UNIT 1

1.1: Introduction:
To engage in business the financial managers of a firm must
find answers to three questions. First, what long-term
investments should the firm take on? This is the capital
budgeting decision. Second, how can cash be raised for the
required investments? We call this the financing decision.
Third, how will the firm manage its day to day cash and
financial affairs? These decisions involve short term finance
and concern net working capital.
Now, let us see how a company can raise cash to finance
their investment decision? This is done by setting or issuing
securities.
These securities are also called as financial instruments or
claims, may be roughly classified as equity or debt.
The cashflow paid to the bondholders and stockholders of the
firm should be higher than the cashflows put into the firm by
them.
Caselet:{Assignment 1}
M & M has decided to expand its operations and announced
an IPO for Rs.10,00,000 shares @ Rs.200 each. It even tried
for a debt of Rs.30,00,000 @ 15% interest. With this finance
it has invested in operating assets 3/4th of the amount and
rest for its day-to-day operations. The M & M was able to
generate a cashflow of Rs.20,00,000 from the fixed assets.
In the next year M&M has increased its working capital by
20% and purchased new machinery for increasing its
turnover for Rs. 30,00,000. For this it has again opted for
IPO of Rs.50,00,000 divided into 10,000 shares.

Now, from the above case:

What are the financing decisions of M&M to expand its
operations for both the years?
How much is the difference in the value of share issued to
the stockholders?
What is the value of working capital in the second year?
Difference between accounting perspective and finance
perspective:
Case let 2:
Jos alukas refines and trades gold. At the end of the year it
sold Rs.2,500 ounces of gold for Rs.10,00,000. The company
had acquired the god for Rs.9,00,000 at the beginning of the
year. They paid cash for the gold when it is purchased.
Unfortunately, it has yet to collect from the consumer to
whom the gold was sold.
From the accounting point of view:
Sales

10,00,000

(-) costs

9,00,000
----------------

Profit

1,00,000
---------------

By GAAP,the sale is recorded even though the customer has

yet to pay. It is assumed the customer will pay soon. So,
from the accounting perspective Jos alukas seems to be
profitable.

However, the perspective of corporate finance is different. It

focuses on cash flows:

Income statement
Cash inflow
(-)Cash outflow

0
9,00,000
-----------

Cash flow generated

(9,00,000)
------------

The perspective of corporate finance is interested in whether

cashflows are being created by the gold trading operations of
jos alukas.
Value creation depends on cash flows.
For Jos alukas value creation depends on whether and when
it actually receives Rs.10,00,000.
Timing of cash flows:
Value of an investment made by the firm depends on
the timing of cashflows. One of the most important
assumptions of finance is that individuals prefer to
receive cash flows earlier rather than later.
One Re. received today is worth morethan one Re.
received next year.
This is the time preference which plays a major role in
cash flows.
Determining cash flows:
The first step in determining cash flow of a firm is to
figure out the cash flow from operations.

The operating cash flow is the cash flow generated by

business activities, including sale of goods and services
and tax payments.
EBIT
(+) Depreciation

xxx
xxxx
------EBDIT
xxxxx
(-) Current Taxes
xxx
-------Operating cash flow xxxx
-------The second step is changes in fixed assets which is the
capital spending or expenditure.
It is the difference between acquisition and sale of fixed
assets between 2 years.
The third and final step is finding the additions for net
working capital.
The total cash flow generated by the firm assets is the sum
of
Operating cash flow less capital spending and deducting
additional investment in net working capital from it.
1.2 Shareholder Value Analysis: (SVA)
The SVA is also called as shareholder value added or
shareholder value approach. This is described by Alfred
Rappaport and is a variation of DCF methodology.(DCF
methodology is a Discounting Cash Flow technique where the
cash flows generated are discounted at the cost of
capital)SVA values the whole enterprise as a single unit.
Value creation:

Value is created to the shareholder if the firm generates

excess returns than the cost of capital.

Centre to the approach:

There are seven value drivers for SVA.
(A value driver is the one on which the other variable
depends.)
1. Sales growth
2. Operating profit margin
3. Cash tax rate
4. Increase in working capital investment
5. Increase in fixed capital investment
6. Cost of capital
7. Competitive Advantage period
1. Sales Growth:
Sales growth creates the revenue required for the
organization through which it can carry its operations.
2. Operating Profit Margin:
It is % of profit obtained after deducting operating costs
form the sales growth or revenue.
Operating costs are the expenses incurred by a company
while doing business. Ex: salaries, Cost of goods sold etc; .
3. Cash tax rate: Many companies pay the current tax but
not the deferred tax on operating profits. So, taxation is
considered to know the exact cash flow.
4. Increase in Working capital Investment:

Working capital refers to the cash a business requires for day

to day operations or short term financing to maintain
Current Assets.
The increase in working capital occur when sales revenue
grows.
5. Increase in Fixed Capital Investment:
A company has to invest in fixed assets to carry its
operations.
These amounts can be found from the balance sheet of a
company.
To calculate this the capital expenditure, disclosed in
companys statement of cash flow should be taken and non
cash depreciation charges from income statement must be
added to this.
Any purchase or sale of fixed assets is also to be taken into
consideration.
6. Cost of Capital: (coc)
It is the return available to the shareholders and
bondholders.
7. Competitive Advantage Period:
It is the duration during which the firm is expected to
generate superior returns in excess of coc.
Steps in SVA:
The SVA involves the following steps:
1. Estimate the Free Cash Flow within the Competitive
Advantage Period by reference to the value drivers.

2. Discount the cash flows using either a company wide

WACC or separate unit discount rates.
3. Calculate the residual value by discounting simplified
cash flows beyond the competitive advantage period.
4. Add the PV of all FCF in the CAP to the residual value
and the resultant is the Value of the Enterprise.
5. Add the market value of non-trade or non-operational
assets to the result to get the corporate value that
belongs to all investors.
6. The value of equity is then determined by deducting the
value of debt.
Practice Problem:1.
Angel Inclusion operates in a retail environment, expects a
reasonable level of growth for four years into the future
and no major improvements in its operating profit margin.
Angel Inclusions forecast value drivers:
PARTICULARS

Sales Growth %
Operating Profit
Margin, %
Sales / NBV of
Assets
W.C invt. / Sales %
Cash tax rate, %
Depreciation /NBV
of Fixed Assets, %

ACTUAL
1999

Competitive Advantage
Period

Future
2004
onwards

8
12

2000 2001
8
6
12
12

2002 2003
5
3
12
12

0
12

2.8

2.8

2.8

2.8

2.8

2.8

15
30
7

15
30
7

15
30
7

15
30
7

15
30
7

15
30
7

Note: NBV Net Book Value ; W.c Working Capital; Invt.

investment.
The value drivers are used to forecast FCF generated by the
Company within the Competitive Advantage Period. Let us
assume WACC is 9% and Market value of debt is 500 million
and its sales were 3,000 million in 1999.
Find the Shareholder value according to SVA.
Solution: Discussed in the class
1. Calculation of FCF:
PARTICULARS

ACTUA
L
1999

Sales (W.N 1) 3,000

Operating Profit
(W.N 2)
(+)Depreciatio
n
(W.N 4)
EBITDA (a)
Tax (b)
(W.N 5)
Expenditure on
Fixed Assets
(W.N- 6)
Increase in
working capital
(d)(W.N 7)
FCF = a-b-c-d

Competitive Advantage Period

Future
2004
onwards

2000
3,24
0
388.
8
81

2001
3,434.
4
412.1

2002
3,606.
1
432.7

2003
3,414.
3
409.72

85

90.2

92.9

92.9

469.
8
116.
6
166.
7

498

522.9

502.62

538.6

123.6

129.8

122.92

133.7

155.3

151.5

131.5

92.9

36

29.2

25.8

16.2

150.

189.9

215.8

232

312.0

3,714.3
445.7

5
Working notes:
1. Sales growth is 8% :
Sales for year 2000 = sales of 1999 + 8% of sales of
1999
= 3,000 +8% of 3,000
= 3,240
Like this sales has to be calculated for 2001 to 2004.
2. Operating profit margin is 12% of sales:
Operating profit for the year 2000 = sales for 2000 x
12%
=388.8
In similar manner operating profit for 2001 to 2004 is to
be calculated.
3. NBV of Fixed Assets:
For calculation of NBV of fixed assets we use the multiple
Sales / NBV of Assets = 2.8
NBV of fixed assets for the year 2000:
= sales for the year 2000/NBV of assets = 2.8
= NBV of assets = 3,240 / 2.8
=1157.4
In the same way NBV for all the competitive advantage
period (CAP) should be calculated.
4. Depreciation: one of the given multiple is
Depreciation /NBV of fixed assets = 7%
Depreciation = 7% x NBV of fixed assets
For the year 2000 depreciation = 1157.4 x 7% = 81
Calculate depreciation for all the CAP
5. Tax is 30 % of operating profits:
Tax for 2000 is 30% of 388.8 = 116.6

Calculate tax for rest of CAP in the same manner.

6. Expenditure on fixed assets:
It is the difference between fixed assets for the two
consecutive years.
7. Working capital: W.C invt. / Sales % is used to find w.c
for each year and then the difference between 2 years
gives the amount of increase in working capital.2nd step:
Discount the cash flows in CAP using WACC :
2000
150.5
0.917

2001
189.9
0.842

2002
215.8
0.772

2003
232
0.708

FCF
Discount
factor 9%
Discounte 138
159.89 166.59 164.25
d
6
FCF
3rd step: Calculate residual value by discounting simplified
cash flows beyond the competitive advantage period.
Residual value = FCF beyond CAP x Discount factor 9%
= 312.0 x 7.871(i.e Discount factor 9%)
=2,455.752
4th step: calculation of the value of the enterprise: for this
add the PV of all FCF in the CAP to the residual value and the
resultant is the Value of the Enterprise.
Sum of CAP FCF = 138 +159.89 +166.59 +164.256
= 628.736
Terminal or residual value = 2,455.752
Value of the firm = Sum of CAP FCF + residual value
= 628.736 + 2,455.72

=3,084.456
5th step:Add the market value of non-trade or nonoperational assets to the result to get the corporate value
that belongs to all investors.
As we dont have any market value of non-operational assets
in the case directly we can move to 6th step.
6th step: The value of equity is then determined by deducting
the value of debt:
Value of equity = Value of firm market value of debt
= 3,084.456 500
= 2584.456
Case 2 for Assignment:1
You have been asked to value a potential acquisition. The
following information regarding the target is available:
Current sales 10 million per annum
Competitive Advantage period 5 years
Value driver information:
Year
Sales
growth %
Operating
profit
margin %
Cash tax
rate %
IFCI% on
sales

1
8

2
5

3
7

4
6

5
5

Beyond
0

20

20

17

15

12

10

30

30

30

30

30

30

IWCI %
10
10
12
8
5
0
on sales
Coc
14
14
14
14
14
14
Depreciation 5 million p.a ; market value of short term
investments is 10 million and the value of debt is 15 million.
Value the business using SVA.
Should mail to the students from here:

Advantages of SVA:
SVA has a principal that the management of a company
should first consider the interest and advantage of the
shareholders before it makes any decision.
The advantages of SVA are as follows:
1. It provides a universal approach that is not subject to
the particular accounting policies that are adopted.
Therefore, it is internationally applicable and can be
used across sectors.
2. If forces the organization to focus on the future and its
customers, in particular the value of future cash flows.
3. SVA holds that management should first and foremost
consider the interests of shareholders in its business
decisions.
4. SVA takes a long-term view and is about measuring and
managing cash flows over time. It provides the user
the clear understanding of value creation or degradation
overtime.
Disadvantages of SVA:
1. Estimation of future cash flows, a key component of
SVA, can be extremely difficult to complete accurately.
This can lead to incorrect or misleading figures forming
the basis for strategic decisions.

2. Development and implementation of a system can be

long and complex.
3. Communication of the approach to the managers can be
difficult.
4. Management of shareholder value require more
complete information than traditional measures.
5. The concentration on shareholder value does not take
into account social needs. SVA benefits only the owners
of the corporation, it does not provide a clear measure
of social practices such as employment, environmental
issues and ethical business practices.
1.3: Ways of linking shareholder value to strategy:
Introduction:
According to strategy analysis the purpose of strategy is to
establish superior value in the eyes of the customer or to
achieve the lowest delivered cost in general.
The purpose of shareholder value from the side of the
company is to increase the value delivered to the
shareholders.
Concept:
The most common financial objective of modern commercial
corporations is the sustainable creation of shareholder value.
This can be achieved by providing shareholders with a total
return that exceeds their risk adjusted required rate of return
on investment.
However, the share price for most companies already reflects
some expected growth in profits.
Current shareholders and more importantly, potential future
investors want to assess whether the companys proposed

business strategies will produce sufficient growth in sales

revenues and profits to support both the current share price
and existing dividend payments, as well as to drive the
capital growth they want to see in the future.
Along this, external stakeholders also need a method of
assessing the risks associated with proposed strategies as
these have a direct effect on the rate of return.
Central theme:
Different ways of linking strategy to shareholder value was
first explained by Alfred Rappaport .This became a base for
many companies to formulate a relationship between their
corporate objective and shareholder value.
The projection below explains how a strategy can be linked to
shareholder value.

Shareholder value

Revenue

Operating
margin

Growth

Direct
costs
volum
e

price

Indire
ct
costs

Asset Efficiency

Expectations

Property
&
Equipmen
Inventory
Receivables
& payables

Company
strengths

External
strengths

The way to establish relationship between corporate objectives

and value drivers was explained by Alfred Rappaport in the
following manner:
The objective of the management is to provide consistent
and positive shareholder value.
By improving cash flow from operations, minimizing the cost of
capital and by making optimal capital structure decisions the
positive shareholder value can be achieved.
The cash flow from operations is determined by the value
drivers and is affected by the operational and investment
decisions taken by the management.
The tale given below shows the implications of this frame work
for value creating strategies as they relate to the financial and
operational value drivers.
The second column shows the value drivers and the third
column shows the various underlying strategies that positively
influence these drivers.
ToAchiev
e

An
increase
in cash

ValueDrivers

StrategicRequirements

Higher revenues
and growth

Patent barriers to entry, niche

markets, innovative products, etc.

Lower costs
and income
taxes

Scale economies, captive access to

raw materials, higher efficiencies in
processes (production, distribution,
services) and labor utilization,
effective tax planning, etc.

flow from
operation
s

A
reduction
in capital
charge

Reduction in
capital
expenditure

Efficient asset acquisition and

maintenance, spin- offs, higher
utilization rates of Fixed assets,
efficient working capital management,
divesture of negative value creating
assets, etc.

Reduced
business risk

Consistent and superior operating

performance compared to competitors,
long-term contracts, project financing,
etc.

Optimize
capital
structure

Achieving and maintaining a capital

structure that minimizes the over all
costs, optimizes tax benefits, etc.

Reduced cost of
debt

Reducing surprises (volatility of

earnings), designing niche
instruments, etc.

Reduced cost
of equity

Consistent value creation

Case:
We will say about Hellions way of linking strategy to its
shareholder value.
Hellions strategic vision is customer satisfaction and it is
achieved through strategic objectives such as repurchase, cross
selling, lower price sensitivity and positive word of mouth.
With these objectives the Hellions should maximize the
shareholder value which is its target.
Customer satisfaction: customer satisfaction involves behavior
of customers that typically relates to purchase or consumption
fo product or services.

Customer satisfaction increases sales which increases the future

cash flows and reduces the FCF variability and there by
increases the shareholder value (as profits increase)
A satisfied customer when retained reduces the cost of finding
new customers (selling and administration expenses) and
increases the FCF.
Conceptual frame work:
A conceptual model between customer satisfaction and
shareholder value can be used to explain the ways of linking the
customer satisfaction as a strategy to increase the shareholder
value.
Relationship between customer satisfaction and shareholder
value:
On the left hand side, the consequences of customer satisfaction
(level-1) are shown which are related to outcome that directly
influence the value drivers of shareholder value.
The outcomes of the satisfaction are linked to the drivers of
shareholder value.
The repurchase behavior of customer accelerates the cash flow
of the business and there after enhances the shareholder value.
Cross-selling behavior of customer increases the base of cash
flows that also increase the value of the shareholder.
Lower price sensitivity is one of the good characteristic of
satisfied customer. As a result companies reduce the risk with
cash flows. The reduction in risk with cash flows increases the
value of shareholders.
Positive word of mouth plays an important role when the matter
comes regarding shareholder value enhancement. Positive word

of mouth gives higher residual value and thereafter enhances

shareholder value.
Consequences

Drivers of
Shareholder value

Repurchase

Customer
satisfacti
on

Acceleration of
CF

Cross - selling

Increase of
CF

Lower
price
sensitivity

Reduction
in risk with

Positive
word of
mouth

Shareholde
r Value

High
Residual
Value

There are many examples of firm employing one or many of

these strategies to create shareholder value. The 3M company
does it by continuously introducing new products; corel does it
by bringing quality products to market very quickly, usually with
more functionality and at a cheaper price than its competitors;
sony does it by introducing high quality products to the market
for which consumers are willing to pay a higher price.
Each organization uses its respective competitive advantage to
dominate their product markets, so that as long as their
operations and capital continue to be managed effectively,
incremental shareholder value will be created.

In reality successful firms employ a combination of these

strategies to achieve competitive advantages, which in turn
create value for their shareholders.
1.4: Exploring Business Value:
A value system is the network of organizations and the value
producing activities involved in the production and delivery of
an offering. The major business processes are the value
producing activities.
Harvard Business School's Michael E. Porter was the first to
introduce the concept of a value chain. It was first discussed in
his book "Competitive Advantage: Creating and Sustaining
Superior Performance
Value system or value chain -Specifically, Porter called the value producing activities of one
organization a value chain and the network organizations
involved in the production and delivery of an offering to the
end customer a value system.
In his book, Porter said a business's activities could be split
into two categories: primary activities and support activities.
Primary activities include the following:
Porter classified the generic value added activities into two
classes which are presented in Figure-1. These activities are:
primary activities which are classified as product and market
related activities and support activities that are related to
infrastructure, technology, procurement, and human resource
management.

Figure-1: Porters Value Chain Activities

Primary activities can be classified into product related
and market related activities which are described below:
Product related activities: The activities that the
organization performs to add value to the products and
services itself. The activities are classified as:
1. Inbound logistics: For the production and development
activities, organizations need inputs as goods which are
received from the suppliers. Inbound logistics refer to all
the activities related to receive goods from the suppliers,
decision about the transportation scheduling, storing the
goods as inventory, managing the inventory, and make the
inputs ready to use for the production of end products.
2. Operations: These include the production process,
development activities, testing, packaging, maintenance,
and all other activities that transform the inputs into
finished product.
3. Services: Organization offers the services after the
products and/or services have been sold. These service
activities enhance the products value in the form of after

sales guarantees, warranties, spare parts management,

repair services, installation, updating, trainings, etc.
Market related activities: The activities that the
organization performs to transfer the finished products or
services to the customers. The activities are classified as:
1. Outbound Logistics: The finished products are
developed using the product related activities. Now
activities are required to transfer the finished products to
the customers via warehousing, order fulfillment,
transportation, and distribution management.
2. Marketing and Sales: These activities include the
advertising, channel selection, product promotion, selling,
product pricing, retail management, etc. The activities are
performed to make sure that the products are transferred
to the targeted customer groups. Marketing mix can be an
instrument to take the competitive advantage to the target
customers.
Support activities: The activities that the organization
performs to assist the primary activities to gain the
competitive advantage. The activities are classified as:
1. Procurement: This is the purchasing activity of the
inputs to transform these into finished products or
services. Procurement adds value by the acquisition of
appropriate goods or services at the best price, at the
right time, and in the desired place with the desired
quality and quantity.
2. Technology Management: This is very important in todays
technological driven environment. Technology can be used in
production to reduce cost, to develop new products, increase
customer service facility, build up cost effective process, etc.
It supports the value chain activities such as research and
development, process automation, process design, etc.
3. Human Resource Management: The key roles of HR are to
support the attainment of the overall strategic business plan
and the objectives. As a strategic business partner HR
designs the work positions by hiring, recognition, reward,

appraisal systems, carrier planning, and employee

development. They act as an advocate of the employees to
motivate them and create a happy working environment. For
the organizational changing situation, HR executes the
strategic needs of the organization with minimum employee
dissatisfaction and resistance to change.
4. Infrastructure: This includes the planning management,
legal framework, financing, accounting, public affairs, quality
management, general management, etc. These are required
to perform the value added activities efficiently to drive the
organization forward to meet the strategic plan and the
objectives.
1.5: Corporate Valuation:
a. Introduction: Corporate valuation provides the financial
manager with several ways to calculate the worth of entity.
The financial manager would like to value the business for many
financial reasons like purchase, sale, merger, litigation, tax
issues and to expand the business line.
b. Concept of value:
value may be defined as a corporates worth in money or other
securities at a given point of time.
There are four broad approaches for appraising the value of a
company. They are:
1. Adjusted book value approach
2. stock and debt approach
3. Direct comparison approach and
4. Discounted cash flow approach
5.1. Adjusted Book value approach:

This method relays on the information provided by the

balance sheet of a firm adjusted for replacement cost or
liquidation value
There are 2 ways of using the balance sheet information to
appraise the value of a firm.
1. The book values of investor claims may be summed up
directly.-investor claim approach
2. The assets of the firm may be totaled the asset liabilities approach and from this total non- investor claims
are deducted
case: Balance sheet of X Ltd.as on 31st march 2015:
Liabilities
Share capital:
Equity
Preference
Reserves and
surplus
Secured loans:
Term loans
Debentures
Unsecured
loans:
Bank credit
Inter-corporate
loans
Current
liabilities and
provisions

Rs. In
crores

Assets

Rs. In
crores

15
15

Fixed Assets:
Gross
(-)Acc.Depreciation

11.20

Investments

59
26
33
1.50

Current Assets, loans

and advances:
Cash and bank
Debtors
Inventories
Prepaid expenses

1
11.40
10.50
0.50

7
7.30
2.50
4.40

10.50

57.90

Miscellaneous
expenditures and
losses

57.90

Find the value of the firm according to adjusted book value

approach.
Solution:
Balancesheet valuation through investor claims approach:
Share capital
Reserves and surplus
Secured loans
Unsecured loans
Total

15
11.20
14.30
6.90
47.40

Balance sheet valuation through asset-liabilities approach:

Total assets
Less: Current liabilities and
provisions

57.90
10.50
47.40

5.1.a Accuracy:
The accuracy of the book value approach depends on how
well the net book values of the assets reflect their fair market
values.
Reasons for divergence of book values:
There are 3 reasons for divergence of book values from
market values. They are:
1. Inflation drives a wedge between the book value of an
asset and its current value. The book value of an asset
is its historical cost less depreciation. Hence , it does
not consider inflation which is definitely a factor
influencing market value.

2. Some assets become obsolete and worthless even

before they are fully depreciated in the books due to the
technological changes.
3. Organizational capital a very valuable asset is not shown
in the balance sheet. Organizational capital is the value
created by bringing together employees, customers ,
suppliers and managers in a mutually beneficial and
productive relationship. An important characteristic of
organizational capital is that it can not be separated
from the firm as a going entity.
5.1.a.1 Adjusting Book Value to Reflect Replacement Cost:
An asset earning power is related to its current replacement
cost but not to its book value. So, the net book values are
substituted by current replacement costs.
The various assets are valued as follows:
1. Cash: cash is cash. Hence there is no problem in
valuing it.
2. Debtors : Generally debtors are valued at their face
value. If the quality of debtors is doubtful
prudence(caution) calls for making an allowance for
likely bad debts.
3. Inventories: inventories are classified into 3 categories:
a. Raw materials
b. Work in-process
c. Finished goods
a. Raw materials are valued at their most recent cost of
acquisition
b. Work in process is approached from the cost point of
view(cost of raw materials plus the cost of processing)
or from the selling price point of view (selling price of
the final product less expenses to be incurred in
translating work in process in to sales)

c. Finished goods inventory is generally appraised by

determining the sale price realizable in the ordinary
course of business less expenses to be incurred in
packaging, handling, transporting, selling and collection
of receivables.
d. Other current assets: other current assets like deposits,
prepaid expenses and accruals are valued at their book
value.
e. Fixed Tangible Assets: Fixed tangible assets consist
mainly of land, buildings, plant and machinery.
Land is valued as if it is vacant and available for sale;
buildings are valued at replacement cost less physical
depreciation. The value of plant and machinery may be
appraised at the market price of similar (used) assets
plus the cost of transportation and installation.
Non-operating Assets: assets not required for meeting
the operating requirements of the business are referred
to as non-operating assets. The more commonly found
non-operating assets arefinancial securities, excess land
and unused buildings. These assets are valued at their
fair market value.
5.1.a.2 Adjusting Book values to reflect liquidation
value:
The most direct approach for approximating the fair
market value of the assets on the balance sheet of a
firm is to find out what they would fetch if the firm were
liquidated immediately. If there is an active secondary
market for the assets, liquidation values equal
secondary market prices. However, active secondary
markets do not exist for any business assets. In such

cases, the appraiser must try to estimate the

hypothetical price at which the assets may be sold.
The principal weakness of the liquidation value approach
is that it ignores organizational capital. Instead of
valuing the firm as a going concern, it values it as a
collection of assets to be sold individually. This
approach makes sense only for a firm that is worth
more dead than alive.
5.2. stock and debt approach:
When the securities of a firm are publicly traded, its value
can be obtained by merely adding the market value of all its
outstanding securities. This approach is called stock and
debt approach to valuation. It is also referred as market
value approach.
The stock and debt approach assumes market efficiency. An
efficient market is one in which market price of a security is
unbiased estimate of its intrinsic value.
Case: on March 31st 2015 X Ltd. Had Rs.1.5 lakh o/s shares.
At the close price of Rs.20 on that day, X Ltd., had a market
value of Rs.30 Lakhs. On March 31st 2015 the firm also had
o/s debt with a market value of Rs.21 lakhs. What is the
value of the firm according to stock and debt approach?
Solution:
Value of firm = market value of stock + market value of debt
= 30 lakhs + 21 lakhs = 51 lakhs
5.3. Direct Comparison Approach:

The direct comparision approach involves valuing a company

on the basis of how similar companies are valued in the
market place.
The direct comparison approach to value a firm involves the
following steps:
a.
b.
c.
d.
e.
f.
g.

Analyse the economy

Analyse the industry
Analyse the subject company
Select comparable companies
Analyse subject and comparable companies
Analyse multiples
Value the subject company

a. Analyse the economy: the first step in the comparable

company approach is to analyse the economy. An analysis of
the economy provides the basis for assessing the prospects
of various industries and evaluating individual companies
with in an industry. Such an analysis calls for examining the
following factors and forecasting their growth rates: gross
national product, industrial production, agricultural output,
inflation, interest rates, balance of payments, exchange rate
and government budget.
b. Analyse the Industry: the second step in the comparable
company approach is to analyse the industry to which the
subject company belongs. This analysis should focus on the
following:
i.
ii.
iii.
iv.

the
the
the
the

relation of the industry to the economy as a whole

stage in which the industry is in its life cycle
profit potential of the industry
nature of regulation applicable to the industry

v.

the relative competitive advantages of procurement of

raw materials, production costs, marketing and
distribution arrangements and technological resources.

c. Analyse the subject company: the third step is to carry out

the in depth analysis of the competitive and financial position
of the subject company. The key aspects to be covered in
this examination are as follows:
i.
ii.
iii.
iv.
v.
vi.
vii.
viii.
ix.
x.

product portfolio and market segments covered by the

firm
availability and cost of inputs
Technological and production capability
Market image, distribution reach and customer loyality
Product differentiation and economic cost position
Managerial competence and drive
Quality of human resources
Competitive Dynamics
Liquidity, leverage and access to funds
Turnover, margins and Return on Investment
d. Select Comparable companies: After the subject
company is studied, the next step is to select
companies which are similar to the subject company
in terms of the lines of business, nature of markets
served, scale of operation and so on. Often it is hard
to find truly comparable companies
becausecompanies are engaged in a variety of
businesses, serve different market segments and
have varying capacities. Hence, in practice the
analyst has to select companies which are
comparable
e. At least in some ways. he should make every effort
to look carefully at 10 to 15 companies in the same
industry and select at least 3 to 4 which come as
close as possible to the subject company.

f. Analyse the financial aspects of the subject and the

comparable companies:
once the comparable companies are selected, the
historical financial statements (income statements
and balance sheets) of the subject and comparable
companies must be analysed to identify similarities
and differences and make adjustments so that they
are put on a comparable basis. Adjustments may be
required for differences in inventory valuation
methods, for intangible assets, for off balance sheet
items and so on. The purpose of these adjustments
is to normalize the financial statements.
g. choose the observable financial variable: For the
direct comparision approach to provide a reliable
estimate of value, the ratio of the value indicator to
the observed financial variable, V/x,must not vary
widely for the comparable firm and the target firm.
Since the variability of V/x depends considerably on
the choice of V and x, the two variables must be
selected with care.
h. The financial variables that are likely to produce a
constant V/x ratio are those that are closely
associated with the value of a firm. Since the value
of a firm is ultimately based on the cash generated
for its investors, financial variables like earnings and
cash flow are the obvious choices for x. in addition
financial variables such as sales and net worth which
indirectly measure earning power can also be
considered.
The value indicator must be in consistent with the financial
variable chosen. If a gross financial variable like EBIT is
chosen then, it should be matched with total firm value. On
the other hand if the appraiser uses a financial variable like

equity value it should be matched with equity value not the

total value of the firm. In such a case the estimated value of
the equity must be added to the estimated value of other
investor claims (debt and preferred stock) which are
separately assessed to calculate the total value of the firm.
The ratios or multiples that are commonly used in the Direct
comparision approach are as follows:
1. Firm value to sales
2. Firm value to book value of assets
3. Firm value to PBIDT
4. Firm value to PBIT
5. Equity value to equity earnings (price earnings
multiple)
6. Equity value to Net worth
i. Value the subject Company:
the final step in this process is to decide whether the subject
company fits in relation to the comparable companies. This
is essentially a judgemental exercise. Once this is done,
appropriate multiples may be applied to the financial
numbers(sales, EBIT and so on) of the subject company to
estimate its value. If several bases are employed, the
several value estimates may be averaged (for this purpose a
simple arithmetic average or a weighted arithmetic average
may be employed.)
Case: the following information is available for company D,a
pharmaceutical company, Earnings Before interest, tax,
depreciation and amortization Rs.400 million ;Book value of
assetsRs.1,000 million; Sales Rs.2,500 million.
Based on an evaluation of several pharmaceutical companies
A, B and C have been found to be comparable to company D.
the financial information for these companies is given below:

Particulars
EBITDA
BOOK VALUE OF
ASSETS
SALES
ENTERPRISE VALUE
EV/EBITDA
EV/BOOK VALUE
EV/SALES

A
280
800

B
360
1000

C
480
1400

1600
2000
7.1
2.5
1.25

2000
3500
9.7
3.5
1.75

3200
4200
8.8
3.0
1.31

Taking into account the characteristics of company D Vs.

Companies A,B and C the following multiples appear
reasonable for company D:
EV/EBITDA = 8.5
EV/SALES = 1.44

EV/BOOK VALUE = 3.0

Applying these multiples to the financial numbers of

Company D,gives the following value estimates:
1.EV = 8.5 X EBITDA = 8.5 X 400 = Rs.3400 million
2.EV = 3.0 x BV = 3.0 x 1000 = Rs.3400 million
3.EV = 1.44 x sales = 1.44 x 2500 = Rs.3600 million
A simple arithmetic average of three value estimates is =
(3400+3400+3600)/3 = Rs.3333 million
Case: Assignment 1
The following details are given for company E, a painting firm:
Particulars
Rs. In million
PBIDT
18
Book value of assets
90
Sales
125
The companies B, C and D were found to be comparable with E.

The details required are:

Particulars
PBIDT
Book value of assets
Sales
Market value(MV)
MV/PBIDT
MV/Book value
MV/sales
Multiples most suitable to E:

Year1
12
75
80
150
12.5
2
1.88

Year2
15
80
100
240
16
3
2.40

Year3
20
100
160
360
18
3.6
2.25

MV/PBIDT = 17, MV/Book value = 3 & MV/sales = 2.2

Find the value of the firm according to direct comparison approach.
1.5.4: Discounted cash flow approach:
Discounted cash flow technique has gained importance from
1990s. it is identical to PV method of capital budgeting. It is
needed for forecasting the cash flow over an indefinite period of
time.
The value of the firm is calculated into time period:
Value of the firm = PV of cash flow during an explicit forecast
period + PV of cash flow after the explicit forecast period
Steps in discounted cash flow approach:
1. Analyzing historical performance
2. Estimating the cost of capital
3. Forecasting performance
4. Finding the continuing value
5. Calculating the firm value and interpreting the
results.
1. Analysing historical performance:

The analysis of historical performance is the first step in

valuing a business. The historical performance valuation
includes calculating the free cash flow, cash flow available to
investors, getting a perspective on the drivers of free cash
flow, extracting valuation related metrics from accounting
statements and Roic.
2. estimating the cost of capital:
The cost of capital shows what the investors expect from
their investment. It is the discount rate used for converting
the expected free cash flow into its present value. It
represents the weighted average cost of various sources of
finance.
3. Forecasting performance:
After analyzing historical performance and estimating coc the
financial manager has to do a financial forecasting which
involves selecting the explicit forecast period, developing a
strategic perspective on the future performance of the
company, converting the strategic perspective into financial
forecasts and checking for consistency.
4. Determining the Continuing Value:
A companys value is the sum of the following:
Present value of cash flow during explicit forecast period +
present value of cash flow after the explicit forecast period.
The second term shows the continuing value or terminal
value. It is the value of the free cash flow beyond the
explicit forecast period.
5. Calculating the firm value and interpreting the results:

The last phase of valuation is concerned with calculating the

value of the firm and interpreting the results.
The value of the firm is equal to the sum of the following
three components:
a. Present value of the free cash flow during the explicit
forecast period
b. Present value of the continuing value at the end of
explicit forecast period.
c. Value of non-operating assets which were ignored in
free cash flow analysis
Case:
The profit and loss a/c and the balance sheet of Matrix Ltd. Is
given below. The year that just ended is year 3.
Profit and Loss a/c
Rs. In Million
Particulars
Net sales
Income from marketable
securities
Non-operating income

Year1
180
---

Year2
200
---

Year3
229
3

----

---

Total income
Cost of goods sold
Selling and administration
expenses
Depreciation
Interest expenses
Total cost and expenses
Profit Before Tax
(-) Taxes
Profit after taxes
Dividend
Retained earnings

180
100
30

200
105
35

240
125
45

12
12
154
26
8
18
11
7

15
15
170
30
9
21
12
9

18
16
204
36
12
24
12
12

Balance sheet
Rs. in million
Particulars
Equity capital
Reserves & surplus
Debt
Total
Fixed assets
Investments
Net current assets
Total

Year1
60
40
100
200
150
50
200

Year2
90
49
119
258
175
20
63
258

Year3
90
61
134
285
190
25
70
285

Find the value of the firm using DCF assuming tax rate of 40%.
DCF 2 stage model:
It is an implication of gordan growth model in this we find 2
stages where the firm will have a higher growth continuously for
A certain period of time and after that it becomes stable to some
extent.
Value of the firm = PV of FCF during the high growth
period + PV of terminal value
Case: Discussed in the class.
DCF 3 STAGE GROWTH MODEL:
Value of the firm = PV of FCF during the high growth
period + PV of FCF during the transition period + PV of
terminal value
Multiform Limited is being appraised by an investment
banker. The following information has been assembled:
value the firm using DCF
Base year (year 0) Information:

Revenues

1,000 m

EBIT

250 m

Capital
Expenditure

295 m

Working capital
as a % of
revenues

20 %

Tax rate

40 % (for all time to

come)

Inputs for high growth period:

Length of the high

growth period

5 years

Growth rate in
revenues ,
depreciation, EBIT &
capital expenditures

25%

Working capital as a %

20 %

of revenues
Cost of Debt

15% (pre tax)

Debt Equity Ratio

1.5

Risk free rate

12%

Market risk premium

6%

Equity Beta

1.583

WACC

14%

Inputs for the transition period:

Length of the transition 5 years

period
Growth rate of EBIT will
decline from 25 % in
year 5 to 10 % in year
10 in linear
movements of 3%
each year
Working capital as a %
of revenues

20 %

Debt Equity Ratio

1:1

Cost of debt

14% (Pre tax)

Risk free rate

11%

Market risk premium

6%

Equity Beta

1.10

WACC

13 %

Inputs for stable growth period:

Growth rate in
revenues ,
depreciation, EBIT &
capital expenditures

10%

Working capital as a %
of revenues

20 %

Cost of Debt

12% (pre tax)

Debt Equity Ratio

0:1

Risk free rate

10%

Market risk premium

6%

Equity Beta

1.583

WACC

16%

Guidelines for corporate valuation:

These are the guidelines which an appraiser must keep in mind:

1.
2.
3.
4.
5.
6.
7.

Understanding of approaches
Use of at least 2 approaches
Defining of value range
Value drivers
Flexibility
Avoid possible pit falls
Blend theory with judgement
1.
Understanding of approaches:
The appraiser must know when to use these methods of valuing
an organization. The adjusted book value approach is suitable
when liquidation is being considered as a distinct possibility. The
stock and debt approach is more suitable when securities of the
firm are actively traded and there si no price manipulation. The
direct comparision approach is quite appropriate when current
earnings of the firm are relative to future earnings capacity and
there are comparable companies.
2.
Use of at least 2 approaches:
The appraiser must always use two different approaches. The
final value should be arrived at by taking weighted average of
valuation figures produced by 2 different approaches.
3.
Defining value of range:
Valuation is a difficult exercise. So, the appraiser must look at
the situation from different scenarios and define a value range
based on the value indicator for these scenarios.
4.
Value drivers:There are several value drivers,i.e.invested
capital return on invested capital growth rate & cost of
capital.Return on invested capital is the most critical value
driver.The appraiser should always go behind the numbers and
examine the entry barriers like economies of scale,product
differential,technological edge,etc.
5.
Flexibility: The appraiser must consider the value of flexibility
in these approaches because management can change its
policies in the circumstances of future development and can
exercise a variety of options suitable to the needs of the
environment. The discounted cash flow approach is totally

incomplete as it is based on cash flows forecasted on the basis of

a current assessment of future prospects.
6.
Avoid possible pit falls:
Valuation is a very difficult exercise. So, the appraiser as well as
the analyst should be aware how to avoid such pit falls. He must
avoid use of short cuts in income statement and balance sheet.
The approach should also assume a hockey stick so that he must
specify clearly an action plan required to bring about a successful
turn around.
7.
Blend theory with judgement:
The valuation of firms requires combining theory, judgement and
experience.