Mergers & acquisitionsFriendly and Hostile takeover Friendly Takeover ... Here the Target Company...

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MERGERS &

ACQUISITIONS Consolidation of Companies or Assets

ABSTRACT The area of corporate finances,

management and strategy dealing

with purchasing and/or joining

with other companies.

Sangapu Pranathi CA FINAL SFM

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Contents Mergers ................................................................................................................................................... 3

Distinguish between Acquisition/Takeover and Amalgamation .......................................................... 5

Types of Mergers .................................................................................................................................... 5

Types of Takeover Strategies ................................................................................................................. 7

Friendly and Hostile takeover ................................................................................................................ 7

Various Anti-Takeover Strategies (or) Defending against Takeover Bid .............................................. 9

Corporate Restructuring ...................................................................................................................... 10

Mode of Consideration ........................................................................................................................ 10

Computation of Minimum Exchange Ratio and Maximum Exchange Ratio ...................................... 11

Financial Evaluation of Merger Proposal............................................................................................. 11

Gains from Mergers or Synergy Effect ................................................................................................. 12

Valuation Techniques of Mergers and Acquisitions ........................................................................... 13

Discounted Cash Flow/Free Cash Flow Method.............................................................................. 13

Cost to Create Method ..................................................................................................................... 14

Capitalized Earnings Method ........................................................................................................... 14

Chop-Shop Method .......................................................................................................................... 14

Market based Valuation of Target Firm .......................................................................................... 14

If Target Firm is a Listed Company ............................................................................................... 15

If Target Firm is not a Listed Company ........................................................................................ 15

Asset based Valuation of Target Firm.............................................................................................. 15

Book Value .................................................................................................................................... 15

Net Adjusted Asset Value or Economic Book Value.................................................................... 15

Liquidation Value ......................................................................................................................... 15

Valuation of Intangible Assets of Target Firm ..................................................................................... 16

Economic Value Added ........................................................................................................................ 17

Demerger .............................................................................................................................................. 17

Financial Restructuring ........................................................................................................................ 18

Restructuring by bringing about changes in Corporate Controls ....................................................... 19

Leveraged Buy-Outs ......................................................................................................................... 19

Management Buy-Outs .................................................................................................................... 19

Shareholder Value Analysis ................................................................................................................. 20

Sustainable Growth Rate ..................................................................................................................... 21

Illustrations ........................................................................................................................................... 23

Example 1 ......................................................................................................................................... 23

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Example: 2 ........................................................................................................................................ 24

Example: 3 ........................................................................................................................................ 25

Example: 4 ........................................................................................................................................ 27

Example: 5 ........................................................................................................................................ 29

Example: 6 ........................................................................................................................................ 29

Example: 7 ........................................................................................................................................ 32

Example: 8 ........................................................................................................................................ 34

Example: 9 ........................................................................................................................................ 36

Example: 10 ...................................................................................................................................... 37

Example: 11 ...................................................................................................................................... 38

Example: 12 ...................................................................................................................................... 39

Example: 13 ...................................................................................................................................... 40

Example: 14 ...................................................................................................................................... 42

Example: 15 ...................................................................................................................................... 46

Example: 16 ...................................................................................................................................... 48

Example: 17 ...................................................................................................................................... 48

Example: 18 ...................................................................................................................................... 50

Example: 19 ...................................................................................................................................... 51

Example: 20 ...................................................................................................................................... 52

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Mergers 1. Mergers mean Unification of two entities into one. In India, in legal sense, Merger is known

as “Amalgamation”

2. Amalgamations and Absorptions are the basic forms of Merger.

3. If two or more Companies, combine together and forms a new company to take-over the

running business of existing companies is known as Amalgamation.

4. In this case, Existing firms will liquidate then Business and New Firms will continue with the

Assets and liabilities of the existing firms.

5. If one firm takes over the Assets and Liabilities of another firm, it is a case of Absorption.

6. In this case the acquiring firm will be continued as going concern and the business of Target

Company will be liquidated.

7. A Merger results in the legal dissolution of one of the companies, and a Consolidation

dissolves both the companies and creates a new company, into which previous entities are merged.

8. Acquisition involves one entity buying out another and absorbing the same.

9. An Acquisition is when both the acquiring companies are still left standing as separate

entities at the end of transaction.

10. It refers to purchase of ownership rights or any other assets by one company in another

company. The acquiring company and target company will be continued as going concerns

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Reasons for Mergers and Acquisitions:

1) Synergy Effect

The combined value of two entities is generally more than the sum of their individual values. This

additional value creation is called Synergy Effect.

2) Desire for Quick Growth

Organic Growth can happen only step-by-step, and takes a longer period of time. On the other hand,

inorganic growth, that is growth by acquisitions, helps a company to grow faster and quicker, the

reason being the shortening of ‘Time to Market’

3) Reduction in Business Risk through Diversification

Merger between two unrelated companies would lead to reduction in Business Risk. It will increase

the market value due to reduction in Discount Rate or Required Rate of Return.

Generally, greater the combination of statistically independent or negatively correlated income

streams of Merged Companies, there will be higher reduction in the Business Risk, in comparison to

Companies having income streams which are positively correlated to each other.

4) Taxation

Provisions of Set off and carry-forward of losses as per Income Tax Act can also be a reason for M&A,

since there will be a tax saving or reduction in tax liability of the Merged Firm. Tax Saving is one of

the main reasons for “Reverse Merger”

Also in case of acquisition, the losses of the Target Company will be allowed to be set off against the

profits of the Acquiring Company.

5) Other Reasons

a. Consolidation of Production Resources

b. Increased Market power and Market Share

c. Entry into new markets

d. Better access to funds and Cash Flow Management

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Distinguish between Acquisition/Takeover and Amalgamation Acquisition/Take over Amalgamation

SEBI is the primary governing law Companies Act 1956 is the governing law

It involves gaining control over the assets of the

company by holding controlling interest in the

Target Company

It involves direct control over the assets of the

target company by absorbing the company

Takeover does not liquidate the Target Company Selling Companies will be liquidated pursuant to

Amalgamation

Assets and Liabilities of the Target Company are

not transferred to the Acquiring Company

Assets and Liabilities of the Selling Companies are

transferred to the Acquiring Company

Court Approval for acquisition is not required, if

the transfer of business is to be accomplished

without allotting shares in the transferee company

to the shareholders of the transferor company

Scheme of Amalgamation or arrangement requires

High Court’s Order

Types of Mergers 1. Horizontal Merger

It is a Merger when the companies which have merged are in the same industry, i.e. producing

either same or competing products.

Advantages -

1. High Market Share for new consolidated Company

2. Moving closer to being a monopoly, economies of Scale

3. Optimum Size

4. Curbing off Competition

5. Usage of unutilized capacity.

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2. Vertical Merger

When two companies having “Buyer-Seller” relationship (or potential buyer-seller relationship)

come together.

Advantages –

1. Improved co-ordination of activities

2. lower inventory levels

3. higher market power of the combined entity

4. Lower costs and eliminating avoidable Sales Tax and /or Excise Duty.

3. Conglomerate Merger

It involves two companies that merge are in different fields altogether, i.e. unrelated type of

business operations.

The business activities of the Acquirer and the Target are not related to each other horizontally or

vertically.

There are no important common factors between the Acquirer and the Target Companies in

Production, Marketing, R&D and Technology.

Advantages –

1. Unification of Different kinds of businesses under one flagship Company

2. Utilization of financial Resource

3. Enlarged debt capacity and enlarged debt capacity and synergy of managerial functions.

4. Congeneric Merger

In these mergers, the Acquirer and the Target Companies are related through basic technologies,

production processes or markets. The Acquired Company represents an extension of product-line,

market participants or technologies of the Acquirer.

These Mergers represent an outward movement by the Acquirer from its current business scenario,

to other related business activities within the overarching industry structure.

5. Reverse Merger

Takeover of Big or Profits making Company by Small or Loss making Company.

Reverse Merger happens when, in order to avail benefit of carry forward of losses which are

available according to tax law only to the Company which had incurred them, the profit making

company (Target Company/Big Company) is merged with Companies having Accumulated Losses

(Acquirer or Small Company).

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It can also be described as acquisition of a public company by a private company so that the private

company can bypass the lengthy and complex process of going public.

Features –

(a) In a Reverse Merger, a smaller company gains control over larger one.

(b) The entire undertaking of the healthy and prosperous company is merged and vested in the

Sick Company which is non-viable and whose net worth has eroded.

(c) Reverse takeover is also applicable to the purchase of a Listed Company by an United

Company with control passing to the Shareholders and Management of the Unlisted Company. This

is known as a Back Door Listing.

(d) A Reverse Takeover may take place by way of a Pure Equity Acquisition, also called as Share

Swap.

Conditions to be satisfied –

(a) Assets of the Transferor Company are greater than the Transferee Company

(b) Equity Capital to be issued by the Transferee Comp any pursuant to the acquisition exceeds

its Original Issued Capital.

(c) There is a change in the Transferee Company, through the introduction of a minority holder

or group of holders.

Types of Takeover Strategies 1. Street Sweep – A technique where the Acquiring Company accumulates larger number of

shares in a Target Company before making an Open Offer. The Advantage is that the Target

Company is left with no option but to agree to the proposal of the Acquirer for Takeover.

2. Bear Hug – When the Acquirer Company threatens the Target Company to make an Open

Offer, the Board of Directors of the Target Company agrees to a settlement with the acquirer for

Change of Control.

3. Strategic Alliance – this involves Disarming the Acquirer by offering a Partnership rather

than Buyout. The Acquirer should assert control from within, and takeover the target company.

4. Brand Power – this refers to entering into an alliance with powerful brands to displace the

Target’s brands, and as a result, buyout the weakened company.

Friendly and Hostile takeover Friendly Takeover

The owners of both the firms agree to the terms of takeover strategy

One firm acquires the other firm and both the firm agreed to such takeover

Hostile Takeover

A takeover opposed by Target Company’s Board of Directors

Acquiring Company offers the Target Company’s Shareholders Cash in exchange for their Shares

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If the acquiring corporation obtains enough shares, it can approve a merger resolution or,

alternatively, simply operate the corporation as its subsidiary by replacing its directors and officers

with its own appointees and direct corporate affairs in this manner.

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Various Anti-Takeover Strategies (or) Defending against Takeover Bid Actions by managers to resist having their firm taken over by other companies

1. Crown Jewel Defence

An act by Board of Directors of Target Company sells off the most valuable Assets of the company to

make the company less attractive to the acquirer

2. Poison Pill

To dilute the Target Company Stock in the Company so much that bidder never manages to achieve

an important part of the company without the consensus of the board.

3. Poison Put

The company issue bonds which will encourage the holder of the bonds to cash in at higher prices which will result in Target Company being less attractive 4. Greenmail

It involves Repurchasing a block of shares by the Target Company which is held by a Single

shareholder or group of shareholders at a premium over the stock Price in return for an agreement.

In this agreement it is stated that the bidder will no longer be able to buy shares for a period more

than 5 Years.

5. White Knight

Here the Target Company approaches a Friendly Company which can acquire majority of shares of

Target Company. The main intention of White Knight is to ensure that the management of the

Target Company is not diluted.

6. White squire

It is a Variation of White Knight.

Instead of Acquiring Major Stake, here the acquiring company acquires a minor stake that is enough

to hinder the hostile bidder from acquiring majority stake

7. Golden Parachutes

An agreement between a company and an employee (usually upper executive) specifying that the employee will receive certain significant benefits if employment is terminated. This will discourage the bidders and hostile takeover can be avoided. 8. Pac-man Defence

The target company itself makes a counter bid for the Acquirer Company and let the Acquirer Company defence itself which will call off the proposal of takeover.

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Corporate Restructuring Corporate Restructuring and reorganization seeks to create new synergies and shift in corporate

strategies, to face the competitive environment and changed market conditions.

It Covers –

1. Expansion or Contraction of a Firm’s operations

2. Changes in Assets

3. Changes in Financial or Ownership structure

4. Changes in Financial or Ownership structure

It can be done internally or externally.

● Internally in the form of new Investments, Hiving off of non-core businesses,

divestment, demerger etc.

● Externally in the form of Mergers and Acquisitions, by forming Joint-Ventures,

having strategic alliances with other firms.

Mode of Consideration The acquiring company has to decide about the mode of consideration to be payable to target

company. The Purchase Consideration is discharged in Cash Mode or in the form of Shares.

1. Cash Mode

It leads to sale of shares by Members of Target Company and attracts Capital Gains Tax.

There is No dilution of control as far as the members of acquiring company are considered.

It will affect the liquidity position of acquiring company.

It is certain to receive fixed amount per share.

The members of Target Company will prefer the cash mode.

2. Share Exchange Mode

There is dilution of control

It is not a sale and does not attract Capital Gain Tax.

The members of the Target Company will be continued as the members of the Acquiring Company as

a Result, the Earnings per Share of Acquiring Company will be diluted in the future.

Appropriate Mode of Discharge of Compensation

Situation Compensation

Acquiring Firm’s Stock is overvalued relative to the Target Company’s Stock Stock

Taxability in the hands of Shareholders of Target Firm Cash

High Risks associated with the stock of Target Firm Cash

Basis of Share Exchange of Share Exchange Ratio –

It can be defined as Number of shares to be offered by the acquiring company to the members of

the Target Company.

For Example, 3:4 share exchange gains can be defined as acquiring company will issue “3” New

Shares for every “4” existing shares held in Target Company.

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Share Exchange Ratio based on –

1. NAV per Share – 𝑁𝐴𝑉 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑇𝑎𝑟𝑔𝑒𝑡 𝐶𝑜𝑚𝑝𝑎𝑛𝑦

𝑁𝐴𝑉 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝐴𝑐𝑞𝑢𝑖𝑟𝑖𝑛𝑔 𝐶𝑜𝑚𝑝𝑎𝑛𝑦

2. MPS – 𝑀𝑃𝑆 𝑜𝑓 𝑇𝑎𝑟𝑔𝑒𝑡 𝐶𝑜𝑚𝑝𝑎𝑛𝑦

𝑀𝑃𝑆 𝑜𝑓 𝐴𝑐𝑞𝑢𝑖𝑟𝑖𝑛𝑔 𝐶𝑜𝑚𝑝𝑎𝑛𝑦

3. EPS - 𝐸𝑃𝑆 𝑜𝑓 𝑇𝑎𝑟𝑔𝑒𝑡 𝐶𝑜𝑚𝑝𝑎𝑛𝑦

𝐸𝑃𝑆 𝑜𝑓 𝐴𝑐𝑞𝑢𝑖𝑟𝑖𝑛𝑔 𝐶𝑜𝑚𝑝𝑎𝑛𝑦

Computation of Minimum Exchange Ratio and Maximum Exchange Ratio

𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 =(𝑉𝑆 + 𝐺𝑆) × 𝑆𝐵

(𝑉𝐵 + 𝐺𝐵) × 𝑆𝑆

Where,

Vs = Value of Selling Company before Merger

VB = Value of Buying Company before Merger

Gs = Share of Selling Company in the Gain on Value due to Merger

GB = Share of Buying Company in the Gain on Value due to Merger

Ss = Shares outstanding in Selling Company before Merger

SB = Shares outstanding in Buying Company before Merger

Minimum Exchange Ratio = (𝑉𝑆+0)×𝑆𝐵

(𝑉𝐵+𝐺𝐵)×𝑆𝑆

Maximum Exchange Ratio = (𝑉𝑆+𝐺𝑆)×𝑆𝐵

(𝑉𝐵+0)×𝑆𝑆

Financial Evaluation of Merger Proposal Financial Evaluation of a Merger Proposal involves computing NPV of the Merger for each firm.

A + B = AB

Cash and Synergy in Value

VAB = VA +VB + Synergy – Cash

NPV of A = VAB - VA

NPV of B = Cash – VB

Maximum Amount that A can pay is VB + Synergy

Minimum Price that B wants is VB

True Cost of Acquisition to A = NPV to B

Stock and Synergy in Value

VAB = VA +VB + Synergy

PAB = VAB

NA+ r. NB

NPV to any firm = (Post merger price – premerger price)* no. of shares

NPV to A = (PAB - PA)* NA

NPV to B = (r.PAB – PB)*NB

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Cash Deal and Synergy in Earning

NPV of the merger to each firm-

PATAB = PATA + PATB + Synergy Assuming P/E ratio remaining the same

VAB= (P/E Ratio *PATAB) - cash

NPVA= VAB –VA

NPV B= Cash –VB

● Stock Deal and Synergy in Earnings

NPV of the merger to each firm- VAB= (P/E Ratio* PATAB) PAB = VAB

NA+ r. NB NPVA = (PAB – PA) NA

NPVB = (r. PAB – PB) * NB

NOTATION VA = Value of firm A VB = Value of firm B VAB = Value of a firm A + Value of a firm B Synergy = VAB - (VA + VB) PAB = Share price of A and B

Gains from Mergers or Synergy Effect Synergy may be defined as

VAB > VA + VB

Combined Values of Two Firms will be more than the individual values.

Synergy represents increase in performance of the Combined Firm, over and above what the two

Firms are already expected or required to accomplish as Independent Firms.

Reasons –

(a) Complimentary Activities - One Company having a good networking of Branches and Sales

Centres, and the other company having efficient production system. Thus, the merged company will

be more efficient than individual companies.

(b) Economies of Scale –

“Real” Economies of Scale arises reduction in factor input per unit of output

“Pecuniary” economies of scale arise paying lower prices for factor inputs for bulk transactions.

Thus, large scale production results in lower average cost of production and consequent Synergy

Effect.

Computation –

1. Combined Value = Value of Acquirer + Stand Alone Value of Target + Value of Synergy

2. Cost of Acquisition (or) Transaction Cost = Premium Price paid over Market Value plus Other

Costs of Integration.

3. Net Gain in Acquisition = Value of Synergy minus Transaction Cost.

Subsequent Value Creation –

1. Even if a merger is non-synergistic at the time of acquisition, operating improvements can

lead to value creation in due course.

2. Better post-merger integration could lead to higher returns and value creation by cutting

down costs, improving revenues and operating profit margins, cash flow position, etc.

Cost of Merger (or) True Cost of Acquisition (or) Premium (or) Good will (or) Transaction Cost

It is the excess consideration paid by Acquiring Company to take over the Current Market Value of

Target Company.

Consideration offered to Target Company – Current MV of Target Company

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Valuation Techniques of Mergers and Acquisitions

Discounted Cash Flow/Free Cash Flow Method Merger proposed is treated as Investment Decision. It can be evaluated by any of the Capital

Budgeting Techniques (NPV, IRR, PI etc.). But NPV is the most common Technique used for

evaluation of Merger Proposals. It takes into consideration the future earnings of the business.

The value of the business depends on projected future revenues and costs, expected Capital

Outflows, number of years of projection, Discounting Rate and Terminal Value of Business.

Procedure –

1. Compute Present Value of Cash Outflows (or) Cost of Acquisition

2. Compute Operating Cash Flows after Tax

Particulars Amount

Sales XXX

Less Cost XXX

Earnings Before Interest and Tax XXX

Less Interest XXX

Earnings Before Tax XXX

Less Tax XXX

Earnings after Tax XXX

Add Depreciation XXX

Cash Flow After Tax XXX

Less Increase in Capital Expenditure XXX

Increase In Working Capital XXX

Free Cash Flows after Tax XXX

3. Terminal Cash Flows

4. NPV is difference between PV of Cash Inflows (PV of Operating Cash Flows and PV of

Terminal Cash flows) and PV Cash Outflows.

5. Discounting factor being WACC of the Acquiring Company.

Assumptions involved

1. Terminal Value is Growing Perpetuity

Cash flows are assumed to grow at a constant rate after the forecast period. The acquirer will not

make any operating improvements or change the capital structure.

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 = 𝐶𝐹𝑡 × (1 + 𝑔)

(𝑘 − 𝑔)

Where, CFt is Cash flow in the last year, g is Constant Growth rate and k is Discount Rate

2. Terminal Value is a Stable Perpetuity

There is no growth in the Total Capital after the forecast period, i.e. either no capital expenditure or

Capital Expenditure exactly equals Depreciation Expense

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𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 =𝐶𝐹𝑡

𝑘

Where, CFt is Cash flow in the last year and k is discount rate

3. Terminal Value is a Multiple Book Value

Terminal Value is taken as an appropriate multiple of the book value. Forecast Book Value and

Market Value are interrelated in the same manner as current M/B Ratio

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 = 𝐵𝑉𝑡 × 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀 ⋰ 𝐵 𝑅𝑎𝑡𝑖𝑜

BVt is Book Value in the last year and

𝑀 ⋰ 𝐵 𝑅𝑎𝑡𝑖𝑜 =𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝐸 + 𝐷)

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝐸 + 𝐷)

4. Terminal Value is a Multiple of Earnings

Terminal Value is taken as an appropriate multiple of the projected Net Operating Profits (NOPAT).

The current PE Ratio will continue after the forecast period.

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 = 𝑁𝑂𝑃𝐴𝑇𝑡 × 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝐸 𝑅𝑎𝑡𝑖𝑜

Where, NOPAT1, is NOPAT in the last year and

𝑃𝐸 𝑅𝑎𝑡𝑖𝑜 =𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

Cost to Create Method Value of Business is Cost of Creating the Business from Scratch + Reasonable Margin

This method is suitable in cases like Build-Operate-Transfer Deals.

Capitalized Earnings Method

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑜𝑓 𝑇𝑎𝑟𝑔𝑒𝑡 𝐹𝑖𝑟𝑚

𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 (𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒)

Net profits of the Target Firm may either be current year profits or Average Profits of Specified

years. Capitalization rate refers to the Return on Investments expected by an Investor, from the new

entity.

Chop-Shop Method This approach seeks to identify Multi-Industry Companies that are undervalued and would have

more value if separated from each other. Under this approach an attempt is made to buy assets

below their replacement value.

Procedure –

1. Identify the Total Segments of the Company

2. Identify Total Assets, Total Sales, Total Profits in each segment

3. Obtain Standard Ratios with respect to Sales, total assets and profits (Capital TO Ratio,

Assets TO Ratio, ROCE – Operating Profit Ratio)

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑚𝑝𝑎𝑛𝑦

=𝑉𝑎𝑙𝑢𝑒 𝑏𝑎𝑠𝑒𝑑 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 + 𝑉𝑎𝑙𝑢𝑒 𝑏𝑎𝑠𝑒𝑑 𝑜𝑛 𝑆𝑎𝑙𝑒𝑠 + 𝑉𝑎𝑙𝑢𝑒 𝑏𝑎𝑠𝑒𝑑 𝑜𝑛 𝑃𝑟𝑜𝑓𝑖𝑡𝑠

3

Market based Valuation of Target Firm Market based Valuation of Target firm is similar to Capitalized Earnings Method; however the

Capitalization Rate is based on Market Rates.

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If Target Firm is a Listed Company Net Profits and Capitalization Rate are taken based on Earnings and Market Capitalization Rate of

similar type of companies.

If Target Firm is not a Listed Company

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠 =𝐹𝑢𝑛𝑑𝑎𝑚𝑒𝑛𝑡𝑎𝑙𝑠 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑜𝑓 𝑇𝑎𝑟𝑔𝑒𝑡 𝐹𝑖𝑟𝑚

𝐴𝑝𝑝𝑟𝑜𝑝𝑟𝑖𝑎𝑡𝑒 𝑀𝑎𝑟𝑘𝑒𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒

(Or)

(Fundamental Financial Variable of Target Firm) × (Appropriate Market Value Multiple)

Fundamental Financial Variable of Target Company may either be Earnings, Book Value or revenue

of the Target Company

Market Multiples/ Capitalization Rate of comparable Listed Companies are taken as base, and

adjusted for differences/variations due to Target Firm’s growth, size, business model, geographical

spread, risk patterns etc. vis-à-vis as those of comparable companies.

Market Multiples or Capitalization Rate may either be Market Capitalizations to Sales, PE ratio, etc.

Asset based Valuation of Target Firm Value of Business = Value of Assets less Value of Liabilities

Book Value This method considers the Book Value (Balance Sheet Value) of all Assets and Liabilities. It does not

take into account, the effect of current market prices/realizable values thereof.

Assets are taken at Historical Cost

Liabilities are taken at Balance Sheet Amounts

Net Adjusted Asset Value or Economic Book Value 1. Value of Going Concern business is computed by adjusting the value of all its assets and

liabilities to the Fair Market Value. This method allows for valuation of Goodwill, Inventories, Real

Estate, Intangibles, and other assets at their current market value.

2. Assets are taken at Current Market Value or Fair Market Value

3. Assets are taken at Fair Market Value, i.e. amount required to settle them in due course.

Liquidation Value 1. If the Business is not to be acquired on Going Concern basis, the Liquidation Value (i.e.

realization from sale of assets and settlement of liabilities) is considered for the purpose of

valuation.

2. Liquidation Value of a company is equal to what remains after all assets have been sold and

all liabilities have been paid.

3. Value of Business using this method should be lower than a valuation reached using the

book value or adjusted asset value method.

4. This is considered to be a better floor price than book value of a company, because if a

company drops significantly below this price, then a Corporate Raider can buy enough stock to take

control of it, and then liquidate it for a riskless profit. However, the company’s Stock Price would

have to be low enough to cover the costs of liquidation, and the uncertainty in what the assets

would actually sell for in the market place.

5. Assets are taken at the price they would fetch on sale, i.e. NRV

6. Liabilities are taken at the actual amount required to settle them immediately

16 | P a g e

Valuation of Intangible Assets of Target Firm 1. Market based Valuation

Value is based on Market Values of similar Intangible Assets

2. Cost based Valuation

Either “Cost to Create” or “Cost to replace” method can be used

Assumes that there is some relationship between cost and value

Ignores Time Value of Money and Capital Maintenance Concept

3. Income based Valuation, i.e. Estimates of Past and Present Economic Benefits

This may be further sub-classified into –

a. Capitalization of Historical Profits Method

b. Gross Profit Differential Method

c. Excess Profits Method

d. Relief from Royalty Method

a. Capitalization of Historical Profits Method

Value of Intangible Assets = Maintainable Historical Profitability of the Asset × Appropriate

Multiple

The appropriate multiple is determined, after assessing the relative strengths of the

Intangible Asset, in the light of factors like leadership, stability, and market share, and

internationality, trend of profitability, marketing, and advertising support and protection.

This method has major short comings, associated with Historical Earning Capability. The

method pays little regard to the future.

b. Gross Profit Differential Method

This method is often associated with Trademark and Brand Valuation.

This method look at the differences in Sale Prices, adjusted for differences in Marketing

Costs. That is the difference between the Margin of Branded and Patented Product and an

unbranded or generic product.

This result is used to determine appropriate Cash-Flows and Value of Intangible Asset.

However, finding generic equivalents for a patent and identifiable price differences is more

difficult than for a Retail Brand.

c. Excess Profits Method

This method looks at the current value of the Net Tangible Assets employed as the

benchmark for an estimated rate of return. This is used to calculate the profits that are required to

induce Investors to invest into those Net Tangible Assets.

Any return over and above those profits required in order to induce investment is

considered to be the Excess Return attributable to the Intangible Assets

While theoretically relying up on Future Economic Benefits from the use of the asset, the

method has difficulty in adjusting to alternative uses of the asset.

● Relief from Royalty Method

This method considers what the Purchaser could afford, or would be willing to pay, for a

license of similar Intangible Assets.

The Royalty Stream is then capitalized, to reflect the risk and return relationship of investing

in that Intangible Asset.

17 | P a g e

Economic Value Added It is the Surplus generated by an entity after meeting an equitable change towards the providers of

Capital.

In other words it is the returns earned by Company in excess of minimum expected return of the

shareholders.

Particulars Amount

EBIT (Operating Income) XXX

Less: Taxes XXX

EAT (Net Operating Profits after Tax) XXX

Less: Cost of Capital Employed XXX

Economic Value Added XXX

Cost of Capital Employed = WACC x Capital Employed

EVA can be increased by –

1. Improving the Operating Profits by efficient operation, without employing additional capital

2. Investing in new projects which give higher returns than cost of their financing

3. Liquidating Unproductive capital (Buy-back of shares, redemption of Debentures etc)

Benefits –

1. It helps in measuring business

2. It helps to Equate Managerial incentives with Shareholder’s interest

3. It helps to improve Financial and Business literacy throughout the firm

Demerger It is a form of Corporate Restructuring, an Undertaking transferred or sold to another entity.

Even after Demerger, the existing company continues to exist, as only part of the entity is sold or

transferred.

Reasons –

1. Need to pay attention to core areas of Business

2. Downsizing of the firm, in case if it is too big

3. Selling off of loss making divisions, in order to Optimize the Profits

4. Window of Opportunity, possibility to sell at a attractive price

5. Lack of adequate capital to continue the project

6. Need for immediate cash

Methods –

1. Sell off

A Sale of an Asset, division, factory, product line, subsidiary, by one entity to another entity for a

Purchase Consideration payable in Cash or in other form of Securities

2. Spin Off

No Change in Ownership

Part of Business is separated and created as a separate firm

Existing Shareholders get proportionate ownership in newly formed entity

Management is spun-off

18 | P a g e

Reasons –

To create separate identity

To avoid takeover attempt by a Predator, by making firm unattractive to him

To Create separate regulated and unregulated lines of business

3. Split Up

Breaking up of entire business into series of spin offs

Parent firm no longer legally exists

Only newly created small entities with Separate Legal entity exists

They are logically more convenient and manageable

It is likely to enhance shareholders value and bring efficiency and effectiveness

4. Carve Out

Similar to Spin-Off

Some shares of new company are sold in the market by making public offer

So there is inflow of Cash

The existing company may sell their majority or minority share depending up on whether they want

to control management or not.

5. Sale of Divisions

The seller company is demerging its business where as the buyer company is acquiring a business.

Financial Restructuring 1. It is also called as Internal Re-construction.

2. Internal Changes made by Management, in the Assets and Liabilities of a Company, with the

consent of its shareholders.

3. It leads to significant changes in the Financial Obligations and Capital Structure of the entity,

leading to a change in the Financing Pattern, Ownership and Control and payment of various

financial charges.

4. It is suitable for entities which have suffered sizeable losses over a period of time.

5. It is suitable to firms which have potential and promise for better financial performance in

future years.

6. It gives a fresh start to the firms.

It aims at re-defining the financial position of the corporate firm, by way of –

1. Seeking re-financing

2. Reduction or waiver in the claims of various stakeholders

3. Revaluation of Assets and Liabilities

4. Using the profit accruing on account of appreciation of assets and waiver of liabilities, to

write off Accumulated Losses and Fictitious Assets.

Who sacrifices – What?

● Equity Shareholders – Change in Rights, Reduction in Face Value of Shares, etc.

● Preference Shareholders – foregoing arrears in Cumulative dividend, reduction in face value

of shares, etc.

● Debenture holders, Lenders and Creditors – waiving a part of the sum payable to them,

acceptance of new securities with lower coupon rates, conversion of debt into equity, conversion of

their dues into equity shares to avert pressure of payment, acceptance of certain assets in full or

part settlement etc.

19 | P a g e

Restructuring by bringing about changes in Corporate Controls This can be done in any of the following ways –

1. Delisting or Going Private

A situation where in a Listed Company is converted into a Private Company by buying back all the

outstanding shares from the markets

2. Equity Buyback

The Company buys back its own shares back from the market. This results in reduction in Equity

capital of the company.

It also strengthens the Promoter’s Position by increasing his stake in the Equity of the Company.

3. Re-structuring of existing business

It involves downsizing and closing some unprofitable departments, reduction in number of

personnel, etc.

4. Buy-outs and Buy-ins

Buy-Outs are divided into Leveraged Buyouts and Management Buy-Outs.

Leveraged Buy-Outs It is Acquisition or Takeover of the company, in which acquisition is substantially financed

through Debt.

Debts may constitute around 80% of the Value of Acquisition

Such debts is obtained on the basis of the Company’s Future Earnings

A large part of Debt is secured by Firm’s Assets and the Lenders take a portion of Firm’s

Equity

It involves settlement of Cash to Sellers (Purchase Consideration is not in the form of Shares)

Management Buy-Outs When Managers buy their company from its Owners it is called Management Buy-Outs

When?

o When the management of the Company is threatened with the sale of the Business to third

parties

o When the Management of the Company is frustrated with the Slow Growth of the Company

They step in and acquire the Business from its Owners, and run the business by and for

themselves.

Buy-Out by Current Management

The current management of the company buys out the Company or Division of the Company

from its owners

This generally happens when the owners loose interest in the company or due to

accumulated losses.

Buy-Out by Private Equity Participant – Buy-In

An active Private Equity Participant may go after weak managements and buy-out their

stake

PEP brings in its own management team to manage the business takeover

That management team takes a stake in the Equity Capital of the Company while coming in,

so it is called as Management Buy-In.

20 | P a g e

Shareholder Value Analysis It focuses on creation on Economic value for shareholders.

It is measured by Share Price Performance and Flow of Funds

It is used a way of linking management strategy and decisions to the creation of value for the

shareholders.

Managerial decisions include – Investment decision, Business decisions and Financing

Decisions. These decisions have impact on the creation of value to shareholders.

Shareholders Value = NOPAT – Cost of Capital

In order to understand value creation in a company it is necessary to locate and understand where

the value is created – which means identification of Value Drivers of the business.

A thorough understanding of the value drivers and their effect on the company’s future cash flows

will help in managerial decision making to create value for shareholders.

Value Drivers include – Growth in Sales, Profit margin, Capital investment decisions etc.

Benefits –

1. It helps management to concentrate on activities which create value to shareholders rather

than on short-term profitability.

2. SVA and EVA helps in strengthening the competitive position of the firm, by focusing o

wealth creation.

21 | P a g e

Sustainable Growth Rate It is the maximum growth rate that can be achieved in sales without exhausting the Operating Cash

Flows.

Objectives –

To maintain target capital structure without losing new Equity

Maintain target dividend payment ratio

Increase sales as rapidly as market conditions allow

Variables –

✓ Net Profit Margins on new and existing revenues

✓ Asset Turnover Ratio

✓ Assets to beginning of the period Equity Ratio

✓ Retention Ratio – Earnings retained in the business

Variants –

Incremental Growth strategy, Profit Strategy and Pause Strategy are the other variants of Stable or

Sustainable Growth Strategy

Analysis –

If a Firm has actual growth rates less than the SGR, the Management’s Principle objective is –

✓ To find out productive uses of cash flows that exist in excess of their needs

✓ To enhance their actual growth rates through acquisition of rapidly growing firms

Computation of Sustainable Growth Rate –

Assumptions –

1. Assets of the Firm will increase proportional to Sales

2. Net Profit is a constant proportion of Sales

3. Dividend Pay-out Ratio and the Debt Equity Ratio of the Firm are given

4. Firm will not raise external Equity Capital

5. Addition to Assets = Addition to Retained Earnings + Addition to Borrowings

Computation –

a) Sustainable Growth Rate (g) = ROE x (1-Dividend Payout Ratio)

Where 𝑅𝑂𝐸 =𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑓𝑡𝑒𝑟 𝑇𝑎𝑥

𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ (this is used in Gordon Model in Dividend Decisions – It recognizes

growth relating to Equity)

b) Sustainable Growth Rate (g) = 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐴𝑠𝑠𝑒𝑡𝑠

𝐴𝑠𝑠𝑒𝑡𝑠 𝑎𝑡 𝑡ℎ𝑒 𝑏𝑒𝑔𝑖𝑛𝑖𝑛𝑔 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟

=𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐴𝑠𝑠𝑒𝑡𝑠

(𝐴𝑠𝑠𝑒𝑡𝑠 𝑎𝑡 𝑡ℎ𝑒 𝑌𝑒𝑎𝑟 𝐸𝑛𝑑 − 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐴𝑠𝑠𝑒𝑡𝑠)

=𝑁𝑒𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 × 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒

𝐴𝑠𝑠𝑒𝑡 𝑡𝑜 𝑆𝑎𝑙𝑒𝑠 − [𝑁𝑒𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 × 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒]

22 | P a g e

𝑆𝑢𝑠𝑡𝑎𝑖𝑛𝑎𝑏𝑙𝑒 𝐺𝑟𝑤𝑜𝑡ℎ 𝑅𝑎𝑡𝑒 =𝑃 × 𝑆0 × 𝑏(1 +

𝐷𝐸)

𝐴 − 𝑃 × 𝑆0 × 𝑏(𝑎 +𝐷𝐸)

Where,

P is Net Profit Margin on Sales

S0 is Sales for the Previous Year

A is Total Net Assets at the end of the Period [Capital Employed]

b is Retention Ratio = (1-Dividend Pay-out Ratio)

D/E is Debt Equity Ratio

Here it is assumed that Debt Component also grows at SGR and this formula cannot be considered for all Equity Firm.

23 | P a g e

Illustrations Example 1 A Ltd wants to acquire T Ltd and has offered a Swap ratio of 1:2 (0.5 shares for every one share of

T Ltd).

Following information is provided –

Particulars A Ltd T Ltd

Profit After Tax Rs. 1800000 Rs. 360000

Equity Shares Outstanding 600000 180000

Earnings per Share Rs. 3 Rs. 2

PE Ratio 10 times 7 Times

Market Price per share Rs. 30 Rs. 14

Required –

a) Number of Equity Shares to be issued by A ltd, for acquisition of T Ltd

b) What is the EPS of A Ltd after the Acquisition

c) Determine the Equivalent Earnings Per share of T Ltd

d) What is the expected Market price per share of A Ltd, after the acquisition, assuming its PE

multiple remains unchanged? Also determine the Market Value of the Merged Firm.

Solution

a) Number of shares to be issued by A Ltd to T Ltd

Existing number of shares of T Ltd 180000

Number of shares issued by A Ltd as a result of Merger = 180000/2 90000

Existing number of shares in A Ltd 600000 Shares

Shares issued to Shareholders of T Ltd as a result of Merger 90000 Shares

Total Number of Shares of A Ltd 690000 Shares

b) Computation of Value of A Ltd Post Merger

Particulars Amount

Profit after Tax of A Ltd 1800000

Profit after Tax of T Ltd 360000

Profit after tax of Merged Entities 2160000

Total number of shares of A Ltd 690000 shares

Earnings per Share of A Ltd (Post-Merger) = 2160000

690000 Rs. 3.13 per Share

PE Multiple of A Ltd 10 Times

MPS of A Ltd (Post-Merger) = PE Multiple x EPS = 10x3.13 Rs. 31.3 per share

Market Value of A Ltd Post-Merger (690000x31.3) Rs. 216 Lakhs

24 | P a g e

c) Equivalent EPS of T Ltd = EPS of Merged Entity x Swap Ratio = Rs. 3.13x0.50 = Rs. 1.565

Therefore, a Shareholder holding one share in T Ltd, will have an EPS of Rs. 1.57 in Merged Entity.

Example: 2 XYZ Ltd is considering merger with ABC Ltd. XYZ Ltd’s Shares are currently traded at Rs. 20. It has

250000 Shares outstanding and its Earnings after Tax amount to Rs. 500000. ABC Ltd has 125000

shares outstanding; its current Market price is Rs. 10 and it’s EAT is Rs. 125000. The Merger will be

effected by means of a stock swap (exchange). ABC ltd has agreed to a plan under which XYZ Ltd

will offer the current market value of ABC Ltd’s Share –

a) What is the Pre-Merger Earnings per Share (EPS) and P/E Ratios of both the companies?

b) If ABC Ltd’s PE Ratio is 6.4, what is its Current Market Price? What is the Exchange Ratio?

What will be the XYZ Ltd’s Post-Merger EPS?

c) What should be the Exchange Ratio, if XYZ Ltd’s Pre-merger EPS are to be same?

Solution

a) Pre-Merger EPS and PR Multiples for XYZ Ltd and ABC Ltd

Particulars XYZ Ltd ABC Ltd

Earnings after Tax Rs. 500000 Rs. 125000

Number of Shares 250000 Shares 125000 Shares

Current market price Rs. 20 Rs. 10

Earnings per share = EAT/Number of Shares Rs. 2 Re. 1

PE Multiple = MPS/EPS 10 Times 10 Times

b) If PE Ratio of ABC Ltd is 6.4, then Current Market Price of ABC Ltd

= PE Multiple x EPS = 6.4x1 = Rs. 6.4

MPS based Exchange ratio = 𝑀𝑃𝑆 𝑜𝑓 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝐶𝑜𝑚𝑝𝑎𝑛𝑦

𝑀𝑃𝑆 𝑜𝑓 𝐵𝑢𝑦𝑖𝑛𝑔 𝐶𝑜𝑚𝑝𝑎𝑛𝑦=

6.4

20=

0.32 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑓 𝑋𝑌𝑍 𝐿𝑡𝑑 𝑓𝑜𝑟 𝑒𝑣𝑒𝑟𝑦 𝑠ℎ𝑎𝑟𝑒 ℎ𝑒𝑙𝑑 𝑖𝑛 𝐴𝐵𝐶 𝐿𝑡𝑑. Number of shares to be issued to ABC Ltd = (Existing number of shares) x (Swap ratio)

= 125000 shares x 0.32 = 40000 shares

XYZ Ltd’s Post Merger EPS 𝑇𝑜𝑡𝑎𝑙 𝐸𝐴𝑇 (𝑃𝑜𝑠𝑡−𝑀𝑒𝑟𝑔𝑒𝑟)

𝑇𝑜𝑡𝑎𝑙 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 (𝑝𝑜𝑠𝑡 𝑀𝑒𝑟𝑔𝑒𝑟)=

500000+125000

250000+40000=

625000

290000= 𝑅𝑠. 2.16

c) EPS based Exchange Ratio – 𝐸𝑃𝑆 𝑂𝐹 𝑆𝐸𝐿𝐿𝐼𝑁𝐺 𝐶𝑂𝑀𝐴𝑃𝑁𝑌

𝐸𝑃𝑆 𝑂𝐹 𝐵𝑈𝑌𝐼𝑁𝐺 𝐶𝑂𝑀𝑃𝐴𝑁𝑌=

1

2=

0.5 𝑆ℎ𝑎𝑟𝑒𝑠 𝑓𝑜𝑟 𝑒𝑣𝑒𝑟𝑦 𝑜𝑛𝑒 𝑠ℎ𝑎𝑟𝑒 ℎ𝑒𝑙𝑑 𝑖𝑛 𝐴𝐵𝐶 𝐿𝑡𝑑. Total Number of Shares in ABC Ltd = 125000 shares

Number of shares issued to ABC Ltd as a result of Merger = 125000x0.5 = 62500 shares of XYZ Ltd

XYZ Post merger EPS = 𝑇𝑜𝑡𝑎𝑙 𝐸𝐴𝑇 (𝑃𝑜𝑠𝑡−𝑀𝑒𝑟𝑔𝑒𝑟)

𝑇𝑜𝑡𝑎𝑙 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 (𝑝𝑜𝑠𝑡 𝑀𝑒𝑟𝑔𝑒𝑟)=

500000+125000

250000+62500=

625000

312500= 𝑅𝑠. 2 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

25 | P a g e

Example: 3 The Share capital of the companies X and Y consist of 75000 shares of Rs. 100 each and 25000

shares of Rs. 100 each respectively. Company X plans to make an acquisition of Y Ltd by exchange

of 4 shares for every 5 shares in Y ltd. The Cost of Equity for X, Y and Combined XY Ltd are 15%,

16% and 14% respectively.

The Cash Flows (EBIT x (1-t) + Depreciation) are likely to be as follows for a period of 5 Years. The

Terminal year Cash Flows are likely to grow by 5% annually from Year 6 in each case – [Rs. In

Lakhs]

Years 1 2 3 4 5

X Ltd 15 16 17 18 19

Y Ltd 4 5 6 7 8

XY Ltd 20 22 24 26 28

a) Evaluate the proposal and give your comments on the scheme of merger

b) If the shares swap exchange ratio is changed to 4.5 shares of X Ltd for every 5 Shares of Y

Ltd, whether the merger scheme is viable. If so, allocate merger gain between the two companies

again.

Solution

Computation of value of Companies

Particulars Year

X Ltd Y Ltd XY Ltd

PVF @

15%

Cash

Flow

Disc.

Cash

Flow

PVF @

16%

Cash

Flow

Disc.

Cash

Flow

PVF @

14%

Cash

Flow

Disc.

Cash

Flow

Annual

Cash

Flows

1 0.870 15 13.05 0.862 4 3.45 0.877 20 17.54

2 0.756 16 12.10 0.743 5 3.72 0.769 22 16.93

3 0.658 17 11.19 0.641 6 3.84 0.675 24 16.20

4 0.572 18 10.30 0.552 7 3.87 0.592 26 15.39

5 0.497 19 9.44 0.476 8 3.81 0.519 28 14.54

Terminal

CF 5 0.497 199.5 99.15 0.476

76.36 36.35 0.519 326.67 169.54

155.23 55.04 250.12

Computation of Terminal Values:

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 =𝐶 × (1 + 𝑔)

𝐾𝑒 − 𝑔

Terminal Value for X Ltd = 19(1.05)

0.15−0.05= 199.5

Terminal Value of Y Ltd = 8(1.05)

0.16−0.05= 76.36

26 | P a g e

Terminal Value of XY Ltd = 28(1.05)

0.14−0.05= 326.67

Computation of Gain on Merger:

Particulars Amount

Value of Merged Entity – XY Ltd 250.12

Less: Value of X Ltd before Merger (155.23)

Less: Value of Y Ltd before Merger (55.04)

Gain on merger 39.85

Computation of Minimum Exchange Ratio and Maximum Exchange Ratio

𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 =(𝑉𝑆 + 𝐺𝑆) × 𝑆𝐵

(𝑉𝐵 + 𝐺𝐵) × 𝑆𝑆

Where,

Vs = Value of Selling Company before Merger

VB = Value of Buying Company before Merger

Gs = Share of Selling Company in the Gain on Value due to Merger

GB = Share of Buying Company in the Gain on Value due to Merger

Ss = Shares outstanding in Selling Company before Merger

SB = Shares outstanding in Buying Company before Merger

Minimum Exchange Ratio =(55.04+0)75

(155.23+39.85)25=

4128

4877= 0.846

Maximum Exchange Ratio = (55.04+39.85)75

(155.23+0)25=

7116.75

3880.75= 1.834

Evaluation of Exchange Ratio

Exchange ratio Comments

4 Shares for 5 Held = 4/5 =

0.8

This is lower than the minimum exchange ratio of 0.846.

So value of shareholders of Y Ltd will erode after merger.

Therefore, Y Ltd will not accept this exchange ratio

4.5 Shares for 5 Held = 4.5/5

= 0.9

This is higher than the minimum exchange ratio of 0.846 and lower

than the maximum exchange ratio of 1.834.

Hence, shareholders of both the Companies will have share in the

gain on merger.

So, this exchange ratio may be acceptable to both the companies.

27 | P a g e

Example: 4 RIL is considering a takeover of Sunflower Industries Ltd (SIL). The particulars of the two

companies are given below –

RIL SIL

Earnings after Tax (EAT) 2000000 1000000

Equity Shares Outstanding 1000000 1000000

Earnings per Share (EPS) 2 1

PE Ratio 10 5

Required –

1. What is the Market Value of each Company before Merger?

2. Assume that the Management of RIL estimates that the Shareholders of SIL will accept an

offer of one share of RIL for four shares of SIL. If there are no synergic effects, what is the Market

Value of the Post-Merger RIL? What is the New Price per Share? Are the Shareholders of RIL better

or worse off than they were before the merger?

3. Due to Synergic effects, the Management of RIL estimates that the earnings will increase

by 20%. What is the new post-merger EPS and price per share? Will the Shareholders be better off

or worse off before the merger?

Solution

1. Market Value of each firm before merger:

Particulars RIL SIL

PE Ratio = 𝑀𝑃𝑆

𝐸𝑃𝑆 10 5

EPS 2 1

MPS = PE Ratio X EPS 20 5

Number of Shares 1000000 1000000

Market Value 200 Lakhs 50 Lakhs

2. Merger Offer – Shareholders of SIL will get one share of RIL for every four shares of SIL.

Total Number of Shares in SIL 1000000

Number of shares offered by RIL as a result of Merger = 1000000/4 250000 shares

Existing number of Shares in RIL

Shares issued to SIL as a result of Merger

1000000

250000

Total Number of Shares of RIL 1250000 Shares

Market Value of RIL – Post Merger – No Synergy Benefit

Particulars Amount

Earnings of RIL post-merger (RIL 20L and SIL 10L) 3000000

Number of Shares Outstanding – Post merger (10L+2.5L) 1250000

28 | P a g e

EPS of RIL Post Merger = (30L/12.5L) 2.40

PE Multiple 10

MPS = PE Multiple X EPS = 10X2.4 24

Market Value of RIL Post Merger = 24X1250000 300 Lakhs

Computation of Gain or Loss to Shareholders – Without Synergy Benefits

For Shareholders of RIL SIL

Number of Shares (Post Merger) 1000000 250000

MPS 24 24

Market Value after Merger 240 Lakhs 60 Lakhs

Less: Market Value Before Merger (200 Lakhs) (50 Lakhs)

Gain to Shareholders 40 Lakhs 10 Lakhs

Shareholders will be better off in terms of wealth due to Merger, in case of No Synergy Benefits.

3. Market Value of RIL – Post Merger with 20% Synergy Benefits

Particulars Amount

Earnings of RIL post-merger [(RIL 20L and SIL 10L)+20% there on] 3600000

Number of Shares Outstanding – Post merger (10L+2.5L) 1250000

EPS of RIL Post Merger = (36L/12.5L) 2.88

PE Multiple 10

MPS = PE Multiple X EPS = 10X2.88 28.8

Market Value of RIL Post Merger = 28.8X1250000 360Lakhs

Computation of Gain or Loss to Shareholders

For Shareholders of RIL SIL

Number of Shares (Post Merger) 1000000 250000

MPS 28.8 28.8

Market Value after Merger 288 Lakhs 72 Lakhs

Less: Market Value Before Merger (200 Lakhs) (50 Lakhs)

Gain to Shareholders 88 Lakhs 22 Lakhs

Shareholders will be better off in terms of wealth due to Merger, in case of 20% Synergy Benefits.

29 | P a g e

Example: 5 ABC Company is considering acquisition of XYZ Ltd, which has 1.5 crores Shares outstanding and

issued. The Market Price per share is Rs.400 at present. ABC’s average cost of capital is 12%.

Available information from XYZ indicates its expected cash accruals for the next three years as

follows: Year 1 – Rs. 250 Crores, Year 2 – RS. 300 Crores, Year 3 - Rs. 400 Crores. Calculate the

range of valuation that ABC has to consider. (PV Factors @ 12% for 1, 2, and 3 years respectively:

0.893, 0.797, 0.712)

Solution:

Computation of Present Value of Future Cash Inflows (in Crores)

Year Cash Inflow PVF @ 12% PV Cash Inflows

1 250 0.893 223

2 300 0.797 239

3 400 0.712 285

Value of Business = PV Cash Inflows 747

Assumptions:

● Project has useful life of only three years

● Project does not have any Terminal Cash Flows

Computation of Market Capitalization

Particulars Amount

Value of Business Rs. 747 Crores

Number of Shares Outstanding 1.5 Crores

Value per Share = 747

1.5 Rs. 498 per Share

Market Price per share Rs. 400 per Share

Market Capitalization = 400x1.5 Rs. 600 Crores

Range of Valuation that the company has to consider is Rs. 600 Crores to Rs. 747 Crores that is range

between Market Capitalization and value determined based on Expected Cash Flows.

Range of Valuation that the Company can consider is Rs. 400 per Share to Rs. 498 per Share

Example: 6 BRS Inc deals in Computer and IT hardware and peripherals. The Expected Revenue for the next 8

Years is as follows:

Years 1 2 3 4 5 6 7 8

Sales

(millions) 8 10 15 22 30 26 23 20

Summarized Financial Position is as follows –

Liabilities Amount Assets Amount

30 | P a g e

Equity Stocks 12 Fixed Assets (Net) 17

12% Bonds 8 Current Assets 3

20 20

Additional Information:

1. Its Variable expenses is 40% of Sales Revenue and Fixed Operating Expenses (Cash) are

estimated as follows:

Period 1-4 Years 5-8 Years

Amount (millions) 1.6 2

2. An additional advertisement and sales promotion campaign shall be launched requiring

expenditure as follows:

Period 1 Year 2-3 Years 4-6 Years 7-8 Years

Amount (Millions) 0.50 1.50 3 1

3. The details as to Capital Expenditures are as follows:

Period 1 2 3 4 5 6 7 8

Amount

(Million) 0.50 0.80 2 2.5 3.5 2.5 1.5 1

4. Fixed Assets are subject to depreciation at 15% as per WDV Method

5. Investment in Working Capital is estimated to be 20% of Revenue

6. Applicable tax rate for the company is 30%

7. Cost of Equity is Estimated to be 16%

8. The free cash flow of the firm is expected to grow at 5% per annum after 8 years.

From the above information you are required to determine value of the firm and value of Equity.

Solution:

Calculation of Weighted Average Cost of Capital

Sources of Funds Cost (%) Weights Weighted Cost ( Cost x Weights)

Equity Stock 16 12/20 = 0.60 9.60

12% Bonds (After Tax) 12(1-0.3) = 8.40 8/20 = 0.40 3.36

12.96

Schedule of Depreciation:

Opening Balance Additions Total Depreciation @ 15% Closing Balance

17.00 0.5 17.50 2.63 14.88

14.88 0.8 15.68 2.35 13.32

13.32 2 15.32 2.30 13.03

13.03 2.5 15.53 2.33 13.20

31 | P a g e

13.20 3.5 16.70 2.50 14.19

14.19 2.5 16.69 2.50 14.19

14.19 1.5 15.69 2.35 13.33

13.33 1 14.33 2.15 12.18

Calculation of Investment:

Sales (1)

Addition Capital = 20% of Revenue

(2)

Capital Expenditure

(3)

Total Required Investment (4) = (2)+(3)

Existing Investment (5) = Opn – (3) + (Op 6)

Addition Investment (6) = (4)-(5)

8.00 1.6 0.50 2.10 3 0.00

10.00 2 0.80 2.80 2.50 0.30

15.00 3 2.00 5.00 2.00 3.00

22.00 4.4 2.50 6.90 3.00 3.90

30.00 6 3.50 9.50 4.40 5.10

26.00 5.2 2.50 7.70 6.00 1.70

23.00 4.6 1.50 6.10 5.20 0.90

20.00 4 1.00 5.00 4.60 0.40

Determination of Present Value Cash Inflows

Particulars Years

1 2 3 4 5 6 7 8

Revenue (Sales) 8.00 10.00 15.00 22.00 30.00 26.00 23.00 20.00

Less Variable Costs (40% of Rev)

3.20 4.00 6.00 8.80 12.00 10.40 9.20 8.00

Cash Operating Expenses

1.60 1.60 1.60 1.60 2.00 2.00 2.00 2.00

Advertisement Cost 0.50 1.50 1.50 3.00 3.00 3.00 1.00 1.00

Depreciation 2.63 2.35 2.30 2.33 2.50 2.50 2.35 2.15

EBIT 0.07 0.55 3.60 6.27 10.50 8.10 8.45 6.85

Taxes @ 30% 0.02 0.17 1.08 1.88 3.15 2.43 2.54 2.06

Operating Profit After Tax 0.05 0.39 2.52 4.39 7.35 5.67 5.92 4.80

Add Depreciation 2.63 2.35 2.30 2.33 2.50 2.50 2.35 2.15

Gross Cash Flows 2.68 2.74 4.82 6.72 9.85 8.17 8.27 6.95

Less Additional Investment

0.00 0.30 3.00 3.90 5.10 1.70 0.90 0.40

Free Cash Flows 2.68 2.44 1.82 2.82 4.75 6.47 7.37 6.55

WACC - 13% 0.8850 0.7831 0.6931 0.6133 0.5428 0.4803 0.4251 0.3762

Discounted Free Cash Flows 2.37 1.91 1.26 1.73 2.58 3.11 3.13 2.46

Here Interest is not deducted because Discounted Cash Flows are treated as Total Value.

If the discounted cash flows are treated as Value of Equity, then we have to deduct Interest.

Total Present Value of Discounted Cash Flows = Rs. 18.549 Millions.

Terminal Cash Flows = 𝐹𝐶𝐹9

𝐾𝑒−𝑔=

6.55(1.05)

0.13−0.05= 𝑅𝑠. 85.84 𝑀𝑖𝑙𝑙𝑖𝑜𝑛𝑠

PV of Terminal Cash Flows = Rs. 85.84x0.3762 = Rs. 32.2749 Millions.

Value of Equity

32 | P a g e

Particulars Amount

Present Value Cash Flows 18.549

PV of Terminal Cash Flows 32.2749

Total value of Firm 50.824

Less: Value of Debt 8

Value of Equity 42.824

Example: 7 XY Ltd which is specialized in manufacturing garments is planning for expansion to handle a new

contract which it expects to obtain. An Investment Bank has approached the company and asked

whether the Company had considered Venture Capital financing. The company has borrowed Rs.

100Lakhs on which interest is paid at 10% per annum.

The company shares are unquoted and it has decided to take your advice in regard to the

calculation of value of the Company to obtain the new contract, the chance for which is 60%.

Turnover for the following year is dependent to some extent on the outcome of the Year 1.

Following are the estimated Turnovers and probabilities:

Year 1 Year 2

Turnover Probability Turnover Probability

2000 0.6 2500 0.7

3000 0.3

1500 0.3 2000 0.5

1800 0.5

1200 0.1 1500 0.6

1200 0.4

Operating Costs inclusive of Depreciation are expected to be 40% and 35% of Turnover

respectively for the years 1 and 2. Tax is to be paid at 30%.

It is assumed that the profits after interest and taxes are Free Cash Flows. Growth in earnings is

expected to be 40% for the years 3, 4, and 5 which will fall to 10% each year after that. Industry

average Cost of Equity is 15%.

Solution:

Computation of Expected Cash Flows for Year 1

Cash Flows Probability Expected Cash Flows

2000 0.6 1200

1500 0.3 450

33 | P a g e

1200 0.1 120

Expected Cash Flows 1770

Less Operating Cost 40% of Turnover (708)

Less Interest on Term Loan of 100Lakhs @ 10% (10)

Operating Profits Before Taxes 1052

Less Taxes at 30% (316)

Operating Profits after Tax 736

Computation of Expected Cash Flows for Year 2

Cash Flows Probability in Year 1 Probability in Year 2 Combined Probability Expected Cash Flow

2500 0.6 0.7 0.42 1050

3000 0.6 0.3 0.18 540

2000 0.3 0.5 0.15 300

1800 0.3 0.5 0.15 270

1500 0.1 0.6 0.06 90

1200 0.1 0.4 0.04 48

Expected Cash Inflow for Year 2 2298

Less Operating Cost at 35% of Turnover (804)

Less Interest on Term Loan of 100Lakhs @ 10% (10)

Operating Profits Before Taxes 1484

Less Taxes at 30% (445)

Operating Profits after Tax 1039

Computation of Value of Equity

Nature Years Cash Flows PVF @ 15% Disc. Cash Flows

Operating Cash Flows after Tax 1 736 0.870 640

2 1039 0.756 786

3 1455 0.658 956

4 2036 0.572 1164

5 2851 0.497 1417

Terminal Value 5 62722 0.497 31184

Value of Company 36148

Terminal Value = 𝐹𝐶𝐹𝐹5(1+𝑔)

𝐾0−𝑔=

2851(1.10)

0.15−0.10= 𝑅𝑠. 62722

Value of Firm = Value of Equity + Value of Debt = Rs. 36148 + Rs. 100 = Rs. 36,248.

34 | P a g e

Example: 8 Given below is the balance sheet of S ltd as on 31.03.20XX –

Liabilities Amoun

t

Assets Amount

Share Capital: Shares of Rs. 10 each 100 Land and Buildings 40

Reserves and Surplus 40 Plant and machinery 80

Creditors 30 Investments 10

Stock 20

Debtors 15

Cash and Bank 5

170 170

You are required to work out the Value of the Company’s Shares on the basis of Net Assets

Method and Profit Earning Capacity (Capitalization) method, and arrive at the Fair Price of the

Shares, by considering the following information –

1. Profit of the current year Rs. 64Lakhs includes Rs. 4Lakhs extraordinary income and Rs.

1Lakh Income from Investments of Surplus funds are unlikely to recur.

2. In subsequent Years, additional Advertisement Expenses of Rs. 5Lakhs are expected to be

incurred each year.

3. Market Value of Land and Building and Plant and Machinery have been ascertained at Rs.

96Lakhs and Rs. 100Lakhs respectively. This will entail additional Depreciation of Rs. 6Lakhs each

year.

4. Effective Income Tax is 30%

5. The Capitalization rate applicable to similar business is 15%

Solution:

Computation of Net Assets Value per Share

Particulars Amount

Revalue Amounts of Land and Buildings 96 + Plant and Machinery 100 196

Book Value Amounts of Investments 10 + Stock 20 + Debtors 15 45

Cash and Bank 5

Total Assets 246

Less: Sundry Creditors -30

Net Asset Value of Company 216

Number of Equity Shares Outstanding 10Lakhs

Net Asset Value per Share 216/10 21.6

In the absence of information on computing Goodwill on the Net Asset Value is not considered in the

above computations.

Value per Share under Earnings Capitalization Method

1. Assuming Additional Depreciation are not Tax Deductible

Particulars Amount Amount

Profit for Current Year 64

Less Extraordinary Income 4

Income from Surplus funds 1

35 | P a g e

Additional Advertisement Expenditure 5

Adjusted Profit before Tax 54

Less Tax @ 30% 16.2

Less Depreciation 6

Future Maintainable Earnings for Valuation Purposes 31.8

2. Assuming Additional Depreciation is Tax Deductible



Less Depreciation 6


Less Tax @ 30% 14.40

Future Maintainable Earnings for Valuation Purposes 33.60

Value per Share


Whether additional depreciation allowed for Tax purposes No Yes

Future Maintainable Profits after Tax 31.8 33.6

Value of Equity = FMP/15% 212 224

Add: Investments out of Surplus Funds as at Valuation Date 10 10

Total Value of Equity 222 234

Value per Share = Value of Equity/10Lakh Shares 22.2 23.4

Here FMP do not include Value of Investments, as we did not include Income from Investments

while calculating FMP.

Computation of Fair Value per Share

Whether additional depreciation allowed for Tax purposes No Yes

Net asset Value per Share 21.6 21.6

Earnings Capitalization Value per Share 22.2 23.4

Fair Value = Average of NAV and ECV = (NAV+ECV)/2 21.9 22.5

36 | P a g e

Example: 9 X Ltd reported a profit of Rs. 65 Lakhs after 35% Tax. An Analysis of the accounts revealed that the

Income included Extra-Ordinary Items Rs. 10Lakhs and an Extra-Ordinary Loss of Rs. 3Lakhs. The

existing operations, except for the extra-ordinary items, are expected to continue in the failure. In

addition, the results of the launch of a new product are expected to be as follows – (Rs. Lakhs)

Sales 60 Labour Costs 10

Material costs 15 Fixed Costs 8

You are required to

1. Compute the Value of Business, given that the capitalization rate is 15%

2. Determine the Market Price per share with X Ltd' s Share Capital being comprised of

100000 11% Preference Shares of Rs. 100 each and 4000000 Equity Shares of Rs. 10 each, and PE

Ratio being 8 times.

Solution

Computation of Value of Business

Particulars Amount

Earnings after Tax 65

Add Tax @ 35% (65x35%)/65% 35

Earnings before tax 100

Less Extra-Ordinary Income (10)

Add Extra-Ordinary Loss 3

Additional Income from New Launch (60-15-10-8) 27

Future Expected Earnings before Tax 120

Less Tax @ 35% 42

Future Expected Earnings after Tax 78

Less Preference Dividend520s (11% of 100 Lakhs) (11)

Equity earnings 67

Value of Whole Business (assuming overall Capitalization rate = 15% =

78Lakhs/15%

520

Assuming Equity Expectations = 15%

Value of Equity = (67/15%)

Value of Preference Capital

446.67

100

546.67

Value of Market Price per Equity Share

Based on Equity

earnings

No. Of equity

shares

Earnings

per Share

PE Multiple Market Price per

Eq Share

Projected Earnings 67 40 1.675 8 13.4

Past Years Earnings 65-11 = 54 40 1.35 8 10.8

37 | P a g e

Example: 10 Using Chop-Shop approach (or Break-up Value Approach), assign a value for Cranberry Limited

whose stock is currently trading at a total Market Price of €4 Million. For Cranberry Ltd. the

accounting data set forth three business segments, Consumer Wholesale, Retail and General

Centers. Data for the Firms three segments are as follows

Business Segment Segment Sales Segment Assets Segment Operating

Income

Wholesale €225000 €600000 €75000

Retail €720000 €500000 €150000

General €2500000 €4000000 €700000

Industry data for “Pure-Play” Firms have been compiled and are summarized as follows –

Business Segment Capitalization/Sales Capitalization/Assets Capitalization/Operati

ng Income

Wholesale 0.85 0.70 9

Retail 1.20 0.70 8

General 0.80 0.70 4

Solution

Particulars Wholesale Retail General Total

Segment Sale based valuation (225000x0.85)

191250

(720000x1.2)

864000

(2500000x0.8)

2000000

3055250

Segment Asset based Valuation (600000x0.70)

420000

(500000x0.70)

350000

(4000000x0.70)

2800000

3570000

Segment Operating Income

based Valuation

(75000x9)

675000

(150000x8)

1200000

(700000x4)

2800000

4675000

Average = 3055250+3570000+4675000

3= €3766750

Break-Up Value =Average of Book Value and Market Value = 3766750+4000000

2= €3883375

38 | P a g e

Example: 11 Calculate Economic Value Added (EVA) from the following –

Financial Leverage 1.4 Times

Capital Structure Equity Capital – Rs. 170Lakhs, Reserves and Surplus – Rs. 130Lakhs,

10% Debentures – Rs. 400 Lakhs

Cost of Equity 17.5%

Tax rate 30%

Solution

1. Computation of WACC

Particulars

(1)

Percentage

(2)`

Amount

(3)

Proportion

(4)

WACC

(5)-(2)X(4)

Equity Capital 17.5% 300 lakhs (170+130) 300/700 7.5%

Debt 10%(1-0.30) = 7% 400 lakhs 400/700 4%

Total WACC 11.5%

2. Computation of Operating Profits after Tax (OPAT)

Financial Leverage = 𝑃𝐵𝐼𝑇

𝑃𝐵𝑇

1.4 = 𝑃𝐵𝐼𝑇

𝑃𝐵𝐼𝑇 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡

1.4 = 𝑃𝐵𝐼𝑇

𝑃𝐵𝐼𝑇 − 40

1.4(𝑃𝐵𝐼𝑇 − 40) = 𝑃𝐵𝐼𝑇

1.4 𝑃𝐵𝐼𝑇 − 56 = 𝑃𝐵𝐼𝑇

0.4𝑃𝐵𝐼𝑇 = 56

PBIT = 56/0.4 = Rs. 140 lakhs

OPAT = PBIT (I-Tax)

OPAT = 140 (1-0.30) = Rs. 98 Lakhs

3. EVA = OPAT – (WACC x Capital Employed)

EVA = 98 – ((11.5%x700 lakhs)

EVA = 98-80.5

EVA = 17.5 lakhs

39 | P a g e

Example: 12 The Following information is given for 3 Companies that are identical except for their Capital

Structure

Particulars Orange Grape Apple

Total Invested capital Debt to Assets Ratio Shares Outstanding Pre Tax Cost of Debt Cost of Equity Operating income (EBIT) Net Income

1,00,000 0.8

6,100 16% 26%

25,000 8,970

1,00,000 0.5

8,300 13% 22%

25,000 12,350

1,00,000 0.2

10,000 15% 20%

25,000 14,950

The Tax Rate is Uniform 35% in all Cases

(a) Compute WACC for Each Company

(b) Compute EVA for Each Company

(c) Based on EVA, which company would be considered for Best Investment? Give Reasons

(d) If the Industry PE Ratio is 11, Estimate the Price for Share of each Company

(e) Calculate the Estimated Market Capitalization for each of the Companies

Solution -

Computation of Weighted Average Cost of Capital


Capital Employed (Debt + Equity) 1,00,000 1,00,000 1,00,000

Debt to Assets Ratio (Wd) 0.80 0.50 0.20

Equity (We) 1-Wd 0.20 0.50 0.80

Post Tax Cost of Debt 16(1-0.35) = 10.40% 13(1-0.35) = 8.45% 15(1-0.35) = 9.75%

Cost of Equity (Ke) 26% 22% 20%

Weighted Average Cost of Capital (Kd x Wd) + (Ke x We)

(0.8x10.4) + (0.2x26) = 13.52%

(0.5x8.45%) + (0.5x22%) = 15.23%

(0.2x9.75%) + (0.8x20%) = 17.95%

Computation of Economic Value Added


Operating Income (EBIT) Less Taxes @ 35%

25,000 (8,750)

25,000 (8,750)

25,000 (8,750)

Operating Profit After Taxes Less WACC x CE

16,250 (13,520) (1,00,000 x 13.52%)

16,250 (15,225) (1,00,000 x 15.23%)

16,250 (17,950) (1,00,000 x 17.95%)

40 | P a g e

Economic Value Added 2,730 1,025 (1,700)

Choice based on EVA - Orange is preferable, as it has the Maximum Economic Value Added i.e. it

earns more than what is required to Service the providers of Finance. The Entire EVA will contribute

to Value of Equity Shareholders.

Computation of Share Price per Share or Market Capitalization


Net Income 8970 12350 14950

No. of Equity Shares 6100 8300 10000

Earnings Per Share 1.470 1.488 1.495

PE Multiple 11 11 11

MPS = EPS x PE 16.17 16.37 16.45

Equity Market Capitalization (PE x Net Income)

98,670 1,35,850 1,64,450

Example: 13 The following information relating to Fortune India Ltd, having two divisions, viz, Pharma Division

and Fast Moving Consumer Goods Division (FMCG Division). Paid Up Share Capital of Fortune India

Lts. Is consisting of 3000 Lakhs Equity Shares of Rs. 1 each. Fortune India Ltd decided to demerge

Pharma Division as Fortune Pharma Ltd. Details of Fortune India Ltd as on 31st March XXXX and

Fortune Pharma Ltd as n 1st April XXX are –

Particulars Fortune Pharma ltd Fortune India ltd

Outside Liabilities

Secured Loans

Unsecured Loans

Current Liabilities and Provisions

400 Lakhs

2400 Lakhs

1300 Lakhs

3000 Lakhs

800 Lakhs

21200 Lakhs

Assets

Fixed Assets

Investments

Current Assets

Loans and Advances

Deferred Tax/Misc. Expenses

7740 Lakhs

7600 Lakhs

8800 Lakhs

900 Lakhs

60 Lakhs

20400 Lakhs

12300 Lakhs

30200 Lakhs

7300 Lakhs

(200) lakhs

The Board of Directors of the company has decided to issue necessary Equity Shares of Fortune

Pharma Limited of Rs. 1 each, without any consideration to the shareholders of Fortune India Ltd.

For that, following points are to be considered –

41 | P a g e

● Transfer of Assets and liabilities at Book Values

● Estimated Profit for next year is Rs. 11400 Lakhs for Fortune India ltd and Rs. 1470 Lakhs

for Fortune Pharma Ltd.

● Estimated Market Price of Fortune Pharma Ltd is Rs. 24.5 per share

● Average PE ratio of FMCG sector is 42 and Pharma Sector is 25, which is to be expected for

both the Companies.

Required –

a) Calculate the ratio in which shares of Fortune Pharma are to be issued to the shareholders

of Fortune India Ltd.

b) Calculate the Expected Market Price of Fortune India Ltd

c) Calculate the Book Value per Share of both the companies immediately after Demerger.

Solution

Summary as to how to solve this problem –

1. Shares to be issued to Pharma Ltd – by using EAT and EPS

2. MPS of Fortune India can be calculated with the help of Earnings of Fortune India Ltd,

Average PE Ratio and number of Shares.

3. NAV of Fortune India, Fortune Pharma and Fast Moving Goods Division

1. Computation of Shares to be issued –

Particulars Amount

Estimated Profit of Fortune Pharma Ltd (Equity

Earnings)

Rs. 1470 Lakhs

Expected EPS = MPS/PE Multiple = 24.5/25 Rs. 0.98 per share

Number of Shares = Earnings/Expected EPS = 1470/0.98 1500 Lakhs Shares

Therefore number of shares to be issued to

Shareholders of Fortune Pharma Ltd

1500 lakhs

2. Expected Market Price of Fortune India Ltd

Particulars Amount

Estimated Profit for the Year Rs. 11400 Lakhs

Number of Equity Shares Outstanding 3000 lakh shares

Earnings per Share(11400/3000) Rs. 3.80 per Share

Average PE Ratio 42

Market Price Per share Rs 159.60

3. Computation of Net Worth (Shareholders Funds)

Particulars Fortune India Ltd

(Consolidated)

Fortune Pharma

Ltd

Fortune

India Ltd

(FMCG)

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(1) (2) (3) (4) = (2)-

(3)

Assets

Fixed Assets

Investments

Current Assets

Loans and Advances

Deferred Tax/Misc. Expenses

20400

12300

30200

7300

(200)

7740

7600

8800

900

60

12660

4700

21400

6400

(260)

Total 70000 25100 44900

Outside Liabilities

Secured Loans

Unsecured Loans

Current Liabilities and Provisions

3000

800

21200

400

2400

1300

2600

(1600)

19900

Total 25000 4100 20900

Net worth [A] – [B] 45000 21000 24000

Number of Shares Outstanding 1500 3000

Book Value per share 14 8

Example: 14 The following is the balance sheet of GFC Ltd as on 31st March 20XX –

Particulars Amount Particulars Amount

Equity Shares of Rs. 100 Each

14% Preference Shares of Rs. 100 each

13% Debentures

Deb Interests Accrued & Payable

Loan from Bank

Trade Creditors

600

200

200

26

74

340

Land and Buildings

Plant and Machinery

Furniture and Fixtures

Inventory

Sundry Debtors

Cash at Bank

Preliminary Expenses

Cost of issue of Debentures

Profit and Loss Account

200

300

50

150

70

130

10

5

525

Total 1440 Total 1440

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The company did not perform well and has suffered sizable losses during the last few years.

However, it is felt that the company could be nursed back to health by proper Financial

Restructuring. Consequently, the following scheme of reconstruction has been drawn up:

a. Equity Shares are to be reduced to Rs. 25 per Share, fully paid.

b. Preference shares are to be reduced (with coupon rate of 10%) to equal number of shares

of Rs. 50 each, fully paid up.

c. Debentures holders have agreed to forego the accrued interest due to them. In the future,

the rate of interest on Debentures is to be reduced to 9%.

d. Trade creditors will forego 25% of the amount due to them.

e. The Company issues 6 lakh Equity Shares at Rs. 25 each and the entire sum was fully

subscribed to promoters.

f. Land and Buildings was to be revalued at Rs. 450 Lakhs, Plant and Machinery was to be

written down by 120 Lakhs and a provision of Rs. 15 lakhs had to be made for Bad and Doubtful

Debts.

Required –

1. Show impact of Financial Restructuring on the Company’s Activities

2. Prepare a Fresh Balance Sheet after reconstruction is completed on the basis of the above

proposals.

Solution

1. Reconstruction Account (Workings are done in the end)


To Plant and Machinery A/c

To Preliminary Expenses

To Cost of Issue of Debentures

To Profit and Loss Account

To Provision for Bad Debts A/c

To Capital Reserve A/c

120

10

5

525

15

236

By Equity Share Capital Account

By 14% Pref. Share Capital A/c

By Accrued Interest on Debentures

By Trade Creditors

By Land and Buildings

450

100

26

85

250

Total 911 Total 911

2. Balance Sheet of GFC Ltd as on 31st March 20XX after Reconstruction

PARTICULARS NOTE AMOUNT

Equity and Liabilities

Shareholders’ Funds

a) Share Capital

b) Reserves and Surplus

Non-Current Liabilities

a) Long Term Borrowings

Current Liabilities

a) Trade Payables - Sundry Creditors (Rs. 340 – Rs. 85 lakhs)

1

2

400

236

274

255

Total 1165

Assets

Non-Current Assets

Fixed Assets

3

680

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Current Assets

a) Inventories

b) Trade Receivables – Sundry Debtors (70-15)

c) Cash and Cash Equivalents (130+150)

150

55

280

Total 1165

Note 1 – Share Capital

Particulars Amount

Issued, Subscribed and Paid up : 12 Equity Shares of Rs. 25 each fully paid up

2 Lakh 10% Preference Shares of Rs. 50 each

300

100

Total 400

Note 2 – Long Term Borrowings

Particulars Amount

9% Debentures (Secured)

Loan from Bank (Secured)

200

74

Total 274

Note 3 – Tangible Assets

Particulars Amount

Land and Buildings (200 + 250)

Plant and Machinery (300-120)

Furniture and Fixtures

450

180

50

Total 680

3. Impact on Financial Restructuring

a. On Capital Base

Equity Capital has been reduced, and due to additional Equity Shares issued to Promoters, their

stake in the Company has been increased

b. On Debt Base

The base of Fixed Cost Funds has reduced, and also the cost of such funds is also reduced. This

contributes to a better Equity Earnings

c. Re-statement of Assets

Re-statement of Assets to their Fair Value will help in knowing in the true return on investment, and

would help compare with the benchmark industry data.

d. Infusion of Capital

Infusion of Capital by Promoters, coupled with lower cost of funds, will result in increased amount

available for capital expansion. This would further result in increased earnings due to increased

business.

45 | P a g e

Journal Entries in the books of GFC Ltd

Particulars Debit Credit

Equity Share Capital Account (Rs. 100)

To Equity Share Capital Account (Rs. 25)

To Capital Reduction Account

(Being Equity Shares of Rs. 100 each has been reduced to

Equity shares of Rs. 25 each)

Dr 600

150

450

14% Preference Share Capital Account

To 10% Preference Share Capital Account


(Being 14% Preference Shares of Rs. 100 has been reduced to

10% Preference Shares of Rs. 50 each)

Dr 200

100

100

13% Debentures Account

To 9% Debentures Account

(Being Debentures has been reduced from 13% to 9%)

Dr 200

200

Debenture Interest Accrued and Payable Account


(Being Debenture Holders agreed to forego the accrued

interest due to them)

Dr 26

26

Trade Creditors Account


(Being Trade Creditors agreed to forego 25% of the amount

due to them) (340x25%)

Dr 85

85

Bank Account

To Equity Share Capital Account

(Being the Company has issued 6 Lakh Equity Shares of Rs 25

each, which were fully subscribed by Promoters)

Dr 150

150

Land and Buildings Account


(Being Upward Revaluation of Land and Buildings to Rs. 450

Lakhs from Rs. 200 Lakhs)

Dr 250

250

Capital Reduction Account

To Plant and Machinery

To Provision for Bad and Doubtful Debts

To Preliminary Expenses

To Cost of Issue of Debentures

To Profit and Loss and Account

(Being Downward revaluation in Plant and Machinery and

provision for bad debts has to be created)

Dr 675

120

15

10

5

525

Capital Reduction Account

To Capital Reserve Account

(Being balancing figure of Capital Reduction Account was

transferred to Capital Reserve Account)

Dr 236

236

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Example: 15 Personal Computer Division of Distress Limited, a Computer Hardware Manufacturing Company

has stated facing Financial Difficulties for the Last Two to three Years. The Management of the

Division headed by Mr. Smith is interested in a Buyout. However to make this Buyout successful

there is an urgent need to attract Substantial Funds from Venture Capitalists

Ven Cap an European Venture Capitalist firm has shown its interest to Finance the proposed

buyout. Distress Limited intrested to sell the Division for 180 Crores and Mr. Smith is of Opinion

that an additional amount of 85 Crores shall be required to make the division viable. The expected

Financing pattern shall be as follows -

Source Mode Amount (crores)

Management Equity Shares of Rs. 10 Each 60

VenCap VC Equity Shares of Rs. 10 Each 9% Debentures with attached Warrant of 100 Each 8% Loan

22.5 22.5 160

Total 265

The Warrants can be exercised any time after 4 Years from now for 10 Equity shares @ 120 per

share.

The Loan is repayable in one go at the end of 8th Year. The Debentures are repayable in equal

Annual Instalment consisting of both Principal and Interest amount over a period of 6 Years

Mr. Smith is of View that the Proposed Dividend shall not be kept more than 12.5% of

distributable profit for the firs. The forecasted EBIT after the proposed Buyout is as follows -

Year 1 2 3 4

EBIT (Crores) 48 57 68 82

Applicable Tax Rate is 35% and it is expected that it shall remain unchanged at least for 5-6 Years.

In order to attract VenCap, Mr Smith stated that Book Value of Equity shall increase by 20% during

above 4 Years. Although VenCap has shown their Interest in Investment but are doubtful about

the Projections of Growth in the Value as per Projections of Mr. Smith. Further VenCap also

demanded that warrants should be convertible in 18 Shares instead of 10 Shares as proposed by

Mr. Smith.

You are required to determine whether or not the book value of equity is expected to grow by

20% per year. Further if you have been appointed by Mr. Smith as advisor then whether you

would suggest to accept the Demand of VenCap of 18 shares instead of 10 or not.

Solution

Calculation of Interest and Principal Payments on 9% Debentures

Annual Interest = (22.50Cr/4.486) = 5.0156 Cr [PVAF (9%, 6Y)=4.486]

(in Crores)

Year Balance Outstanding Interest Instalment Principal Repayment

Balance

1 22.5 2.025 5.0156 2.9906 19.5094

2 19.5094 1.756 5.0156 3.2596 16.2498

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3 16.2498 1.462 5.0156 3.5536 12.6962

4 12.6962 1.143 5.0156 3.8726 8.8236

Statement showing Book value of Equity (in

Crores)

Particulars Year 1 Year 2 Year 3 Year 4

EBIT 48 57 68 82

Interest on 9% Debentures

2.025 1.756 1.462 1.143

Interest on 8% Loan

12.8 12.8 12.8 12.8

EBT 33.1750 42.4440 53.7380 68.0570

Tax @ 35% 11.611 14.855 18.8080 23.8200

EAT 21.5640 27.5890 34.9300 44.2370

DIV @ 12.5% of EAT

2.6955 3.4490 4.3660 5.5300

Retention 18.8685 24.14 30.5640 38.7070

Balance b/f Nil 18.8685 43.0085 73.5725

Balance c/f 18.8685 43.0085 73.5725 38.7070

Share Capital 82.5000 82.5000 82.5000 82.5000

Book Value of Equity

101.3685 125.5085 156.0725 194.7795

In the Beginning of Year 1 Equity was Rs. 82.5 Crores which has been grown to Rs. 194.7795 in the

span of 4 Years. In such a case Compounded Growth rate shall be as follows (194.7795/82.5)% =

23.96%

This growth rate is slightly higher than 20% as projected by Mr. Smith

Viability of Increasing the Number of Underlying Shares in a Warrant

If the Condition of VenCap for 18 Shares is accepted the Expected Shareholding after 4 Years shall be

as follows -

Number of Shares held by Management 6 Crores

No. of Shares held by VenCap at the Starting stage 2.25 Crores

No. of Shares obtained by exercising the Warrant 0.225 Cr deb x 18 Shares

4.05 Crores

48 | P a g e

Total Holdings by VenCap 6.3 Crores

Thus it is likely that Mr. Smith may not accept this condition of VenCap as this may result in losing

their majority ownership and control to VenCap, Mr. Smith may accept their condition if

Management has further opportunity to increase their Ownership through Other Forms.

Example: 16 Company A has Net Operating Profits of Rs. 15 Crores. Applicable Tax Rate is 35%. The Company’s

Capital amounts to Rs. 6 Crores.

Solution -

Shareholders Value Added = (NOPAT - Cost of Capital) = [15(1-0.35) - 6] = Rs. 3.75 Crores

Company A’s SVA is Rs. 3.75 Crores

Example: 17

Following are the financial data of the Platinum Limited for a year - (lakhs)

Equity Shares 100 Effective Tax Rate 30%

8% Debentures 150 Operating Margin 10%

10% Bonds 50 Required Rate of Return of

Investors

15%

Reserves and Surplus 200 Dividend pay-out Ratio 20%

Total Assets 500 Current market Price of

Share

Rs. 13

Assets Turnover Ratio 1.1

You are required to –

(a) Draw Income Statement for the year

(b) Calculate Sustainable Growth Rate

(c) Calculate Fair Price of the company’s Share using Dividend Discount Model

(d) Draw your Opinion in the Company’s Share at Current Price

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Solution

(a) Income Statement –

Particulars Amount

Sales = Total Assets x Asset TO Ratio = 500 x 1.1 Times 550

Operating Profit = Sales x Operating Margin = 550x10% 55

Less: Interest Expense (150x8%) + (50x10%) 17

Operating Profit After Tax, But before Interest 38

Less: Tax at 30% 11.40

Equity Earnings 26.60

Less: Dividend = Equity Earnings x Payout Ratio of 20% 5.32

Retained Earnings 21.28

(b) Sustainable Growth Rate

Factors –

Sales for Last Year (S0) = 550

Net Profit Margin (P) = 26.60/550 = 4.83%

Retention Ratio (b) = 1-0.20 = 80%

Debt Equity Ratio (D/E) = 200/300 = 0.67

Total Assets = 500

𝑆𝑢𝑠𝑡𝑎𝑖𝑛𝑎𝑏𝑙𝑒 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 =𝑃 × 𝑆0 × 𝑏(1 +

𝐷𝐸

)

𝐴 − [𝑃 × 𝑆0 × 𝑏(𝑎 +𝐷𝐸

)]

𝑆𝐺𝑅 =0.0483 × 550 × 0.80(1 + 0.67)

500 − [0.0483 × 550 × 0.80(1 + 0.67)]=

35.49

500 − 35.49= 7.64%

Alternatively, SGR = ROE x (1 – Dividend Pay-out Ratio) = 8.87% x 0.80 = 7.10%

Where ROE = 26.60/300 = 8.87%

(c) Fair Price of Company’s Share using Dividend Discount Model (Gordon’s Model)

𝐷0 =𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 532000

100000 𝑆ℎ𝑎𝑟𝑒𝑠= 5.32

𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝑃0 =𝐷1

𝐾𝑒 − 𝑔=

𝐷0(1 + 𝑔)

𝐾𝑒 − 𝑔=

5.32(1 + 0.0710)

0.15 − 0.0710

= 𝑅𝑠. 72.12

Since Growth Rate of Earnings is considered, Gordon’s Constant Pay-out Model is most appropriate.

Also, Growth Rate for Gordon’s Model = SGR as per 2nd alternative above i.e., 7.10%, based on Return

on Equity, since, Gordon’s Dividend Discount Model considers an All-Equity Firm, where as in 1st

Alternative SGR, Debt Component of Capital is also considered.

50 | P a g e

Since the Current Market Price of Rs. 13 is less than Fair Value Rs. 72.12, it is worthwhile to invest in

the Company’s Shares at present.

Example: 18 ABC (India) Ltd., a market leader in printing industry, is planning to diversify into defense

equipment businesses that have recently been partially opened up by the GOI for private sector.

In the meanwhile, the CEO of the company wants to get his company valued by a Leading

consultants, as he is not satisfied with the current market price of his scrip.

He approached consultant with a request to take up valuation of his company with the following

data for the year ended 2009:

Share Price 66 per share

Outstanding Debt 1934 Lakhs

Number of Outstanding Debts 75 Lakhs

Net Income (PAT) 17.2 Lakhs

EBIT 245 Lakhs

Interest Expenses 218.125 Lakhs

Capital Expenditure 234.4 Lakhs

Depreciation 234.4 Lakhs

Working Capital Growth Rate 8% (from 2010 to 2014) Growth Rate 6% (beyond 2014)

44 Lakhs

Free Cash Flow 240.336 Lakhs (Year 2014 onwards)

The capital expenditure is expected to be equally offset by depreciation in future and the debt

is expected to decline by 30% in 2014.

Required:

Estimate the value of the company and ascertain whether the ruling market price is undervalued

as felt by the CEO based on the foregoing data. Assume that the cost of equity is 16%, and 30% of

debt repayment is made in the year 2014.

Answer:

Computation of Tax Rate:

Particulars Amount (Lakhs)

EBIT 245.000

Less Interest 218.125

PBT 26.875

PAT 17.200

Tax Paid 9.675

Tax Rate = 9.675/26.875 36%

Computation for Increase in Working Capital:


Working Capital (2009) 44

Increase in 2010 = 44 x 0.08 3.52

It will continue to increase @ 8% per annum

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Weighted Average Cost of Capital:


Present Debt 1934

Interest Cost = 218.125/1934 11.28%

Equity Capital = 75 Lakhs x 66 4950

KC = 4950

1934+4950× 16% +

1934

1934+4950× 11.28(1 − 0.36) = 11.51 + 2.028 = 13.54

As Capital Expenditure and depreciation are equal, they will not influence the free cash flows of the

company.

Computation of Free Cash Flows up to 2012

(In Lakhs)

Year 2010 2011 2012 2013 2014

Amount Amount Amount Amount Amount

EBIT (1-t) 169.344 182.890 197.520 213.320 230.39

Increase in Working Capital 3.520 3.800 4.100 4.430 4.780

Debt Repayment (1934 x 0.30) - - - - 580.200

Free Cash Flows 165.824 179.090 193.410 208.890 (354.590)

PVF @ 13.54% 0.8807 0.7757 0.6832 0.6017 0.5300

PV of Free Cash Flow @ 13.54% 146.040 138.920 132.140 125.690 (187.930)

Present Value of Free Cash Flows up to 2014 = Rs. 354.86 Lakhs

Cost of Capital [2014 Onwards]

Debt = 0.7 x Rs. 1934 = Rs. 1353.80 Lakhs

Equity = Rs. 4950 Lakhs

KC = 4950

4950+1353.80× 16% +

1353.80

4950+1353.80× 11.28 (1 − 0.36) = 12.56 + 1.55% = 14.11%

Continuing Value:

240.336

0.1411 − 0.06× (

1

1.1354)5 = 𝑅𝑠. 1570.556 𝐿𝑎𝑘ℎ𝑠

Value of the Firm = PV of Free Cash Flows up to 2014 + continuing value

= Rs. 354.86 Lakhs + Rs. 1570.556 Lakhs

= Rs. 1925.416 Lakhs

Value per Share = [Value of Firm – Value of Debt]/Number of Shares

= [Rs. 1925.416 Lakhs – 1353.80 Lakhs]/75 Lakhs

= Rs. 7.622 < Rs. 66 (Present Market Value)

Therefore, the share price is overvalued in the market.

Example: 19 Herbal Gyan is a small but profitable producer of beauty cosmetics using the plant Aloe Vera. This

is not a high-tech business, but Herbal’s earnings have averaged around Rs. 12 Lakh after tax,

largely on the strength of its patented beauty cream for removing the pimples.

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The patent has eight years to run, and Herbal has been offered Rs. 40 Lakhs for the patent rights.

Herbal’s assets include Rs. 20 Lakhs of working capital and Rs. 80 Lakhs of property, plant, and

equipment. The Patent is not shown on Herbal’s books. Suppose Herbal’s cost of capital is 15

percent. What is its Economic Value Added (EVA)?

EVA = Income Earned – [Cost of Capital x Total Investment]

Total Investments:


Working Capital Property, Plant and Equipment Patent Rights

20 80 40

Total 140

Cost of Capital = 15%

EVA = 12 Lakhs – [0.15 x 140 Lakhs] = Rs. 12 Lakhs – 21 Lakhs = (Rs. 9 Lakhs)

Thus Herbal Gyan has a negative EVA of Rs. 9 Lakhs

Example: 20 The following data pertains to XYZ Inc. engaged in software consultancy business as on 31

December 2010.

($ Millions)

Income from Consultancy 935.00

EBIT Less: Interest on Loan

180.00 18.00

EBT Tax @ 35%

162.00 56.70

105.30

Balance Sheet:


Equity Stock (10 Million shares @ $10 each) Reserves and Surplus Loans Current Liabilities

100 325 180 180

Land and Buildings Computers and Soft wares Current Assets:

Debtors = 150 Bank = 100 Cash = 40

200 295

290

785 785

With the above information and following assumption you are required to compute –

1. Economic value Added

2. Market Value Added

Assuming that:

1. WACC is 12%

2. The share of company currently quoted at $ 50 each

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Determination of Economic Value Added [EVA]

Particulars Amount

EBIT Less Taxes @ 35%

180 63

Net Operating Profit after Tax Less Cost of Capital Employed [W No 1]

117 72.60

Economic Value Added 44.40

Amount (Million)

Market Value of Equity Stock [W No 2] Equity Fund [W No 3]

500 425

Market Value Added 75

Working Notes:

1. Total Capital Employed

Equity Stock Reserve and Surplus Loan

$ 100 Million $ 325 Million $ 180 Million

$ 605 Million

2. Working Note 2

Markey Price per Equity Share [A] No. of Equity Share Outstanding [B]

$ 50 10 Million

Market Value of Equity Stock [A x B] $ 500 Million

3. Working Note 3

Equity Fund Equity Stock

$ 100 Million $ 325 Million

Reserves and Surplus $ 425 Million

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