 common shares outstanding .
The present market value for the common shares is $12.50 per share and
$100 per share for the preferred shares.
Market Value of Common Shares = 200,000 * $12.50 = $25,00 ,000
Market Value of Preferred Shares = 10,000 * $100 = $10,00,000 munotes.in
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Overview of Valuation
5 Total Market Value of Shares = $25,00,000 + $10,00,000 = $35,00,000
Using the figures obtained above:
Market Value Added = $35,00,000 – 15,00,000 = $20,00,000
1.5 MARKET -TO-BOOK VALUE (M/BV)
It is quite simple that every business house maintains a formula to assess
the rati o of development. This ratio can be implemented on different
components of business. What is the exact value of business is counted
through the value of production in market. Every business house has
some portion of capital investment apart from the invest ment done by
investors. This amount is calculated in proportion to the invested amount.
It may be that the historical cost, this is the cost that is being invested by
the company since long, of company is better at all time and accordingly
getting better returns from market.
Market -to-Book Value (M/BV) is a financial ratio that compares a
company's market capitalization to its book value. It is used to evaluate the
relationship between a company's market value, as represented by its stock
price, and its bo ok value, as recorded in its financial statements.
The formula for M/BV is simply the market capitalization of a company
divided by its book value. A market capitalization is calculated by
multiplying the number of outstanding shares by the current market price
per share. The book value is calculated as the difference between a
company's total assets and its total liabilities.
A market -to-book value of 1 indicates that a company's market value is
equal to its book value, meaning that its stock price reflect s its accounting
value. A market -to-book value greater than 1 suggests that the market
believes the company is worth more than its accounting value, while a
market -to-book value less than 1 indicates that the market believes the
company is worth less than its accounting value.
Market -to-book value is often used by investors and analysts as a rough
indicator of a company's financial performance and future prospects. A
high market -to-book value can indicate that a company is growing rapidly
and has strong fut ure prospects, while a low market -to-book value may
suggest that the market has limited confidence in the company's future
prospects. However, it's important to keep in mind that market -to-book
value is just one financial metric and should be evaluated in conjunction
with other financial metrics and information about the company and its
industry.
1.6 ECONOMIC VALUE ADDED (EVA)
EVA is nothing than a calculator. By using this calculator you can confirm
the vale has been created by any investor. This may be yo u as business
owner. A special metric is used to get estimation of the profit of investors
is called EVA. This calculation can be made according to the value of munotes.in
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6 each share. This term is also referred as EPS. Earnings per share are also
counted as a compone nt of metric. This is quite simple way of calculating
the profit. In case you are investing 80% of all business and getting 20%
support from investors, it simply means that at the end of financial year,
you will get 80% of the total benefit received from fund investment.
Remaining 20% will be distributed to the share holders accordingly.
Economic Value Added (EVA) is a financial metric that measures the
economic profitability of a company by taking into account the cost of
both equity and debt capital. It is designed to provide a more accurate
picture of a company's profitability than traditional financial metrics such
as net income, by considering the cost of capital as well as the return on
capital.
The formula for EVA is:
EVA = Net Operating Profit After T axes (NOPAT) - [(Cost of Capital) *
(Capital Employed)]
where NOPAT is the company's net income after taxes and capital
employed is the sum of equity and debt capital. The cost of capital
represents the cost of both equity and debt capital, taking into acc ount the
weighting of each type of capital in the capital structure.
The idea behind EVA is that a company should only be considered to be
adding value if it generates a return on capital that is higher than the cost
of capital. If a company's EVA is posit ive, it means that the company is
generating a return on capital that is higher than the cost of capital and
creating value for its shareholders. If the EVA is negative, it means that
the company is not generating a return on capital that is high enough to
cover the cost of capital and is destroying value for its shareholders.
EVA is a widely used financial metric, particularly in the corporate
finance world, and is considered by many to be a better indicator of a
company's financial performance than tradit ional metrics such as net
income or return on investment (ROI). However, like any financial metric,
it is important to consider EVA in the context of a company's overall
financial position and future prospects.
How to calculate EVA:
Formula 1
EVA = Net Ope rating profit after tax – (Equity capital * % Cost of
equity capital)
Net Operating profit after tax will be calculated as:
Net Profit before interest and tax xxx
(- ) Interest xx
Net Profit before Tax xxx
(-) Tax xx
Net operating profit a fter tax xxx munotes.in
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Overview of Valuation
7 Example:
Calculate EVA from the following:
1. Average operating profit after tax = Rs. 50,00,000 p.a for last three
years
2. Total assets = Rs. 1,50,00,000
3. Average current liability = Rs. 30,00,000
4. Weighted average cost of capital = 10%
Solution:
EVA = NOPAT -WACC * Capital Employed
= 50,00,000 – 10 % * (1,50,00,000 -30,00,000)
= 38,00,000
1.7 FINANCIAL STRATEGY FOR CAPITAL
STRUCTURE
The capital structure of a company refers to the mix of debt and equity
financing used to fund its operations and growth. Financial strategy for
capital structure refers to the approach a company takes to determine the
optimal balance between debt and equity financing, with the goal of
maximizing value for shareholders.
There are several key strategies that companies can employ to optimize
their capital structure, including:
1. Debt Financing: Incorporating debt financing into the capital structure
can help a company lower its cost of capital, increase its financial
leverage, and improve its tax position.
2. Equity Financing : Equity financing can provide a company with a
more stable source of funding and can help it avoid the risk of default
associated with debt financing.
3. Hybrid Financing: Hybrid financing involves a combination of debt
and equity financing, which can provid e a company with the benefits
of both while mitigating some of the risks.
4. Target Capital Structure: A target capital structure refers to a
predetermined mix of debt and equity financing that a company seeks
to maintain over time. A target capital structure can help a company
manage its risk and maintain financial stability.
5. Capital Structure Optimization: Capital structure optimization involves
adjusting the mix of debt and equity financing to maximize
shareholder value. This can involve a dynamic evaluatio n of the
company's financial position and the changing economic environment.
Regardless of the specific strategy a company employs, the goal of
financial strategy for capital structure is to ensure that the company's munotes.in
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8 capital structure is aligned with its f inancial goals and optimized to create
value for shareholders.
It's important to keep in mind that capital structure decisions have long -
term implications and can affect a company's risk profile and financial
stability. As a result, companies should carefu lly consider their capital
structure options and seek professional financial advice when making
important capital structure decisions
1.8 LEVERAGES EFFECT AND SHAREHOLDER’S
RISK
The leverage effect refers to the relationship between a company's debt
financ ing and its equity financing, and the impact that debt financing can
have on the value of the company and its shareholders.
In general, a company that has a higher level of debt financing is said to
have more leverage, which means that a relatively small c hange in the
company's financial performance can have a relatively large impact on its
shareholders' returns. On the one hand, a high level of debt financing can
increase the potential returns for shareholders, as the company uses debt
financing to magnify its profits. On the other hand, a high level of debt
financing also increases the company's risk, as it creates an obligation to
repay the debt, which can put pressure on the company's financial
performance.
The shareholders' risk refers to the level of r isk associated with investing
in a company's stock. Shareholders' risk is directly related to the leverage
effect, as a higher level of debt financing increases the risk associated with
investing in a company's stock. This is because a high level of debt
financing creates an obligation to repay the debt, which can put pressure
on the company's financial performance and increase the risk of default.
In order to manage the leverage effect and shareholders' risk, companies
must carefully consider their capital structure and take steps to minimize
their debt financing and increase their equity financing, where appropriate.
This can help to reduce the company's risk profile and create a more stable
environment for its shareholders.
DIVIDEND POLICY AND VALUE OF TH E FIRM :
Dividend policy refers to the approach a company takes with regards to
the distribution of its profits to its shareholders in the form of dividends.
Dividend policy is an important component of a company's financial
strategy, as it can have a sign ificant impact on the company's financial
performance and the value of the firm.
The value of a firm can be influenced by its dividend policy in several
ways:
1. Shareholder Expectations: A company's dividend policy can impact
the expectations of its sharehol ders and the perception of the munotes.in
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9 company's financial stability and performance. For example, a
company that consistently pays dividends is often viewed as being
financially stable and committed to creating value for its shareholders.
2. Cost of Capital: A compa ny's dividend policy can impact its cost of
capital, as the expectation of consistent dividends can reduce the risk
associated with investing in the company's stock and lower the cost of
capital.
3. Share Price: A company's dividend policy can also impact its share
price, as the expectation of consistent dividends can increase the
demand for the company's stock and boost its share price.
4. Retention of Earnings: A company's dividend policy can also impact
its ability to retain earnings and reinvest in the busine ss. Companies
that choose to retain earnings and reinvest in their business can
potentially increase the value of the firm over the long term.
The optimal dividend policy for a firm will depend on a number of factors,
including its financial performance, f uture growth prospects, and the
expectations of its shareholders. Companies may choose to pay consistent
dividends, increase dividends over time, or choose not to pay dividends at
all, depending on their specific financial situation and goals.
In summary, the dividend policy of a company can have a significant
impact on the value of the firm, and companies must carefully consider
their dividend policy as part of their overall financial strategy.
DIVIDEND AND PRINCIPLE - AGENT CONFLICT :
All the agents, associated with any business house, should clearly
understand that dividend policy is quite firm and changeable only in case
of recession of any natural calamity. All the corporate governing bodies
should consider this fact that agents are the major source to earn business.
Though, these agents are of lower level workers but quite important for
bringing business. You can also assume agents as shareholders. The
agents work on behalf of shareholders. In complete benefit they also need
their share. Though ever y agent is directly depending on the investor
concerned and don’t have direction relation with the business owner.
These agents only collect service charges from the investors. Complete
accounting agency can also be an agent. To maintain proper accounting of
all the financial transactions done with the business house are kept up to
date to get correct benefits. In case the accounting section has missed any
investment, the concerned investor will have to face loss. Though, in
routine business, it has been seen that business house ensures that no
investor is missing with some dividend. Every business house also keeps
master accountant that keeps all records in this regard. Any addition in
principle is not considered for sharing with investors. Increase in ca pital is
solely the right of business house. Different conflicts regarding dividend
are seen in practice. Here both the parties can also be considered as agent.
The party dealing with capital is principal and party depending on profit
percentage is conside red as agent. Many of the issues are there in this munotes.in
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10 regard. Strong information is needed in maintaining correct dividend
records.
Data bank of the business house must be stronger than the investors’ so
that all the financial transactions are recorded better . Some EVA is also
calculated while disbursement of dividend is being finalized. It is also
evident that whenever switching or changing is occurred in management
or any separation made due to any reasons, deviation occurs that the cost
of principal’s inter est. This cost is often counted under conflicts. This
deviation is normally generated by the business houses when their
business is in financial transits. Appointment of financial managers is also
one of the causes of deviation. Every new manager thinks that he will
search some better options for the investment and in this process some
changes are occurred. This is quite obvious. Agency costs are increased
but principle holder doesn’t want to share it with agents.
FINANCIAL OPTIONS AND VALUE OF THE FIRM :
In business field, a number of financial options are in front of business
houses. The same is with the investors too but at the end of business
house, collective funding is considered and hence risk factor looks higher
there. Now look at some of the options to utilize finance. Stocks – This
is one of the prime options to invest funds. Once a certain amount is
invested in this way, it is self explanatory that fund has been blocked for
some time. Though, better returns are desired but owing to market
circumstances, the same may result in loss too. Risk factor exists always.
A business house can evaluate its finance by investing the same in other
options too. Though, investment can also be diverted to some other
options but mostly investing is seen und er securities, budgeting of capital
and acquisition process by a company. As far as investment in acquisition
is concerned, it means this is process of evaluating the risk. Market studies
explain that more than 80% acquisitions are not success. Risk factor is
involved in this process. In case you are investing in some other options
like determining trademarks or patents of a company, you may have lesser
risk factor.
Though, companies may follow some methods of cash flow in discounted
manner. During investin g in some intangible assets, the company may
proceed to some other options and evaluate its functioning. In case your
company is suffering from any investment related issue, you can switch to
some other option. Fluctuation in market is obvious but after al l value of
your firm should be stable. Credibility of your business needs a firm
value. In case you need to shift your business, you should recover even
the basic cost of infrastructure. This is advisable to all companies that they
should maintain the value of their business so that the minimum
inescapable funds can be generated during shifting of business. For this
purpose you should adopt business valuation right from the initiation. This
valuation is needed for ascertaining your capabilities for “would b e”
mergers. To get more accurate information about financial health of the
company, you should calculate the historical financial nature. As far as
financial evaluation of any public company is concerned, that is carried munotes.in
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Overview of Valuation
11 out by the Public accountants havin g certification from government but
the same in case of private business organization, conducted by
Chartered accountants. Audit report rendered by the CAs is valid to
exhibit on all platforms. All the financial statements are prepared
keeping in view the “would be” applications.
1.9 SUMMARY
In many businesses, it has been experienced that financial leverage
affects all the earnings of shareholders.
Fluctuation of different modalities and structure capital, companies
regulate their business on different ca liber. All the shareholders do not
have equal risk because of their investment.
In normal business life, some of the financial risks are also involved.
These risks are defined in various literatures. Normally risk
generated from the operating factor is nor controllable without fiscal
support but risk from non -planning can only be avoided through
efficient management and planning.
Though, some experts are having opinion that accuracy can be
maintained in defining the risk factor but still shareholders sho uld
understand that potential risk factors can be avoided only by adding
financial support. Whenever sales of the business are increased,
variability can increase because of fund flow.
Normally so many events are there which are directly connected
differe nt nature of work. In case you see common economical situation
(fluctuation), which are rarely seen in the period of recession, fund
flow will not be supportive. In recession, every attempt to build the
structure of your capital will become useless as al l the fronts are
normally dull and don’t need any backing up.
Some of the raw materials and technical changes are responsible for
creating adverse situations. Though, you can see that some sales
activities are able to handle any adverse effect on capital structure.
In case your sales are increasing, you can save a handsome amount
for future -investment.
But remember, at the same time you will have to distribute the
percentage of profit in various shareholders according to their
investment. Leverage also affects the economical situations of
business if your management got sudden changes. It is quite possible
that new planning committee is not having same potential as was in
previous committee.
If you decided to make changes in your product, you may face some
uneven changes in your business. This is possible that public getting
the new product with same interest. Commonly leverage puts effect munotes.in
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12 on the shareholders and increases their risk factor, but after all
business activities are carried with some spontan eously done tactics.
1.10 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. Write note on Shareholder Value Creation (SCV).
2. What do you mean by Market Value Added (MVA)?
3. Discuss the steps to calculate EVA.
4. Explain “Financial management is better on quarterly basis as it
provides smooth look after on fiscal manners.”
5. Explain Market -to-Book Value (M/BV)
Long Answers:
1. Give detailed reason to maintain financial goals and strategies.
2. How you will define if a business house has made some financial
goals but not a strategy?
3. What do you understand by Market – to -= Book value? Describe in
your own words.
4. EVA is nothing than a calculator - Discuss
5. Highlight the difference between MVA and M/BV.
6. Discuss Dividend and Principle - Agent Conflict.
B. Multiple Choice Questions:
1. What should be main financial goal in business?
a. Getting optimum of the investors.
b. Providing maximum benefit to all associated with business.
c. Reaching at a stage of equilibrium.
d. None of the above.
2. What is shareholder value creation?
a. Providing loan to any investor.
b. Returning the investment cash to investor with increase.
c. Both A and B above.
d. None of the above. munotes.in
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13
3. What is Market Value Added?
a. Current purchasing power of investor.
b. Price of each share.
c. Current value of business less operational + infrastr ucture cost.
d. All of the above.
4. What is the Market -to-Book value?
a. Capital cost minus present market values.
b. Financial transition charges.
c. EVA – MVA.
d. EVA + MVA.
5. Why Economic Value Added is considered good for business house?
a. EVA is considered only for suppor ting business house.
b. It provides better opportunities of investment.
c. EVA is beneficial only in mixed economies.
d. EVA is good only in capitalism.
Answer: 1 -b ,2-b ,3-c ,4-a ,5-a
C. Fill in the blanks:
1. Efficient management provides smooth functioning to all
……….. without risk.
2. Investor would like to get their cash back with an increase at
…………
3. ………….is an increase as a reward of investment according to
contribution.
4. ………….in business would invite investors with deep faith.
5. …………. helps to meet the specific need s of the foreign buyers.
Answer:
1. investors
2. every time
3. Dividend munotes.in
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14 4. Transparency
5. Product Adaptation
D. State whether the following sentence are True / False:
1. Emotional business dealings are generally not resulted in great
impact on market.
2. Total capital invested is reduced from the current market value and
accurate SCV comes out.
3. EVA is nothing than a calculator.
4. Every shareholder is provided with some benefit in proportion of his
contribution.
5. The investment of business house as well as by inves tors makes a
grand capital and all addition of wealth added on this amount is only
due to the decrease in market.
Answer:
True - 1, 3, 4
False - 2 and 5
1.11 SUGGESTED READINGS
Nag, R. Hambrick. (2000). Strategic Management Journal, London:
Edu-Books.
Ghema wat, Pankaj. (1998). Competition and Business Strategy in
Historical Perspective, Bangkok: Economic Publishing House.
Michael E. Porter. (2003). Harward Business Review, Beijing:
Huang Publishers.
E, Chaffee. (2001, 2nd Edition). Three Models of Strategy. New
Jersey: ABC Publishing Company.
Harper & Row. (1989). The Practice of Management, Kolkata:
Indian Book Depot
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15 2
FINANCIAL STATEMENT & LEVERAGE
AND WORKING CAPITAL FROM
VALUATION PERSPECTIVE
Unit Structure :
2.0 Objectives
2.1 Introduction
2.2 Financial statement Analysis
2.3 Leverages
2.4 Working Capital Management
2.5 The Objectives of Working Capital Management
2.6 Principles of Working capital Management
2.7 Factors Affecting Working Capital
2.8 Issues in Working Capital Management
2.9 Management of Cash
2.10 Summary
2.11 Unit End Questions
2.12 Suggested Readings
2.0 OBJECTIVES
The main purpose of this chapter is –
To explain the financial statement Analysis
To understand Leverages
To discuss Working Capital Management
To describe the Objectives of Working Capital Management
To analyse the p rinciples of Working capital Management
To discuss the f actors Affectin g Working Capital
To understand issues in Working Capital Management
To explain m anagement of Cash.
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16 Corporate Valuation and
Mergers & Acquisitions 2.1 INTRODUCTION
Financial Statement Analysis involves the examination of the
relationship between financial statement numbers and the trends in those
numb ers over a period of time. From an investor’s point of view,
predicting the future is what financial statement analysisis all about,
while from a management’s standpoint, financial statement analysis is
useful in helping anticipate future conditions and, m ore importantly, as a
for starting point in planning actions that will improve the firm’s future
performance.
Working capital is the term used to describe money invested in short -
term assets like cash, various debtors, and other short -term assets.
Utilizin g the facilities offered by buildings, land, and machines requires
current assets. A machine cannot be used by a manufacturing company
without raw materials. Working capital is the sum of money used to
purchase raw materials. A certain amount of money is u ndoubtedly
locked up in raw material inventories, work -in-progress, finished goods,
consumable shops, various creditors, and ongoing cash needs. .
2.2 FINANCIAL STATEMENT ANALYSIS
Financial statements, such as the balance sheet, income statement, and
cash f low statement, play a critical role in valuation from a financial
perspective. Here are a few ways that financial statements can be used in
valuation:
1. Balance Sheet: The balance sheet provides a snapshot of a company's
financial position at a given point i n time, including its assets,
liabilities, and equity. This information is critical in determining the
company's financial stability and its ability to pay its debts, which are
important factors in valuation.
2. Income Statement: The income statement provides information on a
company's revenue, expenses, and net income. This information is
used to determine the company's profitability, which is a key factor in
valuation. The income statement also provides information on the
company's ability to generate cash f low, which is critical in assessing
its financial health and ability to pay its debts.
3. Cash Flow Statement: The cash flow statement provides information
on a company's cash inflows and outflows, including its operating,
investing, and financing activities. This information is used to
determine the company's ability to generate cash and its ability to pay
its debts, which are important factors in valuation.
4. Trend Analysis: Financial statement analysis can also involve
examining trends over time, such as chan ges in revenue, expenses, and
net income. This information can provide valuable insight into a
company's financial performance over time and its ability to create
value for its shareholders. munotes.in
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17 5. Comparable Company Analysis: Financial statement analysis can
also involve comparing a company's financial statements to those of its
peers in the same industry. This information can provide valuable
insight into a company's relative financial performance and its ability
to create value compared to its peers.
In summary , financial statements provide critical information that is used
in valuation from a financial perspective. Financial statement analysis can
involve examining a company's financial position, profitability, cash flow,
and performance over time, as well as c omparing it to its peers in the same
industry, in order to determine the company's ability to create value for its
shareholders
The balance sheet is one of the primary financial statements and can be
used in valuation from several perspectives:
1. Solvency: The balance sheet provides information on a company's
assets, liabilities, and equity, which is used to determine its solvency
and its ability to pay its debts. This is important in valuation because a
company's financial stability and ability to pay its de bts are critical
factors in determining its value.
2. Liquidity: The balance sheet also provides information on a
company's liquidity, which is its ability to convert its assets into cash.
This is important in valuation because a company's liquidity can affec t
its ability to pay its debts and generate cash flow, which are key
factors in determining its value.
3. Asset Value: The balance sheet provides information on a company's
assets, including their value, quality, and mix. This is important in
valuation becaus e a company's assets can have a direct impact on its
value and future growth potential.
4. Capital Structure: The balance sheet provides information on a
company's capital structure, including its mix of debt and equity. This
is important in valuation because a company's capital structure can
affect its cost of capital and its ability to generate cash flow, which are
key factors in determining its value.
5. Trend Analysis: Financial statement analysis can also involve
examining trends over time, such as changes i n assets, liabilities, and
equity. This information can provide valuable insight into a company's
financial performance over time and its ability to create value for its
shareholders.
In summary, the balance sheet provides critical information that can be
used in valuation from several perspectives, including solvency, liquidity,
asset value, capital structure, and performance over time. By analyzing the
balance sheet, financial analysts can gain a better understanding of a
company's financial position, its ability to pay its debts and generate cash
flow, and its potential for future growth. munotes.in
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18 Corporate Valuation and
Mergers & Acquisitions The income statement is one of the primary financial statements and can
be used in valuation from several perspectives:
1. Profitability: The income statement provides info rmation on a
company's revenue, expenses, and net income. This information is
used to determine the company's profitability, which is a key factor in
valuation. A company's profitability affects its ability to generate cash
flow and pay its debts, which ar e critical in determining its value.
2. Revenue Growth: The income statement can also be used to analyze a
company's revenue growth over time. This information can provide
valuable insight into a company's ability to generate income, which is
critical in dete rmining its value.
3. Cost Structure: The income statement provides information on a
company's expenses, which can include operating expenses, cost of
goods sold, and taxes. This information is used to determine a
company's cost structure, which can affect it s profitability and its
ability to generate cash flow.
4. Operating Margins: The income statement can also be used to
determine a company's operating margins, which are a measure of its
profitability. Operating margins can be calculated by dividing a
company y's operating income by its revenue, and they can provide
valuable insight into a company's ability to generate income and its
cost structure.
5. Trend Analysis: Financial statement analysis can also involve
examining trends over time, such as changes in reve nue, expenses, and
net income. This information can provide valuable insight into a
company's financial performance over time and its ability to create
value for its shareholders.
In summary, the income statement provides critical information that can
be u sed in valuation from several perspectives, including profitability,
revenue growth, cost structure, operating margins, and performance over
time. By analyzing the income statement, financial analysts can gain a
better understanding of a company's financia l performance and its ability
to generate income, which are key factors in determining its value.
Objective of financial statement analysis
1. To Help in preparing budgets and analyze the past results with respect
to earnings and financial position of the enterprise.
2. To make interfirm comparison of two or more firms easy.
3. To study the short -term and long -term solvency of the firm with the
help of financial statement analysis. Short -term solvency is useful for
creditors and long-term solvency is useful for debenture holders etc.
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19 4. To enable the calculation of present earning capacity as well as
future earning capacity of the enterprise.
5. To enable the management to find out the overall as well as
department wise department of the firm on the basis of available
financial information.
6. To provide reliable information about the available resources of the
enterprise.
7. To Provide financial information regarding economic resources and
obligations of a business enterprise.
Need for financial statement analysis
The pre paration of financial statements is just the starting point of the
process. After the statements are prepared, they are analyzed. Analysis of
the summary information in the financial statement doesn’t usually
provide detailed answers to the management’s qu estions but it does
identify the areas in which further data should be generated. Decisions
are then made and implemented, and the accounting system captures
the results of these decisions so that new set of financial statements can be
prepar ed. The process then repeats itself. Steps involved are: Prepare
Financial Statements
1) Analyze Financial Statements
2) Gather Additional Information Make Decisions –Operating –
Investing –Financing and Observe
3) Implement Decisions Results Users of financial statements
The important objective of financial statement is to provide information
for the use of following categories of persons
a) Owners and Shareholders - The most critical job of accounting
service is to help the owner or shareholder know w here the company
stands in terms of the financial aspect. It helps in analyzing the profit or
loss and total per annum revenue. Based on this information, the owner or
shareholders can make wise decisions and set financial targets for the
future. It helps in measuring the business's performance and how things
can be changed shortly. With accounting information, the financial
performance of individual departments can be estimated. Every year
specific goals are set, and the data help determine if the plans ha ve been
achieved.
b) Creditors and Lenders - The creditors provide services and goods on
credit, and lenders offer loans for the business's growth and development.
Banks and financial institutions fall under short -term lenders. Now, before
any creditor or lender provides their service, they want to know if the
business can pay off the debt. The banks provide loans even based on the
credit score. The thorough accounting information helps in giving a clear munotes.in
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20 Corporate Valuation and
Mergers & Acquisitions picture of the financial statements. When the cash p osition and flow of
finances are good, it is easy to get credit or loans.
c) Investors - The investors are those who infuse or invest money in the
business and get dividend amounts from the industry's profit. The
investors can even be prospective sharehol ders in the company. Investors
will only invest in a business where they see growth and profit potential.
The company's income statements and financial graph are of particular
interest to investors to tap into the possibility of business growth.
d) Employ ees - An employee works with a company or business to earn
their income. The employees are interested in the financial state of the
company. If the company is running at loss, it is directly going to impact
the salary. The economic gains for the company me an yearly increment
and growth for the employee. The accounting information is essential for
the employees as it helps in knowing about the wages or salary, bonus,
overtime payments, insurance, medical facilities, etc.
e) Government - When the business i s registered, it has to pay different
taxes. The Central and State Government is impressive in the accounting
information majorly for calculation of taxes. It includes corporate tax,
sales tax, income tax of employees, excise duties, custom tax, etc.
Depen ding on the type of business, financial statements are crucial for
becoming eligible for specific welfare schemes.
f) Researchers and General Public - The financial researchers require
the accounting information to study the business's economic backgroun d
and value. It helps in understanding various factors that influence the
economy. Knowing the business or company's financial status is essential
even for the general public, majorly for those who wish to invest in shares.
2.3 LEVERAGES
Leverage is an imp ortant consideration from a valuation perspective, as it
can impact a company's financial performance and the value of the firm.
From a valuation perspective, the importance of leverage can be seen in
several ways:
1. Impact on Earnings: Leverage can have a s ignificant impact on a
company's earnings, as it increases the potential for higher profits, but
also increases the risk of financial distress. This can impact the value
of the firm, as a higher level of leverage can increase the risk
associated with inves ting in the company.
2. Risk Profile: Leverage can also impact a company's risk profile, as a
higher level of leverage increases the risk of default and the possibility
of financial distress. This can have a significant impact on the value of
the firm, as inv estors will typically demand a higher return to
compensate for the increased risk.
3. Cost of Capital: Leverage can also impact a company's cost of
capital, as the expectation of consistent debt repayments can increase munotes.in
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21 the risk associated with investing in th e company and raise the cost of
capital.
4. Debt Capacity: Leverage can also impact a company's debt capacity,
as a higher level of leverage can limit a company's ability to take on
additional debt in the future. This can impact the value of the firm, as a
lower debt capacity can limit the company's ability to grow and invest
in its future.
In conclusion, leverage is an important consideration from a valuation
perspective, as it can impact a company's financial performance, risk
profile, cost of capital, and d ebt capacity. Companies must carefully
consider their leverage as part of their overall financial strategy, in order
to optimize their financial performance and create value for their
shareholders 2.4 WORKING CAPITAL MANAGEMENT
The management of a company's current assets is referred to as working
capital management. It entails the management, control, acquisition, and
financing of existing assets. Current assets include cash marketable
securities, short -term investments, accounts receivable inventory, and s o
on. Current liabilities and bank borrowing are used to finance current
assets. Therefore, working capital management is concerned with the
money needed for the company's daily operations. Therefore, working
capital management becomes more crucial as a me ans of safeguarding the
company against liquidity issues.
Working capital is divided into two categories: gross and net. The firm's
investment in current assets is referred to as gross working capital. Cash,
short -term securities, debtors, accounts receiva ble (also known as book
debts), bills receivable, and stock are all examples of current assets that
can be turned into cash within an accounting year (inventory).
The difference between current assets and current liabilities is referred to
as net working c apital. The term "current abilities" refers to those claims
against third parties, such as creditors (account payable), bills payable, and
unpaid expenses, that are anticipated to become due for payment during an
accounting year. There are two possible val ues for net working capital.
When current assets are greater than current liabilities, a positive net
working capital will result. When current obligations exceed current
assets, there is a negative net working capital.
2.5 OBJECTIVES OF WORKING CAPITAL
MANAGEMENT
All businesses' goals in working capital management are to provide
enough liquidity for the production process to run smoothly throughout
regular business operations. Additionally, the goal is to keep present assets
at their ideal level to prevent the company's capital from sitting around
needlessly. To meet the company's need for working capital, the finance
manager attempts to handle current assets and liabilities effectively. For a
specific company, the main goal of working capital management is to munotes.in
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22 Corporate Valuation and
Mergers & Acquisitions ensure that it has enough liquidity to carry out regular business operations
without interruption. Thus, each company must choose for itself the ideal
level of "working capital" that is to be maintained.
The management seeks to use capital as productiv ely and profitably as
possible. By making an effort to keep the appropriate ratio between
working capital and fixed capital, this is attainable.
The management also wants to increase the firm's profitability or
working capital efficiency; therefore, it wa nts to keep money flowing
smoothly and quickly.
There is no need to keep a cash reserve if cash receipts and cash
outlays are in harmony. It would be a miracle in business if payments
and receipts were perfectly timed and coordinated. Therefore,
business es need to keep enough cash on hand to cover both routine and
unusual financial needs.
2.6 PRINCIPLES OF WORKING CAPITAL
MANAGEMENT
1. Principle of Risk Variation (Current Assets Policies):
Risk here refers to the inability of a firm to meet its obligat ions as and
when they become due for payment. Larger investment in current assets
with less dependence on short -term borrowings increases liquidity,
reduces dependence on short -term borrowings increases liquidity, reduces
risk and thereby decreases the opp ortunity for gain or loss.
On the other hand, less investment in current assets with greater
dependence on short -term borrowings, reduces liquidity and increases
profitability.
In other words, there is a definite inverse relationship between the degree
of risk and profitability. A conservative management prefers to minimize
risk by maintaining a higher level of current assets or working capital
while a liberal management assumes greater risk by reducing working
capital. However, the goal of the management s hould be to establish a
suitable tradeoff between profitability and risk.
The various working capital policies indicating the relationship between
current assets and sales are depicted below: munotes.in
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23
The effect of working capital policies on the profitability of a firm is
illustrated below:
Source: https://www.yourarticlelibrary.com/accounting/working -capital -
management/principles -of-working -capital -management -policy -4-
principles -financial -
analysis/68037#:~:text=This%20principle%20is%20concerned%20with,n
et%20worth %20of%20the%20firm .
Risk and Return (Costs of Liquidity and Illiquidity) Trade off
We have discussed earlier that there is a definite inverse relationship
between the degree of risk and profitability. Risk here refers to the level of
current assets or the cost of liquidity. Higher the investment in current
assets, higher is the cost and lower the profitability, and vice -versa. Thus,”
a firm has to reach a balance (trade off) between the cost of liquidity and
cost of illiquidity.
2. Principle of Cost of Capital:
The various sources of raising working capital finance have different cost
of capital and the degree of risk involved. Generally, higher the risk lower
is the cost and lower the risk higher is the cost. A sound working capital munotes.in
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24 Corporate Valuation and
Mergers & Acquisitions management should alw ays try to achieve a proper balance between these
two.
3. Principle of Equity Position:
This principle is concerned with planning the total investment in current
assets. According to this principle, the amount of working capital invested
in each component should be adequately justified by a firm’s equity
position. Every rupee invested in the current assets should contribute to
the net worth of the firm.
The level of current assets may be measured with the help of two ratios:
(i) Current assets as a percenta ge of total assets and
(ii) Current assets as a percentage of total sales. While deciding about the
composition of current assets, the financial manager may consider the
relevant industrial averages.
4. Principle of Maturity of Payment:
This principle is c oncerned with planning the sources of finance for
working capital. According to this principle, a firm should make every
effort to relate maturities of payment to its flow of internally generated
funds.
Maturity pattern of various current obligations is an important factor in
risk assumptions and risk assessments. Generally, shorter the maturity
schedule of current liabilities in relation to expected cash inflows, the
greater the inability to meet its obligations in time.
To sum up, working capital manageme nt should be considered as an
integral part of overall corporate management. In the words of Louis
Brand, “We need to know when to look for working capital funds, how to
use them and how to measure, plan and control them”.
To achieve the above -mentioned objectives of working capital
management, the financial manager has to perform the following basic
functions:
1. Estimating the working capital requirements.
2. Financing of working capital needs.
3. Analysis and control of working capital.
2.7 FACTORS AFFEC TING WORKING CAPITAL
The company must calculate its working capital very precisely because a
high level of working capital leads to unnecessary inventory accumulation
and capital waste, whereas a low level of working capital interferes with
the efficient o peration of the business and causes it to fall short of its
commitments. munotes.in
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25 Therefore, the finance manager must calculate the proper quantity of
working capital. Before determining the quantity of working capital, the
finance management must take into account the following elements.
1. Length of Operating Cycle:
The length of the operating cycle directly affects how much working
capital is required. The time frame entailed in production is referred to as
the operating cycle. It begins with the purchase of raw materials and
continues until after the sale, when payment is made.
For the operational cycle to run smoothly, working cash is crucial. A
longer operating cycle necessitates more working capital, whereas a
shorter operating cycle necessitates less working capital for businesses.
2. Nature of Business:
The second factor to take into account when determining working capital
is the type of company the organisation is engaged in. Because the
operating cycle is short for a trade company or retail store, less wor king
capital is needed.
As their operational cycles are longer due to maintaining huge inventories
and sometimes selling items on credit, wholesalers need more working
capital than retail stores do. The manufacturing company needs a
significant amount of w orking capital since they must turn raw materials
into completed goods, sell on credit, and keep both raw materials and
finished goods in stock.
3. Scale of Operation:
Large -scale businesses must manage more inventory, debts, etc. As a
result, they often n eed a lot of working capital, whereas small -scale
businesses need less.
4. Business Cycle Fluctuation:
When the economy is in a boom, there is a greater need for working
capital due to increased demand, production, inventory, and debtors.
When demand is lo w, there are fewer inventories to maintain and debtors,
therefore working capital requirements are lower.
5. Seasonal Factors:
The need for working capital is constant for businesses that sell products
year-round, whereas businesses that sell seasonal prod ucts need a
significant amount of capital during the season due to higher demand, the
need to maintain larger inventories, and the need for quick supply.
Conversely, during the off -season or slack season, when demand is at its
lowest, less capital is neede d. munotes.in
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26 Corporate Valuation and
Mergers & Acquisitions 6. Technology and Production Cycle:
If a company uses a labor -intensive production method, then more
working capital is needed because the company needs to keep enough cash
on hand to pay its employees; however, if a company uses a machine -
intensive met hod, then less working capital is needed because an
investment in machinery is a fixed capital requirement and there will be
fewer operating costs.
Because it takes a long time to transform raw materials into completed
items, a long production cycle necess itates more working capital. In
contrast, a short production cycle necessitates less working capital because
less money is invested in inventories and raw materials.
7. Credit Allowed:
Credit policy outlines the typical time frame for collecting sale proce eds.
It is dependent on a variety of variables, including client creditworthiness,
industry standards, and so forth. A company will need more working
capital if its credit policy is liberal, whereas a company with a rigid or
short -term credit strategy can get by with less working capital.
8. Credit Avail:
How much and how long a company receives credit from its suppliers is
another aspect of credit policy. If raw material suppliers offer long -term
credit, a company can operate with less working capital; but , if they only
offer short -term credit, a company will need more working capital to pay
creditors.
9. Operating Efficiency:
A company with a high operational efficiency level needs less working
capital than a company with a poor operating efficiency level, which needs
more.
Businesses with a high level of efficiency have low waste, can manage
with low inventory levels, and also incur fewer costs during their
operating cycles, allowing them to operate with less working capital.
10. Availability of Raw Materi als:
When raw materials are readily available and inputs are in abundant
supply, businesses can operate with less working capital as they won't
need to have as much inventory of raw materials on hand, if any at all.
When raw materials are readily available and inputs are in abundant
supply, businesses can operate with less working capital as they won't
need to have as much inventory of raw materials on hand, if any at all.
11. Level of Competition:
The company must implement a flexible lending policy and de liver goods
on time if the market is competitive. In order to maintain more munotes.in
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27 inventory’s, more working capital is needed. Less working capital will be
needed by a company with little or no competition or a monopoly since it
can set the terms to suit its nee ds.
12. Inflation:
A price increase will result in higher costs for labour and raw
commodities, which will raise the amount of working capital needed.
But there won't be as much of a working capital issue if the corporation
can raise the price of its own i tems as well. For different businessmen, a
price increase will have a varying impact on working capital.
13. Growth Prospects:
Businesses planning to grow their operations will need more working
capital because doing so will necessitate scaling up producti on, which will
require more raw materials, inputs, and other resources, as well as more
working capital.
2.8 ISSUES IN WORKING CAPITAL MANAGEMENT
The management of all elements of working capital —cash, marketable
securities, debtors (receivables), stock (i nventory), and creditors —is
referred to as working capital management (payables). The current asset
levels and mix must be determined by the financial manager. In order to
finance current assets and ensure that current liabilities are paid on time,
he must ensure that the appropriate sources are used. Working capital
management is a crucial responsibility of the financial manager because of
its many facets.
Time : The financial manager must devote a significant amount of time to
working capital management.
Investment : A significant share of the total investment in assets is made
up of working capital.
Critical : Working capital management is important for all businesses, but
small businesses especially depend on it.
Growth : The need for working capital is d irectly related to the firm’s
growth.
Components of Working Capital:
Working capital is composed of various current assets and current
liabilities, which are as follows:
(A) Current Assets:
These assets are generally realized within a short period of time, i.e. within
one year.
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28 Corporate Valuation and
Mergers & Acquisitions Current assets include:
(a) Inventories or Stocks
(i) Raw materials
(ii) Work in progress
(iii) Consumable Stores
(iv) Finished goods
(b) Sundry Debtors
(c) Bills Receivable
(d) Pre-payments
(e) Short -term Investments
(f) Accrued Income and
(g) Cash and Bank Balances
(B) Current Liabilit ies:
Current liabilities are those which are generally paid in the ordinary
course of business within a short period of time, i.e. one year.
Current liabilities include:
(a) Sundry Creditors
(b) Bills Payable
(c) Accrued Expenses
(d) Bank Overdrafts
(e) Bank Loans (short -term)
(f) Proposed Dividends
(g) Short -term Loans
(h) Tax Payments DueThe operating cycle can be determined as given
below: munotes.in
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29
The various components of operating cycle can be calculated by using
following formula given below:
(i) Raw materials storage period
(ii) Work-in-progress holding period
(iii) Finished goods storage period:
(iv) Debtors’ collection period:
(v) Creditors payment period:
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30 Corporate Valuation and
Mergers & Acquisitions Examples 1 :
Prepare an estimate of working capital requirement from the following
infor mation of a trading concern. Projected annual sales 10,000 units
Selling price Rs. 10 per unit
Percentage of net profit on sales 20%
Average credit period allowed to customers 8 Weeks
Average credit period allowed by suppliers 4 Weeks
Average stock ho lding in terms of sales requirements 12 Weeks
Allow 10% for contingencies
Solution :
Statement of Working Capital Requirements
Current Assets Rs.
Debtors (8 weeks) (at cost)
(80,000/52 × 8) 12,307
Stock (12 weeks) (80,000/52 ×12) 18,463
30,770
Less: Current Liability
Credits (4 weeks) (80,000/52 × 4) 6,154
24,616
Add: 10% for Contingencies 2,463
Working Capital Required 27,078
Working Notes
Sales = 10000×10 = Rs. 1,00,000
Profit 20% of Rs. 1,00,000 = Rs. 20,000
Cost o f Sales=Rs.1,00,000 – 20,000 = Rs. 80,000
As it is a trading concern, cost of sales is assumed to be the purchases.
2.9 MANAGEMENT OF CASH
Cash management as the word suggests is the optimum utilization of cash
to ensure maximum liquidity and maximum prof itability. It refers to the
proper collection, disbursement, and investment of cash.
For a small business, proper utilization of cash ensures solvency. Hence,
cash management is a vital business function; it is a function that manages
the collection and ut ilization of cash. munotes.in
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31 Importance of cash management
Just like a ‘no cash situation’ in our day to day lives can be a nightmare,
for a business it can be devastating. Especially for small businesses, it can
lead to a point of no return. It affects the credibi lity of the business and
can lead to them shutting down.
Hence, the most important task for business managers is to manage cash.
Management needs to ensure that there is adequate cash to meet the
current obligations while making sure that there are no id le funds. This is
very important as businesses depend on the recovery of receivables. If a
debt turns bad (irrecoverable debt) it can jeopardize the cash flow.
Therefore, cash management is also about being cautious and making
enough provision for continge ncies like bad debts, economic slowdown,
etc.
Functions of cash management
In an ideal scenario, an organization should be able to match its cash
inflows to its cash outflows. Cash inflows majorly include account
receivables and cash outflows majorly inclu de account payables.
Practically, while cash outflows like payment to suppliers, operational
expenses, payment to regulators are more or less certain, cash inflows can
be tricky. So the functions of cash management can be explained as
follows:
Inventory management
Higher stock in hand means trapped sales and trapped sales means less
liquidity. Hence, an organization must aim at faster stock out to ensure
movement of cash.
Receiv ables Management
An organization raises invoices for its sales. In these cases, the credit
period for receiving the cash can range between 30 – 90 days. Here, the
organization has recorded the sales but has not yet received cash for the
transactions. So, the cash management function will ensure faster recovery
of receivables to avoid a cash crunch.
If the average time for recovery is shorter, the organization will have
enough cash in hand to make its payments. Timely payments ensure lesser
costs (interests , penalties) to the organization. Receivables management
also includes a robust mechanism for follow -ups. This will ensure faster
recovery and it will also assist the business to predict bad debts and
unforeseen situations.
Forecasting
While planning inves tments, the managers need to be very careful as they
need to plan for future contingencies and also ensure profitability. For this,
they must use efficient forecasting and management tools. When the cash munotes.in
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32 Corporate Valuation and
Mergers & Acquisitions inflows and outflows are efficiently managed it give s the firm good
liquidity.
Short term investments
Avoiding cash crunch, insolvency and ensuring financial stability are the
main criteria’s of cash management. But it is equally important to invest
the surplus cash in hand wisely. Despite being a liquid as set, idle cash
does not generate any returns. While investing in short -term investments
an organization must ensure liquidity and optimum returns.
Therefore, this decision needs to be taken with prudence. Here, the
quantum/amount of investment needs to be calculated and decided
carefully. This caution is necessary because an organization cannot invest
all the available funds. Businesses need to reserve cash for contingencies
(cash in hand) too.
2.10 SUMMARY
Profitability of firms depends on how well their working capital is
managed.
When working capital is affected relative to sales without a
corresponding change in production, the profitability of the firm is
seriously influenced.
Management of working capital is critical for every firm.
There are two b asic concepts of working capital.
Net working capital and temporary working capital.
The amount of working capital required b the firm depends on size,
activities of the firm, availability of credit, attitude towards profits and
risk.
Gross working capit al is the total of all current assets. Net working
capital is the difference between current assets and current liabilities.
In the management of working capital, two features of current assets
must be kept in mind: (i) small life span, and (ii) swift transformation
into other asset forms.
The working capital necessities of an organization are influenced by
several factors: (i) nature of business, (U) seasonality of operations,
(iii) production policy, (iv) market conditions, and (v) conditions of
supply.
A significant working capital policy choice is concerned with the level
of share in current assets. Defining the optimal level of current assets
includes a trade -off between costs that increase with current assets and
costs that drop with current assets. Th e former is devoted to as
transport costs and the final as shortage costs. munotes.in
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Financial Statement &
Leverage and Working
capital from valuation
perspective
33 2.11 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. Explain the concept of working capital.
2. What do you mean by financial statement analysis?
3. Write note on Management o f Cash.
4. Discuss the objectives of Working capital management.
5. Discuss different types of working capital.
Long Answers:
1. What are the different factors determining working capital?
2. Discuss the principles of working capital?
3. Analyse the issues in working cap ital management.
4. Discuss the various users of financial statement analysis.
5. Explain Need for financial statement analysis.
B. Multiple Choice Questions:
1. Short -term financial decisions usually contain cash flows within:
a. 1 year
b. 10 years
c. 15 years
d. None of these
2. Accounts payable is examined by:
a. The average number of days it takes to pay a supplier invoice.
b. The average number of days it takes to turn over the sale of a
product.
c. The average number of days it takes to collect an account
d. None of these
3. Inventory is examined by:
a. The average number of days it takes to pay a supplier invoice.
b. The average number of days it takes to turn over the sale of a
product. munotes.in
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34 Corporate Valuation and
Mergers & Acquisitions c. The average number of days it takes to collect an account
d. None of these
4. Accounts receivable is determined by:
a. The average number of days it takes to pay a supplier invoice.
b. The average number of days it takes to turn over the sale of a
product.
c. The average number of days it takes to bring together an account.
d. None of these
5. Common sources of short -term working cap ital financing are:
a. Equity
b. Trade creditors
c. Line of credit
d. All of these
1-a, 2-a, 3-b, 4-c, 5-d
C. Fill in the blanks:
1. Net working capital is represented as………….
2. The type of working capital required by the food processing industry
is:.
3. What is neede d to meet the working capital need for financing?
4. The various components of current assets and liabilities have an
immediate impact on the calculation of working capital and
the..................
5. …………. the operating cycle period, lower will be the requirem ent of
working capital
Answer:
1. Current assets – Current liabilities
2. Seasonal working capital
3. Bank credit
4. Operating cycle
5. Shorter
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Financial Statement &
Leverage and Working
capital from valuation
perspective
35 D. State whether the following sentence are True / False:
1. Creditors are the part of current assets.
2. Net working capital refer s to the excess of total current assets over
total current liabilities.
3. Working capital refers to the funds invested in current assets.
4. The total of investments in all current assets is known as net working
capital
5. Bills receivable are included in current assets
Answer:
True - 2, 3 and 5
False - 1 and 4
2.12 SUGGESTED READINGS
Nag, R. Hambrick. (2000). Strategic Management Journal, London:
Edu-Books.
Ghemawat, Pankaj. (1998). Competition and Business Strategy in
Historical Perspective, Bangkok: Economic Publishing House.
Michael E. Porter. (2003). Harward Business Review, Beijing:
Huang Publishers.
E, Chaffee. (2001, 2nd Edition). Three Models of Strategy. New
Jersey: ABC Publishing Company.
Harper & Row. (1989). The Practice of Management, Kolkata:
Indian Book Depo
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36 3
CALCULATION OF VALUATION INPUTS
Unit Structure :
3.0 Objectives
3.1 Introduction
3.2 Concept of Risk
3.3 Calculation of valuation inputs for risk measurement
3.4 Cost of capital, FCFF (Free Cash Flow to Firm), FCFE (Free Cash
Flow to Equity), and growt h rates
3.5 Summary
3.6 Unit End Questions
3.7 Suggested Readings
3.0 OBJECTIVES
The main purpose of this chapter is –
Recognize the concept of Risk
Understand calculation of valuation inputs for risk measurement
Discuss Cost of capital, FCFF (Free Cash Flow to Firm), FCFE (Free
Cash Flow to Equity), and growth rates
3.1 INTRODUCTION
Risk refers to the possibility of loss or damage that may occur as a result
of an uncertain event. It is a fundamental aspect of many areas of life,
including finance, busine ss, and personal decision -making. In order to
manage risk, individuals and organizations often employ various
strategies, such as diversification, insurance, and hedging. Understanding
and managing risk is important because it can help prevent negative
outcomes and promote success in various endeavors. Some common types
of risk include financial risk, operational risk, reputational risk, and
strategic risk.
3.2 CONCEPT OF RISK
When we refer to a situation as being at risk, we mean one in which there
are mu ltiple potential outcomes for a current action and where the
probabilities and specifics of those outcomes are known in the form of a
frequency distribution. Risk is a term for variation. In financial analysis, it
is typically assessed by the beta coeffici ent or the standard deviation. Risk munotes.in
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Calculation o f Valuation
Inputs
37 technically refers to a situation where the potential outcomes of the
decision being made are understood.
Demands that result in a range of income returns make up risk. Price and
interest are the two key factors that inf luence risk. Both internal and
external factors have an impact on risk. Uncontrollable external hazards
have a significant impact on investments.
Systematic risk is the name for these external risks. Unsystematic risk is
risk resulting from factors in a co mpany's internal environment or those
influencing a specific sector. A company or industry -specific unsystematic
risk. The investor is unaffected. Consumer preferences, irregular,
disorganised management strategies, and labour strikes are only a few
exampl es of the causes of unsystematic risk.
3.3 CALCULATION OF VALUATION INPUTS FOR
RISK MEASUREMENT
The calculation of valuation inputs for risk measurement involves using
various quantitative and qualitative factors to estimate the expected returns
and risk a ssociated with an investment. Here are some of the key factors
involved in the calculation:
1. Market risk: This refers to the risk associated with the overall market,
such as changes in interest rates, inflation, and economic conditions.
To estimate market r isk, analysts may use historical data, forward -
looking indicators, and economic models.
2. Company -specific risk: This refers to the risks associated with a
particular company, such as its financial health, management quality,
and competitive position. To est imate company -specific risk, analysts
may use financial statement analysis, industry research, and other
sources of information.
3. Expected return: This is the estimated rate of return that an
investment is expected to generate. To calculate expected return,
analysts typically use a combination of historical returns, market data,
and other factors.
4. Risk tolerance: This refers to the level of risk that an investor is
willing to accept. To determine risk tolerance, analysts may consider
the investor's investmen t goals, time horizon, and other factors.
5. Discount rate: This is the rate at which future cash flows are
discounted to account for the time value of money. To calculate the
discount rate, analysts may use a risk -free rate, such as the yield on
government b onds, and add a risk premium to account for the
additional risk associated with the investment.
Overall, the calculation of valuation inputs for risk measurement is a
complex process that requires a combination of quantitative analysis and
subjective judgm ent. By considering a wide range of factors and using munotes.in
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38 Corporate Valuation and
Mergers & Acquisitions sound analytical methods, analysts can estimate the expected returns and
risk associated with an investment and make informed investment
decisions.
When calculating valuation inputs for risk measurement , looking for
relationships in data is an important step in the process. This is because
identifying relationships between different factors can help analysts to
better estimate the expected returns and risk associated with an
investment. Here are some com mon techniques that analysts use to look
for relationships in data:
1. Correlation analysis: This involves measuring the strength and
direction of the relationship between two variables. For example, an
analyst might use correlation analysis to determine whet her there is a
relationship between a company's revenue growth and its stock price
performance.
2. Regression analysis: This involves using a mathematical model to
estimate the relationship between one or more independent variables
and a dependent variable. F or example, an analyst might use
regression analysis to estimate the impact of interest rates on stock
prices.
3. Factor analysis: This involves identifying underlying factors that
explain the variation in a set of variables. For example, an analyst
might use factor analysis to identify the underlying factors that explain
the variation in a company's financial performance.
4. Machine learning: This involves using algorithms to identify patterns
and relationships in data. For example, an analyst might use machine
learning to identify patterns in financial data that can be used to predict
future stock prices.
By using these and other techniques to look for relationships in data,
analysts can better understand the factors that drive investment returns and
risk. This can help them to make more informed investment decisions and
manage risk more effectively.
3.4 COST OF CAPITAL, FCFF (FREE CASH FLOW TO
FIRM), FCFE (FREE CASH FLOW TO EQUITY),
AND GROWTH RATES
The cost of capital, FCFF (Free Cash Flow to Firm), FCFE (Free Cash
Flow to Equity), and growth rates are all important concepts in finance
and investment analysis. Here's a brief explanation of each term:
1. Cost of capital: This is the minimum rate of return that a company
must earn on its investments in order to satis fy its investors. It
represents the opportunity cost of capital and includes the cost of debt
and the cost of equity. The cost of capital is used to evaluate
investment opportunities and to determine the discount rate for cash
flows. munotes.in
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39 2. FCFF (Free Cash Flow t o Firm): This is the amount of cash flow
that is available to all investors, including both debt and equity
investors, after all expenses and investments have been made. It is
calculated as EBITDA minus capital expenditures, plus or minus
changes in workin g capital and taxes.
3. FCFE (Free Cash Flow to Equity): This is the amount of cash flow
that is available to equity investors after all expenses and investments
have been made. It is calculated as FCFF minus interest and debt
repayments, plus or minus change s in debt and equity.
4. Growth rates: This refers to the rate at which a company's earnings or
cash flows are expected to grow over time. It is an important factor in
investment analysis and can be used to estimate future cash flows and
determine the value o f an investment.
Overall, the cost of capital, FCFF, FCFE, and growth rates are all
important concepts in finance and investment analysis. By understanding
these concepts and using them to analyze investment opportunities,
investors can make more informed investment decisions and manage risk
more effectively.
There are two main types of cost of capital:
1. Cost of debt: The cost of debt is the interest rate that a company pays
on its debt. It is calculated as the weighted average of the interest rates
on all o f the company's outstanding debt.
2. Cost of equity: The cost of equity is the return that investors require
on their investment in the company's stock. It is generally higher than
the cost of debt, as equity investors are taking on more risk than debt
invest ors. The cost of equity is calculated using the Capital Asset
Pricing Model (CAPM) or other models that consider the risk and
return of the stock.
In addition to these two types of cost of capital, some analysts also
consider the cost of preferred stock or other types of financing. However,
these are less commonly used in practice.
The weighted average cost of capital (WACC) is a commonly used metric
that combines the cost of debt and the cost of equity to reflect the overall
cost of capital for a company. The WACC is calculated as the weighted
average of the cost of debt and the cost of equity, with the weights based
on the proportion of debt and equity in the company's capital structure.
Overall, the cost of capital is an important concept in finance and
investment analysis, as it is used to evaluate investment opportunities,
determine the discount rate for cash flows, and make other financial
decisions.
munotes.in
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40 Corporate Valuation and
Mergers & Acquisitions Here are the formulas for the two main types of cost of capital:
1. Cost of debt:
2. Cost of Debt = (Interes t Rate) x (1 - Tax Rate)
3. This formula takes into account the tax -deductibility of interest
payments. By multiplying the interest rate by the difference between 1
and the tax rate, the formula reflects the fact that interest payments are
tax-deductible, and therefore reduce the after -tax cost of debt.
4. Cost of equity:
5. Cost of Equity = Risk -Free Rate + Beta x (Market Risk Premium)
6. The Capital Asset Pricing Model (CAPM) is a commonly used method
for calculating the cost of equity. The formula includes three var iables:
the risk -free rate, the beta of the company's stock, and the market risk
premium. The risk -free rate is the return that an investor can earn on a
risk-free investment, such as a Treasury bond. Beta is a measure of the
volatility of the stock, relat ive to the overall market. The market risk
premium is the excess return that investors require for investing in the
stock market, above the risk -free rate.
In addition to these two types of cost of capital, the weighted average cost
of capital (WACC) is a commonly used metric that combines the cost of
debt and the cost of equity. The formula for WACC is:
WACC = (Weight of Debt x Cost of Debt) + (Weight of Equity x Cost of
Equity)
The weights used in this formula are based on the proportion of debt and
equit y in the company's capital structure. By combining the cost of debt
and the cost of equity, the WACC reflects the overall cost of capital for
the company.
Cost of Preference share
The cost of preference share is the rate of return that the company must
pay to its preference shareholders in order to compensate them for their
investment. It is a type of cost of capital and is generally lower than the
cost of equity.
The cost of preference share is calculated by dividing the annual dividend
paid to preference shareholders by the net proceeds from the sale of
preference shares. The formula is as follows:
Cost of preference share = Annual dividend / Net proceeds from sale of
preference shares
For example, if a company issues preference shares with a par value of
$100 each and a fixed dividend rate of 5%, and sells them for a net
proceeds of $95 each, the cost of preference share can be calculated as
follows: munotes.in
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Calculation o f Valuation
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41 Cost of preference share = 5 / 95 = 0.0526 or 5.26%
This means that the company must pay a 5.26% annual div idend to its
preference shareholders in order to satisfy their investment.
It is worth noting that the cost of preference share is not tax -deductible,
unlike the cost of debt. As a result, the after -tax cost of preference share is
generally higher than the after-tax cost of debt.
Cost of reserves
The cost of reserves refers to the cost of retaining earnings and profits
within a company, instead of distributing them as dividends to
shareholders. Retaining earnings can be a cost -effective way for
companies to raise capital, as it allows them to finance their operations
without incurring debt or issuing new shares of stock. However, there is a
cost associated with retaining earnings, as the funds are not available to
shareholders and can potentially result in l ower returns.
The cost of reserves is typically calculated using the opportunity cost of
the retained earnings, which is the return that shareholders could earn if
the earnings were distributed as dividends and invested elsewhere. The
formula for the cost of reserves is as follows:
Cost of reserves = Expected return on investment - Cost of capital
The expected return on investment is the return that shareholders could
earn by investing the dividends elsewhere. The cost of capital is the cost of
the company' s capital structure, including the cost of debt and the cost of
equity.
For example, if a company retains $1 million in earnings and has a cost of
capital of 10%, and the expected return on investment is 8%, the cost of
reserves would be calculated as foll ows:
Cost of reserves = 8% - 10% = -2%
This means that the cost of retaining the earnings is actually negative, as
the expected return on investment is lower than the cost of capital. In this
case, it may be more beneficial for the company to distribute th e earnings
as dividends to shareholders, rather than retaining them.
WACC stands for Weighted Average Cost of Capital.
It is a financial metric that represents the average cost of all of a
company's sources of capital, including debt, equity, and any othe r forms
of financing.
The formula for calculating WACC is:
WACC = (E/V) x Re + (D/V) x Rd x (1 - T)
where: E = the market value of the company's equity D = the market value
of the company's debt V = the total market value of the company (E + D) munotes.in
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42 Corporate Valuation and
Mergers & Acquisitions Re = the co st of equity Rd = the cost of debt T = the company's marginal
tax rate
The formula uses the market values of the company's equity and debt,
rather than their book values, in order to reflect the current market
valuation of the company. The weights for each component are
determined by their proportion in the company's capital structure.
The cost of equity (Re) is calculated using the Capital Asset Pricing Model
(CAPM), which takes into account the risk -free rate, the company's beta,
and the expected market r isk premium.
Cost of Debt
The cost of debt (Rd) is the interest rate the company pays on its debt. The
after-tax cost of debt is used in the formula, which takes into account the
tax deductibility of interest payments.
The WACC is used as a discount rate i n discounted cash flow (DCF)
analysis, which is a method of valuing a company based on its future cash
flows. It is also used as a benchmark for evaluating potential investments
or projects, as any project or investment should have a return that is
greater than the WACC in order to be considered financially viable
Free Cash Flow to Firm (FCFF) is a financial metric that represents the
amount of cash flow a company generates after accounting for its capital
expenditures and working capital requirements. It i s a key measure of a
company's ability to generate cash flow from its core operations that can
be used to pay its debt and equity holders.
The formula for calculating FCFF is:
FCFF = EBIT(1 - tax rate) + Depreciation and Amortization - Capital
Expenditures - Change in Net Working Capital
where: EBIT = earnings before interest and taxes tax rate = the company's
marginal tax rate Depreciation and Amortization = non -cash expenses
related to depreciation and amortization Capital Expenditures = the
amount of mon ey the company spends on capital investments, such as
property, plant and equipment (PPE) Change in Net Working Capital = the
change in the company's current assets (excluding cash) and current
liabilities
The formula starts with EBIT, which is a company's earnings before
interest and taxes. It then adds back non -cash expenses such as
depreciation and amortization, as these expenses do not require an outflow
of cash. The formula then subtracts capital expenditures, which represents
the amount of money the c ompany has spent on investments in property,
plant and equipment, and the change in net working capital, which
represents the change in the company's current assets and liabilities. munotes.in
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43 FCFF can also be calculated as the sum of the cash flows available to all
of the company's capital providers, including debt and equity holders. This
can be expressed mathematically as:
FCFF = CFO - Capital Expenditures
where: CFO = cash flow from operations
In this formula, CFO represents the cash generated from the company's
core operations, and capital expenditures represent the amount of money
the company spends on investments in property, plant and equipment
Free Cash Flow to Firm (FCFF}
Free Cash Flow to Firm (FCFF) is a financial metric that represents the
amount of cash f low a company generates after accounting for its capital
expenditures and working capital requirements. It is a key measure of a
company's ability to generate cash flow from its core operations that can
be used to pay its debt and equity holders.
The formu la for calculating FCFF is:
FCFF = EBIT(1 - tax rate) + Depreciation and Amortization - Capital
Expenditures - Change in Net Working Capital
where: EBIT = earnings before interest and taxes tax rate = the company's
marginal tax rate Depreciation and Amorti zation = non -cash expenses
related to depreciation and amortization Capital Expenditures = the
amount of money the company spends on capital investments, such as
property, plant and equipment (PPE) Change in Net Working Capital = the
change in the company' s current assets (excluding cash) and current
liabilities
The formula starts with EBIT, which is a company's earnings before
interest and taxes. It then adds back non -cash expenses such as
depreciation and amortization, as these expenses do not require an outflow
of cash. The formula then subtracts capital expenditures, which represents
the amount of money the company has spent on investments in property,
plant and equipment, and the change in net working capital, which
represents the change in the company' s current assets and liabilities.
FCFF can also be calculated as the sum of the cash flows available to all
of the company's capital providers, including debt and equity holders. This
can be expressed mathematically as:
FCFF = CFO - Capital Expenditures
where: CFO = cash flow from operations
In this formula, CFO represents the cash generated from the company's
core operations, and capital expenditures represent the amount of money
the company spends on investments in property, plant and equipment.
munotes.in
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44 Corporate Valuation and
Mergers & Acquisitions How to c alculate Free Cash Flow to Equity?
Free Cash Flow to Equity (FCFE) is a financial metric that represents the
amount of cash flow available to a company's equity holders after
accounting for capital expenditures, debt payments, and working capital
requireme nts. It is a measure of the cash flow that is available for
distribution to the company's shareholders.
The formula for calculating FCFE is:
FCFE = CFO - Capital Expenditures + Net Borrowing
where: CFO = cash flow from operations Capital Expenditures = the
amount of money the company spends on capital investments, such as
property, plant and equipment (PPE) Net Borrowing = the difference
between the amount of money the company borrows and the amount of
debt it repays
In this formula, CFO represents the cash generated from the company's
core operations, and capital expenditures represent the amount of money
the company spends on investments in property, plant and equipment. The
net borrowing component takes into account any new debt that the
company has taken on, as well as any debt repayments it has made.
Alternatively, FCFE can be calculated by starting with FCFF and
adjusting for the cash flows that are available to debt holders. This can be
expressed mathematically as:
FCFE = FCFF - (Interest x (1 - Tax Ra te)) + Net Borrowing
where: FCFF = free cash flow to firm Interest = the amount of interest the
company pays on its debt Tax Rate = the company's marginal tax rate
In this formula, interest represents the cost of debt, and the adjustment for
(1 - Tax Rate) reflects the tax shield associated with the company's interest
payments. Net borrowing is calculated as the difference between the
amount of money the company borrows and the amount of debt it repays
Growth rate is a financial metric that measures the rat e of increase or
decrease in a company's key financial metrics over a period of time. It is
used to evaluate a company's financial performance and to project its
future financial performance. There are several types of growth rates,
including:
1. Revenue Grow th Rate: This measures the percentage change in a
company's revenue from one period to another. It is calculated as
follows:
2. Revenue Growth Rate = (Current Period Revenue - Prior Period
Revenue) / Prior Period Revenue
3. Earnings Growth Rate: This measures th e percentage change in a
company's earnings from one period to another. It is calculated as
follows: munotes.in
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45 4. Earnings Growth Rate = (Current Period Earnings - Prior Period
Earnings) / Prior Period Earnings
5. Dividend Growth Rate: This measures the percentage change in a
company's dividend payments from one period to another. It is
calculated as follows:
6. Dividend Growth Rate = (Current Period Dividend - Prior Period
Dividend) / Prior Period Dividend
7. Book Value Growth Rate: This measures the percentage change in a
comp any's book value from one period to another. It is calculated as
follows:
8. Book Value Growth Rate = (Current Period Book Value - Prior Period
Book Value) / Prior Period Book Value
9. Free Cash Flow Growth Rate: This measures the percentage change
in a company' s free cash flow from one period to another. It is
calculated as follows:
10. Free Cash Flow Growth Rate = (Current Period Free Cash Flow - Prior
Period Free Cash Flow) / Prior Period Free Cash Flow
Growth rates
Growth rates can be used to evaluate a company's financial performance
and to forecast future performance. Higher growth rates may indicate that
a company is performing well, while lower growth rates may indicate that
a company is struggling. It is important to consider growth rates in
conjunction with other financial metrics when evaluating a company's
financial health
To calculate the earnings growth rate for a company, you need to follow
these steps:
1. Identify the earnings for two periods: Choose two periods for which
you want to calculate the earnings growth rate. For example, you may
choose to calculate the earnings growth rate for the past year and the
year before that. Identify the earnings figures for those two periods.
2. Calculate the difference between earnings: Subtract the earnings
figure for the earlier period from the earnings figure for the later
period. For example, if the earnings figure for the earlier period is
$500,000 and the earnings figure for the later period is $600,000, then
the difference is $100,000.
3. Divide the difference by the ea rnings in the earlier period: Divide
the difference by the earnings figure for the earlier period to get the
earnings growth rate. Multiply the result by 100 to express the
earnings growth rate as a percentage. For example, if the earnings
figure for the e arlier period is $500,000, then the earnings growth rate
can be calculated as: munotes.in
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46 Corporate Valuation and
Mergers & Acquisitions 4. Earnings Growth Rate = (($600,000 - $500,000) / $500,000) x 100% =
20%
This means that the earnings grew by 20% over the selected period.
Note that you can also calculate the ea rnings growth rate using the
earnings figures for more than two periods. The calculation would be the
same - you would simply choose more than two earnings figures and use
the earliest earnings figure as the denominator.
To calculate the dividend growth ra te for a company, you need to follow
these steps:
1. Identify the dividend payments for two periods: Choose two
periods for which you want to calculate the dividend growth rate. For
example, you may choose to calculate the dividend growth rate for the
past ye ar and the year before that. Identify the dividend payments for
those two periods.
2. Calculate the difference between dividends: Subtract the dividend
payment for the earlier period from the dividend payment for the later
period. For example, if the dividend payment for the earlier period is
$2 per share and the dividend payment for the later period is $2.50 per
share, then the difference is $0.50 per share.
3. Divide the difference by the dividend payment in the earlier
period: Divide the difference by the divi dend payment for the earlier
period to get the dividend growth rate. Multiply the result by 100 to
express the dividend growth rate as a percentage. For example, if the
dividend payment for the earlier period is $2 per share, then the
dividend growth rate can be calculated as:
4. Dividend Growth Rate = (($2.50 - $2) / $2) x 100% = 25%
This means that the company increased its dividend payment by 25% over
the selected period. Note that you can also calculate the dividend growth
rate using the dividend payments for more than two periods. The
calculation would be the same - you would simply choose more than two
dividend payments and use the earliest dividend payment as the
denominator
To calculate the free cash flow (FCF) growth rate for a company, you need
to fol low these steps:
1. Identify the FCF for two periods: Choose two periods for which you
want to calculate the FCF growth rate. For example, you may choose
to calculate the FCF growth rate for the past year and the year before
that. Identify the FCF figures for those two periods.
2. Calculate the difference between FCF: Subtract the FCF figure for
the earlier period from the FCF figure for the later period. For
example, if the FCF figure for the earlier period is $500,000 and the munotes.in
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47 FCF figure for the later period is $600,000, then the difference is
$100,000.
3. Divide the difference by the FCF in the earlier period: Divide the
difference by the FCF figure for the earlier period to get the FCF
growth rate. Multiply the result by 100 to express the FCF growth rate
as a per centage. For example, if the FCF figure for the earlier period is
$500,000, then the FCF growth rate can be calculated as:
4. FCF Growth Rate = (($600,000 - $500,000) / $500,000) x 100% =
20%
This means that the FCF grew by 20% over the selected period.
Note that you can also calculate the FCF growth rate using the FCF
figures for more than two periods. The calculation would be the same -
you would simply choose more than two FCF figures and use the earliest
FCF figure as the denominator.
3.5 SUMMARY
When calculat ing valuation inputs for risk measurement, looking for
relationships in data is an important step in the process.
The cost of capital is used to evaluate investment opportunities and to
determine the discount rate for cash flows.
The weighted average cost of capital (WACC) is a commonly used
metric that combines the cost of debt and the cost of equity to reflect
the overall cost of capital for a company.
The cost of preference share is the rate of return that the company
must pay to its preference sharehold ers in order to compensate them
for their investment.
Retaining earnings can be a cost -effective way for companies to raise
capital, as it allows them to finance their operations without incurring
debt or issuing new shares of stock.
The cost of debt (Rd) is the interest rate the company pays on its debt.
Free Cash Flow to Firm (FCFF) is a financial metric that represents the
amount of cash flow a company generates after accounting for its
capital expenditures and working capital requirements.
3.6 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. What do you mean by risk?
2. Write note on Cost of Debt.
3. Explain discount rate.
4. What do you mean by Cost of capital?
5. Explain Free Cash Flow to Firm. munotes.in
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48 Corporate Valuation and
Mergers & Acquisitions Long Answers:
1. Describe factors involved in the calculation of valuation inputs for risk
measurement.
2. Explain the types of cost of capital.
3. Discuss various types of growth rates.
4. Explain the steps to calculate the free cash flow (FCF) growth rate for
a company.
5. How to calculate Free Cash Flow to Equity?
B. Multiple Choice Questions:
1. ……………. refers to the risk associated with the overall market, such
as changes in interest rates, inflation, and economic conditions.
a. Market risk
b. Expected return
c. Discount rate
d. Company -specific risk
2. …………… involves identifying underly ing factors that explain the
variation in a set of variables.
a. Machine learning
b. Correlation analysis
c. Regression analysis
d. Factor analysis
3. FCF stands for ……..
a. Free Cost Flow to Firm
b. Free Cash Flow to Firm
c. Fresh Cash Flow to Firm
d. None of these
4. ……………… …is a commonly used metric that combines the cost of
debt and the cost of equity to reflect the overall cost of capital for a
company.
a. WAC
b. WAAC
c. WACC
d. None of these
5. The ……………………….. is the rate of return that the company must
pay to its preference shareh olders in order to compensate them for
their investment.
a. cost of preference share
b. cost of debt
c. cost of equity
d. None of these
Answers: 1 -a, 2-d, 3-b, 4- c, 5-a munotes.in
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Calculation o f Valuation
Inputs
49 C. Fill in the blanks:
1. The ……………… refers to the cost of retaining earnings and profits
within a company.
2. Cost of reserves = Expected return on investment - …………….
3. The cost of debt (Rd) is the interest rate the company pays on
its………...
4. FCFF = …………… - Capital Expenditures.
5. FCFF = EBIT(1 - tax rate) + …………………… - Capital
Expenditures - Change in Net Wor king Capital
Answer:
1. cost of reserves
2. Cost of capital
3. debt
4. CFO
5. Depreciation and Amortization
3.7 SUGGESTED READINGS
Nag, R. Hambrick. (2000). Strategic Management Journal, London:
Edu-Books.
Ghemawat, Pankaj. (1998). Competition and Business Strategy in
Historical Perspective, Bangkok: Economic Publishing House.
Michael E. Porter. (2003). Harward Business Review, Beijing:
Huang Publishers.
E, Chaffee. (2001, 2nd Edition). Three Models of Strategy. New
Jersey: ABC Publishing Company.
Harper & Row. (1989). The Practice of Management, Kolkata:
Indian Book Depot
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50 4
DISCOUNTED APPROACH TO
VALUATION
Unit Structure :
4.0 Objectives
4.1 Introduction
4.2 Discounted Cash Flow Valuation
4.3 Methods of capital budgeting of evaluation
4.4 Dividend Discount Model
4.5 Summary
4.6 Unit End Questions
4.7 Suggested Readings
4.0 OBJECTIVES
The main purpose of this chapter is –
To discuss various methods of capital budgeting evaluation
To explain Discounted Cash Flow Valuation
To understand Dividend Discount Model
4.1 INTRODUCTION
Discounted approaches to valuation are methods th at use the concept of
time value of money to determine the value of an asset, business, or
investment by discounting its expected future cash flows back to their
present value. The two most common discounted approaches to valuation
are the discounted cash flow (DCF) method and the dividend discount
model (DDM).
The DCF method involves estimating the future cash flows of an asset or
business, discounting those cash flows back to their present value using a
discount rate that reflects the time value of money and the risk associated
with the investment. The sum of the discounted cash flows represents the
present value of the asset or business.
The DDM method is similar to the DCF method, but it is specifically used
to value stocks that pay dividends. The DDM in volves estimating the
future dividends of a stock and discounting those dividends back to their
present value using a discount rate that reflects the time value of money
and the risk associated with the stock. The sum of the present value of the
expected d ividends represents the intrinsic value of the stock. munotes.in
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Discounted Approach to
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51 Discounted approaches to valuation are widely used in finance, investment
banking, and corporate finance to determine the fair value of an asset or
business, to make investment decisions, and to assess the potential return
on investment.
4.2 DISCOUNTED CASH FLOW VALUATION
Assume a company has projected free cash flows of Rs.10 million, Rs.12
million, and Rs.15 million for the next three years, respectively. The
company has a terminal value of Rs.200 mill ion and a discount rate of
10%. Using the DCF method, the present value of the projected cash flows
would be calculated as follows:
PV of Year 1 Cash Flow = Rs. 10 million / (1 + 10%)^1 = Rs.9.09 million
PV of Year 2 Cash Flow = Rs.12 million / (1 + 10%)^2 = Rs.9.92 million
PV of Year 3 Cash Flow = Rs.15 million / (1 + 10%)^3 = Rs.11.35 million
PV of Terminal Value = Rs.200 million / (1 + 10%)^3 = Rs.148.81
million
The sum of the present values of the projected cash flows and the terminal
value is Rs 179.1 7 million, which represents the estimated enterprise value
of the company.
a. Estimating Inputs: Let's say a business expects free cash flows of Rs 8
million, Rs 9 million, and Rs 10 million over the course of the following
three years. With a 12% discount rate, the company has a terminal value
of Rs 150 million. An analyst may perform the following in order to
estimate the inputs for the DCF model:
Based on the company's previous growth rates and industry growth
estimates, the analyst may project a long -term growth rate of 3%.
b. Estimate the Discount Rate: The analyst may use the capital asset
pricing model (CAPM) to estimate the company's cost of equity, which
can then be used to calculate the discount rate. Assuming a risk -free rate
of 2%, a market risk premium of 6%, and a beta of 1.5, the cost of equity
would be 11%. The analyst may also adjust the discount rate to account
for any company -specific risks or uncertainties.
c. Calculate the Terminal Value: The analyst may use the perpetuity
formula to calc ulate the terminal value, assuming a long -term growth rate
of 3% and a discount rate of 12%. The terminal value would be Rs 150
million.
d. Discount the Cash Flows: The analyst may use the DCF model to
discount the predicted cash flows to present value usi ng the estimated
growth rate, discount rate, and terminal value. The projected enterprise
value of the company would then be calculated by adding the present
values of the cash flows. munotes.in
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52 Corporate Valuation and
Mergers & Acquisitions The DCF model's inputs can have a substantial impact on the estimated
enterprise value of a company, therefore it's crucial to keep this in mind.
Careful consideration and analysis are therefore required to ensure correct
results.
Estimating Inputs
Since corporate valuation involves figuring out a company's anticipated
future cash flows and discounting them to their present value, estimating
inputs is a crucial component of the process. These future cash flows are
projected using inputs including revenue growth rates, margins, capital
expenditures, and discount rates. It is imp ossible to exaggerate how
important it is to estimate these inputs correctly because they are essential
for figuring out a company's intrinsic value.
First and foremost, revenue growth rates are a crucial component of
forecasting future cash flows. Future revenues, a major factor in future
cash flows, can be projected by analysts with the use of accurate estimates
of revenue growth rates. Inputs like margins are crucial since they affect
how profitable a business is. Projecting future earnings and cash flow s
requires accurate margin estimation.
Capital expenditures are yet another crucial factor in valuing a
corporation. These are the costs a business incurs to continue and grow its
activities. Analysts can forecast future investments a business will need to
make to continue its growth, which has an impact on future cash flows, by
accurately estimating capital expenditures.
Projected growth flows
The estimated future expansion of a company's free cash flows is referred
to as "projected growth flows" or "growt h flows." Growth flows, then, are
the projected rise in a company's cash flows over time as a result of things
like revenue growth, margin expansion, and expense savings. Growth
flows are a crucial component of the Discounted Cash Flow (DCF)
Valuation appr oach since they help predict the company's future cash
flows and establish its intrinsic value. The validity of the DCF valuation
depends critically on the accuracy of the growth flows estimate, since any
inaccuracies in the growth assumptions might result in a material
overvaluation or undervaluation of the company.
Growth Patterns in valuation
Because they have an impact on a company's potential cash flows and,
ultimately, its intrinsic value, growth patterns are significant in valuation.
The predicted ra te and consistency of a company's revenue and earnings
growth over time is referred to as its growth pattern. The growth pattern
can be either stable or cyclical, with stable growth denoting an increase in
revenue and earnings that is consistent and predic table over time, while
cyclical growth denotes fluctuations in revenue and earnings brought on
by changes in the business cycle. munotes.in
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Discounted Approach to
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53 Growth patterns are significant in valuation since they improve analysts'
ability to predict the company's future cash flows. F uture cash flows can
be estimated more easily since stable growth businesses are typically
easier to anticipate and more predictable. Contrarily, cyclical businesses
are more challenging to forecast since their sales and profits can be
impacted by outside variables like the state of the economy and the price
of raw materials.
Additionally, the selection of the valuation methodology might be
impacted by growth patterns. For instance, the Dividend Discount Model
may be a superior tool for valuing stable growi ng corporations than the
discounted cash flow method for cyclical businesses.
In general, accounting for a company's development pattern is crucial to
valuation since it ensures that the valuation is founded on reasonable
projections of the company's futur e performance.
Discount Rates
As they are used to determine the present value of future cash flows,
discount rates are a crucial part of company valuation. The discount rate
takes into account both the risk involved in the investment and the time
worth of money. The discount rate can have a big impact on a company's
valuation, so it's crucial to estimate it accurately.
The following reasons help to clarify the significance of discount rates in
business valuation:
Time Value of Money: Because the discount ra te considers this factor,
a dollar obtained in the future is worth less than a dollar received
today. This is so that the discount rate may account for the future
worth of an investment that can be made today to generate a return.
Risk: The investment's r isk is also reflected in the discount rate. For
assets that are thought to be riskier, a larger discount rate is applied.
Higher discount rates are associated with riskier investments, which
leads to lower present values of future cash flows.
The discount rate is a crucial component of the sensitivity analysis,
which is used to assess the effects of changes to inputs on value.
Analysts can assess the effects of changes in the perceived risk of an
investment on value by varying the discount rate.
Discount rates are crucial for comparability when comparing items. By
adopting the same discount rate while discounting two investments'
future cash flows, two different investments with differing risk profiles
can be compared side by side.
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54 Corporate Valuation and
Mergers & Acquisitions 4.3 METHODS OF CAPIT AL BUDGETING OF
EVALUATION
The payback period method is a simple and widely used method of capital
budgeting evaluation. It measures the time it takes for a project to recover
its initial investment. Here are some of the advantages and disadvantages
of the payback period method:
The amount of time needed to recover an initial project expenditure is
known as the pay -back period. The simplest and most fundamental choice
tool is the payback period. With this approach, you are essentially
estimating how long it will take for the project's initial investment to be
repaid. You can determine this by taking the project's total cost and
dividing it by the amount of annual cash inflow you anticipate; this will
give you the total number of years or the payback time. Fo r example, if
you are considering buying a gas station that is selling for Rs.2,00,000 and
that gas station produces cash flows of Rs. 40,000 a year, the payback
period is five years.
Pay-back period = Initial investment
Annual cash inflows
Advantages:
Simplicity: The payback period is easy to calculate and understand,
making it a popular method for small businesses or projects with
straightforward cash flows.
Liquidity: The payback period focuses on how quickly a project can
generate cash flow, making it u seful for evaluating projects that
require short -term liquidity.
Risk: The payback period takes into account the risk of a project by
focusing on the time it takes to recover the initial investment. This can
help companies avoid projects that take too long to generate cash flow,
increasing the risk of not recovering the investment.
Disadvantages :
Time value of money: The payback period does not take into account
the time value of money. It assumes that a dollar received today is
worth the same as a dollar r eceived in the future, ignoring the potential
for inflation and the opportunity cost of not investing that money
elsewhere.
Ignoring cash flows beyond payback: The payback period does not
consider cash flows beyond the payback period. This means that
proje cts with longer -term benefits may be undervalued or ignored.
Subjectivity: The payback period does not provide a clear criterion for
evaluating projects. Companies may have different criteria for what munotes.in
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Discounted Approach to
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55 constitutes an acceptable payback period, leading to su bjective
decisions about which projects to pursue.
Accept /Reject criteria
If the actual pay-back period is less than the predetermined pay-back
period, the project would be accepted. If not, it would be rejected.
Illustration 1: Project cost is Rs. 60,000 and the cash inflows are Rs.
20,000, the life of the project is 5 years. Calculate the pay-back period. = Rs. 60,000/ Rs.20000
= 3 years
Uneven Cash Inflows
Normally the projects are not having uniform cash inflows. In those cases
the pay-back period is calculated, cumulative cash inflows will be
calculated and then interpreted.
Illustration 2: Certain projects require an initial cash outflow of Rs.
25,000. The cash inflows for 6 years are Rs. 5,000, Rs. 8,000, Rs. 10,000,
Rs. 12,000, Rs. 7,000 and Rs. 3,000.
Solution:
Year Cash Inflows (Rs.) Cumulative Cash Inflows Rs.)
1 5,000 5,000
2 8,000 13,000
3 10,000 23,000
4 12,000 35,000
5 7,000 42,000
The above calculation shows that in 3 years Rs. 23,000 has been
recovered Rs. 2,000, is balanc e out of cash outflow. In the 4th year the
cash inflow is Rs. 12,000. It means the pay-back period
is three to four years, calculated as follows:
Pay-back period = 3 years+2000/12000×12 months
= 3 years 2 months.
Post Pay-back Profitability Method
One of t he main drawbacks of the pay -back period method is that it does
not take into account cash inflows made after the pay -back period and if
the project's true profitability cannot be determined. This approach can be
enhanced by taking the receivable into acco unt after the pay -back term.
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56 Corporate Valuation and
Mergers & Acquisitions ACCOUNTING (BOOK) RATE OF RETURN
The average yearly net income of the project (also known as incremental
income) is measured as a percentage of the investment by the accounting
rate of return.
The Accounting Rate of Return (A RR), also known as the Book Rate of
Return, is a method of capital budgeting evaluation that measures the
average annual profit of an investment as a percentage of the initial
investment. Here are some advantages and disadvantages of the
Accounting Rate of Return method:
Average rate of return means the average rate of return or profit
taken for considering the project evaluation. The accounting rate of
return of an investment measures the average
annual net income of the project (incremental income) as a p ercentage of
the investment. This method is one of the traditional methods for
evaluating the project proposals:
The annual cash inflow is calculated by considering the amount of net
income on the amount of depreciation project (Asset) before taxation bu t
after taxation. The income precision earned is expressed as a percentage of
initial investment, is called unadjusted rate of return. The above problem
will be calculated as below:
Unadjusted rate of return = Annual Return /Investment × 100
= Rs. 10,0 00/ Rs.30,000*100
= 33.33%
Illustration 3: From the following particulars, compute:
1. Payback period.
2. Post pay-back profitability and post pay-back profitability index.
(a) Cash outflow (After tax before depreciation)
Annual cash inflow Estimate Lif e
(b) Cash outflow
Annual cash inflow Rs. 1,00,00
(After tax depreciation) Rs. 25,000
First five years Next five years
Estimated life Salvage value 6 years
Solution Rs. 1,00,000 munotes.in
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Discounted Approach to
Valuation
57 (i) Pay-back period = Rs. 20,000
Rs. 8,000
10 Years
Rs. 16,000
Initial investment = 1,00,000 = 4 years
= Annual cash inflows 25,000
(ii) Post pay-back profitability
=Cash inflow (Estimated life - Pay-back period)
=25,000 (6 - 4) =Rs. 50,000
(iii) Post pay-back profitability index
50,000
= 1,00,000 × 100 = 50%
(a) Cash inflows are equal; therefore, payback period is calculated as
follows:
Years Cash Inflows (Rs.) Cumulative Cash Inflows (Rs.)
1 20,000 20,000
2 20,000 40,000
3 20,000 60,000
4 20,000 80,000
5 20,000 1,00,000
6 8,000 1,08,000
7 8,000 1,16,000
8 8,000 1,24,000
9 8,000 1,32,000
10 8,000 1,40,000
(ii) Post pay-back profitability.
= Cash inflow (estimated life - pay-back period)
= 8,000 (10-5) = 8000×5 = 40,000
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58 Corporate Valuation and
Mergers & Acquisitions (iii) Post pay-back profitability index
40,000
= 1,00,000 ×100 = 40%
Advantages :
Simplicity: The ARR method is simple to calculate and understand. It
requires only basic accounting information, making it accessible for
small businesses and projects.
Use of accounting data: The ARR method uses accounting data that
is already available, wh ich can save time and resources in the
evaluation process.
Incorporates both income and expenses: The ARR method takes
into account both the income generated by the investment and the
costs incurred, providing a more comprehensive view of the
investment's profitability.
Disadvantages :
Ignores time value of money: The ARR method does not take into
account the time value of money, meaning it assumes that a dollar
earned in the future is worth the same as a dollar earned today. This
can lead to inaccuracies in evaluating the investment's profitability.
Ignores cash flows beyond the payback period: Similar to the
payback period method, the ARR method does not consider cash flows
beyond the payback period, ignoring the long -term benefits of the
investment.
Subjec tivity: The ARR method requires subjective judgment in
determining the appropriate rate of return to use in the calculation.
This can lead to inconsistency in evaluating investment opportunities.
Ignores non -financial benefits: The ARR method focuses solel y on
financial returns and does not consider non -financial benefits, such as
the impact of the investment on the company's reputation, social
responsibility, or strategic positioning.
Accept/ Reject criteria
If the actual accounting rate of return is more than the predetermined
required rate of return, the project would be accepted. If not it would be
rejected.
Illustration 4: A company has two alternative proposals. The details are as
follows: Suppose a project requiring an investment of Rs.10,00,000 yield s
profit after tax and depreciation as follows:
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Discounted Approach to
Valuation
59 Year s Profit after tax and depreciation (Rs.)
1. 50,000
2. 75,000
3. 1,25,000
4. 1,30,000
5. 80,000
Total 4,60,000
Suppose further that at the end of 5 years, the plant and machinery of the
project can be sold for Rs. 80,000. In this case the rate of return can be
calculated as follows:
This rate is compared with the rate expected on other projects, had the
same funds been invested alternatively in those projects. Sometimes, the
managem ent compares this rate with the minimum rate (called -cut off
rate) they may have in mind. For example, management may decide that
they will not undertake any project which has an average annual yield
after tax less than 20%. Any capital expenditure proposa l which has an
average annual yield of less than 20% will be automatically rejected.
(b) If Average investment is considered, then,
4.4 DIVIDEND DISCOUNT MODEL
a. Constant Growth Model
The constant growth model, also known as the Gordon growth model or
the dividend discount model, is a widely used method in corporate
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60 Corporate Valuation and
Mergers & Acquisitions valuation. It is based on the assumption that a company's value is equal to
the present value of its future cash flows, discounted at a certain rate of
return.
In the constant growth model, the company's value is calculated as
follows:
V = D / (r - g)
where V is the company's value, D is its current dividend, r is the required
rate of return, and g is the expected growth rate of dividends.
The model assumes that the company's dividends will grow at a constant
rate indefinitely. This growth rate is usually estimated based on the
company's historical growth rate, its expected future growth rate, or
industry benchmarks.
The constant growth model can be used to value both dividend -paying and
non-dividend -paying companies, as long as the company is expected to
start paying dividends at some point in the future.
However, the model has its limitations. It assumes that the company's
growth rate will remain constant, which may not be realistic in the long
run. It also relies heavily on the accuracy of the growth rate estimate,
which can be difficult to predict. Therefore, it is important to use this
model in conjunction with other valuation methods to arrive at a more
accurate valuation.
b. Zero Growth Model
The zero growth model, also known as the constant dividend model or the
perpetuity model, is a simple method used in corporate valuation to
estimate the present value of a company's future cash flows. It is based on
the assumption that the company's dividen ds will remain constant forever.
In the zero growth model, the company's value is calculated as follows:
V = D / r
where V is the company's value, D is its current dividend, and r is the
required rate of return.
The model assumes that the company's dividen ds will remain constant
indefinitely, which means that the company's growth rate is zero. This
assumption is often used for mature companies that have stabilized their
operations and are not expected to experience significant growth in the
future.
The zero growth model is a useful tool for estimating the intrinsic value of
a company's stock, as it provides a simple and straightforward method of
valuing the company's future cash flows. However, it is important to note
that this model is based on several simp lifying assumptions and may not
accurately reflect the true value of a company. Therefore, it is often used munotes.in
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Discounted Approach to
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61 in combination with other valuation methods to arrive at a more accurate
estimate of a company's value.
c. Two stage model
The two -stage model is a com monly used method in corporate valuation
that takes into account the expected growth rate of a company's earnings
over two distinct periods. The first period is a high -growth phase, while
the second period is a more mature, stable phase.
In the two -stage m odel, the company's value is calculated as follows:
V = (PV of high -growth phase cash flows) + (PV of mature phase cash
flows)
The high -growth phase is typically defined as a period of rapid earnings
growth that is expected to last for a finite number of y ears. During this
phase, the company is expected to reinvest a significant portion of its
earnings back into the business, resulting in a high growth rate. The
growth rate during this phase is usually estimated based on industry
benchmarks, the company's h istorical growth rate, and management
projections.
The mature phase is typically defined as a period of slower, more stable
earnings growth. During this phase, the company is assumed to have
reached a steady state, where earnings and dividends grow at a mo re
sustainable rate. The growth rate during this phase is typically estimated
based on factors such as inflation, the company's cost of capital, and
industry growth rates.
The two -stage model is a useful tool for valuing companies that are
expected to expe rience a high growth phase followed by a more stable
phase. However, it is important to note that the accuracy of the model
depends heavily on the accuracy of the growth rate estimates used for each
phase. Therefore, it is important to use the model in com bination with
other valuation methods and to perform sensitivity analyses to account for
variations in the growth rate assumptions.
d. H model
The H model is a variation of the two -stage model that incorporates a
transition phase between the high -growth phase and the mature phase.
This model is useful for valuing companies that are expected to experience
a period of high growth, followed by a transitional period where growth
rates gradually decline before stabilizing in the mature phase.
In the H m odel, the company's value is calculated as follows:
V = (PV of high -growth phase cash flows) + (PV of transition phase cash
flows) + (PV of mature phase cash flows)
The high -growth phase and mature phase are defined in the same way as
in the two -stage mode l. However, the transition phase is a new concept munotes.in
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62 Corporate Valuation and
Mergers & Acquisitions that represents the gradual decline in the growth rate from the high -growth
phase to the mature phase. During this phase, the company's earnings
growth rate is assumed to decline linearly until it reaches t he stable growth
rate in the mature phase.
The H model is useful because it captures the gradual transition of a
company's growth rate from high to stable, which may be more realistic
for many companies. However, it also requires additional assumptions
about the length of the transition phase and the rate of decline in the
growth rate during that phase, which can make the model more complex
and difficult to use.
Like the two -stage model, the accuracy of the H model depends heavily on
the accuracy of the gro wth rate estimates used for each phase. Therefore, it
is important to use the model in combination with other valuation methods
and to perform sensitivity analyses to account for variations in the growth
rate assumptions.
e. Three stage model
The three -stage model is a method used in corporate valuation that takes
into account three distinct phases of a company's growth: an initial high -
growth phase, a transitional phase, and a final stable growth phase. This
model is useful for valuing companies that are expe cted to experience
multiple phases of growth over their lifetime.
In the three -stage model, the company's value is calculated as follows:
V = (PV of high -growth phase cash flows) + (PV of transition phase cash
flows) + (PV of stable growth phase cash flows )
The high -growth phase is defined in the same way as in the two -stage
model and represents a period of rapid earnings growth that is expected to
last for a finite number of years. The growth rate during this phase is
estimated based on industry benchmarks , the company's historical growth
rate, and management projections.
The transitional phase is a new concept that represents a period of
declining growth rates between the high -growth phase and the stable
growth phase. During this phase, the company's earni ngs growth rate is
assumed to decline gradually until it reaches the stable growth rate in the
final phase.
The stable growth phase represents a period of more sustainable earnings
growth that is expected to continue indefinitely. The growth rate during
this phase is typically estimated based on factors such as inflation, the
company's cost of capital, and industry growth rates.
The three -stage model is more complex than the two -stage model and
requires additional assumptions about the length of the transit ional phase
and the rate of decline in the growth rate during that phase. However, it
may be more accurate for companies that are expected to experience
multiple phases of growth. munotes.in
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63 Like the two -stage and H models, the accuracy of the three -stage model
depen ds heavily on the accuracy of the growth rate estimates used for each
phase. Therefore, it is important to use the model in combination with
other valuation methods and to perform sensitivity analyses to account for
variations in the growth rate assumption s.
1.5 SUMMARY
The annual cash inflow is calculated by considering the amount of net
income on the amount of depreciation project (Asset) before taxation
but after taxation.
The accounting rate of return of an investment measures the average
annua l net income of the project (incremental income) as a percentage
of the investment.
If the actual pay-back period is less than the predetermined pay-back
period, the project would be accepted.
One of the main drawbacks of the pay -back period method is th at it
does not take into account cash inflows made after the pay -back period
and if the project's true profitability cannot be determined.
The income precision earned is expressed as a percentage of initial
investment, is called unadjusted rate of return.
The three -stage model is more complex than the two -stage model and
requires additional assumptions about the length of the transitional
phase and the rate of decline in the growth rate during that phase.
The H model is a variation of the two -stage mode l that incorporates a
transition phase between the high -growth phase and the mature phase.
The high -growth phase is typically defined as a period of rapid
earnings growth that is expected to last for a finite number of years.
The zero growth model , also known as the constant dividend model or
the perpetuity model, is a simple method used in corporate valuation to
estimate the present value of a company's future cash flows. It is based
on the assumption that the company's dividends will remain const ant
forever.
4.6 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. What is payback period method?
2. What is accounting rate of return method?
3. Explain Zero growth model.
4. What do you mean by Growth Patterns? munotes.in
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64 Corporate Valuation and
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1. Discuss its relative merits and demerits of payback period?
2. What is Accounting rate of return method? Discuss its relative merits
and demerits?
3. Explain the various methods of capital budgeting techniques.
4. Discuss Two and three model of valuation.
5. Examine H model theory.
B. Multiple C hoice Questions:
1. The …………….. of an investment measures the average annual net
income of the project (incremental income) as a percentage of the
investment.
a. Profitability index
b. IRR
c. NPV
d. accounting rate of return
2. Pay-back period = Initial investment /………...
a. Annual cash inflows
b. Annual cash outflow
c. Annual cash inflows and outflow
d. None of these
3. Which of the following is the Traditional methods of capital
budgeting?
a. Net Present Value Method
b. Internal Rate of Return Method
c. Profitability Index Method
d. Pay-back Period Methods
4. The amount of time needed to recover an initial project expenditure is
known as the ……………
a. pay-back period.
b. Net Present Value Method
c. Internal Rate of Return Method
d. None of these
5. Identify the disadvantage of Accoun ting Rate of Return:
a. Easy to calculate and simple to understand
b. Based on the accounting information rather than cash inflow
c. Ignores the time value of money
d. Considers the total benefits associated with the project
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Discounted Approach to
Valuation
65 6. The………………, also known as the Go rdon growth model.
a. constant growth model
b. H model
c. Two factor
d. Three factor
7. The …………….model is a useful tool for estimating the intrinsic
value of a company's stock
a. H model
b. zero growth
c. Two growth
d. Three growth
Answers: 1 -d, 2-a, 3-d, 4-a, 5-c, 6-a, 7-b
C. Fill in the blanks:
1. ……………….. is the time required to recover the initial investment in
a project.
2. The income precision earned is expressed as a percentage of initial
investment, is called……………...
3. …………………….means the average rate of return or profit
taken for considering the project evaluation.
4. The annual cash ………………is calculated by considering the
amount of net income on the amount of depreciation project (Asset)
before taxation but after taxation.
5. The simplest and most fundamental choice tool i s the……………..
6. The ………….is a variation of the two -stage model that incorporates a
transition phase between the high -growth phase and the mature phase.
7. The ……… phase is a new concept that represents a period of
declining growth rates between the high -growth p hase and the stable
growth phase.
Answer:
1. Pay-back period
2. unadjusted rate of return
3. Average rate of return
4. inflow
5. payback period
6. H model
7. transitional munotes.in
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66 Corporate Valuation and
Mergers & Acquisitions D. State whether the following sentence are True / False:
1. Payback period considers the time value of money .
2. Pay-back period = Initial investment/ Annual cash outflows
3. Unadjusted rate of return =Annual Return /Inflation × 100
4. If the actual accounting rate of return is more than the
predetermined required rate of return, the project would be rejected.
Answer:
True- 1
False - 2, 3, 4
4.7 SUGGESTED READINGS
1. Financial Management by Prasanna Chandra.
2. Financial Management by I.M. Pandey.
3. Financial Management by Khan & Jain.
4. Organization & Management by R.D. Aggarwal.
5. Financial Management and Policy by R.M. Srivasta va
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OTHER NON -DCF VALUATION MODELS
Unit Structure :
5.0 Objectives
5.1 Introduction
5.2 Net Present Value (NPV) Method
5.3 Profitability Index
5.4 Internal Rate of Return Method
5.5 Relative Valuation Model
5.6 Book Value Approach
5.7 Stock and Debt Approac h
5.8 Special Cases for Valuation
5.9 Summary
5.10 Unit End Questions
5.11 Suggested Readings
5.0 OBJECTIVES
The main purpose of this chapter is –
To discuss Net Present Value (NPV) Method
To explain Profitability Index
To Analyse Internal Rate of Return Method
To Understand Relative Valuation Model
To explain Book Value Approach
To describe Stock and Debt Approach
To analyse Special Cases for Valuation
5.1 INTRODUCTION
In addition to the discounted cash flow (DCF) and dividend discount
model (DDM) approach es, there are several other non -DCF valuation
models that are commonly used in finance and investment. These include:
1. Comparable company analysis (CCA): This method compares the
financial ratios and multiples of a company to those of its peers in the
same industry or sector to determine its relative value. munotes.in
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68 Corporate Valuation and
Mergers & Acquisitions 2. Precedent transaction analysis (PTA): This method compares the
price paid for similar companies in the same industry or sector to
determine the fair value of the company being valued.
3. Asset -based valuatio n: This method calculates the value of a
company by adding up the value of its assets and subtracting its
liabilities.
4. Sum -of-the-parts analysis: This method breaks down a company into
its different business units or segments and values each one separately ,
then sums up the individual values to arrive at a total value for the
company.
5. Real options analysis: This method uses option pricing theory to
value a company's investment opportunities or strategic options that
are not explicitly reflected in its finan cial statements.
Each of these non -DCF valuation models has its own strengths and
weaknesses and may be more or less appropriate depending on the specific
circumstances of the company or asset being valued. It's important to use
multiple valuation models a nd methods to arrive at a range of values and
make a well -informed investment decision.
5.2 NET PRESENT VALUE (NPV) METHOD
Net present value method is one of the modern methods for evaluating the
project proposals. In this method cash inflows are considere d with the time
value of the money. Net present value describes as the summation of the
present value of cash inflow and present value of cash outflow. Net
present value is the difference between the total present value of future
cash inflows and the total present value of future cash outflows. The net
present value method is a classic method of evaluating the investment
proposals. It is one of the methods of discounted cash flow techniques. It
recognises the importance of time value of money. It correctly postulates
that cash flows arising at different time periods differs in value and are
comparable only with their equivalents i.e., present values are found out.
“It is a present value of future returns, discounted at the required rate of
return minus the p resent value of the cost of the investment.” ----Ezra
Solomon
NPV is the difference between the present value of cash inflows of a
project and the initial cost of the project.
Steps for computing net present value:
1. An appropriate rate of interest should be selected to discount the cash
flows. Generally, this will be the “Cost of Capital” of the company, or
required rate of return
2. The present value of inflows and outflows of an investment proposal
has to be computed by discounting them with an appropriate cost of
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69 3. The net present value is the difference between the present value of
cash inflows and the present value of cash outflows
Advantages :
Incorporates time value of money: The NPV method takes into
account the time value of money by discountin g future cash flows to
their present value. This provides a more accurate assessment of the
investment's profitability.
Considers the entire life of the project: The NPV method considers
all expected cash flows throughout the life of the project, providing a
more comprehensive analysis of the investment's profitability.
Provides a clear decision criterion: The NPV method provides a
clear decision criterion by comparing the present value of expected
cash flows to the initial investment. A positive NPV indica tes that the
investment is expected to generate returns that exceed the cost of
capital, making it financially viable.
Considers risk: The NPV method considers the risk of the investment
by discounting future cash flows at the appropriate risk -adjusted rat e.
Disadvantages:
Requires accurate cash flow estimates: The accuracy of the NPV
calculation is highly dependent on the accuracy of cash flow estimates.
Small errors in estimating future cash flows can have a significant
impact on the NPV calculation.
Difficulty in selecting appropriate discount rate: Selecting the
appropriate discount rate can be challenging, as it depends on the risk
of the investment and the company's cost of capital.
Can be time -consuming: The NPV calculation can be time -
consuming, espe cially when dealing with complex projects that require
extensive cash flow analysis.
Ignores non -financial benefits: Like other financial methods, the
NPV method focuses solely on financial returns and does not consider
non-financial benefits, such as the impact of the investment on the
company's reputation, social responsibility, or strategic positioning.
Accept/ Reject criteria
If the present value of cash inflows is more than the present value of cash
outflows, it would be accepted. If not, it would be rejected.
Illustration 5:
The Ashish Company limited considering the purchase of a new
machine. Two alternative machines 1 and 2 have been suggested,
each having an initial cost of Rs. 80,000/ - and requiring Rs. munotes.in
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70 Corporate Valuation and
Mergers & Acquisitions 4,000/ - as additional working capital at the end of the 1st year.
Cash flows after taxes are as follows:
Cash Flows
Year Machine 1 Machine 2
1 8000 24000
2 24000 32000
3 32000 40000
4 48000 24000
5 32000 16000
The company has a target return on capital of 10% and on this basis you
are requir ed to compare the profitability of the machines and state which
alternative you consider as financially preferable.
Solution:
Present Value of Cash Outflow = Initial investment + Present Value of
Additional Working Capital = Initial investment + (Addition al Working
Capital x Discounting Factor)
= Rs. 80,000 + (4,000 x *0.9091) = Rs. 80,000 + 3636 = Rs. 83636
Statement showing the NPV of two machines
Cash Flow Present Value of Cash Flows
Year Machine 1
(a) Machine 2
(b) *Discounting
Factor @ 10% (c) Machine 1
(Rs.) (a)x(c) Machine 2
(Rs.) (b)x(c)
1 8000 24000 0.9091 7272 21818
2 24000 32000 0.8265 19836 26448
3 32000 40000 0.7513 24042 30052
4 48000 24000 0.683 32784 16392
5 32000 16000 0.6209 19868 9934
144000 136000 103802 104644
Less: Pres ent Value of Cash
Outflow (Initial Investment + PV
of additional working capital)
-83636 -83636
Net Present Value of cash flows -20166 -21008
**Discounting Factor @ 10% accessed from present value table.
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71 Interpretation:
Machine 2 is prefera ble to Machine 1. Though total cash inflow of
machine 1 is more than the of machine 2 by 8,000/ - the net present value
of cash flows of Machine 2 is more than that of Machine 1. Moreover, in
case of Machine 2, cash inflow in the earlier years is comparativ ely higher
than that of machine 1.
Illustration 6: ABC Ltd is a small company that is currently analyzing
capital expenditure proposals for the purchase of equipment; the company
uses the net present value technique to evaluate projects. The capital
budget is limited to 500,000 which ABC Ltd believes is the maximum
capital it can raise. The initial investment and projected net cash flows
for each project are shown below. The cost of capital of ABC Ltd is 12%.
You are required to compute the NPV of the different projects.
Solution:
5.3 PROFITABILITY INDEX
One of the methods of comparing such proposals is to work out what is
known as the ‗Desirability factor‘, or ‗Profitability index‘. In general
terms a project is acceptable if its profitability index value is
greater than 1. Mathematically: The desirability factor is
calculated as below:
Illustration 7: Suppose we have three projects involving discounted cash
outflow of Rs. 5,50,000, Rs 75,000 and Rs. 1,00,20,000 respectively. Suppose
further that the sum of discounted cash inflows for these projects are Rs.
6,50,000, Rs. 95,000 and Rs. 1,00,30,000 respectively. Calculate the desirabili ty
factors for the three projects.
Solution: The desirability factors for the three projects would be as follows:
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72 Corporate Valuation and
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It would be seen that in absolute terms project 3 gives the highest cash
inflows yet its desirability factor is low. This is because the outflow is
also very high. The Desirability/ Profitability Index factor helps us in
ranking various projects.
Advantages :
Incorporates time value of money: The PI method takes into account
the time value of money by discounting future cash flows to their
present value. This provides a more accurate assessment of the
investment's profitability.
Provides a clear decision criterion: The PI method provides a clear
decision criterion by comparing the present value of expected cash
flows to the initial investment. A PI greater than 1 indicates that the
investment is expected to generate returns that exceed the cost of
capital, making it financially viable.
Considers the entire life of the project: The PI method considers all
expected cash flows throughout the life o f the project, providing a
more comprehensive analysis of the investment's profitability.
Measures relative profitability: The PI method measures the relative
profitability of different projects, making it useful for comparing
projects with different initi al investments.
Disadvantages :
Ignores the absolute size of the project: The PI method does not take
into account the absolute size of the project, which can be a
disadvantage in situations where the size of the investment is critical.
Assumes that all cas h flows are reinvested at the required rate of
return: The PI method assumes that all cash flows are reinvested at the
required rate of return, which may not be realistic.
Difficulty in selecting appropriate discount rate: Selecting the
appropriate discoun t rate can be challenging, as it depends on the risk
of the investment and the company's cost of capital.
Ignores non -financial benefits: Like other financial methods, the PI
method focuses solely on financial returns and does not consider non -
financial be nefits, such as the impact of the investment on the
company's reputation, social responsibility, or strategic positioning.
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73 5.4 INTERNAL RATE OF RETURN METHOD
The internal rate of return method considers the time value of money, the initial
cash investment, and all cash flows from the investment. But unlike the net
present value method, the internal rate of return method does not use the
desired rate of return but estimates the discount rate that makes the present value
of subsequent net cash flows equal to the initial investment. This discount
rate is called IRR. IRR Definition: Internal rate of return for an investment
proposal is the discount rate that equates the present value of the expected net
cash flows with the initial cash outflow.
This IRR is then comp ared to a criterion rate of return that can be the
organization‘s desired rate of return for evaluating capital investments.
This method advocated by Joel Dean, takes into account the magnitude
and timing of cash flows. This is another important discounted cash flow
technique of capital budgeting decisions. IRR can be defined as that rate
which equates the present value of cash inflows with the present value of
cash outflows of an investment proposal. It is the rate at which the net
present value of the inv estment proposal is zero.
“The internal rate as the rate that equates the present value of the expected
future receipts to the investment outlay” ----Weston and Brigham
If the IRR is greater than the cost of capital the funds invested will earn
more than their cost, when IRR of a project equal the cost of capital, the
management would be indifferent to the project as it would be expected to
change the value of the firm. It is computed by the formula
Internal Rate of Return (IRR) = L + [(P1 - C) x D/(P1 - P2) x 100]
Where;
L=Lower rate of interest
P1=Present value at lower rate of interest
P2=Present value at higher rate of interest
C= Capital Investment
D= Difference in rate of interest
Computation:
The internal rate of return is to be determined by trail and error method.
The following steps can be used for its computation:
1. Compute the present value of the cash flows from an investment, by
using an arbitrary selected interest rate
2. Then compare the present value so obtained with capital outlay
3. If the present value is higher than the cost, then the present value of munotes.in
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74 Corporate Valuation and
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4. This procedure is to be continued until the present value of the inflows
from the investment is approximately equal to its outflow
5. The in terest rate that brings about this equality is the internal rate of
return. If the internal rate of return exceeds the required rate of return,
then the project is accepted.
If the project’s IRR is lower that the required rate of return, it will be
reject ed. In case of ranking the proposals, the technique of IRR is
significantly used. The projects with higher rate of return will be ranked as
first compared to the lowest rate of return projects. Thus, the IRR
acceptance rules are
Accept if r>k Reject if r
Accept if r>k Reject if r
Reject if r < k
May accept or reject if r=k
Where; r = internal rate of return
k=cost of capital
Advantages :
Considers the entire life of the project: The IRR method considers all
expected cash flows throughout the life of the proj ect, providing a
more comprehensive analysis of the investment's profitability.
Incorporates time value of money: The IRR method takes into account
the time value of money by discounting future cash flows to their
present value. This provides a more accura te assessment of the
investment's profitability.
Provides a clear decision criterion: The IRR method provides a clear
decision criterion by comparing the calculated rate of return to the
required rate of return. If the calculated rate of return is greater than
the required rate of return, the investment is financially viable.
Measures the efficiency of an investment: The IRR method measures
the efficiency of an investment by providing a measure of the rate of
return generated by the investment.
Disadvantage s:
May produce multiple answers: The IRR method may produce
multiple answers or no answers in some situations where there are
non-normal cash flows. munotes.in
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75 Difficulty in selecting appropriate discount rate: Selecting the
appropriate discount rate can be challengi ng, as it depends on the risk
of the investment and the company's cost of capital.
May not be suitable for comparing projects with different sizes:
The IRR method may not be suitable for comparing projects with
different sizes, as it does not take into acc ount the absolute size of the
investment.
Ignores non -financial benefits: Like other financial methods, the IRR
method focuses solely on financial returns and does not consider non -
financial benefits, such as the impact of the investment on the
company's r eputation, social responsibility, or strategic positioning.
Illustration 8: Calculate the internal rate of return of an investment of Rs. 1,
36,000 which yields the following cash inflows:
Year Cash Inflows (in Rs.) 1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
Solution: Calculation of IRR
Since the cash inflow is not uniform, the internal rate of return will have to be
calculated by the trial and error method. In order to have an approximate idea
about such rate, the ‗Factor‘ must be found out. ‗The factor reflects the same
relationship of investment and cash inflows as in case of payback calculations‘:
F = I/ C, Where, F = Factor to be located, I = Original Investment, C =
Average Cash inflow per year for the project,
The factor thus calculated will be located in the present value of Re.1 received
annually for N year‘s table corresponding to the estimated useful life of the
asset. This would give the expected rate of return to be applied for discounting
the cash inflows. In case of the project, the rate comes to 10%.
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76 Corporate Valuation and
Mergers & Acquisitions The present value at 10% comes to Rs. 1,38,280, which is more than the initial
investment. Therefore, a higher discount rate is suggested, say, 12%.
The internal rate of return is, thus, more than 10 % but less than 12%. The
exact rate can be obtained by interpolation:
Acceptance Rule: The use of IRR, as a criterion to accept capital
investment decision involves a comparison of IRR with the required rate
of return known as cut off rate. The project should the accepted if IRR is
greater than cut -off rate. If IRR is equal to cut off rate the firm is
indifferent. If IRR less than cut off rate the project is rejected.
5.5 RELATIVE VALUATION MODEL
a) PE Ratio: The price -to-earnings (PE) ratio is a commonly use d
valuation metric that compares a company's stock price to its earnings per
share (EPS). The PE ratio can be calculated as the market value per share
divided by the earnings per share. A higher PE ratio indicates that
investors are willing to pay a premiu m for the company's future earnings
potential.
b) PEG Ratio: The price -to-earnings growth (PEG) ratio is a variation of
the PE ratio that takes into account a company's expected earnings growth
rate. The PEG ratio can be calculated as the PE ratio divided by the
expected earnings growth rate. A lower PEG ratio indicates that the
company's stock price may be undervalued relative to its earnings growth
potential.
c) Relative PE Ratio: A company's PE ratio is compared to that of its
competitors or the larger m arket using the relative PE ratio. Investors can
use this to determine whether a company's stock price is overvalued or
undervalued in comparison to its rivals or the market as a whole.
d) Enterprise Value Multiples: A variant of stock valuation multiples
known as enterprise value (EV) multiples considers a company's overall
value, which includes debt and other liabilities. The EV/EBITDA
(earnings before interest, taxes, depreciation, and amortisation) and
EV/sales ratios are two examples of EV multiples. T he comparison of
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77 prospective acquisition targets might both benefit from using these
multiples.
e) Choosing the Right Multiples: Choosing the appropriate multiples that
are most pertinent to the company being valued and its industry is crucial
when employing relative valuation methods. The company's capital
structure, profitability, and potential for expansion are all important
factors to take into account. The constraints of each multiple, s uch as how
accounting rules and other non -operational factors affect the value, should
also be taken into account.
5.6 BOOK VALUE APPROACH
The book valuation approach is one of several methods used in corporate
valuation. It calculates a company's value based on the value of its net
assets as shown in its financial statements. The book value is simply the
value of a company's assets minus the value of its liabilities and preferred
stock.
The book value approach is most commonly used to value companies that
are not expected to generate significant future earnings or cash flows, such
as distressed companies or companies in industries with low growth
prospects. This approach can also be useful for valuing companies that
hold significant tangible assets, such as rea l estate or machinery.
To use the book valuation approach, the value of the company's net assets
is adjusted to reflect the fair market value of its assets and liabilities. This
may involve making adjustments to the value of intangible assets, such as
good will or patents, or adjusting the value of assets that are not carried at
fair market value in the financial statements, such as inventory or
property.
One limitation of the book valuation approach is that it does not take into
account the value of a compa ny's future earnings or cash flows. This can
be a significant limitation for companies with high growth prospects or
significant intangible assets that are not reflected on the balance sheet.
5.7 STOCK AND DEBT APPROACH
The stock and debt approach is a method used in corporate valuation to
determine the value of a company's equity and debt. This approach is
based on the idea that a company's value is equal to the sum of the value
of its equity and debt.
The stock and debt approach is based on the following form ula:
Value of the company = Value of equity + Value of debt
The value of the equity is calculated as the market value of the company's
shares outstanding, multiplied by the number of shares outstanding. The
market value of the shares is based on the compan y's current stock price
and the number of outstanding shares. munotes.in
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78 Corporate Valuation and
Mergers & Acquisitions The value of the debt is calculated as the present value of the company's
future cash flows from debt, discounted at the cost of debt. This
calculation takes into account the company's outstandi ng debt, as well as
any expected future debt issuances or repayments.
The cost of debt is based on the company's current interest rates, the credit
risk associated with the company's debt, and the market risk premium.
This rate is often calculated using th e weighted average cost of capital
(WACC), which takes into account the cost of both equity and debt.
One advantage of the stock and debt approach is that it takes into account
the value of a company's debt, which is an important consideration for
investor s and lenders. However, this approach can be complex and
requires accurate projections of future cash flows and interest rates.
5.8 SPECIAL CASES FOR VALUATION
a) Brand Valuation and Human Valuation: A key intangible asset that
makes a major contribution to a company's overall value is its brand value.
The worth of a brand is established by evaluating the financial gains it
offers the business, such as elevated customer loyalty, premium pricing,
and market share. Various valuation techniques, including the cost
approach, market approach, and income approach, can be used to evaluate
the brand value. Human Values: In some circumstances, the value of a
person's contribution to a firm can be a key factor of the organisation's
overall value. For instance, a famous p erson or important CEO may make
a substantial contribution to the business' success. The human valuation
approach involves estimating the value of an individual's contribution to
the company based on their skills, experience, and track record.
b) Real Esta te: Real estate's physical, economic, geographic, and
demand -supply dynamics are all taken into consideration when
determining its value. The income approach, cost approach, and sales
comparison approach are a few typical real estate valuation techniques.
The cost strategy entails evaluating the cost of replacing the property,
whereas the income approach involves assessing the present value of
future revenue derived from the property. The sales comparison method
compares the property to nearby properties th at are similar in order to
determine its fair market value.
c) Start -Up Firm: Due to the lack of prior financial data and the
uncertainty surrounding future cash flows, valuing a start -up business can
be difficult. In these situations, the business's poten tial and the market it
serves are taken into account when valuing the company. The discounted
cash flow (DCF) method, the market approach, and the venture capital
(VC) method are some popular ways for valuing start -up businesses. The
market approach compar es the startup with similar businesses that have
previously been sold, whereas the DCF method entails predicting the
current value of future cash flows. Using the amount of investment
received and the ownership percentage granted to investors, the VC
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79 d) Firms with Negative Earnings: Forecasting future cash flows and
determining the terminal value are necessary when valuing companies
with negative earnings. The potential of the company, its competitive
advantage, a nd its capacity to produce future cash flows may all be taken
into account when determining the valuation. In these circumstances,
valuation techniques like the DCF method and the market approach can be
applied.
e) Financial Service Companies: In order to value financial service
organisations, it is necessary to evaluate the risks and potential rewards
connected to their business model. Depending on the structure of the firm
and the accessibility of financial data, valuation techniques including the
dividen d discount model, the DCF method, and the market approach can
be utilised.
f) Distressed Firms: Assessing a distressed company's assets, liabilities,
and restructuring prospects is part of the valuation process. Depending on
the unique conditions of the tr oubled organisation, valuation methods like
the DCF approach and liquidation value method may be applied.
g) Valuation of Cash and Cross Holdings: Valuing cash and cross
holdings involves estimating their market value and their impact on the
overall valuat ion of the company. Cash and cross holdings can be valued
using the market approach or the income approach, depending on the
specific circumstances.
h) Warrants and Convertibles: In order to value warrants and
convertibles, one must first determine whether they have the ability to be
converted into equity. Then, one must estimate their fair market value
using the conversion ratio, exercise price, and other pertinent variables. In
these circumstances, valuation techniques like the market approach and
the opt ion pricing model can be applied.
i) Cyclical and Non -Cyclical Companies: Assessing the effects of
economic cycles on a company's operations and predicting its growth and
cash flow potential are necessary for valuing both cyclical and non -
cyclical business es. Depending on the unique circumstances of the
company, valuation techniques like the DCF method and the market
approach can be applied.
j) Holding Companies: Valuing holding firms entails determining the
worth of their underlying businesses and assets a s well as the synergies
and growth possibilities. Depending on the unique conditions of the
holding company, valuation techniques like the sum -of-the-parts (SOTP)
method and the market approach may be utilised.
k) E -commerce Firm: E-commerce company valuat ion involves
analysing the business model, growth prospects, and competitive
advantage of the company. Depending on the unique circumstances of the
e-commerce organisation, valuation techniques including the DCF
method, the market approach, and the option pricing model may be
utilised. munotes.in
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80 Corporate Valuation and
Mergers & Acquisitions 5.9 SUMMARY
Net present value describes as the summation of the present value of
cash inflow and present value of cash outflow.
NPV is the best method for the selection of mutually exclusive
projects.
The procedures for computin g the internal rate of return vary with the
pattern of net cash flows over the useful life of an investment.
If IRR is equal to cut off rate the firm is indifferent. If IRR less than
cut off rate the project is rejected.
The book valuation methodology is a helpful method for evaluating
businesses with sizable tangible assets or businesses that are not
anticipated to produce sizable future revenues or cash flows.
For valuing businesses with both equity and debt, the stock and debt
methodology is a useful to ol.
E-commerce company valuation involves analysing the business
model, growth prospects, and competitive advantage of the company.
Valuing cash and cross holdings involves estimating their market
value and their impact on the overall valuation of the comp any.
5.6 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. Discuss the relative merits and demerits of IRR Method?
2. Write note on Net Present Value method.
3. Explain Profitability Index Method.
4. Explain the Steps for computing net present value.
5. What is PE Ratio?
6. Write note on Enterprise Value Multiples.
7. Explain Special Cases for Valuation with reference to Brand Value
and Human valuation.
8. Write note on Special Cases for Valuation in reference to Warrants
and Convertibles.
Long Answers:
1. Discuss the relative merits and demerits of Present Value Method?
2. Discuss the suitability of Profitability Index Method?
3. Explain the merits and demerits of Internal Rate of return.
4. Discuss the Steps for computing IRR. munotes.in
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Other Non -DCF Valuation Models
81 5. Explain the difference between PE Ratio and Relativ e PE Ratio.
6. Describe Book Valuation Approach.
7. Explain Stock Debt Approach.
B. Multiple Choice Questions:
1. NPV is the difference between the present value of cash inflows of a
project and the initial cost of the project.
a) IRR
b) NPV
c) Profitability
d) None of thes e
2. Net present value method is one of the modern methods for evaluating
the project proposals.
a. Profitability index
b. IRR
c. NPV
d. None of these
3. …IRR stands for.
a. Internal Risk of Return
b. Internal Rate of Risk
c. Internal Rate of Return
d. International Rate of Retur n
4.Value of the company = …………… + Value of debt
a. Value of equity
b. Value of asset
c. Value of preference
d. Value of stock
5. Valuing ………involves assessing its physical and economic
characteristics, location, and demand -supply dynamics.
a. Brand Value
b. Hum an Valuation
c. real estate
d. None of these
6. EV stand for :
a. Enterprise vague
b. Enterprise value
c. Exceptional value
d. Extraordinary value
Answers: 1 -b, 2-c , 3- c, 4-a, 5-c , 6-b munotes.in
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82 Corporate Valuation and
Mergers & Acquisitions C. Fill in the blanks:
1. …………. is the difference between the total present value of future
cash inflows and the total present value of future cash outflows.
2. Internal rate of return for an investment proposal is the discount rate
that equates the present value of the expected net cash flows with
the…………..
3. ……………. technique helps in achieving the objective of
minimisation of shareholders wealth.
4. The stock and debt approach is a method used in corporate valuation to
determine the value of a company's equity and……...
5. A company's brand value is a crucial ………… asset that contributes
significantly to it s overall value.
Answer:
1. Pay-back period
2. unadjusted rate of return
3. Net present value
4. debt
5. intangible
D. State whether the following sentence are True / False:
1. The IRR approach creates a peculiar situ ation if we compare two
projects with different inflow/outflow patterns.
2. NPV means the average rate of return or profit taken for considering
the project evaluation.
3. Net Present Value Method is the modern method of capital busgeting
Answer:
True - 1, 2
False- 3
5.7 SUGGESTED READINGS
1. Financial Management by Prasanna Chandra.
2. Financial Management by I.M. Pandey.
3. Financial Management by Khan & Jain.
4. Organization & Management by R.D. Aggarwal.
5. Financial Management and Policy by R.M. Srivastava
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83 6
OPTION PRI CING APPLICATIONS IN
VALUATIONS
Unit Structure
6.0 Objectives
6.1 Introduction
6.2 Features of Option pricing applications in valuation
6.3 Importance of Option pricing applications in valuation
6.4 Advantages of Option pricing applications in valuation
6.5 Limitati ons of Option pricing applications in valuation
6.6 Black -Scholes model in option pricing valuation
6.7 Binomial option pricing model
6.8 Underlying asset's price
6.9 Unit End Questions
6.10 Suggested Readings
6.0 OBJECTIVES
The main purpose of this chapter is –
o To discuss the features of Option pricing applications in valuation
o To explain importance of Option pricing applications in valuation
o To understand advantages of Option pricing applications in valuation
o To describe limitations of Option pricing applications in valuation
o To understand Black -Scholes model in option pricing valuation
o To analyse Binomial option pricing model
o To highlight underlying asset's price
6.1 INTRODUCTION
Option pricing is a method used in financial mathematics to determine the
fair value or theoretic al price for a stock or an option, based on certain
variables such as the stock price, strike price, volatility, time to expiration,
and the risk -free interest rate. This method is used to value both calls and
puts, and can be applied in the context of sec urities valuation, risk
management, and investment decision making. For example, it can be
used to determine the value of a call option as part of a larger valuation of munotes.in
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84 Corporate Valuation and
Mergers & Acquisitions a company that has issued the option, or to evaluate the potential return on
an option trading strategy.
6.2 FEATURES OF OPTION PRICING APPLICATIONS
IN VALUATION
The following are some of the key features of option pricing applications
in valuation:
1. Theoretical value: Option pricing models provide a theoretical value
for the option, which ca n be used as a benchmark for its fair value.
2. Inputs: Option pricing models rely on inputs such as stock price,
strike price, volatility, time to expiration, and the risk -free interest rate
to determine the theoretical value of an option.
3. Risk management: Option pricing can be used to manage the risk of
investments in stocks or other securities. By determining the
theoretical value of options, investors can make informed decisions
about their investment strategies.
4. Real -time updates: Option pricing models ca n be updated in real -time
to reflect changes in market conditions and other relevant variables,
providing up -to-date valuations for options.
5. Multiple models: Different option pricing models exist, each with its
own strengths and limitations. Users can choo se the model that best
suits their needs and risk tolerance.
6. Flexibility: Option pricing models can be used to value options on a
wide range of underlying assets, including stocks, bonds, currencies,
commodities, and more.
7. Portfolio management: Option pric ing can also be used to manage a
portfolio of options, allowing investors to evaluate the potential impact
of different option trading strategies on their overall portfolio.
6.3 IMPORTANCE OF OPTION PRICING
APPLICATIONS IN VALUATION
The importance of optio n pricing applications in valuation can be
summarized as follows:
1. Improved decision making: By providing a theoretical value for
options, option pricing models help investors make informed decisions
about their investment strategies and risk management.
2. Better risk management: Option pricing allows investors to evaluate
and manage the risk associated with their investments, providing a
deeper understanding of the potential returns and losses from options
trading. munotes.in
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Option Pricing Applications in Valuations
85 3. Increased transparency: Option pricing model s provide transparency
in the pricing of options, enabling investors to make more informed
decisions about their investments.
4. Better alignment of expectations: Option pricing models help align
the expectations of buyers and sellers of options, reducing the potential
for mispricing and improving market efficiency.
5. Support for portfolio management: Option pricing models can be
used to manage a portfolio of options, providing investors with a more
comprehensive view of the potential impact of different option trading
strategies on their overall portfolio.
6. Increased accuracy: Option pricing models are based on
mathematical models that have been tested and refined over time,
providing a high level of accuracy in the pricing of options.
7. Improved market efficiency: By providing a standardized method for
pricing options, option pricing models contribute to the overall
efficiency of the market, enabling investors to make informed
decisions based on accurate pricing information.
6.4 ADVANTAGES OF OPTION PRICING
APPLICA TIONS IN VALUATION
Option pricing applications in valuation offer several advantages,
including:
1. Improved investment decision making: Option pricing models
provide a theoretical value for options, allowing investors to make more
informed decisions about th eir investment strategies and risk
management.
2. Better risk management: Option pricing helps investors evaluate and
manage the risk associated with their investments, providing a deeper
understanding of the potential returns and losses from options trading.
3. Increased transparency: Option pricing models provide transparency
in the pricing of options, enabling investors to make more informed
decisions about their investments.
4. More efficient markets: By providing a standardized method for
pricing options, optio n pricing models contribute to the overall
efficiency of the market, reducing the potential for mispricing and
improving market efficiency.
5. Flexibility: Option pricing models can be used to value options on a
wide range of underlying assets, including stoc ks, bonds, currencies,
commodities, and more.
6. Improved portfolio management: Option pricing can be used to
manage a portfolio of options, providing investors with a more munotes.in
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86 Corporate Valuation and
Mergers & Acquisitions comprehensive view of the potential impact of different option trading
strategies on t heir overall portfolio.
7. Increased accuracy: Option pricing models are based on mathematical
models that have been tested and refined over time, providing a high
level of accuracy in the pricing of options.
8. Real -time updates: Option pricing models can be up dated in real -time
to reflect changes in market conditions and other relevant variables,
providing up -to-date valuations for options.
6.5 LIMITATIONS OF OPTION PRICING
APPLICATIONS IN VALUATION
Option pricing applications in valuation have some limitations , including:
1. Model assumptions: Option pricing models rely on a set of
assumptions about market conditions and other variables, which may
not always hold true. As a result, the accuracy of option pricing models
can be limited.
2. Model uncertainty: Different option pricing models may produce
different results, leading to uncertainty about the true value of an
option.
3. Data quality: The accuracy of option pricing models is dependent on
the quality of the data used as inputs. Inaccurate data can lead to
incorrect valuations.
4. Model complexity: Option pricing models can be complex, requiring a
high level of mathematical and financial expertise to understand and
use effectively.
5. Limited scope: Option pricing models may not be appropriate for all
types of options or a ll market conditions, and may not provide reliable
results in some cases.
6. Limited predictive ability: Option pricing models provide a
theoretical value for options, but do not guarantee actual market prices
or returns. They do not account for unexpected ev ents that may
significantly impact market conditions.
7. Market volatility: Option pricing models may be less reliable in
volatile market conditions, when market conditions can change rapidly
and unpredictably.
8. Model limitations: Option pricing models have li mitations and may
not be able to fully capture all the relevant factors that determine the
value of an option.
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Option Pricing Applications in Valuations
87 6.6 BLACK -SCHOLES MODEL IN OPTION PRICING
VALUATION
Black -Scholes model in option pricing valuation?
The Black -Scholes model is a widely used mathematical model for pricing
European call and put options in the financial markets. It was developed
by Fisher Black, Robert Merton, and Myron Scholes in the 1970s. The
model takes into account factors such as the current stock price, the
option's strik e price, the time to expiration, the risk -free interest rate, and
the stock's volatility.
The Black -Scholes formula provides a theoretical estimate of the fair price
or theoretical value for an option, assuming European exercise style and
efficient markets . This model is widely used by traders, financial
institutions, and investors to make informed decisions about buying and
selling options. However, it has limitations and does not always accurately
reflect market prices, especially for options with extreme or non -standard
features, or for markets with significant market frictions.
Assumptions of the Black -Scholes -Merton Model
Lognormal distribution : The Black -Scholes -Merton model assumes
that stock prices follow a lognormal distribution based on the princip le
that asset prices cannot take a negative value; they are bounded by zero.
No dividends : The BSM model assumes that the stocks do not pay any
dividends or returns.
Expiration date : The model assumes that the options can only be
exercised on its expiratio n or maturity date. Hence, it does not
accurately price American options. It is extensively used in the
European options market.
Random walk : The stock market is a highly volatile one, and hence,
a state of random walk is assumed as the market direction can never
truly be predicted.
Frictionless market : No transaction costs, including commission and
brokerage, is assumed in the BSM mode l.
Risk -free interest rate : The interest rates are assumed to be constant,
hence making the underlying asset a risk -free one.
Normal distribution : Stock returns are normally distributed. It implies
that the volatility of the market is constant over time.
No arbitrage : There is no arbitrage. It avoids the opportunity of
making a riskless profit.
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88 Corporate Valuation and
Mergers & Acquisitions Limitations of the Black -Scholes -Merton Model
Limited to the European market : As mentioned earlier, the Black -
Scholes -Merton model is an accurate determinant of European option
prices . It does not accurately value stock options in the US. It is
because it assumes that options can only be exercised on its
expiration/maturity date.
Risk-free interest rates : The BSM model assumes constant interest
rates, but it is hardly ever the reality.
Assumption of a frictionless market : Trading generally comes with
transaction costs such as brokerage fees, commission , etc. However,
the Black Scholes Merton model assumes a frictionless market, which
means that there are no transaction costs. It is hardly ever the reality in
the trading market.
No returns : The BSM model assumes that there are no returns
associated with the stock options. There are no dividends and no
interest earnings. However, it is not the case in the actual trading
market. The buying and selling of options are primarily focused on the
returns.
6.7 BINOMIAL OPTION PRICING MODEL
The binomial option pricing model is a mathematical model used to
calculate the fair price or theoretical value for a financial option. It is
based on the idea that the underlying asset's price can either go up or dow n
over a given time period, creating a binomial tree of possible price
outcomes. The model takes into account the current stock price, the
option's strike price, the time to expiration, the risk -free interest rate, and
the probability of the stock price go ing up or down.
The binomial model is considered a simpler alternative to the Black -
Scholes model and is often used to value options with non -standard
features or to value American -style options, which can be exercised before
expiration. However, it can be come computationally intensive for longer
time horizons and multiple steps in the binomial tree.
Like the Black -Scholes model, the binomial option pricing model provides
a theoretical estimate of an option's value and is widely used by traders,
financial i nstitutions, and investors in their decision -making processes.
However, it is important to note that theoretical option prices generated by
any model may differ from actual market prices.
6.8 UNDERLYING ASSET'S PRICE
The underlying asset's price refers to the current market price of the
financial instrument or asset that is being used as the basis for a financial
option. This can be a stock, a commodity, a currency, a futures contract, or
any other tradable asset. The underlying asset's price is a key facto r in munotes.in
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Option Pricing Applications in Valuations
89 determining the price of an option, as the value of an option is tied to the
price of the underlying asset.
For example, if an investor owns a call option on a stock, the underlying
asset's price would be the current market price of the stock. If the stock's
price increases, the value of the call option is likely to increase as well,
while if the stock's price decreases, the value of the option is likely to
decrease. The underlying asset's price is therefore a crucial consideration
for option traders a nd investors when making investment decisions.
The price of an option can change based on various factors, which can be
grouped into two main categories: intrinsic factors and extrinsic factors.
Intrinsic factors:
1. Underlying asset price: The price of the u nderlying asset is the most
important factor affecting the price of an option. An increase in the
underlying asset's price generally increases the value of a call option
and decreases the value of a put option, and vice versa.
2. Strike price: The strike pric e is the price at which the option gives the
right to buy (in the case of a call option) or sell (in the case of a put
option) the underlying asset. The difference between the underlying
asset's price and the strike price can have a significant impact on t he
value of an option.
3. Time to expiration: The time to expiration, also known as time decay,
refers to the amount of time left until the option's expiration date. As
the expiration date approaches, the time decay of the option increases,
which can have a n egative impact on the option's value.
Extrinsic factors:
1. Volatility: Volatility refers to the degree of variation in the price of the
underlying asset. A high level of volatility can increase the value of an
option, as it increases the probability of a lar ge move in the underlying
asset's price.
2. Interest rate: The interest rate can affect the price of an option because
it determines the cost of holding the underlying asset. Higher interest
rates can increase the cost of holding the underlying asset, which c an
have a negative impact on the value of an option.
3. Dividends: If the underlying asset pays dividends, this can also have an
impact on the price of an option. If a call option is in the money, the
holder may choose to exercise the option and receive the d ividend,
which can reduce the value of the option.
It's important to note that the impact of these factors can be interrelated
and can change over time. Option traders and investors must continually
monitor these factors and make adjustments to their optio n positions as
necessary. munotes.in
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90 Corporate Valuation and
Mergers & Acquisitions 6.9 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. What are the advantages of Option pricing applications in valuation ?
2. Discuss limitations of Option pricing applications in valuation .
3. Write note on Black -Scholes model in option pricing valuation .
4. Explain the intrinsic and extrinsic factors of underlying asset's price .
Long Answers:
1. Discuss the limitations of the Black -Scholes -Merton Model
2. What are the advantages of the Black -Scholes -Merton Model?
3. Discuss the importance of Option pricing applications in valuation
4. Explain the importance of option pricing applications in valuation .
B. Multiple Choice Questions:
1. ……….. provide a theoretical value for options, allowing investors to
make more infor med decisions about their investment strategies and risk
management .
a) IRR
b) NPV
c) Option pricing models
d) None of these
2. Identify the disadvantage of option pricing applications in valuation:
a) Flexibility
b) Increased accuracy
c) Real-time updates
d) Model uncertainty
3. The ……………. formula provides a theoretical estimate of the fair
price or theoretical value for an option .
a) Binomial pricing
b) Black -Scholes
c) Internal Rate of Return
d) Net present value
Answers: c -b, 2-d, 3- b
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Option Pricing Applications in Valuations
91 C. Fill in the blanks:
1. The …………….. model is con sidered a simpler alternative to the
Black -Scholes model.
2. The ………………. refers to the current market price of the financial
instrument or asset that is being used as the basis for a financial option.
3. ……….. refers to the degree of variation in the price of the underlying
asset.
Answer:
1. binomial
2. underlying asset's price
3. Volatility
6.10 SUGGESTED READINGS
1. Financial Management by Prasanna Chandra.
2. Financial Management by I.M. Pandey.
3. Financial Management by Khan & Jain.
4. Organization & Management by R.D. Aggarwal.
5. Financial Management and Policy by R.M. Srivastava
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92 7
WRITING A VALUATION REPORT
Unit Structure
7.0 Objectives
7.1 Introduction
7.2 Steps in writing a Valuation report
7.3 Methods for writing a corporate valuation report
7.4 Users of Corporate Valuation report
7.5 Advantages of Corporate Valuation report
7.6 Disadvantages of Corporate Valuation report
7.7 Format of Corporate Valuation report
7.8 Summary
7.9 Unit End Questions
7.10 Suggested Readings
7.0 OBJECTIVES
The main purpose of this chapter is –
To discuss steps in writing a Valuation report
To understand methods for writing a corporate valuation report
To describe users of Corporate Valuation report
To anlayse advantages of Corporate Valuation report
To understand disadvantages of Corporate Valuation report
To discuss format of Corporate Valuation report
7.1 INTRODUCTION
The history of corporate valuation dates back to the late 19th and early
20th centuries, when the first financial models for valuing stocks and
bonds were developed.
In the 1930s, financial economists and academics began to formalize the
theory of valuation, developing the discoun ted cash flow (DCF) method
and the net present value (NPV) concept, which are still widely used
today.
In the mid -20th century, the increased popularity of publicly traded stocks
and the development of the stock market as a major source of capital led to
the expansion of corporate valuation methods. With the advent of
computers and the growth of financial modeling software, the accuracy
and reliability of corporate valuation reports improved significantly. munotes.in
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Writing a Valuation Report
93 In the 1990s and 2000s, new corporate valuation met hods were developed,
such as real options analysis and comparable company analysis, reflecting
the growing complexity of financial markets and the increasing
importance of intangible assets, such as intellectual property and brand
value.
Today, corporate v aluation is an important tool used by businesses,
investors, and regulators to make informed decisions about the value and
potential of companies. It continues to evolve as new financial products
and markets emerge and as the global economy changes.
7.2 STEPS IN WRITING A VALUATION REPORT
A corporate valuation report is a document that provides an estimate of the
value of a company. Writing a corporate valuation report typically
involves the following steps:
1. Define the purpose of the valuation: Determine th e reason for the
valuation and the intended use of the report. This will guide the
methodology used and the information included in the report.
2. Gather information: Collect relevant financial and non -financial
information about the company, including financ ial statements, market
data, and industry trends.
3. Choose the valuation method: Select the most appropriate valuation
method, based on the purpose of the valuation and the information
available. Common methods include discounted cash flow analysis,
comparab le company analysis, and discounted earnings analysis.
4. Calculate the value: Use the chosen valuation method to calculate an
estimate of the company's value. This may involve making
assumptions about future financial performance, growth rates, and
discount rates.
5. Write the report: Organize and present the findings in a clear and
concise manner, including a detailed explanation of the methodology
used and the key inputs and assumptions made.
6. Review and finalize: Review the report for accuracy and
completeness and make any necessary revisions. Finalize the report
and distribute it to the intended audience.
It's important to note that corporate valuation is a complex and
constantly evolving field, and a well -written corporate valuation report
requires a deep und erstanding of financial analysis, accounting
principles, and valuation methodologies. It's also important to seek the
help of a professional valuation expert when preparing a corporate
valuation report, as the accuracy and reliability of the report can hav e
significant financial and legal implications.
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94 Corporate Valuation and
Mergers & Acquisitions 7.3 METHODS FOR WRITING A CORPORATE
VALUATION REPORT
There are several methods for writing a corporate valuation report,
including:
1. Discounted Cash Flow (DCF) Analysis: This method involves
forecasting the c ompany's future cash flows and discounting them
back to their present value to arrive at an estimate of the company's
value.
2. Comparable Company Analysis (Comps): This method involves
comparing the subject company to similar publicly traded companies
to det ermine the value of the subject company.
3. Discounted Earnings Analysis: This method is similar to DCF
analysis, but instead of forecasting cash flows, it forecasts earnings
and discounts them back to their present value.
4. Asset -Based Valuation: This method i nvolves estimating the value of
the company based on the value of its assets, such as real estate,
machinery, and intellectual property.
5. Market Capitalization: This method involves determining the value
of the company based on its market capitalization, or the total value of
its outstanding shares of stock.
6. Option Pricing Model: This method involves using option pricing
theory to estimate the value of the company based on its expected
future performance and volatility.
7. Real Options Analysis: This method is similar to option pricing, but
it specifically focuses on the value of real options, such as the option
to expand a business or enter new markets.
These are some of the most commonly used methods for writing a
corporate valuation report, and the appropriat e method will depend on the
specific circumstances of the company and the purpose of the valuation. A
professional valuation expert should be consulted to determine the most
appropriate method and to ensure the accuracy and reliability of the report.
7.4 USERS OF CORPORATE VALUATION REPORT
A corporate valuation report is an important tool for various stakeholders,
including:
Investors: Investors use corporate valuation reports to make informed
investment decisions, including decisions about buying, selling, or
holding shares of a company's stock.
Management: Corporate valuation reports provide management with
a clear understanding of the value of their company and can be used to munotes.in
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Writing a Valuation Report
95 inform strategic decision -making and identify opportunities for value
creation.
Bankers and Lenders: Banks and other lenders use corporate
valuation reports to assess the creditworthiness of a company and
make lending decisions.
Mergers and Acquisitions: Corporate valuation reports play a critical
role in the due diligence process dur ing mergers and acquisitions.
They provide potential buyers with an independent estimate of the
value of the company they are considering acquiring.
Employees: Corporate valuation reports can also be used to help
determine the value of employee stock optio ns or restricted stock units
(RSUs) and to inform decisions about equity -based compensation
programs.
Regulators: Regulators may also use corporate valuation reports to
assess the financial stability of companies and ensure that they are in
compliance with regulations.
Overall, a corporate valuation report provides a comprehensive,
independent assessment of a company's value, and helps stakeholders
make informed decisions about the company. A well -prepared corporate
valuation report can help improve the tra nsparency and accountability of a
company, and can contribute to its long -term success
7.5 ADVANTAGES OF CORPORATE VALUATION
REPORT
Corporate valuation reports provide several advantages, including:
Informed Decision -Making: By providing an independent ass essment
of a company's value, corporate valuation reports can help
stakeholders make informed decisions about buying, selling, investing,
or lending to the company.
Improved Transparency: Corporate valuation reports increase the
transparency of a company b y providing a clear and detailed
understanding of its value.
Better Understanding of the Company: A well -prepared corporate
valuation report provides a comprehensive understanding of a
company's financial performance, market position, and growth
potential, which can be used to inform strategic decision -making.
Increased Confidence: Corporate valuation reports can increase the
confidence of stakeholders by providing an independent and reliable
estimate of a company's value.
Improved Negotiating Position: In the case of mergers and
acquisitions, a corporate valuation report can provide a better munotes.in
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96 Corporate Valuation and
Mergers & Acquisitions negotiating position by providing a clear and objective estimate of the
value of the company being acquired.
Better Alignment of Interests: By providing a clear underst anding of
the value of a company, corporate valuation reports can help align the
interests of stakeholders and ensure that they are all working towards
the same goals.
Improved Financial Planning: Corporate valuation reports can be
used to inform financial planning, including the development of
budgets, the allocation of resources, and the determination of the
optimal capital structure.
Overall, corporate valuation reports provide a valuable tool for improving
the transparency, accountability, and performan ce of a company, and can
contribute to its long -term success
7.6 DISADVANTAGES OF CORPORATE VALUATION
REPORT
While corporate valuation reports offer several advantages, they also have
some potential disadvantages, including:
Cost: Corporate valuation repor ts can be expensive to prepare,
especially if they require the use of complex valuation methods or the
input of specialized professionals.
Subjectivity: Corporate valuation reports are based on a number of
subjective inputs, such as revenue and earnings pr ojections, discount
rates, and market comparables. This subjectivity can introduce a
degree of uncertainty into the results.
Data Limitations: The accuracy and reliability of corporate valuation
reports can be limited by the quality and availability of dat a. In some
cases, the data may not be up -to-date or may be incomplete, which can
impact the accuracy of the report.
Limited Relevance: Corporate valuation reports are based on a
specific set of assumptions and conditions and may not be relevant or
applicab le in other situations.
Dependence on External Factors: Corporate valuation reports are
subject to external factors, such as changes in the economy, industry
trends, and market conditions, which can impact their accuracy.
Short -Term Focus: Some corporate v aluation reports may be focused
on short -term results, and may not take into account the long -term
potential of a company.
Potential Misuse: Corporate valuation reports can be misused by
stakeholders, such as management or investors, who may use them to munotes.in
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97 support their own interests rather than making decisions that are in the
best interests of the company.
While these disadvantages should be taken into consideration, corporate
valuation reports can still provide a valuable tool for improving the
transparency , accountability, and performance of a company, as long as
they are prepared by experienced professionals and used in an appropriate
manner
7.7 FORMAT OF CORPORATE VALUATION REPORT
The format of a corporate valuation report can vary depending on the
specif ic needs of the company and the purpose of the valuation. However,
typical formats of corporate valuation reports include the following
sections:
Executive Summary: A brief overview of the key findings and
conclusions of the report, including the estimated value of the
company.
Background Information: Information about the company being
valued, including its history, operations, products, and services.
Valuation Methods: A description of the valuation methods used in
the report, including a detailed explana tion of the inputs and
assumptions used.
Financial Analysis: A comprehensive analysis of the company's
financial performance, including its revenue, earnings, margins, and
cash flows.
Market Analysis: An analysis of the company's competitive position
and m arket trends, including a comparison to similar companies.
Valuation Results: A detailed presentation of the results of the
valuation, including a breakdown of the estimated value by method.
Sensitivity Analysis: An analysis of the impact of changes in key
assumptions and inputs on the estimated value of the company.
Conclusion: A summary of the key findings and recommendations of
the report, including a discussion of the limitations and uncertainties of
the valuation.
Appendices: Additional information and supporting data, such as
financial statements, market data, and references to relevant sources.
This format is not set in stone, and the contents and format of a corporate
valuation report can be customized to meet the specific needs of the
company and th e stakeholders involved.
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98 Corporate Valuation and
Mergers & Acquisitions 7.8 SUMMARY
A corporate valuation report is a document that provides an estimate of
the value of a company.
A professional valuation expert should be consulted to determine the
most appropriate method and to ensure the accuracy an d reliability of
the report.
A well -prepared corporate valuation report can help improve the
transparency and accountability of a company, and can contribute to
its long -term success.
Corporate valuation reports can be expensive to prepare, especially if
they require the use of complex valuation methods or the input of
specialized professionals.
The format of a corporate valuation report can vary depending on the
specific needs of the company and the purpose of the valuation.
7.9 UNIT END QUESTIONS
A. Descr iptive Questions:
Short Answers:
1. Explain the Format of Corporate Valuation report.
2. Write note on disadvantages of Corporate Valuation report .
3. What is Corporate Valuation report ?
Long Answers:
1. Discuss the advantages of Corporate Valuation repor t?
2. Who are the Users of Corporate Valuation report ?
3. Explain the methods for writing a corporate valuation report.
4. Analyse the steps in writing a corporate valuation report.
B. Multiple Choice Questions:
1. ……………. involves forecasting the company's future cash flows and
discounting them back to their present value to arrive at an estimate of the
company's value .
a) Discounted Cash Flow (DCF) Analysis
b) Comparable Company Analysis (Comps)
c) Asset -Based Valuation
d) Option Pricing Model
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99 2. ………………… method is si milar to option pricing, but it specifically
focuses on the value of real options
a) Discounted Earnings Analysis
b) Real Options Analysis
c) Option Pricing Model
d) None of these
3. An analysis of the company's competitive position and market trends,
including a comparison to similar companies
a) Background Information
b) Valuation Methods
c) Market Analysis
d) Valuation Results
Answers: 1 -a, 2-b , 3- c,
C. Fill in the blanks:
1. …………… is an important tool used by businesses, investors, and
regulators
2. A summary of the key findings and recommendations of the report,
including a discussion of the limitations and uncertainties of the
valuation is………….
3. ………………. is additional information and supporting data, such as
financial statements, market data, and r eferences to relevant sources .
Answer:
1. corporate valuation
2. conclusion
3. Appendices
7.10 SUGGESTED READINGS
1. Financial Management by Prasanna Chandra.
2. Financial Management by I.M. Pandey.
3. Financial Management by Khan & Jain.
4. Organizatio n & Management by R.D. Aggarwal.
5. Financial Management and Policy by R.M. Srivastava
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100 8
INTRODUCTION TO MERGERS &
ACQUISITIONS
Unit Structure
8.0 Objectives
8.1 Introduction
8.2 Concept of Merger & Acquisitions
8.3 Benefits of Merger & Acquisitions
8.4 Types of restructuring
8.5 Regulatory considerations
8.6 Takeover code
8.7 M&A process
8.8 Summary
8.9 Unit End Questions
8.10 Suggested Readings
8.0 OBJECTIVES
The main purpose of this chapter is –
To understand the concept of Merger & Acquisitions
To discuss the b enefits of Merger & Acquisitions
To describe the t ypes of restructuring
To unde rstand regulatory considerations
To explain Takeover code
To highlight M&A process
8.1 INTRODUCTION
During the last few decades, the global industrial landscape has been
completely redrawn by the forces of globalisation, deregulation and
unprecedented tech nological development. Companies have responded to
the competitive pressures unleashed by these forces and they are today
vying with each other in search of excellence and competitive edge,
experimenting with various tools and ideas. The changing national and
international environment is radically altering the way business is
conducted. With the pace of change so great, corporate restructuring has
assumed paramount importance. munotes.in
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101 8.2 CONCEPT OF MERGER & ACQUISITIONS
Mergers and acquisitions (M&A) refer to the processes of combining or
acquiring businesses or assets from other companies. M&A can be an
important strategic tool for companies looking to expand their operations,
increase their market share, or diversify their portfolio.
A merger typically involves t wo companies joining together to form a new
entity. This can happen through a variety of means, including a stock
swap, a cash transaction, or a combination of both. In a merger, both
companies’ stocks are often combined, and the shareholders of both
compa nies typically become shareholders in the new entity.
An acquisition, on the other hand, involves one company purchasing
another company or its assets. The purchasing company will typically buy
the majority of the shares of the target company, giving it co ntrol over the
company's operations and assets.
However, M&A can also be risky and costly. Integration of two
companies can be challenging, and cultural differences between the two
companies can lead to friction and decreased productivity. Additionally,
M&A can be expensive, with legal, accounting, and other fees adding up
quickly.
Overall, M&A can be an effective tool for companies looking to grow or
diversify their operations, but it should be approached with caution and a
thorough understanding of the ri sks and potential benefits.
8.3 BENEFITS OF MERGER & ACQUISITIONS
M&A can have a number of potential benefits, such as:
Increased market share: Combining two companies can allow them to
capture a larger share of the market than either company could on its
own.
Diversification: M&A can allow companies to diversify their product
or service offerings, reducing their reliance on a single market or
product.
Access to new markets: M&A can give companies access to new
markets or geographic regions, which can be di fficult to enter on their
own.
Increased efficiency: Merging two companies can result in cost
savings through economies of scale and the elimination of duplicate
operations.
8.4 TYPES OF RESTRUCTURING
Corporate restructuring refers to the process of reorga nizing a company's
assets and operations in order to improve its financial or operational munotes.in
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Mergers & Acquisitions performance. There are several different types of restructuring that a
company may undertake, depending on its specific needs and goals. Here
are some of the most com mon types of corporate restructuring:
Financial restructuring: This type of restructuring typically involves
changing a company's capital structure, such as through debt
restructuring, refinancing, or issuing new equity. The goal of financial
restructuring is often to improve the company's financial stability and
flexibility.
Operational restructuring: This type of restructuring involves
changes to a company's operations, such as reorganizing departments
or business units, outsourcing non -core functions, or streamlining
processes. The goal of operational restructuring is often to improve
efficiency and reduce costs.
Strategic restructuring: This type of restructuring involves making
changes to a company's overall strategy or business model, such as
through m ergers and acquisitions, divestitures, or entering new
markets. The goal of strategic restructuring is often to create new
opportunities for growth or to better position the company in the
market.
Organizational restructuring: This type of restructuring in volves
changes to a company's organizational structure, such as through
changes to reporting lines or the creation of new roles or departments.
The goal of organizational restructuring is often to improve
communication and collaboration, and to better alig n the company's
structure with its strategic goals.
Rebranding or Marketing restructuring: This type of restructuring
involves changes to a company's brand identity or marketing strategy,
such as repositioning the brand or changing its visual identity. The
goal of rebranding or marketing restructuring is often to better reflect
the company's current identity, to differentiate it from competitors, or
to better appeal to its target market.
Each type of restructuring has its own unique goals and challenges, an d
the success of any restructuring effort depends on careful planning,
execution, and communication. Companies may choose to undertake one
or more of these types of restructuring, depending on their specific needs
and goals.
8.5 REGULATORY CONSIDERATIONS
Mergers and acquisitions (M&A) are subject to various regulatory
considerations that companies must take into account when planning and
executing these transactions. Here are some of the key regulatory
considerations that companies should be aware of:
Antit rust and competition laws: Antitrust laws are designed to
prevent companies from engaging in anti -competitive behavior that munotes.in
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103 could harm consumers or reduce competition in the market. M&A
transactions are subject to review by antitrust authorities to ensure that
they do not result in a significant reduction in competition. If the
transaction is likely to lead to a substantial reduction in competition,
the authorities may require the companies to make divestitures or other
concessions in order to gain approval .
Securities laws: M&A transactions often involve the purchase or sale
of securities, such as stocks or bonds. Companies must comply with
securities laws when issuing or selling securities, including disclosure
requirements and restrictions on insider trad ing.
Tax laws: M&A transactions can have significant tax implications for
both the buyer and the seller. Companies must be aware of tax laws
and regulations to ensure that they are taking advantage of any
available tax benefits, while also complying with a ll applicable tax
rules and requirements.
Environmental laws: Companies must consider any potential
environmental liabilities that may be associated with the target
company's operations, such as hazardous waste disposal or pollution.
Failure to address the se liabilities could result in legal, financial, and
reputational consequences.
Employment laws: M&A transactions can have significant
implications for employees, including changes in job responsibilities,
compensation, and benefits. Companies must comply with all
applicable employment laws and regulations, such as those governing
employee benefits, wage and hour laws, and anti -discrimination laws.
Intellectual property laws: M&A transactions often involve the
transfer or acquisition of intellectual propert y, such as patents,
trademarks, or copyrights. Companies must ensure that they are
complying with all applicable laws and regulations governing the
transfer and protection of intellectual property.
8.6 TAKEOVER CODE
The takeover code is a set of regulation s that govern the process of
acquiring control of publicly traded companies. The takeover code is
typically enforced by a regulatory body or securities exchange, and it is
designed to ensure that any change of control of a public company is
conducted in a fair and transparent manner that protects the interests of all
stakeholders, including shareholders, employees, and customers.
The specifics of the takeover code can vary by jurisdiction, but some
common features include:
Mandatory offer rules: The takeove r code typically requires a
potential acquirer to make a public offer to acquire all or a majority of
the shares of the target company once it has acquired a certain
percentage of the company's shares. The mandatory offer rules are munotes.in
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104 Corporate Valuation and
Mergers & Acquisitions designed to protect mino rity shareholders and to ensure that all
shareholders have an equal opportunity to sell their shares at a fair
price.
Disclosure requirements: The takeover code typically requires
acquirers to make certain disclosures about their intentions and plans
for t he target company. This can include information about the
acquirer's financing, the terms of the proposed offer, and any plans to
restructure or reorganize the target company.
Fair treatment of shareholders: The takeover code typically requires
acquirers t o treat all shareholders fairly and equitably, and to ensure
that they receive a fair price for their shares. This can include
provisions for protecting minority shareholders, such as requiring a
higher offer price for their shares or ensuring that they ar e not
excluded from the offer.
Timelines and procedures: The takeover code typically sets out
specific timelines and procedures for the offer process, including
deadlines for submitting offers and responding to counteroffers, as
well as rules for the condu ct of negotiations and the announcement of
the offer.
8.7 M&A PROCESS
The M&A (mergers and acquisitions) process is a complex series of steps
that companies undertake when they want to merge with or acquire
another company. The process typically involves s everal stages, including
the following:
Strategy and planning: The first stage of the M&A process involves
identifying the strategic reasons for pursuing the merger or acquisition.
The companies will need to identify their objectives, including the
types o f companies they are interested in, the industries they are
targeting, and the expected outcomes.
Target identification and screening: In this stage, the acquirer will
identify potential target companies that fit their criteria. They will
conduct a prelimi nary screening to evaluate whether the target
companies meet their strategic goals.
Due diligence: Due diligence involves conducting a thorough
investigation of the target company to determine its value and potential
risks. This process includes reviewing financial statements, contracts,
intellectual property, and legal documents, as well as conducting
interviews with key stakeholders.
Valuation: Once the due diligence process is complete, the acquirer
will determine the fair market value of the target comp any. This will
involve analyzing financial statements, market trends, and other
factors to arrive at a valuation. munotes.in
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105 Negotiation and structuring: In this stage, the acquirer will negotiate
the terms of the merger or acquisition, including the purchase price,
payment structure, and other details. They will work with lawyers and
other advisors to structure the deal in a way that meets their strategic
objectives.
Financing: If the acquirer needs to raise funds to finance the deal,
they will secure financing from banks, private equity firms, or other
sources.
Regulatory approval: Depending on the jurisdiction, the merger or
acquisition may require regulatory approval from government
agencies. The acquirer will need to comply with any regulatory
requirements before the deal can be completed.
Integration: After the deal is completed, the acquirer will need to
integrate the target company into their operations. This process
includes merging IT systems, consolidating employees and operations,
and ensuring that the targe t company is fully aligned with the
acquirer's strategic goals.
The M&A process can be complex and time -consuming, but it can be an
effective way for companies to achieve strategic objectives and gain a
competitive advantage in their industry. Companies th at are considering a
merger or acquisition should seek advice from legal, financial, and
strategic advisors to ensure that they are able to navigate the process
successfully.
8.8 SUMMARY
Mergers and acquisitions (M&A) refer to the processes of combining
or acquiring businesses or assets from other companies. M&A can be
an important strategic tool for companies looking to expand their
operations, increase their market share, or diversify their portfolio.
Corporate restructuring refers to the process of reorg anizing a
company's assets and operations in order to improve its financial or
operational performance.
The takeover code is typically enforced by a regulatory body or
securities exchange, and it is designed to ensure that any change of
control of a public company is conducted in a fair and transparent
manner that protects the interests of all stakeholders, including
shareholders, employees, and customers.
Once the due diligence process is complete, the acquirer will
determine the fair market value of the t arget company.
A joint venture is a partnership between two or more companies to
pursue a specific project or goal. munotes.in
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106 Corporate Valuation and
Mergers & Acquisitions In a management buyout, the existing management team of a company
purchases the company from its current owners.
Each strategy has its own b enefits and risks, and companies should
carefully evaluate their options before choosing a strategy that best fits
their needs.
8.9 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. Explain the concept of Merger and Acquisition.
2. Write note on benefits of Merger & Acquisitions .
3. What is Rebranding or Marketing restructuring ?
4. Explain Regulatory considerations in Mergers and acquisitions .
5. Write note on Strategic Alliances.
Long Answers:
1. Discuss the types of restructuring.
2. Discuss the features of Takeover code .
3. Explain the steps involved in M&A.
B. Multiple Choice Questions:
1. ….. type of restructuring typically involves changing a company's
capital structure, such as through debt restructuring, refinancing, or
issuing new equi ty.
a) Financial restructuring
b) Operational restructuring
c) Strategic restructuring
d) Organizational restructuring
2. Net present value method is one of the modern methods for evaluating
the project proposals.
a) Financial restructuring
b) Operational restructuring
c) Strategic restructuring Profitability index
d) Rebranding or Marketing restructuring
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107 3. The ……… is a set of regulations that govern the process of acquiring
control of publicly traded companies.
a) Antitrust and competition laws
b) Securities laws
c) Takeover code
d) None of these
Answers: 1 -a, 2-d , 3- c,
C) Fill in the blanks:
1. …………… type of restructuring involves changes to a company's
brand identity or marketing strategy.
2. …………………is a type of corporate restructuring in which one
company acquires another by purchas ing a controlling interest in the
target company.
3. In a…………, the companies typically have equal ownership in the new
entity, and the shareholders of both companies receive stock in the new
entity.
Answers:
1. Marketing restructuring
2. takeover
3. merg er
8.10 SUGGESTED READINGS
1. Financial Management by Prasanna Chandra.
2. Financial Management by I.M. Pandey.
3. Financial Management by Khan & Jain.
4. Organization & Management by R.D. Aggarwal.
5. Financial Management and Policy by R.M. Srivastava
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108 9
MERGERS & ACQUISITIONS
VALUATION AND MODELLING
Unit Structure
9.0 Objectives
9.1 Introduction
9.2 Steps involved in M&A valuation and modelling
9.3 Inputs to valuation model
9.4 Input from Due Diligence
9.5 Calculation of the value of the company
9.6 Summary
9.7 Unit End Questions
9.8 Sugg ested Readings
9.0 OBJECTIVES
The main purpose of this chapter is –
To discuss steps involved in M&A valuation and modelling
To understand Inputs to valuation model
To explain Input from Due Diligence
To describe calculation of the value of the company
9.1 INTRODUCTION
Mergers and acquisitions (M&A) valuation and modeling are the
processes of assessing the financial and economic value of a company that
is being considered for acquisition or merger. Valuation and modeling
involve various techniques and metho ds to analyze a company's financial
performance, growth potential, and market position. The goal is to
determine the appropriate purchase price for the target company and
assess the potential financial impact of the acquisition or merger on the
acquirer's business.
9.2 STEPS INVOLVED IN M&A VALUATION AND
MODELLING
The following are some of the key steps involved in M&A valuation and
modeling:
1. Financial statement analysis: This involves analyzing the target
company's financial statements, including the balan ce sheet, income munotes.in
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109 statement, and cash flow statement, to evaluate its financial
performance and growth potential.
2. Comparable company analysis: This involves comparing the target
company's financial performance and valuation metrics with those of
similar com panies in the same industry.
3. Discounted cash flow analysis: This involves projecting the target
company's future cash flows and discounting them to present value to
determine the company's intrinsic value.
4. Market analysis: This involves analyzing the marke t and competitive
landscape in which the target company operates to assess its market
position and growth potential.
5. Merger modeling: This involves creating financial models to estimate
the potential impact of the acquisition or merger on the acquirer's
financial statements, including income statement, balance sheet, and
cash flow statement.
6. Due diligence: This involves conducting a comprehensive review of
the target company's operations, financials, legal, and other aspects to
identify potential risks and opportunities associated with the
acquisition or merger.
9.3 INPUTS TO VALUATION MODEL
Valuation models are used to estimate the value of a company or an asset.
Inputs to the valuation model are the assumptions and data used to
calculate the value of the c ompany or asset. The following are some of the
key inputs to valuation models:
1. Financial statements: The financial statements of the company are
the primary source of data for valuation models. The balance sheet,
income statement, and cash flow statement p rovide information about
the company's financial performance, assets, liabilities, and cash
flows.
2. Growth rate: The projected growth rate of the company is an
important input to valuation models. This rate is used to estimate the
future earnings and cash f lows of the company.
3. Discount rate: The discount rate is used to discount the future cash
flows of the company to their present value. This rate takes into
account the risk associated with the company and the time value of
money.
4. Cost of capital: The cost of capital is the cost of financing the
company's operations, including the cost of debt and equity. This cost
is used in valuation models to calculate the company's weighted
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110 Corporate Valuation and
Mergers & Acquisitions 5. Multiples: Multiples are ratios used to compare t he company's
financial performance with that of similar companies in the same
industry. These multiples can be used to estimate the value of the
company based on its earnings, revenue, or other financial metrics.
6. Market data: Market data, such as stock pri ces and interest rates, can
also be used as inputs to valuation models. These data points can help
to estimate the market value of the company and the cost of capital.
7. Assumptions: Assumptions, such as the length of the forecast period
and the terminal val ue, are important inputs to valuation models. These
assumptions can have a significant impact on the calculated value of
the company.
Valuation models require accurate and reliable inputs to produce
meaningful results. The inputs should be based on the bes t available data
and information, and should be adjusted for the specific circumstances of
the company being valued.
9.4 INPUT FROM DUE DILIGENCE
Due diligence is a comprehensive review of the target company's
operations, financials, legal, and other aspec ts to identify potential risks
and opportunities associated with the acquisition or merger. The findings
from the due diligence process can provide important inputs to the M&A
valuation and modeling process. The following are some of the inputs that
may be obtained from due diligence:
1. Financial data: Due diligence can provide access to the target
company's financial data, including historical financial statements,
budgets, forecasts, and other financial metrics. This data can be used to
validate assumptions made in the valuation and modeling process.
2. Business and market data: Due diligence can also provide valuable
insights into the target company's operations, markets, customers, and
competitors. This information can be used to adjust growth
assumptions and risk factors used in the valuation and modeling
process.
3. Legal and regulatory data: Due diligence can also identify any legal
or regulatory issues that could impact the value of the target company.
For example, pending litigation or regulatory investigati ons could
impact the company's financials and growth prospects.
4. Human resources data: Due diligence can also provide insights into
the target company's human resources, including key employees,
organizational structure, and employee contracts. This informa tion can
be used to assess the impact of the acquisition on the acquirer's
workforce and human capital.
5. Intellectual property data: Due diligence can identify any
intellectual property assets held by the target company, including munotes.in
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111 patents, trademarks, and c opyrights. This information can be used to
assess the value of the target company's intellectual property and the
potential for future revenue streams.
6. Operational data: Due diligence can also provide insights into the
target company's operations, includin g production processes, supply
chain, and inventory management. This information can be used to
assess the efficiency and effectiveness of the target company's
operations and identify potential cost savings opportunities.
The inputs obtained from due dilig ence can help to validate assumptions
and provide additional insights into the target company's financials,
operations, and market position. This information can be used to refine the
valuation and modeling process and ensure that the acquisition or merger
is based on accurate and reliable data.
9.5 CALCULATION OF THE VALUE OF THE
COMPANY
There are several methods used to calculate the value of a company,
including:
Discounted Cash Flow (DCF) analysis : DCF analysis is a method used
to estimate the value of an investment based on its expected future cash
flows. The future cash flows are estimated, and then discounted back to
their present value using a discount rate. The sum of the present values of
the future cash flows is the estimated value of the investme nt.
The advantages of using Discounted Cash Flow (DCF) analysis to value a
company are:
Focus on future cash flows: DCF analysis is a forward -looking
method that takes into account the expected future cash flows of a
company. By estimating future cash flow s and discounting them to
their present value, DCF analysis provides a comprehensive view of
the company's long -term prospects.
Flexibility: DCF analysis is flexible and can be used to value
companies in different industries and with different business mod els.
The method can accommodate a wide range of assumptions about
future growth, capital expenditures, and other key drivers of value.
Sensitivity analysis: DCF analysis allows for sensitivity analysis,
which means that the impact of changing key assumptio ns on the
company's value can be evaluated. This enables investors and analysts
to identify the most critical assumptions and assess the potential
impact of changes in those assumptions.
Comprehensive: DCF analysis takes into account all sources of cash
inflows and outflows, including capital expenditures and changes in
working capital. This results in a comprehensive valuation that munotes.in
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112 Corporate Valuation and
Mergers & Acquisitions provides a more accurate estimate of a company's value than methods
that rely on more simplistic metrics.
Consistency: DCF ana lysis provides a consistent method for valuing
companies over time, which makes it easier to compare the values of
different companies and monitor changes in their valuations over time.
Comparable company analysis (CCA): CCA is a method used to
estimate th e value of a company by comparing it to similar publicly traded
companies in the same industry. Financial ratios and multiples are
calculated for the comparable companies, and then applied to the target
company to estimate its value.
The advantages of usin g Comparable Company Analysis (CCA) to value a
company are:
Objectivity: CCA is based on the market prices of similar companies
that are publicly traded. This makes the valuation more objective and
less prone to subjective opinions and biases.
Availability of data: Since CCA uses publicly available data on
comparable companies, the data is easily accessible and transparent.
This makes the valuation more reliable and easier to validate.
Easy to understand: CCA is a simple method that is easy to
understand an d communicate to others. This makes it a useful tool for
communicating the value of a company to stakeholders and investors.
Widely used: CCA is a widely used method for valuing companies,
which means that there is a large body of knowledge and expertise
available to support its use. This makes it a reliable and well -
established method for valuing companies.
Useful for companies without cash flows: CCA can be particularly
useful for companies that do not have a history of generating cash
flows, such as star tups or companies in emerging industries. In these
cases, the market prices of comparable companies can provide a basis
for estimating the value of the company.
Precedent transaction analysis (PTA): PTA is a method used to estimate
the value of a company b y analyzing the prices paid for similar companies
in previous mergers and acquisitions. The transaction prices are used as a
basis for estimating the value of the target company.
The advantages of using Precedent Transaction Analysis (PTA) to value a
compa ny are:
Objective: PTA is based on actual transaction prices paid for similar
companies in the past. This makes the valuation more objective and
less prone to subjective opinions and biases.
Focus on recent transactions: PTA focuses on recent transactions,
which provides a more current view of market conditions and munotes.in
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113 valuation multiples. This can be particularly useful in industries with
rapidly changing market conditions.
Access to detailed information: PTA often involves a thorough
analysis of past transact ions, including detailed information on the
terms of the deal, the structure of the transaction, and the strategic
rationale behind the deal. This can provide valuable insights into the
market and the value of similar companies.
Reliable: PTA is a reliable method for valuing companies that has
been widely used in the industry for many years. This means that there
is a large body of knowledge and expertise available to support its use.
Useful for illiquid markets: PTA can be particularly useful in illiquid
markets where there are few comparable companies and little public
information available. In these cases, past transaction prices can provide a
useful benchmark for estimating the value of the company.
Asset -based approach: The asset -based approach estimate s the value of a
company based on the value of its assets, both tangible and intangible.
This method is commonly used for companies with significant tangible
assets, such as real estate or equipment.
The advantages of using an asset -based approach to value a company are:
Objective: An asset -based approach is based on the actual value of the
assets owned by the company. This makes the valuation more
objective and less prone to subjective opinions and biases.
Useful for companies with valuable assets: An asse t-based approach
can be particularly useful for companies with valuable assets, such as
real estate or intellectual property. In these cases, the value of the
assets can be a significant contributor to the overall value of the
company.
Simple: An asset -based approach is a simple method that is easy to
understand and communicate to others. This makes it a useful tool for
communicating the value of a company to stakeholders and investors.
Applicable to distressed companies: An asset -based approach can be
useful for valuing distressed companies, as the value of the assets may
be more reliable than other valuation methods that rely on assumptions
about future cash flows.
Provides a floor value: An asset -based approach provides a floor
value for the company, as i t represents the minimum value that the
company would be worth in a liquidation scenario.
Earnings multiple approach: The earnings multiple approach estimates
the value of a company based on its earnings, using a multiple of the
company's earnings as a bas is for estimating its value. munotes.in
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114 Corporate Valuation and
Mergers & Acquisitions The advantages of using the earnings multiple approach to value a
company are:
Widely used: The earnings multiple approach is a widely used method
for valuing companies, particularly in industries with stable and
predictable ea rnings.
Easy to understand: The earnings multiple approach is a simple
method that is easy to understand and communicate to others. This
makes it a useful tool for communicating the value of a company to
stakeholders and investors.
Focus on earnings: The e arnings multiple approach focuses on the
company's earnings, which can be a good indicator of its future
potential. This can be particularly useful for growth -oriented
companies that may not have a long history of profitability.
Reflects market sentiment: The earnings multiple approach reflects
the market's sentiment about the company, as the multiple is often
based on the valuations of comparable companies in the same industry.
Provides a range of values: The earnings multiple approach provides
a range of values based on different multiples, which can be useful for
evaluating the sensitivity of the valuation to changes in the multiple.
Each of these methods has its own strengths and weaknesses, and the
choice of method will depend on the specific circumstan ces of the
company being valued. In practice, multiple methods may be used to
estimate the value of a company, and the results of each method may be
weighed and combined to arrive at a final estimate of the company's value.
9.6 SUMMARY
Inputs to the valuat ion model are the assumptions and data used to
calculate the value of the company or asset.
Valuation models require accurate and reliable inputs to produce
meaningful results.
The findings from the due diligence process can provide important
inputs to th e M&A valuation and modeling process.
The inputs should be based on the best available data and information,
and should be adjusted for the specific circumstances of the company
being valued.
DCF analysis is a method used to estimate the value of an inves tment
based on its expected future cash flows.
CCA is a method used to estimate the value of a company by
comparing it to similar publicly traded companies in the same
industry.
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Mergers & Acquisitions
Valuation and Modelling
115 9.7 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. Discuss the Steps involved in M&A valuation and modelling .
2. What is Discounted cash flow analysis?
3. Write note on Input from Due Diligence .
4. Explain the Comparable company analysis (CCA).
Long Answers:
1. Explain Inputs to valuation model.
2. Discuss the advantages of Precedent transaction analysis (PTA).
3. Explain the advantages of Discounted Cash Flow (DCF) analysis.
4. Analyse Earnings multiple approach.
B. Multiple Choice Questions:
1. The ………… estimates the value of a company based on its earnings,
using a multiple of the company's earnings as a basis for estimating its
value.
a) Precedent transaction analysis
b) asset -based approach
c) earnings multiple approach
d) None of these
2. ………… is a comprehensive review of the target company's
operations, financials, lega l
a) Profitability index
b) IRP
c) Due diligence
d) None of these
3. PTA stands for.
a) Prudent transaction analysis
b) Public transaction analysis
c) Precedent transaction analysis
d) Precedent transaction assessment
Answers: 1 -c, 2-c , 3- c,
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116 Corporate Valuation and
Mergers & Acquisitions C. Fill in the blanks:
1. …….. are ratios used to compare the company's financial performance
with that of similar companies in the same industry .
2. ………. involves creating financial models to estimate the potential
impact of the acquisition or merger on the acquirer's financial
statements, including income statement, balance sheet, and cash flow
statement.
3. Mergers and acquisitions (M&A) valuation and modeling are the
processes of assessing the financial and ………… value of a company
that is being considered for acquisition or merger.
Answe r:
1. Multiples
2. Merger modeling
3. economic
9.8 SUGGESTED READINGS
1. Financial Management by Prasanna Chandra.
2. Financial Management by I.M. Pandey.
3. Financial Management by Khan & Jain.
4. Organization & Management by R.D. Aggarwal.
5. Financi al Management and Policy by R.M. Srivastava
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117 10
DEAL STRUCTURING AND FINANCIAL
STRATEGIES
Unit Structure
10.0 Objectives
10.1 Introduction
10.2 Negotiations
10.3 Payments and legal considerations
10.4 Tax and accounting consideration
10.5 Financing of the deal
10.6 Summary
10.7 Unit End Questions
10.8 Suggested Readings
10.0 OBJECTIVES
The main purpose of this chapter is –
To discuss Negotiations
To understand Payments and legal considerations
To describe Tax and accounting consideration
To explain Financing of the deal
10.1 INTRODUCTION
Deal structuring and financial strategies refer to the methods and
techniques used by companies and investors to structure and finance
business transactions. These strategies are essential for companies to
optimize their capital structure, manage risks, and increase their
profitability.
Deal structuring involv es the arrangement of the terms and conditions of a
business transaction, such as mergers and acquisitions, joint ventures, and
partnerships. The goal of deal structuring is to create a favorable
agreement for all parties involved, considering factors such as legal and
tax implications, financing arrangements, and governance structures.
Financial strategies, on the other hand, are used by companies to manage
their financial resources effectively. These strategies include methods for
raising capital, managin g cash flow, and reducing financial risks. Financial munotes.in
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118 Corporate Valuation and
Mergers & Acquisitions strategies are essential for companies to maintain financial stability and
achieve long -term growth.
10.2 NEGOTIATIONS
Negotiations play a crucial role in deal structuring and financing
strategies. Effec tive negotiations can lead to favorable terms and
conditions for all parties involved, while poor negotiations can result in
unfavorable deals and potential conflicts.
Here are some key factors to consider when negotiating deals:
Preparation: Before enteri ng into negotiations, it is important to
conduct thorough research and analysis to understand the deal's
potential risks and benefits. This preparation will help you identify
your goals and objectives and create a strategy for achieving them.
Communication : Effective communication is essential in
negotiations. It is important to clearly articulate your position, listen to
the other party's perspective, and be willing to compromise to reach a
mutually beneficial agreement.
Creativity: Negotiations often requ ire creative thinking to find
solutions that meet both parties' needs. Be open -minded and willing to
explore new ideas and possibilities.
Flexibility: Negotiations are rarely straightforward, and unexpected
issues may arise. It is important to remain flexi ble and adaptable to
changing circumstances to reach a successful outcome.
Legal considerations: It is important to consider the legal
implications of any deal and seek advice from legal experts when
necessary to ensure that the terms and conditions are le gally binding
and enforceable.
In financing strategies, negotiations are also crucial to secure the best
terms for funding. Here are some key factors to consider when negotiating
financing deals:
Funding sources: Identify potential funding sources, such as banks,
private equity firms, and venture capitalists, and research their terms
and conditions to negotiate favorable financing deals.
Interest rates and repayment terms: Negotiate interest rates and
repayment terms that are favorable to your business and consider the
potential impact on your cash flow.
Collateral: Consider offering collateral to secure financing and
negotiate the terms and conditions of the collateral.
Guarantees: Negotiate guarantees, such as personal guarantees or
third -party guarantees, to provide lenders with additional security and
potentially reduce the interest rate or other financing costs. munotes.in
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Deal Structuring and Financial Strategies
119 Overall, effective negotiations are essential for successful deal structuring
and financing strategies. By considering these key factors and ado pting a
strategic approach to negotiations, companies can secure favorable terms
and conditions and achieve their business objectives.
10.3 PAYMENTS AND LEGAL CONSIDERATIONS
Payments and legal considerations are critical components of deal
structuring and financing strategies. The terms and conditions of payments
and legal requirements can significantly impact the success of a deal and
the long -term financial performance of a company.
Here are some key factors to consider when structuring payments and
addre ssing legal considerations:
Payment structure: The payment structure should be carefully
designed to ensure that both parties' interests are protected. For
example, in a merger or acquisition, the payment structure may
involve a combination of cash, stock, and debt financing.
Payment timing: The timing of payments should be aligned with the
objectives of the deal and the cash flow needs of both parties. For
example, the payment of the purchase price in a merger or acquisition
may be structured over several years.
Legal documentation: Legal documentation should be carefully
drafted to ensure that the terms and conditions of the deal are legally
binding and enforceable. It is important to seek advice from legal
experts to ensure compliance with applicable laws and regulations.
Due diligence: Due diligence should be conducted to identify
potential legal and regulatory risks associated with the deal. This
process involves reviewing financial and legal records, conducting
interviews, and assessing potential liabil ities.
Tax considerations: The tax implications of the deal should be
carefully considered to minimize tax liabilities and ensure compliance
with tax laws and regulations. It is important to seek advice from tax
experts to ensure compliance with applicable tax laws and regulations.
Intellectual property: Intellectual property rights should be carefully
reviewed and addressed to ensure that all necessary licenses and
agreements are in place to protect intellectual property assets.
Compliance with regulations : The deal should be structured in
compliance with applicable regulations, such as antitrust and securities
laws. It is important to seek advice from legal and regulatory experts
to ensure compliance with applicable regulations.
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120 Corporate Valuation and
Mergers & Acquisitions 10.4 TAX AND ACCOUNTING C ONSIDERATION
Tax and accounting considerations are important factors to consider in
deal structuring and financing strategies. Proper planning and management
of tax and accounting issues can help companies optimize their financial
resources, minimize tax l iabilities, and maximize financial benefits. Here
are some key considerations:
Tax implications: Deal structuring and financing strategies can have
significant tax implications for both parties involved. It is important to
consider the tax implications of the deal and develop a tax strategy to
minimize tax liabilities and maximize tax benefits.
Tax compliance: It is important to ensure that the deal is structured in
compliance with applicable tax laws and regulations. Failure to
comply with tax laws can res ult in penalties and legal consequences.
Accounting treatment: The accounting treatment of the deal can
impact the financial statements of both parties involved. It is important
to understand the accounting treatment of the deal and its impact on
financial statements.
Due diligence: Due diligence should be conducted to identify any
potential tax and accounting risks associated with the deal. This
process involves reviewing financial and accounting records,
conducting interviews, and assessing potential liab ilities.
Transfer pricing: Transfer pricing is an important tax consideration
in international deals. It involves determining the pricing of goods or
services transferred between related entities in different tax
jurisdictions to ensure compliance with app licable tax laws and
regulations.
Valuation: The valuation of assets and liabilities is an important
accounting consideration in deal structuring. It is important to ensure
that assets and liabilities are accurately valued to avoid any potential
disputes o r legal consequences.
Financial reporting: Proper financial reporting is essential in deal
structuring and financing strategies. It is important to ensure that
financial statements are accurate, transparent, and comply with
applicable accounting standards and regulations.
10.5 FINANCING OF THE DEAL
Financing is a critical component of deal structuring, as it provides the
necessary capital to execute the deal. The financing strategy should be
carefully designed to ensure that the deal is properly funded and that the
financial risks are appropriately allocated between the parties involved.
Here are some key considerations in financing a deal: munotes.in
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Deal Structuring and Financial Strategies
121 Funding sources: The sources of funding for the deal should be
carefully considered. This may include equity financing, debt
financing, or a combination of both. It is important to determine the
optimal funding mix to minimize financial risks and optimize returns.
Valuation: The valuation of the target company or assets is an
important factor in determining the financing s trategy. It is important
to ensure that the valuation is accurate and reflects the true value of the
company or assets.
Debt financing: Debt financing can be used to fund a deal, but it also
involves financial risks. The terms and conditions of the debt fi nancing
should be carefully negotiated to ensure that they are favorable to the
parties involved.
Equity financing: Equity financing can be used to fund a deal and
may provide greater flexibility than debt financing. However, equity
financing involves the issuance of ownership shares in the company,
which can dilute the ownership of existing shareholders.
Capital structure: The capital structure of the company after the deal
should be carefully considered. This includes the level of debt, equity,
and other financing instruments.
Financial covenants: Financial covenants may be included in debt
financing agreements to ensure that the borrower meets certain
financial requirements. It is important to carefully negotiate the
financial covenants to ensure that the y are reasonable and achievable.
Due diligence: Due diligence should be conducted to identify
potential financial risks associated with the deal. This process involves
reviewing financial records, conducting interviews, and assessing
potential liabilities.
10.6 SUMMARY
Deal structuring and financial strategies refer to the methods and
techniques used by companies and investors to structure and finance
business transactions.
Equity financing can be used to fund a deal and may provide greater
flexibility tha n debt financing.
The financing strategy should be carefully designed to ensure that the
deal is properly funded and that the financial risks are appropriately
allocated between the parties involved.
Failure to comply with tax laws can result in penalties and legal
consequences.
The deal should be structured in compliance with applicable
regulations, such as antitrust and securities laws.
munotes.in
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122 Corporate Valuation and
Mergers & Acquisitions The terms and conditions of payments and legal requirements can
significantly impact the success of a deal and the lon g-term financial
performance of a company.
10.7 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. Discuss Tax and accounting consideration .
2. Write note on Financing of the deal .
3. Explain factors to consider when negotiating deals .
4. What do you mean by negotiation?
5. Explain Deal structuring and financial strategies.
Long Answers:
1. Discuss the factors to consider when structuring payments and
addressing legal considerations .
2. Analyse the factors to consider when negotiating financing deals.
B. Multiple Choice Questions:
1. Effective ………. is essential in negotiations.
a) communication
b) contact
c) counselling
d) None of these
2. ……….. is an important tax consideration in international deals.
a) Profitability index
b) Transfer pricing
c) Net Present Value
d) None of these
3. …….. can be used to fund a deal and may provide greater flexibility
than debt financing .
a) WACC
b) Debt financing
c) Equity financing
d) DCF
Answers: 1 -a, 2-b, 3- c,
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Deal Structuring and Financial Strategies
123 C. Fill in the blanks:
1. Deal structuring and ……….. refer to the methods and techn iques used
by companies and investors to structure and finance business
transactions .
2. …….. play a crucial role in deal structuring and financing strategies.
3. ………………. technique helps in achieving the objective of
minimisation of shareholders wealth.
Answer:
1. financial strategies
2. Negotiations
3. Net present value
10.8 SUGGESTED READINGS
1. Financial Management by Prasanna Chandra.
2. Financial Management by I.M. Pandey.
3. Financial Management by Khan & Jain.
4. Organization & Management by R.D. A ggarwal.
5. Financial Management and Policy by R.M. Srivastava
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124 11
ALTERNATE BUSINESS
RESTRUCTURING STRATEGIES
Unit Structure
11.0 Objectives
11.1 Introduction
11.2 Joint ventures
11.3 Strategic alliances
11.4 Demergers or Spin -offs
11.5 Split off
11.6 Divestitures
11.7 Equity carves out
11.8 Summary
11.9 Unit En d Questions
11.10 Suggested Readings
11.0 OBJECTIVES
The main purpose of this chapter is –
To understand the concept of Joint ventures in alternative business
strategies
To discuss Strategic alliances
To explain demergers or Spin -offs
To understand Split o ff
To describe divestitures
To explain equity carves out
11.1 INTRODUCTION
Restructuring is a decision made by a firm to radically change its
operational and financial characteristics, typically in response to financial
challenges. Restructuring is a sort of corporate action that involves
significantly changing a company's debt, operations, or structure in an
effort to reduce financial harm and enhance the enterprise.
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Alternate Business Restructuring Strategies
125 A corporation may frequently consolidate its debt and change the terms of
its debt in a d ebt restructuring to find a solution to pay off bondholders
when it is having trouble making the payments on its debt. A business can
also alter the way its operations are run or how it is organised by reducing
expenses like wages or reducing its size thro ugh the sale of assets.
11.2 JOINT VENTURES
In addition to mergers and acquisitions, there are several other alternative
business restructuring strategies that companies can use to achieve their
strategic objectives. Some of these strategies include:
Joint ventures: A joint venture is a partnership between two or more
companies to pursue a specific project or goal. Joint ventures can be used
to share risks and costs associated with a project while leveraging each
partner's expertise and resources.
Advantage s of Joint Ventures:
Shared resources: Joint ventures allow organizations to share
resources, expertise, and costs, which can reduce the financial burden
and risks associated with starting a new project or entering a new
market.
Access to new markets: Joint ventures can provide access to new
markets, customers, and distribution channels that would be difficult to
obtain independently. This can increase sales and profits, and can also
help to diversify a company's revenue streams.
Increased competitiveness: Joint ventures can increase the
competitiveness of the organizations involved by combining their
strengths and capabilities. This can result in more efficient operations,
improved product quality, and better customer service.
Increased innovation: Joint ve ntures can promote innovation by
combining the resources and expertise of multiple organizations. This
can lead to the development of new products, technologies, and
processes that would not have been possible for each organization to
develop on its own.
Disadvantages of Joint Ventures:
Potential conflicts: Joint ventures can create potential conflicts
between the partner organizations, particularly if they have different
cultures, goals, or operating styles. This can lead to communication
breakdowns, confl icts, and delays in decision -making.
Loss of control: Joint ventures involve sharing control and decision -
making power with another organization, which can result in a loss of
control over certain aspects of the business. This can be particularly
challengi ng if the partner organization has different values, goals, or
priorities. munotes.in
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126 Corporate Valuation and
Mergers & Acquisitions Intellectual property concerns: Joint ventures can create intellectual
property concerns, particularly if the organizations involved have
different approaches to protecting their in tellectual property. This can
lead to conflicts over ownership of intellectual property or a loss of
proprietary information.
Dependence on partners: Joint ventures can result in a dependence
on partner organizations for resources, expertise, or market acc ess.
This can be risky if the partner organization experiences financial
difficulties, or if the partnership ends for any reason.
11.3 STRATEGIC ALLIANCES
Strategic alliances involve two or more companies collaborating to
achieve a specific goal or objecti ve. Unlike joint ventures, strategic
alliances are not typically focused on a specific project or goal, but rather
a broader strategic partnership between companies.
Advantages of Strategic Alliances:
Increased market reach: Strategic alliances allow compa nies to
expand their market reach by partnering with other organizations that
have complementary strengths, expertise, and resources. This can
result in increased sales, increased brand awareness, and greater
market penetration.
Increased innovation: Strat egic alliances can promote innovation by
combining the resources and expertise of multiple organizations. This
can lead to the development of new products, technologies, and
processes that would not have been possible for each organization to
develop on it s own.
Risk sharing: Strategic alliances allow organizations to share risks
and costs associated with the development and marketing of new
products and services. This can help reduce the financial burden on
each organization, and can also provide access to new markets and
resources that might be difficult to obtain independently.
Increased competitiveness: Strategic alliances can increase the
competitiveness of the organizations involved by leveraging each
other's strengths and capabilities. This can lead t o more efficient
operations, improved product quality, and better customer service.
Disadvantages of Strategic Alliances:
Coordination challenges: Strategic alliances can be difficult to
coordinate and manage, particularly if the organizations involved hav e
different cultures, goals, and operating styles. This can lead to
communication breakdowns, conflicts, and delays in decision -making.
Loss of control: Strategic alliances involve sharing resources and
expertise with other organizations, which can result in a loss of control munotes.in
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Alternate Business Restructuring Strategies
127 over certain aspects of the business. This can be particularly
challenging if the partner organization has different values, goals, or
priorities.
Intellectual property concerns: Strategic alliances can create
intellectual property con cerns, particularly if the organizations
involved have different approaches to protecting their intellectual
property. This can lead to conflicts over ownership of intellectual
property or a loss of proprietary information.
Dependence on partners: Strategi c alliances can result in a
dependence on partner organizations for resources, expertise, or
market access. This can be risky if the partner organization
experiences financial difficulties, or if the partnership ends for any
reason.
11.4 DEMERGERS OR SPIN -OFFS
A spin -off is a type of divestiture in which a company creates a new,
independent company out of a division or subsidiary. This strategy can be
used to focus on core competencies, unlock value, or simplify the
organizational structure.
Advantages:
Simplified operations: A spin -off can simplify a company's operations
by allowing it to focus on its core business.
Increased shareholder value: The distribution of shares of the new
company can increase shareholder value, as investors can choose to
invest in the new company or the parent company.
Increased transparency: A spin -off provides increased transparency
and disclosure for the newly created company, which can improve
investor sentiment and increase the company's valuation.
Improved management focus: The management of the new company
can focus on the specific business objectives of the spun -off division
without the distractions of the parent company.
Disadvantages :
Complexity: A spin -off can be complex and involves significant
transaction costs, includi ng legal and accounting fees.
Reduced economies of scale: The spun -off division may lose
economies of scale and cost efficiencies that it enjoyed as part of the
larger parent company.
Loss of synergies: The parent company may lose synergies that existed
between the spun -off division and other parts of the company. munotes.in
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128 Corporate Valuation and
Mergers & Acquisitions Reduced diversification: The parent company may become less
diversified as a result of the spin -off.
11.5 SPLIT OFF
Split off is a type of corporate restructuring in which a company separates
a subsidiary or business unit from its operations to become a separate
independent entity. This process is usually done to create a new company
with its own assets, liabilities, and management team.
In a split -off, the parent company distributes shares of the new company to
its existing shareholders in exchange for the shares of the parent company
they hold. This allows shareholders to own shares in both the parent
company and the newly created subsidiary.
Split -offs are typically used when a company wants to f ocus on its core
business operations and divest non -core assets. By creating a separate
entity, the parent company can simplify its operations and allocate
resources more efficiently.
Split -offs are also used to raise capital by selling shares of the newly
created subsidiary to the public. This can provide a source of funds for the
parent company to invest in its core business or pay down debt.
Advantages:
Focus on core operations: A split off allows a company to divest
non-core businesses and focus on its core operations, which can
improve efficiency and profitability.
Increased shareholder value: A split off can create value for
shareholders by providing them with ownership of both the parent
company and the newly created subsidiary.
Simplified operations: By creating a separate entity, a split off can
simplify the operations of the parent company and make it easier to
allocate resources.
Access to capital: A split off can provide the newly created subsidiary
with access to capital by selling shares to the public.
Greater transparency: A split off can increase transparency by
separating the financial statements of the parent company and the
newly created subsidiary.
Disadvantages:
Costly: Split offs can be expensive due to legal, accounting, and
advisory fee s associated with the separation.
Loss of diversification: A split off can reduce diversification if the
parent company divests a business that was providing stability to the
overall company. munotes.in
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Alternate Business Restructuring Strategies
129 Disruption of operations: A split off can disrupt operations as
employees, systems, and processes are transitioned to the newly
created subsidiary.
Market uncertainty: The market may view a split off as a sign of
weakness or lack of strategic direction, which can lead to a decrease in
the value of the parent company's stock.
Risks associated with a new entity: The newly created subsidiary
may face risks associated with being a new entity, such as lack of
brand recognition, limited resources, and difficulty attracting
customers.
11.6 DIVESTITURES
Divestitures involve sel ling off a portion of a company's assets or business
units. This strategy can be used to raise capital, focus on core
competencies, or exit a particular market or industry.
Advantages of Divestitures:
Increased focus: Divesting a business unit can help a c ompany to
focus on its core business, thereby increasing efficiency and
profitability. By shedding non -core assets, the company can allocate
more resources to the remaining business units and invest in growth
opportunities.
Increased profitability: Divesti ng an underperforming or non -core
business unit can improve the overall profitability of a company. The
company can sell the business unit and use the proceeds to pay down
debt, invest in more profitable areas, or return value to shareholders
through divid ends or share buybacks.
Improved strategic fit: Divestitures can help a company to align its
strategy with its core competencies. By selling off non -core assets, the
company can focus on its strengths and pursue growth opportunities in
areas where it has a competitive advantage.
Reduced risk: Divestitures can reduce a company's exposure to risk by
shedding assets or business units that are not performing well or that
are no longer aligned with the company's strategic goals.
Disadvantages of Divestitures:
Loss of revenue: Divesting a business unit can result in a loss of
revenue, which can impact the company's financial performance in the
short term. This can be especially problematic if the divested unit was
a significant contributor to the company's overall revenue.
Cost of divestiture: Divesting a business unit can be a time -
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130 Corporate Valuation and
Mergers & Acquisitions as well as costs associated with restructuring and downsizing the
company.
Employee morale: Divestitures can have a negative impact on
employee morale, particularly if the employees of the divested
business unit are not offered positions within the remaining company.
This can result in decreased productivity, increased turnover, and
lower employee satisfaction.
Strategi c misalignment: Divestitures can also lead to a misalignment
between the company's strategic goals and its operations, particularly
if the divested business unit was closely tied to the company's core
business. This can result in missed opportunities or th e need to acquire
new assets or business units to replace the divested unit.
11.7 EQUITY CARVES OUT
An equity carve -out is a type of corporate restructuring strategy in which a
company creates a new, independent company out of a division or
subsidiary by s elling a minority stake (usually up to 20% to 25%) to
outside investors, while retaining majority ownership of the newly created
company. The purpose of an equity carve -out is to unlock value for
shareholders by separating a high -growth, high -potential bus iness unit
from the parent company.
In an equity carve -out, the parent company will typically retain control of
the newly created company and may also provide management and
administrative services to the new entity. The new company, which is
usually liste d on a stock exchange, can raise capital through the sale of
shares to the public, and its stock price will reflect the value of the
subsidiary.
Equity carve -outs can be beneficial for both the parent company and the
newly created company. For the parent company, an equity carve -out can
unlock value, provide a source of capital, and allow the parent company to
focus on its core business. For the newly created company, an equity
carve -out can provide access to capital markets, increase visibility, and
enabl e the company to pursue growth opportunities independently.
Advantages:
Unlock value: An equity carve -out can unlock value for shareholders
by separating a high -growth, high -potential business unit from the
parent company.
Source of capital: The newly crea ted company can raise capital
through the sale of shares to the public, providing a source of capital
for both the parent company and the new entity.
Increased transparency: An equity carve -out provides increased
transparency and disclosure for the newly c reated company, which can
improve investor sentiment and increase the company's valuation. munotes.in
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131 Focus on core business: The parent company can focus on its core
business while the new entity focuses on the specific business
objectives of the carved -out division .
Disadvantages:
Complexity: An equity carve -out can be complex and involves
significant transaction costs, including legal and accounting fees.
Control issues: The parent company may face challenges in
maintaining control over the newly created company, p articularly if
there are outside investors involved.
Risk of failure: The newly created company may not be able to
achieve the same level of success as the parent company, which could
lead to a decline in the overall value of the company.
Potential conflic ts: There may be potential conflicts of interest
between the parent company and the newly created company,
particularly if they are operating in the same industry or market.
11.8 SUMMARY
A split off can be an effective way for a company to focus on core
operations, increase shareholder value, and access capital. However, it
requires careful planning and execution to ensure that the benefits
outweigh the costs and risks associated with the separation.
Joint ventures are often formed when companies want to c ombine their
strengths to pursue a business opportunity that would be difficult to
achieve alone. Joint ventures can be structured in a number of ways,
including as a separate legal entity, a contractual arrangement, or a
partnership.
In an equity carve -out, the parent company will typically retain control
of the newly created company and may also provide management and
administrative services to the new entity.
11.9 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. Discuss the advantages and dis advantages of Joint Venture .
2. What is Equity Carves out?
3. Explain Divestitures.
4. Highlight the concept of strategic alliances.
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132 Corporate Valuation and
Mergers & Acquisitions Long Answers:
1. Discuss the difference between Split offs and Spin offs.
2. Analyse the advantages and disadvantages of Equity Carves o ut.
3. Highlight the advantages and disadvantages of Demergers.
B. Multiple Choice Questions:
1. ……………. involves making changes to the organizational structure,
processes, or product lines to improve operational efficiency and drive
growth.
a) Strategic restructurin g
b) Spin-off
c) Split -off
d) Divestitures
2. ……….. involve selling off a portion of a company's assets or business
units.
a) Spin-off
b) Split -off
c) Equity carve out
d) Divestitures
3. A joint venture is a partnership between two or more companies to
pursue a specific project or goal.
a) Spin-off
b) Split -off
c) joint venture
d) Divestitures
Answers: 1 -a, 2-d, 3- c,
C. Fill in the blanks:
1. ……….. can be used to share risks and costs associated with a project
while leveraging each partner's expertise and resources .
2. …….. involve selling off a p ortion of a company's assets or business
units.
3. A …….. is a type of divestiture in which a company creates a new,
independent company out of a division or subsidiary.
Answer:
1. Joint ventures
2. Divestitures
3. spin-off
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133 11.10 SUGGESTED READINGS
1. Fina ncial Management by Prasanna Chandra.
2. Financial Management by I.M. Pandey.
3. Financial Management by Khan & Jain.
4. Organization & Management by R.D. Aggarwal.
5. Financial Management and Policy by R.M. Srivastava
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