Module 4: Intellectual Capital Valuation

Components and Valuation of Intellectual Capital: Market to book ratio, Tobin’s Q,

Analytical Approaches: Economic Value added, Balanced Score Card, Human Resource
Accounting.

Intellectual Capital

Intellectual capital is knowledge that can be exploited for some money-making or other
useful purpose. The term combines the idea of the intellect or brain-power with the economic
concept of capital, the saving of entitled benefits so that they can be invested in producing
more goods and services. Intellectual capital can include the skills and knowledge that a
company has developed about how to make its goods or services; individual employees or
groups of employees whose knowledge is deemed critical to a company's continued success;
and its aggregation of documents about processes, customers, research results, and other
information that might have value for a competitor that is not common knowledge.

Intellectual capital is all the knowledge resources possessed by organization and its dynamic
development and renewal can ensure organization’s advanced position in the market
competition at the era of knowledge economy.

The intellectual capital is defined as “the sum of everything people know which gives a
competitive advantage in the market” (Stewart, 1991)

Components of Intellectual Capital

Intellectual capital consists of three elements:

• Human capital
• Structural capital (or organizational capital)
• Relational (customer) capital

1. Human Capital: refers to the skills/competences, training and education, and experience
and value characteristics of an organisation’s workforce that in the minds of individuals:
knowledge, skills, competences, experience, know-how, capabilities, expertise of the human
members of the organization.

2. Relational Capital (also Relationship Capital, Customer Capital, External Capital). All
relations a company entertains with external subjects, such as suppliers, partners, clients.
External capital comprises relationships with customers and suppliers, brand names,
trademarks and reputation.

3. Structural Capital (also Organizational Capital, Internal Capital) - "that which is left after
employees go home for the night": processes, information systems, databases, policies,
intellectual property, culture, etc. Thus, the knowledge embedded in organisational structures
and processes.

Market to Book Ratio

The market-to-book ratio is simply a comparison of market value with the book value of a
given firm. In other words, it suggests how much investors are paying against each dollar of
book value in the balance sheet. Also known as price-to-book value, this ratio tries to
establish a relationship between the book values expressed in the balance sheet and the actual
market price of the stock. Arithmetically, it is the ratio of market value to book value.

Market-to-book ratio formula=market price per share / book value per share
Interpreting the Ratio
A low ratio (less than 1) could indicate that the stock is undervalued (i.e. a bad investment),
and a higher ratio (greater than 1) could mean the stock is overvalued (i.e. it has performed
well). When ratio is equal to 1 it implies that the firm has valued same not valued either low
or high.

The market-to-book ratio helps a company determine whether or not its asset value is
comparable to the market price of its stock. It is best to compare Market to Book ratios
between companies within the same industry.

Tobin’s Q

The Tobin's Q ratio equals the market value of a company divided by its assets' replacement
cost. Thus, equilibrium is when market value equals replacement cost.
The Tobin's Q ratio is a quotient popularized by James Tobin of Yale University, Nobel
laureate in economics, who hypothesized that the combined market value of all the
companies on the stock market should be about equal to their replacement costs. While Tobin
is often attributed as its creator, this ratio was first proposed in an academic publication by
economist Nicholas Kaldor in 1966. In earlier texts, the ratio is sometimes referred to as
"Kaldor's v."

Tobin’s Q=Total Market Value of Firm/Total Asset Value of Firm

If q>1 = it implies that the firm stock is over valued

If q=1 it means No change

If q< 1 it implies that the firm stock is undervalued (means that the cost to replace firms
assets is greater than the value of its stock)

Balanced Scorecard

The balanced scorecard (BSC) is a strategic planning and management system that
organizations use to:

• Communicate what they are trying to accomplish

• Align the day-to-day work that everyone is doing with strategy
• Prioritize projects, products, and services
• Measure and monitor progress towards strategic targets
A key benefit of using a disciplined framework is that it gives organizations a way to
“connect the dots” between the various components of strategic planning and management,
meaning that there will be a visible connection between the projects and programs that people
are working on, the measurements being used to track success (KPIs), the strategic objectives
the organization is trying to accomplish, and the mission, vision, and strategy of the
organization.

A balanced scorecard is a strategic management performance metric used to identify and

improve various internal business functions and their resulting external outcomes. Balanced
scorecards are used to measure and provide feedback to organizations. Data collection is
crucial to providing quantitative results as managers and executives gather and interpret the
information and use it to make better decisions for the organization.
Human Resource Accounting: Meaning, Definition, Objectives and Limitations.
Meaning:
Human resources are considered as important assets and are different from the physical
assets. Physical assets do not have feelings and emotions, whereas human assets are subjected
to various types of feelings and emotions. In the same way, unlike physical assets human
assets never gets depreciated. Therefore, the valuations of human resources along with other
assets are also required in order to find out the total cost of an organization.

Definition:
1. The American Association of Accountants (AAA) defines HRA as follows: ‘HRA is a
process of identifying and measuring data about human resources and communicating this
information to interested parties’.
2. Flamhoitz defines HRA as ‘accounting for people as an organizational resource. It involves
measuring the costs incurred by organizations to recruit, select, hire, train, and develop
human assets. It also involves measuring the economic value of people to the organization’.

3. According to Stephen Knauf, ‘HRA is the measurement and quantification of human

organizational inputs such as recruiting, training, experience and commitment’.

Need for HRA:

The need for human asset valuation arose as a result of growing concern for human relations
management in the industry.

1. Under conventional accounting, no information is made available about the human

resources employed in an organization, and without people the financial and physical
resources cannot be operationally effective.

2. The expenses related to the human organization are charged to current revenue instead of
being treated as investments, to be amortized over a period of time, with the result that
magnitude of net income is significantly distorted. This makes the assessment of firm and
inter-firm comparison difficult.

3. The productivity and profitability of a firm largely depends on the contribution of human
assets. Two firms having identical physical assets and operating in the same market may have
different returns due to differences in human assets. If the value of human assets is ignored,
the total valuation of the firm becomes difficult.

4. If the value of human resources is not duly reported in profit and loss account and balance
sheet, the important act of management on human assets cannot be perceived.

5. Expenses on recruitment, training, etc. are treated as expenses and written off against
revenue under conventional accounting. All expenses on human resources are to be treated as
investments, since the benefits are accrued over a period of time.

Objectives of HRA:
1. Providing cost value information about acquiring, developing, allocating and maintaining
human resources.
2. Enabling management to monitor the use of human resources.

3. Finding depreciation or appreciation among human resources.

4. Assisting in developing effective management practices.

5. Increasing managerial awareness of the value of human resources.

6. For better human resource planning.

7. For better decisions about people, based on improved information system.

8. Assisting in effective utilization of manpower.

Methods of Valuation of Human Resources:

There are certain methods advocated for valuation of human resources. These methods
include historical method, replacement cost method, present value method, opportunity cost
method and standard cost method. All methods have certain benefits as well as limitations.

Benefits of HRA:
1. The system of HRA discloses the value of human resources, which helps in proper
interpretation of return on capital employed.

2. Managerial decision-making can be improved with the help of HRA.

3. The implementation of human resource accounting clearly identifies human resources as

valuable assets, which helps in preventing misuse of human resources by the superiors as
well as the management

4. It helps in efficient utilization of human resources and understanding the evil effects of
labour unrest on the quality of human resources.

5. This system can increase productivity because the human talent, devotion, and skills are
considered valuable assets, which can boost the morale of the employees.

6. It can assist the management for implementing best methods of wages and salary
administration.
Limitations of HRA:
1. The valuation methods have certain disadvantages as well as advantages; therefore, there is
always a bone of contention among the firms that which method is an ideal one.

2. There are no standardized procedures developed so far. So, firms are providing only as
additional information.

3. Under conventional accounting, certain standards are accepted commonly, which is not
possible under this method.

4. All the methods of accounting for human assets are based on certain assumptions, which
can go wrong at any time. For example, it is assumed that all workers continue to work with
the same organization till retirement, which is far from possible.

5. It is believed that human resources do not suffer depreciation, and in fact they always
appreciate, which can also prove otherwise in certain firms.

6. The lifespan of human resources cannot be estimated. So, the valuation seems to be
unrealistic.

Economic Value Added

Economic value added (EVA) is a measure of a company's financial performance based on

the residual wealth calculated by deducting its cost of capital from its operating profit,
adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, as it
attempts to capture the true economic profit of a company.

Understanding Economic Value Added (EVA)

EVA is the incremental difference in the rate of return over a company's cost of capital.
Essentially, it is used to measure the value a company generates from funds invested into it. If
a company's EVA is negative, it means the company is not generating value from the funds
invested into the business. Conversely, a positive EVA shows a company is producing value
from the funds invested in it.

EVA = Net Operating Profit after Tax – (Invested Capital x WACC)

EVA= (ROCE-WACC)X Capital Employed

ROIC= NOPAT/ Capital Employed /Invested Capital x 100

As shown in the formula, there are three components necessary to solve EVA: net operating
profit after tax (NOPAT), invested capital, and the weighted average cost of capital
(WACC) operating profit after taxes (NOPAT) can be calculated, but can usually be easily
found on the corporation's income statement.

Benefits and Drawbacks of EVA

EVA assesses the performance of a company and its management through the idea that a
business is only profitable when it creates wealth and returns for shareholders, thus
requiring performance above a company's cost of capital.

EVA as a performance indicator is very useful. The calculation shows how and where a
company created wealth, through the inclusion of balance sheet items. This forces managers
to be aware of assets and expenses when making managerial decisions. However, the EVA
calculation relies heavily on the amount of invested capital, and is best used for asset-rich
companies that are stable or mature. Companies with intangible assets, such as technology
businesses, may not be good candidates for an EVA evaluation.
 Calculating EVA

Net Sales xxx

(-) Operating expenses/ Cost xxx
EBIT/Operating Cost xxx
(-) taxes xxx
EBT/NOPAT xxx
(-) Capital Charges xxx
(invested capital – cost of capital)
EVA xxx
 Problems on Economic Value Added Method

1. Multiflex Limited is considering a capital project for which the following information
is available.
Investment outlay : 5000 Depreciation Method: Straight Line
Project Life : 4 years (for tax purposes)
Salvage value :0 Tax rate : 40%
Annual Revenues : 6000 Debt-equity ratio : 4:5
Annual Costs : 9000 Cost of equity : 18%
(Excluding depreciation Cost of debt : 9%
Interest and taxes) (post- tax)
Calculate the EVA of the project over its life and compute the NPV of the project.

2. “A” Limited is considering a capital project for which the following information is
available.
Investment outlay : 8000 Depreciation Method: Straight Line
Project Life : 5 years (for tax purposes)
Salvage value :0 Tax rate : 35%
Annual Revenues : 9000 Debt-equity ratio : 2: 3
Annual Costs : 7000 Cost of equity : 12%
(Excluding depreciation Cost of debt : 9%
Interest and taxes) (post- tax)
Calculate the EVA of the project over its life and compute the NPV of the project.

3. Polyflex Limited is considering a capital project for which the following information
is available.
Investment outlay : 10000 Depreciation Method: Straight Line
Project Life : 5 years (for tax purposes)
Salvage value :0 Tax rate : 30%
Annual Revenues : 14000 Debt-equity ratio : 1: 1
Annual Costs : 9000 Cost of equity : 16%
(Excluding depreciation Cost of debt : 8%
Interest and taxes) (post- tax)
Calculate the EVA of the project over its life and compute the NPV of the project.
4. Following is the condensed income statement of a firm for the current year:

Income Statement (in Rs. Lakhs)

Sales Revenue 500
Operating costs 300
Interest costs 12
Earnings before tax 188
Taxes @ 40% 75.2
Earnings after taxes 112.8
The firm‘s existing capital consists of Rs. 150 lakh equity funds, having 15 per cent
cost and Rs. 100 lakh 12 per cent debt. Determine the economic value added during
the year.
Assume the sales revenue is Rs. 330 Lakhs. What is the Earnings after Tax and
EVA?

5. From the following condensed income statement of a corporate for the current year,
determine the EVA during the year.

Income Statement (in Rs. Crores)

Sales revenue 100
Less: Cost of goods sold 40
Administrative expenses 4
Selling expenses 16
Interest 10 70
Earnings before taxes 30
Less: Taxes @ 40% 12
Earnings after taxes 18
The firm‘s weighted average cost of total capital employed (consisting of equity
and debt of Rs. 150 crore) is 12 per cent, its cost of equity capital is 15 per cent.
 6. The Balance Sheet of International Computers Limited (ICL) at the end of 2017 is
given below:

Balance Sheet as on December 31, 2017

Liabilities Rs. Assets Rs.
Equity 50 Fixed Assets 80
Debt 50 Current Assets 40
Non-interest bearing
Liabilities 20

120 120

The income statement for the year 2018 is given

below: Revenues 90
Cost of goods sold 50
Gross profit 40
Operating expenses 16
Interest 4
Earnings before tax 20
Tax 7
Earnings after tax 13
ICL‘s equity has a beta of 0.9. The risk free return is 6 per cent and the market
risk premium is 6 per cent. The interest rate on ICL‘s debt is 8 per cent. The
tax rate for ICL is 35 per cent.
Answer the following questions:
i. What is the capital employed at the beginning of 2018?
ii. What is the NOPAT for 2018?
iii. What is the return on capital for 2018?
iv. What is the cost of equity?
v. What is the average cost of capital?
What is the EVA for 2018?
 7. With the help of the following information of Jatayu Limited
compute the EVA: Capital Structure : Equity Capital –Rs. 160 Lakhs

Reserves and Surplus – Rs. 140 lakhs

10% Debentures – Rs. 400 Lakhs
Cost of Equity : 14%
Financial Leverage : 1.5 times
Income tax rate : 30%

8. DISA & Co., has provided the following information:

Rs. In Lakhs
Equity Share Capital (Rs. 10 each) 400
15% Preference Share Capital (Rs. 10 each) 200
Reserves and Surplus 220
15% Debentures 1600
10% Non-trade Investments (Nominal Value Rs. 100 Lakhs) 140
Land and Buildings held as investment 20
Advance given for purchase of plant 10
Capital work in progress 30
Underwriting commission (not written off) 20
Earnings per share Rs. 16
Tax Rate 30%
Beta Factor 1.65
Market rate of return 16.25%
Risk free rate 9.85%
Calculate Economic Value Added by the Company

9. RST Ltd’s current financial years income statement reported its net income as
Rs.25,00,000. The applicable corporate tax rate is 30%

Following is the capital structure of RST Ltd., at the end of current financial year:
Debt (coupon rate 11%) Rs. 40 Lakhs
Equity (Share capital + Reserves) Rs. 125 Lakhs
Invested capital Rs. 165 Lakhs
Following data is given to estimate cost of equity capital:
 Beta of RST Ltd., 1.36
Risk-free rate i.e., current yield on Government Bonds 8.5%
Average market risk premium (i.e., excess of return on 9%
market portfolio over risk-free rate)
(i) Estimate Weighted Average Cost of Capital (WACC) of RST Ltd., and
(ii) Estimate Economic Value Added (EVA) of RST Ltd.
(Ans: 17.58%, (-) Rs. 92,700)