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  CA EXAMS - Important Announcement

Publication on Valuation: Professionals' Insight- Series- 3 by VSB ICAI
August, 12th 2019
Valuation: Professionals' Insight
                     Series -3

               Valuation Standards Board
          ICAI Registered Valuers Organisation
The Institute of Chartered Accountants of India
           (Set up by an Act of Parliament)
                       New Delhi
© The Institute of Chartered Accountants of India
All rights reserved. No part of this publication may be reproduced, stored in a
retrieval system, or transmitted, in any form, or by any means, electronic,
mechanical, photocopying, recording, or otherwise, without prior permission,
in writing, from the publisher.
The views expressed in this book are of the author(s). The Institute of
Chartered Accountants of India may not necessarily subscribe to the views
expressed by the author(s).
The information cited in this book has been drawn from various sources.
While every effort has been made to keep the information cited in this book
error free, the Institute or any office of the same does not take the
responsibility for any typographical or clerical error which may have crept in
while compiling the information provided in this book

First Edition              :       July 2019

Committee/Department       :       Valuation Standards Board

E-mail                     :

Website                    :

Price                      :       ` 150 /-

ISBN No                    :       978-81-8441-000-0

Published by               :       The Publication Department on behalf of
                                   the Institute of Chartered Accountants of
                                   India, ICAI Bhawan, Post Box No. 7100,
                                   Indraprastha Marg, New Delhi - 110 002.
Printed by                 :       Sahitya Bhawan Publications, Hospital
                                   Road, Agra 282 003
The success of an institutional framework depends on the well-organized,
efficient and effective working of the institutions involved in it. As per the
Companies (Registered Valuers and Valuation) Rules, 2017, the Registered
Valuers Organsiations are the frontline Regulators to regulate and promote
the continuous education of the registered valuers who derive value on which
the economic growth of a country depends.
Value is always influenced by a variety of factors: the preconceptions and
bias of the asset's owner, the valuer's understanding of the market, the
methodology that is being used, and the complexity of the underlying
business. These influences impact the assumptions being made by valuers.
Decision makers must be confident that the assumptions applied are
appropriate, and that they are not overly optimistic or needlessly pessimistic.
This is why it is essential to know, and understand, the basis of the
assumptions made by a valuer.
To continuously upgrade the knowledge of the Valuers, the ICAI Registered
Valuers Organisation is working jointly with the Valuation Standards Board of
the Institute of Chartered Accountants of India and bringing out various
publications, organizing the webcasts, training programmes, workshops etc
apart from conducting 50 hours educational course.
I am extremely happy that in continuing with the joint endeavours, the
Valuation Standards Board of ICAI and ICAI Registered Valuers Organisation
(ICAI RVO) are bringing out this Third Series of publication on `Valuation:
Professionals' Insight' to give a thoughtful insight of the practices followed by
other valuers and professionals.
I would like to put on record my appreciation to the Institute of Chartered
Accountants of India for all the joint initiatives with ICAI RVO. My thanks to
the Valuation Standards Board (VSB) of ICAI under the Chairmanship of CA.
N. C. Hegde and Vice Chairmanship of M. P. VijaKumar and to the members
of the Board of ICAI RVO, Shri I. Y. R Krishna Rao, Shri Samir Kumar Barua,
Shri Ashok Haldia for this joint initiative. I convey my heartfelt thanks to CA.
Prafulla P. Chhajed, CA. Atul Kumar Gupta and CA. Nilesh S. Vikamsey­ the
Directors of ICAI RVO, for their support in this initiative.
I would like to thank CA. Sarika Singhal, Secretary Valuation Standards
Board who is involved in compiling and contributing the articles.
I sincerely believe that this Educational Material will be of immense use to
the valuer members and others stakeholders.
                                              Justice Anil R. Dave (Retd.)
                                       ICAI Registered Valuers Organisation
Date: June, 2019
Place: New Delhi
With globalisation and dismantling of trade barriers, corporates are
increasingly making international forays- be it accessing capital or making
acquisitions abroad. This has led to increase in the demand for valuation
experts as Companies are seeking accurate valuations for their businesses.
The Valuation profession got further recognition with the introduction of the
concept Registered Valuers in the Companies Act, 2013
In the valuation process, valuation expert values the organisation by using
technology, applying specific methods of valuation (which can be termed as
Science) and by his own experience in taking various assumptions. The
importance of Valuation cannot be undermined as understanding what an
asset is worth, and what drives that value, is very essential, when both
management and stakeholders need to make informed and effective
business and investment decisions.
I appreciate the efforts of the Valuation Standards Board and ICAI
Registered Valuers Organisation in taking the joint initiatives for upgradation
of knowledge of valuers. In continuation of these endeavours, the publication
titled - `Valuation: Professionals' Insight' containing the views in the form of
Articles capturing the varied practices of valuation is been brought out.
I sincerely appreciate the dedicated efforts put in by CA. N. C. Hedge,
Chairman, Valuation Standards Board and CA. M. P. Vijay Kumar, Vice-
Chairman, Valuation Standards Board and other members of the VSB for
bringing out this publication in the form of Series.
I am hopeful that this this Series of the publication will further enhance the
knowledge and wisdom of valuers and at the same time ensure quality work
being done by the valuers.

                                                      CA. Prafulla P. Chhajed
                                                                President ICAI
                                                            Director ICAI RVO
Date: June 2019
Place: New Delhi
An important aspect of valuation is that the value often depends on the
intended purpose of the valuation. Therefore, the same business often has
different values depending on the purpose of valuation. Nonetheless, placing
the right value on a particular business which is necessary for a number of
reasons, is the ultimate purpose of a valuation.
It's more than a year since the valuation spectrum has been formally
regulated by the Government as a professional practice. The Companies
(Registered Valuers and Valuation) Rules, 2017 provides an institutional set-
up comprising of four main pillars. The pillars are Registered Valuers,
Registered Valuers Organisation the Insolvency and Bankruptcy Board of
India and the Ministry of Corporate Affairs which has the most important role
of administering the entire framework of valuation as per Section 247 of the
Companies Act, 2013 and Rules thereunder.
The Implementation of any system does not only depend on the law, but also
on the institutions involved in administration and execution of the same. It
depends on the effective functioning of all the institutions but a very critical
role is played by the Registered Valuers who have a vital role to play in the
entire valuation process.
As part of the continuous efforts towards upgradation of knowledge and to
bring to the fore the practices followed by the registered valuers, the
Valuation Standards Board jointly with ICAI Registered Valuers Organisation
has decided to bring out Third Series of the publication titled "Valuation:
Professionals' Insights" covering practical insights on valuation.
This publication like the other two series, is a compilation of articles on
varied valuation topics written by experts in this field. The objective of the
publication is to make available the knowledge of the valuers of the
professional practices followed by them in the field of valuation.
We may clarify that the views expressed in this publication are the views of
the authors and are not the views of the Institute.
In this connection, we take this opportunity in thanking the President ICAI
and Director ICAI RVO CA. Prafulla P. Chhajed, and the Vice President ICAI
and Director ICAI RVO CA. Atul Kumar Gupta for their moral support and
encouragement in bringing out the publication.
Our gratitude towards the Board of ICAI RVO comprising of Hon'ble
Mr. Justice Anil R. Dave (Retd.), Chairman of the Board and other Directors,
Shri I.Y.R Krishna Rao, Shri Ashok Haldia, Prof. Samir K. Barua and
CA. Nilesh S. Vikamsey, Past President, ICAI for joining in the constant
endeavours of the Board.
We would also like to thank all members, co-opted members, special invitees
of the Board for their support and guidance in bringing out this publication.
We would also like to thank CA. Dhinal A. Shah, CA. Rajan Wadhawan,
Shri Shankar Bhargava, CA. Dipam Patel, CA. Nitesh Bhuta, CA. Aseem
Mankodi, CA. Aparna Khatri, CA. Harsh Vardhan Bhandari, Ms. Nisreen
Sura, Shri Neeraj Garg, CA. Abraham Mathews, CA. Amrish Garg,
CA. Gandharv Jain, CA. Paras Gupta, CA. Chinmaya Arikutharam and
CA. Gaurang Shah who have contributed articles featured in the publication.
We would like to put on record the efforts put in by CA. Sarika Singhal,
Secretary Valuation Standards Board, Ms. S. Rita and Ms. Seema Jangid for
contributing articles and providing the technical and administrative support.
We sincerely wish that this third series of the publication would be useful to
our members and other stakeholders.
CA. N. C. Hegde                                       CA. M. P. Vijay Kumar
Chairman                                                      Vice Chairman
Valuation Standards Board, ICAI              Valuation Standards Board, ICAI

Date: June, 2019
Place: New Delhi

S. No   Subject                                                  Page No
 1.     Institutional Framework of Valuation                        1
 2.     Frontiers of Valuation                                      6
 3.     Valuation- Through the Judicial Lens                       11
 4.     Valuation- Peculiarities of Valuing a Private Business     18
 5.     Computing Beta - The most critical input to the            26
 6.     Valuation of Preference shares                             45
 7.     Fair Value Measurement-IND AS 113-Definition               56
 8.     Cost of Capital in goodwill impairment                     62
 9.     Brand Valuation                                            70
 10.    Valuation of Intangibles                                   81
 11.    Nuances of Valuation of Intangible Assets                  90
 12.    Practical Solution to Situations faced while carrying      94
        out Valuation Exercises
 13.    Investment Terms vis-a-vis Valuation                      102
 14.    Tax Amortisation Benefit                                  112
 15.    Valuation of a Financial Service Company                  117
                                                                 Chapter 1
    Institutional Framework of Valuation
The Ministry of Corporate Affairs (MCA) vide its notification dated October
18, 2017, brought into force the provisions of Section 247 of the Companies
Act, 2013, which deals with the Valuation of, inter alia, property, stocks,
shares, debentures or net worth of a company by the Registered Valuers.
The distinguishing feature is that the subject of Valuation and the regulation
of the profession of Valuation is covered under Section 247 of the
Companies Act, 2013 which is a single section in one chapter of the Act. Any
important decision to be taken by a banker, businessman, shareholder,
investors any stakeholder is dependent on the report of the valuer.
The Valuation as a practice and as a profession is being regulated now to
improve Corporate Governance and better transparency in the corporate
sector which is imperative to infuse confidence amongst investors in Indian
market and abroad.
Valuation of a business requires understanding and analysis of various
complex factors and has a major impact on all type of businesses whether
big or small.
As we all know that the Valuation assignment is distinctive and there are no
uniform practices that are being adopted by the valuers in carrying Valuation.
So, tailoring a Valuation about the most suitable and appropriate procedures
to be relevant to each assignment is somewhat a very technical issue.
The intention of bringing the Rules is to make the valuers more accountable
as Valuation plays a significant role in the capital growth of the country. It is
the economic and social activity. Valuation denotes the worth of the
underlying assets as on a particular date. Better Corporate Governance is
likewise prompting requirement of independent Business Valuations.
The introduction of these Rules would not only ensure a streamlined
methodology but would also ensure an increase in the standard of
professional judgment utilized in Valuation process. This would also lead to
Valuation being a specialized profession and offer a host of opportunities to
the existing professionals including Chartered Accountants, Company
Valuation: Professionals' Insight

Secretaries, Cost Accountants and MBA/ PGDBM in finance, however it is a
very onerous endeavour and has come with lot of responsibilities as it now
stands regulated.
The Rules also provide that the Insolvency and Bankruptcy Board of India
("IBBI") should be established to be the "Authority" which will hold
examinations and grant certifications of the designation of a "Registered

Responsibility of a Registered Valuer under Section
247(2) of the Companies Act, 2013.
(a)   Make an impartial, true and fair Valuation of assets which may be
      required to be valued;
(b)   Exercise due diligence while performing the functions of a valuer;
(c)   Make the Valuation in accordance with such rules as may be
      prescribed; and
(d)   Not undertake Valuation of any assets in which he has a direct or
      indirect interest or becomes so interested at any time during or after
      the Valuation of assets.

Applicability of the Rules
1.    The Companies Act, 2013
2.    Insolvency and Bankruptcy Code, 2016
3.    Any other Authority which provides for adoption of the same
      framework as that of Companies (Registered Valuers and Valuation)
      Rules, 2017.

Institutional Set up under the Companies (Registered
Valuers and Valuation) Rules, 2017
The Companies (Registered Valuers and Valuation), Rules, 2017 provides an
institutional set-up comprising of five pillars:
·     Registered Valuers- To conduct the Valuation under the Companies
      Act, 2013 and the Insolvency and Bankruptcy Code, 2016, the role of
      the Registered Valuer encompasses a wide range of functions, which

                                          Institutional Framework of Valuation

      include adhering to procedure of the law, as well as accounting and
      finance related functions.
·     Registered Valuers Organsiation- To enrol and regulate Registered
      Valuers as its members in accordance with the Section 247 of the
      Companies Act, 2013 and read with Companies (Registered Valuers
      and Valuation), Rules, 2017.
·     Insolvency and Bankruptcy Board of India- An authority who will
      oversee these organsiations and to perform legislative, executive and
      quasi-judicial functions with respect to the Registered Valuers and
      Registered Valuers Organisations.
·     The Ministry of Corporate Affairs- The Ministry is a Regulator which is
      primarily concerned with administration of the Companies Act 2013,
      and rules & regulations framed there-under mainly for regulating the
      functioning of the corporate sector in accordance with law.
·     Adjudicating Authority- The National Company Law Tribunal (NCLT),
      established under the Companies Act, 2013 would function as an
The implementation of any system does not only depend on the law, but also
on the institutions involved in administration and execution of the same. It
depends on the effective functioning of all the institutions but the Registered
Valuers have a vital role to play in the entire process.

Recognition of Registered Valuers Organisations
A company registered under section 8 of the Companies Act, 2013 (or
section 25 of the erstwhile Companies Act, 1956), with the sole object of
dealing with matters relating to regulation of valuers of an asset class or
classes and professional institutes established by an Act of Parliament.
They are eligible to be registered as Registered Valuers Organisations,
provided they meet the following key requirements:
·     Conducts educational courses /training in Valuation, in accordance
      with the syllabus as prescribed by the IBBI.
·     Grants memberships to individuals who possess qualifications and
      experience as prescribed under the Registered Valuers and Valuation
      Rules, 2017.

Valuation: Professionals' Insight

·     Reviews and monitors the functioning, including quality, of services, of
      valuers who are its members.
ICAI Registered Valuers Organisation formed by the Institute of
Chartered Accountants of India- Journey so far.
ICAI Registered Valuers Organisation (RVO) is a Section 8 private company
formed by the Institute of Chartered Accountants of India which has been
recognized by the IBBI to enroll and regulate registered valuers or valuer
member as its members in accordance with the Companies (Registered
Valuers and Valuation) Rules, 2017, and functions incidental thereto. ICAI
RVO is registered for Securities or Financial Assets Class.
Some of the important roles of ICAI RVO are as follows-
(a)   ensure compliance with the Companies Act, 2013 and rules,
      regulations and guidelines issued thereunder governing the conduct of
      Registered Valuers Organisation and Registered Valuers;
(b)   employ fair, reasonable, just, and non-discriminatory practices for the
      enrolment and regulation of its members;
(c)   be accountable to the authority in relation to all bye-laws and
      directions issued to its members;
(d)   develop the profession of registered valuers;
(e)   promote continuous professional development of its members;
(f)   continuously improve upon its internal regulations and guidelines to
      ensure that high standards of professional and ethical conduct are
      maintained by its members; and
(g)   provide information about its activities to the authority.
Rule 5 (1) of the Companies (Registered Valuers and Valuation) Rules, 2017
provides that the authority shall, either on its own or through a designated
agency, conduct Valuation examination for one or more asset classes, for
individuals, who possess the qualifications and experience as specified in
Rule 4, and have completed their educational courses as member of a
Registered Valuers Organisation, to test their professional knowledge, skills,
values and ethics in respect of Valuation:
Rule 5 (2) provides that the authority shall determine the syllabus for various
Valuation specific subjects or assets classes for the Valuation examination

                                          Institutional Framework of Valuation

on the recommendation of one or more Committee of experts constituted by
the authority in this regard.
IBBI has notified the syllabus and mandated a 50 hours training by the
Registered Valuers Organisation which is a precondition to take examination
to become Registered Valuer and revised the same.
Training Conducted
In this direction, from June, 2018 onwards, ICAI RVO has conducted the 50
hours training across the country and batches have been held at Delhi (3),
Mumbai (3), Kolkata(2), Chennai (2), Bangalore(2), Ahmedabad, Jaipur,
Gurugram, Coimbatore, Hyderabad, Salem, Ernakulam, Pune, Indore, Jaipur,
Vasai, Ludhiana, Chandigarh, Baroda.
Valuer Members trained:
As on date 1300+ members have been trained by ICAI RVO at its
Educational course of 50 hours.
Registered valuers registered as on 25th June, 2019
ICAI RVO has the highest number of registration of Registered Valuers under
the Asset Class- `Securities or Financial Asset'. As on 25th June, 2019, 555
Registered Valuers have been registered by the Insolvency and Bankruptcy
Board of India under the Asset Class Securities or Financial Assets. Out of
which, 322 Registered Valuers (58%) are ICAI RVO members.

The real fair value is when the same is calculated by stepping in the shoes of
the stakeholder for whom the value is calculated. Further, regulation brings in
discipline but the self- regulation is most important.
The increased transparency and fairness in the Valuation system would also
boost stakeholder confidence by bringing uniformity.

                                                                 Chapter 2
                                  Frontiers of Valuation
History of Valuation
For a big part of the 20th century, tangible assets, which include fixed assets
such as buildings, land, and machinery, were considered to be the main
source of the commercial value for any business. They were usually recorded
in the financial statement based on their cost and/or outstanding value. The
company's assessment on profitability and performance focused on all
assets except intangible assets. Intangibles were generally excluded as the
specific value of such assets wasn't always clear.
The Original methodology used for Valuation was Assets minus Liabilities, or
just the equity. Later, the regulatory requirements for better tax accountancy,
prohibition, the tax breaks and compensation paid to some businesses by the
Governments formed a new viewpoint. This revolutionary concept was that a
company was actually worth far more than simply its assets minus its
liabilities or only its equity. Since then, the methodology has seen significant
changes. The inputs, risk factors and range of information which are used to
calculate the final company Valuation based on their current circumstances
has also evolved to become more robust and complete. This development
brought about new concepts including the value of future profit and goodwill
in calculating company Valuation.
In the past couple of decades, as the awareness of creating value for the
shareholders increased dramatically, the significance of intangible assets
and their Valuation changed. Although several stakeholders paid little
attention to the benefits from intangible assets, the management of the
company was aware of the importance of such assets. Intangible assets
often give businesses their competitive advantage. Most businesses were
successful due to effective corporate management of intangible assets such
as brands, patents, technology and employees. However, because they have
no physical characteristics, their value can be hard to determine.
                                                       Frontiers of Valuation

Shifting Paradigm
Business Valuation focus has shifted from just the value of tangible assets to
become more comprehensive. It also includes Earnings capability, Intangible
assets, Innovative capabilities and Management capabilities which are now
considered critical in the Valuation of any business. With several companies
becoming service oriented rather than product oriented, the proportion of
intangibles to the entire business has increased. This led to the serious
realization of the need for some guidelines in valuing the intangible assets.
Several standard setting bodies developed guidelines for Valuation of various
kinds of assets using various approaches like:
·     Market approach - based on market evidence of what third parties
      have paid for comparable assets
·     Income approach ­ based on the present value of future earnings
      from the asset
·     Cost approach - based on the costs of developing or acquiring a new
      asset that is of similar use as the existing one
These methods look at things like comparable transactions, excess earnings,
relief from royalty, replacement or reproduction costs and simulation
analysis. As for Goodwill, value is based on the calculation of a residual
value, by subtracting the net value of assets from the enterprise value of the

Need for Regulation and Valuation Standards
Corporate Valuation is necessary for the purpose of corporate finance
activities, accounting and regulatory requirements or for internal
management reporting. However, Valuation is not an exact science, it
depends on various factors such as purpose, size of business, industry,
location of business, risk, management assumptions, promoter strength, etc.
The wide variation in Valuation methodologies and approaches across
markets has made it difficult to compare Valuations.
Further, international investors require greater levels of transparency and
confidence in the Valuations to enable them to make sound investment

Valuation: Professionals' Insight

Valuations also form a key part of audited financials which should provide
transparency and comparability in relation to the value of companies and
therefore impact share prices. This is important for the purpose of financial
market stability and ultimately, a stable economy.
Considering the above, Government has enacted Section 247 of the
Companies Act, 2013 ("the Act" or "Companies Act"). Further, the MCA also
issued the Companies (Registered Valuation and Valuation) Rules, 2017.
Section 247
As per Section 247, where a Valuation is required to be made in respect of
any property, stocks, shares, debentures, securities, goodwill or any other
assets or liabilities or net worth of a company under the provisions of the Act.
It shall be valued by a person, registered as a valuer and being a member of
a recognised organisation.
The valuer appointed shall:
·     make an impartial, true and fair Valuation of any assets which may be
      required to be valued;
·     exercise due diligence while performing the functions as valuer
·     make the Valuation in accordance with prescribed rules
·     not undertake Valuation of any assets in which he has a direct or
      indirect interest or becomes so interested at any time during or after
      the Valuation of assets

Onus on Valuer
The aforesaid provisions, rules and Valuation standards clearly spell out the
responsibilities and duties of the Valuer. The stringent penalty provisions
under the Companies Act should act as a deterrent, increasing compliance
and ultimately promote consistency in Valuation methodologies. These
increase in compliances and responsibility cast on the valuer has resulted in
people shying away from the field of Valuation. However, it must be noted
that such regulatory oversight was the need of the hour to increase
transparency and accountability in Valuation engagements. The Act
encourages high quality reporting and ensures that good professionals who
are able to take on such responsibility shall thrive in the field of Valuation.

                                                          Frontiers of Valuation

Companies (Registered Valuation and Valuation) Rules, 2017
The Companies (Registered Valuation and Valuation) Rules, 2017 prescribe
the rules for eligibility, qualification and registration of valuers and Valuation
professional organizations.
Further, the said rules also state that a Registered Valuer shall make
Valuations as per the Valuation Standards notified by the Central
Government. However, until such time as the Valuation Standards are
notified by the Central Government, a valuer shall make Valuations as per
·     internationally accepted valuation standards;
·     Valuation standards adopted by any registered valuers organisation;
It must be noted that the Central Government has not issued such Valuation
Standards at this point of time.
Valuation Standards issued by the ICAI
The Institute of Chartered Accountants of India (ICAI) has issued the
following Valuation Standards:
·     Preface to the ICAI Valuation Standards
·     Framework for the Preparation of Valuation Report in accordance with
      the ICAI Valuation Standards
·     ICAI Valuation Standard 101 - Definitions
·     ICAI Valuation Standard 102 - Valuation Bases
·     ICAI Valuation Standard 103 - Valuation Approaches and Methods
·     ICAI Valuation Standard 201 - Scope of Work, Analyses and
·     ICAI Valuation Standard 202 - Reporting and Documentation
·     ICAI Valuation Standard 301 - Business Valuation
·     ICAI Valuation Standard 302 - Intangible Assets
·     ICAI Valuation Standard 303 - Financial Instruments

Valuation: Professionals' Insight

Positive impact of ICAI Valuation Standards on Valuers
While the Valuation Rules have put the onus on valuers in terms of increased
liability and responsibility, the Valuation Standards have the following
positives for valuers:
·     Valuation standards ensure consistency and reduce discretionary
      `judgement calls' taken by valuers.
·     They increase comparability between different valuers and Valuation
      firms by promoting use of consistent Valuation methodologies.
·     The Standards ensure that `best practices' of Valuation are followed
      and there is fairness in Valuation services.
·     They promote credibility, relevancy & transparency of Valuation
·     The Standards cover Valuation of all assets, liabilities and businesses
      (cash flows). Accordingly, there is more guidance available on
      Valuation of complex financial instruments as well as unusual items.
·     The Standards specify usage and give direction on various items such
      as discount rates to be used, illiquidity discounts, discount for lack of
      control etc.
·     The Standards help Valuer in preparing information checklist, choosing
      Valuation method and finalising Valuation reports.
In conclusion, the field of Valuation is witnessing a revolution and conduct of
Valuations by quality Valuation professionals will improve public confidence
in Valuations.

                                                                 Chapter 3
    Valuation-Through the Judicial Lens
One of the parameters for evaluating a Valuation outcome is its ability to
stand the rigors of scrutiny by the various stakeholders. With Valuation
outcomes impacting tax revenues of the country, the Government too is
interested in the correctness of the Valuation results and hence, amongst
others, the Indian tax authorities have been closely scrutinizing Valuation
reports on the basis of which transactions have been carried out. The past
year has witnessed a flurry of judicial rulings on a variety of Valuation related
aspects by various tax courts across the country. As professionals in the field
of Valuation, we cannot help but take note of this.
This Chapter accordingly takes us through some of the relevant observations
made by courts in judgements and orders pronounced by them. While these
may, at times, be more pertinent in the specific facts of the case, they do
also provide guidance to the practitioners in general and may aid in the
Valuation process.

Sanctity of Choice of Selection of Method
Section 56(2)(vii)(b) of the Income-Tax Act, 1961 (Act) aims at taxing excess
share premium received by a closely held company from resident investors.
This provision read with Rule 11UA of the Income-tax Rules, 1962 (Rules)
inter alia grants the taxpayer a choice to determine the Fair Market Value of
the shares using the Discounted Cash Flow (DCF) method in addition to the
Net Asset Value Method. This option to use DCF as the Valuation method is
important as it allows the taxpayer to demonstrate the appropriateness of the
pricing based on future cash flows (and not just book the value of the net
assets), which is also often the basis for pricing of actual transactions
between parties.
Taxpayers have faced challenges on this front where the actual operating
results have differed from the cash flow projections/ estimates or where there
have been differences in the underlying assumptions adopted by the valuer
as compared to those considered by the Assessing Officer (AO) during the
scrutiny process. The AO has, in certain cases, not only challenged the DCF
Valuation: Professionals' Insight

computation but also rejected the method and asked the taxpayer to
determine the share price as per the Net Asset Value Method, which would
throw up a very different (and lower) share price thereby leading to a greater
tax outflow.
However, the Courts have come to the rescue of the taxpayers. The Bombay
High Court in the case of Vodafone M-Pesa Ltd 1 held that the AO can
scrutinize the Valuation report and determine a fresh Valuation either by
himself or by calling a final determination from an independent valuer to
confront the taxpayer. But the basis has to be DCF method and he cannot
change the method of Valuation which has been adopted by the taxpayer.
This view has also been upheld amongst others by the Bangalore Bench of
the Income Tax Appellate Tribunal (ITAT) in the case of Innoviti Payment
Solutions Ltd 2 and by the Jaipur Bench of the ITAT in the case of
Rameshwaram Strong Glass (P) Ltd 3. This is indeed a welcome relief.
Here, it is pertinent to note that a contrary view has been taken by the Delhi
Bench of the ITAT in the case of Agro Portfolio Pvt Ltd 4 wherein, on perusing
the long disclaimer appended by the merchant banker of not undertaking any
independent examination of the financial data, the Tribunal concluded that
the valuer did not do anything reflecting his expertise except by applying the
formula. Further, the ITAT held that if the taxpayer does not provide any
evidence to substantiate the data on which the DCF Valuation is based and
does not provides reasonable connectivity between those projections in cash
flow with the reality evidences by the material, it is not possible even for the
Departmental Valuation Officer to conduct any exercise of verification of the
acceptability of the value determined by the merchant banker, the AO has
the power to reject the DCF method and value the shares using the NAV
Following this, the Bangalore Bench of the ITAT, in the case of TUV
Rheinland NIFE Academy Pvt Ltd 5 held that since the taxpayer was unable to

1 164 DTR 257
2 ITA No. 1278/Bang/2018
3 ITA No. 884/JP/2016

4 ITA No. 2189/Del/2018

5 ITA No. 3160/Bang/2018

                                             Valuation-Through the Judicial Lens

substantiate the projections on the basis of which the value was determined
using the DCF Method, the AO could proceed with the NAV method.
While the above judgements appear to be conflicting, there is still a common
thread running through them ­ in order to stand the test of scrutiny, it is
imperative for the taxpayer to consider the best estimate drawn up on a
scientific basis and considering the relevant economic factors. Similarly, it is
imperative that the valuer maintains robust documentation and gives a sound
reasoning for underlying inputs and assumptions made while drawing up the
projections. This would help defend in case of a challenge even where the
actual numbers vary significantly from the projections.
The above is also supported by the observations of the Jaipur Bench of the
ITAT in the case of Rameshwaram Strong Glass (P) Ltd, (supra) which gave
due cognizance to the ground work done by the Chartered Accountant (CA)
while undertaking the Valuation exercise. The ITAT observed that the CA had
considered the plant capacity, industry and market conditions as prevailed in
the state, the sanctioning of the loan by the bank which factors formed a
reasonable basis of projections and that the Valuation reports were prepared
by the CA as per the guidelines given by the ICAI. The AO had not found any
fault. Accordingly, the ITAT did not find any rational or sound basis in the
order of the AO rejecting the Valuation report submitted by the taxpayer
based on DCF Method.

Guidelines for Application of the DCF Method
The Bangalore Bench of the ITAT in the case of Innoviti Solutions discussed
above, while examining the application of the DCF method, emphasized on
the importance of appropriateness of the cash flows, which forms the
foundation of the Valuation. Taking note of the Technical Guide on Share
Valuation (issued in 2009) by the Research Committee of The Institute of
Chartered Accountants of India (ICAI) and other rulings 6, the ITAT stated that
the Cash Flow projection based on which the Valuation report is prepared by
the Chartered Accountant needs to be estimated with reasonable certainty.
The taxpayer needs to demonstrate that the projections are a reliable
estimate achievable with reasonable certainty on the basis of facts available

6 Bharat Earth Movers v CIT [245 ITR 428] and Rotork Controls India (P) Ltd. v. CIT
[314 ITR 62]

Valuation: Professionals' Insight

on the date of Valuation and actual result of future cannot be a basis for
saying that the estimates of the management are not reasonable and
The ITAT recognised that in the case of a start-up where no past data is
available, it should not be insisted upon that the cash flow projection should
be on the basis of reliable future estimate. It rules that in such cases, the
projections may be on the basis of expectations as long as it is shown that
such expectations are reasonable after considering various macro and micro
economic factors affecting the business.
The ITAT further observed that the primary onus to prove the correctness of
the Valuation Report is on the taxpayer as he has special knowledge and he
is a privy to the facts of the company and only he has opted for this method.
Hence, he has to satisfy about the correctness of the projections, discounting
factor and terminal value etc. with the help of empirical data or industry norm
if any and/or scientific data, scientific method, scientific study and applicable
guidelines regarding DCF Method of Valuation. If the taxpayer cannot
establish that the cash flow is achievable with reasonable certainty, the
future cash flow cannot be recognized and the DCF method is not workable.

Substance of The Security ­ Preference Versus Equity
Recently, the Bangalore Bench of the ITAT in the case of 2M Power Health
Management Services Pvt Ltd 7, while examining the dispute around
Valuation of preference shares directed that the substance of the securities
being issued needed to be looked at while undertaking the Valuation
In this case, the taxpayer allotted compulsorily convertible preference shares
at a premium. The holders of these shares had the right to attend the general
meetings of the company and vote on resolutions directly affecting their
interest. After examining the facts of the case, the ITAT held that the nature
of the issued share was that of an equity share and not preference share. It
further stated that it was important to decide, based on the evidence, if the
share premium is received for equity shares to be issued later or for
preference shares issued now, the prescribed Valuation methodology should
be applied.

7   ITA No.2880/Bang/2018

                                               Valuation-Through the Judicial Lens

For the purposes of calculating FMV under Section 56, Rule 11UA of the
Rules provides Valuation methodology for equity shares as well as
preference shares. Rule 11UA(1)(c)(c) provides that the FMV of preference
shares should be the price the shares would fetch if sold in the open market
on the Valuation date. Based on the above, it may be possible that the AO
will value the shares as equity (per Rule 11UA) and not as preference shares
(i.e. applying the price fetched if they are sold on the open market), if
depending on the nature and terms of its issue, the instrument fails to satisfy
the test of being preference shares. Accordingly, just going by the
nomenclature of the security would not suffice therefore, it would be
important to examine the terms thereof.
In the following case too, the Mumbai Bench of the ITAT gave due
importance to the features of the security being valued. The ruling was
pronounced in the case of Golden Line Studio Pvt. Ltd 8. In this case, the
ITAT ruled that for the purposes of determining whether excessive premium
has been charged on the issue of redeemable non-cumulative preference
shares, its fair market value (FMV) should not be calculated on the basis of
the Net Asset Value (NAV) of the issuing company as there was a difference
in equity and preference shares and they both could not be valued the same
The taxpayer argued that considering that the return on preference shares is
fixed whether in terms of dividend or at the time of winding up, the
preference shareholders get a preference over equity shareholders on
payment of dividend and repayment of capital. Accordingly, preference
shares are akin to quasi debt instruments and should be valued based on the
returns they fetch and not the company's NAV. The Tribunal appreciated the
above arguments while deciding in favour of the taxpayer.

In the past, there have been judgements e.g. in the case of G. L. Sultania 9
where the Supreme Court (SC) has held that unless it is shown to the court
that some well accepted principles of Valuation have been departed from
without any reason or that the approach adopted is patently erroneous or that

8   I.T.A. No. 6146/Mum/2016
9   G. L. Sultania and Another v. SEBI and Others (5 SC 133) (SC)

Valuation: Professionals' Insight

relevant factors have not been considered by the valuer or that the Valuation
was made on a fundamentally erroneous basis or that the valuer adopted a
demonstrably wrong approach or a fundamental error going to the root of the
matter, the court cannot interfere with the Valuation of an expert. However,
considering that appropriateness of a Valuation result depends on the facts
and underlying assumptions, the issue is more fact driven than by law.
Similarly, the SC in the case of Hindustan Lever 10 and Miheer Mafatlal 11 had
observed that Valuation of shares is a technical and complex problem which
can he appropriately left to the consideration of experts in the field of
accountancy and that even courts are not equipped to question the
assumptions made by a valuer.
As regards approach towards Valuation, it is known that there are bound to
be differences in the Valuations undertaken by two valuers and hence, even
the value determined by the AO could differ from that undertaken by the
professional valuer but does that vitiate the Valuation done by the latter
needs to be pondered over. In the book "Study on Share Valuation",
published by the ICAI, the following observation has been made in the
Foreword to the first edition:
"The subject of Valuation of shares has always been controversial in the
accounting profession. No two accountants have ever agreed in the past or
will ever agree in the future on the Valuation of shares of a company, as
inevitably they involve the use of personal judgment on which professional
men will necessarily differ ..."
The above was acknowledged by the Gujarat High Court in the case of
Kiritbhai Hiralal Patel and Ors. vs Arvind Intex Ltd. 12
Inspite of the above guidance by the highest courts of the country, one of the
fundamental questions that keeps coming up is whether the AO can question
/ revisit the assumptions followed while preparing the projections and the
various inputs / variables considered to arrive at the Valuation. This is on
account of the fact that Valuation is a fact and judgement driven process and
the likelihood of a challenge cannot be ruled out.

10 Hindustan Lever Employees Union v. Hindustan Lever Ltd and Others (1995) (83

Comp. Cases 30 (SC)
11 Miheer H. Mafatlal v. Mafatlal Industries Ltd. (1997) (1 SCC 579) (SC)

12 Equivalent citation: 107 Comp. Cas 232 Guj

                                          Valuation-Through the Judicial Lens

To conclude, while over the years there have been favourable rulings
supporting the position of the professional valuer, considering the recent
spate of judgements and the increasing focus on due diligence and
independence expectations around the Valuation process, one cannot rule
out the possibility of a challenge to the work done by the valuer and it is in
his/ her own interest to demonstrate appropriateness of the method selected,
analysis undertaken in the given facts and adequately documenting the

                                                                Chapter 4
       Valuation-Peculiarities of Valuing a
                         Private Business
In the Indian context, it is crucial to understand the nuances of valuing a
private company. This is all the more crucial because the number of private
businesses exceed the publicly listed businesses multi-fold times. This is
evidenced by the fact that multiple business formats are available for private
businesses, ranging from sole proprietorship to limited liability partnerships,
in addition to private limited companies. The website of the Bombay Stock
Exchange ( also mentions that a total number of
companies with listed equity capital on its stock exchange is only 4,713. Add
a few hundred more listed on the small and medium enterprises' platform,
and the number of publicly listed companies in India is forming a very small
part of the universe of businesses in India. The Ministry of Corporate Affairs,
had in November 2017, mentioned that a total of 17,11,806 companies have
been registered in India. The registration of companies, limited liability
partnerships (LLPs), partnerships and sole proprietorships are only
Given the Indian scenario, it is all the more necessary for a practicing valuer
to understand the nuances that form part of the Valuation exercise of a
private business.

Setting the Context
Fundamentally, the approaches that are considered for valuing a private
business are similar to those used for valuing publicly listed companies.
However, it is crucial to consider that the expectations of the investors are
different in each transaction depending on the facts of each transaction.
Broadly speaking, it is convenient to value publicly traded companies
because of some assumptions that are inherently considered by the valuer.
However, it is crucial to understand the outlook of the investors towards the
target business being valued. It is certain that for the same business having
                        Valuation-Peculiarities of Valuing a Private Business

the same financial practices, an investor shall have separate outlook for the
one which is a publicly traded business vis-à-vis the one which is a private
business. Considering the varying outlook of the investors, it is crucial to
evaluate the impact this outlook is likely to have on the cost of capital for the
private business.

Two entities having the same business and same financial practices shall
have the same risk. However, two people looking at the same business can
have different perspectives on the risk in the business. A very important
assumption that underlies in the Valuation of a publicly traded company is
that the investor in the publicly traded company is adequately diversified. The
assumption supposes that the Investor is rational and attempts to maximise
expected returns, given the risk taken. In the process, the investor ends up
with diversified portfolios and uses information to make reasoned judgments
on value. In the scenario of a private business, it is not always correct to
assume that the investor has adequate diversification. To the extent that the
investor in a business is not diversified, the investor may like to incorporate
some or all firm-specific risk into its discount rates, thus reducing the value.
This may be called lack of diversification discount. Accordingly, the cost of
equity and the resultant cost of capital shall be different for a private
business when compared to a publicly traded company.
When we use a beta to measure risk, we are measuring only that portion of
the risk that cannot be diverted away. We are assuming that the remaining
risk is ignored because it can be diverted. Hence, when valuing private
business, this factor needs to be considered and addressed by a valuer while
determining the discounting rate.

Liquidity and Control
What is lack of liquidity? Illiquidity can be simply put as a characteristic of
asset of not easily getting converted into cash. Illiquidity for a market can be
defined as one with few participants and a low volume of activity. Private
businesses, when compared to publicly traded businesses, tend to be more
illiquid. The ideal manner to look at this is that all assets are illiquid, with
some assets being more liquid than others. There is no single yardstick to
measure the liquidity of any asset. However, availability of a marketplace and

Valuation: Professionals' Insight

participants in the marketplace can be considered to be a reasonable
yardstick for the liquidity of the asset. Having said that, it is to be understood
that publicly traded companies amongst themselves also have varying
degrees of liquidity. Treasury bonds and bills may be considered to be most
liquid assets, whereas stock in publicly traded company with small float may
be more illiquid than the stock in publicly traded company having wide
trading. Real estate may be more liquid than a private business. Moreover,
private business amongst themselves may also have varying degrees of
liquidity, especially private businesses offering control (more liquid) vis-à-vis
private businesses without control (less liquid).
This brings us to the next important characteristic of control in a transaction.
Generally, while valuing a publicly traded business, the transactions are
frequent and the intention of the buyer may not be to obtain control, and
hence, the control characteristic in such transactions is not of paramount
importance. However, when a private business is being valued, more often
than not, the intention may always include control. Lack of obtaining control
in a transaction involving a private business generally calls for suitable
adjustment by factoring a discount for lack of control.

It is important to understand that each characteristic is separate and needs
to be treated as such. The degree and magnitude of each discount will vary
not only across firms but also for the same firms, across time and for
different transactions. Without valuing each one separately, one cannot
estimate the correct discount. It is also crucial to understand that each needs
to be counted separately. Trying to consolidate these discounts into one
number is a dangerous exercise and can lead to miscounting and double
counting of risks.
While valuing a target entity, the valuer needs to understand that each of the
characteristic is negotiable. The fact that one can value something (lack of
diversification, lack of control or lack of liquidity) does not mean that the
same shall be included in the price too. While concluding on each of the
above factors/characteristic, the valuer needs to exercise judgment and
decide as per the facts of the case in a pragmatic manner.
The following can be the guiding principles for the valuer to take into account
before addressing each of the above characteristic:

                       Valuation-Peculiarities of Valuing a Private Business

--    Don't discount multiple times for the same factor: If the valuer has
      already upped the discount rate for a firm, because it is illiquid, the
      valuer should not again discount the resultant value for a lack of
      liquidity discount.
--    Be aware of the assumptions in the cash flow model: While valuing a
      firm, the valuer must be aware as to how the cash flows have been
      estimated and what assumptions have been made about how the firm
      will be run. If the model has already incorporated the "sub-optimal"
      practices into cash flows, the valuer cannot apply a minority (control)
      discount to the estimated value.
--    Consider but don't blindly apply the rule of thumb: It is generally
      observed that the lack of liquidity is adjusted at around 20-30% of the
      value derived. Well, the rule of thumb can naturally be taken as
      guidance, but should not be blindly applied. A valuer should exercise
      judgment and determine the discount to be applied to each case.

Best Buyer
This brings us to the next important characteristic in valuing a private
business namely the buyer. The characteristic of the buyer also plays an
important role in the Valuation exercise of a private business. The long-term
buyer for a profitable cash flow generating business may not have the same
illiquidity factor for the business as would a cash-constrained short term
buyer have for the same business. Discount rate for the profitable cash flow
generating business may not also be the same as that for unprofitable
negative cash flow businesses.
Buyer Synergy: If the buyer is confident that the buyer can dramatically
improve his/its own overall earnings by ownership of the target, he/it can
afford to pay more. Synergy may come from simple cross sale of capabilities
to a greater breadth of customers (buyer to seller and vice versa). It may
come from ability to reduce overhead in the combination. It may come from
dozens of possible benefits of combination. Regardless of specific source or
reason, the buyer has value in synergy when he/it knows that he/it can add
more to his/its overall performance than just the simple addition of combining
his/its earnings with those of the seller.

Valuation: Professionals' Insight

Market positions and sentiment: This also plays an important role in
determining the value. One cannot be away from the market while valuing a
business. Discount at the time of the 2008 crisis and the one sometime later
when things looked better, would not be the same. Even established
businesses have trouble in raising funds in an economically negative
situation. For private businesses, it is even worse. The discount varies
across companies, buyers and time.
Moreover, in private businesses, sometimes, the choice to sell the business
may not be to the best buyer. This can be understood with the help of an
example. A general medical practitioner who has been practising as such for
the past many years may want to retire and sell off her practice. For such a
private business, the best available buyer shall be in the form of another
medical practitioner. The choice for the seller to sell the business may not be
to the best buyer. This is due to the inherent limitation of certain private
businesses of not being able to approach the best buyer. Amongst the
available choices for any transaction, the owner of a private business may
not be able to approach all the possible options and carry out a `price
discovery' unlike a publicly traded company, which can generally afford to do
so. In a transaction wherein Valuation of a publicly traded company's
business is done, the underlying assumption is always there that the seller
shall sell the business to the buyer who is likely to offer the highest price.
The exploration continues amongst various parties including:
--    A private owner
--    A private equity fund/venture capital fund
--    A publicly traded company
Different buyers shall have a different measure of risk that is seen in the
same business, resulting into different value.

Inherent Issues in Valuing Private Businesses
The process of valuing private companies is not much different from the one
adopted for valuing publicly traded companies. Either the free cash flow to
firm is discounted at the cost of capital (WACC) or the free cash flow to
equity is discounted at the cost of equity. It is also necessary to appreciate
and understand the most standard problems faced while valuing private
companies. The same are enumerated below:

                        Valuation-Peculiarities of Valuing a Private Business

Absence of market value of equity and debt: Generally, in valuing a
business, especially that relating to publicly traded companies, for calculating
the weighted average cost of capital (WACC), market values of equity and
debt are taken into consideration for assigning weights and deriving the
WACC. This serves as a good benchmark and reliable information while
working on value of publicly traded companies. Generally, private businesses
do not have market value of either equity or debt, leading to the valuer to
have to rely on the limited information that is available. Private businesses
are generally funded significantly with promoter's money. The promoter of
the private business may or may not be charging any interest on the said
funding. Lack of even credit rating of the private businesses leads to a
situation where significant judgment has to be exercised while deciding on
various aspects.
Disclosure problems with private companies: Generally, publicly traded
companies are subject to stringent corporate governance standards leading
to adequate, timely and correct disclosures of financial information.
Generally, there are significant disclosure problems with private firms as they
have a limited historical period as well as lack of discipline in appropriate
reporting of financial information.
Absence of market price: Inherent in a Valuation exercise is the fall back of
the valuer on the market price of the asset. This can be called the inherent
bias of the valuer. In case of a private company, there is no established stock
price and hence, validation of the derived value with the market price is not
available. Lack of market information plays a key role in Valuation of a
private business.
Larger issues with the cash flow: Generally, private firms are not
habituated with complex predictions considering multiple eventualities. Such
exercises have hardly been undertaken by such firms. In such a case, the
valuer has to consider the larger issues with the cash flow prediction and
forecast, especially considering historical performance and prudence in
achievability of the projected cash flow.
Shorter history: Generally, private firms have been in business for shorter
periods of time as compared to publicly traded companies.
Accounting standards: Differences in Accounting Standards plays a key
role in decision making about reliability of financial information. Periodic

Valuation: Professionals' Insight

accounting is prevalent largely in our country where people account for
various items at periodic intervals.
Intermingling of personal and business expenses: While valuing a
transaction, it is imperative for the valuer to broadly consider the
intermingling of personal and business expenses. In our country, for private
businesses, it is very common to have an overlap of personal and business
expenses. Largely, selling promoters represent a larger than reality
proportion of expenses to be personal in nature, trying to prove higher
operating cash flows, which may result in a higher value to them. The valuer
has to exercise adequate care in addressing this sensitive area.
Separating salaries from dividends: Generally, sole owners do not charge
their salary. Moreover, sole owners do a lot of chores which may not be
continued by them after a particular transaction. It is extremely important to
understand that while projecting cash flows for a business, it should be
considered as to which expenses shall continue beyond and which expenses
shall add up if the owner is no longer the sole owner. Various roles such as
accountant, marketing, etc. by owner can add up to costs after a particular
transaction. What would cost one to replace the owner is important while
valuing a private company as one may need multiple people to do what the
owner did previously.
Key person value - Mainly CAs, Doctors, dentists, chefs, other
professionals, have key person value. Key person value is the variable which
can lead to loss of revenue due to the key person's absence. It can be
understood by way of an example: If a dentist sells her practice to another
dentist, a patient visiting after the transaction on not seeing the previous
dentist may choose to walk out of the clinic rather than getting attended by
the new dentist. Key person value mostly affects businesses having personal
services. A valuer may have to clean up the financial statements for the
purpose of Valuation. Cleaning up of financial statements includes adjusting
cash flows for items such as expenses which shall increase/decrease post
the transaction. Generally, in real life, the key person assists in transition.
Also, non-compete needs to be factored into Valuation if it is factored into the
Related party transactions: Indian private businesses have a tendency to
enter into multitude of related party transactions. More often than not, the
said related party transactions are entered into at a price which may be
calculated on the basis of some ulterior motive of the promoters of the

                       Valuation-Peculiarities of Valuing a Private Business

private business. The valuer should exercise due care while considering the
quantum, implication and importance of the related party transactions on the
business being valued. If adjustments are required to be made, appropriate
adjustments after exercising due care must be done.
Royalty payments: Some private businesses might charge royalty on the
use of the trademark of the promoter of the private business registered in
any other personal's entity's/name. A valuer should consider such royalty
payments and its implication on the value.

Different Purposes of Valuing Private Firms
The purpose of Valuation is also crucial for the private business' Valuation.
There are multiple reasons for which a private business might require a
--    Regulatory requirement: Preferential issue, rights' issue, employee
      stock option, etc. as per the requirement of the Companies Act, 2013.
--    Private businesses might sometimes ask for a Valuation out of
      curiosity to know what the business is worth?
--    Sometimes, for split or family settlements, the Valuation is needed.
--    Sometimes, fair value accounting, does not lead to any transaction.
--    Sale of one partner's interest to the other partner, and so on.
Knowing the purpose of Valuation is crucial for the valuer for considering the
relevant factors affecting the transaction purported and reliance of the said
transaction on the value derived.

Broadly, Valuation is an exercise which is unique for every transaction and
requires efforts, involvement, application of mind and thought for each
assignment separately. Only guiding principles can be adopted and
considered by the valuer while undertaking each assignment. A summary of
some key factors to consider have been presented in this Chapter which can
be taken into consideration in the next Valuation assignment for a private
business by the readers.

                                                                Chapter 5
    Computing Beta -- The Most Critical
                     Input to the CAPM
Valuers/analysts across the globe adopt Capital Asset Pricing Model (CAPM)
as one of the methodologies to arrive at the cost of equity and consequently
the cost of capital. One of the most critical inputs to the CAPM is `Beta' i.e.
the sensitivity of the subject company/asset to the market. In this article we
look at the ways to compute beta for listed as well as unlisted entities.
The method to arrive at beta is by taking the company's returns over a time
period and compare the Index returns say Sensex or Nifty for the same
period. Now, we have both data sets, we take the co-variance of the stock
returns and the index returns for the same period and divide it by the
variance of the index returns. This gives you a coefficient which measures
the relative risk of your company with respect to the market, for example if
the coefficient you arrive is at is 1.5, then if the index moves by 1% up or
down then your company moves 1.5% in the respective direction.

                  Beta () = Covariance (X, Y)/ Variance (Y)

                                X = Stock Return

                                Y = Index Return

This is basically running a regression on both the data sets - returns on the
stock and returns of the index, the slope of the line is your beta, this gives
you a statistical answer to what is the beta for the company. This coefficient
(beta) could come with a standard error and is just an estimate.
Let us try and compute beta with the help of an illustration. Given below is
the data pertaining to Tata Steel's stock price and Nifty 50 for the period Oct
1, 2015 to September 30, 2016.
                 Computing Beta -- The most critical input to the CAPM

Tata Steel
  Date       Open     High     Low    Close     Volume Adj Close
01-10-2015    215    215.5 210.25 212.25        4872900       212.25
05-10-2015   214.9   225.8    214.2      225    8121300          225
06-10-2015   227.7     229 223.15      227.5    7359800        227.5
07-10-2015    225    237.7    223.6    236.8    9838500        236.8
08-10-2015   237.9   242.7    236.2    240.8    8915500        240.8
09-10-2015   242.4     253    242.2    251.1 10520000          251.1
12-10-2015   255.1 261.95     249.8 250.85 10570000           250.85
13-10-2015    248 248.65 243.25          245    5821200          245
14-10-2015    244      253 243.55 248.35        6290100       248.35
15-10-2015 249.15    257.2 248.05 255.25        7008000       255.25
16-10-2015   255.9   256.7    248.4    252.9    5326500        252.9
19-10-2015   253.1   254.1 246.75      248.4    4478300        248.4
20-10-2015 247.05    248.9      240    240.8    5248500        240.8
21-10-2015   241.7 246.45 238.25       244.4    8042200        244.4
23-10-2015   247.4   251.6 244.15        246    5005800          246
26-10-2015 247.35 251.55 246.25 249.65          4188000       249.65
27-10-2015 248.85    250.3 244.05 245.95        3403600       245.95
28-10-2015   244.5   248.5      244 247.15      3436900       247.15
29-10-2015   246.3 251.45     244.7    247.6    4589000        247.6
30-10-2015   248.4   254.8 245.15      246.6    6173200        246.6
02-11-2015   246.5   246.6    236.3    238.9    4909500        238.9
03-11-2015   241.7     243    234.9    235.7    4492700        235.7
04-11-2015 239.15      240 233.85      235.4    4861300        235.4
05-11-2015    236      236    224.3    225.4    8801600        225.4
06-11-2015   218.9 221.85     215.1 220.25      9906300       220.25
09-11-2015    215    224.4 212.65 222.25        6272600       222.25
10-11-2015   220.8 222.25 217.15 218.05         4536400       218.05
11-11-2015 218.05 218.05 218.05 218.05                 0      218.05
13-11-2015   218.7   223.6    216.6 222.65      4426900       222.65

Valuation: Professionals' Insight

 16-11-2015 222.85       231.9      220.2   230.6   6923300    230.6
 17-11-2015     231.9 235.75        230.9 234.55    5240900   234.55
 18-11-2015     234.1      235      225.2 225.85    5283600   225.85
 19-11-2015     227.5    229.7      225.6 228.75    3661100   228.75
 20-11-2015     228.1 232.75        228.1    230    3859400     230
 23-11-2015 230.85 230.85           223.1 224.45    4102300   224.45
 24-11-2015 223.35       226.4      222.5 224.35    4179000   224.35
 26-11-2015     225.5      230      224.2   227.9   4588000    227.9
 27-11-2015     227.9      235 227.55 231.25        5393000   231.25
 30-11-2015     232.4    234.4      228.8   229.6   4556700    229.6
 01-12-2015     230.8    238.5      230.3 237.55    6586500   237.55
 02-12-2015 239.95       245.9      238.1 243.85    8858300   243.85
 03-12-2015 240.15       243.5      236.8 240.15    7107800   240.15
 04-12-2015 238.05 244.25           237.1 240.25    5538100   240.25
 07-12-2015     244.8    247.5 242.45 243.55        4936400   243.55
 08-12-2015 242.05 243.05           233.5 234.75    4545900   234.75
 09-12-2015       234 235.85        224.9 226.85    4727600   226.85
 10-12-2015 227.25 234.75           226.5    233    4804800     233
 11-12-2015     235.1    243.9      235.1   240.9 11922400     240.9
 14-12-2015       239    248.9 238.45        245 11314400       245
 15-12-2015       247 247.25 241.25 244.35          5218800   244.35
 16-12-2015 246.55       248.6      242.1   244.7   5759800    244.7
 17-12-2015     246.9 257.95 246.05         257.1 12112200     257.1
 18-12-2015     256.5 257.95         254 255.65     6944200   255.65
 21-12-2015     255.5    261.4 254.65 258.45        6195200   258.45
 22-12-2015       259    261.8 256.55       257.4   4544200    257.4
 23-12-2015 262.25       266.4 262.25 264.45        7702900   264.45
 24-12-2015       266      266      260.6 263.35    3843700   263.35
 28-12-2015 263.95       264.3       253    254.1   5317600    254.1
 29-12-2015     255.8 257.15 253.35         255.3   3800500    255.3
 30-12-2015     256.4    261.8      255.1   258.7   6812700    258.7

                 Computing Beta -- The most critical input to the CAPM

31-12-2015    260    260.8 256.95      259.8    4446600        259.8
04-01-2016    255    263.2    253.1    256.9    6981400        256.9
05-01-2016 257.55    276.4 257.55      274.3 15008900          274.3
06-01-2016   272.8   274.6      266 268.75      7454700       268.75
07-01-2016    263    263.3    248.2    249.9    9503700        249.9
08-01-2016    252    256.3 249.05      253.6    6299400        253.6
11-01-2016    247 253.35 244.25 251.65          6085300       251.65
12-01-2016 253.05    255.3 243.15 245.75        5425300       245.75
13-01-2016   248.5   251.8      237    246.6    7482400        246.6
14-01-2016    235 242.55      231.5 238.75      8884800       238.75
15-01-2016   242.5     243    228.1    229.7    5991600        229.7
18-01-2016   229.8     244    225.2    235.9    8417400        235.9
19-01-2016 237.55 240.95 231.25          238    6304100          238
20-01-2016   232.8     234    226.5      232    5486800          232
21-01-2016   234.7 239.35 231.25       235.6    6245300        235.6
22-01-2016   238.3   250.8 237.65      247.8    6510700        247.8
25-01-2016    249    256.4    248.8    254.9    5576500        254.9
27-01-2016    255    259.9    253.4    257.6    6235600        257.6
28-01-2016    257 258.45      252.4    254.2    6016700        254.2
29-01-2016 254.65    258.8 247.45      249.7    6747900        249.7
01-02-2016   248.9 254.95     246.5    249.3    4420700        249.3
02-02-2016 250.25      251    230.1 231.45      8388400       231.45
03-02-2016   227.9   233.9 221.45        224    7791500          224
04-02-2016   224.4   228.6      219 225.95 11709400           225.95
05-02-2016    216    238.3      216 233.85 25803300           233.85
08-02-2016   238.6 243.95 232.05       234.1 10332400          234.1
09-02-2016   230.9   237.3    230.1    235.5    7562800        235.5
10-02-2016 234.85 237.75      227.1    235.7    7616000        235.7
11-02-2016 235.95    237.3 220.85      224.5    6151600        224.5
12-02-2016    226 229.35 211.15        217.5    9373700        217.5
15-02-2016    222      248      222    246.7 13602300          246.7

Valuation: Professionals' Insight

 16-02-2016     249.6    251.6 243.15 244.85        9146800   244.85
 17-02-2016       245    252.9       238 251.25     8295400   251.25
 18-02-2016       255    256.5      243.2 250.85    9459300   250.85
 19-02-2016     248.5 254.45 246.85 253.25          6770600   253.25
 22-02-2016     253.6    257.5      251.7 255.25    4810300   255.25
 23-02-2016     255.8    261.6      252.1 253.55    8452300   253.55
 24-02-2016     250.6 253.75 246.95         247.9   4743800    247.9
 25-02-2016     247.1 249.85        244.6 248.15    5588100   248.15
 26-02-2016     249.5    251.7 243.15 248.45        5336800   248.45
 29-02-2016     246.9 263.65        245.1   249.1   9850400    249.1
 01-03-2016       250 258.15 246.55 257.05          7111200   257.05
 02-03-2016       260    269.5      259.5 267.55    7645600   267.55
 03-03-2016       273      289      272.1 287.05 17533000     287.05
 04-03-2016       289    291.2      284.5 288.55    9170100   288.55
 08-03-2016     287.8    296.7       287    291.8   9281500    291.8
 09-03-2016     283.5    296.5      281.3   295.4 10158400     295.4
 10-03-2016     296.3 301.25        293.3   296.7   8556900    296.7
 11-03-2016       296    298.2 290.35 294.05        7633600   294.05
 14-03-2016 295.95 300.25 295.25            296.7   4445300    296.7
 15-03-2016       297      302      294.1 300.45    6978000   300.45
 16-03-2016       300 302.75        294.2   299.5   7039300    299.5
 17-03-2016     304.5 305.65        294.9   295.9   8005500    295.9
 18-03-2016     299.7 302.75 296.95         302.2   7314400    302.2
 21-03-2016       302 305.95 300.65 303.55          5651700   303.55
 22-03-2016     303.1    311.8 301.35       309.8   6579000    309.8
 23-03-2016     311.8    317.9 310.55       317.2   6377700    317.2
 28-03-2016     318.4    318.4      297.4 299.15    9069700   299.15
 29-03-2016       300 307.75         300 303.85     5937100   303.85
 30-03-2016 309.45 325.75           305.3   324.3 12438800     324.3
 31-03-2016     324.9    324.9      314.4   319.7 13349900     319.7

                   Computing Beta -- The most critical input to the CAPM

 Nifty 50
   Date     Open         High     Low    Close  Volume Adj Close
01-10-2015 7992.05       8008.25 7930.65 7950.9   156900  7950.9
05-10-2015 8005.1 8128.8999         8005.1    8119.3   183100    8119.3
06-10-2015 8180.45 8180.9502        8096.5    8152.9   178500    8152.9
07-10-2015 8146.2 8188.8999 8132.9 8177.4              193900    8177.4
08-10-2015 8196.75 8196.75 8105.85 8129.35             171700   8129.35
09-10-2015   8186.35   8232.2002   8139.65    8189.7   199700    8189.7
12-10-2015    8231.5      8244.5    8128.2    8143.6   199100    8143.6
13-10-2015   8121.95     8150.25    8088.6    8131.7   145900    8131.7
14-10-2015    8102.4   8139.2998   8096.35    8107.9   138900    8107.9
15-10-2015   8134.35   8190.5498    8129.8    8179.5   167200    8179.5
16-10-2015   8193.65   8246.4004   8147.65   8238.15   156400   8238.15
19-10-2015   8262.55   8283.0498    8239.2   8275.05   124500   8275.05
20-10-2015    8280.3   8294.0498    8229.2   8261.65   155100   8261.65
21-10-2015   8258.35   8294.4004   8217.15    8251.7   144800    8251.7
23-10-2015   8308.25   8328.0996   8280.75   8295.45   152000   8295.45
26-10-2015   8333.65   8336.2998   8252.05   8260.55   133900   8260.55
27-10-2015   8230.35   8241.9502   8217.05    8232.9   156700    8232.9
28-10-2015    8188.9   8209.0996    8131.8    8171.2   188900    8171.2
29-10-2015   8175.45   8179.6001      8098   8111.75   217500   8111.75
30-10-2015   8123.55   8146.1001    8044.4    8065.8   199500    8065.8
02-11-2015   8054.55   8060.7002    7995.6    8050.8   136100    8050.8
03-11-2015   8086.35   8100.3501   8031.75    8060.7   132500    8060.7
04-11-2015    8104.9   8116.1001    8027.3    8040.2   122100    8040.2
05-11-2015   8030.35   8031.2002    7944.1   7955.45   132100   7955.45
06-11-2015   7956.55   8002.6499   7926.15    7954.3   219500    7954.3
09-11-2015 7788.25 7937.75 7771.7 7915.2               211800    7915.2
10-11-2015 7877.6 7885.1001 7772.85 7783.35            165200   7783.35
11-11-2015 7838.8 7847.9502         7819.1    7825      21700      7825
13-11-2015 7762.45 7775.1001        7730.9 7762.25     160900   7762.25
16-11-2015 7732.95 7838.8501 7714.15          7806.6   149500    7806.6

Valuation: Professionals' Insight

17-11-2015 7848.75 7860.4502          7793 7837.55      145000   7837.55
18-11-2015 7823.15 7843.3999 7725.05 7731.8             143600    7731.8
19-11-2015 7788.5 7854.8999 7765.45 7842.75             132600   7842.75
20-11-2015    7841.9 7906.9502       7817.8 7856.55     151900   7856.55
23-11-2015    7869.5    7877.5       7825.2 7849.25     127000   7849.25
24-11-2015    7837 7870.3501 7812.65           7831.6   130600    7831.6
26-11-2015 7837.15 7897.1001    7832           7883.8   219800    7883.8
27-11-2015    7910.6   7959.2998    7879.45    7942.7   150300    7942.7
30-11-2015   7936.25        7966     7922.8   7935.25   216300   7935.25
01-12-2015   7958.15   7972.1499    7934.15    7954.9   138600    7954.9
02-12-2015    7976.7   7979.2998     7910.8   7931.35   126300   7931.35
03-12-2015    7902.3   7912.2998     7853.3   7864.15   125700   7864.15
04-12-2015    7817.6   7821.3999     7775.7    7781.9   152500    7781.9
07-12-2015   7816.55   7825.3999    7746.05    7765.4   137600    7765.4
08-12-2015    7738.5     7771.25    7685.45    7701.7   135100    7701.7
09-12-2015    7695.5   7702.8501     7606.9    7612.5   140000    7612.5
10-12-2015    7643.3   7691.9502       7610    7683.3   140800    7683.3
11-12-2015    7699.6   7703.0498     7575.3   7610.45   167800   7610.45
14-12-2015    7558.2   7663.9502    7551.05   7650.05   148900   7650.05
15-12-2015   7659.15        7705     7625.1    7700.9   134300    7700.9
16-12-2015   7725.25   7776.6001    7715.75    7750.9   154300    7750.9
17-12-2015   7783.05   7852.8999    7737.55   7844.35   175900   7844.35
18-12-2015    7828.9   7836.1499    7753.35   7761.95   191400   7761.95
21-12-2015   7745.65     7840.75    7733.45   7834.45   126300   7834.45
22-12-2015    7829.4   7846.2998    7776.85    7786.1   125700    7786.1
23-12-2015   7830.45   7871.4502     7826.1   7865.95   117900   7865.95
24-12-2015   7888.75     7888.75     7835.5   7861.05    93500   7861.05
28-12-2015    7863.2 7937.2002    7863 7925.15          122900   7925.15
29-12-2015    7929.2 7942.1499 7902.75 7928.95          113000   7928.95
30-12-2015    7938.6 7944.75 7889.85 7896.25            106800   7896.25
31-12-2015    7897.8 7955.5498 7891.15 7946.35          150900   7946.35
04-01-2016 7924.55 7937.5498         7781.1    7791.3   134700    7791.3

                   Computing Beta -- The most critical input to the CAPM

05-01-2016    7828.4 7831.2002 7763.25 7784.65         145200    7784.65
06-01-2016 7788.05 7800.9502        7721.2      7741   147100       7741
07-01-2016 7673.35 7674.9502        7556.6    7568.3   188900     7568.3
08-01-2016 7611.65 7634.1001 7581.05 7601.35           157400    7601.35
11-01-2016 7527.45 7605.1001 7494.35 7563.85           189000    7563.85
12-01-2016    7587.2 7588.2998      7487.8    7510.3   163900     7510.3
13-01-2016    7557.9 7590.9502      7425.8    7562.4   215200     7562.4
14-01-2016    7467.4   7604.7998    7443.8    7536.8    200800    7536.8
15-01-2016   7561.65      7566.5    7427.3    7437.8    197500    7437.8
18-01-2016   7420.35   7463.6499    7336.4      7351    233600      7351
19-01-2016    7381.8     7462.75   7364.15    7435.1    188300    7435.1
20-01-2016      7357   7470.8999    7241.5    7309.3    225600    7309.3
21-01-2016   7376.65   7398.7002      7250    7276.8    240700    7276.8
22-01-2016    7355.7   7433.3999    7327.6   7422.45    229200   7422.45
25-01-2016   7468.75   7487.1499    7421.2   7436.15 163156900   7436.15
27-01-2016    7469.6   7477.8999    7419.7   7437.75    187600   7437.75
28-01-2016    7426.5   7468.8501    7409.6   7424.65    274500   7424.65
29-01-2016   7413.35   7575.6499    7402.8   7563.55    298700   7563.55
01-02-2016    7589.5   7600.4502   7541.25   7555.95    200400   7555.95
02-02-2016   7566.65   7576.2998   7428.05   7455.55    230200   7455.55
03-02-2016   7392.45   7419.3999    7350.3    7361.8    192000    7361.8
04-02-2016   7411.45   7457.0498   7365.95      7404    222700      7404
05-02-2016   7418.25   7503.1499   7406.65    7489.1    249800    7489.1
08-02-2016    7489.7   7512.5498    7363.2   7387.25    171500   7387.25
09-02-2016   7303.95   7323.4502   7275.15    7298.2    212100    7298.2
10-02-2016    7264.3   7271.8501   7177.75    7215.7    246900    7215.7
11-02-2016    7203.6   7208.6499   6959.95   6976.35    292300   6976.35
12-02-2016 7023.65 7034.7998          6869 6980.95     333900    6980.95
15-02-2016 7057.35 7182.7998        7056.8 7162.95     354200    7162.95
16-02-2016 7201.25 7204.6499 7037.7 7048.25            253800    7048.25
17-02-2016 7058.85 7123.7002 6960.65 7108.45           260000    7108.45
18-02-2016    7177.4 7215.1001 7127.85 7191.75         246700    7191.75

Valuation: Professionals' Insight

19-02-2016 7170.55 7226.8501 7145.95 7210.75               192300     7210.75
22-02-2016 7208.85 7252.3999         7200.7 7234.55        154400     7234.55
23-02-2016 7240.3 7241.7002          7090.7 7109.55        194400     7109.55
24-02-2016    7075 7090.7998 7009.75           7018.7      199700      7018.7
25-02-2016 7029.85 7034.2002 6961.4            6970.6      283100      6970.6
26-02-2016 7039.3 7052.8999          6985.1 7029.75        206700     7029.75
29-02-2016 7050.45 7094.6001         6825.8 6987.05        473400     6987.05
01-03-2016    7038.25      7235.5    7035.1    7222.3      275100      7222.3
02-03-2016     7321.7   7380.3501   7308.15   7368.85      338500     7368.85
03-03-2016    7429.55   7483.9502   7406.05    7475.6      278600      7475.6
04-03-2016     7505.4   7505.8999    7444.1   7485.35      281700     7485.35
08-03-2016     7486.4   7527.1499   7442.15    7485.3      257000      7485.3
09-03-2016     7436.1        7539    7424.3    7531.8      245100      7531.8
10-03-2016    7545.35   7547.1001    7447.4   7486.15      224700     7486.15
11-03-2016    7484.85   7543.9502    7460.6    7510.2      198700      7510.2
14-03-2016     7542.6   7583.7002   7515.05   7538.75      166900     7538.75
15-03-2016    7535.85   7545.2002    7452.8    7460.6      193700      7460.6
16-03-2016    7457.05        7508   7405.15   7498.75      195400     7498.75
17-03-2016     7557.4   7585.2998    7479.4   7512.55      239600     7512.55
18-03-2016    7534.65   7613.6001    7517.9   7604.35      237400     7604.35
21-03-2016     7619.2   7713.5498    7617.7   7704.25      196800     7704.25
22-03-2016    7695.55   7728.2002    7643.8    7714.9      208900      7714.9
23-03-2016    7717.45   7726.8501    7670.6    7716.5      199600      7716.5
28-03-2016       7741   7749.3999    7587.7    7615.1      242400      7615.1
29-03-2016    7606.55   7652.8999   7582.25      7597      216800        7597
30-03-2016     7651.1   7741.9502   7643.45    7735.2      232600      7735.2
31-03-2016    7727.65   7777.6001      7702    7738.4      380100      7738.4
For computing the beta using the above information, we need to compute the
daily returns both for the stock i.e. Tata Steel and the index i.e. Nifty 50 by
applying the following formula:

                    Computing Beta -- The most critical input to the CAPM

                             % Daily Return =

      (Current Day Adjusted Close Price - Previous Day Adjusted Close

 The daily returns for Tata Steel as well as Nifty 50 have been computed
 below for demonstration purpose:

Tata Steel
   Date      Open   High   Low    Close     Volume        Adj      Daily
                                                         Close    Returns
01-10-2015 215      216    210    212     48,72,900     212
05-10-2015 215      226    214    225     81,21,300     225       6%
06-10-2015 228      229    223    228     73,59,800     228       1%
07-10-2015 225      238    224    237     98,38,500     237       4%
08-10-2015 238      243    236    241     89,15,500     241       2%
09-10-2015 242      253    242    251     1,05,20,000   251       4%
12-10-2015 255      262    250    251     1,05,70,000   251       0%
13-10-2015 248      249    243    245     58,21,200     245       -2%
14-10-2015 244      253    244    248     62,90,100     248       1%
15-10-2015 249      257    248    255     70,08,000     255       3%
16-10-2015 256      257    248    253     53,26,500     253       -1%
19-10-2015 253      254    247    248     44,78,300     248       -2%
20-10-2015 247      249    240    241     52,48,500     241       -3%
21-10-2015 242      246    238    244     80,42,200     244       1%
23-10-2015 247      252    244    246     50,05,800     246       1%
26-10-2015 247      252    246    250     41,88,000     250       1%
27-10-2015 249      250    244    246     34,03,600     246       -1%

Valuation: Professionals' Insight

28-10-2015 245     249      244     247   34,36,900   247   0%
29-10-2015 246     251      245     248   45,89,000   248   0%
30-10-2015 248     255      245     247   61,73,200   247   0%
02-11-2015 247     247      236     239   49,09,500   239   -3%
03-11-2015 242     243      235     236   44,92,700   236   -1%
04-11-2015 239     240      234     235   48,61,300   235   0%
05-11-2015 236     236      224     225   88,01,600   225   -4%
06-11-2015 219     222      215     220   99,06,300   220   -2%
09-11-2015 215     224      213     222   62,72,600   222   1%
10-11-2015 221     222      217     218   45,36,400   218   -2%
11-11-2015 218     218      218     218   -           218   0%
13-11-2015 219     224      217     223   44,26,900   223   2%
16-11-2015 223     232      220     231   69,23,300   231   4%
17-11-2015 232     236      231     235   52,40,900   235   2%
18-11-2015 234     235      225     226   52,83,600   226   -4%
19-11-2015 228     230      226     229   36,61,100   229   1%
20-11-2015 228     233      228     230   38,59,400   230   1%
23-11-2015 231     231      223     224   41,02,300   224   -2%
24-11-2015 223     226      223     224   41,79,000   224   0%
26-11-2015 226     230      224     228   45,88,000   228   2%
27-11-2015 228     235      228     231   53,93,000   231   1%
30-11-2015 232     234      229     230   45,56,700   230   -1%
01-12-2015 231     239      230     238   65,86,500   238   3%
02-12-2015 240     246      238     244   88,58,300   244   3%
03-12-2015 240     244      237     240   71,07,800   240   -2%
04-12-2015 238     244      237     240   55,38,100   240   0%

                 Computing Beta -- The most critical input to the CAPM

07-12-2015 245   248   242     244     49,36,400     244       1%
08-12-2015 242   243   234     235     45,45,900     235       -4%
09-12-2015 234   236   225     227     47,27,600     227       -3%
10-12-2015 227   235   227     233     48,04,800     233       3%
11-12-2015 235   244   235     241     1,19,22,400   241       3%
14-12-2015 239   249   238     245     1,13,14,400   245       2%
15-12-2015 247   247   241     244     52,18,800     244       0%
16-12-2015 247   249   242     245     57,59,800     245       0%
17-12-2015 247   258   246     257     1,21,12,200   257       5%
18-12-2015 257   258   254     256     69,44,200     256       -1%
21-12-2015 256   261   255     258     61,95,200     258       1%
22-12-2015 259   262   257     257     45,44,200     257       0%
23-12-2015 262   266   262     264     77,02,900     264       3%
24-12-2015 266   266   261     263     38,43,700     263       0%
28-12-2015 264   264   253     254     53,17,600     254       -4%
29-12-2015 256   257   253     255     38,00,500     255       0%
30-12-2015 256   262   255     259     68,12,700     259       1%
31-12-2015 260   261   257     260     44,46,600     260       0%
04-01-2016 255   263   253     257     69,81,400     257       -1%
05-01-2016 258   276   258     274     1,50,08,900   274       7%
06-01-2016 273   275   266     269     74,54,700     269       -2%
07-01-2016 263   263   248     250     95,03,700     250       -7%
08-01-2016 252   256   249     254     62,99,400     254       1%
11-01-2016 247   253   244     252     60,85,300     252       -1%
12-01-2016 253   255   243     246     54,25,300     246       -2%
13-01-2016 249   252   237     247     74,82,400     247       0%

Valuation: Professionals' Insight

14-01-2016 235     243      232     239   88,84,800     239   -3%
15-01-2016 243     243      228     230   59,91,600     230   -4%
18-01-2016 230     244      225     236   84,17,400     236   3%
19-01-2016 238     241      231     238   63,04,100     238   1%
20-01-2016 233     234      227     232   54,86,800     232   -3%
21-01-2016 235     239      231     236   62,45,300     236   2%
22-01-2016 238     251      238     248   65,10,700     248   5%
25-01-2016 249     256      249     255   55,76,500     255   3%
27-01-2016 255     260      253     258   62,35,600     258   1%
28-01-2016 257     258      252     254   60,16,700     254   -1%
29-01-2016 255     259      247     250   67,47,900     250   -2%
01-02-2016 249     255      247     249   44,20,700     249   0%
02-02-2016 250     251      230     231   83,88,400     231   -7%
03-02-2016 228     234      221     224   77,91,500     224   -3%
04-02-2016 224     229      219     226   1,17,09,400   226   1%
05-02-2016 216     238      216     234   2,58,03,300   234   3%
08-02-2016 239     244      232     234   1,03,32,400   234   0%
09-02-2016 231     237      230     236   75,62,800     236   1%
10-02-2016 235     238      227     236   76,16,000     236   0%
11-02-2016 236     237      221     225   61,51,600     225   -5%
12-02-2016 226     229      211     218   93,73,700     218   -3%
15-02-2016 222     248      222     247   1,36,02,300   247   13%
16-02-2016 250     252      243     245   91,46,800     245   -1%
17-02-2016 245     253      238     251   82,95,400     251   3%
18-02-2016 255     257      243     251   94,59,300     251   0%
19-02-2016 249     254      247     253   67,70,600     253   1%

                 Computing Beta -- The most critical input to the CAPM

22-02-2016 254   258   252     255     48,10,300     255       1%
23-02-2016 256   262   252     254     84,52,300     254       -1%
24-02-2016 251   254   247     248     47,43,800     248       -2%
25-02-2016 247   250   245     248     55,88,100     248       0%
26-02-2016 250   252   243     248     53,36,800     248       0%
29-02-2016 247   264   245     249     98,50,400     249       0%
01-03-2016 250   258   247     257     71,11,200     257       3%
02-03-2016 260   270   260     268     76,45,600     268       4%
03-03-2016 273   289   272     287     1,75,33,000   287       7%
04-03-2016 289   291   285     289     91,70,100     289       1%
08-03-2016 288   297   287     292     92,81,500     292       1%
09-03-2016 284   297   281     295     1,01,58,400   295       1%
10-03-2016 296   301   293     297     85,56,900     297       0%
11-03-2016 296   298   290     294     76,33,600     294       -1%
14-03-2016 296   300   295     297     44,45,300     297       1%
15-03-2016 297   302   294     300     69,78,000     300       1%
16-03-2016 300   303   294     300     70,39,300     300       0%
17-03-2016 305   306   295     296     80,05,500     296       -1%
18-03-2016 300   303   297     302     73,14,400     302       2%
21-03-2016 302   306   301     304     56,51,700     304       0%
22-03-2016 303   312   301     310     65,79,000     310       2%
23-03-2016 312   318   311     317     63,77,700     317       2%
28-03-2016 318   318   297     299     90,69,700     299       -6%
29-03-2016 300   308   300     304     59,37,100     304       2%
30-03-2016 309   326   305     324     1,24,38,800   324       7%
31-03-2016 325   325   314     320     1,33,49,900   320       -1%

Valuation: Professionals' Insight

Nifty 50
   Date      Open     High    Low       Close       Volume      Adj      Daily
                                                               Close    Returns
01-10-2015    7,992   8,008    7,931        7,951   1,56,900    7,951
05-10-2015    8,005   8,129    8,005        8,119   1,83,100    8,119     2%
06-10-2015    8,180   8,181    8,097        8,153   1,78,500    8,153     0%
07-10-2015    8,146   8,189    8,133        8,177   1,93,900    8,177     0%
08-10-2015    8,197   8,197    8,106        8,129   1,71,700    8,129    -1%
09-10-2015    8,186   8,232    8,140        8,190   1,99,700    8,190     1%
12-10-2015    8,232   8,245    8,128        8,144   1,99,100    8,144    -1%
13-10-2015    8,122   8,150    8,089        8,132   1,45,900    8,132     0%
14-10-2015    8,102   8,139    8,096        8,108   1,38,900    8,108     0%
15-10-2015    8,134   8,191    8,130        8,180   1,67,200    8,180     1%
16-10-2015    8,194   8,246    8,148        8,238   1,56,400    8,238     1%
19-10-2015    8,263   8,283    8,239        8,275   1,24,500    8,275     0%
20-10-2015    8,280   8,294    8,229        8,262   1,55,100    8,262     0%
21-10-2015    8,258   8,294    8,217        8,252   1,44,800    8,252     0%
23-10-2015    8,308   8,328    8,281        8,295   1,52,000    8,295     1%
26-10-2015    8,334   8,336    8,252        8,261   1,33,900    8,261     0%
27-10-2015    8,230   8,242    8,217        8,233   1,56,700    8,233     0%
28-10-2015    8,189   8,209    8,132        8,171   1,88,900    8,171    -1%
29-10-2015    8,175   8,180    8,098        8,112   2,17,500    8,112    -1%
30-10-2015    8,124   8,146    8,044        8,066   1,99,500    8,066    -1%
02-11-2015    8,055   8,061    7,996        8,051   1,36,100    8,051     0%
03-11-2015    8,086   8,100    8,032        8,061   1,32,500    8,061     0%
04-11-2015    8,105   8,116    8,027        8,040   1,22,100    8,040     0%
05-11-2015    8,030   8,031    7,944        7,955   1,32,100    7,955    -1%
06-11-2015    7,957   8,003    7,926        7,954   2,19,500    7,954     0%
09-11-2015    7,788   7,938    7,772        7,915   2,11,800    7,915     0%
10-11-2015    7,878   7,885    7,773        7,783   1,65,200    7,783    -2%
11-11-2015    7,839   7,848    7,819        7,825     21,700    7,825     1%

                     Computing Beta -- The most critical input to the CAPM

13-11-2015   7,762    7,775    7,731        7,762   1,60,900   7,762   -1%
16-11-2015   7,733    7,839    7,714        7,807   1,49,500   7,807   1%
17-11-2015   7,849    7,860    7,793        7,838   1,45,000   7,838   0%
18-11-2015   7,823    7,843    7,725        7,732   1,43,600   7,732   -1%
19-11-2015   7,789    7,855    7,765        7,843   1,32,600   7,843   1%
20-11-2015   7,842    7,907    7,818        7,857   1,51,900   7,857   0%
23-11-2015   7,870    7,878    7,825        7,849   1,27,000   7,849   0%
24-11-2015   7,837    7,870    7,813        7,832   1,30,600   7,832   0%
26-11-2015   7,837    7,897    7,832        7,884   2,19,800   7,884   1%
27-11-2015   7,911    7,959    7,879        7,943   1,50,300   7,943   1%
30-11-2015   7,936    7,966    7,923        7,935   2,16,300   7,935   0%
01-12-2015   7,958    7,972    7,934        7,955   1,38,600   7,955   0%
02-12-2015   7,977    7,979    7,911        7,931   1,26,300   7,931   0%
03-12-2015   7,902    7,912    7,853        7,864   1,25,700   7,864   -1%
04-12-2015   7,818    7,821    7,776        7,782   1,52,500   7,782   -1%
07-12-2015   7,817    7,825    7,746        7,765   1,37,600   7,765   0%
08-12-2015   7,739    7,771    7,685        7,702   1,35,100   7,702   -1%
09-12-2015   7,696    7,703    7,607        7,613   1,40,000   7,613   -1%
10-12-2015   7,643    7,692    7,610        7,683   1,40,800   7,683   1%
11-12-2015   7,700    7,703    7,575        7,610   1,67,800   7,610   -1%
14-12-2015   7,558    7,664    7,551        7,650   1,48,900   7,650   1%
15-12-2015   7,659    7,705    7,625        7,701   1,34,300   7,701   1%
16-12-2015   7,725    7,777    7,716        7,751   1,54,300   7,751   1%
17-12-2015   7,783    7,853    7,738        7,844   1,75,900   7,844   1%
18-12-2015   7,829    7,836    7,753        7,762   1,91,400   7,762   -1%
21-12-2015   7,746    7,841    7,733        7,834   1,26,300   7,834   1%
22-12-2015   7,829    7,846    7,777        7,786   1,25,700   7,786   -1%
23-12-2015   7,830    7,871    7,826        7,866   1,17,900   7,866   1%
24-12-2015   7,889    7,889    7,836        7,861    93,500    7,861   0%
28-12-2015   7,863    7,937    7,863        7,925   1,22,900   7,925   1%
29-12-2015   7,929    7,942    7,903        7,929   1,13,000   7,929   0%
30-12-2015   7,939    7,945    7,890        7,896   1,06,800   7,896   0%

Valuation: Professionals' Insight

31-12-2015   7,898    7,956    7,891        7,946    1,50,900    7,946   1%
04-01-2016   7,925    7,938    7,781        7,791    1,34,700    7,791   -2%
05-01-2016   7,828    7,831    7,763        7,785    1,45,200    7,785   0%
06-01-2016   7,788    7,801    7,721        7,741    1,47,100    7,741   -1%
07-01-2016   7,673    7,675    7,557        7,568    1,88,900    7,568   -2%
08-01-2016   7,612    7,634    7,581        7,601    1,57,400    7,601   0%
11-01-2016   7,527    7,605    7,494        7,564    1,89,000    7,564   0%
12-01-2016   7,587    7,588    7,488        7,510    1,63,900    7,510   -1%
13-01-2016   7,558    7,591    7,426        7,562    2,15,200    7,562   1%
14-01-2016   7,467    7,605    7,444        7,537    2,00,800    7,537   0%
15-01-2016   7,562    7,567    7,427        7,438    1,97,500    7,438   -1%
18-01-2016   7,420    7,464    7,336        7,351    2,33,600    7,351   -1%
19-01-2016   7,382    7,463    7,364        7,435    1,88,300    7,435   1%
20-01-2016   7,357    7,471    7,242        7,309    2,25,600    7,309   -2%
21-01-2016   7,377    7,399    7,250        7,277    2,40,700    7,277   0%
22-01-2016   7,356    7,433    7,328        7,422    2,29,200    7,422   2%
25-01-2016   7,469    7,487    7,421        7,436 16,31,56,900   7,436   0%
27-01-2016   7,470    7,478    7,420        7,438    1,87,600    7,438   0%
28-01-2016   7,427    7,469    7,410        7,425    2,74,500    7,425   0%
29-01-2016   7,413    7,576    7,403        7,564    2,98,700    7,564   2%
01-02-2016   7,590    7,600    7,541        7,556    2,00,400    7,556   0%
02-02-2016   7,567    7,576    7,428        7,456    2,30,200    7,456   -1%
03-02-2016   7,392    7,419    7,350        7,362    1,92,000    7,362   -1%
04-02-2016   7,411    7,457    7,366        7,404    2,22,700    7,404   1%
05-02-2016   7,418    7,503    7,407        7,489    2,49,800    7,489   1%
08-02-2016   7,490    7,513    7,363        7,387    1,71,500    7,387   -1%
09-02-2016   7,304    7,323    7,275        7,298    2,12,100    7,298   -1%
10-02-2016   7,264    7,272    7,178        7,216    2,46,900    7,216   -1%
11-02-2016   7,204    7,209    6,960        6,976    2,92,300    6,976   -3%
12-02-2016   7,024    7,035    6,869        6,981    3,33,900    6,981   0%
15-02-2016   7,057    7,183    7,057        7,163    3,54,200    7,163   3%
16-02-2016   7,201    7,205    7,038        7,048    2,53,800    7,048   -2%

                     Computing Beta -- The most critical input to the CAPM

17-02-2016   7,059    7,124    6,961        7,108   2,60,000   7,108   1%
18-02-2016   7,177    7,215    7,128        7,192   2,46,700   7,192   1%
19-02-2016   7,171    7,227    7,146        7,211   1,92,300   7,211   0%
22-02-2016   7,209    7,252    7,201        7,235   1,54,400   7,235   0%
23-02-2016   7,240    7,242    7,091        7,110   1,94,400   7,110   -2%
24-02-2016   7,075    7,091    7,010        7,019   1,99,700   7,019   -1%
25-02-2016   7,030    7,034    6,961        6,971   2,83,100   6,971   -1%
26-02-2016   7,039    7,053    6,985        7,030   2,06,700   7,030   1%
29-02-2016   7,050    7,095    6,826        6,987   4,73,400   6,987   -1%
01-03-2016   7,038    7,236    7,035        7,222   2,75,100   7,222   3%
02-03-2016   7,322    7,380    7,308        7,369   3,38,500   7,369   2%
03-03-2016   7,430    7,484    7,406        7,476   2,78,600   7,476   1%
04-03-2016   7,505    7,506    7,444        7,485   2,81,700   7,485   0%
08-03-2016   7,486    7,527    7,442        7,485   2,57,000   7,485   0%
09-03-2016   7,436    7,539    7,424        7,532   2,45,100   7,532   1%
10-03-2016   7,545    7,547    7,447        7,486   2,24,700   7,486   -1%
11-03-2016   7,485    7,544    7,461        7,510   1,98,700   7,510   0%
14-03-2016   7,543    7,584    7,515        7,539   1,66,900   7,539   0%
15-03-2016   7,536    7,545    7,453        7,461   1,93,700   7,461   -1%
16-03-2016   7,457    7,508    7,405        7,499   1,95,400   7,499   1%
17-03-2016   7,557    7,585    7,479        7,513   2,39,600   7,513   0%
18-03-2016   7,535    7,614    7,518        7,604   2,37,400   7,604   1%
21-03-2016   7,619    7,714    7,618        7,704   1,96,800   7,704   1%
22-03-2016   7,696    7,728    7,644        7,715   2,08,900   7,715   0%
23-03-2016   7,717    7,727    7,671        7,717   1,99,600   7,717   0%
28-03-2016   7,741    7,749    7,588        7,615   2,42,400   7,615   -1%
29-03-2016   7,607    7,653    7,582        7,597   2,16,800   7,597   0%
30-03-2016   7,651    7,742    7,643        7,735   2,32,600   7,735   2%
31-03-2016   7,728    7,778    7,702        7,738   3,80,100   7,738   0%

By applying the formula Beta () = Covariance (X, Y)/ Variance (Y) where, X
= Stock Return and Y = Index Return, we get the Beta as 1.72.

Valuation: Professionals' Insight

          Unlevered Beta = Beta()/[1+Debt/Equity*(1-Tax Rate)]

The above-mentioned method is applicable if the company you are valuing is
listed. What if you want to value a private company, where the stock returns
are not available. In such a case, the first step is to identify the sector that
the company you are valuing is operating within. Then identify the
comparable listed peers of the company in the respective sector on the basis
of product profile, geography of operations and the risk that they are exposed
to. After identifying the peers, we have to compute their beta which would
give us the relative risk of the comparable companies. However, as the
comparable companies wouldn't necessarily have an identical capital
structure as the unlisted company, we need to remove the impact of leverage
by unlevering the beta. The formula for unlevering the beta is :

       Levered Beta = Unlevered Beta*[1+Debt/Equity*(1-Tax Rate)]

After we have collated the unlevered beta for all the comparable companies,
we compute the industry average/median unlevered beta. The industry
average/median unlevered beta is then re-levered using the unlisted
company's debt-equity ratio to arrive at the beta of the unlisted company.
The formula for re-levering the beta is mentioned below:
Now that, we have walked through the process of computing beta for listed
as well as unlisted entities, the input needs to be inserted in the CAPM
model, to arrive at the cost of equity using the below mentioned formula:

     Cost of Equity = Risk-Free Rate + Beta x (Market Return - Risk-Free

                              Ke = Rf +  * (Rm-Rf)

                                                                Chapter 6
                Valuation of Preference Shares
With the Indian accounting requirements moving from Indian Generally
Accepted Accounting Principles (`I-GAAP') to Indian Accounting Standards
(`Ind AS'), a critical change is the requirement to recognize financial
instruments at their fair value (albeit with few exceptions) in the financial
statements as at the reporting date. This Chapter attempts to discuss
Valuation of preference shares, a common financial instrument appearing in
the financial statements. The following Ind AS standards apply to them:
·    Ind AS 32: Presentation and classification of financial instruments;
·    Ind AS 109: Recognition, de-recognition,              classification   and
     measurement of financial instruments;
·    Ind AS 113: Principles of fair value measurement that would be
     applicable to financial instruments;
·    Ind AS 107: Disclosures required with respect to financial instruments.
With respect to fair value measurement of preference share, we rely primarily
on the principles discussed in Ind AS 113 and terms of its measurement as
indicated in Ind AS 109.

Key Characteristics of Preference Shares
There are 3 main characteristics which define and drive a preference share
Valuation ­ nature of coupon, redemption terms and conversion terms.
1.     Coupon: Coupon can be zero, cumulative or non-cumulative.
       Additionally, one might see instances involving moratorium in accrual/
       payment of coupon for a part of the preference share tenure.
2.     Redemption: Redemption is the settlement in cash, either at maturity
       or in an amortizing fashion over multiple redemption dates.
       Redemption may be defined in terms of a fixed redemption premium,
       but far more popular option is to define it by an effective IRR
       requirement, with redemption premium quantum getting adjusted for
       coupon payments already made prior to redemption.
Valuation: Professionals' Insight

3.    Conversion: Conversion indicates settlement in equity shares of the
      Issuer. Conversion may be defined in terms of a fixed or formula
      driven conversion ratio/ price.
Combinations of the above characteristics lead to various types of preference
shares and this Chapter discusses Valuation of the following:
1.    Redeemable preference shares (`RPS');
2.    Compulsorily convertible preference shares (`CCPS');
3.    Optionally convertible preference shares (`OCPS');

Before we discuss Valuation of preference shares, it will be useful to have a
quick look at three classical Valuation approaches and some thoughts on
Valuation approach, which are typically applied in business Valuation and
can be extended to financial instruments as well.
Income Approach: The discounted cashflow (DCF) analysis is the primary
methodology used for Valuation of preference shares. Two inputs to the DCF
model are cash-flows and the discount factor. Cash-flows are defined as per
coupon, redemption and conversion terms of the underlying preference
share. A Valuer must assess the achievability of the cash-flows required to
service the coupon and redemption premiums indicated in the term sheet of
preference shares. For the purpose of our discussions in this Chapter we
have assumed that the company issuing the preference shares would have
access to sufficient cash-flows. Discount factor is based on market yield that
a comparable instrument will need to offer to raise funds as at the Valuation
Market Approach: Convertible preference shares issued in the time vicinity
of the Valuation date can be used as indicators of price, especially in case of
redeemable preference shares. However, our quick assessment of the listed
preference shares market in India indicates that the market lacks the depth.
Most of the preference shares are privately placed and full feature disclosure
is not available in the public domain. Further, trade information/ frequency in
case of listed preference shares is low. This poses a challenge to carrying
out any meaningful analysis based on comparable transaction method.
Cost Approach: Ind AS 109 allows recognizing financial asset/ liabilities
through the amortized cost method, under specific circumstances, when the

                                                Valuation of Preference Shares

concept of SPPI (Solely held to collect principal and interest) is fully satisfied.
This approach is not discussed further here.
Also, it would be relevant to observe that Valuation of certain preference
shares (especially those involving conversion) could require business/ equity
Valuations, which is outside the scope of this Chapter. We assume that the
reader is aware of business/ equity Valuation principles and the required
Valuation numbers are available with the Valuer. Secondly, this Chapter
discusses Valuations largely from the perspective of investor who has
invested in to the preference shares.

Valuation of Preference Shares
Redeemable Preference Share (RPS)
Three variations can be noted on the basis of the nature of the coupon and
redemption premium:
1.    Zero coupon redeemable preference share;
2.    Non-cumulative redeemable preference share;
3.    Cumulative redeemable preference share.
We have provided hereunder the illustrative workings on how each type,
listed above, can be fair valued.
1.    Company A has issued a redeemable preference share to Company B.
      The RPS is zero coupon, with redemption IRR of 0%. It was issued on
      31 March 2017 and will mature 5 years from the Issue date, i.e., 31
      March 2022. A fair Valuation is required as at 29 March 2019.
In order to estimate the fair value of the RPS on 29 March 2019, the fair
value yield as on 29 March 2019 has to be re-estimated. Further, as
discussed earlier, it is assumed that the Company A has sufficient cash-flows
to honor these preference shares.
Re-assessment of the yield can be done from two starting points:
      Option 1: If comparable preference shares (w.r.t. features) has been
      issued close to the Valuation date, then the yield indicated by the
      transaction can be referred. The Valuer must ensure that the aforesaid
      preference share transaction should be recent, should be at arm's-
      length and in the same currency as those issued by Company A.

Valuation: Professionals' Insight

      Option 2: If Option 1 cannot be applied (due to non-availability of
      data), bond yields for comparable credit rating as that of Company A
      can be used as a starting point. Bond yield can be based on
      comparable bonds (of similar credit rating as Company A), if recently
      traded data as at the Valuation date is available. However, if sufficient/
      reliable data is not available, the Valuer may choose to compute the
      bond yield based on methodology prescribed in the FIMMDA Valuation
      of Investments circular dated 29 March 2019. The bond yield is
      thereafter grossed up for the tax benefit (dividend on preference
      shares is tax free in the hands of the investor), in accordance with the
      guidance presented for tax free bonds in the FIMMDA Valuation of
      Investments circular dated 29 March 2019, in the case where there is
      no redemption premium 13. The bond yield is thereafter adjusted for
      subordinated status to bonds 14 to arrive at the yield that can be used
      for the fair Valuation of the Company A RPS as at the Valuation date.

                                                                  In INR
                          Dates                           Cashflows
                        31-Mar-17                                (100.0)
                        29-May-19                                    -
                        31-Mar-22                                 100.0

       IRR                                                      0.0%
       Valuation date                                      29-Mar-19
       Re-assessed yield*                                     10.2%
       Fair value of RPS                                        76.0
       * Valuer re-assessed yield as at the Valuation Date

13 In cases where there is a redemption premium, the bond yield will need to be
assessed in view of long term capital gains tax applicability.
14 In our experience, the Valuers have made an addition of 1-2% to discount rate to

adjust for subordinated status of preference shares to bonds/ debt instruments.

                                               Valuation of Preference Shares

2.   The RPS has a non-cumulative coupon of 15%. It was issued on 31
     March 2017 and will mature 5 years from the Issue date, i.e., 31 March
     2022. A fair Valuation is required as at 29 March 2019.
     It would be relevant to observe that dividend on preference shares, if
     not paid, does not accrue. Depending on cash-flows generation in the
     business, it is possible to argue that dividend for certain years may not
     be paid. In such a case, dividend not expected to be paid, should be
     excluded from the RPS cash-flows, as no compensatory payment can
     be made in the future years.
     The yield assessment is in-line with the options available to ZCRPS as
     mentioned above. The key point of difference is the usage of the par
     yield (i.e. bonds which have regular coupon payment frequency)
     instead of the zero coupon yield data. The zero coupon yield curve will
     be at a premium to the par yield curve, mainly because the absence of
     regular coupon payment increases the credit risk of the instrument and
     hence, the choice of curve is important to note.
                                                                              In INR
                    Dates           RPS Contractual       Cashflows if dividend not
                                         Cashflows expected to be received for FY19
                  31-Mar-17                  (100.0)                         (100.0)
                  31-Mar-18                    15.0                             -
                  29-Mar-19                     -                               -
                  31-Mar-19                    15.0                             -
                  31-Mar-20                    15.0                            15.0
                  31-Mar-21                    15.0                            15.0
                  31-Mar-22                   115.0                           115.0

     IRR                                     15.0%
     Valuation date                       29-Mar-19
     Re-assessed yield                       10.0%
     Fair value estimates                    127.3                            112.3

3.   The RPS has a cumulative coupon of 15%. It was issued on 31 March
     2017 and will mature 5 years from the Issue date, i.e. 31 March 2022.
     A fair Valuation is required as at 29 March 2019.
     The yield assessment is in-line with the options available to non-
     cumulative yield. The table below presents the contractual cash-flows
     and cash-flows considering FY18 dividend, which is expected to be
     received together with FY19 dividend.

Valuation: Professionals' Insight
                                                                             In INR
                     Dates              Contruactual    Cashflows - FY18 cashflows
                                          cashflows      expected to come in FY19
                   31-Mar-17                  (100.0)                       (100.0)
                   31-Mar-18                    15.0                           -
                   29-Mar-19                     -                             -
                   31-Mar-19                    15.0                          30.0
                   31-Mar-20                    15.0                          15.0
                   31-Mar-21                    15.0                          15.0
                   31-Mar-22                   115.0                         115.0

      IRR                                     15.0%
      Valuation date                       29-Mar-19
      Re-assessed yield                       10.0%
      Fair value estimates                    127.3                         142.3

Compulsorily Convertible Preference Shares (CCPS):
The variation in the nature of coupons ­ i.e., zero, non-cumulative and
cumulative remains relevant in the case of CCPS as well and should be
assessed in line with the discussions presented in the RPS section of this
A further step in the CCPS fair Valuation is the factoring in of the conversion
terms. Conversion terms could be of the following types:
1.    Conversion price is equal to fair value of the underlying share;
2.    Conversion ratio is 1:1;
3.    Either conversion ratio or conversion price is based on a formula
      (generally linked to revenue or profit achieved at maturity)
We have provided below illustrative working on how each type, listed above,
can be fair valued.
1.    Company A has issued a Compulsorily Convertible Preference Share
      (`CCPS') to Company B. The CCPS has a cumulative compounding
      coupon of 0.1%. The CCPS will be compulsorily convertible into equity
      shares of Company A at the maturity date. The Conversion price is
      equal to the fair value of the equity share of Company A. CCPS was
      issued on 31 March 2017 and will mature 5 years from the Issue date,
      i.e. 31 March 2022. A fair Valuation is required as at 29 March 2019.
      In this example, the accrued dividend and principal on the maturity
      date would be divided by the then fair value per share of Company A
      to arrive at the number of shares. The fair value of the CCPS is
      therefore nothing but the rolled up (for coupon) principal amount as at
      the Valuation date.

                                             Valuation of Preference Shares

2.   Company A has issued a Compulsorily Convertible Preference Share
     (`CCPS') to Company B. The CCPS has a cumulative coupon of 0.1%.
     The CCPS will be compulsorily convertible into equity shares of
     Company A at the maturity date. Conversion ratio is 1:1, i.e., each
     preference share shall convert into one equity share of Company A.
     CCPS was issued on 31 March 2017 and will mature 5 years from the
     Issue date, i.e., 31 March 2022. A fair Valuation is required as at 29
     March 2019.
     The above instrument is considered quasi equity. Since the conversion
     ratio is fixed at 1:1, the fair value of each CCPS is nothing but the fair
     value per share of Company A as at the Valuation date. There is an
     argument to consider discount to the fair value per share of Company
     A to reflect the lack in marketability till the maturity date.
3.   Company A has issued a Compulsorily Convertible Preference Share
     (`CCPS') to Company B. The CCPS has a cumulative compounding
     coupon of 0.1%. The CCPS will be compulsorily convertible into equity
     shares of Company A at the maturity date. Conversion ratio is linked to
     achievement of actual performance (say, EBITDA) by Company A at
     maturity date, i.e., each preference share shall convert to X equity
     shares of Company A. And, X is based on EBITDA at maturity date.
     CCPS was issued on 31 March 2017 and will mature 5 years from the
     Issue date, i.e. 31 March 2022. A fair Valuation is required as at 29
     March 2019.
     Expected conversion ratio as at the maturity date, needs to be
     estimated on the Valuation date. There are two solutions (while many
     other variants may be considered) on how the EBITDA at maturity
     should be determined
     Solution 1: Deterministic: EBITDA based on future projections as
     prepared by the management of Company A. The expected conversion
     ratio is worked out based on this expected EBITDA in FY22. The fair
     value of the CCPS on the Valuation date is the aforementioned
     expected conversion ratio multiplied with fair value per share of
     Company A as at the Valuation date.
     Solution 2: Simulated: Possible equity values of Company A as at
     the maturity date can be simulated using Monte Carlo simulations ­
     Black Scholes framework. For each EBITDA, a simulated conversion

Valuation: Professionals' Insight

      ratio is computed. The fair value of the CCPS on the Valuation Date is
      the average of the aforementioned expected conversion ratios
      multiplied with fair value per share of Company A as at the Valuation
      Note: Sensitivity of the end result to the profitability multiple should be
      assessed and quantified.
      The usage of either solutions enumerated above is debatable. One
      might argue that Solution 1 is easy to implement and regular re-
      Valuation exercise takes it closer to the payoff achieved at maturity.
      Solution 1 however does not consider probability of occurrence
      weighted scenarios for the EBITDA values at maturity and therefore is
      generally further away from the true price than Solution 2 on a given
      Valuation Date. Solution 2 requires technical knowledge w.r.t
      implementation of the Monte Carlo simulation.
The examples above make a simplistic assumption w.r.t the conversion being
allowed only at maturity. There might be cases of conversion at the option of
the Investor, which adds to the complexity of the fair Valuation of the CCPS.
Option models which allow for scenario analysis such as Binomial model and
Monte Carlo models can be used to model these complexities.
Optionally convertible redeemable preference shares (OCRPS)
The variations in the nature of coupons ­ i.e zero, non-cumulative and
cumulative remain relevant in the case of OCRPS as well and should be
assessed in line with the discussion presented in the RPS section of this
A further step in the OCRPS fair Valuation is the factoring in of the choice
between redemption and conversion that the investor is faced with. The
following are the types:
1.    Redemption value at maturity date is assessed at the accrued unpaid
      value, conversion is at fair value of the underlying share;
2.    Redemption value at maturity date is assessed at the accrued unpaid
      value, conversion ratio is 1:1;
3.    Redemption value at maturity date is assessed at the accrued unpaid
      value, either conversion ratio or conversion price is based on a
      formula (generally linked to revenue or profit achieved at maturity)

                                             Valuation of Preference Shares

We have provided hereunder illustrative working on how each type, listed
above, can be fair valued
1.    Company A has issued an optionally convertible redeemable
      preference share (OCRPS). The OCRPS has a cumulative
      compounding coupon of 10%. The OCRPS will be can be either
      redeemed or converted at the option of Company B. Redemption value
      at the maturity date is the accrued value of the investment. Conversion
      is the accrued value of investment divided by the fair value of the
      underlying share as at the maturity date. OCRPS was issued on 31
      March 2017 and will mature 5 years from the Issue date, i.e., 31 March
      2022. A fair Valuation is required as at 29 March 2019. As OCRPS are
      convertible into equity shares at fair value of equity shares, accrued
      amount of OCRPS is equal to their fair value as on Valuation Date.
2.    Company A has issued an optionally convertible redeemable
      preference share (OCRPS) to Company B. The OCRPS has a
      cumulative compounding coupon of 10%. The OCRPS will be can be
      either redeemed or converted at the option of Company B.
      Redemption value at the maturity date is the accrued value of the
      investment. Conversion ratio is 1:10. OCRPS was issued on 31 March
      2017 and will mature 5 years from the Issue date, i.e. 31 March 2022.
      A fair Valuation is required as at 29 March 2019.

Valuation: Professionals' Insight

                                                In INR
                Dates                  Accrued value
              31-Mar-17                       (100.0)
              31-Mar-18                        110.0
              31-Mar-19                        121.0
              31-Mar-20                        133.1
              31-Mar-21                        146.4
              31-Mar-22                        161.1

    Face value/ preference share                   10 INR
    # preference shares                            10 (A)

    Value derived through
    redemption (as at maturity
    date)                                       161.1 (B)
    Value derived through
    conversion (as at maturity date)            161.1 (C)

    Discount factor (@ 7%, as at
    31-Mar-19 for residual tenor)             0.8163 (D)

    Fair value of OCRPS/ share                   13.1 (B)*(D)/(A) or (C)*(D)/(A)

                Dates                  Accrued value
              31-Mar-17                       (100.0)
              31-Mar-18                        110.0
              31-Mar-19                        121.0
              31-Mar-20                        133.1
              31-Mar-21                        146.4
              31-Mar-22                        161.1 (A)

    Face value/ preference share                   10 INR
    # preference shares                            10 (B)

    Value derived through                        13.1 (C) = Present Value ((A)/(B))
    redemption/ preference share
    (as at maturity date)

    Fair value/ share of Company B
    @ Valuation Date                             12.0
    Strike price                                 13.1 (C)
    Risk free rate                               7.0%
    Dividend yield                               0.0%
    Volatility                                  20.0%
    Residual tenor                                3.0
    Call option value                             1.2 (D)

    Fair value of OCRPS/ share                   14.4 (C)+(D)

                                           Valuation of Preference Shares

     The call option captures the upside that the investor might get to
     participate over and above the value accrued through the redemption
3.   Company A has issued an optionally convertible redeemable
     preference share (OCRPS) to Company B. The OCRPS has a
     cumulative compounding coupon of 10%. The OCRPS will be can be
     either redeemed or converted at the option of Company B.
     Redemption value at the maturity date is the accrued value of the
     investment. Conversion ratio is linked to achievement of a particular
     EBITDA by Company A at maturity, i.e each preference share shall
     convert to X equity shares of Company A. And X is defined based on
     EBITDA at maturity date. OCRPS was issued on 31 March 2017 and
     will mature 5 years from the Issue date, i.e 31 March 2022. A fair
     Valuation is required as at 29 March 2019.
     The solutions offered in CCPS (3) are available fora Valuation of a
     financial instrument of this type. However the introduction of the
     redemption feature payout acts as a floor against which the payout of
     the conversion feature needs to be tested against. Option models such
     as binomial model and Monte Carlo model, with provision for defining
     a floor (based on redemption value) can be considered in carrying out
     the fair Valuation exercise.

                                                             Chapter 7
    Fair Value Measurement-Ind AS 113 :
Fair value is the mantra of today in financial reporting across borders. In
India also, the Institute of Chartered Accountants of India (ICAI) converged
its accounting standards with IFRSs and accordingly, corporate financial
statements beginning accounting year 2016-17 started disclosing financial
figures based on fair value measurement. One of the purposes of fair value
measurement is to narrow the gap between the balance sheet value and
market value of a company. Fair value measurement aims at fair recording of
a business transaction so that the financial statements are able to show a
true and fair view of the profitability and financial position.
Indian Accounting Standard (Ind AS) 113 is a dedicated standard which
provides guidance on Fair Value Measurement (FVM). In this Chapter we will
discuss about the objective, scope, key concepts and definitions, as
prescribed in Ind AS 113 on Fair Value Measurement.

A. Objective of Ind AS 113
This Ind AS:
·     Defines Fair Value
·     Sets out a Framework for measuring Fair Value
·     Requires Disclosures about fair value measurements

B. Scope
This Ind AS applies when another Ind AS requires or permits fair value
measurements or disclosures about fair value measurements
The measurement and disclosure requirements of this Ind AS do not apply to
the following:
·     Share based payment transactions within the scope of Ind AS 102,
      Share based Payment
·     Leasing transactions within the scope of Ind AS 17, Leases
                                               Valuation of Preference Shares

·     Measurements that have some similarities to fair value but are not fair
      value, such as net realisable value in Ind AS 2, Inventories , or value in
      use in Ind AS 36, Impairment of Assets
The disclosure requirements by this Ind AS do not apply to the following:
·     Plan assets measured at fair value in accordance with Ind AS 19,
      Employee Benefits
·     Assets for which recoverable amount is fair value less costs of
      disposal in accordance with Ind AS 36, Impairment of Assets.

C. Definitions
1. Fair Value (FV)
"Fair Value is the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between Market participants at the
Measurement Date.
1   FV is Exit Price           Fair Value is the price to sell an asset or
                               transfer a liability, and therefore represents an
                               exit price, not an entry price
2   FV is Not Transaction The transaction price is NOT presumed to
    Price                 represent the fair value of an asset or liability
                          on its initial recognition
3   FV in Principal Market     Fair value is an exit price in the principal
                               market (or in absence of a principal market, the
                               most advantageous market) in which reporting
                               entity would transact
4   FV is Market based Fair Value is a market based measurement,
    measurement        not an entity specific measurement
5   FV           excludes Fair Value measurements should not be
    Transaction Costs     adjusted for transactions costs
Note: The definition of fair value focuses on assets and liabilities because
they are a primary subject of accounting measurement. In addition, this Ind
AS shall be applied to an entity's own equity instruments measured at fair

Valuation: Professionals' Insight

2. Active Market
A market in which transactions for the asset or liability take place with
sufficient frequency and volume to provide pricing information on an ongoing
3. The Asset or Liability
A fair value measurement is for a particular asset or liability. An entity shall
take into account the characteristics of the asset or liability at the time of
measurement of fair value as if market participants would take those
characteristics into account when pricing the asset or liability at the
measurement date. Such characteristics include, for example, the following:
·     the condition and location of the asset; and
·     restrictions, if any, on the sale or use of the asset
4. Entry Price
When an asset is acquired or a liability is assumed in an exchange
transaction for that asset or liability, the transaction price is the price paid to
acquire the asset or received to assume the liability.
5. Exit Price
The fair value of the asset or liability is the price that would be received to
sell the asset or paid to transfer the liability.

D. Key Concepts
Transfer of Liability versus. Settlement of Liability
1.    When liability is transferred to market participants then it continues
      and not settled.
2.    "Transfer" reflects market-based measurement & excludes firm
      specific efficiencies or inefficiencies
Fair Value may not be equal to Transaction Price
1.    When transaction is between related parties
2.    Where transaction occurs under duress or force
3.    Unit of account represented by the transaction is different from that of
      the asset or liability

                                                 Valuation of Preference Shares

4.    Market in which the transaction occurs is different from the principal or
      most advantageous market
Fair value for Financial Reporting vs. Fair Market Value (FMV)
1.    Fair value has a hierarchy of inputs for Valuation but FMV does not
      have it
2.    Fair Value uses HABU for non ­ financial assets Valuation resulting in
      maximising value against consensus value under FMV
3.    DLOM adjustments may be required in certain cases under Fair Value
      but DLOC is doubtful
4.    Fair value disregards blockage discount (decline in value due to size)
Particular asset or liability that is the subject of measurement
A fair value measurement is for a particular asset or liability. The
characteristics of the asset or liability that market participants would take into
account when pricing the asset or liability at the measurement date shall be
taken into account. Such characteristics include:
·      the condition and location of the asset
·      restrictions, if any, on the sale or use of the asset
The asset or liability measured at fair value might be either of the following:
·     a stand-alone asset or liability (e.g. a financial instrument or a non-
      financial asset); or
·     a group of assets, a group of liabilities or a group of assets and
      liabilities (e.g. a cash-generating unit or a business).
Principal (or most advantageous) market
The transaction to sell the asset or transfer the liability takes place either:
·     in the principal market or
·     in the absence of a principal market, in the most advantageous
Highest and best use for a non-financial asset
A fair value measurement of a non-financial asset takes into account a
market participant's ability to generate economic benefits by using the asset
in its highest and best use. The highest and best use of a non-financial asset
takes into account the use of the asset that is

Valuation: Professionals' Insight

a.    Physically Possible
b.    Legally Permissible
c.    Financially feasible
Highest or best use is usually (but not always) the current use ­ if for
competitive reasons an entity does not intend to use the asset at its highest
and best use, the fair value of asset still reflects its highest and best use by
market participants (defensive value).
Fair Value Hierarchy
To increase the consistency and comparability in fair value assignments and
related disclosures, fair value hierarchy categorises inputs into three levels
as defined below.
·     Input Level 3 (Unobservable)
      Inputs that reflect management's own assumptions about the
      assumptions that a market participant would make (E.g. Projected
      cash flows used to value a business or non-controlling interest in an
      unlisted entity)
·     Input Level 2 (Indirectly Observable)
      a.     Prices in active markets for similar assets / liabilities
      b.     Quoted prices for identical / similar items in markets that are not
      c.     Inputs other than quoted prices (E.g. Interest Rates and yield
             curves, implied volatilities etc.)
·     Input Level 1 (Directly Observable)
      Quoted prices in active markets for identical assets / liabilities (E.g.
      Quoted prices for an equity security on the BSE/ NSE).

                                                  Valuation of Preference Shares

                     Level 1

                                                  Level 2
                               Definition - Inputs
  Definition - Quoted          other than quoted            Definition -

                                                                               Level 3
  prices (unadjusted) in       prices within Level 1        Unobservable
  active markets for           those are directly/          inputs for
  identical assets/            indirectly observable        asset/ liability
  liabilities that entity      Examples -                   Examples -
  can access at                - Quoted prices of
  measurement date                                          - Financial
                               similar assets/              Forecasts
  Examples-                    liabilities in active or
                               unquoted markets             - Historical
  - Quoted prices of                                        Volatility
  shares traded on             - Market corroborated
  stock exchange               inputs
  - Dealer Markets
  - Brokered Markets

*Quoted prices are given the highest priority and unobservable inputs the

                                                                 Chapter 8
                        Cost of Capital in Goodwill
Impairment means the state of being diminished, weakened, or damaged.
Goodwill impairment is a charge that companies record when goodwill's
carrying value on financial statements exceeds its fair value. In accounting,
goodwill is recorded after a company acquires assets and liabilities, and pays
a price in excess of their identifiable value. Goodwill impairment arises when
there is deterioration in the capabilities of acquired assets to generate cash
flows, and the fair value of the goodwill dips below its book value.
Indian Accounting Standard (Ind AS) 36, Impairment of Assets (the standard)
sets out the requirements to account for and report impairment of most non-
financial assets. As a result, goodwill impairments have inevitably increased
and companies have placed an additional focus on their impairment testing
One of the key inputs while performing the impairment test is the cost of
capital or discount rate. Determining the appropriate cost of capital is often
like a pandora box, but in uncertain economic conditions, its difficulty even
compounds due to volatile share prices affecting betas; risk free rates
reaching record lows; and reduction in debt liquidity affecting the cost of debt
for many companies.
Indian Accounting Standards require the annual impairment testing of
goodwill and other assets in accordance with Ind AS 36. Ind AS 36 specifies
when an entity needs to perform an impairment test, how to perform it,
recognition of any impairment losses and the related disclosures.
Ind AS 36 deals with impairment testing for all tangible and intangible assets,
except for assets that are covered by other Ind AS. Ind AS 36 requires that
assets should be carried at no more than their recoverable amount. To meet
this objective, the standard requires entities to test all assets that are within
its scope for potential impairment when indicators of impairment exist or, at
least, annually for goodwill and intangible assets with indefinite useful lives.
The process for measuring and recognising impairment loss under Ind AS 36
could be presented in a flowchart:
                                                       Cost of Capital in Goodwill Impairment

                                                  Are there any                         N
                                                other indicators of

                                                                                                    Is the asset
                                                            Y                                        goodwill or
                                                                                                    an intangible
                                                                                                     asset with
                                                                                       Y              indefinite
                                Y                  Can RA of the                                     useful life?
         Determine RA                             individual asset
                                                   be estimated?

                                         Identify CGU to which the asset

          Is CA>RA?
    N                                    If goodwill cannot be allocated to
                                         an individual CGU, allocate it to a
                                                   group of CGUs

        Reduce CA to RA

                                                   Is CA>RA for
                                                     or group of


                                              Reduce CA of goodwill

                                         Reduce other assets of CGU pro
                                           rata on the basis of their CA


               RA = Recoverable amount     CA = Carrying amount        CGU = Cash generating unit

Key components/requirements as presented in the diagram above are
discussed below.

Key Requirements of IND AS 36
The entity assesses, at each reporting date, whether there is any indication
that an asset may be impaired.
·       If there is an indication that an asset may be impaired, the recoverable
        amount of the asset (or, if appropriate, the cash generating unit (CGU)
        which is defined by the standard as "the smallest identifiable group of

Valuation: Professionals' Insight

      assets that generates cash inflows that are largely independent of the
      cash inflows from other assets or groups of assets" [Ind AS 36, Para
      6]) is determined.
·     The recoverable amount of goodwill, intangible assets with an
      indefinite useful life and intangible assets that are not available for use
      on the reporting date, is required to be measured at least on an annual
      basis, irrespective of whether any impairment indicators exist.
·     The asset or CGU is impaired if its carrying amount exceeds its
      recoverable amount.
·     The recoverable amount is defined as higher of the `fair value less
      costs to sell' and the `value in use'.
·     Any impairment loss is recognised as an expense in the profit or loss
      for assets carried at cost. If the affected asset is a revalued asset, as
      permitted by Ind AS 16 Property, Plant and Equipment and Ind AS 38,
      Intangible Assets, any impairment loss is recorded first against
      previously recognised revaluation gains in other comprehensive
      income in respect of that asset.
·     Extensive disclosure is required for the impairment test and any
      impairment loss recognised.
·     An impairment loss recognised in prior periods for an asset other than
      goodwill is required to be reversed if there has been a change in the
      estimates used to determine the asset's recoverable amount.

Indicators of impairment
The standard requires an entity to assess, at each reporting date, whether
there are any indicators that assets may be impaired. An entity is required to
consider information from both external sources (such as market interest
rates, significant adverse changes in the technological, market, economic or
legal environment in which the entity operates, market capitalisation being
lower than net assets) and internal sources (such as internal restructurings,
evidence of obsolescence or physical damage to the asset). Notwithstanding
whether indicators exist, recoverability of goodwill and intangible assets with
indefinite useful lives or those not yet in use are required to be tested at least

                                         Cost of Capital in Goodwill Impairment

Recoverable amount
The recoverable amount of an asset is the greater of its `fair value less costs
to sell' and its `value in use'. To measure impairment, the asset's carrying
amount is compared with its recoverable amount. The recoverable amount is
determined for individual assets. However, if an asset does not generate
cash inflows that are largely independent of those from other assets, the
recoverable amount is determined for the CGU to which the asset belongs. A
CGU is the smallest identifiable group of assets that generate cash inflows
that are largely independent of the cash inflows from other assets or groups
of assets.

Fair value less cost to sell
Fair value less costs to sell (FVLCS) is the amount obtainable from the sale
of the asset in an arm's length transaction between knowledgeable and
willing parties, less the costs of disposal.

Value in use
Value in Use (VIU) in effect assumes that the asset will be recovered
principally through its continuing use and ultimate disposal. VIU is therefore
`entity-specific' in that it reflects the entity's intentions as to how an asset will
be used. VIU therefore differs from fair value because fair value reflects the
assumptions that market participants would use when pricing the asset.
Value in use (VIU) is the present value of the future cash flows expected to
be derived from an asset or a CGU. When considering Value in Use, Ind AS
36 lays down prescriptive rules around the use of discounted cash flow
methodologies, including guidance on the explicit forecast period,
appropriate terminal growth rates, and the determination of the discount rate.

Estimating the Future Cash Inflows and Outflows
The starting point for estimating future cash flows is the most recent financial
budget or forecast approved by management. From this starting point, the
budget or forecast typically needs to be both adjusted and extrapolated. Ind
AS 36 specifically requires that these budgets/forecasts are adjusted to:
·      exclude any estimated future cash inflows/outflows expected to arise
       from future restructuring or improving or enhancing the asset's
       performance (Para 33)

Valuation: Professionals' Insight

·     exclude cash inflows or outflows from financing activities or income tax
      receipts/payments (Para 50)
·     include costs for day-to-day servicing, future directly attributable
      overheads (Para 41) and cash flows necessary to maintain the level of
      economic benefits expected to arise from the asset in its current
      condition (Para 49)
·     cover a maximum period of five years (unless a longer period can be
      justified). Cash flow projections needed beyond the period covered
      must be estimated by extrapolating the budget/ forecast projections
      using a steady or declining growth rate for subsequent years (unless
      an increasing rate can be justified) (Para 33)
·     incorporate net cash flows, if any, to be received (or paid) for the
      disposal of the asset at the end of its useful life (Para 39).
This list of adjustments is not exhaustive. The specific adjustments required
in each case will naturally vary depending upon the basis of the budgets or
projections used as a starting point and the nature of expected cash flows. It
is also essential to ensure that the estimates and projections are based on
reasonable and supportable assumptions.

Applying the Appropriate Discount Rate
The discount rate applied to the estimated cash flows should reflect the
return that investors would require if they were to choose an investment that
would generate cash flows of amounts, timing and risk profile equivalent to
those that the entity expects to derive from the asset (Para 56). In other
words, the estimated cash flows in the VIU calculation are entity-specific, but
the discount rate is not.

Pre-tax versus post-tax discount rate
While Ind AS 36 requires the use of `a pre-tax discount rate' for the
discounting of cash flows, it has long been accepted by Valuation
practitioners that the direct determination of a pre-tax cost of capital is
difficult if not impossible to derive.
When valuing a firm or business, the most widely used method for
determining a discount rate is the weighted average cost of capital
("WACC"). In theory, this is calculated by weighing the costs of debt and
equity capital at a target or optimal capital structure. The capital asset pricing

                                       Cost of Capital in Goodwill Impairment

model ("CAPM") is most often used as the basis for determining the cost of
equity. The data needed to build up the cost of equity using CAPM is
generally based on observable market-based information. As companies pay
tax in the real world, the equity market data observable to derive inputs such
as beta, gearing, etc. is all based on post-tax observations. Pre-tax
equivalents are not directly observable.

How to calculate Pre-Tax Rate
One solution to this problem could be simple grossing up your post-tax
market rate and tax rate, like in the following formula:
           PRE-TAX RATE = POST-TAX RATE / (1 ­ TAX RATE)
Although this method is very simple, it should be used rarely.. For example,
when the asset or CGU is not that material to your company, or variance in a
discount rate does not cause any material errors in value in use.
Why not use this simple method as the basic one? The main reason is that in
most cases, the timing of your tax payments is never the same as the timing
of your tax base (income and expenses). Many entities pay taxes one year
after obtaining taxable revenues and expenses. And that might cause
significant difference in your real pre-tax rate and pre-tax rate calculated this
way. You should bear in mind that pre-tax rate must take not only assets' /
CGU's post-tax rate and relevant tax rate into account, but also assets' /
CGU's useful life and timing of future cash flows.
So how to calculate pre-tax rate more precisely? If you have obtained market
rate that is post-tax and you have pre-tax cash flow projections for your asset
/ CGU under review, you can try to use this method. It's kind of other way
round and involves the following 3 steps:
Step 1: Estimate post-tax cash flows
First of all, we shall calculate asset's / CGU's value in use with application of
post-tax rate. But hang on for a minute ­ we have post-tax rate and pre-tax
cash flows and this inconsistency would not give us the answer even close to
correct. Therefore, we need to do the following:
·     Estimate future tax payments from our pre-tax cash flow projection. Do
      it on a year-by-year basis. But be careful here. If you want to be really
      precise, you should take various tax issues into account ­ for example,
      future tax allowances related to asset / CGU, utilization of future tax

Valuation: Professionals' Insight

      losses, temporary differences, etc. Simply ­ try to estimate tax
      payments as realistic as possible, not by multiplying tax base and tax
·     Deduct estimated future tax payments from pre-tax cash flows. And
      also do it on a year-by-year basis.
Step 2 ­ Calculate value in use on post-tax basis
That is clear. You have post-tax cash flows in your table and you also have
post-tax discount rate. So, using discounting technique, get present value of
your post-tax cash flows.
 When calculating value in use, you should be consistent to avoid double
counting. And, you should arrive to the same result. So, when you calculate
value in use using post-tax cash flows and post-tax discount rate, that rate
shall be the same as calculated from pre-tax values. In other words:
= post-tax cash flows discounted by post-tax rate
= pre-tax cash flows discounted by pre-tax rate
= value in use
Step 3 ­ Calculate pre-tax rate from value in use and pre-tax cash flows
We just need to work out the rate at which the present value of pre-tax cash
flows equals the value in use. This is not as easy as it seems, because it
requires using certain iteration technique. But all is doable!

Generally, companies and their advisors have accepted that the practical
solution to this problem is to determine the value in use using post-tax cash
flows and a post-tax WACC. The pre-tax WACC needed for disclosure as
required by Ind AS 36 can then be determined by eliminating tax from the
cash flows and back solving (an iterative process) to determine the pre-tax
WACC that equates to the same value in use.
It should be noted that simply grossing up the post-tax WACC based on the
marginal tax rate will not, in most circumstances, result in the same pre-tax
Further, International Accounting Standard 36 Para BCZ 85 states that in
theory, discounting post tax cash flows at a post-tax discount rate and
discounting pre-tax cash flows at a pre-tax discount rate should give the

                                       Cost of Capital in Goodwill Impairment

same result, as long as the pre-tax discount rate is the post-tax discount rate
adjusted to reflect the specific amount and timing of the future tax cash flows.
The pre-tax discount rate is not always the post-tax discount rate grossed up
by a standard rate of tax. The same paragraph in the "Basis for Conclusions"
provides an example as to how both approaches might differ and result in
different indications for value in use.
As a result, a supportable impairment review requires that the discount rate
and the long-term growth rate are both technically correct and also consistent
with each other and the forecast cash flows. Industry norms can therefore
provide a benchmark, but a rigorous review of the specific circumstances of
the asset being valued and the risk associated with the expected cash flows
is still required.

                                                                Chapter 9
                                              Brand Valuation
"If this business were to be split up, I would be glad to take the brands,
trademarks and goodwill and you could have all the bricks and mortar - and I
would fare better than you"
                                  -John Stuart, Former Quaker Oats Chairman
"Your brand is what people say about you when you are not in the room"
                                                     Jeff Bezos, CEO Amazon

Brands and their underlying trademarks are an important element of the
value of a business. They are intangible assets that contribute to the
increasing gap between observed market capitalizations versus reported
book values of companies. In today's world of new age technology and
consumer awareness, the scope of brand for an organization is not just
limited to a name or a logo but much more than that. This is all because of
the impact a brand can have on the customer choices, investors, company's
image etc.
The term `brand', refers to names, signs, symbols, colors, logos etc. that help
to identify goods, services or companies. It is something which a consumer
associates itself with and considers as a promise by the brand that they will
conform to the expectations that they have created over time in the minds of
their customers.
World's five most valuable brands as recognized by Forbes magazine for
2018 are :
      Apple: $182.8 billion
      Google: $132.1 billion
      Microsoft: $104.9 billion
      Facebook: $94.8 billion
      Amazon: $70.9 billion
                                                            Brand Valuation

Reasons/ Need For Brand Valuation
A study by Interbrand in association with JP Morgan concluded that on an
average brands account for more than one-third of shareholder value. Thus,
brands are one of the most important strategic assets of an organization and
may require Valuation under following circumstances:
·   Financial Reporting - Purchase Price Allocation
·   M&A Decisions
·   Licensing
·   Tax Planning
·   Dispute Resolution
·   Liquidation
·   Litigations
·   Raising Funds etc.

Brand Valuation Approaches/ Methods
There are various ways to approach the Valuation of a brand, and many of
them are debatable. The concept of brand Valuation often can be a difficult
concept to understand. This is because image of the brand in the minds of its
customers may be different for different people. This is somewhat similar to
works of art, these works of art have a market, but the values at which they
change hands are not computed mechanistically.
Popular brand Valuation methods and approaches include:

Valuation: Professionals' Insight

A. Cost Approach
This approach is primarily concerned with the cost in creating or replacing
the brand. It comprises of following two methods:
1. Reproduction Cost Method
This method aggregates all the historical marketing costs as the value of the
brand. In other words, the method involves historical cost of creating the
brand as the actual brand value. It is often used at the initial stages of brand
creation when specific market application and benefits cannot yet be

                                                              Brand Valuation

2. Replacement Cost Method
This method values the brand by considering the expenditures and
investments necessary to replace the brand with a new one that has an
equivalent utility to the company. Although this method is easy in terms of
calculation, it neglects the success of an established brand. The first brand in
the market has a natural advantage over the other brands as they avoid
clutter and with each new attempt, the probability of success diminishes.
This approach is generally not considered because there is no direct
correlation between cost incurred in creating the brand and market value of
the brand.
B. Market Approach
In this approach a comparison with the other brands in the market is done.
For example, if a person wishes to buy a property in place A, it is quite likely
that the price at the neighborhood would be checked before arriving at a
conclusion on the existing property, leading to an approach based on the
market. This Valuation method relies on the estimation of value based on
similar market transactions (e.g. similar license agreements) of comparable
brand rights.
This approach contains two methods namely:
1.    Sales Comparison Method
2.    Market Multiples Method
Both of these methods involve Valuation of the brand by looking at the recent
transactions involving similar brands in the same industry and referring to
comparable multiples.
This approach is generally not considered due to non-availability of reliable
data for comparable brands. Also, the price paid for a similar brand includes
the synergies and the specific objectives of the buyer and it may vary leading
to the value of similar brand not being directly comparable to the brand being
C. Income Approach
It is the most common approach to measure the value of a brand. This
approach estimates the price an asset could be sold for in an arm's length
transaction on the basis of the asset's expected future income stream. This
involves estimating the present value of future economic benefits attributable

Valuation: Professionals' Insight

to the owner of an asset and incorporating as much observable market data
into the Valuation as possible. In the Income Approach, expected future
returns from an investment in the form of cash flows are discounted to
present value at an appropriate rate of return for the investment. The
selected discount rate or rate of return should reflect the degree of
uncertainty or risk associated with the future returns and returns available
from alternative investments. Higher uncertainty or risk leads to higher
expected rate of return, which produces a lower value for the investment.
This approach can be characterized by six methods which are explained
1. Relief from Royalty Method
This is the most widely resorted method used to determine the value of the
brand. This method assumes that the brand is not owned by the branded
business but is licensed from a third party. If brand has to be licensed from a
third-party, a royalty rate on turnover will be charged for privilege of using the
brand. Thus, the brand value is deemed to be the present value of the royalty
payments saved by virtue of owning the brand.
2. Relative Discounted Cash Flow Method
The incremental cash flow method identifies all cash flows generated by the
brand in a business, by comparison with comparable businesses with no
such brand. Cash flows are generated through both increased revenues and
reduced costs. However it is rare to find conditions for this method to be
used since finding similar unbranded companies can be difficult.
3. Residual Value Method
The method entails segregation of the value of the total tangible assets from
the total business value. The residual value after deducting the value of
tangible assets from the business value is attributable to the intangible
4. Premium Price Method/ Profit Differential Method
Under this method, the asset is valued by considering the premium profit
generated by a company, using intangible assets and comparing it with a
business not utilizing a comparable intangible asset. The resultant figure is
then capitalized to form a value for the intangible assets.

                                                             Brand Valuation

5. Multi-Period Excess Earnings Method (MEEM)
The Multi-Period Excess Earnings Method is commonly used when a reliable
direct measurement of future economic benefits generated by an intangible
asset is not possible. However, revenue and earnings to those assets can be
readily determined. The method adopts a `residual approach' for estimating
the income that an intangible is expected to generate. The premise of the
excess earnings method is that the value of an asset is represented by the
discounted future earnings specifically attributed to that asset, that is, in
excess of returns for other assets that contributed to those earnings. The
excess earnings method examines the economic returns contributed by all
assets utilized in generating earnings, and then isolates the excess return
that is attributed to the specific asset being valued.
MEEM is applied to a wide variety of intangible assets, especially those that
are close to the `core' of the business model. Customer relationship assets,
technology, and IPR&D are among the intangible assets which are frequently
valued using MEEM.
Under this method, the value of an asset is a function of:
·     Projected revenue and earnings generated by the asset;
·     Expected economic life of the asset;
·     Contributory asset charges that would be paid to the requisite
      operating assets; and
·     A discount rate which reflects risk associated with receiving future
      cash flows.
6. Favourable Contract Method
A favourable contract arises from an arrangement that affords one of the
parties a below-market rate for a good or service. This may be from paying
rent for a building at below-market rates or being granted the use of a
trademark for a royalty rate that is lower than the going market rate. Similar
to the "with and without" method to value the arrangement, cash flows are
computed using market rates and also under the present arrangement. The
difference between these values is the value of the asset.
In the next section, Royalty Relief Method is explained in detail which is the
most widely used method to determine the value of the brand.

Valuation: Professionals' Insight

Relief from Royalty Method (RRF)
This is the most widely used method to determine brand cash flows, the
reason being that it is grounded in commercial reality and can be easily
benchmarked against real world transactions. This method is a combination
of market and income approach where value is determined on the basis of
avoided cost.
Key factors to be considered while using this method are:
a) Appropriate Royalty Rate
b) Revenue Projections
c) Discount Rate
Various steps involved in RRF are as presented below:
Step 1: Ascertaining the Brand Specific Financial and Revenue Data
For brand Valuation via RRF, firstly we need to ascertain the brand revenue
to be generated from utilizing the brand over its projected life. Projected
brand revenue is generally estimated after considering the historical revenue
trends of the company, doing industry analysis and discussion with the
management. Further market demand of the company's products in relation
to its competitors should also be taken into account along with long term
GDP growth of the country.
Step 2: Ascertaining the Royalty Rate in Relation to the Brand
Royalty rates cannot be evaluated in vacuum. Arm's length licensors and
licensee negotiate royalties within a dynamic matrix of strategic, economic
and legal considerations, each term and condition in a license agreement
may shift the risk from one party to the other and therefore shall be
considered in determining the appropriate royalty rate or range thereof.
There are various sources, both internal and external which help the valuer in
the determination of royalty rate.
1)    Some of external sources are listed below:
·     License agreement covering a similar patent or trademark granted by
      the licensor owning the subject property to a third party
      These agreements can be extracted from various royalty data bases
      such as: Royaltystat, Royalty source, ktMINE etc.

                                                            Brand Valuation

·    News articles and magazines such as Financial World which provide
     an annual survey of some top value Brands names.
     Royalty rates extracted above need to be adjusted (up or down) to fit
     the particular facts and circumstances. For this, their compatibility is
     evaluated on various factors such as:
           Industry/ Subject Business
           Nature of Product/ Service
           Exclusivity- exclusive arrangements may command higher rates
           Market Positioning ­ brands with better market positioning may
           command higher rates
2)   Internal source includes using the price premium method for
     calculating the royalty rates.
     ·   In this Royalty rates are computed based on the price premium
         commanded by company in each product category/ segment. In
         order to calculate the price premium, prices for company's product
         is compared with the prices of similar products of other
         competitors. Please note, prices to be considered here should be
         the price at which product is sold to the first party and nor the
         retail price of the product which are generally adjusted for
         discounts. Further, to get a better understanding of prices and to
         confirm the price premium, discussion with the various industry
         participants such as wholesalers, retailers etc. should be done if
     ·   Further an effective product premium for each product segment is
         calculated by multiplying the price premium with the sales
         proportion of the respective geographies.
     ·   The price premium calculated above can't be entirely attributable
         to Brand. There are various other factors which contribute to this
         price premium. Accordingly, based on various factors associated
         with the industry such as customer reach, distribution, scale of
         operations etc. and on the basis of the discussion with the
         management and industry participants (wholesalers & retailers) an
         appropriate weightage for brand is assumed and final royalty rate
         is selected.

Valuation: Professionals' Insight

Step 3: Ascertainment of Net Royalty Saving Post Tax
Royalty rates computed above is applied on the brand revenue to calculate
the royalty savings on account of owning the brand. This royalty saving is
then reduced by the estimated brand promotion and marketing expenses
which are incurred by the owner of the brand. These expenses are generally
considered on the basis of percentage of sales on account of historical
trends of the company, to calculate the net royalty savings.
Net royalty savings are further reduced by the marginal income tax, to
calculate net royalty savings post tax.
Step 4: Ascertainment of Appropriate Discount Rate
An appropriate discount rate needs to be ascertained which can be applied
on the post-tax royalty savings to calculate their present value
The calculation of the appropriate discount rate to estimate an intangible
asset's fair value requires certain considerations which are as follows:
·     The discount rate should be determined considering the market-
      participant assumption
·     The discount rate should reflect the risks commensurate with the
      intangible asset's individual cash flows
In general, the risk profile of each asset category should be considered when
estimating the appropriate rates of return. The valuer should consider the
liquidity of the assets on the balance sheet on a spectrum from working
capital (most liquid) to the intangible assets (least liquid). In addition, the
valuer can consider the assets based on their ability to be financed by debt
or equity.
Therefore, the weighted average cost of capital (WACC) is calculated and
further an appropriate risk premium is adjusted to calculate the discount rate.
Step 5: Ascertainment of Brand Value
The discount rate calculated as above is applied on the net royalty savings to
calculate their net present value. These net present values for explicit years
are added to calculate the value of the brand. Further notional benefit of tax
amortization benefit ("TAB") is added to calculate the final value of the brand.
The above method can be explained through an illustration as presented

                                                                                                                          Brand Valuation
                                           FYE                                           Year Ending March 31:
                   Particulars          31-Mar-19   2020       2021       2022        2023       2024       2025          2026       2027       2028
Revenues                                  500,000   510,000    520,200    530,604     541,216      552,040     563,081    574,343    585,830    597,546
  % Growth Rate                                      2.00%      2.00%      2.00%       2.00%         2.00%      2.00%      2.00%      2.00%      2.00%
Royalty Expense                             2.50%    12,750     13,005     13,265      13,530       13,801      14,077     14,359     14,646     14,939
Less: Effective Tax Rate                   30.00%    (3,825)    (3,902)    (3,980)     (4,059)       (4,140)    (4,223)    (4,308)    (4,394)    (4,482)
After Tax Royalty                                     8,925      9,104      9,286       9,471        9,661       9,854     10,051     10,252     10,457
Discount Period (Mid Year Convention)                  0.50       1.50       2.50        3.50          4.50       5.50       6.50       7.50       8.50
Discounting Factor                         15.00%    0.9325     0.8109     0.7051      0.6131        0.5332     0.4636     0.4031     0.3506     0.3048
Present Value of Cash Flows                           8,323      7,382      6,547       5,807        5,151       4,568      4,052      3,594      3,188

Sum of Present Values                      48,612                                                Discount Rate (WACC)                              15%
Add: Tax Amortization Benefit (TAB)        11,909                                                Perpetuity Growth Rate                             2%
Concluded Value                            60,521

                                      Sensitivity Analysis
                                                    Discount Rate
                                        14%                    15%                    16%
    Royalty Rate

                      2.0%            48,417               48,417                    48,417

                      2.5%            60,521               60,521                    60,521

                      3.0%            72,625               72,625                    72,625

Other Points to be Considered
1. Tax Amortization Benefit
In the Valuation exercise of individual intangible assets, the future
amortization of an individual intangible asset must be considered as a
component of the aggregate value of the subject intangible asset. In the
context of valuing intangible assets, the tax amortization benefit is an uplift to
reflect the value of the tax-shield afforded by the amortization of capitalized
intangible assets.
This exercise assumes that a hypothetical buyer could capitalize the
intangible asset and reduce future taxable income through amortization over
a certain period pursuant to the applicable tax regulations. This tax shield is
discounted to present value and added to the pre-amortization value to
determine the fair value.
2. Remaining Useful Life
Economic and useful lives are key inputs to Valuation and generated income
of acquired assets. The key considerations include:
·                  Longevity: The period over which the asset is expected to be used and
                   contributing to the cash flows

Valuation: Professionals' Insight

·     Typical product life cycle of the asset: Any legal, regulatory or
      contractual provisions that may limit the useful life must also be
·     Historical experience of using a similar acquired asset
·     The impact of anticipated changes in consumer demands, preferences
      and tastes along with the impact of other economic and industry
·     The level of expenditures (including ongoing marketing and
      advertising) required to maintain the asset
·     The life of other related assets
·     Technical, technological,      commercial     or   any    other   type   of
Factors that impact the amortization period of an asset should also be
considered in determining the period of cash flows to be used in valuing the
asset. For this reason, companies typically look for the period over which
cash flows used in the asset's Valuation are forecasted in order to determine
an appropriate amortization period or reach to an indefinite-life classification.

                                                               Chapter 10
                              Valuation of Intangibles
What is an Intangible Asset?
The International Glossary of Business Valuation Terms describes intangible
assets as non-physical assets such as franchises, trademarks, patents,
copyrights, mineral rights, customer contracts or relationships, etc. that grant
rights and privileges, and have value for the owner.
Intangible assets are assets in addition to financial and tangible assets and
working capital. Under Ind AS 38 an intangible asset is defined as An
identifiable non-monetary asset without physical substance. From an
accounting perspective, it has the following key attributes:
·     Identifiability - they are separable or may arise from contractual or
      other legal rights,
·     Future economic benefits ­ their existence depends on expectation of
      future benefit such as revenue or cost savings or other benefits
      resulting from their use; and
·     Control - the owner can control the use or restrict the access to the
      future economic benefit

Need for Valuation of Intangibles
Intangibles are an increasingly key component in determining the value of an
enterprise. In industries such as pharmaceuticals, technology, fashion and
consumer goods, to name a few, intellectual property is a major enterprise
value driver.
Furthermore, the convergence of Indian Accounting Standards with IFRS has
brought Valuation of intangible assets to the fore as they comprise a
significant asset class in the allocation of the purchase price in case of
Business Combinations under Ind AS 103 and Ind AS 38 which deal with the
accounting treatment of intangible assets.
Besides financial reporting, intangible assets such as patents, brands,
technical know-how, etc. are also bought and sold / transferred; albeit
Valuation: Professionals' Insight

through usually confidential agreements; which obscures the basis on which
its value is determined. How then, is the value of such an asset determined?

Principle for Measurement
The measurement principle under Ind AS used to value an asset is fair value,
which means that it is the price that would be received to sell an asset in an
orderly transaction between market participants at the measurement date
under current market conditions. While it emphasizes a market-based
measurement, it is likely that observable market data may not always be
available. In such cases, Valuation techniques maximizing the use of
relevant observable inputs and minimizing the use of unobservable inputs
are used, the underlying aim being to use assumptions that market
participants would employ when pricing the asset, including assumptions
about risk, restrictions on its sale or use, condition of the asset, geographical
use restrictions, etc.

Valuation Approaches and Methodologies
The generally accepted Valuation approaches comprise of Market Approach,
Income Approach, and Cost Approach. Each approach has its own
advantages and disadvantages. Thus, depending on the circumstances of
each case; for instance, asset type, information availability and quality
thereof, risk characteristics, etc. a particular approach might be used. The
selection of the approach and methodology is a process of elimination and
often the valuer will use more than one method under different approaches to
corroborate or set a guideline for an estimate of the fair value. Moreover,
depending on the approach and methodology used, the Valuation may be
predicated on either historical or prospective financial information along with
contemporaneously available market data.
The Valuation approaches and key methodologies under each are briefly
discussed hereunder:
(1)   Market Approach: This approach uses market-based indicators of
      value. It is based on the premise of efficient markets and supply &
      demand. It estimates fair value by reference to observable market
      price data or transactions of comparable intangible assets. However,
      given that there is no active market for trading in intangible assets,
      comparable transactions may be used under this approach.

                                                               Brand Valuation

      Comparable Transaction Method: Transactions occurring in a free
      and open market between knowledgeable and willing buyers and
      sellers conducted on an arm's length basis can be used to determine
      benchmark metrics for the purpose of valuing the comparable
      intangible asset. While evaluating comparability, factors such as age
      of the asset, applicability of use, locational / geographical access or
      use, risk and expected return characteristics, etc. are considered.
      Typical benchmarks include multiples of revenue or profitability.
      However, while an ideal method, it has limited practical applicability.
      For one, observable market-based transactions of identical or
      substantially similar intangible assets are often difficult to obtain. Such
      transactions are generally confidential and often involve other
      negotiated terms with respect to marketing, financing, use restrictions,
      etc. which influence price but the existence of such arrangements is
      not publicly known. A further limitation is a lack of comparability - by
      nature, intangible assets usually enjoy unique characteristic, which
      almost always necessitates adjustments to be made to the benchmark
      Consequently, depending on the quality of data, if available, the
      method is generally used as a means to corroborate the value arrived
      at under other Valuation methods.
(2)   Income Approach: The income approach uses estimates of future
      estimated economic benefits or cash flows and discounts them for the
      associated time and risks involved to a present value. The method is
      founded on the principal of anticipation ­ whether of revenue streams
      or cost savings or other economic benefit. Thus, it finds maximum
      applicability in the Valuation of intangible assets such as brands,
      customer relationships, copyrights, patents, etc. which generate a
      future income or cash inflow stream. However, a key area of difficulty
      under this approach lies in separating the cash flows exclusively
      pertaining to the asset under Valuation from that of the enterprise as a
      The discount factors typically used in such instances are the weighted
      average cost of capital (WACC), or weighted average return on assets
      (WARA), or the Internal Rate of Return (IRR) of the investor specific to
      the asset being valued. Thus, depending on the risk and return profile

Valuation: Professionals' Insight

      of the asset, a suitable discount factor would be applied to the cash
      flow stream to arrive at the present value.
      This approach includes the following commonly used methods:
      (i)   Relief from Royalty Method: The Relief from Royalty method
            is based on the principle that, if the business did not own the
            asset, it would have to in-license it in order to earn the returns
            that it is earning. Alternatively, the business could out-license
            the asset if it did not wish to use it. Thus, the value of the asset
            is calculated based on the present value of the royalty stream
            that the business is saving by owning the asset.
            Under this method, a royalty that could be expected to be
            obtained in normal commercial practice is applied to an
            estimated level of future maintainable sales and the resultant
            after-tax royalty stream is computed. Such computed after-tax
            royalty stream is discounted using a relevant discount factor to
            arrive at the value of the asset.
            The method is popularly employed in the Valuation of intangible
            assets such as brands, licences and technical know-how, where
            transacted royalty rates for similar assets are often available.
            These rates are then adjusted for asset specific risks and
            returns such as geographical use restrictions, brand recall, etc.
            to arrive at a suitable royalty rate.
            Pitfalls with rules of thumb: It may be the case that past or
            current transactions for royalty rates for similar assets may not
            be available. In such instances, a generally accepted heuristic is
            the "25%-profit split" method. The 25% Rule as defined by
            Goldscheider et al (2002) suggests that a licensee should pay a
            royalty rate equivalent to about 25 % of the expected profits for
            the product that incorporates the subject IP. The genesis of the
            25 % rule was an observation by Robert Goldscheider that the
            average royalty from a small sample of licensing agreements for
            a bundle of IP from one company, Philco, reached in the 1950s
            was about 25 % of operating profit. However, this is not backed
            by reliable evidence. Empirical evidence suggests extremely
            wide variation depending on the industry. Nevertheless, it still
            enjoys wide-spread acceptance. Thus, the valuer should be

                                                               Brand Valuation

              cautious in its use, and should employ it as a cross-check with
              suitable up/down adjustment and in addition to other data
              sources to arrive at an appropriate royalty rate.
      (ii)    Multi-period Excess Earnings Method: Under the multi-period
              excess earnings method, the present value of the cash flows
              generated by, and only by, the intangible asset is considered. In
              order to arrive at cash flows from the intangible asset only, the
              cash flows generated by the intangible asset in combination with
              other assets are reduced by subtracting notional cash outflows
              for the "contributory" assets (the contributory asset charges).
              This procedure treats the contributory assets as being leased
              from a third-party, to the extent necessary for the generation of
              the cash flows. The method is particularly useful in case the
              intangible asset being valued is a significant value driver with
              other assets being secondary in nature to it.
      (iii)   With and Without Method/ Premium Profits Method: This
              method measures the economic contribution of the asset by
              calculating the net present value of the incremental cash flows
              to be derived from the use of the asset. This method requires
              the determination of the future cash flows from the existing
              business with the asset and the future cash flows from a
              notional business without the asset. Non-compete arrangements
              are commonly valued using this method.
(3)   Cost Approach: This approach is based on the economic principle of
      substitution and covers opportunity costs during the stage of
      development of the asset as well. However, it ignores the amount,
      duration and timing of future economic benefit arising from the asset.
      Further, it does not consider the risk characteristics of the asset nor its
      performance in a competitive environment. Hence, it is not generally
      useful in valuing assets such as patents, copyrights, brands, etc.
      which mainly derive their value from their future earning ability.
      Nevertheless, it is used when either the data required under other
      Valuation approaches is not available or the asset is unique or there is
      no active market for the asset under consideration.
      The approach is best used in valuing intangible assets such as
      technical drawings or internally developed software that do not
      generate a direct cash inflow stream, or assembled workforce; which

Valuation: Professionals' Insight

      although not separately recognized on the balance sheet, is used to
      arrive at the fair value of other assets). There are two commonly used
      methodologies under this approach:
      (i)    Historical Method: This method considers the historic or suck
             cost or purchase price to value the asset. This method does not
             consider future benefits arising out of the use of assets. Hence, it
             usually is not a good indicator of the true value of the intangible
      (ii)   Replacement Cost Method: The method considers estimating
             the costs to recreate / replace an asset with equivalent
             functionality at current prices and costs, including adjustments for
             factors like physical deterioration and functional / economic
             obsolescence, wherever applicable. It is based on the premise
             that a prudent third-party would pay no more for an asset than its
             replacement cost.

Tax Amortization Benefit (TAB)
Based on the above methodologies, the valuer arrives at the value of an
asset on a stand-alone basis, which is its pre-tax value. However, tax
jurisdictions allow an intangible asset to be amortized over its useful life. The
present value of such tax benefit is considered in the fair Valuation of the
asset. The process is iterative taking into account the amortization period,
the discount factor and the applicable marginal tax rate to arrive at the fair
value of the asset post TAB.

Generally, the valuer will use more than one method for determining the fair
value depending on the nature of the intangible asset and data availability. A
summary of the commonly used approaches in Valuation of intangible assets
is as follows:
Asset                                         Primary Secondary         Tertiary
Patent, Brand, Technical know-how,            Income Market             Cost
Customer relationship                         Income     Cost           Market
Internally developed software                 Cost       Market         Income
Assembled workforce                           Cost       Income         Market

                                                                  Brand Valuation

Assembled Workforce - Replacement Cost Method
Particulars                                         INR Mn
Current Annual CTC of Assembled Workforce           215
Hiring Cost (1 month's CTC)                         18
Training Cost (1.5 month's CTC)                     27
Inefficiency Cost (50% for 2 month's CTC)           18
Replacement Cost of Workforce                       278

Brand Valuation - Royalty Relief Method                                    (INR Mn)
      Particulars                  2020 2021      2022    2023     2024    Terminal

Net Sales                           400    750 1,100 1,400 1,600               1,680

Pre-Tax Relief from       5.00%      20     38      55       70       80         84

Income Tax                34.94%      7     13      19       24       28         29

After Tax Royalty                    13     24      36       46       52         55
Discounting Factor        19.50%   0.84    0.70    0.38    0.22     0.16        0.16

Growth Rate               5.00%

PV of Cash Flows                     11     17      14       10        8          9

Sum of PV of Cash Flows     60
PV of Perpetuity            61

Fair Value of Brand        121

     Royalty Rate is based on prevailing rates charged for brand licence by
     company to franchisees.
     Discount factor is based on company WACC with adjustment for risk
     premium for asset

Valuation: Professionals' Insight

Non-Compete Valuation - With and Without Method                     INR Mn
Particulars                                     2020 2021 2022 2023 2024
Cash flows (with Non-compete)                   19   24   32   35    40
Cash flows (without Non-compete)                2    5    17   25    33
Difference in Cash flows                        17   19   15   10    7
Discount factor                          17.50% 0.85 0.72 0.39 0.23 0.16
PV of Differential Cash Flows                   14   14   6    2     1
Sum of Differential Cash Flows           38
Probability of competing                 50%
Fair Value of Non-compete                19
Cash flow with Non-compete
Particulars                                     2020 2021 2022 2023 2024
EBIT                                            50   58   65   70    74
Less: Income Tax                         34.94% 17   20   23   24    26
Net Income                                      33   38   42   46    48
Add: Dep                                        2    2    2    2     1
Less: Capex                                     12   12   10   10    8
Less: Increase in Working Capital               4    4    3    2     2
Cash flows with non-compete                     19   24   32   35    40
Cash flow without Non-compete
Particulars                                     2020 2021 2022 2023 2024
EBIT                                            20   32   49   56    70
Less: Income Tax                         34.94% 7    11   17   20    24
Net Income                                      13   21   32   36    45
Add: Dep                                        2    2    2    2     1
Less: Capex                                     12   12   10   10    8
Less: Increase in Working Capital               2    6    7    3     6
Cash flows without Non-compete                  2    5    17   25    33

                                                         Brand Valuation

   Cash-flows are considered for the period of non-compete
   The dependency ratio on the non-compete has been considered to
   arrive at cash flows with non-compete, which reduces with time as
     Particulars            2020 2021 2022 2023            2024
     Dependency Ratio       60%        45%   25%   20%     5%

   A probability that the seller may compete of 50% has been considered
   to arrive at the Fair Value of Non-compete.

                                                               Chapter 11
       Nuances on Valuation of Intangible
As investment in intangible assets continues to grow globally across
industries, investment in intangibles often matches or exceeds investment in
traditional capital such as plant and equipment, machinery and buildings.
Intensified global competition, emergence of new business models in the
world of startups and increasing importance of the services sector have
amplified the prominence of intangibles. Global gaints such as Apple,
Microsoft, Starbucks, Prada, Gucci, BMW etc. rely heavily on intangible
assets to drive firm value. In Indian context it has also been seen that certain
brands despite having zero or no sales have still been transacted at a value,
e.g. Dalda, Cibaca, Ambassador
Ind AS 38-Intangible Assets, defines an intangible asset as "an identifiable
non-monetary asset without physical substance". Intangible assets represent
a company' right or claim to future benefits arising from their use. Brands,
trade names and trademarks, customer relationships, franchises, patents,
copyrights, contracts and goodwill etc. are commonly recognised intangible
assets. Examples of some of the generally considered intangibles in various
industries include:
·     IT industry: Patents, technical know-how, internet domain names,
      technology, software codes etc.;
·     Pharmaceutical industry: Product molecules, in-process research &
      development, licensing agreements, trade names and trademarks etc.;
·     Telecommunication industry: spectrum licenses, software, customer
      relationships, trademarks etc.;
·     Business services industry: customer/ vendor relationships, order
      backlogs, non-compe agreements etc.
The adoption of Ind AS in India has also increased the importance of
intangible assets on a company's reported financials. Intangible assets have
to be fair valued in case the Ind AS 103-Business Combinations is applicable
in a controlling transaction. Furthermore, financial statement implications
                                  Nuances on Valuation of Intangible Assets

associated with amortization and impairment testing (under Ind AS 36-
Impariment of Assets) have to be carefully accessed with respect to the
intangible assets of a company.
The recent advances in the Indian Valuation landscape, has warranted a
greater emphasis on the accurate Valuation of intangible assets, as these
assets become critical drivers of corporate value. The common approaches
considered in Valuation of intangible assets are:
(A)   Income approach ­ considers the future expected cash flows derived
      from the asset;
(B)   Market approach ­ based on market based metrics, such as prices
      paid in actual transactions with similar characteristics and functionality;
(C)   Cost approach ­ based on cost to purchase or replace an asset of
      equal utility.
Among these Valuation approaches, the Income approach is widely utilized
as it considers the future benefits from use of the subject intangible asset.
Due to the paucity of market data that would form a reliable proxy of the
specific attributes of a subject intangible asset, the Market approach, though
utilized often, has limited application in the Valuation of intangible assets.
The Cost approach assumes that the value of an intangible can be
determined based on its replacement cost. As such the Cost approach is
often utilized in valuing specific intangibles such as assembled workforce and
internally developed software. However, the Cost approach also assumes
that intangible assets can be rapidly recreated and a market participant will
not be willing to pay a significant premium for the ability to use the subject
asset immediately. Thus this approach is normally used to value intangible
assets that are not primary or significant in nature from market participants'
point of view.
While there is variability in the nuances of application, depending on the
subject intangible that needs to be valued, three common methods for
valuing intangibles using the Income approach are:
(A) Relief-from-royalty method ­ This method is based on a hypothetical
royalty (typically calculated as a percentage of the forecasted revenue) that
the owner will otherwise be willing to pay in order to use the asset assuming
it was not already owned. Thus, the royalty savings are considered as the
expected future cash flows from the subject intangible asset.

Valuation: Professionals' Insight

(B) With and without method ­ The fundamental concept underlying this
method is that the value of the subject intangible asset is the difference
between an established, ongoing business and one where the subject
intangible asset does not exist. This results in a stream of incremental cash
flows in terms of either incremental revenue (on account of charging a
premium by the owner of the subject intangible asset), and/or cost savings
(as the subject intangible asset allows its owner to lower the cost). Key
inputs of this method are the assumptions to what extent and how long the
cash flows of the business get affected (adversely) in the absence of the
subject intangible asset.
(C) Excess earnings method ­ This method calculates the value of an asset
based on the expected revenue and profits related to that particular asset,
adjusted for the portion of profits attributable to other assets (tangible and
intangible) that contribute to the generation of cash flow (for example,
working capital, fixed assets, assembled workforce, etc.). This method is
typically used in order to determine the value of the primary cash generating
intangible of the business.
While valuing intangible assets, consideration needs to be given to key
aspects such as:
(i)    Isolating future cash flows associated exclusively with the subject
       intangible assets which are independent of the other assets and
       liabilities of the company. This can often be challenging to ascertain
       given that a company's management usually provides overall cash
       flows of the company as a starting point. The Valuation professional
       has to work closely with the management of the company to isolate the
       cash flows pertaining to the subject asset including assumptions such
       as obsolescence/ attrition rates, add backs with respect to sales and
       marketing/ research and development expenses yet to be incurred
       based on the nature of the subject intangible asset.
(ii)   Charges for supporting/ contributory assets ­ how do the company's
       other assets help contribute to the cash flow generation of the subject
       intangible? Identifying these supporting assets and separating them
       from the other assets/ liabilities is critical in the application of the
       excess earnings method. A return for these `supporting assets' should
       be reflected in the Valuation of the primary intangible. Additionally, the
       excess earnings method is not typically used to value both the primary
       intangible as well as other supporting intangibles due to the potential

                                   Nuances on Valuation of Intangible Assets

        double counting of cash flows as well as issues related with `cross
        charging'. Furthermore, the supporting assets should also be
        considered at fair value while assessing the fair value of the subject
(iii)   The discount rate applied to estimate the present value of future cash
        flows of an intangible asset should be considered based on the stage,
        type and nature of the asset, and an assessment of the inherent risks
        embedded in the future cash flows of the subject intangible.
(iv)    The economic life of an intangible asset plays a crucial role in
        Valuation, as the future cash flows from the asset are considered over
        its economic life. Thus, the Valuation appraiser needs to analyse the
        company's assumption regarding the future use of the subject
        intangible, market participants' view point on the potential future use
        and should corroborate the fact pattern with an industry benchmark
In conclusion it can be said that intangible assets play an increasingly pivotal
role in enhancing firm value. As such it is imperative to correctly estimate the
value of intangible assets utilizing globally accepted Valuation methodologies
in order to protect and enhance shareholder value.

                                                             Chapter 12
Practical Solutions to Situations faced
while carrying out Valuation Exercises
How do you compute the number of equity shares, for the purpose of
determining the value per share? How do you value respective
instruments, once the enterprise value is computed? How do you treat
different instruments for this purpose such as -
(a)   Compulsory convertible debentures (CCD)
(b)   Non-convertible debentures (NCD),
(c)   Partially convertible debentures (PCD),
(d)   Optionally convertible debentures (OCD),
(e)   Compulsorily convertible preference shares (CCPS),
(f)   Redeemable preference shares (RPS)
(g)   Equity shares issued with reverse vesting conditions,
(h)   Options issued under an Employees Stock Option Plan (ESOP)
(i)   Options issued which are attached to debt or other instruments
(j)   Convertible notes
(k)   Equity issued with differential voting rights
(l)   Restricted stock unit plans
(m)   Share warrants
(n)   Others.
The simpler approach to Valuations, typically, is to compute enterprise value,
apportion the value to debt like instruments, and thereafter apportion the
value to equity like instruments. For this purpose, one needs to identify the
instruments as debt and equity, to allocate values. To ascertain the nature of
the instruments the following characteristics need to be assessed:
(a)   Rate of interest payable on the instrument
      Practical Solutions to Situations faced while carrying out Valuation...

(b)   Rate of dividend payable on the instrument, and whether cumulative
(c)   Liquidation preference
(d)   Anti-dilution protection
(e)   Right to vote on major decisions taken by the company, whether
      restricted to the class of instruments or in expanded form and
      combination with other classes
(f)   Right to board seats / board observer seats / advisor status
(g)   Right to have their prior approval for certain decisions.
(h)   Right to convert into equity shares, drag along and tag along rights.
(i)   Treatment of such instruments by regulatory bodies such as RBI, and
      accounting treatment as per GAAP.
After assessing these characteristics, we could identify instruments as being
near equity, if the rate of interest or dividend payable on the instrument is
marginal, meaning that the return to the investor comes out of the other
characteristics; if there is anti-dilution protection, right to vote similar to
equity shares, rights to board seats in proportion to fully diluted status of
equity, etc. In fact, based on the proportion of shareholding of such
instruments, one can even assess whether there is a controlling interest
residing in such instruments.
Instruments to be considered as part of the pre-money number of equity
shares outstanding on a fully diluted basis, are likely to be the following ­
(a)   CCDs
(b)   Convertible portion of PCDs
(c)   OCDs, if the likelihood of conversion is greater than 50%
(d)   CCPS
(e)   The option pool under ESOP, whether granted or not
(f)   Options attached to other instruments
(g)   Share warrants, assuming that the likelihood of calling for equity
      shares is greater than 50%
(h)   Convertible notes, if they are likely to be converted and terms are

Valuation: Professionals' Insight

Instruments more likely to be considered as debt are as follows ­
(a)    NCDs
(b)    Non-convertible portion of PCDs
(c)    OCDs if unlikely to be converted
(d)    Redeemable preference shares
(e)    Other instruments that are unlikely to be converted, including
       convertible notes.
While computing the weighted average cost of debt, it is necessary to identify
the cost of debt for each of the instruments assessed as debt, as above. For
instance, the cost of RPS would be higher on post-tax basis as compared to
NCDs on post-tax basis, as dividends are not tax deductible.
Allocation of enterprise value to each of the debt instruments outstanding on
the Valuation date can be done, by computing the value of each instrument,
given its characteristics
(a)    In the case of NCDs, PCDs, OCDs treated as debt ­ the cash flows
       due to the instruments can be computed, net of tax, comprising the
       interest payouts, and the premium, if any, on redemption of
(b)    In the case of RPS, the rate of dividend can be used as the
       capitalization rate to arrive at the value of the RPS, and suitably
       increased for the premium on redemption, if any.
The Valuation model should also factor in the time at which redemption is
likely to take place. Once the value of each debt instrument is computed and
reconciled with the value of debt, from the enterprise Valuation, one can
deduct and arrive at the value of the equity instruments.

Allocation of Values to Equity-Like Instruments
(a) CCPS - If the rate of dividend on CCPS is negligible (say 0.01%), the
value attribution to this dividend is marginal. Value attribution to liquidation
preference is also likely to be small, if the cash flows show low probability of
liquidation. In this situation, the real value is attributable to the rights that are
very similar to the rights of the equity shares. Value of the CCPS is
dependent on the ratio at which the CCPS will convert into equity shares,
and the value per equity share, is likely to be very similar to the value of
CCPS, subject to a marginal adjustment for dividend.

       Practical Solutions to Situations faced while carrying out Valuation...

(b) CCD ­ Here again, if the rate of interest on CCD is negligible (say
0.01%), the value attribution to the interest is marginal. Similarly, value
attribution to liquidation rights will be as above. Value per CCD is likely to be
very similar to the value of equity shares, subject to a marginal adjustment
for interest.
(c) ESOP ­ There is an interesting question to be addressed, namely
whether value attribution should be given to options earmarked for grant to
employees, but not yet granted.
The option pool is typically adjusted by investors from the pre-money
Valuation, rather than from the post-money Valuation. Similarly, whether
options granted but not vested, or vested but not exercised, will have a
similar value as equity shares outstanding.
Also, in the Valuation of options, one should consider the fair value of options
or the intrinsic value of options. The suggested approach to Valuation is to
consider the entire option pool in the pre-money computation of the number
of shares outstanding. The value of the ESOP can be adjusted for the grant
price/expected grant price of unexercised options, with suitable discounting
for the time at which options are likely to be exercised.
The value of the option itself, will be the intrinsic value, in case this method is
used, and the fair value of the options (which should typically be higher than
the intrinsic value).
In order to handle the issue of fair Valuation of options ­ let's look at the
perspective from which the Valuation of options is done.
"Fair Valuation of options is done from the perspective of arriving at an
accounting value for stock option grants. However, from the viewpoint of the
enterprise, it is to be kept in mind that it is writing the options that are being
granted. The Valuation from this perspective is therefore what we have
stated above, i.e., the option pool has value which is similar to the value of
the other shares of the enterprise, less the amount receivable for the grant
price of the options."
1.    When Valuation of options granted under an ESOP is to be done?
What are the factors to be kept in mind while issuing Valuation reports
for ESOP?

Valuation: Professionals' Insight

Applicability of Legal Framework
(a)   Section 61(1)(b) of Companies Act, 2013 and Rule 12 of the
      Companies (Share Capital and Debentures) Rules, 2014 cover the
      issue of employee stock options. A reference is also to be made to
      SEBI regulations under sub-rule (11), in the case of listed companies.
(b)   SEBI (Share based Employee Benefits) Regulations, 2014 cover issue
      of employee stock options by listed companies.
(c)   Section 17(2)(vi) of the Income Tax Act, 1961 and Rule 3(8) of the
      Income tax rules.(perquisite )
(d)   Ind AS 102 on Share-Based Payment and Guidance Note on
      Accounting for Employee share-based payments (2005).
It would be a good practice for a company to get a Valuation of the
company's equity shares and its option grants done every year, for the
purpose of determining the intrinsic value/ fair value of options. This serves
the purposes of substantiating the accounting treatment of stock option
costs, and computation of the perquisite value on exercise of options. In the
latter case, the Valuation may have to be done by a merchant banker, rather
than a registered valuer, in the case of unlisted companies.
The valuer needs to collate basic data such as -
(a)   Volatility of the stock
(b)   Risk free rate
(c)   Expected dividend yield
(d)   Expected option life
(e)   Market price of the stock
(f)   Exercise price of the option.
A choice has to be made between the appropriate Valuation model to be
followed ­
(a)   Binomial Model or
(b)   Black Scholes Model (BSM)
Theoretically, the value derived under either model should converge, if
multiple steps are assumed in the binomial model. The Binomial Model is
preferable for valuing American options, though, as stated, with sufficient

      Practical Solutions to Situations faced while carrying out Valuation...

number of steps, the value under the BSM should converge with the BSM
model Valuation.

Obtaining Data
(a) Volatility of the stock ­ The measure of volatility used in option pricing
models is the annualized standard deviation of the continuously compounded
rates of return on the stock over a period of time. In some circumstances,
historical data may not be available, e.g., in the case of a start-up enterprise.
It may not be appropriate to choose overall market volatility for a start-up
enterprise, since it is likely suppress the estimation of volatility. A sectoral
average or the volatility for similar enterprises may be more appropriate. The
historical volatility of the stock over the most recent period that is
commensurate with the expected life of the option being valued, could be
(b) Risk free rate ­ Current yield on government securities with similar
residual maturity could be considered.
(c) Exercise price and Expected dividend yield will be provided by
(d) Expected option life ­ While estimating the expected option life, it is
sensible to segregate employees into homogenous groups if possible, since
there could be a difference in behavior between groups. Thereafter,
estimating the life of the options could be kept simple (e.g., (min life plus max
life)/2 to arrive at the average life).
The next step is computing the value of the option, for which we may even
use any option calculator, that is available online. It is important that the
Valuation report outlines the scope of work, the methodology followed,
parameters used, the references to public databases, assumptions made,
and suitable disclaimers.
2.    How much of credence needs to be given to cost optimization
plans outlined by the management?
It is possible that an acquisition transaction is based on the premise that
there will be cost synergies in the acquisition. As a part of the assessment of
the synergy, the selling enterprise may share information that major cost
optimization drives have been identified and initiated, and the enterprise
Valuation correspondingly is higher, assuming that benefits of these cost
savings accrue to the selling enterprise.

Valuation: Professionals' Insight

An independent valuer is faced with assessing the situation where huge
enterprise value is created by assuming large incremental cash flows from
these cost savings. There has to be a critical analysis of the enterprise in
comparison to others in the industry, and the performance of the enterprise
over time. This requires approaching the enterprise using the EIC model, i.e.,
assessing the economy, the industry and then the company.
A common size analysis would enable comparison of the enterprise with
other enterprises in the same industry and against itself over time. Based on
the analysis, we get insights about the industry growth rates vs the
company's growth rate, the high performers and laggards in the industry, the
cost structures in the industry, industry segmentation, customer
segmentation, assessment of product features and positioning in relation to
competition. Once we have common size analysis of the company's cost
structure, we would be better placed to assess the likelihood of cost
optimization initiatives resulting in savings. Thereafter, an assessment of
management's capability in delivering on these initiatives needs to be done,
and a probability assigned to the likelihood of success of these initiatives.
Is there a conflict, if reports for allocation of purchase price, indicate
that Valuations at which acquisitions have been done are overpriced? Is
there a possibility of there being a charge to the P&L account
immediately based on the purchase price allocation report due to
impairment of assets?
Post-acquisition, it would be essential for an enterprise to obtain a purchase
price allocation (PPA) report, which provides an independent assessment of
the values at which the purchase price is to be allocated to the various
tangible and intangible assets that have been acquired, and the resulting
goodwill. Since the auditors need to frame an independent viewpoint on
these reports and the values at which assets and liabilities are stated, the
PPA report would be done by independent valuers. Hence, there are likely to
be multiple viewpoints with significant differences in approach, to the
Valuation of the business being acquired.
Management's Valuation includes synergies that could result from the
acquisition. The expert involved in the PPA may not have been involved in
the acquisition process and may have been brought in solely for the PPA
report. The auditors need to assess that financial statements are true and
fair. In this situation, if the PPA report allocates significant values to goodwill,

      Practical Solutions to Situations faced while carrying out Valuation...

there would have to be an assessment of whether the goodwill is impaired,
from the outset, however improbable. The allocation of goodwill to the cash
generating units to which the goodwill is attributable would be done in the
PPA report. Impairment testing of the goodwill can be done in accordance
with Ind AS 36, at the cash generating unit level, and if the testing indicates
that there is an impairment, the asset values need to be written down.
Is it necessary to obtain a Valuation report for a rights issue?
a)    Section 62(1)(a) of Companies Act, 2013 requires any further issue of
      shares to be made to the existing shareholders in proportion to their
      existing holdings and shall be deemed to include a right to renounce
      the shares in favor of any other party.
b)    Section 56(2)(vii) of the Income Tax Act applies to a rights issue only if
      it is not a bona fide business transaction, and if the rights issue is not
      in proportion to the existing shareholding.
c)    FEMA regulations state that the rights issue to a person outside India
      should not be at a price that is less than the price offered to a person
      resident in India.
Hence, based on the existing legislative framework, there is no need for a
Valuation report in the case of a rights issue.

                                                                Chapter 13
   Investment Terms vis-a-vis Valuation
Generally, any discussion on Valuation would be mostly concentrated on the
Valuation or its concepts as relatable to a large corporations/ listed entities
the only exception being the recent buzz about the start up Valuation. The
Valuation of a closely held company with few investors (whether professional
or otherwise) is a completely different play where few generally accepted
norms of Valuation do not work, some essential requirements would not be at
the reach in the right way and so on. In this Chapter, we would try to
understand one of the areas of closely held company's Valuation namely the
Investment Terms.
Private Equity/ Venture Capital funding will be bound by specific set of terms
and conditions which form the basis of investment decision making and price
negotiation, of course apart from the core business considerations and the
business environment. This is in contrast to the investment in publicly traded
securities which would be guided by regulated market prices. These
investment terms and conditions would be agreed upon by and amongst the
shareholders (including promoters) and the company through Shareholder's
Agreement or Share Purchase Agreement or Investment Agreement, as may
be relevant.
Herein, impact of the Investment Terms on the Valuation of the Company/
Shares, along with background and intent of such terms and all aspects to be
considered while undertaking the Valuation exercise are discussed.
Firstly, we will see certain adjustments to be made for determining the value
of closely held companies including for PE, VC and Angel investments.
Amongst them, Discount for Lack of Marketability (DLOM), Control Premium
and DLOC are most important and have a play in almost every closely held
company Valuation. Ensuing few paragraphs discuss the meaning, need and
impact of DLOM and DLOC in Valuation exercise.
DLOM is based on the premise that an asset which is readily marketable
commands a higher value than an asset which requires longer marketing
period to be sold or an asset having restriction on its ability to sell (Para 38,
ICAI Valuation Standard ­ 103: Valuation Approaches and Methods).
                                       Investment Terms vis-a-vis Valuation

Traded price of a publicly traded stock would usually reflect Value of a
Marketable Minority Share. Application of DLOM on such value would derive
Value of a Non-Marketable Minority Share ­ which is relevant in case of an
unlisted closely held company.
Control premium is an amount that a buyer is willing to pay over the current
market price of a publicly traded company to acquire a controlling interest in
an asset. It is opposite of DLOC to be applied in case of Valuation of a non
controlling/minority interest (Para 43, ICAI Valuation Standard ­ 103:
Valuation Approaches and Methods).
Control premium would usually be applied in cases where the Investor
acquires ability to control operational decision making and/or financial
decision making of the company. In converse situations, DLOC would be
applied to derive value of minority shareholding from value of control stake.
In addition to the general considerations given for determination of DLOM,
Control Premium and DLOC as above, specific consideration is to be given to
the terms of investment as per the Investment Agreements and their impact
on Valuation.

Key Investment Terms and Valuation Considerations
Following are the investment terms which are generally sought after by the
Investors/ preferred by the promoters.
A.    Conversion Rights
Most of the private equity and venture capital investors prefer to invest in
dilutive securities such as compulsorily or optionally convertible preference
shares/ debentures to pure equity shares for investment in early stage and
start-up companies for various reasons including flexibility and down-side
investment protection which these instruments offer.
Conversion ratio for a dilutive security can be agreed upon upfront (say, in
the ratio of 1:1) or it may be linked to the Valuation that instruments can
claim in the future investment rounds (say, 30% discount to the next round of
investment) or any other business performance linked conditions. It may be
noted that none of the regulations in India provide for any specific direction
on treatment of these terms of investment, except for the rules to Companies
Act, 2013 as discussed herein.

Valuation: Professionals' Insight

Rule 13 of Companies (Share Capital and Debentures) Rules, 2014
prescribes that where convertible securities are offered on a preferential
basis with an option to apply for and get equity shares allotted, the price of
the resultant shares pursuant to conversion shall be determined-
-     either upfront at the time when the offer of convertible securities is
      made, on the basis of Valuation report of the registered valuer given at
      the stage of such offer, or
-     at the time, which shall not be earlier than thirty days to the date when
      the holder of convertible security becomes entitled to apply for shares,
      on the basis of Valuation report of the registered valuer given not
      earlier than sixty days of the date when the holder of convertible
      security becomes entitled to apply for shares
It is important to note that the company shall take a decision on the above at
the time of offer of convertible security itself and make appropriate disclosure
of the same.
Further, conversion of the instrument can be either compulsory or optional at
the will of investor. However, you may see in many instances that investment
terms shall be drafted in such a manner to mandate conversion at the end of
an agreed time period, with an option of conversion at the will of investor at
any time during such agreed time period. This offers down-side investment
protection to investors for any happening of liquidation events during the
agreed time period.
While Optionally Convertible Securities are generally treated on par with
Debt Securities, application of Option Pricing Models appropriately factors
the impact of optionality clauses and conversion terms on Valuation. Though
none of the regulations in India, including ICAI Valuation Standards mandate
application of Option Pricing Model, it is the most preferred methodology of
valuing hybrid securities.
B.    Distribution Rights
Proportionate claim to dividend and liquidation proceeds can differ from
instrument to instrument based on face value, paid-up value, conversion and
differential rights of respective instruments.
Distribution rights may also differ from Investor to Investor based on
liquidation preference and minimum return claim held by such Investor (as
deliberated further). These are the rights relating to the special treatment to

                                       Investment Terms vis-a-vis Valuation

be provided to one or more of the investors or classes of instruments in
comparison to the rest with respect to claim in dividend and liquidation
The valuer, while determining dilution effect of each class of instrument and
thereby the value of instrument, should duly consider and factor in specific
distribution rights of such instruments or investors holding such instruments.
C.    Minimum Guaranteed Return
Venture capital and private equity funds procure funds from investors offering
minimum guarantee return (IRR) on investment. In order to achieve the
agreed IRR and for few other reasons, such venture capital and private
equity funds in turn set minimum IRR benchmarks to companies for every
investment made (this is to put it in very simple terms and only to provide a
context ­ though the constraints and aspects to be considered here are
In certain instances, achievement/ non-achievement of such minimum
guaranteed IRR by the investee company may lead to automatic alteration of
any specific terms of investment, including conversion ratio, distribution
rights, voting rights or liquidation preference.
Minimum guaranteed IRR restriction can have two-way impact on Valuation
of the instruments:
-     Minimum guaranteed IRR reflects risk rating of the equity investment
      made from investor's perspective and thereby the return expectations.
      Such IRR may act as a better indicator of cost of capital (of course
      after duly adjusting for investor specific considerations or aspects
      relating to the investee company), than a market determined cost of
-     Upon achievement or otherwise of minimum guaranteed IRR by the
      investee company, the conversion, distribution or liquidation
      preference terms would get altered. This would in-turn have the impact
      on the enterprise value and also the proportionate instrument value. In
      such a scenario, option pricing models needs to be adopted to factor
      in the probability impact of minimum guaranteed IRR on Valuation,
      with scenarios built for both down-side and up-side probability.
D.    Voting Rights:
As per the regulatory framework under Companies Act, 2013, equity

Valuation: Professionals' Insight

shareholders alone shall be vested with voting rights in proportion to
respective holding of paid-up equity share capital. However, when it is
approved by the shareholders, a company can issue equity shares with
differential voting rights, i.e higher, lower or nil voting rights.
Dilutive securities, i.e. convertible preference shares or convertible
debentures shall not have voting rights as per the Regulatory framework
unless in instances where rights of such instruments are directly impacted.
In order to gain decision making powers and bridge the control gap, investors
who generally prefer Dilutive Securities for investment may subscribe to and
hold nominal equity shares with differential (higher) voting rights and holding
of such equity shares can be tied to holding of Dilutive Securities.
While determining value of any Dilutive Instrument, to which holding of equity
shares with differential voting rights is tied up to, DLOC is to be determined
considering voting rights and control held by respective holding of Equity
E.    Lock-in, Drag along, Tag along and related restrictions
One of the major considerations for Angel or VC or PE Investors for
investment in any early-stage or start-up entity is strength and reliability of
the management, i.e., the promoter group. Value propositions of an
investment might change based on continuance or discontinuance of such
promoters with the company and in most cases there may not be any value
left in the company if the promoters are not there.
In order to ensure continuing of management of the investee company, as a
part of investment terms usually lock-in restrictions will be placed on
promoter shareholding, i.e., promoter cannot dispose/transfer their
shareholding in the company until completion of an agreed period or unless
approved by the investors and restrictions would impact liquidity of the
instruments part of promoter shareholding. The Valuer should consider the
same appropriately for determining DLOM specific to such instruments.
In addition to lock-in restrictions on promoter holding, investors in general
would be provided with tag along, drag along rights and right of first refusal.
If promoters or any other shareholders of the company are undertaking any
transactions involving sale of their respective shareholding. Tag along right
gives option to investor or holder of respective instrument to participate in
such sale transaction along with promoter or selling shareholder and offer
their shareholding for sale. If such option is exercised, promoter or selling

                                        Investment Terms vis-a-vis Valuation

shareholder shall ensure that the instruments with tag along rights are sold at
the same value that is offered to their shareholding and as per same terms.
Conversely, drag along right gives right to the investor or holder of respective
instrument to force the promoters or other shareholders of the company, as
may be agreed upon, to sell their shareholding to a third-party buyer in a sale
transaction through which holder of drag along instruments is selling
respective shareholding.
If any of the shareholders are intending to undertake a transaction involving
sale of their respective shareholding, the right of first refusal provides an
opportunity to the Investors or holders of such right to purchase the shares of
transferring shareholders at the same price and terms as that would be
offered under the intended transaction with third party. This would benefit the
investors by helping them to retain control over the company and protect
against potential dilution.
Holders of tag along, drag along rights and right of first refusal would have
liquidity benefit over other shareholders whose holding is subject to such tag
along or drag along rights and same is to be appropriately considered while
determining DLOM for respective instruments.
F.    Liquidation Preference
Liquidation preference is one of the primary considerations for venture
capital and private equity investment. Liquidation preference terms
summarise the sequence of preference of various classes of instruments or
investors over the liquidation proceeds of the company.
As per general regulatory framework under Companies Act, 2013, in case of
liquidation of company, liquidation proceeds of the company shall be first
distributed to debenture holders along with other creditors/borrowers.
Thereafter, balance proceeds shall be distributed to preference shareholders
any leftover proceeds shall be distributed to equity shareholders. Here the
claims of debentures and preference shareholders shall be limited to their
nominal value and unsettled interest or dividend, unless otherwise provided.
However, in majority of the instances venture capital and private equity
investors acquire dilutive instruments at a premium and would seek
liquidation preference even for the component of premium, along with agreed
return if any. To accommodate this, liquidation preference as a part of
investment terms would be set in following manner:

Valuation: Professionals' Insight

-     Liquidation proceeds (after remittance of all the debts and external
      commitments of the company) would be first distributed to investors to
      settle their claim of preference, i.e repayment of investment amount
      (nominal value plus premium paid) along with minimum guarantee
      return if any (for example, 1.5 times of the amount invested).
-     In case liquidation proceeds are not sufficient to settle preference
      claims of all the investors, such liquidation proceeds shall be
      distributed to investors in proportion to their inter-se shareholding or
      preference amount.
-     Liquidation proceeds remaining after settlement of preference claims
      of investors shall be distributed to promoters or other non-preference
-     Investors shall have an option to forgo liquidation preference claim and
      participate in the distribution on fully converted basis, i.e assuming
      their holding of dilutive instruments are converted to equity shares if
      such basis of distribution is beneficial.
Liquidation preference significantly affects proportionate value of instruments
held by investors and shareholders/ other non-preference holders. In these
situations, option pricing model ­ waterfall distribution approach needs to be
adopted for allocation of equity value for appropriately factoring in the impact
of liquidation preference.

Option Pricing Model
In multiple places above we have discussed about option pricing model ­ so
it would be pertinent to look at this and understand it. Following paragraphs
summarise the basic understanding of key methodologies of OPM and how
the same can be implemented.
A.    Binomial Model
Binomial call option pricing model (American/ European as may be relevant)
can be applied for factoring the impact of investment terms on Valuation,
-     Conversion of optionally convertible instruments;
-     Conversion linked to future conditions;
-     Achievement/non-achievement of minimum guaranteed IRR and
      resultant alternation of terms of investment;

                                         Investment Terms vis-a-vis Valuation

Under Binomial option pricing model, scenarios can be built for probability of
upside or downside movement of underlying asset value for multiple periods
and iterations.
Final outcome under this model is based on iterations of such upside and
downside probability, where in probability is in-turn dependent on underlying
risk (volatility) and risk-free return.
Key Inputs for Binomial call option pricing model
Time to Expiry                  Time period between Valuation date and date
                                of lapse of optionality condition
Number of Nodes                 Number of Iterations
Time Interval        of   Node Time to Expiry/Number of Nodes
Risk Free Return (r)            Benchmark Risk Free Rate
Volatility (v)                  Volatility of underlying Equity
Uptick (u)                      e ^ (v* Square-root of DeltaT)
Downtick (d)                    1/u
Upside Probability (Pu)         [{e^(r*DeltaT)}-d]/[u-d]
Downside Probability (Du)       (1-Pu)
Current Stock Price (S)         Value of Equity/Instrument on Valuation Date
Exercise Price (E)              Price to be paid to exercise the Option

Valuation: Professionals' Insight

                               Spot Equity

                              Value of OCRPS =

             S1a = S*u                             S1b = S*d
            PO1a= Max                             PO1b= Max

          PV of PO2a=                           PV of PO2b=
       (PO2aa*Pu+PO2ab*D                    (PO2ba*Pu+PO2bb*Du

       S2aa =             S2ab =             S2ba =             S2bb =
       S1a*u               S1a*d             S1b*u               S1b*d

 Valuation of Optionally Convertible Preference Shares ("OCRPS")
 with Redemption Value `X'
     1. For the purpose of illustration 2 iterations are considered. Accuracy
        of the outcome would improve with the number of iterations.
     2. It is assumed that OCRPS is redeemable or convertible at any time
        during the Time to Expiry and hence, American call option pricing
        model is applied.

B.      Black-Scholes Model
Black-Scholes call option pricing model is widely used for allocation of equity
value amongst current value method, probability weighted expected return
method and option pricing model.
For allocation of equity value under Black-scholes call option pricing model,
breakpoints of distribution of assumed liquidation proceeds is to be
determined in line with conversion, distribution and liquidation preference
terms of various dilutive instruments of the company. Breakpoint is where the
distribution proportion of assumed incremental liquidation proceeds changes.

                                         Investment Terms vis-a-vis Valuation

Implied value of each such breakpoints is then determined using Black-
Scholes call option pricing model considering transition values of the break
points as strike prices and equity value as spot price. Incremental of implied
value of breakpoints so determined above represents equity value allocated
to each of such breakpoint, which shall further be allocated to various
classed of dilutive instruments based on their respective distribution claims at
such breakpoints. Value of each of class of Instrument is equivalent to equity
Value so allocated to such instruments divided by number of Dilutive
Instruments under such class.
   Key Inputs for Black-option pricing model for Equity Allocation
   Time to Liquidity (T)          Time period between Valuation Date and
                                  Likely Date of Liquidity Event as per
                                  Investment Terms
   Risk Free Return (r)           Benchmark Risk Free Rate
   Volatility (v)                 Volatility of underlying Equity
   Spot Price (S)                 Current Equity Value
   Strike Price (K)               Transition Value of Breakpoint

       Black-Scholes Call Option Pricing Model = SD1-(D2*K*e^(-r*T))

            d1 = [N.Log(S/K)+((r+(v^2)*0.5)*T]/(v*Square root of T);
                        d2 = d1-(v*Square root of T);
           D1 = Normal Distribution(d1); D2 = Normal Distribution(d2);

                                                               Chapter 14
                            Tax Amortisation Benefit
The term `Tax amortisation benefit' has not been explicitly defined anywhere
but as a concept is widely accepted by all global professional bodies. In India
too, TAB is commonly applied, especially by valuers who regularly carry out
Valuations for the purpose of financial reporting. TAB in a layman's term is a
benefit that is availed by claiming amortisation of an acquired asset as an
allowable expense under tax laws. As an expert however, one would define
TAB as a hypothetical benefit arising from future amortisation of an acquired
intangible asset that could be available to an acquiring entity which is
recording such an intangible asset in its books of accounts. The Indian
Valuation Standard 302 on Intangible Assets issued by The Institute of
Chartered Accountants of India in 2018 explains TAB as a hypothetical
benefit available to a market participant by way of amortisation of the
acquired intangible asset, thereby reducing the tax burden.
The points below are relevant to correctly understand, apply and calculate
1.    TAB is a hypothetical concept
The premise of TAB arises from the assumption that while acquiring the
asset, hypothetically the acquirer would have factored in the determination of
the acquisition price, such amortisation benefit that would be available on
acquisition of the asset in the future. The premise of TAB is thus hypothetical
and is applied irrespective of whether such amortisation is actually claimed
or not. While its premise is hypothetical, its applicability is not. If there is
reason to believe that the structure of a transaction or the purpose of the
Valuation or the tax laws are such that there may not be any amortisation
benefit available, then TAB would not be available.
2.    The asset should be seen to be acquired in isolation and not as
part of a business
 TAB is based on the premise that the benefit would be available on
amortisation of an asset, and hence it is implied that only if the asset can be
isolated and recorded separately, it can be amortised. If the asset is taken as
part of a business, the asset loses its identity and cannot be recorded
                                                      Tax Amortisation Benefit

separately and will not be amortised and the question of TAB would not
arise. There is some confusion among valuers as to whether this implies that
TAB would be applicable only on asset purchase transactions and not on
stock purchase transactions. However it has been settled that TAB should be
applied irrespective of whether the transaction is an asset purchase or a
stock purchase, as long as the asset is being accounted and recorded
3.    The applicability of TAB depends on the purpose of the Valuation
Just like any other Valuation, the purpose of Valuation is also important to
assess when TAB should be applied. TAB being a hypothetical benefit, it is
important that TAB is not arbitrarily applied as it would erroneously inflate the
value of the asset. TAB is therefore applied only if the intangible asset is
being valued separately which generally it is when a purchase price
allocation has been carried out (either to account for a business combination
for the purpose of financial reporting or at the time of a slump / group sale for
tax reporting) or when the intangible is been sold / acquired separately. For
financial reporting, the inherent assumption under which the Valuation is
carried out assumes a hypothetical sale of the intangible asset; in case of a
purchase price allocation for a slump / group sale, the very reason the
purchase price allocation is carried out is to claim tax amortisation.
4.    The applicability of TAB depends on the Valuation approach
When the cost or market approach is used to value an asset, it is understood
that the estimated cost to create / replace the subject asset and the market
price used to realise the value of the subject asset respectively takes into
account the value of all benefits and therefore there is no reason to
additionally add the value of TAB when valuing an asset under these
approaches. However when an income approach is used to value an asset,
because the cash flows / earnings / cost savings pertain only to the use of
the subject asset, the amortisation benefit does not get captured in the
calculation and hence the need to add TAB separately when valuing an asset
under the income approach.
As amortisable tangible assets are valued using either the cost approach or
the market approach or both, it is by implication clear that TAB is applicable
only when valuing intangible assets and that too only if they are valued using
the income approach.

Valuation: Professionals' Insight

5.   TAB applicability depends on the tax amortisation laws of the
country in which the asset is used
Although the amortisation is claimed in the books of the acquirer entity, it is
the location where the asset is used that determines the applicability and the
amount of TAB. For eg. if an acquirer in India buys an intangible asset used
in Europe, if the European tax laws do not allow for amortisation of the
acquired intangible asset, TAB should not be applied even if the acquired
intangible asset is allowed to be amortised as per Indian tax laws.
6.    The value of TAB is calculated as per the amortisation method
allowed by the laws of the country in which the asset is used
As mentioned earlier, once it is established that TAB is applicable, the
method of amortisation to calculate TAB would also depend on the location
where the asset is used. For eg. if an intangible asset used in India, is
acquired, as per the tax laws of India, such an intangible asset would be
amortised at the rate of 25% per annum based on the written down value
method. However if the asset was being used in the US, the amortisation
method would be the straight line method and the number of years over
which the asset could be amortised would be different. The value of TAB
would hence be different in different countries for the same intangible asset.
7.    Calculation of TAB
The four primary inputs that go in the calculation of TAB are the amortisation
rate, the discounting rate, the tax rate and the duration.
Amortisation Rate
As mentioned earlier, the amortisation rate is dependent on the situs where
the intangible asset is used. Depending on the amortisation laws, the
amortisation policy and the amortisation method, the amortisation rate should
be decided.
Discounting Rate
Intangible assets are perceived to be riskier than the company as a whole
and hence the discounting rate used to value an intangible asset is higher
than that used to value a company. There is hence some debate over which
discounting rate should be used to present value the tax savings for
calculating TAB.
While some valuers use the company's discount rate commonly referred to
as the weighted average cost of capital (`WACC') to discount the tax savings

                                                     Tax Amortisation Benefit

to calculate the present value of TAB, some others discount the tax savings
using the discounting rate of the intangible asset. The school of thought
which uses WACC to calculate TAB is of the view that as the amortisation
benefit can be used to reduce the tax burden of the entire company, it is
appropriate to use the WACC of the company. Proponents of the other
school of thought believe that as the amortisation benefit is calculated on an
intangible asset which is valued based on its own attributable cash flows
/earnings / cost savings which are separate from the business, the intangible
asset specific discounting rate should be used.
Both approaches are followed and are in vogue. The Valuation Standards
issued by the Institute of Chartered Accountants of India as well the
International Valuation Standards issued by the International Standards
Valuation Council allow the use of both approaches. However one needs to
be careful that the same is applied consistently in the entire Valuation
process. For example, where an intangible asset specific discounting rate is
being used to calculate TAB, the tax rate used to calculate TAB also should
be the one pertaining to the intangible asset and not the business as a whole
and vice versa.
Tax Rate
As mentioned earlier, depending on what discounting rate is being used for
calculation of TAB, the tax rate should be considered so as to be consistent
with the logic.
The duration for which TAB is calculated is directly related to the
amortisation rate. Where the amortisation method followed is the straight line
method, the duration would be inversely proportionate to the amortisation
rate. For eg. if the amortisation rate prescribed is 10%, then the duration over
which the benefit would accrue would be 10 years. In some countries, the life
itself is prescribed such as the US where the amortizable life prescribed is 15
years. In countries like India, the amortisation rate prescribed is 25% per
annum and the method prescribed is the written down value method. As the
method prescribed is a reducing balance method, TAB is generally calculated
for a duration by which the present value of the tax savings becomes
Although transactions involving intangible assets have increased, Valuation
of intangible assets is not as widely accepted or understood as say a

Valuation: Professionals' Insight

business or an equity Valuation and because the information available in
public domain about intangible assets exchanging hands is limited. In India, it
is easy to err. In India, the value of TAB can constitute almost 25% to 30% of
the value of the intangible asset and hence it is a double edged sword that
should be understood and applied with caution depending on the purpose of
the Valuation, the Valuation approach and the tax laws of the relevant

                                                                Chapter 15
              Valuation of a Financial Service
India has a diversified financial sector undergoing rapid expansion, both in
terms of strong growth of existing Financial Service Companies and new
entities entering the market. The sector comprises of Commercial Banks,
Insurance Companies, Non-Banking Financial Companies, Co-operatives,
Pension Funds, Mutual Funds and other smaller Financial Entities. The
Government of India has introduced several reforms to liberalise, regulate
and enhance this industry. But valuing such companies has its own
The two major challenges in valuing a Financial Service Company are:
Debt: The debt of a Financial Service Company is difficult to define and
measure, making it difficult to estimate firm value or cost of capital. In a non-
Financial Service Company, funds are raised through equity as well as from
debts to make its investment. When we value the firm, we value the assets
owned by the firm and not just the equity value of the firm. But for most of the
Financial Service Companies, debts are raw material rather than a source of
capital. The Financial Service Company raises debt to fund its operation and
earn operating revenue. Thus, defining debt in a Financial Service Company
is extremely difficult.
Estimating cash flow: Financial Service companies are highly regulated.
The regulatory authority governs where they can invest their fund and how
much they can invest. Two major reinvestment items are net capital
expenditure and change in working capital. However, financial company has
its own challenges. Unlike a non-financial company which invests in plant
and machinery, land and building and other fixed assets, a Financial Service
Company primarily invests in marketing, human capital and other intangible
assets like brand name. Such investments are often categorized as operating
expenses and are expensed out in books. With, working capital we face a
different problem i.e. to categorise debt and investment into current or non-
current, inter-changing such number can give a bizarre Valuation.
Valuation: Professionals' Insight

Thus, due to the above mentioned challenges in debt and cash flow,
"Discounted Cash Flow Method" ­ the method which is most commonly used
for valuing a firm is not suitable for valuing a Financial Service Company.
Under "Discounted Cash Flow Method" we value firms by discounting
expected After Tax Cash Flows prior to debt payments at the weighted
average cost of capital and we value equity by discounting cash flows to
equity investors at the cost of equity. Estimating cash flows prior to debt
payments at weighted average cost of capital is problematic as the nature of
debt cannot be easily identified. To value equity, we have to estimate free
cash flow to equity, defined as follows:
Free Cash flow to Equity = Net Income available to Equity Shareholders +
Depreciation ­ Change in non-cash working capital ­ Net Capital Expenditure
­ Net Debt repayment.
Since we cannot estimate capital expenditure, working capital and nature of
debt in a Financial Service Company as discussed before, we cannot clearly
estimate the Free Cash flow to Equity.
We now look at the different Valuation methodology which can be used to
value a Financial Service Company.
(a)   Excess Return Model: The Value of Equity under the "Excess Return
Method" can be derived as the sum of Value of Equity as on the date of
Valuation and the present value of expected excess returns to the Equity
The given model focuses on just the value of equity in a firm, thus eliminating
the difficulty in defining the nature of debt in a financial company.
Value of Equity = Value of Equity as on the date of Valuation + Present Value
of Expected Excess Returns to the Equity Investors.
The model focuses on its excess returns earned by the equity investors of
the company over the fair market rate of return on such investments. A firm
that earns below the market return on its equity investment will see its equity
value dip below the equity capital currently invested and vice versa.
The Value of Equity as on the date of Valuation is usually the Book Value of
Equity of the company. The Book Value of Equity of the Financial Service
Company is more reliable measure to consider as the Value of Equity for
various reasons. First, unlike in a Non-Financial Service Company where
depreciation plays a major role in determining the Book Value of Firm,

                                    Valuation of a Financial Service Company

depreciation is often negligible in a Financial Service Company. Secondly,
the assets of a Financial Service Company are often financial assets and
hence are marked up to market, thus eliminating the deviation between book
value and market value of such assets.
The Excess Returns can be stated as the difference between Profit after tax
to equity shareholders and equity cost.
Excess returns = Profit after tax to Equity Shareholders ­ Equity Cost
The profit after tax to Equity Shareholders can be derived based on mutli-
year forecast, similar to the projections as required for "The Discounted Cash
Flow Method".
The equity cost shall be determined by the general market expectation for
such investments. To ascertain the equity cost, cost of equity shall be
multiplied by the average book value of equity.
Cost of Equity shall be derived based on Capital Assets Pricing Model and is
computed as under:
Cost of Equity = Risk Free Rate of Return + Beta (Market Risk Premium)
Equity Cost = Cost of Equity * Average Book Value of Equity
The Terminal Value of Excess Returns to Equity Investor can then be
computed by applying Gordon Growth Model.
                   Expected Excess Return of Explicit forecast period(1+g)
Terminal Value =

Where: CoE = Cost of Equity

        g = constant growth rate beyond the forecast horizon
Terminal Value is then discounted to its present value using the discounting
factor for the last year of the forecast horizon.

(b)    Assets Based Valuation: In this model, we value assets of the
Financial Service Company, netting off the debt and other liabilities and the
difference is the value of equity.
The biggest merit of this model while valuing a Financial Service Company is
that the assets held by a financial service company are often financial assets
and hence are marked up to market, thus eliminating the need to revalue the
assets as on the Valuation date.

Valuation: Professionals' Insight

But this model has its own limitations, in as much as it ignores the growth
potential of the company, thereby ignoring the future earning potential of the
business. It is also difficult to arrive at the value of intangible assets, like
brand name, human capital, etc.
(c)    Relative Valuation: Under the Relative Valuation Approach, series of
multiplies are used to value firms.
Multiplies such as "Value to EBITDA" or "Value to EBIT" cannot be easily
used to value Financial Service Companies, as neither Value nor Operating
Income can easily be estimated for Financial Service Companies.
For valuing a Financial Service Company, the multiples which can be used
must be equity linked multiplies like price earnings ratio and price to book
value ratios.
Price Earnings Ratio: Also known as the price multiple or the earnings
multiples, the ratio for valuing a company that measures its current share
price relative to its per-share earnings.
                                  Market Value Per Share
         Price Earnings Ratio =
                                    Earnigs Per Share

An issue, specific to valuing a Financial Service Company using P/E ratio is
the use of provisions for expected losses: eg provision for non- performing
assets by banks. Such provisions reduce the reported income and affect the
reporting P/E ratio. Banks which are more conservative about categorizing
bad loans will report lower earning and have higher P/E ratio, whereas banks
that are less conservative will report higher earnings and lower P/E ratio.
Price to Book Value Ratio: This ratio expresses the relationship between
the price of share to the book value of equity per share.
The higher growth rates in earnings, lower cost of equity and higher returns
on equity all results in lower price to book ratios. The strength of the
relationship between price to book ratios and return on equity should be
stronger for Financial Service Company than for Non-Financial Service
Company, as the book value of equity of Financial Service Company is much
likely to be in line with market value of the equity invested in existing assets.
Valuation principles for valuing a Financial Service Company are the same
as those of Non-Financial Service Company. However, the methodologies
used in both the companies are quite different. This is mainly because, first

                                   Valuation of a Financial Service Company

in a Financial Service Company it is difficult to categorize the nature of debt
and secondly estimating cash flow has it's own challenges with capital
expenditure and working capital, which are not easily estimated in Financial
Service Company. Excess Return Method which focuses on excess return
earned by equity investor on the equity investments is by far the most
suitable method under income approach for a Financial Service Company.
 Under relative Valuation we face challenges in using multiplies like Value to
EBITDA or Value to EBIT as neither value nor operating income can be
easily estimated for Financial Service Company. Hence, price to earnings
ratio and price to book value ratio are the most suitable methods under the
relative approach.

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