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Educational Material on ICAI Valuation Standard- 301- Business Valuation as brought out by VSB ICAI and ICAI RVO
February, 19th 2021

Educational Material on
ICAI Valuation Standard 301-

Business Valuation

Valuation Standards Board
and

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.

DISCLAIMER:

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 : February, 2021

Committee/Department : Valuation Standards Board

E-mail : valuationstandards@icai.in

Price : ` 250/-

ISBN No : 978-81-8441-

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.

Typeset by : Elite-Art, New Delhi

Printed by : Sahitya Bhawan Publications, Hospital
Road, Agra 282 003
Foreword

As we all know that Valuation also forms 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.

Business Valuation, the process of determining the true value of a business,
differs for each and every assignment since every assignment and business is
unique in its own way due to the various parameters existing on the date of
valuation.

In order to have a uniform practices across the country and promote Make in
India and concept of Aatma Nirbhar Bharat of Government of India under the
able leadership of Prime Minister Sh. Narendra Modiji, the Institute of
Chartered Accountants of India formulated and issued ICAI Valuation
Standards 2018 which provide detailed guidance and are in conformity with
the Laws and Regulations in India. One of the Standards is specifically on
Business Valuation. This Standard contains additional requirements that
valuer needs to consider while undertaking business / share valuation.

Considering the complexity and distinctiveness, it was felt that an Educational
Material that elucidates in depth, various requirements under ‘ICAI Valuation
Standard 301: Business Valuation’ along with practical aspects, Case studies
may be brought out.

At this juncture, I compliment Valuation Standards Board of ICAI and ICAI
Registered Valuers Organisation in taking this joint initiative and coming out
with this ‘Educational material on ICAI Valuation Standard 301: Business
Valuation’, to facilitate the valuers in understanding various aspects of
business valuation and drive greater efficiency in valuation activities
undertaken by them.

I extend my sincere appreciation to the entire Board of ICAI RVO and Valuation
Standards Board of ICAI specially to CA. Pramod Jain, Chairman and CA.
Dheeraj Kumar Khandelwal, Vice- Chairman of the Board for initiating this
Educational Material.
I am of the firm belief that this Educational Material would be of great help for
the stakeholders.

Date: 4th February 2021 CA. Atul Kumar Gupta
Place: New Delhi President ICAI

Director ICAI RVO
Preface

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. 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.

Business Valuation is an act or process of determining the value of a business
enterprise or ownership interest therein which involves many assumptions and
hence cannot be expected to provide a precise estimate of value. Valuation of
business is a complex assignment which requires informed judgement and
decision making.

The Institute of Chartered Accountants of India issued ICAI Valuation
Standards 2018 and one of the standards is on Business Valuation. ICAI
Valuation Standard -301 on Business Valuation describes the basic principles
which govern the valuer’s professional responsibilities and which shall be
complied with whenever an engagement to estimate value is carried out. It also
prescribes usage of multiple methods in valuation instead of single method for
better judgement and greater comfort in finalizing the valuation

As part of its continuous attempt towards knowledge dissemination, the
Valuation Standards Board of ICAI jointly with the ICAI Registered Valuers
Organisation (ICAI RVO) has brought out this Educational Material on ICAI
Valuation Standard- 301, Business Valuation. The purpose of this Educational
Material is to provide guidance by way of illustrations and Frequently Asked
Questions (FAQs) explaining the principles enunciated in the Standard.

This Educational Material contains summary of ICAI Valuation Standard- 301
discussing the key requirements of the Standard in brief, Case Studies,
Illustrations and the Frequently Asked Questions (FAQs) covering the issues,
which are expected to be encountered frequently while implementing this
Standard. The text of ICAI Valuation Standard- 301 has been included as an
Appendix to make this publication comprehensive.

We may bring to the kind attention of the readers that the views expressed in
this publication are the views of the Valuation Standards Board and are not
necessarily the views of the Council of the Institute. The purpose of this
publication is to provide guidance for implementing this ICAI Valuation
Standard effectively by explaining the principles enunciated in the Standard
with the help of examples. However, while applying Valuation Standards in a
practical situation, reference should be made to the text of the Standard.

In this connection, we take this opportunity in thanking the President of ICAI
CA. Atul Kumar Gupta and Vice President, CA. Nihar N. Jambusaria for their
thought leadership and continued encouragement in bringing out the
publication.

We would also like to convey our sincere thanks and gratitude towards the
Board of ICAI RVO comprising of Shri Rajeev Kher, Chairman of the Board
and other Directors, Shri Pawan Singh Tomar, Shri Ashok Haldia, Prof. Anil
Saini, Shri Prafulla P. Chhajed and Shri Rakesh Sehgal for taking this joint
initiative and to provide guidance on implementation of ICAI Valuation
Standard 301- Business Valuation.

We also wish to place on record our appreciation to members of the Valuation
Standards Board, Co-opted members and Special Invitees for their help and
guidance in framing and bringing out this publication.

We, on behalf of the Valuation Standards Board, would like to put on record
our appreciation to CA. T. V. Balasubramanian, CA. Parag Kulkarni, CA. Tarun
Mahajan, CA. Janani Vijaykumar and CA. S. V. Mathangi for their contribution
in developing this Educational Material.

We would like to thank CA. Sarika Singhal, Secretary, Valuation Standards
Board and CEO Designate ICAI Registered Valuers Organisation, Ms. S. Rita,
Deputy Secretary ICAI, Ms. Seema Jangid, CA Pragya Agrawal and CA.
Vaishali Sharma for initiating this Educational material and for providing
technical and administrative support in finalising the Educational Material.

We sincerely believe that this Educational Material will be of great help in
understanding the requirements of ICAI Valuation Standard 301 and in
implementation of the same.

CA. Pramod Jain CA. Dheeraj Kumar Khandelwal
Chairman Vice-Chairman
Valuation Standards Board, ICAI
Valuation Standards Board, ICAI

Date: 3rd February, 2021
Contents

ICAI Valuation Standard 301 (Business Valuation) — Summary ......................... 1
Business Valuation Process – Detailed study of Steps Involved ........................ 23
Equity/Business Valuation – Critical Business Analysis and Key Tools Used for
same................................................................................................................... 54
DCF Valuation – Practical Approach .................................................................. 70
Valuation of Start-up Companies........................................................................ 81
Business Valuation under Mergers and Acquisitions........................................ 100
Frequently Asked Questions ............................................................................ 106
Illustrations ....................................................................................................... 116
Case Studies .................................................................................................... 136
Detailed Case Study of an automobile company to recommend ‘buy or not to buy
decision’ with Monte Carlo Simulation .............................................................. 161
APPENDIX “A”: ICAI Valuation Standard- 301
Business Valuation ........................................................................................... 179
Chapter-1

ICAI Valuation Standard 301
(Business Valuation) — Summary

[The purpose of this summary is to help the readers gain a broad
understanding of the principal requirements of ICAI VS- 301 (or ‘the
Standard’). Reference should be made to the complete text of the Standard for
a complete understanding of these requirements or in dealing with a practical
situation.]

1. Background and Scope

The Standard prescribes guidance for business valuers who are performing
business valuation or business ownership interests valuation engagements
and describes the basic principles which govern the valuer’s professional
responsibilities and which shall be complied with whenever an engagement to
estimate value is carried out.

ICAI VS 301 should be applied in valuation for business and business interest,
except the following:

a. where any requirement of the Standard is inconsistent with the
requirements prescribed; or

b. valuation procedures specified by any law, regulations, rules or
directions of any government or regulatory authority, or Court order.

2. Business Valuation

Business Valuation is the act or process of determining the value of a business
enterprise or ownership interest therein.

Business valuation is required for transactions including fund raising, mergers
& acquisitions (M&A), sale of businesses, strategic business decisions like
family or shareholders disputes, voluntary value assessment and also for
regulatory compliance, tax and financial reporting. Valuations of business,
business ownership interests may be performed for a wide variety of purposes
including the following:
EM on ICAI Valuation Standard 301 Business Valuation

a. Valuation of financial transactions such as acquisitions, mergers,
leveraged buyouts, initial public offerings, employee stock ownership
plans and other share-based plans, partner and shareholder buy-ins or
buy-outs, and stock redemptions;

b. valuation for dispute resolution and/ or litigation/pending litigation
relating to matters such as marital dissolution, bankruptcy, contractual
disputes, owner disputes, dissenting shareholder and minority
ownership oppression cases, employment disputes, etc.;

c. Valuation for compliance oriented engagements, like financial reporting;
and tax matters such as corporate reorganisations, purchase price
allocations etc.

d. valuation for other purposes like the valuation for planning, internal use
by the owners etc;

e. valuation under Insolvency and Bankruptcy Code.

3. Types of Business Values

When valuing a business or business ownership interest, a valuer may express
either an exact number or a range of values. There could be different
benchmarks at which the estimate of value of an entity could be expressed by
the Valuer. For example:

a. Enterprise Value

b. Business Value

c. Equity Value

These are explained below:

a. Enterprise Value: Enterprise Value is the value attributable to the
equity shareholders plus the value of debt and debt like items, minority
interest, preference share less the amount of non-operating cash and cash
equivalents. It can also be formulated as:

Enterprise value = Common equity at equity value + Debt at market value +
Minority Interest at market value, if any - Short term and
long-term investments - Associate company at market
value, if any + Preference capital at book value - Cash
and cash-equivalents.

2
ICAI Valuation Standard 301 (Business Valuation) — Summary

Also,
Enterprise Value = Free Cash Flow to the Firm (“FCFF”)/ Weighted Average

Cost of Capital = (Earnings Before Interest and Tax * (1-
tax rate) + Depreciation – Capital Expenditure – Increase
in Non-Cash Working Capital)/ WACC
b. Business Value: Business value is the value of the business
attributable to all its shareholders including equity shareholder, redeemable
preference share, Cumulative preference shareholders etc.
c. Equity Value: Equity Value is the value of the business attributable to
equity shareholders after all expenses, reinvestments and debt obligations
have been met by the company.
Equity Value = Free Cash Flow to Equity (“FCFE”)/ Cost of Equity
= (Net Income or Profit After Tax + Depreciation & Amortization
– Capital Expenditure – Increase in Non-Cash Working
Capital + Change in Debt)/ Cost of Equity
Equity value is calculated by multiplying price of a single share of stock with
the number of equity shares outstanding whereas enterprise value is
calculated after deducting cash, investments and adding debt from equity
value.
The key difference between the Equity and Enterprise Value is that Equity
value is the total value of all outstanding Equity stock of the company whereas
enterprise value is the total worth of a company including the net debt.

4. When is Valuation required?

Valuation is required in any of following cases:
1. Strategic

a. Pre-transaction valuation
b. Swap ratios for merger
c. Fairness Opinions for transactions
2. Restructuring
a. Transfer of holding companies across jurisdictions
3. Regulatory/ Tax

a. FEMA valuations

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EM on ICAI Valuation Standard 301 Business Valuation

b. Tax valuations
4. Financial Reporting/Taxation Driven

a. Purchase Price allocation
b. Impairment testing
Above is not an exhaustive list.

5. Issues in Business Valuation.

Typically while undertaking business valuation, some of the key issues which
arise are as under:
• Issues in forecasting
• Selection of methods
• Difficulty in obtaining comparable multiples
• Thinly traded/ Dormant Scrip - Low Floating Stock, Unusual fluctuations

in Market Price
• Loss making companies
• Start-up companies
• Valuation of e-commerce companies – Which is the appropriate

method?
• Illiquidity discount & control premium
• Transaction Structure
• Procedural and Regulatory Issues
• Management Representations and the extent to which it could be relied

upon
Some of these aspects have been discussed in detail in the appropriate place
in this document.

6. Valuation Approaches and methodologies –
Business/Enterprise Valuation

Globally Accepted Approaches to Value

4
ICAI Valuation Standard 301 (Business Valuation) — Summary

Valuation
Approaches

Market Income Cost
Approach Approach Approach

Approaches and Methodologies Market Cost Approach
Approach Income Approach Approach

Value Income Approach considers Estimates the fair Fair value is based on
Estimation the expected cash flows/ value based on summation of net
income the business is market multiples assets in the balance
expected to generate and is or transactions sheet/ replacement
considered most appropriate involving sale of cost – adjusted for
in case of a ‘going concern’. comparable assets. amortisation/
obsolescence.

Methods Discounted Cash Flow Comparable Summation of
(‘DCF’)/ Capitalization Market/ individual

of Earnings Transaction piecemeal values
Multiples of assets less value
of liabilities in the

balance sheet/
Replacement Cost

Steps in selection of methods.
The key factors that a valuer needs to consider while selecting an approach

are as under:
• nature of asset to be valued;
• availability of adequate inputs or information and its reliability;
• strengths and weakness of each valuation approach and method; and
• valuation approach/method considered by market participants.

5
EM on ICAI Valuation Standard 301 Business Valuation

Situation Approach

Knowledge based companies Income/Market

Manufacturing Companies Income/ Market/ Cost

Brand Driven companies Income/Market

Investment/Property Cost/ Income
companies

Company going for liquidation Cost

7. Income Approach

The income approach involves looking at an entity’s financial history or past
financials trends to make projections about their future profits / cashflows.
There are two methods typically used for valuing a company using the income
approach:

The capitalization of net income / cash flow method is used to determine value
by dividing the historical net income / cash flows of a business by its
capitalization rate, a rate that reflects the riskiness of a business and its
expected growth in the future. In this approach the upside is that it uses actual
net income / cashflows from the company’s past, however the downside is
assuming the future will be representative of the past.

The discounted cash flow method arrives at a value by projecting the cash
flows in the future and then discounting the cash flows back to the date of the
valuation. The advantage of this approach is that the value considers the future
cashflows, however the disadvantage is that it is often difficult to predict the
future.

Discounted Cash Flow method has following advantages and limitations:

• Forward-looking and focuses on cash generation;

• Recognises time value of money;

• Allows operating strategy to be built into a model;

• Only as accurate as assumptions and projections used;

• Works best in producing a range of likely values

6
ICAI Valuation Standard 301 (Business Valuation) — Summary

7.1 DCF Methodology
Discounted Cash Flow Method has three broad steps; namely
i) Forecasting Cash Flow
ii) Discounting Factor derivation &
iii) Terminal Value Consideration
7.1.1 Forecast cash flows
a) Key factors to be considered while projecting cash flows

• For whom? (equity shareholders or firm) – FCFF vs. FCFE
• Real vs. nominal cash flows
• Currency used for projections
• Length of forecast period:

- Theoretically, till company’s growth reaches sustainable growth
period

- 3-5 year period common in practice
- Longer periods suitable for finite life projects and / or early

negative cash flow (infrastructure projects)
- In cyclical industries, must ensure that the entire cycle is

captured in the ‘projection period’
- Accuracy of the DCF is heavily dependent on the quality of

forecasts.
b) Specific consideration to be kept in mind while estimating future cash

flows in accordance to IND AS-36

• The Standard specifies that, “an entity shall base cash flow
projections on reasonable and supportable assumptions that
represent management’s best estimate of the range of economic
conditions that will exist over the remaining useful life of the asset.
Greater weight shall be given to external evidence.”

• Base cash flow projections utilized for the Value in Use, shall
exclude any estimated future cash inflows or outflows expected to
arise from future restructurings (to which an entity is not yet
committed) or from improving or enhancing the asset’s
performance.

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EM on ICAI Valuation Standard 301 Business Valuation

• Projections based on budgets/forecasts shall cover a maximum
period of five years unless a longer period can be justified.
Management may use cash flow projections longer than five years
if it is confident that these projections are reliable and it can
demonstrate its ability, based on past experience, to forecast cash
flows accurately over that longer period.

• The Standard guides entities to estimate cash flow projections
beyond the period covered by the most recent budgets/forecasts
by extrapolating the projections based on the budgets/forecasts
using a steady or declining growth rate for subsequent years
unless an increasing rate can be justified. This growth rate shall
not exceed the long- term average growth rate for the products,
industries, or country or countries in which the entity operates, or
for the market in which the asset is used, unless a higher rate can
be justified.

Illustration 1

Management of Company ABC Limited has prepared historical financials
as well as projections. The workings have been provided to you to
perform an independent valuation. What should be the queries/thoughts
for following:

1. Key observations based on your preliminary review before discussing
the provided information with Management;

2. Additional data and clarifications you would request from the client;

3. Areas of the cash flow analysis that would require your special
attention.

Answer

Key observations:

• Historical P&L is it correct? Historical performance vs. Projections – are
there large variances?

• Does management have enough visibility to build a long-term forecast?

• Basis of projected revenue, operating expenses/margins

• How do the projected revenues and operating expense compare to the
industry and to market participants?

8
ICAI Valuation Standard 301 (Business Valuation) — Summary

Additional data and clarifications to be requested from the client:
• Details on underlying projected revenue and operating expenses
• Tax computation including treatment of historical losses
• Projected balance sheets to support forecasted working capital

assumptions
• Supporting evidence for long term capital expenditure.
Areas of the cash flow analysis that you would focus upon:
• Detailed discussions with Management to understand the drivers of the

cash flows
• How is the business expected to perform compared to historicals and

current year to date performance
• Assessment of key business risk factors and their impact on the

discount rate selected
• Revenue growth and EBITDA margins benchmarking with industry and

competitors
• Cash flow scenario analysis
7.1.2 Discount Rate Derivation

We determine discount rate to measure the risk and return that investors
expect from the business/entity.

For calculating Equity Value using Free Cash Flow to Equity, we use Cost of
Equity (COE) as discount rate while for calculating Enterprise Value using Free
Cash Flow to Firm approach, Weighted Average Cost of Capital (WACC) is
used to discount the future cash flows. Of course, to both the COE and WACC,
suitable premiums or discounts may be adjusted to arrive at the discount rate
based on the factors such as liquidity, control, size, specific risks etc.

The Cost of Equity (“COE”) reflects the return expected by the equity
shareholders, to compensate for the risk assumed through their investment in
the business.

The Cost of Debt (“COD”) is based on the current or expected borrowing rate
for the company, which may be provided by the management of the company
and is generally assumed to be the market rate.

The weighted average cost of capital (“WACC”) is based on the

9
EM on ICAI Valuation Standard 301 Business Valuation

proportionate weights of each component of the source of capital, i.e.,
Weighted average of COE and COD wherein the ratio of Equity/Debt on total
capital is the proportionate weights.

DCF methodology– WACC - Discount Rate Derivation

WACC = Kd x D + Ke x E

D+E D+E

Post tax cost of debt Cost of equity (CAPM)

Kd = (Rf + DM ) x (1-t) Ke = Rf + (β x ERP) + Alpha

Where; Where;
kd - Cost of debt financing ke - Cost of equity financing
Rf - Risk-free rate of return Rf - Risk-free rate of return
DM - Debt margin β - Beta
T - Tax rate ERP - Equity market risk premium
D - Debt Alpha – Company specific risk
E – Equity premium

Illustration 2

Particulars 31 March 2018
Risk free rate 7.4%
Market Risk-premium 7.0%
Unlevered beta (industry average) 0.73
Debt-Equity ratio 22%
Re-levered beta 0.89
Cost of debt (pre-tax) 10.8%
Tax rate 27.82%
Cost of debt (post-tax) 7.8%
Cost of Equity 13.6%
WACC(Post-Tax)- Rounded
12.50%

7.1.3 Terminal Value Consideration

The terminal value captures value beyond the explicit projection period into
perpetuity and is consistent with a “going concern” premise. Caution has to be

10
ICAI Valuation Standard 301 (Business Valuation) — Summary

applied when the ability of a business to generate cash flows into perpetuity is
questionable.
The terminal value could account for a significant portion of total value
especially for cases where subdued growth is expected over the explicit
period. The cash flows utilized to determine the terminal value should reflect
the “normalized” annual level of cash flows that the business expects to earn.
i.e.. has depreciation, capex, working capital and tax been normalized? Long
term growth assumptions have a profound impact on this computation.
a) Terminal Value Computation
Common models considered while computing terminal value:
• Gordon growth or constant growth model: Suitably applied in cases

where the business has or is close to achieve a mature stage of growth
by the end of the explicit period cash flows.
• Two Stage/Multi period growth model: Technically sound, but requires
assumptions on growth post the discrete period.
• Exit multiple: A suitable market based multiple is applied to the
appropriate normalized cash flows to arrive at the terminal value.
b) Gordon Growth Model
It is the most commonly used method for terminal value computation and its
formula is as under
PV = Eo (1+g)/(k-g)
Where
Eo = Economic cash flows expected in the last year of the discrete period
forecasts;
k = discount rate applicable to the forecasts;
g = long-term growth rate

11
EM on ICAI Valuation Standard 301 Business Valuation

Illustration 3

Terminal Value - Constant growth model Amount Rs in Mn
Free cash flows for terminal year 107
Discount rate (k)
Long term growth 14.50%
Value at the end of explicit period 4.00%
Present Value factor (say)
Terminal Value 1020
0.54
555

Illustration 4
DCF Methodology

INR Million Fiscal Year ending March 31, Normalize
d Period
Particulars 2018 2019 2020 2021
Operating 430 481 529 569 2022
Revenue
Revenue 603 627
growth
Operating 15.0% 12.0% 10.0% 7 .5 6.0% 4.0%
EBITDA 113 140 161 % 180 188
EBITDA
Margin 17 1
Tax
Depreciation 26% 29% 30% 30% 30% 30%
EBIT
EBIT Margin 11 11 12 14 15 19
Tax
Tax as % of 103 129 149 157 165 169
EBIT 24% 27% 28% 28% 27% 27%
Operating
Income 35 44 51 53 56 57
(After Tax) 33.39 33.39 33.39 33.39 33.39 33.39%
Plus:
Depreciation % % % % % 111
68 85 98 104 109

11 11 12 14 15 19

12
ICAI Valuation Standard 301 (Business Valuation) — Summary

INR Million Fiscal Year ending March 31, Normalize
d Period

Particulars 2018 2019 2020 2021 2022

Less : Capex 19 14 15 31 16 19

as % of 4% 3% 3% 5% 3% 3%
Revenue

Less : 14 10 9 6 6 4

Change in

NWC

NWC 79 89 98 104 110 114

as % of 18% 18% 18% 18% 18% 18%
Revenue

Free Cash 46 73 86 80 103 107
Flows

Partial period 1.0 1.0 1.0 1.0 1.0
factor

Mid-year 0.5 1.5 2.5 3.5 4.5
convention

Present Value 0.93 0.82 0.71 0.62 0.54
factor 14.5%

PV of Free 43 59 62 50 56
Cash Flows

Terminal Value – Constant Growth Model 107
Free cash flows for terminal year 0.145
Discount rate (k) 0.04
Growth at the end of explicit period 1020
Value at the end of explicit period 0.54
Present Value factor
Terminal Value 555
Sum of explicit period cash flows 270
Add: Terminal Value 555

13
EM on ICAI Valuation Standard 301 Business Valuation

Enterprise Value 824

Add: Surplus Assets 15

Less: Debt 50

100% Operating Equity 789

Capitalization of Earnings Method

It estimates value based on the expression for the value of a growing
perpetuity and is essentially a stable growth (single stage) free cash flow
mode. It is very occasionally seen in the valuation of private companies and is
used most often for the valuation of annuity based/stable private companies.
It is rarely used for the valuation of public companies, larger private
companies, or in the context of acquisitions or financial reporting.

V f = FCFF1/(WACC – g f )  

where:
Vf = Value of the firm
FCFF1 = Free cash flow to the firm for next twelve months
WACC = Weighted average cost of capital
g f = Sustainable growth rate of free cash flow to the firm

Loose ends that matters in Income Approach

i) Garbage in garbage out! How realistic are your projections?
- Is the business on track to achieve the projections?

- What is the basis for growth in market share?

- How do EBITDA margins compare with the industry?
ii) Terminal value assumptions:

- Terminal growth assumptions
- Sustainable profitability

- Re-investment capital expenditure and working capital

- Tax rate into perpetuity

iii) Factoring non-operating assets and liabilities in the valuation

iv) Value of synergies (in a transactional setting) which may need to be
factored.

14
ICAI Valuation Standard 301 (Business Valuation) — Summary

8. Market Approach

The Market approach is a relative valuation approach that estimates the value
of a business by looking at the pricing of similar companies / transactions
relative to a common set of variable(s). The following are the common
methodologies for the market approach

a) Market Price Method
b) Comparable Companies Method (CCM)

c) Comparable Transaction Multiple (CTM)
Market Price method would apply when the business is itself having a market
quote available for it. For instance, listed company shares could be valued by
shareholders using the market price available from the listed markets itself.
In respect of cases where there is no direct market price quote available,
comparable companies or transactions could be used instead.

Major steps in deriving a value using the CCM/CTM method:

Define the
multiple

Apply the Market Describe the
multiple Approach multiple

Analyse
the

multiple

Types of Market Multiples – based on guideline/comparable companies
Multiple is computed by dividing the price of the guideline company’s stock as
on the valuation date (Market Capitalization or Enterprise Value) by a relevant
economic variable observed.

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EM on ICAI Valuation Standard 301 Business Valuation

The most common Multiples used are
• EV/Revenue
• EV/EBITDA
• EV/EBIT
• P/E
• P/B
Examples of Industry Specific Multiples:
EV/operating beds – relevant in hospitals EV/MW – relevant in power
generation EV/Room – relevant in hotels
Careful consideration must be given while selecting which type of multiple is
most relevant given the nature of the valuation subject.
The merits and demerits of various multiples under Market/relative Valuation
is as under
a) Enterprise Value/EBIDTA

• EBITDA is the closest proxy in the P&L for cash flow from
operations

• It cannot be used in case of negative EBITDA
• It eliminates the impact of financial leverage like the EV to Sales

multiples
• Impacted by accounting policies, except for depreciation policy
b) Price/Earnings
• It is widely used due to simplicity of computation and easy

availability:
• One needs to be cautious
• There can be differences in accounting policies and hence

unviable
• It cannot be used when earnings are negative
• Considerations

a. Growth phase

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ICAI Valuation Standard 301 (Business Valuation) — Summary

b. Stock liquidity and trading volumes

c. Comparable time period

c) Price to Book Value

Book value of equity is:

Difference between book value of assets and book value of liabilities

It is a relatively intuitive measure of value which can be compared to the
market price:

• Firms with negative earnings can be evaluated
• Cannot be used when book value itself is negative
• Book values, like earnings, are affected by accounting policies

Illustration 5

Subject Co.'s Particulars (INR Mn) TTM March 2018

Revenue 57.2
Operating EBITDA 8.0
EBITDA margins 13.9%

TTM MARCH 2018

EV/ Revenue EV/EBIDTA

Low High Low High

Selected Market Multiple 0.8x 0.9x 8.0x 10.0x
Range
57 57 8 8
Selected TTM March 2018
Financial Metric 46 52 64 80

Enterprise Value 11 11 11 11

Less: Debt 35 41 53 69

Non-controlling minority
equity value

9. Cost Approach

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In this approach value of business is equivalent to the Value of underlying
assets and liabilities appearing in the balance sheet of the Company
a) Value of an asset can be based on the cost to purchase or the cost to

construct an asset of equal utility (Based on the concept of substitution)
and that no one would pay more for an asset than it costs to replace it
b) This approach is applicable in the following situations:
i) Businesses with no or limited on-going operations
ii) Valuation of tangible and certain intangible assets
c) It is most applicable for following businesses: -
i) A loss making Company
ii) A Real – Estate (Land Stage Company)
iii) A company making inadequate return on capital
iv) Any company facing potential liquidation
d) It is least applicable for following entities:-
i) A service industry company
ii) A non-capital intensive business
iii) A company with substantial Intangible Assets
iv) A high growth company

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ICAI Valuation Standard 301 (Business Valuation) — Summary

10. Adjustments in Valuation

Control • The power to declare dividends
Premium • The right to name persons to the board of directors
• The ability to set one’s own compensation
Minority • The power to liquidate the business
Interest • The right to sell the business or its assets
Discount
• Minority interests are worth less than majority/control interests.
• The minority shareholder, even with voting rights, is unable to

effectively influence the affairs or fortunes of the business.
• If the valuation methods employed yield a conclusion that reflects

the benefits (and power) of control, an appropriate discount must
be applied to the result before an opinion of minority interest
value is formed.
• Reciprocal of premium for control may be considered for
benchmarking:

Minority Discount = 1 – [1 / (1 + control premium)]

Lack of • Stock is perceived to have a higher value the quicker it can be
Marketability converted to cash

Now let us look at each of them in detail:

10.1 Control Premium and Discount for Lack of Control

Control Premium generally represents the amount paid by acquirer for the
benefits it would derive by controlling the acquiree’s assets and cash flows.

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.

But why would a buyer pay more for control?

Business owners consider a controlling interest to have greater value than a
minority interest under the premise that the purchaser will be able to effect
changes in the business structure and influence overall business policies.
Empirical market data corroborates that control premiums observed in
successful transactions vary greatly.

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Amongst the plethora of factors affecting the magnitude of a given control
premium select factors could include:

i) The nature of business opportunities which are currently not being
effectively monetized,

ii) Perceived quality of existing management,

iii) The ability of the target company to integrate into the acquirer’s
business and the probability that management will be able to implement
change/new initiatives and,

iv) Competitive landscape of the industry in which the target operates.

Determining an appropriate level of Control Premium and DLOC can be
subjective process accordingly, the specific nature and characteristics of the
asset and the facts and circumstances surrounding the valuation should be
considered.

A valuer shall use his professional judgement while applying control premiums
and DLOC, considering the factors such as amount/ extent of control in the
asset to be valued, distribution of control of the remaining interest in the subject
entity, statutory provision relating to protection of minority shareholders; the
shareholder protection restrictions contained in the articles of incorporation,
the bye-laws and/or the shareholders’ agreement, blockage discount, etc.

10.2 Discount for Lack of Marketability (DLOM)

DLOM is based on the premise that an asset which is readily marketable
commands a higher value than an asset which requires longer period / more
efforts to be sold or an asset having restriction on its ability to sell.

An investor will always pay less for an illiquid asset when compared with a
similar asset with higher liquidity. Liquidity means ability to buy or sell rapidly
in large volumes without incurring significant cost and without affecting the
price materially. One way of capturing the cost of illiquidity is by determining
the difference between the transaction cost of less liquid assets as compared
to more liquid assets.

Transaction costs are the costs to sell an asset or transfer a liability in the
principal (or most advantageous) market for the asset that is directly
attributable to the disposal of the asset or transfer of liability and which meet
both the following criteria:

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ICAI Valuation Standard 301 (Business Valuation) — Summary

i) they result directly from and are essential to that transaction;
ii) they would not have been incurred by the entity, had the decision to sell

the asset or transfer the liability not been made.

Hence, transaction cost consists of directly attributable costs like brokerage,
commission, marketing cost, duties etc. but there are many indirect costs too
like market impact cost. Market impact costs are incurred by extracting liquidity
from the market in order to acquire or dispose of a large position of the asset.
If an investor is buying/selling a large block of shares, the stock price will
increase/decrease (all else remaining equal) due to change in the demand and
supply economics. Market impact cost is of two types – temporary and
permanent. The temporary component is transitory in nature and reflects the
price concession needed to attract counterparties at the time of order
execution. The permanent component reflects the information that is
transmitted to the market by the buy/sell imbalance.
How much will be the market impact cost for a particular stock/security? The
complex models can provide a probable estimate, but actual impact cost
depends on market conditions at the time of execution.
Generally, restrictions on marketability that are only inherent in the asset to be
valued shall be considered while valuing the asset. Marketability restrictions
that are specific to a particular owner of the asset are not generally considered
for discount adjustment.

Determining an appropriate level of DLOM can be a complex and subjective
process. Accordingly, the specific nature and characteristics of the asset and
the facts and circumstances surrounding the valuation should be considered.

a) Some of the various models which could be used for determining
DLOM are as under:
i) Restricted stock and private placement studies

ii) Initial Public Offering studies

iii) Synthetic bid-ask spreads
iv) Protective put method of David Chaffe

v) Average strike put option of John Finnerty

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b) A valuer shall use his professional judgement while applying
DLOM and consider the relevant factors including but not limited
to-

i) size and nature;

ii) time and costs associated with marketing or for making a public
offer;

iii) restrictions on transferability;

iv) history of past transactions;

v) exit rights; or

vi) lack of or limitation to access to information.

10.3 Synergy
Synergies is a concept which indicates that the combining effect of two or more
assets or group of assets and liabilities or two or more entities in terms of their
value and benefits will be or is likely to be, greater than that of their individual
values on a standalone basis. Synergy is a term that is most commonly used
in the context of mergers and acquisitions.

Synergy results from incremental benefits that accrue to the acquirer on
account of economies of scale or other post-acquisition factors, such as
realisation of increased discretionary cash flow or reduced risk in attaining
same when two businesses combine.

Synergies may arise in any of the visible components of FCF (operating profit
after tax, non-cash deductions, Net working capital, or capital expenditure) or
WACC.

i) Revenue synergies – arising from better pricing, cross-selling,
marketing or selling similar products, gaining access to new markets or
customer segments, sharing distribution channels, reduction or
elimination of competition

ii) Cost synergies – Reduction of costs of employees, administrative or
factory overheads, elimination of excess facilities, increase in
purchasing power

iii) Financial synergies – tax strategies, debt capacity, cash flows with less
than perfect correlation

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Chapter-2

Business Valuation Process –
Detailed study of Steps Involved

Steps in the process of Business Valuation

Business valuation is an estimate of a business or business ownership
interest, arrived at by applying the valuation procedures appropriate for a
valuation engagement and using professional judgment as to the value or
range of values based on those procedures.
In performing a valuation assignment, a valuer shall perform following steps:
• Step 1- Engagement Letter and terms of engagement
• Step 2 - Define the valuation base and premise of the value
• Step 3 - Analyse the business to be valued and undertake accounting

analysis and exercise due diligence
• Step 4- collect the necessary financial and non-financial information

about business, both historical and projected
• Step 5- Identify the adjustments to the financial and non-financial

information for the valuation
• Step 6- consider and apply appropriate valuation approaches and

methods
• Step 7- Arrive at a Value or a Range of Values
• Step 8- Identify the Subsequent Events
• Step 9- Draft and Finalise Valuation Report
The steps are explained in detail hereunder:
1. Step 1: Engagement Letter and terms of engagement
There should be clarity of terms of the valuation engagement between the
valuer and the client and in order to avoid misunderstanding the terms of the
valuation assignment shall be documented in writing in an engagement letter.
Any changes to the agreed upon terms of the engagement shall be again
documented in writing.
EM on ICAI Valuation Standard 301 Business Valuation

The engagement letter shall at the minimum include:
• details of the client
• details of any other user/s of the valuation report apart from the client,

if any
• details of the valuer
• purpose of the valuation
• identification of the subject matter of valuation
• valuation date
• basis and premise of valuation
• responsibilities of the client and the valuer
• confidentiality obligations of the client and the valuer
• Other than statutory requirements
• scope/ limitations
• fees
• details of third party expert, if any, and their scope of work, scope

limitations, and responsibilities.
In case the valuer does not agree to any change in the terms of engagement
and/or is not permitted to continue as per the original terms, he should
withdraw from the engagement and should consider whether there is an
obligation, contractual or otherwise, to report the circumstances necessitating
the withdrawal to the client.
2. Step 2 - Define the Valuation base and premise of the value
ICAI Valuation Standard-102 (Valuation Bases) provides for the Valuation
Base and Premise of Value.
2.1. Valuation Base

The Valuation base means the indication of the type of value being used in an
engagement. The basis of value is closely related to the purpose of a given
valuation exercise. Different valuation bases may lead to different conclusions
of value. Therefore, it is important for the valuer to identify the bases of value
pertinent to the engagement.

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Business Valuation Process – Detailed study of Steps Involved

Valuation
Bases

Fair Value Participant Liquidation
Specific Value
Value

Before we embark onto understanding the types of valuation bases defined in
the Valuation Standard 102, it is pertinent to note that there could be
requirement for another specific valuation base to be applied as prescribed in
a statute or regulations or in an agreement / arrangement between the parties.

In such cases, the valuer may require to choose a different valuation base
and the fact shall be disclosed in the valuation report.

Types of Valuation Bases

a. Fair Value

Ind AS-113 on Fair Value Measurement defines ‘Fair Value’ as “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.”

Fair value is usually synonymous to fair market value except in certain
circumstances where characteristics of an asset translate into a special asset
value for the party(ies) involved.

Now let us understand these four highlighted features in detail

i) Price

Fair value assumes that

a. the price is negotiated in a free market

b. Fair value reflects characteristics of an asset which are available to
market participants in general and do not consider advantages/
disadvantages which are available only to particular participant.

c. The price in the principal (or most advantageous) market is used to
measure the fair value of the asset and it shall not be adjusted for
transaction costs. To this end, a market in which the volume and level
of activities is high, or one in which the realisation from an asset is
maximum, is considered.

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ii) Orderly Transactions

Orderly transaction is a transaction that assumes that there is sufficient period
before the valuation date to allow for marketing activities that are usual and
necessary for transactions involving such assets or liabilities and it is not a
forced transaction. The length of exposure time will vary according to the type
of asset and market conditions.

iii) Market participants

Market participants are willing buyers and willing sellers in the principal market
for the asset or liability that have all of the following characteristics:

a. they are independent of each other, that is, they are not related parties;

b. they are knowledgeable, having a reasonable understanding about the
asset or liability and the transaction using all available information,
including information that might be obtained through due care that is
usual and customary;

c. they are able to enter into a transaction for the asset or liability; and

d. they are willing to enter into a transaction for the asset or liability, i.e.,
they are motivated but not forced or otherwise compelled to do so.

iv) Valuation date

Valuation date is the specific date at which the valuer estimates the value of
the underlying asset.

Valuation is time specific and can change with the passage of time due to
changes in the condition of the asset to be valued and/ or market. Accordingly,
valuation of an asset as at a particular date can be different from other date(s)

The valuation date is sometimes also referred to as measurement date.

Example: the value of share can vary significantly over a short time span of a
few months, depending on factors such as financial performance and the
overall robustness of the economy.

b. Participant Specific Value

“Participant specific value” is the estimated value of an asset or liability
considering specific advantages or disadvantages of either of the owner or
identified acquirer or identified participants.

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Business Valuation Process – Detailed study of Steps Involved

Participant specific value may be measured for an existing owner or for an
identified acquirer or for a transaction between two identified parties and
consider factors which are specific to such party(ies) and which may not be
applicable to market participants in general.

For example:
i) participant specific value for transfer of 2% stake by a minority

shareholder to a shareholder holding 49% stake will consider aspects
such as minority discount and control premium while valuing business
or business interest.

ii) participant specific value for a potential acquirer in connection with
acquisition of a manufacturing facility will consider aspects such as
location specific advantage or synergies which may not be available to
market participants in general.

The factors to be taken into consideration to determine the “Participants
Specific Value” are as follows:-

• the respective economic needs and abilities of the parties to the
transaction or event

• risk aversion or tolerance

• the motivation of the parties

• business strategies and business plans
• synergies and relationships

• strengths and weaknesses of the target business

• form of the organization of the target business
• estimates of future cash flows or earnings

• tax advantages

• synergy to other products
• other strategic advantages

Example of Considerations that are not available to market in general and
hence are Participant specific consideration.
• Synergy: Fair value will consider synergies which are available to

market participants in general, Participant Specific Value will consider

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synergies which may be specifically available only to the concerned
participant(s).
• Acquirer specific considerations: on account of other assets owned/
operated by such entity it has the ability to utilise an asset in an unique
manner which is not there with market participants in general
• Legal/ tax implications: which are specific to a business or entity (e.g.,
implication of the Competition Act or an ability of an acquirer to utilise
the available tax losses in an accelerated manner)
c. Liquidation Value
“Liquidation value is the amount that will be realised on sale of an asset or a
group of assets when an actual/hypothetical termination of the business is
contemplated/ assumed.
Liquidation value can be carried out under the premise of an orderly
transaction with a typical marketing period or under the premise of forced
transaction with a shortened marketing period. The valuer must disclose
whether an orderly or forced transaction is assumed.
If the Entity/ Firm does not have the potential to revive itself and is not a going
concern, then Liquidation value is to be used.
The liquidation value of a firm can be determined by aggregating the value that
the assets of the firm would command if sold at market prices, net of
transactions and legal costs. The value of equity can be obtained by
subtracting the value of the outstanding debt from such asset value.
Value of equity = Liquidation value of assets – Outstanding debt
2.2. Premise of Value

ICAI Valuation Standard 101 (Definitions) defines Premise of value to be the
conditions and circumstances how an asset is deployed. (Any reference to an
asset, includes a liability).
ICAI Valuation Standard 102 identifies following five common premises in a
valuation. A valuer may use one or more of these premises for the purposes
of valuation depending on the circumstances.

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Business Valuation Process – Detailed study of Steps Involved

Base- Fair Base - Liquidation
Value/Participant Value

Specific Vale

Premise of Premise of
Value Value

Highest and Going As is where Orderly Forced
Best Use Concern is value Liquidation Transaction

Value

Premise, in common parlance, refers to an assumption or a statement, based
on which a study is undertaken. Valuation is not only asset-specific and may
vary depending on the client, for whom the valuation is conducted.

a. Highest and Best Use

As per the premise, the highest-and-best value of an asset is the value when
used by a market participant who puts the asset to its maximum use. However
its existing use may or may not be the highest and best by the current owner.
Example- To protect its competitive position, or for other reasons, an entity
may intend not to use an acquired non-financial asset actively according to its
highest and best use.

The current use of an asset is presumed to be at its highest and best, unless
a market or other factor proves to the contrary. If the current use is not at its
Highest and Best, the valuer shall also consider the cost of conversion required
to put the asset from its current position to its highest and best use. IND AS
113 mandates that a fair value measurement of non-financial assets must
assume the highest and best use of the assets by market participants,
irrespective of its present actual use while also considering its physical, legal
and financial feasibility.

i. Physical Feasibility: takes into account the physical characteristics of
the asset that market participants would consider when pricing the
asset. For E.g. - the location or size of a property.

ii. Legal Feasibility: takes into account any legal restrictions on the use
of the asset that market participants would take into account when
pricing the asset. For E.g. - the zoning regulations applicable to a
property.

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iii. Financially Feasibility: it takes into account whether a use of the asset
generates adequate income or cash flows (taking into account the costs
of converting the asset to that use) to produce an investment return that
market participants would require from an investment in that asset put
to that use.

b. Going concern
Going Concern Value is the value of an enterprise which is expected to
continue its operations and not liquidated in the near future. The value apart
from the tangible assets, also includes intangible assets such as Goodwill due
to the trained workforce, the presence of an operational plant, necessary
licenses, marketing systems, procedures in place, etc.
c. As-is-where-is
This represents the existing use of the asset. This may or may not be the
Highest and Best Use of the asset. This may be used in a valuation for the
purposes of Financial Reporting.
d. Orderly liquidation
An orderly liquidation refers to the realisable value of an asset in the event of
a liquidation after allowing appropriate marketing efforts and a reasonable
period of time to market the asset on an as-is, where-is basis. What is a
reasonable period of time may vary depending on the asset type, market
conditions, etc.
e. Forced Transaction
Sometimes, an owner of the asset may be under a compulsion to sell the asset
within a limited period of time, as a result of which, he may not fetch its true
value. Thus, it refers to a transaction in which the seller is forced to sell an
asset without adequate marketing efforts or reasonable period of time to
market the asset.
A marketing constraint is not a forced sale. Sale in an inactive market also
cannot be construed as a forced transaction. The limitation should be on the
time required for marketing the product and sell it at reasonable price. A typical
example of a forced transaction would be an auction.

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Business Valuation Process – Detailed study of Steps Involved

3. Step 3 - Analyse the business to be Valued and undertake
accounting analysis and exercise due diligence

a. Analyses

The valuer is required to carry out relevant analyses and evaluations through
discussions, inspections, survey, calculations and such other means as may
be applicable and available to that effect.

In case the valuer relies on the information available in public domain, the
valuer has to assess the credibility/reliability of such information taking into
account, the purpose of valuation, and materiality vis-à-vis the valuation
conclusion.

The analysis of the business to be valued shall assist the valuer in considering,
evaluating, and applying the various valuation approaches and methods to the
valuation engagement. The nature and extent of the information required to
perform the analysis depends on the following:

• nature of the business to be valued
• scope and purpose of the valuation engagement
• the valuation date
• the intended use of the valuation
• the applicable ICAI Valuation Standard
• the applicable premise of value
• assumptions and limiting conditions
• applicable governmental regulations or regulations prescribed by other

regulators or other professional standards;
b. Accounting Analysis by Valuer
When there are large potential distortions, accounting analysis can add
considerable value. Accounting analysis is an important step in the process of
business valuation and helps in removing any noise and bias introduced by
the accounting rules and management decisions. Sound accounting analysis
improves the reliability of conclusions from financial analysis.

There are six key aspects of accounting analysis.

• Evaluation of accounting values - The analyst should identify the key
accounting policies and estimates that the firm uses to measure its

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critical success factors and risk. As a result, it influences the company’s
profits or asset base, if overestimated/ underestimated, it will distort the
financial position.

• Flexibility – The analysts evaluate the degree of flexibility available to
managers in selecting accounting policies and estimates related to the
firm’s key success factors, given the accounting rules and conventions.
The relevance of accounting data for understanding a company’s
business is severely impacted by the degree of flexibility available to
managers in choosing accounting policies and estimates and how this
flexibility is exercised by managers.

• Accounting discretion – The analysts assess and understand whether
the managers have used their accounting discretion to give a realistic
view of the affairs of the company or hide its true performance.

• Understandability of financial statements - The adequacy and
quality of a firm’s disclosures about its business activities and their
economic consequences are assessed. This would enable the analyst
to assess the quality of accounting and use its financial statements to
understand the true business economics.

• Identifying accounting policies and transactions - The analyst
should identify questionable accounting policies/ transactions needing
further investigation with considerable variations from past years’
figures, unusual transactions, changes in accounting treatment etc.

• Removal of Distortions - The analysts remove all distortions where
the accounts do not reflect a true state of affairs and restate accounting
numbers. The purpose is to remove any noise and bias introduced by
the accounting rules and management decisions.

c. Due Diligence on Business Valuation

Due diligence depicts clear and transparent business facts based on robust
and reliable statement, and valuation based on such statement is very
effective. To enhance the value of the business, the management of the
company may have overvalued the assets or there may be some hidden
liabilities of the business. The objective of due diligence process is to look
specifically for any such hidden liabilities or overvalued assets.

It is a very common and popular term in the corporate world in relation to
corporate restructuring, merger & acquisition, joint venture, spinoffs,

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Business Valuation Process – Detailed study of Steps Involved

amalgamations, etc. Due diligence is one of the key elements in all these types
of transactions because of the fact that the transactions are being done
between two unrelated parties, who don’t have a deep understanding about
the business which they are going to take over or merge with. The purpose of
due diligence exercise is to assist the purchaser or the investor in finding out
all the facts and figures about the business he is going to acquire or invest
prior to completion of the transaction.
i) Few examples of hidden liabilities are as follows:
• The company may not disclose show cause notice which have not

matured into demands, as contingent liabilities
• Letter of comfort given to banks and financial institutions, which are not

disclosed in the financial statements of the company as they are not
guarantees.
• Long pending sales tax/income tax assessment
• Future lease liabilities
• Environmental problems/third party claims
• Product and/or other liability claims, warranty liabilities, liquidity
damages etc.
• Huge labour claims under negotiation
ii) Few examples of overvalued assets
• Uncollected and/ or uncollectible receivables
• Intangibles having no value
• Group company balances under reconciliation
• Litigated assets
• Investment carrying a very low rate of income
• Deferred revenue expenditures
• Obsolete, slow moving or non-moving stock valued above net realisable
value
• Obsolete or under used plant and machinery
• Capitalisation of expenditure which is in the nature of revenue

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Various types of due diligence that is followed as a discipline for businesses
are as follows:

• Commercial or operational due diligence: It is generally performed
by the concerned acquirer enterprise and involves an evaluation from a
commercial, strategic or operational perspective. For example, whether
the proposed merger would create operational synergies.

• Financial due diligence: It commences after a price has been agreed
for the business. The principal objective of financial due diligence is
usually to look behind the veil of initial information provided by the
company and to assess the benefits and costs of the proposed
acquisition/merger by inquiring into all relevant aspects of the past,
present and future of the business to be acquired/merged with.

• Tax due diligence: This is conducted to ensure whether the company
is adhering to the tax provisions, the tax benefits available for the target
and the tax related implications of the proposed transaction or valuation
on the tax positions of the target.

• Information system due diligence: This is to assess the accuracy and
completeness of Information System of the company.

• Legal due diligence: It is to find out whether or not the company is
complying with the legal provisions. For example, whether the company
is filing annual returns or not, whether necessary board resolutions are
being passed or not, whether the minute’s book is being maintained and
updated or not.

Typically, due diligence is a process which is undertaken in a transaction
before the same is consummated. Based on the findings arising from the due
diligence exercise, there may be a need for forensic accounting to be
undertaken in respect of specific areas identified as a concern with regard to
the financial position or performance of the target entity.

4. Step 4 - collect the necessary financial and non-financial
information about business, both historical and projected

While analysing the business to be valued, the valuer shall gather, analyse
and adjust the relevant information necessary to perform a valuation,
appropriate to the nature or type of the engagement. The type, availability, and
significance of such information may vary with the business to be valued. A
valuer shall read and evaluate the information to determine the
reasonableness of information.

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Business Valuation Process – Detailed study of Steps Involved

The judgments made by the valuer during the course of assignment, including
the sufficiency of the data made available to meet the purpose of the valuation,
must be adequately supported.

(a) Information to be collected can be broadly categorized under
following heads:

(a) non-financial information; (b) ownership details;

Information to
be collected

(c) financial information; and (d) general information

i) Non-Financial Information
A valuer shall obtain sufficient non-financial information to enable him to
understand the underlying business, such as:
• nature, background, and history of the business
• facilities;
• organizational structure
• management team (which may include officers, directors, and key

employees)
• products or services, or both
• capital markets providing relevant information; e.g., relevant public

stock market information and relevant merger and acquisition
information
• prior transactions involving the subject business, or involving interests
in, the securities of, or intangible assets in the subject business
• economic environment
• geographical markets
• industry markets

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• key customers and suppliers
• competition
• business risks
• future outlook for the business
• strategy and future plans
• governmental or regulatory environment
• legal status of the asset being valued

ii) Ownership Information

A valuer shall obtain ownership information regarding the asset to be valued
to enable him to:
• determine the type of ownership interest being valued and ascertain

whether that interest exhibits control characteristics
• analyse the different ownership interests of other owners and assess

the potential effect on the value of the asset
• understand the classes of equity ownership interests and rights

attached thereto
• understand other matters that may affect the value of the subject

interest, such as:
✓ for a business, business ownership interest: shareholder

agreements, partnership agreements, operating agreements,
voting trust agreements, buy-sell agreements, loan covenants,
restrictions, and other contractual obligations or restrictions
affecting the owners and the asset to be valued;
✓ for an intangible asset: legal rights, licensing agreements,
sublicense agreements, nondisclosure agreements, development
rights, commercialization or exploitation rights, and other
contractual obligations.

iii) Financial Information

A valuer shall obtain, where applicable and available, financial information on
the underlying business such as:
• historical financial information (including annual and interim financial

statements and key financial statement ratios and statistics) for an
appropriate number of years

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Business Valuation Process – Detailed study of Steps Involved

• prospective financial information (for example, budgets, forecasts, and
projections) in the absence of which the valuer could consider
information on future developments or course of the business

• comparative summaries of financial statements or information covering
a relevant time period

• comparative common size financial statements for the subject entity for
an appropriate number of years

• comparative common size industry financial information for a relevant
time period

• income tax returns for an appropriate number of years
• information on compensation for owners including benefits and personal

expenses
• information on previous valuations with the purpose and the reports
• ongoing litigations, disputes and evaluation thereof
• details of management’s response to the inquiry regarding:

✓ advantageous or disadvantageous contracts;
✓ contingent or off-balance-sheet assets or liabilities;
✓ surplus/ non-operating assets;
✓ non- recurring and non-operating income and expenses.

A valuer shall read and evaluate the information to determine that it is
reasonable for the purposes of the engagement.
iv) General Information
A valuer shall gather and analyse the relevant general information which may
affect the business directly or indirectly and/or which are deemed relevant by
the valuer.
(b) Management Representations

With respect to certain information a valuer may obtain management
representation in course of valuation, based on his judgement. A written
representation obtained from the management or those charged with
governance becomes part of the evidence obtained by the valuer which forms
a basis for his valuation report.

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However, the existence of a management representation letter shall not
preclude the valuer from exercising reasonable skill and care with respect to
the information obtained regarding the valuation.

The valuer shall carry required procedures in the performance of his valuation
assignment in respect of the information included in the management
representation letter.

5. Step 5 - Identify the adjustments to the financial and non-financial
information for the valuation

Adjustments to financial information are modifications to reported financial
information which is relevant and significant to the valuation process.
Adjustments may be appropriate for the following reasons, amongst others:

• to present financial data of the underlying and comparable companies
on a consistent basis;

• to adjust revenues and expenses to levels that are reasonably
representative of continuing operations;

• to adjust for non-operating/non-recurring assets and liabilities, and any
revenues and expenses related to the non-operating items.

Adjustment shall be made to information available from the historical financial
statements, if appropriate, to reflect the appropriate asset value, income, cash
flows and/or benefit stream, as applicable, to be consistent with the valuation
method(s) selected by the valuer.

6. Step 6 - consider and apply appropriate valuation approaches and
methods

There are largely the following methods which are used in the process of
Business Valuation:-

Valuation
Approaches

Market Income Cost
Approach Approach Approach

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Business Valuation Process – Detailed study of Steps Involved

A. Approaches of Valuation
• 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
B. Factors considered in Selection of Correct Approach
Valuation though backed by research and analysis, involves significant amount
of judgment, hence the valuer needs to select the most appropriate approach
or method very responsibly as there is no single approach or method that is
best suited in every situation.
(i) The valuation approaches and methods shall be selected in a manner

which would maximise the use of relevant observable inputs and
minimise the use of unobservable inputs. Some examples of same
are as under:-
• Observable Inputs –
✓ Price/Cost for similar or identical assets in active market
✓ Actual Cash Flow Generated
• Unobservable Inputs –
✓ Estimated Price/Cost for Unidentical assets
✓ Projected Cash Flow Generated
(ii) The key factors that a valuer needs to consider while selecting an
approach are as under:
• nature of asset to be valued;
• availability of adequate inputs or information and its reliability;
• strengths and weakness of each valuation approach and method;

and
• valuation approach/method considered by market participants.
(iii) Another very important element in selection of appropriate valuation
methods is the purpose/ base of valuation.

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• If the valuation is for the purpose of liquidation, the valuer would
use the Realizable Value of the Net Assets i.e., Cost Approach
and not the Income approach as in this case, the company will not
exist and going concern is questionable, hence predicting future
cash-flows is not possible.

• In case of valuing a start-up, since it is more privately held and are
illiquid as compared to investments in publicly traded companies
hence there can be lack of adequate market comparables. Further
in absence of another identical company, Market Approach might
not be appropriate for reliable valuation in such case Income
approach can be considered subject to the availability of adequate
observable inputs like Actual Cash flows and projected growth.

• In some cases, the statutory requirements may drive the valuation
approach wherein, the statute may have prescribed the valuation
approach / method to be adopted or may have even spelt out the
computation for the given specific requirement.

C. Methods that are more often preferred in certain conditions
Typically various methods are more often preferred in certain
conditions:
a. Discounted Cash Flow Method

• Growth phase or new projects
• Cash flow projections are available and reliable
• Unique business model
• Long term outlook
b. Earnings Capitalisation Method
• Stable business
• Standard business model
c. Market Multiples Method
• Stable business
• Peer group companies available
• Short to medium term outlook
• Where revenue / cash flow streams not determinable

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Business Valuation Process – Detailed study of Steps Involved

d. Cost Method
• Nascent stage projects with high capex involvement
• No significant intangibles are involved

6.1 Market Approach
In Market Approach business value is determined by comparing the subject,
company or assets with its peers in the same industry of the same size and
region. Most Valuations in stock markets are market based and it is based on
the premise of efficient markets and supply & demand.
Market approach, also referred to as relative approach, is a valuation approach
that uses prices and other relevant information generated by market
transactions involving identical or comparable (i.e., similar) assets, liabilities
or a group of assets and liabilities, such as a business. This is also known as
relative valuation approach.
a. Market/ Relative Approach is almost pervasive

• Most valuations on Wall Street are relative valuations.
• Almost 85% of equity research reports are based upon a multiple

and comparables.
• More than 50% of all acquisition valuations are based upon

multiples.
• Rules of thumb based on multiples are not only common but are

often the basis for final valuation judgments.
• While there are more discounted cashflow valuations in consulting

and corporate finance, they are often relative valuations
masquerading as discounted cash flow valuations.
Methodologies under Market Approach
6.1.1 Market Price Method
In Market Price method, a valuer considers the traded price observed over a
reasonable period while valuing business/firm which are traded in the active
market. A valuer also considers the market where the trading volume of asset
is the highest when such asset is traded in more than one active market.
Further the valuer should consider using weighted average or volume weighted
average to reduce the impact of volatility or any one time event in the asset.

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6.1.2 Comparable Companies Multiple (CCM) Method
Major steps in deriving a business value using the CCM method are as follows:
i) Identifying and selecting the market comparable
A valuer shall consider the factors in identifying the comparables :-
• Industry to which the asset belongs;
• Geographic area of operations;
• Similar line of business, or similar economic forces that affect the asset

being valued;
• Other parameters such as size (for example - revenue, assets, etc.),

stage of life-cycle of the asset, profitability, diversification, etc. This list
is not an exhaustive list, there may be certain other factors which a
valuer shall consider while identifying and selecting the market
comparables.
ii) Computing Market Multiples
Multiples are a ratio of the enterprise value or equity value over different
financial parameters like Revenue, Earnings before Interest, Tax, Depreciation
and Amortisation (“EBITDA”), Profit after Tax (“PAT”), Earnings per Share
(“EPS”), book value etc., with some being preferred over the others.
In some cases in addition to market multiple based on the financial metrics
such multiples may also be considered by the valuer which are based on non -
financial Metrics. For example,
• Enterprise Value (EV) / Tower in case of tower telecom companies,
• EV/Tonne in case of cement industry, etc.
• EV/Oil Barrel for Oil Companies
iii) Adjustments to the market multiple
The following are some of the differences between the business to be valued
and market comparable that the valuer may consider while making
adjustments to the market multiple:
• size of the asset;
• geographic location
• profitability;

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Business Valuation Process – Detailed study of Steps Involved

• stage of life-cycle of the asset;
• diversification;
• historical and expected growth; or
• Management profile.
iv) Arriving at the value of asset to be valued
Finally apply the adjusted market multiple to the relevant parameter of the
asset to be valued to arrive at the value of such asset; and adjust it (discount/
premium) to factor in for the specifics of the asset.
6.1.3 Comparable Transaction Multiple (CTM) Method
It is a variant of the Comparable Companies Multiple Method and uses
transaction multiples in place of trading multiples. Transaction multiples, as
the name suggests, are the multiples implied in the recent acquisitions/
disposals of comparable companies/business.
While identifying and selecting the comparable transaction, a valuer may
consider the factors such as-
• transactions that have been consummated closer to the valuation date

are generally more representative of the market conditions prevailing
during that time.
• the selected comparable is an orderly transaction;
• availability of sufficient information on the transactions to enable the
valuer to reasonably understand the market comparable and derive the
transaction multiple;
• availability of information on transaction from reliable sources such as
regulatory filings, industry magazines, Merger & Acquisition databases,
etc.
6.2 Income Approach
Discounted Cash Flow Method
The Discounted Cash Flow (“DCF”) method, an application of the Income
Approach is arguably one of the most recognized tool to determine the value
of a business.

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a. When to use DCF Method?
DCF method can be used in following cases:
• Limited life projects
• Large initial investments and predictable cash flows
• Regulated business
• Start-up companies

b. Parameters of DCF
(i) Cash Flows:

• Projections
• FCF to Firm or FCF to Equity
• Horizon (Explicit) period
(ii) Discounting rate
• Cost of Equity
• Cost of Debt
• Debt Equity ratio
(iii) Terminal Value
• Growth rate for perpetuity
• Expected cash flow after Explicit Period
• Terminal Value(n) = Expected FCF(n+1) / (Discount Rate –

Expected Growth Rate)
• Or as an alternative, exit multiple based terminal value
c. DCF- Steps to be carried out?
• Analyse the historical performance of the business
• Determine what you are valuing
• Develop financials projections (generally for 3-5 years)
• Calculate ‘free cash flows’ for the projection period – FCFF or

FCFE
• Calculate the discount factor - WACC or Cost of Equity
• Discount free cash flows by the appropriate factor. Sum of the

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Business Valuation Process – Detailed study of Steps Involved

discounted free cash flows during the projection period is termed
as the ‘primary value’

• Estimate the terminal growth rate and calculate the terminal value

• Add the primary and terminal values to arrive at the ‘Enterprise’
or ‘Equity’ value (depending upon whether FCFF or FCFE was
used)

• Deduction of net debt from enterprise value results in equity value

Sample Discounted Cash Flow Valuations (without considering
impact of financial structure and leverage)

Particular Year Terminal

1 2 3 45

Revenue xxx xxx xxx xxx xxx
Total Cost (xxx) (xxx) (xxx) (xxx) (xxx)
xxx xxx xxx xxx xxx
Book Profit
(+) Non-Cash xxx xxx xxx xxx xxx
Expense (e.g.:
depreciation)

Cash Profit xxx xxx xxx xxx xxx

(-) Non-Current

Investments for (xxx) (xxx) (xxx) (xxx) (xxx)
business

(+/-) Working Capital xxx xxx xxx xxx xxx
Changes

Free Cash Flow xxx xxx xxx xxx xxx Xxx

Discount Rate % % % % % %

Present Value xxx xxx xxx xxx xxx Xxx

Sum of Present

Value xxx

(+) Surplus Assets xxx

Enterprise

Value/Equity Value xxx

Valuation utilizing the Discounted Cash Flows is thus based on following
three factors majorly;-

• Discount Rate

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• Cash Flow Projections

• Terminal Value
These have been discussed and explained in details in Educational
Material for ICAI Valuation Standard 103 – Valuation Approaches and
Methods.
6.3 Cost Approach

This approach tends to determine the business value on the basis of value of
assets of the business. It is specifically useful for asset intensive firms, valuing
holding companies as well as distressed entities that are not worth more than
their overall net tangible value. The cost approach is based on the inherent
assumption that the value of a business or investment can be determined
based on the cost to rebuild or replace the business.

Procedure for Valuation of an entity Under Cost Approach

The steps necessary for valuation using Cost Approach /Underlying Asset
basis are:

• Audit/Examine the Balance Sheet and Other Financial records
• Ascertainment of value of assets.

• Ascertainment of value of liabilities (including contingent liabilities).
Value of Equity Capital = (Value of Assets – Value of Liabilities)/No. of

Equity Shares

a) Valuation of Assets
(i) Fixed Assets

✓ Estimate replacement or reproduction cost of Asset
✓ Estimate total economic life and effective age;
✓ Depreciate replacement/reproduction cost new over economic

life to reflect obsolescence related to effective age; and
✓ Adjust for additional functional/economic obsolescence.
(ii) Investments
Shares and securities that are regularly traded in stock exchange may be
valued on the basis of the prices quoted thereat. It must, however, be seen
that there is regular trading in those scrips, as an isolated transaction may lead

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Business Valuation Process – Detailed study of Steps Involved

to erroneous results. In cases of quoted shares with isolated transactions and
unquoted shares, a secondary valuation may be necessary, if the amount is
material. Such unquoted shares and infrequently traded shares may be valued
using relative valuation methods or income approach methods of valuation.

(iii) Inventory

Depending on the purpose and need for valuation, it could be based on cost
with due allowance/adjustment be made for any obsolete, unusable or
unmarketable stocks held by the company or based on current market prices
or net realisable value on sale of the such inventory.

(iv) Sundry Debtors

As debtors are reflected as money receivable, it could be valued considering
the time value of recovery and after making appropriate allowance/adjustment
credit risk (any bad debts and debts which are doubtful of recovery).

(v) Contingent Assets

If the company has made escalation claims, insurance claims or other similar
claims, then the possibility of their recovery should be carefully made on a
conservative basis, particularly having regard to the time frame in which they
are likely to be recovered.

(vi) Development Expenses

These arise:

• in the case of a new company, when it is in the process of executing its
project; and

• in the case of an old company, when there is an expansion of the
existing production lines or diversification for entering into new
business.

These should be reviewed and the costs that have been incurred for
completing the project should be included.

(vii) Intangible assets

Intangible Assets of a company have also to be considered, no matter whether
they are reflected in the books or not. Intangible assets generally consist of
goodwill, patents, trade-marks, copyrights, etc. Their book value/net
replacement cost/net realisable value/fair value, as the case may be, has to
be considered. Goodwill is generally inseparable from business, and it can
fetch a price only if the business is sold on a going concern basis.

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b. Valuation of Liabilities

The amount of liabilities reflected in the books of companies may generally be
accepted after proper scrutiny. Due consideration should, however, be given
to contingent liabilities if any, necessary legal opinion should be sought for
ascertaining the sustainability of claims or contingent liabilities.

Where liability for taxation has not been provided in the accounts, appropriate
amount should be included in the liability. Similar adjustment may be required
for proposed dividend.

In case the company has set aside any specific reserves to meet any future
losses, it should be ascertained whether they are reserves or provisions. If
there is a definite reason to regard them as provisions, they should either be
included in liabilities or deducted from the related assets.

While valuing equity shares, the dues of preference shareholders have also to
be reduced from the enterprise value to determine the value attributed to the
equity share holders. These dues can be ascertained from the terms of issue.
Where such shareholders also have a right to participate in the surplus, the
applicable amounts of such surplus should be included as liabilities, together
with the paid-up value of such preference shares.

7. Step 7 – Arrive at a Value or a Range of Values

a. Single or Multiple Approach in Valuation

The three approaches to valuation as discussed earlier are globally accepted
valuation approaches and each one relies on different criteria for valuation and
has their own advantages and short comings.

The Valuer may consider adopting a single approach or might also choose
multiple approaches to arrive at a reliable conclusion.

Using more than one approach is specially recommended under scenarios
when there are insufficient factual inputs for a single method to arrive at a
reliable value.

In arriving at the value, the valuer shall:
• Assess the reliability of the results under the different approaches and

assign weights to value indications reached on the basis of various
methods.

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Business Valuation Process – Detailed study of Steps Involved

• The selection of and reliance on appropriate methods and procedures
depends on the judgment of the valuer and not on any prescribed
formula. One or more approaches may not be relevant to a particular
situation, and more than one method under an approach may be
relevant.

• The valuer must use informed judgment when determining the relative
weight to be accorded to indications of value reached on the basis of
various methods, or whether an indication of value from a single method
shall be conclusive. In any case, the valuer shall provide the rationale
for the selection or weighting of the method or methods relied on in
reaching the conclusion.

• In assessing the relative importance of indications of the value
determined under each method, or whether an indication of value from
a single method shall be the value, the valuer shall consider factors
such as:

✓ the applicable premise of value

✓ the purpose and intended use of the valuation

✓ whether the underlying business is an operating company, a real
estate or investment holding company, or a company with
substantial non-operating or excess assets

✓ the quality and reliability of data underlying the value

✓ such other factors that in the opinion of the valuer, are
appropriate for consideration.

The values under different approaches adopted should not be at a significant
variance from each other. If the initial workings are not meeting this criterion,
the valuer should revisit his or her analysis before concluding.

Also, there could be specific requirements which may apply to a given purpose
of the valuation.

For instance, as per Circular No. LIST/COMP/02/2017-18 dated May 29, 2017
issued by BSE Limited and Circular No. NSE/CML/2017/12 dated June 01,
2017 issued by National Stock Exchange of India Limited, following disclosure
needs to be made by a valuer in the valuation report (in respect of any scheme
of arrangement involving exchange ratio for shares):

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Valuation Approaches XYZ LTD PQR LTD

Value per Weight Value per Weight
share share

Income Approach X A Y D

Market Approach X B Y E

Cost/Asset Approach X C Y F

Relative Value per Share X Y

Exchange Ratio XX

RATIO:

x (xxx) equity shares of XYZ Ltd of INR 10 each fully paid up for every y (yyy)
equity shares of PQR Ltd of INR 10 each fully paid up.

In case any of the approach mentioned in the table above is not used for
arriving at the share exchange / entitlement ratio, detailed reasons for the
same needs to be provided by the valuer in his report.

8. Step 8 : Identify the Subsequent Events

Subsequent Event is an event that occurs subsequent to the valuation date
and could affect the value so arrived at by the Valuer. The valuation date is
the specific date at which a valuer estimates the value of the asset. Hence,
subsequent events are indicative of the conditions that were not known or
knowable at the valuation date, including conditions that arose subsequent to
the valuation date.

Generally, a valuer would consider only circumstances existing at the valuation
date and events occurring up to the valuation date. However, events and
circumstances occurring subsequent to the valuation date may be relevant to
the valuation depending upon, inter alia, the basis, premise and purpose of
valuation. Hence, the valuer should apply his professional judgement, to
consider any of such circumstances / events which are relevant for the
valuation. Such circumstances / events could be relating to, but not limited to,
the business being valued, comparables and valuation parameters used.

In the event, such circumstances / events that are considered by the valuer
should be explicitly disclosed in the valuation report.

Events subsequent to the valuation date should not be taken into consideration
when valuing business interests, except when at least one of the following

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Business Valuation Process – Detailed study of Steps Involved

conditions is true:
(a) The subsequent events were reasonably foreseeable as of the valuation

date.

(b) The subsequent events are relevant to the valuation, and appropriate
adjustments are made to take into account the differences between the
facts and circumstances on the valuation date and the date of such
subsequent events.

(c) The subsequent events are not used to arrive at the valuation, but only
as a means to confirm the value already arrived at.

(d) Subsequent events may be evidence of value rather than as something
that affects value.

9. Step 9 : Draft and Finalise Valuation Report and Documentation
a. Valuation Report
ICAI Valuation Standard 202: Valuation Report and documentation provides
all the requirements in preparation of Valuation Report and provides guidance
on the documentation to be maintained for the preparation of a valuation
report. Relevant valuation documentation that meets the requirements of this
Standard provides evidence of the valuer’s basis for arriving at the value and
that the valuation was planned and performed in accordance with the relevant
ICAI Valuation Standards.

A valuer shall prepare the valuation report with due professional care and shall
document matters which are important in providing evidence that the valuation
assignment was carried out in accordance with the ICAI Valuation Standards
and support his assessment or the valuation report submitted by him.

The form and content of the valuation report depends on the following:
i) nature of the engagement

ii) purpose of the valuation

A valuer shall at a minimum include the following in the valuation report:
i) background information of the business being valued

ii) Base and Premise of the valuation and appointing authority

iii) the identity of the valuer and any other experts involved in the valuation

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iv) disclosure of the valuer’s interest or conflict, if any
v) date of appointment, valuation date and date of the valuation report
vi) inspections and/or investigations undertaken
vii) nature and sources of the information used or relied upon
viii) Valuation approach adopted in carrying out valuation and valuation

standards followed
ix) valuation methodology used
x) A valuer may use a combination of methods and approaches to arrive

at the value
xi) restrictions on use of the valuation report, if any
xii) major factors that were taken into account during the valuation
xiii) conclusion
xiv) caveats, limitation and disclaimers to the extent they explain or

elucidate the limitations faced by valuer, which shall not be for the
purpose of limiting his responsibility for the valuation report. A valuer
shall exercise reasonable restraint in using caveats while writing the
valuation report
xv) Lastly the valuation report shall include the signature of valuer and the
signature shall contain the name of the valuer vested with signing
authority, entity name, individual and entity’s registration number along
with the date and place where the valuation report is signed.
A valuer shall appropriately disclose his interest/conflict of interest, if any, in
the assets to be valued in the valuation report. In case where the relevant law
prohibits the acceptance of an assignment by a valuer due to the existence of
any interest in the asset valued, or any conflict of interest, the valuer shall not
accept the valuation engagement
b. Documentation
The term documentation includes the record of valuation procedures
performed, relevant evidence obtained, and conclusions that the valuer has
reached.

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Business Valuation Process – Detailed study of Steps Involved
A valuer shall maintain documentation which provides:
i) sufficient and appropriate record of the basis of the valuation report
ii) evidence that the valuation assignment was planned and performed in

accordance with the ICAI Valuation Standards and applicable legal and
regulatory requirements, as the case may be
The information received and relied upon, as well as analyses thereon differ
for every valuation engagement, however, the following documents/
information/analyses shall, at the minimum, be documented:
• engagement or appointment letter which appoints the valuer to
undertake the valuation
• tabulation of data obtained during the course of valuation
• workings undertaken to arrive at the value
• copies of relevant circulars, extracts of legal provisions
• the base/s, approach/es, and method/s, or a combination thereof, used
to arrive at the value
• assumptions, a change in which, may materially affect the value
• a copy of the signed valuation report issued
• management/client representation letter or such communication
received, if any.

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Chapter-3

Equity/Business Valuation – Critical
Business Analysis and Key Tools
Used for same

1. Introduction

Equity valuation is analysis of an entity’s business, business environment,
business model, industry analysis & regulatory framework to estimate the
worth or value of business. Each share is assumed to have an economic worth
based on its present and future earning capacity. This is called its intrinsic
value or fundamental value. It is pertinent at this point to clearly understand
the concept of “value” and “price”.

A value is an estimate of the value of a business or business ownership
interests, arrived at by applying the valuation procedures appropriate for a
valuation engagement and using professional judgment as to the value or
range of values based on those procedures.

The term ‘price’ indicates the amount at which particular asset is bought or
sold in an open market in a particular transaction.

The term ‘value’ indicates the worth of that asset in normal circumstances or
the amount at which it should be exchanged. While the price may be
understood as “the amount of money or other consideration asked for or given
in exchange for something else”. Thus price may or may not have relationship
with the value of an underlying asset. The price is, an expost measure i.e.,
outcome of a transaction whereas the value may not necessarily require the
existence of a transaction.

Value Price

Not precisely measurable Can be measured precisely

Not a static figure Static figure defined by a given transaction

Measure of economic Takes into consideration noneconomic factors

vQaulueestion for thought: Doestopori.ce of an asset define its value?
Equity/Business Valuation – Critical Business Analysis and Key…

2. Fundamental/ EIC Analysis – Economic, Industry &
Company Analysis

An investor who would like to be rational and scientific in his investment activity
has to evaluate a lot of information about the past performance and the
expected future performance of companies, industries and the economy as a
whole before taking the investment decision, such evaluation or analysis is
called fundamental analysis. Hence Fundamental Analysis is a detailed
analysis of the fundamental factors affecting the performance of companies.

The purpose of fundamental analysis is to evaluate the present and future
earning capacity of a share based on the economy, industry and company
fundamentals and thereby assess the intrinsic value of the share. The
discerning investor can then compare the intrinsic value of the share with the
prevailing market price to arrive at an investment decision. If the market price
of the share is lower than its intrinsic value, the investor would decide to buy
the share as it is under-priced, while on the contrary, when the market price of
a share is higher than its intrinsic value, it is perceived to be overpriced.

Fundamental analysis thus provides an analytical framework for rational
investment decision-making or for that matter in arriving at a professional
approach to valuation.  This analytical framework is known as EIC framework,
or economy-industry-company analysis.

Company Analysis

Industry Analysis

Economy Analysis

This three-tier analysis means that the company performance depends not
only on its own efforts, but also on the general industry and economic factors .
A company belongs to an industry and the industry operates within an

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economy, thus industry and economy factors affect the performance of a
company.
a. Economic Analysis
In business, economic analysis allows to incorporate elements from the
economic environment such as inflation, interest rates, exchange rates and
GDP growth into the corporate planning. Every organization is an open system
that impact and is impacted by the external context. This means that a proper
assessment of economic variables facilitates the identification of opportunities
and threats that could affect the company’s performance.
Factors Studied under Economic Analysis
• GDP of the Country
• Level of Savings & Investments
• Inflation Rate
• Interest Rate
• Growth in Primary, Secondary and Tertiary Sectors
• Tax Structure
• Economic forecasts
• Infrastructural facilities
• Demographic Factors
• Climatic Conditions
• State of Economy
• Balance of Payments situation
• Government Budget
• Linkage to World Economy
b. Industry Analysis
There is certain level of market risk faced by every company and the valuation
decline during recession in the economy, however the defensive kind of stock
is affected less by the recession as compared to the cyclical category of stock.
In the industry analysis, such industries are highlighted that can stand well in

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Equity/Business Valuation – Critical Business Analysis and Key…
front of adverse economic conditions. Thus, for valuation, it is a critical part of
the analysis to understand the industry to which the company belongs.
Factors Studied under Industry Analysis
• Growth rate of Industry
• Type of industry – Growth, Cyclical etc
• Nature of competition
• Nature of product
• Subsidies, incentives, concessions
• Tax framework
• Import and export policies
• Financing norms
• State of technology
• Industrial policies
• Socio-demographic trends
• Government programs and projects
• Supply sector
• Industry life cycle
• SWOT analysis
c. Company Analysis
In company analysis different companies are considered and evaluated from
the selected industry so that the comparative standing of the company can be
identified. Additionally in company analysis, the financial ratios of the company
are analyzed in order to ascertain the category of the entity. Ratios as in
Dupont analysis, return on equity etc. can be analyzed to ascertain the
potential company for making investment.
Factors Studied under Company Analysis
• Competitive advantage
• Financial stability & performance
• Growth Rate / Sales

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• Market Share
• Financial leverage and borrowing capacity
• Previous track record
• Profits of the company
• Corporate image
• SWOT analysis
• Management
• Operating efficiency
• Future estimate of sales

3. Strategic Analysis

It is about looking at what is happening outside the organisation now and in
the future. It asks two questions:

i) How might what's happening affect the organisation?

ii) What would be the organisation’s response to likely changes?

It’s called strategic because it’s high level, about the longer term, and about
the whole organisation. It’s called analysis because it’s about breaking
something that’s big and complex down into more manageable chunks.

In Strategic Analysis the focus is external because factors outside the
organisation have a powerful influence on it. Organisations appreciate that
they can learn to manage their response to those influences, rather than
assume there is nothing they can do. It's part of the overarching process of
strategic planning and involves both Internal as well as External components.

External Internal

(i) Environmental analysis (i) Shape and fitness of the
covering organisation

• Macro-economic picture (ii) Identify potential inhibitors
that diminish organisational
• General Economic effectiveness
outlook
(iii) Examples
• Industry trends • Cultural changes that must
take place
(ii) Competitor’s strategies

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Equity/Business Valuation – Critical Business Analysis and Key…

External Internal
• training requirements
(iii) Situation analysis on key • insufficient resources
inputs

(iv) Analysis of user industries/
consumer trends

Strategic Analysis in the Three Schools are as under

Deliberate Emergent Adaptive

Analysis to position for Analysis to review Analysis to see what

the future. patterns and learn from opportunities are

experience. available.

SWOT analysis Reflection of learnings Environmental
Scanning

Strategic Planning Listening to many Creating a responsive,

sources adaptive culture

Environmental Scanning

Scenario Planning

Now let us look into some of the popular tools which are used in Business
Analysis.

A Five Forces

Michael Porter said that “An industry’s profit potential is largely determined by
the intensity of competitive rivalry within that industry.”

Using a framework rather than a formal statistical model, Porter identified the
relevant variables and the questions that the user must answer in order to
develop conclusions tailored to a particular industry and company. He
identified following as the Five Forces:-

(i) Threat of Entry

(ii) Bargaining Power of Suppliers

(iii) Bargaining Power of Buyers
(iv) Development of Substitute Products or Services
(v) Rivalry among Competitors

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Potential
entrants

Bargaining power of Threat of new entrants
suppliers
Industry
Suppliers Competitors

Buyers

Threat of substitute Bargaining power of
products or services buyers

Substitutes

Barriers to Entry • Large capital requirements or the need to gain
economies of scalequickly

• Strong customer loyalty or strong brand
preferences

• Lack of adequate distribution channels or access
to raw materials

Power of Suppliers • A small number of dominant, highly concentrated

high when… suppliers exists

• Few good substitute raw materials or suppliers are

available

• The cost of switching raw materials or suppliers is
high

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Equity/Business Valuation – Critical Business Analysis and Key…

Power of Buyers is • Customers are concentrated, large or buy in
high when… volume

• The products being purchased are standard or
undifferentiated making it easy to switch to other
suppliers

• Customers’ purchases represent a major portion of
the sellers’ total revenue

Substitute • The relative price of substitute products declines
products…competitiv • Consumers’ switching costs decline
e strength is high • Competitors plan to increase market penetration or
when
production capacity

Rivalry amongst • The number of competitors increases or they
competitors… become equal in size
intensity increases
when • Demand for the industry’s products declines or
industry growth slows

• Fixed costs or barriers to leaving the industry are
high

Impact of the Five Forces

Impact of five forces can be categorised as under
(i) Industries with low barriers have low pricing power
(ii) Incumbents protected barriers to entry enjoy benign competitive

environment and have greater pricing power.
(iii) Industry concentration is a sign that an industry may have pricing power
(iv) Tight capacity gives participants more pricing power as demand

exceeds supply.
(v) Overcapacity leads to price cutting
Relevance to Valuation of Five Forces
• Telecom

- How the licencing regime automatically creates a value once
licence is acquired

• Microsoft

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- An example of the power of the supplier

• AMD was valued lower than Intel
- Concentration of supplies to Apple

• Impact of Mobile Number Portability
- How many of you might opt for change of service?
- How many of you have not changed the service in the past only
because of the mobile number?

• Valuation of BPO companies in the current scenario
- Likely to be much lower, as clients would have a wider choice
available in the market

• Coke and Pepsi
- Classic case of business rivalry – the beverages are priced at a very
competitive price with lower margins

B SWOT Analysis

SWOT analysis stands for
• Strengths – internal strengths on which to capitalize
• Weaknesses – Internal weaknesses that hinder sustainability or growth
• Opportunities – external opportunities on which to capitalize
• Threats – external threats to position or value in the marketplace

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Equity/Business Valuation – Critical Business Analysis and Key…
SWOT or TOWS Matrix

STRENGTHS - S WEAKNESSES - W

List strengths List weaknesses

OPPORTUNITIES - O SO STRATEGIES WO STRATEGIES

List opportunities Overcome weaknesses by
Use strengths to take

taking advantage of
advantage of opportunities

opportunities

THREATS - T ST STRATEGIES WT STRATEGIES

List threats Use strengths to avoid Minimize weaknesses and

threats avoid threats

Matching Key External and Internal Factors to Formulate Alternative
Strategies

Key Internal Factor Key External Resultant Strategy
Factor

Excess working + 20% annual growth = Acquire an identified
capacity (an internal in the industry (an target for market
external
strength) opportunity)

Exit of two major

Insufficient capacity foreign competitors = Buy competitors’
(an internal + from the industry facilities
weakness)
(an external
Strong R & D
expertise (an opportunity
internal strength)
+ Decreasing = Develop new
Poor employee numbers of young products for older
morale (an internal adults (an external
adults
weakness) threat)

+ Strong union activity = Develop a new
(an external threat) employee-benefits

package

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Relevance to Valuation of SWOT analysis
• Case of one specific Tyre company

- In the specific tyre industry, this is valued way above the largest
player

- His predominant strength in “off the road tyres” and due to which a
significant export market

C PEST Analysis

Pest Analysis stands for:
• Political: local, national and international political developments – how

will they affect the organisation and in what way/s?
• Economic: what are the main economic issues – both nationally and

internationally – that might affect the organisation?
• Social: what are the developing social trends that may impact on how

the organisation operates and what will they mean for future planning?
• Technological: changing technology can impact on competitive

advantage very quickly!
Examples of PEST Analysis
• Growth of China and India as manufacturing centres over the past

years.
• Concern over treatment of workers and the environment in less

developed countries who may be suppliers.
• The future direction of the interest rate, consumer spending, etc.
• The changing age structure of the population.
• The popularity of ‘fads’ like the Atkins Diet.
• The move towards greater political regulation of business.
• The effect of more bureaucracy in the labour market.
Relevance to Valuation of PEST Analysis
• Y2K and the dawn of Indian IT Industry

- It was the global Y2K problem that made international companies
to look to India.

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Equity/Business Valuation – Critical Business Analysis and Key…

- There was a need to scale up and provide solutions and support
fast

- This opportunity gave rise to the Indian IT industry which then had
moved from there on into further strengths

• The famous Horsewhip Story
- Texas based famous Horse Whip manufacturer of early 1900
- Saw tremendous opportunity and bought over many ailing Horse
Whip manufacturers across the country
- Until, one day they found that the reason other companies have
been failing is because of the invention of locomotives and
reduction in horse carriages!
- By then, it was too late…

D CORE Competencies

Core competencies are Real sources of advantage and are not based on
businesses. Core competencies are collective learning in the organization,
especially: how to coordinate diverse production skills by integrating multiple
streams of technologies.
Identifiers of CORE Competencies
• Provide potential access to a wide variety of markets / products /

services.
• Are difficult to imitate.
• Are driven by knowledge and learning.
EXAMPLES
i) Engines and Power Trains can be core competencies in Cars,

motorcycles and generators business
ii) Optic, Imaging & Microprocessor controls are examples of core

competencies in businesses dealing in Copiers, laser printers, cameras
& Mobile Phones.
iii) Other kinds of Core Competencies
a. Systems Integration

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b. Virtual reality

c. Bioengineering

d. Delighting the customer

Example 1 of Relevance to Valuation

In most valuations on the premise of going concern, the emphasis is on the
future potential. This requires a thorough evaluation of the future potential in
economic and financial terms. There may be no one right value, an example
of same is as under:-

• Bell Atlantic offered $73/share for Air Touch communications- Dec 31,
1998

o Bell’s stock fell 5%

• Vodafone agreed to pay $97/share for the same AirTouch
communications- Jan 15, 1999

o Vodafone stock price increased 14% on the day deal was
announced!

Reason: More valuable synergies for Vodafone as against Bell Atlantic in the
acquisition!

Example 2 of Relevance in Valuation

The Novelis story

Novelis was World’s largest producer of aluminium rolled products with 19%
share; 30 plants all over the world; Networth of $322mio; debt of $2.3 Billion
and a debt:equity ratio of 7.23:1

For Jan-Sep 06 on net sale of $7.4Billion it made a net loss of $170Mi. Birlas
paid $3.6 Billion for 100% equity and this translates to Market cap /PBT (2007
guidance) of 36 against 17.81 applicable to Corus sale of cold rolled aluminium
products to Aleris in Mar 06.

So why did Birlas pay so much? Firstly loss in Novelis was due to a price
protection given to customers like Coke and Ford which was expected to be
there till 2010 only. Secondly the deal catapults Birlas into Fortune 500
overnight.

Further Hindalco belonging to Birlas was only in Upstream business and
Novelis helped them get into Downstream business which was 40% of global

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Equity/Business Valuation – Critical Business Analysis and Key…
aluminium consumed was rolled products where Hindalco did not have
presence.
Novelis brought latest technology including latest fusion technology; which
would have taken Hindalco 10 years to develop such technology. Natural
hedge for Hindalco was given against fall in LME prices. Lastly, the deal gave
them access to global plants and markets.

E GE/McKinsey Matrix

It is a Cross matrix analysis of:-
i) Industry Attractiveness
ii) Competitive Position
It carried out using various parameters as relevant to the business / industry
i) Competitive position determined by

• Market share,
• Technological know-how,
• Product quality
• Service network
• Price competitiveness
• Operating costs
ii) Industry Attractiveness determined by
• Market growth
• Market size
• Capital requirements
• Competitive intensity

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Competitive Position

Industry High Good Medium Poor
Attractiveness Medium Winner Winner ???????
Winner Average
Low Business Loser
Profit Loser
Producer Loser

F ADL Matrix

Combination of the two dimensions (Industry Maturity and Competitive
position) helps decision-making. Competitive position has five main
categories:

• Dominant - Extraordinary position; Some form of monopoly position or
customer lock-in e.g. Microsoft Windows being the dominant global
operating system.

• Strong - Companies have a lot of freedom since position in an industry
is comparatively powerful e.g. Apple's iPod products.

• Favourable - Companies with a favourable position tend to have
competitive strengths in segments of a fragmented market place. No
single global player controls all segments. Here product strengths and
geographical advantages come into play.

• Tenable - Here companies may face erosion by stronger competitors
that have a favourable, strong or competitive position. Difficult for them
to compete since they lack sustainable competitive advantage.

• Weak - Companies in this undesirable space are in an unenviable
position. Of course there are opportunities to change and improve, and
therefore to take an organization to a more favourable, strong or even
dominant position.

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Equity/Business Valuation – Critical Business Analysis and Key…
69
Chapter-4

DCF Valuation – Practical Approach

SOME KEY ITEMS - HOW TO DEAL IN DCF
1. Contingent Liability

In determining equity value, after the free cash flow is determined in the DCF
valuation, adjustment may have to be made towards contingent liability. Such
adjustment becomes a difficult proposition in the context of the following:
• Most popular is to use a probability discount rule. The determination of

the probability of a future event is necessarily speculative and
uncertain.
• Indeed, consistent with that, courts abroad confronted with the
challenge appear uniformly to punt on the issue and instead assume,
with little or no analysis, either a 50% or 100% probability.
Other options for considering the same include:
• Evaluation of whether it is one contingency or many
• Applying hindsight, where later events have occurred
• Other comparable instances in the past

2. Tax Implications

Tax outflow in explicit period shall necessarily consider and factor:-
• Benefits of carry forward losses, if any
• Reduced rate of tax during tax holiday periods
• MAT implications
• Current tax to be considered as an outflow (and not adjusted for

deferred tax)
Tax impact for terminal value computations
• Generally to be considered at the full applicable rate.
DCF Valuation – Practical Approach

• PV of any significant carry forward loss, MAT or Tax holiday impact for
periods post the explicit period may be present valued and adjusted
separately.

3. Surplus Cash (Cash Not Used in Business)

Many a times, it is possible that the company may be having surplus cash or
cash equivalents in the company. Cash and cash equivalents which is part of
the business requirement is to be dealt with as part of the net working capital
movement. However, any surplus cash and cash equivalent which is not
required for the day-to-day operation of the business is to be separately added
to the enterprise value arrived at using DCF valuation. Any interest income
from deployment of such surplus cash should also be eliminated from the cash
flow projections.

4. Negative Working Capital

Some businesses such as retail sales / petrol pumps / stock exchanges end
up with negative working capital. In view of the cash cycle in the business
operations, as the business grows, instead of needing to invest further monies
into working capital, these businesses end up having more cash in hand. How
can this be considered? as this by normal model would lead to significantly
higher EV.

• One model perhaps is to ignore such cash inflow from working capital
in the free cash flow computation

• Instead may consider interest income at a rate not exceeding the risk
free rate or what is practically feasible to realise, if lower. Generally,
interest income from cash surplus being re-invested is excluded from
free cash flow computations

• The logic in the instant case is: Payment of the liability is a certainty
Only benefit, which we can garner is the income generated from such
surplus cash

5. Surplus Assets (Assets not used in business)

This refers to the assets of the company which are not actively held in the use
for the business, for instance, there could be land held by the company which
is not in the use of the business or there could be investments held by the
company.

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These are surplus assets and are not considered in the cash flow projections.
Any income / expenditure related to the same are also not considered in the
business cash flow projections. The fair value of these assets are added to
the enterprise value arrived at using DCF valuation.

6. Investment in a Subsidiary – part of the business

Sometimes investment could be in subsidiaries which are actually part of the
business structure. For instance, subsidiary in a foreign country to sell the
products manufactured by the parent in such geography. In such cases, it is
ideal to consider the business projections (cash flows) on a consolidated basis
and not treat the subsidiary as a surplus asset.

Alternatively, each subsidiary could be valued separately using DCF and
considered. Under such circumstance, dividend etc., from subsidiary should
not be treated as cash inflow.

7. Share Application Money at the Valuation date

Present requirement of issue of shares within 60 days of receipt of application
money need to be considered while determining the projected cash flow. Full
facts of the share application money and the agreement / arrangement behind
the same need to be understood to give the correct impact. Accordingly, it
could be adjusted either as a debt on the date of the valuation and thus
reduced from the enterprise value or it can also be adjusted in the number of
shares for computing the equity value per share, as appropriate. The Valuation
Report should consider this and clearly explain the same with appropriate
rationale.

8. Preference Shares

The impact of Preference shares on Business valuation depends on the nature
of the instrument and its convertibility and hence a valuer needs to understand
and evaluate it each case:-

i) CCPS, convertible into fixed number of equity shares – It is ideal to
adjust the same in the number of equity shares considered for the per
equity share valuation.

ii) CCPS convertible into variable number of equity shares based on
performance in future – It is ideal to adjust for the same in the number
of equity shares considered for the per equity share valuation – taking

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DCF Valuation – Practical Approach

the assumption of conversion in sync with the projected performance
considered

iii) OCPS – Ideal to value the OCPS using stock option models and
consider the same accordingly for adjustment

iv) Redeemable PS – Treat as debt

Remember – These are only a point of view and there is no one solution which
fits all scenarios

9. Short Term Debt/Bank Over Draft

Movement in Short Term Debt/Bank Over Draft is considered as part of
working capital change and any balance debt at the end of explicit period is
reduced from enterprise value at its present value. Interest on it shall also be
reduced from free cashflow. Hence, following broad impact to be considered:

• Repayments / reduction is reduced from free cashflow

• This interest and debt is not considered in computing WACC

• Interest considered as cost/ outflow in FCFF

• Part repayments of short-term debt considered for cash flows

Though, what is stated above for short term debt is probably the more
appropriate model, in India, as information is sometimes not available on this
basis and all debts are aggregated. Further, even utilisation could be mixed
up. This leads to a practical approach of considering short term debt also akin
to long term debt in DCF computations, as an alternative.

10. Further Capital Infusion

Additional Capital Infusion is normally not considered, as the DCF valuation
anyway considers the investment made – independent of the source of such
funding in future. However, this need to be carefully considered as in some
cases, the value being derived may be significantly connected to such infusion
of capital in future and the resultant investment therefrom being enabled. The
whole projection may have to be shrunk, if the future capital raise or fund
infusion is not achieved.

PRE MONEY AND POST MONEY VALUATION – WHICH IS
APPROPRIATE?

This is an area of greyness – especially many times one does not appreciate
the difference between “value” and “price”. Mr. Damodaran in one of articles

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states:
• A DCF valuation, done right, always yields a pre- money value for a

business.
• The value of a business, after a capital infusion, will have to incorporate

the cash that comes into the business, pushing up the post-money
value.
• The "ownership value” on which the ownership proportion is negotiated
will move towards the post- money value, when there is an active and
competitive (venture) capital market, and towards the pre-money value,
when there is not one.

11. Sectoral Variations in Cost of Capital

Following are the major determinants of Cost of Capital:-
• Inflation
• Country specific risk premium
• Government Rules – FDI / SLR etc.,
• Liquidity – The long term G-sec and Overnight rates
• Risk perception
Further Sectoral differences in Cost of Capital is determined by:-
• Restrictions in terms of FDI, debt investment by FII in the concerned

sector
• Capital structure choices for each industry sector
• Government policies applicable to the sector
• Risk structure specific to the Company
• Risk perception of the investor

12. Impact of Inflation

Inflation is a general increase in prices leading to a general decline in the real
value of money. In times of inflation, the fund providers will require a return
made up of two elements:
(i) Real return for the use of their funds
(ii) Additional return to compensate for inflation

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DCF Valuation – Practical Approach
The overall required return is called the money or nominal rate of return . Real
and nominal rate are linked by the formula:
(1+i) = (1+r) (1+h) or
(I+r) = (1+i)/(1+h)
In which
r = real rate
i = money/nominal interest rate
h = general inflation rate

13. Methods of Dealing with Inflation

Methods of Dealing
with Inflation

Real Method Money/Nominal
Method

1. Do not inflate the cash flow – 1. Inflate each cash flow by
Leave them in Real Terms ie, in its specific inflation rate ie,
Today’s (T0) Prices – Real Flows convert it to a Money Flow

2. Discount using the 2. Discount using the
Real Rate money rate

REAL/real MONEY/money

BE CONSISTENT
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The Real Method can only be used if all cash flows are inflating at the general
rate.

14. Discounts and Premium in Valuation

Typical Discounts and Premiums are as under:-
• Illiquidity Discount
• Control Premium
• Minority Discount
• Company Risk Discount
• Business Size Discount / Premium
• Synergy Premium
• Key person discount
• Trapped in Capital Gains discount
• Block sale discount / premium

15. Measuring Illiquidity Discount

Two methods have been presented by Mr. A. Damodaran and available in his
website for measuring Illiquidity Discount.
i) Bid-Ask Spread Method
The model is based on extensive bid – ask spread analysis done in the United
States. The underlying principle is the spread between bid and ask price in the
market and is reflective of the level of illiquidity of the stocks which are listed.
This had been tested and a relationship established with the following
parameters (based on observed data of bid – ask spreads).
• Revenue
• Net Earnings – whether positive or negative
• Ratio of cash and marketable securities in the firm value
• Trading volume / Value (which will be Zero in case of unlisted entities)

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DCF Valuation – Practical Approach

ii) Size of the firm based model
It is based on research in the United States which established a relationship
of the discount for illiquidity to the size of the firm. The relationship is based
on the following parameters of
• Revenue size of the firm
• Whether the firm is making profits or losses
• Size of the block of shares which are the subject matter of the

transaction

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16. Control Premium

Empirical data on Control Premium shows that the premium varies widely.
However, conceptually, there is a clear understanding that control does
provide for a premium in comparison to the valuation applicable for non-
controlling stakes.
It can be said that the valuation ought to be impacted positively with increasing
stake share in the entity whenever each threshold of additional rights are
crossed, starting from insignificant holdings to when it crosses 10%, thereafter
when it touches 26%, 51% and so on until it crosses 90% and then 100%.

17. Minority Discount

The minority discount relates to the lack of control that minority shareholders
have over the operation and corporate policy of a given investment. The
minority shareholders can generally neither direct the size or timing of
dividends nor appoint management. A minority shareholder can also not veto
the acquisition, sale or liquidation of assets. Minority discounts are therefore
usually applied when valuing a non-controlling interest to discount the value
for lack of control.

18. Key Person Discount

One person can make a a–lot–of difference! and impact valuation of a
company immensely any such person are key persons.
Examples of same
i) The impact Jamie Dimon had on company’s stock

When Jamie Dimon was fired as president of Citibank in Nov 1998 its
stock sank by $11 billion! When he was named CEO of Banc One in late
March 1999 thereafter its stock rose by $ 7 billion!
ii) Resignation of Steve Jobs as CEO of Apple Inc saw the price dropping
immediately by 5% in Aug 2011.

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DCF Valuation – Practical Approach

19. Valuation Technique for DLOM Measurement

Approach Measurement Rationale

Financial A put option represents the value of a right to sell. It
Modelling: theoretically matches the DLOM concept of an inability to
put option exercise a right to sell. This type of model measures DLOM
method by dividing the put option value by the current stock value.
For e.g. Chaffe Model (1993), Longstaff model (1995) and
Finnerty Model (2003)

Empirical The IPO stock price is compared with the stock price in a
Studies: Pre- private transaction sometime prior to the IPO when the
IPO stock entity is not yet public. For Eg: Emory Studies and
studies Valuation Advisors studies

Empirical A publicly traded entity issues non-trading stocks directly to
Studies: an investor in a private placement. Due to laws and
Restricted regulations, these privately placed stocks cannot be freely
Stock traded in a public market for a period of time. Prices of the
Studies liquid stock and the restricted stocks are compared. For
e.g. SEC Institutional Investors Studies, FMV Opinions
Studies and Willamette Management Associate Studies

Court Cases No Universal consensus and depends on precedent cases
Reference in each jurisdiction

20. Valuation Technique for DLOC Measurement

Approach Measurement Rationale

Empirical Studies: Premiums paid for acquisitions of listed entities
Acquisition compared with trading prices of the listed entities prior
premium studies to the acquisition announcements are studied. For e.g.
Mergerstat studies

Empirical Studies: If NAV listed entities can be reasonably estimated at
NAV Discount transaction dates, the percentage of discount observed
Studies in minority interest transactions compared with the
underlying NAV of the listed entities are studied.

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Approach Measurement Rationale

Empirical Studies: Studies comparing trading price of stocks with and
Voting and Non- without voting rights
Voting Stock
studies

Court Cases No Universal Consensus and depends on precedent

Reference case in each jurisdiction

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Chapter-5

Valuation of Start-up Companies

1. Introduction

In August 2015, the Hon’ble Prime Minister, Shri Narendra Modi, announced
the launch of the national flagship initiative – Start-up India, with a mandate to
promote and encourage young entrepreneurs of our country. He envisioned
the aim of the initiative to transform India into a Start-up nation, “a country of
job creators instead of job seekers”.

India has managed to retain its position as the 3rdlargest start-up ecosystem
in the world with more experienced professionals taking the entrepreneurial
route. It has also climbed three places in 2018 to position itself in the 57th rank
in the Global Innovation Index from 60th position in the previous year. Besides
this, India also holds the title for the highest Unicorn holder of 8 ventures right
after the US and China (However, post Covid-19 Pandemic, few of the unicorns
worldwide have are no more entitled to such status- ‘Unicorn’). The Indian
Unicorn list was expected to add 10 more businesses by the end of 2020,
however, due to the prevailing conditions, we need to see how this will be met.

Further, the value of a newly formed business is often required for bringing in
investments either by way of debt or equity funding. There are some
peculiarities involved in valuation of a start-up business arising from the fact
that there is no historical data available on the basis of which future projections
can be drawn.

Valuation poses many challenges at this firm, since there is little useful
information to go on. In the initial stage of business products are generally
untested and do not have an established market. Operations of firm are at
small level, no operating history and no comparable firms used to exist.

The value of this firm rests entirely on its future growth potential, which, in
many cases is based on an untested idea and may not have been based on
adequate sampling of consumer behaviour or anticipated consumer behaviour.
The estimates of future growth are also often based upon assessments of the
competence, drive, and self-belief of, at times, very highly qualified and
intelligent managers and their capacity to convert a promising idea into
commercial success.
EM on ICAI Valuation Standard 301 Business Valuation

2. Definition of Start up

An entity shall be considered as a Start-up:
i. Upto a period of ten years from the date of incorporation/ registration, if

it is incorporated as a private limited company (as defined in the
Companies Act, 2013) or registered as a partnership firm (registered
under section 59 of the Partnership Act, 1932) or a limited liability
partnership (under the Limited Liability Partnership Act, 2008) in India.
ii. Turnover of the entity for any of the financial years since incorporation/
registration has not exceeded one hundred crore rupees.
iii. Entity is working towards innovation, development or improvement of
products or processes or services, or if it is a scalable business model
with a high potential of employment generation or wealth creation.
Provided that an entity formed by splitting up or reconstruction of an existing
business shall not be considered a ‘Start-up’.
Explanation-
An entity shall cease to be a Start-up on completion of ten years from the date
of its incorporation/ registration or if its turnover for any previous year exceeds
one hundred crore rupees.

3. Requirements of Start-up Companies

• Incorporation/Registration Certificate
• Director details
• Proof of concept like pitch deck/website link/video (in case of a

validation/ early traction/scaling stage start-up) respectively
• Patent and trademark details (Optional)
• PAN Number

4. What documents are not required?

• Letter of Recommendations
• Sanction Letters
• Udyog Aadhar
• MSME Certificate
• GST Certificate

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Valuation of Start-up Companies

5. Venture Capital Investors (VCs) and Valuation

Venture Capital Investors (VCs) often value newly born companies on a
‘multiple’ of proposed/ existing ‘revenue/ EBITDA’. This approach is flawed in
a sense that it applies constant multiples to all entities with differing
characteristics but with similar Revenue/ EBITDA. We try to work around this
defective valuation approach to help IBBI registered valuers follow a more
scientific method. First we will read through typical approach that VCs follow.

Investors particularly venture capitalists (VCs) add value to start-ups in a lot
of ways1:

a. Stakeholder Management: Investors manage the company board and
leadership to facilitate smooth operations of the start-up. In addition,
their functional experience and domain knowledge of working and
investing with start-ups imparts vision and direction to the company.

b. Raising Funds: Investors are best guides for the start-up to raise
subsequent rounds of funding on the basis of stage, maturity, sector
focus etc. and aid in networking and connection for the founders to pitch
their business to other investors.

c. Recruiting Talent: Sourcing high-quality and best-fit human capital is
critical for start-ups, especially when it comes to recruiting senior
executives to manage and drive business goals. VCs, with their
extensive network can help bridge the talent gap by recruiting the right
set of people at the right time.

d. Marketing: VCs assist with marketing strategy for your product/service.

e. M&A Activity: VCs have their eyes and ears open to merger and
acquisition opportunities in the local entrepreneurial ecosystem to
enable greater value addition to the business through inorganic growth.

f. Organizational Restructuring: As a young start-up matures to an
established company, VCs help with the right organizational structuring
-and introduce processes to increase capital efficiency, lower costs and
scale efficiently.

1https://www.startupindia.gov.in/;
http://www.nrdcindia.com/NationalProjectDetail/3

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6. Multiple Based Valuation

Newly Established Entity ‘A’ has marginal revenue and negative EBITDA.
Recently, company received investment of ‘Rs. 50 Lakhs’ in ‘Round A funding’
at dilution of 10% equity stake (i.e. at post money valuation = Revenue of Rs.
50 Lakhs x Multiple of 9 + Equity Infusion of Rs. 50 Lakhs = Rs. 5 Crore). This
investment was made on the basis of presumed multiple of 9 onto expected
revenue of immediately next year (often existing revenue is preferred over
future revenue.) of Rs.50 Lakhs. Following are key financial pointers of Entity
A:

Particulars Rs. In Lakhs

Sources of Finance

Money invested by Promoters 100

% Share Holding by Promoters (Before VC 100%
investment)

Cost Incurred and Capitalised in Year 0 30

(may be on account of development expenditure of
technology product)

Operational Expenses of Year 1 60

Revenue 50

Loss for the Year 10

Cash Available at the end of Year 1 10 (i.e. 100 – 60 –
(i.e. before VC investment) 30)

Amount Invested in Round A 50

Shareholding Pattern

i) By Promoters 90%

ii) By VC 10%

Cash Available immediately after VC funding 60 (i.e. 10 + 50)

On the face, above valuation appears acceptable. However, there are multiple
flaws to this approach.

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Valuation of Start-up Companies

This approach completely ignores the fact that ‘most of the start-ups’ don’t
survive and this risk of failure is not at all built in the model above. Mul tiple of
9 quoted above is usually calculated on the basis of data of matured
companies without alteration/ adjustment to make it specific to start-ups. We
believe that legitimising ‘multiple approach’ without entity specific logical
adjustments is abuse of valuation standard. Such approach not only offers
flexibility but also offers different valuers to undersign ‘similar values of broadly
differing organisations’ or to undersign ‘widely differing values of similar
organisations.’

7. Start-up life cycle

Following is a sample projection of Entity A:

(All Amounts in Rs. In Lakhs)

Year Revenues Cost Earnings Stage
-10 Development Stage
1 0 -10 -20
-10 Revenue of 1st year on
2 0 -20 which VC investment of Rs.
-30 50 Lakhs is received at
3 50 -60 Post Money Valuation of
-40 Rs. 5 Crore (using Revenue
4 100 -130 10 Multiple of 9)
45 Cash Available at the
5 200 -240 50 beginning of Year is Rs. 1
55 Crore (–) Cost of 3 years
Rs. 90 Lakhs (+) VC Equity
Infusion of Rs. 50 Lakhs =
Rs. 60 Lakhs
Future Projections

6 240 -230

7 280 -235

8 290 -240

9 300 -245

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Valuer needs to be cautious while certifying valuations of new entities as these
entities don’t have any history to rely on, they have marginal or no revenues
along with negative earnings, growth is typically dependent on private equity
infusion, and they carry loss of failure.

Observed probability of failure is quoted by comparing data on number of
organisations that started in year 1994 as follows:

Year Surviving Survival Rate Since Years of
Survival
Establishments Birth

1994 10,917 100.00% 1 Year

1995 8,582 78.61% 2 Years

1996 7,311 66.97% 3 Years

1997 6,403 58.65% 4 Years

1998 5,651 51.76% 5 Years

1999 4,992 45.73% 6 Years

2000 4,502 41.24% 7 Years

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Valuation of Start-up Companies

Year Surviving Survival Rate Since Years of
Survival
Establishments Birth

2001 4,023 36.85% 8 Years

2002 3,610 33.07% 9 Years
30.48% 10 Years
2003 3,327 28.05% 11 Years
26.57% 12 Years
2004 3,062 24.98% 13 Years
23.88% 14 Years
2005 2,901 22.81% 15 Years
21.27% 16 Years
2006 2,727 20.17% 17 Years
18.75% 18 Years
2007 2,607 17.63% 19 Years
16.35% 20 Years
2008 2,490 15.69% 21 Years
14.18% 22 Years
2009 2,322 13.53% 23 Years
12.73% 24 Years
2010 2,202 12.10% 25 Years
11.49% 26 Years
2011 2,047

2012 1,925

2013 1,785

2014 1,713

2015 1,548

2016 1,477

2017 1,390

2018 1,321

2019 1,254

In the above sample, 10,917 entities, started in Year 1994, presenting sectors
such as Construction, Mining, Manufacturing, Transportation, Information etc.
are analysed until Year 2019. Out of 10,917 entities established in Year 1994,
only 1,254 entities are transacting until Year 2019 representing Probability of
Failure in 26 years to be 88.51% (i.e. 100% - 11.49%).

8. Growth Assets

While using celebrated Discounted Cash Flow Approach, little of the value of

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Start-up companies is derived from ‘existing assets’. Rather, most of the value
is derived from ‘growth assets’.

It is tough to confidently claim the monetisation of growth assets but with
techniques such as rationing/ calibration, may help to control and put some
reasonableness to estimations. Reinvestment out of future earnings drives
growth. Hence, growth is a function of Return on Investment and Reinvestment
Rate.

Typically, growth assets are created when Return on Capital is more than Cost
of Capital. In early years, return on capital is negative and hence, difficult to
predict growth assets until earnings turn positive. However, until such period
growth can be facilitated through equity infusion (for e.g. Entity A received
Rs.50 Lakhs as a Round A funding from VCs.)

9. Few More Flaws of Multiple Based Valuation

Given Equity Infusion of Rs.50 Lakhs in Year 4, cash available at the beginning
of Year 4 would be Rs. 60 Lakhs. Despite this fact, projections quoted Cost of
Rs.1.30 Crore in Year 4 – this is unrealistic and mathematically impossible.
You can’t spend Rs. 1.30 Crore out of Rs. 60 Lakhs available to you. Hence,
projections are faulty and neither considers resource restrictions nor identifies
potential growth possibilities.

10. Better Approach of Start-up Valuation

Step I – Estimation of Cash Flows

First of all, it is required to identify reinvestment required to achieve targeted
revenue and profitability. This can be done by comparing capital available to
us and cost estimated to be incurred. Difference between the later and former
is additional capital/ reinvestment requirement.

Year Capital Addition Return on Earnings Capital Cost Required
for the Reinvestment
Employed During Capital During Employed Year = Cost for the

at the the Year Employed the Year at the End Year -
Opening
Beginning % of Year Capital

A B C = (-) I D = E/A E F=B+C+ G H I

E

1 100 - -10.00% (10) 90 (Given) (10) Reinv. Not

Required

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Valuation of Start-up Companies

Year Capital Addition Return on Earnings Capital Cost Required
for the Reinvestment
Employed During Capital During Employed Year = Cost for the

at the the Year Employed the Year at the End Year -
Opening
Beginning % of Year Capital

2 90 - -22.22% (20) 70 (Given) (20) Reinv. Not

Required

3 70 - -14.29% (10) 60 (Given) (60) Reinv. Not

Required

4 60 70 -50.00% (30) 100 Calculated (130) 70

5 100 140 -40.00% (40) 200 Calculated (240) 140

6 200 30 5.00% 10 240 Calculated (230) 30

7 240 - 18.75% 45 285 Estimated (235) Reinv. Not
Required

8 285 - 17.54% 50 335 Estimated (240) Reinv. Not
Required

9 335 - 16.42% 55 390 Estimated (245) Reinv. Not
Required

10 390 - 14.10% 55 445 Estimated (250) Reinv. Not
Required

In this Concept Paper ‘how minutely you should analyse the cost structure’ is
a primary focus. Consequently, other aspects of the valuation procedure have
not been elaborated. However, as a pointer it is stated that you must duly
consider operational costs, tax benefits, and imputed cost related to owner (for
e.g. ‘Owner Music Composer’ may not be drawing fair salary from his
organisation but had he been employed by another company he would have
earned a fair salary. Such additional salary to make operating costs more
realistic and comparable, is required to be duly considered as imputed costs.)

Step II – Estimation of Discount Rates

Typically, start-ups may not raise debt funding on absence of collateral
security. Hence, in this Concept paper, it is presumed that ‘Equity’ is the only
source of financing. Cost of Equity is a combination of Equity Risk Premium,
Entity Specific Beta, and Risk Free Rate of Return related to currency in which
entity generates cash flow.

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Though many perform levering and unlevering of beta to make beta more
specific to entity, they often fail to further adjust it for absence of investor’s
diversification.

Cost of Equity = Risk Free Rate + Equity Risk Premium x Beta + Country Risk
Premium

Equity Risk Premium = Market Rate of Return – Risk Free Rate

Risk Free Rate = *10 Year Government Bond Rate – Country Risk Premium

*instead of 10 years, you may choose to consider differently maturing bond,
however, it is accepted practice to use 10 year bond rate which co-exists with
cash flow estimation of 5 or 10 years.

Step III - Calculation of Beta

You may observe 2 year beta of multiple listed entities across globe (need not
restrict to particular region) from similar industry (i.e., industry of company
under valuation). Calculate simple average of all 2 Year Betas and Unlever it
using Average Debt and Average Market Capitalistion of companies above.

Levered Beta = Unlevered Beta x (1 + Average Debt/ Average Market
Capitalisation)

Thus, Unlevered Beta = Simple Average of Regression Betas / (1 + Average
Debt/ Average Market Capitalisation)

‘Equity’ has been assumed as the only source of funding, unlevered beta
calculated above can be treated as entity specific beta before adjustment for
diversification of investor.

Sole Owner of a start-up usually represents that individual who has put in all
eggs into one basket i.e., his all/ substantial investments are represented by
his start-up and hence he is least diversified. Similarly, early-stage VCs
possess portfolio of investments that are less diversified. Hence, both sole
owner and early-stage VCs are less diversified investors. Subsequent rounds’
VC investors are comparatively better diversified but still less diversified than
investors who invest in IPO/ Listing.

We can identify Correlation between entities in industry of a start up with the
market (i.e., all listed entities). Total Beta (i.e., Beta along with market risk of
less diversified investor) can be calculated as Levered Beta Calculated above
divided by Correlation between Entities in Industry and the Entire Market.

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Valuation of Start-up Companies

Total Beta = Levered Beta/ Correlation (Industry of Start Up and Market)

Thus, revised Cost of Equity = Risk Free Rate + Total Beta (Equity Risk
Premium) + Country Risk Premium.

Step IV - Applying Discount Rates

It can be observed that Entity A needs 3 rounds of funding for Year 4, Year 5,
and Year 6 respectively. Assume 4th year investment is made by ‘least
diversified’ VC investor, 5th Year investment is made by ‘moderately diversified
investor’ and 6th Year investment is made by ‘widely diversified investor’, then
Beta related to each of these investors shall be applied to identify cost of
capital (i.e., cost of equity ke or weighted average cost of capital WACC) to
calculate year specific discounting factor.

In calculating Intrinsic Value i.e., present value of future cash flows,
discounting factors for 4th, 5th, and 6th year shall be representative of investor
characteristics. This means, cost of equity for 4th year is calculated using Beta
that is calculated as follows:

Total Beta = Levered Beta/ Correlation (Industry of Start Up and Market)

If Levered Beta is say 0.70 and Correlation between Industry of Start-up is say
0.80, then Adjusted Levered Beta = 0.70/0.80 = 0.88

Levered Beta Least Moderately Widely
Correlation Diversified Diversified Diversified
Adjusted
Investor Investor Investor
0.7 0.7 0.7
0.8 0.9 1.00
0.88 0.78 0.70

You can observe that as start-up moves from least diversified investor to
widely diversified investor, related beta (i.e., measure of systematic risk)
reduces from 0.88 to 0.70.

If we presume, risk free rate to be 3%, country risk premium to be 6%, and
equity risk premium to be 5%, cost of equity for 3 different investors will be
calculated as follows:

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Risk Free Rate Least Moderately Widely
Country Risk Premium Diversified Diversified Diversified
Equity Risk Premium
Beta Investor Investor Investor
Cost of Equity 3% 3% 3%
6% 6% 6%
5% 5% 5%
0.88 0.78 0.70

13.38% 12.89% 12.50%

On this basis, discounting factors will be calculated as follows:

Year Discounting Discounting
Rate Factor

1 13.38% 0.882028666
0.777974568
2 13.38% 0.68619587
0.605244428
3 13.38% 0.536141717
0.476570416
4 13.38% 0.423618147
0.376549464
5 12.89% 0.334710635 (i.e. 0.6052/(1+12.89%)
0.297520564 (i.e. 0.5361/(1+12.50%)
6 12.50%

7 12.50%

8 12.50%

9 12.50%

10 12.50%

Step V - Estimating Terminal Value

There are 3 possibilities –

1. Company will flourish and continue as a going concern in perpetuity
(Scenario 1)

2. Company will flourish and continue as a going concern for a limited
period (Scenario 2)

3. Company is a failure and goes into distress sale (Scenario 3)

Terminal Value in case of Scenario 1 is calculated as expected annual cash
flow divided by Cost of Equity minus Growth Rate.

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Valuation of Start-up Companies
Terminal Value = Free Cash Flow of nth Year (1+ Growth rate after nth Year)
/ (*Cost of Equity – Growth rate after nth Year)
*As scenario presumed Equity as only source of financing, we use ‘Cost of
Equity’ as a compounding/ discounting rate.
Terminal Value in case of Scenario 2 is estimation of cash flows from nth year
to end of limited period (say 5 years after nth year). It is better in such case to
plot cash flows for all years including 5 years subsequent to n years.
Terminal Value in case of Scenario 3 is salvage value of assets at the end of
expected life of start-up. If valuers can’t reasonably estimate this value, they
should presume it to be ‘nil’ in case of service-based start-ups where asset
base is insignificant.
However, for those start-ups where significant asset base is represented by
immovable property, it is suggested to appoint IBBI registered Valuer from
such asset class to identify distress value of such immovable properties and
consider such value into your valuation model. Valuers should avoid arbitrary
assumptions such as ‘distress value is presumed to be 35% of book value/
market value.’
Step VI - Adjustment for Probability of Failure
Expected Value = Value as a Going Concern x (1- Probability of Failure) +
Distress Sale x Probability of Failure
We have already referred to a table quoting survival rate. Such rate helps us
identify probability of failure as follows. Say, we estimated cash flows for 5
years, then probability of surviving for 5 years (you observe this probability
from table previously quoted) is 51.76%.
Thus, probability of failure = 1- 51.76% = 48.24%.
Expected Value of Start-up (Before Liquidity Discount) = Value as a Going
Concern x (1- 48.24%. i.e. Probability of Failure) + Distress Sale x 48.24%.
i.e., Probability of Failure.

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11. Stage of Development of Product Development
Companies

Start-up can be analysed per its stage of development.

Particulars Stage 1 Stage 2 Stage 3 Stage 4 Stage 5 Stage 6

Revenue No History No History No History Some Enhancing Established
History

Expenses Limited Significant Significant Significant Established Established
History History

Profitability Losses Losses Losses Losses Breakeven/ Established

Profit History

Management Incomplete Expanding Complete Complete Complete Complete
Team

Product Some Some but Beta Started Continued On-going
not yet at Testing Executing Executing
Development Beta Orders Orders
Testing

Financing Angels/ VCs VCs/ Mezzanine Strategic Out of own
Sources Early VCs Strategic Financing/ Investors/ Profits
Investors Bridge IPO
Loans/
Last round
by VCs/
Strategic
Investors

You as a valuer are expected to write a commentary on each of the stage
identification pointers and conclude the stage of the development of the entity
under valuation. Such analysis often supports ‘DCF based number you
derived’ to be a fair value. This exercise can also help valuer judge qualitative
fairness of his valuation. For example, if valuer concludes an entity to be in
Stage 2, then he needs to document a timeline expected by himself and the
management of company to reach a stage 5 when breakeven can be achieved.

Traditionally, management has been undertaking a breakeven point at as early
as 2nd year of establishment. Valuers should not accept such claim on the face
of management representation letter unless it is logically tenable.

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Valuation of Start-up Companies

Valuers are suggested to frame their questions based on following
representative points:
• Understand original business plan
• Has proof of concept been achieved?
• Has Beta Test been carried? What is the outcome?
• Whether company possesses related regulatory approvals for

manufacturing (important in terms of pharma companies)?
• Who are key customers?
• How entity secures raw material, equipment, or work force?
• Has company started shipping orders?
• What is the profitability of company?
Apart from above, valuer is suggested to write a commentary on observations
related to following:
• State of Industry & Economy – while valuer writes content under this

chapter, he should not refer to study made by any institute unless he
has bought that study/ research and possess legal right to reproduce
the result in his valuation report.
• Management and BoD
• Marketplace & Major Competitors
• Barriers to Entry
• Competitive Forces
• Intangible Right/ Propriety Right in technology
• Human Resource
• Customer and Supplier/ Vendor characteristics
• Strategic Relationship with key customers/ suppliers
• Major Investors

12. Embedded Rights and Valuation Modelling

Funding can be achieved by issuance of various types of securities such as
equity or debt. However, most investments in start-up are received in the form
of ‘Preferred Stock’.

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Following are common mistakes made by valuers:
1. Treating preferred stock on fully dilutive basis i.e., assuming it to be

equity
2. Treating preferred stock as a debt
Preferred stock carries a preferential right in liquidation. Thus, it definitely
cannot be treated as equity even if it is fully convertible at the option of
investor.
Following types of rights in various investments made by VCs, or strategic
investors have been observed:
i. Cumulative Preference Dividends
ii. Non-Cumulative Preference Dividends
iii. Non-Participating Liquidation Preference
iv. Participating Liquidation Preference
v. Mandatory Redemption
vi. Conversion in Fixed Number of Equity Shares
vii. Conversion in Variable Number of Equity Shares
viii. Anti-Dilution Right
ix. Voting Rights
x. Protective Provisions
xi. Right to Board Composition
xii. Drag Along
xiii. Right to participate in future rounds
xiv. Right of First Refusal
xv. Right of Tag Along
Out of the various rights observed above, valuation model shall be customized
for first 8 rights. Valuation model may not need specific adjustment to account
for rights from 9 to 15. Customization to valuation model (for rights from point
1 to point 8) is a matter of professional expertise / advanced knowledge and is
not dealt in this concept paper.

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Valuation of Start-up Companies

13. Measurements Specific to Internet Companies

Measurements Valuer’s Consideration

Number of Visitors/ Visitors reflect a reach of the Internet Based

Month Company. Companies can use ‘google

analytics tool’ to identify:

1. No. of Visitors/ Month

2. No. of New Visitors/ Month

3. % of New Users

4. Bounce Rate

5. Length of Visitor Session

Analysing above data can help valuer verify
claims of the management related to
commercial acceptance and stage of maturity
of the company.

Customer Conversion Data from above matrix can be compared with
Rate actual number of orders received in a month/
week to verify customer conversion rate.

With a descent history, customer conversion
rate can be applied on to expected number of
visitors over projected period (suggested not to
be more than 3 years) to substantiate the
projected revenue.

Average Revenue/ Once revenue is substantiated, valuer can
Order Revenue/ verify current value of average revenue per
Average order or per customer and projected values of
Customer such averages to check reasonability of
projection.

Monthly Recurring Product based companies may earn recurring
Revenue monthly revenue (e.g., Microsoft earns
recurring monthly revenue for Office 365
subscription).

E-commerce companies such as Netflix use
this matrix to estimate their fair values.

Customer Acquisition Marketing cost is one of the significant cost of

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Cost internet based companies. Valuer is suggested
Churn Rate to analyse historical data along with growing or
Burn Rate declining pattern of number of customers to
establish a judgement on future projections of
the management. If current customer
acquisition cost is more than revenue per
customer, then valuer must understand and
elaborate on expected growth in revenue vis-a-
vis current and expected marketing cost.

This means rate of customers entity lost to total
number of customers. Valuer can tabulate
current, new, and closing number of customers
to identify number of lost customers.

For example, if entity has 100 customers at the
beginning of year 3, it adds 20 more customers
during year 3, however, customers at the end of
year 3 are 110, then churn rate is (100 + 20 –
110) / 100 = 10%.

Historical identification of churn rate can help
valuer establish stage of a life cycle of the
company.

It is a cash lost vis-à-vis cash balance. Burn
rate = Total Cash Balance / Cash Expense
during month.

In the early stages of enterprise, valuer can use
burn rate to identify ‘time of survival’ with
existing cash and ‘time of additional investment’
to maintain current/ projected burn rate.

14. Lessons Learnt

The two most appropriate methods of valuing a start-up company are the
income approach and the market comparable approach. Income approach, as
noted, is sometimes limited because of the uncertainty of the future success
of the company, much less its revenues, expenses, and cash flow. The market
comparable approach, however, is also often limited because there are usually
few truly comparable publicly traded companies for a new or very young
company. It is preferable to use Income Approach assuming entity specific

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Valuation of Start-up Companies
cash flows can be estimated after due adjustments related to various entity
specific risks.

15. Conclusion

It should be recognized that in terms of Fair Value, or as appraisers use the
term, Fair Market Value, there is often a substantial difference between the
enterprise value of a privately held company and one that is now publicly
traded. So, while using comparable approach analyst should discount the
Multiple of the publicly traded firm due to size, liquidity and other factors.

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Chapter-6

Business Valuation under Mergers
and Acquisitions

A merger is the combination of two companies into a single business entity.
An example would be merger of Vodafone India with Idea Cellular Limited in
2018 to form a new merged entity of Vodafone Idea Limited. The merger was
reported to be valued around $23 Billion and was pushed majorly to achieve
Synergy benefits on Cost and network optimization, as survival for telecom
giants individually was becoming difficult due to drastic price reduction post
entry of Reliance Jio.

An acquisition is the purchase of one company/business by another
company. The most recent example of one of the biggest acquisitions will be,
Walmart Acquisition of Flipkart, wherein Walmart went ahead to acquire 77%
stake in Flipkart for $16 Billion. This marked Walmart's entry into India Market
against its global competitor Amazon.

Hence it can be seen that the purpose of mergers and acquisitions revolves
around a company’s growth/survival strategy i.e.. to increase market share and
reduce competition or to enter a new sector or product line or even geography.
Hence the ultimate objective of combining two or more companies through
M&A deal is to increase shareholder value in business. This increase in
shareholders’ value takes place primarily on account of Synergy benefits
achieved post the deal. Synergy results from incremental benefits that accrue
to the acquirer on account of economies of scale or other post-acquisition
factors, such as realisation of increased discretionary cash flow or reduced
risk in attaining same when two businesses combine. Synergy can be
categorized as under

(1) Revenue synergies - tend to play out in the product markets and are
subject to the market forces beyond the control of the firm. Hence, it is the
least predictable and reliable of the three. It involves majorly greater market
share and reduction of competition

(2) Cost synergies- cost reduction strategies are under the control of the
combined entity and hence, the most reliable. In addition, these are recurring
in nature as are any economies of scale benefits.
Business Valuation under Mergers and Acquisitions

(3) Under financial synergies, tax strategies are easier to understand and
harder to realize considering the limitations imposed on carry forward losses
and change in ownership. Similarly, debt capacity synergies are easier to
understand in that they reduce the cost of borrowing or increase the ability to
raise debt. However, quantifying this reduced cost of borrowing is not
necessarily a synergy. If the individual firms are able to optimize their debt
equity ratios on a stand-alone basis and achieve the same result, this is not a
synergy. When the synergy is the result of better borrowing power due to a
shift in the optimum debt capacity needed to lower WACC, this can be
quantified as a synergy. Typically, this result is achieved through
diversification or combining two entities with less than perfectly correlated
cash flows to achieve a more stable total cash flow

Valuations in case of Mergers and Acquisitions

The decision to merge / demerge is not only based on the market study,
competitor analysis, legal and procedural aspects, forecasting of synergies,
etc., but also need to take into account valuation of businesses involved in
merger / demerger. Valuation in mergers and acquisition is absolutely
indispensable and rather most crucial activity. In any M&A transaction it is
extremely critical to bring on table the valuation of financial aspects of all
entities involved. Without the valuation it is absolutely impossible to determine
how much of additional value creation will be done for shareholders through
the M&A transaction. No matter how lucrative the strategic or business model
of the deal may look but until valuation is carried out the basic question will
remain unanswered i.e. “what amount are we willing to pay?”.

M&A valuation involves the use of different methods to analyse the financial
profile of companies before they are merged and also that of the final merged
company after the two companies are combined. The primary goal is to
determine whether the Buyer’s earnings per share will increase or decrease
as a result of the transaction.

─ An increase in expected earnings is referred to as accretion, and this
type of merger or acquisition is known as an accretive acquisition.

─ A decrease in expected earnings is called dilution; this type of merger
or acquisition is known as a dilutive acquisition.

Ultimately, whether the transaction is accretive or dilutive is a function of the
purchase price for the Target, as well as the number of shares issued for
raising capital to finance the purchase.

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Valuation under M&A transaction involves following key steps:-

1) Identifying the assumptions in the M&A Deal, e.g.: how it will be
financed, DLOC/Control Premium, Synergy Analysis etc.

2) Deep Analysis and due-diligence study of the financials of all the
companies involved in the deal.

3) Projection of income and net cash flow for all the companies involved in
the deal on a standalone basis.

4) Projecting the income statement or net cash flow for the future merged
company by merging their standalone income statements and adjusting
same for following:

Type of consideration offered (cash or stock) and the impact this will
have on results
Goodwill and other balance sheet adjustments

Transaction costs

Synergy impacts
DLOM/DLOC/Control Premium

5) Analysis of accretion/dilution and balance sheet impact by determining
the EPS before the deal and after the deal.

6) Finally Answering the basic Question i.e., optimum Purchase price for
the deal

Approaches Used in Valuation of M&A deals

In case of Merger, a valuer needs to determine a ‘share exchange /swap ratio’
which would be based on the relative valuation of the transferor and transferee
companies. Both the transferor & transferee companies are generally valued
using same approaches and similar weightage is assigned to different methods
used. However it can vary in case the companies are in different industries.
Out of the three approaches Cost Approach is hardly used in valuation of M&A
deals and it is majorly the Relative/Market approach or Discounted Cash Flow
method that comes into picture. Cash Approach is generally used in
combination with other approaches or in case the company being acquired is
a distressed company or company under liquidation.

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Business Valuation under Mergers and Acquisitions

Market Approach

The Market value approach is based on valuation basis Valuation multiples
derived from comparison with a company’s peers. For example, if the average
price/earnings multiple for a group of similar companies is 20 times earnings,
applying this multiple to the target company’s earnings will yield a theoretical
stock price. The various multiples that are used in the approach are as under

Price multiples:

Price-to-earnings ratios (P/E ratio, P/EBIT ratio, and P/EBITDA ratio)

Price-to-sales ratio

Price-to-book ratio

Enterprise value multiples:

EV/EBITDA multiple

EV/Sales multiple

Considering the efficiency of public markets one might always think that
valuation as per market approach will give good result, but in reality it is not
so. One will frequently see stocks are either grossly undervalued or overvalued
in the market as it doesn’t look into the intrinsic valuation of company.

Comparable Transaction Values help us to value a target company in the
context of other deals done in the industry. Applying multiples from recent and
similar acquisitions that are comparable to the deal at hand gives an indication
of how the company should be valued in the context of a deal. This approach
uses the transaction multiples of comparables deals and applies those
multiples to the target’s operating metrics. For example, if the average multiple
of sales for five comparable transactions is 1.5 times, the proposed target
should probably also sell for a multiple of sales in this range. This is one of the
most commonly used approaches in and M&A transaction especially for Start-
up companies.

Discounted Cash Flow Method (DCF)

DCF Method is another commonly used method in valuing a merger and
acquisition transaction. It helps in determining the intrinsic valuation of a
business as it evaluates the projected cash flows of a target company using a
discount rate that approximates the target’s cost of financing. The cash flows
for a defined projection period plus a terminal value approximating the cash

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EM on ICAI Valuation Standard 301 Business Valuation

flows beyond the projection period for the company are discounted back to the
present value, using a discount rate. As discussed earlier, in M&A firms are
valued both on individual basis (based on their individual projected cash flow)
& also for merged entity (based on the projected cash flow of merged entity)
to determine the exchange ratio/swap ratio

Other Analyses

Contribution Analysis- This method compares the contribution of various
financial factors like revenues, gross profits, operating profits, and earnings of
each company that is a party to the transaction to the ultimate merged
company. It benchmarks the contribution of each company that are part of the
deal. For example, if a company contributes 60% of revenues, gross profits
and earnings to the combined company yet its shareholders receive 40% of
the ownership in the combined company, it may make sense to revisit the deal.

Legal & Regulatory Requirements

Further various laws under regulatory bodies also requires appointment of
valuers in M&A deals and also prescribes the methodology to be used for e.g.:
Companies Act 1956 & SEBI

The MCA notified the Companies (‘Registered Valuer Rules’) with effect from
October 18, 2017, although the Companies Act 2013 does not provide any
specific valuation methods/formulae to be followed, the Registered Valuer
Rules require a Registered Valuer to conduct valuations in compliance with
the valuation standards as notified by the Central Government. Until such
notification, a Registered Valuer needs to carry out valuation as per:

a. internationally accepted valuation standards; or

b. valuation standards adopted by any Registered Valuers Organisation
(‘RVO’).

In case of any scheme of arrangement involving a listed company, the draft
scheme of arrangement needs to be approved by stock exchange(s) before
the same is filed with the National Company Law Tribunal (‘NCLT’). In this
regard, SEBI, through its regulations and circulars has laid down various
conditions for grant of approval, guidelines in respect of pricing and disclosure
requirements for mergers / demergers involving listed companies.

As per Circular No. LIST/COMP/02/2017-18 dated May 29, 2017 issued by
BSE Limited and Circular No. NSE/CML/2017/12 dated June 01, 2017 issued
by National Stock Exchange of India Limited, following disclosure needs to be

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Business Valuation under Mergers and Acquisitions
made by a valuer in the valuation report:

Valuation Approaches XYZ LTD PQR LTD

Value per Weight Value per Weight

share share

Income Approach X A Y D

Market Approach X B Y E

Cost/Asset Approach X C Y F

Relative Value per Share X Y

Exchange Ratio XX

RATIO:

x (xxx) equity shares of XYZ Ltd of INR 10 each fully paid up for every y (by)
equity shares of PQR Ltd of INR 10 each fully paid up

The valuer In case any of the approach mentioned in the table above is not
used for arriving at the share exchange / entitlement ratio, detailed reasons for
the same needs to be provided by the valuer in his report.

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Chapter-7

Frequently Asked Questions

Q1. What do you understand by the term “business valuation”?

A1. In common parlance, business valuation is about estimating the worth
or value of the business. It is a process of arriving at the worth of a
business given the information available, assumptions and limiting
conditions as on the valuation date.

According to the definition in The International Glossary of Business
Valuation Terms, business valuation is the act or process of determining
the value of a business, business ownership interest, security, or
intangible asset”.

Q2. What are “off balance sheet” items?

A2. Off-balance sheet (OBS) items are assets or liabilities that do not
appear on a company's balance sheet. Although not recorded on the
balance sheet, they are still assets and liabilities of the company. Off-
balance sheet items are typically those not owned by or are a direct
obligation of the company. It is necessary for the valuer to value the off
balance sheet items to arrive at a fair value of the business as a whole.

For example, when loans are securitized and sold off as investments,
the secured debt is often kept off the bank's books. An operating lease
is one of the most common off-balance items.

Q3. What are the factors that affect the valuation of a business?

A3. The factors that affect valuation of a business are as follows:

• Value is specific in Point of time

Value is determined at a specific point of time e.g. as on 31st March,
2019. Businesses always remain in the state of change as a result of
various economic, political, geographical, or strategic factors like
acquisitions or sale of business segments or changes in product lines,
management, financing arrangements, market conditions, general and
business-specific economic conditions, industry and competitive
conditions and so on.
Frequently Asked Questions

Hence, it would be difficult or even impossible at times to change the
value with the change in each factor. So, valuation is done on a
particular day and time or it can be said that the value is time
specific.

• Value principally depends on the ability of the business to
generate discretionary cash flow

Discretionary cash flow can be determined as cash flow from operations
of the business less income taxes thereon, net trade working capital
requirements, and capital investment requirements net of the related
income tax shield (Discounted Cash flow technique). Hence, more the
cash generation by the business, more will be the value of the business.

• Value also depends greatly on the market forces

The market rate of return is affected by the following market forces:

i) General economic conditions, particularly short and long term
borrowing rates. Short term borrowing rates tend to influence
activity level, whereas anticipated long-term borrowing rates tend
to influence required rate of return;

ii) Quality and type of purchasers in the market and the motivations,
level of risk awareness and investment philosophy of each. This
in return affects the value of property/assets/business.

• Principle of Risk and Return

In valuation, the risk and return principle simply suggests that risks need
to be adequately factored. In theory, risk can be factored in two ways –
either in cash flows (Certainty equivalent method) or in the discount rate
(Risk Adjusted Discount Rate method). The RADR method is widely
used in practice. Simply, it can be concluded that more return is
demanded for more risk and there should be a reasoned adjustment for
the risk in the valuation.

• Principle of Reasonableness and Reconciliation of Value

In valuation, a large number of uncertainties are dealt with and these
principles simply refer to reviewing the reasonableness of assumptions
about uncertainties and reconciling the values obtained under different
approaches. In fact, reconciliation exercise would help to correct some
unrealistic assumptions. Valuation of a business involves taking
significant responsibility.

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This makes it crucial to check the valuation for –

i) inconsistency in judgments and assumptions

ii) conceptual flaws

iii) projection modelling and formula errors

A valuation without reasonable check and reconciliation exercise is not
complete and would be difficult to defend.

A sound valuation will be based upon all the relevant facts, but the
elements of common sense, informed judgment and reasonableness
must enter into the process of weighing those facts and determining
their aggregate influence.

• Value is influenced by Underlying Net Tangible Assets.

In general, the existence of higher underlying net tangible asset value
[measured in terms of both value in use (i.e. going concern value) and
liquidation value] support a higher value, all other things being equal.

• Value is influenced by Liquidity

As a general rule the greater the liquidity of a business interest, defined
in terms of the number of prospective buyers and sellers, the greater
will be the value of the business interest. All other things being equal,
greater liquidity decreases risk, which in turn leads to higher value.

In an open market transaction, the seller typically maximizes proceeds
by pursuing as many prospective purchasers as possible as opposed to
notifying only one or a few possibly interested parties.

• The Value of Minority Interest is less than the Value of a
Controlling Interest

In general, the value of a controlling interest in a business may have a
greater value per share than does a minority-interest in the same
business when each is viewed in isolation, subject to anything specially
mentioned in shareholders’ agreement or by any legislation.

Q4. What are the components to be kept in mind by the valuer before
accepting any proposal for valuation of business?

A4. Before accepting any proposal for the valuation of business, the valuer
must keep the following aspects in mind:-

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Frequently Asked Questions

• Purpose of engagement

• Profile and expectations of the client.

• Valuation Base

• Premise of value

• Information about Industry, Economy and Company.

• Application of discounts and premium.

Q5. What does ‘Due Diligence’ mean?

A5. It is a very common and popular term in the corporate world in relation
to corporate restructuring, merger & acquisition, joint venture, spin-offs,
amalgamations, etc. Due diligence is one of the key elements in all
these types of transactions because of the fact that the transactions are
being done between two unrelated parties, who don’t have a deep
understanding about the business which they are going to take over or
merge with. The purpose of due diligence exercise is to assist the
purchaser or the investor in finding out all the facts and figures about
the business he is going to acquire or invest prior to completion of the
transaction.

Q6. Explain the various types of due diligence that are followed as a
discipline for businesses.

A6. Various types of due diligence that is followed as a discipline for
businesses are as follows:

• Commercial or operational due diligence: It is generally
performed by the concerned acquirer enterprise and involves an
evaluation from a commercial, strategic or operational perspective.
For example, whether the proposed merger would create
operational synergies.

• Financial due diligence: It commences after a price has been
agreed for the business. The principal objective of financial due
diligence is usually to look behind the veil of initial information
provided by the company and to assess the benefits and costs of
the proposed acquisition/merger by inquiring into all relevant
aspects of the past, present and future of the business to be
acquired/merged with.

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• Tax due diligence: This is conducted by the tax authorities or on
their behalf by any professional to ensure whether the company is
adhering to the tax provisions or not.

• Information system due diligence: This is to assess the
accuracy and completeness of Information systems of the
company.

• Legal due diligence: It is to find out whether or not the company
is complying with the legal provisions. For example, whether the
company is filing annual returns or not, whether necessary board
resolutions are being passed or not, whether the minute’s book is
being maintained and updated or not.

Q7. What is the effect of due diligence on Valuation?

A7. Due diligence depicts clear and transparent business facts based on
definite and a fool proof statement. To enhance the value of the
business, the management of the company may have overvalued the
assets or there may be some hidden liabilities of the business. The
objective of due diligence process is to look specifically for any such
hidden liabilities or overvalued assets.

Q8. Specify the areas that interest the Valuation Analyst during due
diligence.

A8. Due diligence provides useful information to protect the interest of
business. It needs a dynamic team of employees, integration of
management philosophy, installation of an accounting system and
creation of monthly financial reporting. For the purpose of due diligence,
relevant areas of concern in business include:

• Intellectual property.

• Real and personal property

• Insurance coverage

• Employee benefits

• International transactions

• To ensure, that the claims, about the business are correct.

• Past business, financial performance accounts.

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Frequently Asked Questions

• Forecasted financial performance of the business.
• Valuation of property and other assets.
• Legal and tax compliance.
• Major customer contracts.
• Environmental deals.
Q9. Give a few examples of hidden liabilities.
A9. Few examples of hidden liabilities are as follows:
• The company may not show any show cause notice which have

not matured into demands, as contingent liabilities
• Letter of comfort given to banks and financial institutions, which

are not disclosed in the financial statements of the company as
they are not guarantees.
• Long pending sales tax/income tax assessment
• Future lease liabilities
• Environmental problems/third party claims
• Product and/or other liability claims, warranty liabilities, liquidity
damages etc.
• Huge labour claims under negotiation
Q10. Give a few examples of overvalued assets.
A10. Few Examples of Overvalues assets are as follows:
• Uncollected and/ or uncollectible receivables
• Intangibles having no value
• Group company balances under reconciliation
• Litigated assets
• Investment carrying a very low rate of income
• Deferred revenue expenditures
• Obsolete, slow moving or non-moving stock valued above net
realisable value

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• Obsolete or under used plant and machinery
• Capitalisation of expenditure which is in the nature of revenue
Q11. What are factors to be taken care of by the Valuer before accepting
the engagement?
A11. Following factors must be identified before accepting the engagement
of valuation:
• Subject and interest to be valued
• Scope of work
• Date of valuation
• Valuation Bases
• Purpose of valuation
• Premise of value
• Assumption, Limiting conditions and scope limitations
• Nature of Business
• Knowledge of the Industry
• Sources of information available
• Governing laws and Regulations
Q12. What are the requirements that a Valuer needs to follow to carry
out a Valuation procedure?
A12. Valuer should keep a few things in mind before proceeding with the
Valuation process, namely-
• False and misleading information must not be there.
• Valuer must exercise due professional care in the performance of

services and obtain adequate documentation.
• Ethical rules and standards should be followed
• Valuer must maintain a high degree of integrity, knowledge and

competency regarding valuation.
• Valuer shall exercise due diligence and exercise independent

professional judgement.

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Frequently Asked Questions

• Disclosure must be there by a valuer regarding conflict of interest
and duty.

• Valuer must maintain an adequate internal code of conduct for
proper valuation.

• Consistency in services provided to client.

• Strict vigilance of funds and investments of corporate

• Considerations of cost benefit analysis

• Methods of valuation must be examined in depth for the test of
appropriateness.

• Confidential information must not be disclosed to any other person
unless it is required or permitted by Standard or Law.

• Transparency must be there in the valuation report.

Q13. How is a firm valued for buy/sell agreements?

A13. Valuation of a business in case of a buy and sell agreement is
dependent on the terms mutually agreed between the parties and
specified in the agreement. For the majority of these kinds of
agreements, the first approach is an arbitrary formula and the other
commits the parties to utilise a fair market value. Where the agreement
refers to use fair market value, such a value is sought to be determined
and arrived at by an independent party being an appraiser. There are
however, troublesome situations when the buy and sell agreement does
not refer to utilizing a professional valuation, but rather tries to
accomplish the same result through application of some predetermined
formula. A point worth noting is that there is no single formula or
approach that is going to be fair to both sides of an agreement.

The two common formulas used are:

(i) Stock will be purchased at book value, based on the latest
audited balance sheet.

(ii) Stock will be purchased at ‘x’ times EBITDA, based on the latest
audited financial statement.

In both cases, the formula is applied to audited financial statements.
This means that at a minimum the figures to be used for the purpose of
valuation have been reviewed by an independent professional and the

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statements were prepared in accordance with the generally accepted
accounting practice.
At last, it can be said that valuation in case of buying and sell agreement
should be done according to the formula or approach given in the
agreement itself. If there is no formula given, discounted cash flow
valuation is the best approach considering the facts given in the original
agreement.
Q14. What are the specific Aspects to be considered in respect of
Business Assets and Surplus Assets while using Discounted Cash
Flow Method?
A14. Specific Aspects to be considered in respect of Business Assets and
Surplus Assets while using DCF Method are as follows:
i) Business Assets
• DCF method is based on Cash Flows
• Income from Business Assets included in Cash Flows
• Value of Business Assets implicitly captured in Cash Flows
• Fair Value of Assets used for the purpose of business not relevant
• Disposals and acquisitions to be reflected in Cash Flows
ii) Surplus Assets
Surplus Assets refers to assets not actively used for the purpose of
business. For instance, there could be land held by the company which
is not in the use of the business
• Income from such assets not to be considered for Cash Flows
• Disposals and acquisitions not to be reflected in Cash Flows
• Fair value of such assets to be added to EV
• Fair value of such surplus assets may be determined through

appropriate method
Q15. What are the specific Aspects to be considered in respect of trade

investments and Non-trade investments while using Discounted
Cash Flow Method?
A15. Specific aspects to be considered in respect of trade investments and
Non-trade investments while using DCF Method are as follows:

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Frequently Asked Questions
Trade Investments
• Income from such investments to be considered for Cash Flows
• Disposals and acquisitions to be reflected in Cash Flows
• Generally, consolidated Cash Flows can be considered in case of

subsidiary companies
• Alternatively, DCF value of subsidiary companies can be added to

DCF value of parent company
• Cash flows of subsidiary companies not be considered in parent

company
Non Trade Investments
• Income from such investments not to be considered for Cash

Flows
• Disposals and acquisitions not to be reflected in Cash Flows
• Fair value of investments to be added to EV
• Fair value may be determined through appropriate method.

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Chapter-8

Illustrations

Q1. The estimated betas for ABC Limited, XYZ Limited, and PQR
Limited are 1.80, 1.50, and 0.80, respectively. The risk-free rate of
return is 6.54 percent, and the equity risk premium is 8.49 percent.
Calculate the required rates of return for these three stocks using
the CAPM.

A1. Rates of return using the CAPM (R)
= Risk-free rate of return(Rf)+ Beta(β)*Equity Risk Premium [E(Rm)-
Rf]
ABC Limited
R =Rf+β[E(Rm)-Rf],
=6.54%+1.80(8.49%)
=6.54%+15.28%
=21.82%.

XYZ Limited
R=Rf+β[E(Rm)-Rf]
=6.54%+1.50(8.49%)
=6.54%+12.74%
=19.28%.

PQR Limited
R=Rf+β[E(Rm)-Rf]

=6.54%+.80(8.49%)
=6.54%+6.79%
=13.33%.
Illustrations

Q2. An analyst wants to account for financial distress and market-
capitalization as well as market risk in his cost of equity estimate
for a particular traded company. Which of the following models is
most appropriate for achieving that objective?

a. The capital asset pricing model (CAPM).

b. The Fama–French model.

c. A macroeconomic factor model.

A2. The Fama–French model incorporates market, size, and value risk
factors. One possible interpretation of the value risk factor is that it
relates to financial distress.

Q3. The following facts describe Sriram Manufacturing Company
Limited’s component costs of capital and capital structure. Based
on the information given, calculate Sriram Manufacturing
Company Limited‘s WACC.

Component Costs of Capital:

Cost of equity based on the CAPM: 15.84%

Pre-tax cost of debt: 12%

Tax rate: 25%

Target weight in capital structure: Equity 75, Debt 25

A3. Debt Equity weightage =25%:75%

Cost of equity =15.84%

Cost of debt =12%*(1-25%)= 9%

Weight * Cost =15.84%*75%+9%*25% =11.88%+2.25%
=14.13%

WACC is 14.13%

Q4. The management of C Limited is considering the company's peer
group, which of the following statements is not correct?

a. Comments from the management of the company about
competitors are generally used when selecting the peer group.

b. The higher the proportion of revenue and operating profit of the

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peer company derived from business activities similar to the
subject company, the less meaningful the comparison.

c. Comparing the company's performance measures with those for
a potential peer-group company is of limited value when the
companies are exposed to different stages of the business cycle.

d. Companies in diversified businesses operating in different
geographies are not considered as peers.

A4. B is correct because it is a false statement. Companies in similar
businesses and scale of operations make meaningful peers.

Q5. When selecting companies for inclusion in a peer group, a
company operating in three different business segments would:

a. be in only one peer group.

b. not be included in any peer group.

c. possibly be in more than one peer group.

A5. C is correct. The company could be in more than one peer group
depending on the demand drivers for the business segments, although
the multiple business segments may make it difficult to classify the
company.

Q6. Jothi is evaluating the stocks of Pfizer Electric (PE) and Pfizer
Pharma (PP). Jothi is testing the appropriateness of the dividend
discount model (DDM) for valuing PE and PP and has compiled the
following data for the two companies for from 2009 to 2016.

Year EPS DPS Payout EPS DPS Payout
ratio ratio
-0.01
2016 2.37 1.3 0.55 -69.2 1 -0.24
-0.10
2015 2.19 1.18 0.54 -4.25 1 0.48
0.47
2014 1.96 1.06 0.54 -19.25 2 0.77
1.96
2013 1.81 0.97 0.54 4.19 2 0.34

2012 1.75 0.92 0.53 4.28 2

2011 1.71 0.88 0.51 2.6 2

2010 1.61 0.81 0.50 1.02 2

2009 1.47 0.72 0.49 5.93 2

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Illustrations

Is Divided Discount model the right approach to value both the
companies. Give your reasons.

A6. PE and PP have both declared dividends and have a track record that
can be used to forecast the future dividends. On examining PE we find
that the EPS has been steadily increasing over the years and
correspondingly the Dividend per share has also increased. There is a
linear relationship between EPS and DPS. The company has
maintained the Dividend payout ratio over the years. Hence DDM can
be used to value PE.

In PP the company has made negative EPS over some years but has
continued to pay dividends. There is no discernible relationship between
EPS and DPS. The company continuing to pay Dividend despite losses
show that the company is not reinvesting back into business and is
utilising the reserves to pay the dividend. This is not a positive sign for
the growth and performance for the company and may not be long
standing and stable. Hence DDM cannot be used to value PP.

Q7. During the period 1990–2015, earnings of the Nifty Bank Index
companies have increased at an average rate of 7 percent per year,
and the dividends paid have increased at an average rate of 5.3
percent per year. Assume the followings:

a. Dividends will continue to grow at the 1990–2015 rate.

b. The required return on the index is 8 percent.

c. Companies in the Nifty bank Index collectively paid 175
crores in dividends in 2015.

Estimate the aggregate value of the Nifty bank Index component
companies at the beginning of 2016 using the Gordon growth
model.

A7. Increase in earnings from 1990-2015 = 7.00%

Increase in Dividend paid- (g) = 5.30%

Required rate of return- (r) = 8.00%

Dividend paid in 2015- (D1) = 175

Estimated Value (V0)=D1/(r-g) = 175*(1+.05)/(0.08-0.053)

= 6825 crores

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Applying the Gordon growth model, with the assumed dividend growth
rate of 5.3%, results in an estimated value of Rs. 6825 crores for the
Nifty Bank index.
Q8. Assuming Gordon (constant) growth model is appropriate to value
the shares of Stable Steel Company Limited. The company had an
EPS of Rs 3 in 2015. The retention ratio is 0.55. The company is
expected to earn an ROE of 14 percent on its investments, and the
required rate of return is 10 percent. All dividends are paid at the
end of the year.
a. Calculate the company's sustainable growth rate.
b. Estimate the value of the company's stock at the beginning

of 2016.
c. Calculate the present value of growth opportunities.
d. Determine the fraction of the company's value that comes

from its growth opportunities.
A8. The calculations are given below:

i) retention ratio (b) = 0.55,
ii) the dividend pay-out ratio = 1 − b = 1 − 0.55 = 0.45.
iii) Sustainable growth rate (g)

g = b(ROE)
= 0.55(0.14)
= 0.077 or 7.70%

iv) Dividend per share paid by the company in 2015
D1 = (1 – b)*(EPS)
= 0.45*(3)
= Rs. 1.35

v) The estimated value at the beginning of 2016 is
V0 = D1/(r-g)
= 1.35*(1+0.077)/(0.10-0.077)
= 63.22

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Illustrations

vi) If the company was a no-growth company, that is it paid out all
its earnings and did not reinvest any, its earnings would stay the
same. The value of such a company would be the value of a
perpetuity, which is

D/r = E/r = 3/0.10 = Rs.30.00.

This amount is the no-growth value per share.

So, Present Value of Growth = 63.22 − 30 = 33.22.

vii) The fraction of the company’s value that comes from its growth
opportunities is 33.22/63.22 = 52.5%

Q9. Standard Company Limited has a trailing P/E of 9. As per Analysts
prediction Standard’s dividends will continue to grow at its recent
rate of 4.5 percent per year perpetually. Given a current dividend
and EPS of 0.8 per share and 2.00 per share, respectively, and a
required rate of return on equity of 8 percent, determine whether
Standard Company is undervalued, fairly valued, or overvalued.
Justify your answer.

A9. The calculations are given below:

The payout ratio =DPS/EPS =0.80/ 2.00

= 0.40

= 1 − b,

where b is the earnings retention ratio, therefore P/E is as shown below:

P0/E0 =[(1-b)*(1+g)]/(r-g)

=[0.40*(1+0.045)]/(0.08-0.045)

=11.94

Therefore, the justified trailing P/E based on fundamentals is 11.94

Because the market-trailing P/E of 9 is less than 11.94,

Standard Company shares appear to be undervalued (i.e., selling at a
lower than warranted P/E).

Q10. You are analysing the value of shares of Apollo Limited, a
healthcare company, as of late June 2016. The share price is 10.20.
The company's dividend per share for the fiscal year ending 30

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June 2016 was 0.35. You expect the dividend to increase by 10
percent for the next three years and then increase by 8 percent per
year forever. You estimate the required return on equity of Apollo
Limited to be 11 %.
a. Estimate the value of Apollo using a two-stage dividend

discount model.

b. Judge whether Apollo is undervalued, fairly valued, or
overvalued.

A10. The calculations are given below:

a. Let r be the required rate of return. Also, let t = 0 indicate the
middle of 2016. Because the dividend growth rate becomes
constant from the middle of 2019 (t = 3), the value of the mature
phase can be expressed as

DPS in 2017 =D1=Do*(1+g) =0.35*1.10 =Rs. 0.385
DPS in 2018 =D2=D1*(1+g) =0.385*(1.10) =Rs. 0.424

DPS in 2019 =D3=D2*(1+g) =0.424*(1.10) =Rs. 0.466

DPS in 2020 =D4=D3*(1+g) =0.466*(1.08) =Rs. 0.503
Value in 2019 =V3=D4/(r-g) =0.503/(0.11-0.08) =Rs. 16.77

Value in 2016 (V0) can be written as

V0 =[D1/(1+r)]+ [D2/(1+r)^2]+ [D3/(1+r)^3]+ [V3/(1+r)^3]
=[0.385/(1+0.11)]+[0.424/(1+0.11)^2]+[0.466/(1+0.11)^3]+
[16.77/((1+0.11)^3]

=Rs 13.294
b. Because Apollo’s estimated value of 13.294 is more than the

market price of 10.20, Apollo appears to be undervalued at the
market price.
Q11. Indicate the effect on this period's FCFF and FCFE of a change in
each of the items listed here. Assume Rs100 lakhs increase in each
case and a 40 percent tax rate.
a. Net income.

b. Cash operating expenses.

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Illustrations

c. Depreciation.
d. Interest expense.
e. EBIT.
f. Accounts receivable.
g. Accounts payable.
h. Property, plant, and equipment.
i. Cash dividends paid.
j. Proceeds from issuing new shares.
k. Common shares bought back.
A11. The calculations are given below:

For a Rs100 lakhs Change in Change in

increase in FCFF in lakhs FCFE in lakhs

Net income +100 +100

Cash operating expense -60 -60

Depreciation +40 +40

Interest expense 0 -60

EBIT +60 +60

Accounts receivable -100 -100

Accounts payable +100 +100

PPE -100 -100

Cash dividends 0 0

Proceeds from issue of 0 0

shares

Shares bought back 0 0

Q12. Atlas Corpn has FCFF of 18 crores and FCFE of 13crores. Atlas's
WACC is 11 percent, and its required rate of return for equity is 13
percent. FCFF is expected to grow forever at 7.5%, and FCFE is
expected to grow forever at 8 percent. Company has debt
outstanding of 15 crores.

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EM on ICAI Valuation Standard 301 Business Valuation

What is the total value of Atlas's equity using the FCFF valuation
approach? What is the total value of Proust's equity using the FCFE
valuation approach?
A12. The calculations are given below:
The firm value is the present value of FCFF discounted at the WACC,
or
Firm value = FCFF1/(WACC-g) = FCFF0*(1+g)/(WACC-g)

= 18*(1.075)/(0.11-0.075)
= Rs. 552.85 crores
The firm value using FCFE valuation is
Firm Value = FCFE1/(r-g)
= FCFE0(1+g)/(r-g)
= 13*(1+8%)/(13%-8%)
= 280 crores.
Q13. Paradigm Company is valued by using the FCFF and FCFE
valuation approaches:
• Paradigm has net income of 300 million,
• Depreciation of 100 million,
• Capital expenditures of 150 million,
• and an increase in working capital of 40 million.
• Paradigm will finance 40 percent of the increase in net fixed
assets (capital expenditures less depreciation) and 40
percent of the increase in working capital with debt
financing.
• Interest expenses are 150 million.
• The current market value of Paradigm's outstanding debt is
2000 million.
• FCFF is expected to grow at 6.0 percent, and FCFE is
expected to grow at 7.0 percent.
• The tax rate is 30 percent.

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Illustrations

• Paradigm is financed with 40 percent debt and 60 percent
equity.

• The pre-tax cost of debt is 9 percent, and the before-tax cost
of equity is 15 percent.

• Paradigm has 10 million outstanding shares.

a. Using the FCFF valuation approach, estimate the total
value of the firm, the total market value of equity, and
the per-share value of equity.

b. Using the FCFE valuation approach, estimate the total
market value of equity and the per-share value of
equity. ( q 7)

A13. The calculations are given below:

a. Total value of the firm, the total market value of equity, and
the per-share value of equity using the FCFF method:

Free Cash Flow for Firm = Net Income + Non Cash Considerations
+ Interest*(1-Tax Rate)-Fixed Capital
Investments – Working Capital
Investments

= NI+NCC+Int*(1-Tax rate)-FCInv-WCinv

= 300+100+150*(1-0.30)-150-40

= Rs. 315/-

The WACC = [Pre Tax Cost of Debt (1-Tax Rate)*
weight of Debt] + [Cost of Equity*weight
of equity]

WACC = 9%*(1-0.30)*(0.40)+15%*(0.60)

= 11.52%

The value of the firm:

Firm value = FCFF1/(WACC-g)

= FCFF0*(1+g)/(WACC-g)

= 315*(1.06)/(0.1152-0.06)

= Rs. 6048.91/-

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EM on ICAI Valuation Standard 301 Business Valuation

The total value of equity is the total firm value minus the value of debt,
Equity = 6048.91 million − 2,000 million = 4,048.91 million.

Dividing by the number of shares gives the per share estimate of V0 =
€4048.91million/10 million = 404.89 per share.

b. The free cash flow to equity is

Free Cash Flow for Firm = Net Income + Non Cash considerations –
Working Capital Investments + Net
Borrowing

= NI+NCC-FCInv-WCInv+Net borrowing

= 300+100-150-40+0.40*(150-100+40)

= Rs 246 million

Because the company is borrowing 40 percent of the increase in net
capital expenditures (150 − 100) and working capital (40) net borrowing
is equal to 0.40*(150-100+40).

The total value of equity is the FCFE discounted at the required rate of
return of equity,

Equity value = FCFE1/(r-g)

= FCFE0*(1+g)/(r-g)

= 246*(1.07)/(0.15-0.07)

= 3290.25

The value per share is V0 = 3290.25 million/10 million = 329.02 per
share.

Q14. An investor intends to use market multiple P/E and the method of
comparables as a basis for purchasing shares of one of two peer-
group companies in the business of manufacturing ATMs. Neither
company has been profitable to date, nor is expected to have
positive EPS over the next year. Data on the companies' prices,
trailing EPS, and expected growth rates in sales (five-year
compounded rates) are given in the following table:

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Illustrations

Company Price Trailing EPS P/e Expected
growth
Swift money 25 2.2 NM
45%
Ready cash 12 1.25 NM 40%

Unfortunately, because the earnings for both companies have been
negative, their P/Es are not meaningful. On the basis of this
information, address the following: Discuss how the investor might
make a relative valuation in this case. State which share the
investor would prefer.

A14. The investor can measure and then grade the two stocks by earnings
yield (E/P). A lower E/P reflects a richer (higher) valuation irrespective
of whether EPS is positive or negative, and a ranking from high to low
E/P is useful. Neither business, however, has a history of profitability.
When year-ahead EPS is expected to be positive, forward P/E is
positive. Thus, the use of forward P/Es sometimes addresses the
problem of trailing negative EPS. Forward P/E is not meaningful in this
case, however, because next year’s earnings are expected to be
negative.

Swift money has an E/P of −0.088, and Ready cash has an E/P of −0.10.
A higher earnings yield has an interpretation that is similar to that of a
lower P/E, so Hand appears to be relatively undervalued. The difference
in earnings yield cannot be explained by differences in sales growth
forecasts. In fact, Swift money has a higher expected sales growth rate
than Ready cash. Therefore, the analyst should recommend Swift
money.

Q15. If an analyst uses the Nifty index as a comparison asset in valuing
a share, which price multiple would cause concern about the
impact of potential overvaluation of the equity index?

A15. The use of any price multiple for valuation has a similar concern. If the
stock market is overvalued, an asset that appears to be fairly or even
undervalued in relation to an equity index may also be overvalued.

Q16. IC Limited is a multinational distributor of semiconductor chips
and related products to businesses. Its leading competitor around
the world is Logic gate Electronics. IC Limited has a current market
price of 10.00, 20 million shares outstanding, annual sales of 1

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EM on ICAI Valuation Standard 301 Business Valuation

billion, and a 5 percent profit margin. Logic gate has a market price
of 20.00, 30 million shares outstanding, annual sales of 1.6 billion,
and a profit margin of 4.9 percent. Based on the information given,
answer the following questions:

a. Which of the two companies has a more attractive valuation
based on P/S?

b. Identify and explain one advantage of P/S over P/E as a
valuation tool.

A16. The calculations are given below:

P/S = Price/Sales = (Price per share*No. Of shares Outstanding)/Annual
Sales

a. IC Limited:

P/S = (Rs.10/share*20 million shares)/[(1 billion sales)]

= (10*20,000,000)/(1,000,000,000)

= 0.2

b. Logic Gate:

P/S = (Rs.20/share*30 million shares)/(1.6 billion sales)

= (20*30,000,000/(1,600,000,000)

= 0.375

IC Limited has a more attractive valuation than Logic Gate based
on its lower P/S but comparable profit margin.

Advantage of P/S over P/E is that the decisions relating to accounting
have a much greater impact on reported profits than they are likely to
have on reported sales. Although companies are able to make a number
of legitimate business and accounting decisions that affect earnings,
their discretion over reported sales (revenue recognition) is limited.
Another advantage is that sales are almost always positive, so using
P/S eliminates issues that arise when EPS is zero or negative.

Q17. Top research has a client who has inquired about the valuation
method best suited for comparing companies in an industry with
the following characteristics: Principal competitors within the
industry are located in the London, Paris, Korea, and Mexico. The

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Illustrations

industry is currently operating at a cyclical low, with many
companies reporting losses. Should Top research consider the
following valuation ratios: P/E. P/B. EV/S.

A17. For companies in the industry described, EV/S would be superior to
either of the other two ratios. Among other considerations, EV/S is:
more useful than P/E in valuing companies with negative earnings;
better than either P/E or P/B for comparing companies in different
countries that are likely to use different accounting standards (a
consequence of the multinational nature of the industry);

Less subject to manipulation than earnings (i.e., through aggressive
accounting decisions by management, who may be more motivated to
manage earnings when a company is in a cyclical low, rather than in a
high, and thus likely to report losses).

Q18. Determine the relative valuation of two companies in the Defence
industry, National Heavy Industries (NHI) and Ajantha Group (AG).
EBITDA Comparisons (in Rs Millions except Per-Share and Share-
Count Data).

AG NHI

PRICE PER SHARE 120 80

Shares outstanding 5 2

Debt 25 75

Cash 5 2

Net income 52 14

Net income from continuing operations 52 8

Interest expense 3 5

Depreciation 8 4

Tax 2 3

Using the information in the table, answer the following questions:

a. Calculate EV/EBIDTA for NHI and AG.

b. Which of the two companies is over-valued

A18. EBIDTA for AG = Earnings before Interest Depreciation Tax and
Amortisation

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EM on ICAI Valuation Standard 301 Business Valuation

EBIDTA for AG = 52+8+3+2 =65

EBIDTA NIH = 8+4+5+3 =20

Enterprise value = Market value of equity+debt- cash

Enterprise value for AG = 120*5+25-5 = 620

Enterprise value for NIH = 80*2+75-2 = 233

P/EBIDTA for AG = (120*5)/65 = 9.23

P/EBIDTA for NIH = (80*2)/20 = 8.00

EV/ EBIDTA for AG = 620/65 = 9.54

EV / EBIDTA for NIH = 233/20 = 11.65

AG is undervalued. AG is relatively undervalued on the basis of
EV/EBITDA.

EBITDA is a pre-interest flow; therefore, it is a flow to both debt and
equity, and the EV/EBITDA multiple is more appropriate. P/EBITDA
does not consider and reflect differences in the use of debt and its
impact on business. Substantial differences in leverage exist in this case
(NIH uses much more debt), so the preference for using EV/EBITDA
rather than P/EBITDA is supported.

Q19. While valuing a company which is the least important factor when
assessing the long-run economic and financial outlook of a
company?

a) Prospects of the relevant industry

b) Expected changes in EPS.

c) Expected return on equity.

d) General economic condition

A19. General economic condition. While general economic condition is
relevant while valuing a company to understand the market growth
potential etc, compared to other factors it is less significant. Other
factors have a more direct bearing on the valuation.

Q20. Which of the following does not indicate high quality of earnings
for a non-investment company?

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Illustrations

a) The firm has no extraordinary income.

b) Earnings are from financing activities.
c) Conservative accounting methods were used to calculate

earnings.

d) Earnings are stable.
A20. Earnings from financing activities. The company is expected to deploy

the resources available at its disposal in business activities to improve
the earnings from business and grow the business.
Q21. Three companies in the Auto industry and find the following
current ratios: Hatchback Limited = 1.2, Sports car Limited = 1.3,
Sedan Limited = 0.8, and SUV Limited = 0.95. Which firm seems to
be best able to pay its immediate liabilities?

A21. The current ratio measures the ability of the firm to pay its immediate
liabilities and is determined by dividing current assets by current
liabilities. In this case, Sedan’s current ratio of 0.8 is significantly below
other firms in its industry, which suggests Sedan’s liquidity is the best
of the four.

Q22. Which of the following indicators show that the market is
overvalued?

a) high average price-to-book ratio.
b) high average dividend yield.

c) high average P/E ratio.

d) high average ratio of stock prices to corporate sales.
A22. High average price to book ratio, high average P/E ratio and High

average Price to sales ratio indicate that the market is overvalued.
Average dividends yield merely indicates the pay-out and does not
indicate the price.

Q23. The quality and depth of a company’s management is an important
criterion in assessing a company’s business value. What are the
factors considered by a valuer to assess the quality and depth of
a firm’s management?

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EM on ICAI Valuation Standard 301 Business Valuation

A23. Factors considered by a valuer to assess the quality and depth of a
firm’s management are as follows:
a) Management’s performance record. Management receives a
positive assessment if the firm has prospered under the current
management.
b) Meet directly with management, conduct interviews and attend
presentations by management.
c) Evaluate evidence of management’s strategic planning and
attempts to determine the ability of management to achieve its
stated goals.

Q24. How is Applying Benchmarks to financial ratios different from
comparing a firm's ratios to industry averages over time?
a) In benchmarking you compare your firm's performance to a
previous "benchmarked" period and not industry averages.
b) It creates a benchmark of numerous industries for
comparison purposes rather than a single industry due to
wild fluctuations within specific industries.
c) It creates a benchmark that compares your firm to the best
world-class competitors rather than an entire industry.
d) It creates a benchmark by taking an average of a portfolio of
industries over a specific time period, usually 5 years, rather
than a single industry in a single year due to wild fluctuations
within specific industries over short periods of time.

A24. It creates a benchmark that compares your firm to the best world-class
competitors rather than an entire industry.

Q25. For the purpose of common-size analysis every balance sheet item
is divided by __________ and every income statement is divided
by __________
a) its corresponding base year balance sheet item; its
corresponding base year income statement item.
b) its corresponding base year income statement item; its
corresponding base year balance sheet item.
c) net sales or revenues; total assets.
d) total assets; net sales or revenues

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Illustrations

A25. Total Assets; Net sales or revenue

Q26. In conducting an index analysis every balance sheet item is divided
by __________ and every income statement is divided by
__________

a) its corresponding base year balance sheet item; its
corresponding base year income statement item

b) its corresponding base year income statement item; its
corresponding base year balance sheet item

c) net sales or revenues; total assets.

d) total assets; net sales or revenues

A26. Its corresponding base year balance sheet item; its corresponding base
year income statement item

Q27. Match the Ratios on the right side to what they measure.

Activity Name of the ratio

1. Measure a firm's ability to meet a) Activity ratios
short-term obligations

2. Relate the financial charges of a b) Liquidity ratio
firm to its ability to service them

3. Measure how effectively the firm is c) Profitability ratio
using its assets

4. Relate profits to sales and d) Coverage ratio
investment

A27.

1. Measure a firm's ability to meet short-term obligations – Liquidity
ratios.

2. Relate the financial charges of a firm to its ability to service them
– Coverage Ratios.

3. Measure how effectively the firm is using its assets – Activity
ratios.

4. Relate profits to sales and investment – Profitability ratios.

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EM on ICAI Valuation Standard 301 Business Valuation

Q28. Cream Donuts, a local Doughnut joint is compared with Dunkin’
Donuts for the purpose of valuing a 7% interest in Cream Donuts,
but the minority aspect is ignored for the purpose of this valuation.
This analysis does consider the quality of donuts between the two
companies as many local doughnut shops make awesome lip-
smacking doughnuts.

Key points on business of Dunkin’s:

• Dunkin’s has over 10,000 locations internationally

• Makes $20 billion in overall revenues,

• Serves over 1 million doughnuts a day,

• Has 40% of total revenues coming from digital ordering
channels,

• Has a 20% U.S. Doughnut market share.

What are the factors that will contribute to the discount?

A28. The following factors contribute to the discount factor of Cream Donuts
compared to Dunkin Donuts.

• The quality of food in the local joint will be good they will have a
very good local customer base and recurring sales. The
Doughnut joint may offer a few other products. But the varieties
and new innovative foods coming up every month of frequently
will be very low.

• The owner and sales team will be restricted to the shop itself and
may work within their locality but will not have a reach outside
and hence they cannot grow outside their locality.

• While international brands can afford spending on all latest
technology with ease like bring multiple modern payment
gateways to food ordering platforms and extensively implement
them across all their branches, the local joint cannot incur costs
on technology. Technological upgrades for sales and delivery
will be constrained.

• Technological implementations on production and quality will
also be constrained for Cream Donuts compared to Dunkin
Donuts.

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Illustrations

• Cream Donuts will have passionate and talented owners, but
they will not have a management team that will share and convert
this experience across multiple units.

• With pure local recognition they may not have competitive edge
outside their locality and may not be recognised or even known
outside their locality.

• Capital crunch for expansion beyond locality.

• Many similar eat outs may open locally and compete with Cream
Donuts.

Q29. Amongst Dividend Discount Model and Discounted Cash Flow
Method, what is the model that a retail investor and institutional
investor will use to value a company before investing in the same?

A29. A retail investor gets ownership of the asset. However, they do not have
control over the assets. Hence, they are at the mercy of the dividend
policy of the company and cannot predict their cash flows in any other
manner. In this case, a discounted dividend approach may be more
suitable as compared to other approaches.

Institutional investors have deep pockets and are capable of buying a
stake which is large enough to get the management to change the
dividend pay-out policy. In this case, the discounted dividend model may
not be very applicable. Instead, what matters is the amount of free cash
flow that can be generated by the company. Hence institutional
investors tend to use discounted free cash flow models more often.

Q30. Discuss three types of stocks or investment situations for which a
valuer could appropriately use P/B in valuation.

A30. Although the measurement of book value has a number of widely
recognized shortcomings, P/B may still be applied fruitfully in several
circumstances: The company is not expected to continue as a going
concern.

When a company is likely to be liquidated (so ongoing earnings and
cash flow are not relevant), the value of its assets less its liabilities is of
utmost importance. The valuer must establish the fair value of these
assets.

The company is composed mainly of liquid assets, which is the case for
finance, investment, insurance, and banking institutions. The company’s
EPS is highly variable or negative.

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Chapter-9

Case Studies

Case Study 1: Case study Based on Free Cash Flow to
Firm & Free Cash Flow to Equity

Mr. Dev, a research analyst, has been hired to value RC Ltd., a company
that is currently experiencing rapid growth and expansion. Dev is
convinced that a value for the equity of RC Ltd. can be reliably obtained
through the use of a three-stage FCFE model with declining growth in the
second stage. He has determined that the current FCFE/share is Rs.1.00.
He has prepared a forecast of expected growth rates in FCFE as follows:

Stage 1: 8% for years 1 through 3; Stage 2: 7.0% in year 4, 6.5% in year 5,
6.0% in year 6; Stage 3: 4.0% in year 7 and thereafter. Moreover, Dev has
determined that the company has a beta of 1.6. The current risk-free rate is
3.0%, and the equity risk premium is 5.0%. Outstanding shares: 100 lakhs;
Tax rate: 40.0% Interest expense: Rs.30,00,000.

1) What is the required Rate of Return?

2) What is the terminal value in year 6?

3) The per share value Dev should assign to RC Ltd is?

4) What is the Free Cash Flow to Firm or FCFF?

Solution:

1)

Discount Rate Derivation

Risk free rate of return(Rf) 3%

Equity Risk Premium (ERP) 5%

Beta 1.6

Discount Rate= Rf+Beta*ERP 11.0%
Case Studies

2)

FCFE Computation

Time Today 1 2 3 4 5 6 Normal Terminal

Period ized Value
--->

FCFE 1 1.08 1.16 1.26 1.34 1.43 1.52 1.58 22.6
per
share 8% 8% 8% 7% 6.50% 6% 4% =[1.583/

Annual (11%-4%)]
growth

3)

FCFE Computation

Time Period -- Today 1 2 3 4 5 6 Normalized Terminal

-> Value

FCFE per 1 1.08 1.17 1.26 1.35 1.44 1.52 1.58 22.61
share

Annual growth 8% 8% 8% 7% 6.50% 6% 4%

Period (end 1 2 3 4 5 6 7
period)

PV Factors 11.0% 0.9 0.8 0.7 0.7 0.6 0.5 0.5

based on 11%

PV of FCFE 1.0 0.9 0.9 0.9 0.9 0.8 12.1

per share

Val per share 17.48
(Discrete+
Terminal)
(INR)

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4)

FCFF Computation

FCFE (as given) per share 1
Interest Expense (INR) 30,00,000
Interest Expense per share
Post Tax Int. Expense/share 0.3
FCFF per share 0.18
FCFF ( INR lakhs) 1.18
118

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Case Studies

Case Study 2: Case Study Based on Market Approach

Company Book Value Sales Shares Price
of 2015 (INR Outstanding (INR)
Drugs, Inc.
Apps Inc. Equity2015 Mn) 2015 (INR 31.37
(INR Mn) Mn) 25.63

19,950 32,373 6,162

61,020 32,187 10,771

Peer Group Mean P/B Median Mean P/S Median
P/B P/S

Medical – Drug 5.62 4.25 8.71 4.53

application 4.1 2.1 3.42 1.44
Software

Drugs Inc belongs to the Medical - Drugs group and Apps Inc belongs to the
Applications Software group.

Question 1: The current price - to - book and price - to - sales ratios for
Drugs, Inc are closest to:

P/B P/S

A. 3.238 5.254

B. 3.238 5.971

C. 9.688 5.971

Solution

For Druga Inc

Book value per share = Book value of equity/ Number of shares
outstanding

= 19950/ 6162 = 3.24

P/B = Market price per share/ Book value per share

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EM on ICAI Valuation Standard 301 Business Valuation

= 31.37/ 3.238 = 9.69

Sales/ share = Sales/ Number of shares outstanding

= 32373/ 6162 = 5.25

P/S = Market price per share/ Sales per share

= 31.3/ 5.254 = 5.97

Answer C is correct

Question 2: The current price - to - book and price - to - sales ratios for
Apps Inc are closest to:

P/B P/S

A. 4.524 8.578

B. 5.665 2.988

C. 4.524 2.988

Solution

For Apps Inc

Book value per share = Book value of equity/ Number of shares
outstanding

= 61020/ 10771 = 5.67

P/B = Market price per share/ Book value per share

= 25.63/5.665 = 4.52

Sales/ share = Sales/ Number of shares outstanding

= 32187/ 10771 = 2.99

P/S = Market price per share/ Sales per share

= 25.63/ 2.99 = 8.58

Answer A is correct

Question 3:

Which of the following statements is most accurate, given the financial
data on Drugs Inc, Apps, Inc and the two industries?

A. Both stocks are relatively overvalued.

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Case Studies
B. Both stocks are relatively undervalued
C. One stock is relatively overvalued and the other is relatively

undervalued
Solution: A
Both stocks are relatively overvalued. The P/B and P/S ratios for Drugs Inc are
9.69 and 5.971. The P/B ratio of Drugs Inc exceeds the mean P/B ratio for
peer group (5.622) as well as the median P/B ratio (4.250) for the peer group.
Therefore, by this measure, the stock would appear to be overvalued. The P/S
ratio also exceeds the median P/S (4.530) for the peer group. Similar is the
case for Apps, Inc.

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Case Study 3: Cadbury India Limited Buyback

Back Ground

Cadbury India Ltd. was incorporated on 19th July 1948 under the name of
Cadbury Fry (India) Pvt. Ltd. Cadbury India was a subsidiary of Cadbury
Schweppes Overseas Limited which in turn was held by Cadbury Plc, UK. This
was later taken over by Kraft Food Inc. Cadbury has a policy of operating
globally only through wholly-owned subsidiaries however exceptions have had
to be made only for compelling business reasons, foreign investment laws or
foreign exchange restrictions. From 1948 to 1977 Cadbury India was a wholly-
owned subsidiary of Cadbury Schweppes. In 1977, the policy of the
Government then in power required Cadbury Schweppes to dilute its
shareholding in Cadbury India from 100% to 60%. It was only then that
Cadbury India ceased to be a wholly-owned subsidiary of Cadbury
Schweppes.

Following economic liberalisation of 2002, FDI was allowed up to 100%.
Thereafter, Cadbury Schweppes and another group company, i.e., Cadbury
Mauritius Ltd. increased their collective holdings in Cadbury India to 90%, by
making various open market offers, and public shareholding fell below 10%.
Consequently, Cadbury India got de-listed from the stock exchanges. Over
time, the shareholding of the Cadbury Group increased to about 97.58%
through a series of open and buy back offers. The details of some of these are
listed below.

Year of Price per No. Of shares

Buyback share bought Back

2002-2006 500 14,15,271
13,52,605
2006 750 11,53,374
10,20,300
2007 815 11,16,168

2008 950

2009 1030

In 2009 only 2.4% of shares were held by public, CIL made an offer to these
remaining minority shareholders at Rs. 1,340 per share, based on valuation
reports from two reputed and independent valuers, Valuer 1 and Valuer 2.
Against same petition was filed by the minority shareholders before Hon’ble

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Case Studies

Mumbai High Court on the contention that Cadbury India Ltd has been under-
valued and they are being suppressed due to minority shareholding.

Thereafter an order was passed by the Hon’ble High Court appointing M/s.
Valuer 3 as independent valuers. This valuation was to be as on the appointed
date and based on the unaudited balance sheet as on 31st July 2009, taking
into account the same material as was provided to Valuer 1 and Valuer 2.
Valuer 3 was permitted to call for additional information.

On the date of the petition the issued share capital of Cadbury India Ltd. stood
at Rs. 31,06,95,530 divided into 3,10,69,553 equity shares of Rs. 10/- each
and the subscribed share capital was Rs. 31,06,70,400 divided into
3,10,67,040 equity shares of Rs. 10 each. The audited accounts of the
Company for the year ending 31st December 2008, showing the financial
position of the company was as follows:

Particulars Rs in Mn
Net worth(share Capital & Reserves) 4,644.0
Secured Loans 320.2
Unsecured Loans 96.8
Fixed Assets (incl CWIP & Adv) 7,552.5
Investments 29.2
Current Assets Loan & Advances 5,818.8
Current Liabilities & Provision 4,495.7
Net Current Assets 1,323.1
PBT 2008 2,018.9
PAT 2008 1,657.8

Valuer 3 submitted its valuation report on 20th May 2010 ("the first report")
wherein it adopted the Comparable Companies Multiples ("CCM") method of
valuation using Nestle, GSK & Britannia as the comparable companies, and
returned a value of Rs. 1,743/- per fully paid up equity share.

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CIL - valuation as per Comparable Companies' Multiples method (Rs.
millions)

SALES PAT

Comparable CAGR for CAGR Net CAGR PAT / P/E
Companies period of Sales of PAT Total multiple
sales of incom $
compa e
rables margin
(Rs in of
Mn) compa
rables

Cadbury India CY 1999 - xxx% xxx xxx% xxx

Limited CY 2008

Nestle India CY 1999 - xxx% xxx xxx% xxx Xxx

Limited CY 2008

GlaxoSmithKli CY 1999 - xxx% xxx xxx% xxx Yyy

ne Consumer CY 2008

Healthcare Ltd

Britannia FY 1999 - xxx xxx Zzz

Industries Ltd FY 2008 xxx% xxx%

Multiple considered for valuation analysis# AAA

Amount of Consolidated PAT for the year ended March 31, 2009

Equity Value

Less: Amount paid on buyback of 1,116,168 equity shares from April
01, 2009 to September 30, 2009 at a price of ` 1,030 per equity share

Equity value of CIL as at September 30, 2009 based on CCM Xxxxxx
method (Rs in million)

In this report following is worth noting

1) Valuer did not take into account any premium,

2) The PE multiple was arrived at considering factors like stock market
trends, size and growth trends of comparable companies vis-à-vis CIL,
market share of CIL in the chocolate segment.

3) The selected PE multiple was higher than the then prevailing PE multiples
of BSE Sensex and BSE FMCG Index

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Case Studies

4) Nestle and Britannia both had factories located in tax benefit zone in
Uttarakhand

However, the minority shareholders opposed this report as well and produced
their own valuation of Rs 2,500 per share and demanded that the valuation
shall be done on DCF Method. This valuation of 2,500 was not based on any
data or material pertaining to Cadbury India, but on the supposed market value
of Nestle India Limited. The minority shareholders held that since on 19th
January 2010, Nestle's shares were being traded at Rs. 2,542/- per share,
Cadbury India's shares should be at least Rs. 2,500/-, for the two must be held
to be "competitors". The court found the valuation approach completely
untenable and further directed Valuation 3 to update its valuation report dated
20th May 2010 taking into account the valuation of the Company based on the
Discounted Cash Flow ("DCF") method along with the CCM method.

Approach Methodology Used Remarks

Market Market Price No • The shares of CIL were not listed
on any stock exchange.
approach method

Income Comparable Yes • This method was used considering
approach Companies that there were stocks of
method comparable companies like
Cost Nestle, GSK Consumer
approach Comparable No Healthcare and Britannia being
Transactions traded on the Indian stock
method exchanges
DCF method Yes
• Method not used due to lack of
Net Asset No availability of credible and
Value complete data about the
transactions in public domain

• Initially, did not use this method
as the financial projections were
not provided. However, later with
Court orders, CIL provided the
same and the DCF method was
used

• CIL’s business being a B2C
business with huge brand recall,

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the value lied in the business
operations and not the
underlying assets of the
Company
• Though there was value in the
real estate owned by the
company, however, all of these
were being used for business
operations.

Valuer 3 performed valuation basis both the methods giving equal weightage
to both and came up with a valuation of Rs. 2,014.5 per share. The basic
assumptions considered in same were as under

1) CAGR of sales for next 10 years considered at 18.3% as against 14.5%
of last 10 years

2) Cost of Equity considered at 11% , wherein Rf = 7% and Rm = 15% ;
Beta Considered based on betas of comparable companies @ 0.50

3) Debt/Equity Ratio = 0, hence WACC = Cost of Equity

4) Terminal Growth Rate considered @6% based on comparison between
future projections with past performance, and with the projections of
comparable companies.

5) Income Tax considered flat at 33.33% assuming that Tax regimes are
liable to change at short notice. Hence in long run a flat tax rate in a
projection might, in fact, provide a very realistic and fairer value than
something that is presently at a lower marginal rate.

6) Equal Weightage Given to both CCM and DCF method to arrive at final
valuation

Conclusion

The revised Valuation of Rs 2014 as well was challenged by the minority
shareholders but The High Court, in a detailed judgment, agreed with Valuer’s
approach and dismissed all objections raised against the report.

“The court held that in order to decline sanction it must be shown that the
valuation is ex-facie unreasonable. The mere existence of other possible
methods of valuation would not be sufficient to deny sanction to such a

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scheme. It was held that the assent of the court would be given if: (1) the
scheme is not against the public interest; (2) the scheme is fair and just; and
(3) the scheme does not unfairly discriminate against or prejudice a class of
shareholders”
Hence it was held that the valuation of Rs. 2,014.50/- per fully paid up
equity share arrived at by the Court-appointed valuer in its second
(supplementary) report dated 29th July 2011 is accepted.

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Case Study 4: Case study based on Discounted
Cash Flow Methodology with tax benefits and MAT
credit.

Introduction

On 20th Apr 2017 you have been asked by your Partner to undertake valuation
of ABC India Pvt Ltd which is a non-listed company and has two units one in
Bengaluru and the other in SEZ enjoying tax exemption till 31st March 21.

You have been asked to ascertain the value per share for the company on
behalf of a potential buyer XYZ ltd. You have been asked to use DCF approach
as they are convinced that value of ABC Ltd can be accurately ascertained
using same as future projections for the purpose of valuation’ can be correctly
determined.

Due Diligence for ABC India Pvt Ltd. Historical Financials upto 31st Mar 2017
has been carried out by ALP Consultants Ltd. and hence you can put full
reliance on same. The management of ABC India Pvt Ltd. will be sharing
projected financial statements for next five years which needs to be critically
analysed by you.

I. Assumptions

After management interviews and review of prospective financial information
developed by the company following are the Basic information & assumptions
and projected balance sheet & P&L

Particulars Mar 31, Source
2017
Risk Free rate % (Rf)
Terminal Growth in final year 8.50% 10 Years Govt. Bond yield rate
Growth rate
Interest Rate of Loan / Debt 5.21%
Annual capex from 2021-22
onwards (INR mn) 2% Presumed
Illiquidity discount
Tax Rates 8% LIBOR + 3%
Normal Tax Rate - upto 2018
50.00

15% Presumed

33.22%

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Case Studies

Normal Tax Rate - 2019 and 30% SEZ and Section 10A benefits
onwards have been
MAT - upto 2018 19.93% considered in tax provisioning
MAT - 2019 and onwards 20.00%
Total no. of Equity Shares 42,40,694 As per financials as on March
31, 2017
Average depreciation 24%
Services 10%
Manufacturing

Balance Sheet as on Mar 31, 2017 along with 5 Years Amount (in Mn Rs.)
Projection

Particulars 2016-17 2017-18 2018-19 2019-20 2020-21 2021-22

SOURCES OF FUNDS

Share Capital

Called up and Paid up 42.41 338.50 338.50 338.50 338.50 338.50

Reserves & Surplus

Securities Premium 47.59 47.59 47.59 47.59 47.59 47.59

General Reserve

P&L account:

Opening balance 39.22 54.54 86.63 288.38 591.89 982.38

Profit / (loss) during 15.32 32.09 201.75 303.51 390.49 411.53
the year

Closing balance 54.54 86.63 288.38 591.89 982.38 1,393.91

Funds belonging to 144.54 472.72 674.48 977.98 1,368.47 1,780.00
Equity Shareholders

Deferred Tax Liability -

External Commercial 102.00 322.10 322.10 322.10 241.58 80.53
Borrowings (ECB)

TOTAL 246.54 794.82 996.58 1,300.08 1,610.04 1,860.53

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Balance Sheet as on Mar 31, 2017 along with 5 Years Amount (in Mn Rs.)
Projection

Particulars 2016-17 2017-18 2018-19 2019-20 2020-21 2021-22

APPLICATION OF
FUNDS

Fixed Assets

Gross Block (including 133.48 612.60 639.20 639.20 639.20 639.20
additions)

Less : Accumulated 37.20 23.95 73.57 123.20 172.82 222.44
Depreciation

Net Block 96.28 588.65 565.63 516.00 466.38 416.76

Capital WIP 64.09

Deferred tax Asset 7.27

Investments -

Current Assets :

Current Assets 96.34 258.04 388.49 763.51 1,066.30 1,356.78
(Excluding Cash &
Bank)

Cash & Bank Balances 19.33 35.16 155.71 228.09 290.00 305.12

Total Current Assets 115.67 293.20 544.20 991.60 1,356.30 1,661.90

Less: Current 36.78 87.00 113.20 207.52 212.60 218.19

Liabilities & Provisions

Net Current Assets 78.89 206.20 431.00 784.08 1,143.70 1,443.71

TOTAL 246.54 794.85 996.63 1,300.08 1,610.08 1,860.47

Projected Profit and Loss Account Amount (in Mn Rs.)
2019-20 2020-21 2021-22
Particulars 2016-17 2017-18 2018-19
3,534.50 4,493.82 4,728.13
Income

Sales and 299.54 544.85 2,412.90
Income
from
services

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Case Studies

Other 0.06 - - - - -
Income 299.61
544.85 2,412.90 3,534.50 4,493.82 4,728.13
Gross 26.50
Income 123.40 83.35 1,512.76 2,349.74 3,089.63 3,245.98
138.84 196.71 295.85 354.17 380.91
Operating 119.07
Expenses 268.97 257.82 435.77 519.50 596.84 633.46
Cost of 480.01 2,145.24 3,165.09 4,040.64 4,260.35
sales
Personnel
Cost
Operating
and
Administrat
ion
expenses

Total
Operating
Expenses

EBTIDA 30.63 64.84 267.66 369.41 453.17 467.78

% 10.22 11.90 11.09 10.45 10.08 9.89

Depreciati 12.06 23.95 49.62 49.62 49.62 49.62
on & 18.58 40.89 218.04 319.79 403.55 418.15
Amortisati 8.77
on
Depreciatio
n

PBIT

Interest 16.28 16.28 13.06 6.62
Charges 1.80

PBT 16.78 32.12 201.75 303.51 390.49 411.53

% 5.60 5.90 8.36 8.59 8.69 8.70

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II Computation of WACC and Discounting Factor

i) Calculating Rm - Market rate of Return based on BSE Sensex over
almost 40 Years

Market Rate of Return Ascertainment

BSE Sensex Values

Particulars Date Value

Base value of the Sensex 01-Apr-79 100.00
Sensex Value 21-Apr-17 33,314.56
Number of years
Sensex multiple - Current over the Base year 38.64
Average Market Return 333.15
16.22%

We already have Rm and Rf now, hence for determining Cost of Equity we
need Beta. For determining Beta we have used comparable multiple method
under relative approach and considered average beta of all the comparable
companies as beta for ABC India Pvt ltd.

Beta Ascertainment

Beta of Comparable Companies

S.No Company Name Beta
0.94
1 Competent Automobiles Co. Ltd. 1.05
0.68
2 Empire Industries Ltd. 1.18
0.51
3 Khaitan (India) Ltd. 0.82
0.75
4 Salora International Ltd. 1.44
1.05
5 B N R Udyog Ltd. 0.76
0.019
6 In House Productions Ltd. 0.69
0.82
7 Sparsh B P O Services Ltd.

8 Timex Group India Ltd.

9 Roto Pumps Ltd.

10 Cenlub Industries Ltd.

11 Polymechplast Machines Ltd

12 A B C Bearings Ltd.

Average

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Case Studies

Hence for ABC India Pvt Ltd. The weighted average cost of capital can be
calculated as under

Calculation of Cost of Equity

Cost of Equity:

Risk Free Beta Equity Risk
Premium
Return(Rf)
[Beta*(Rm-Rf)]
8.50% 0.82
14.86% 6.36%

Cost of Equity

Cost of Debt:

Cost of Debt Interest*(1-t) Interest Tax
Rate 33.22%
Debt 8.00%
5.34% 10.92%
41.37% Equity 15.00%
12.56%
58.63%

Weighted Average Cost of
Capital

Add: Liquidity premium

Adjusted Cost of Equity

III Calculation of Tax payouts for both the units and tax benefits from
Fixed assets post explicit period

Note for SEZ:

1. The average depreciation rate for the period of projections is taken to
be 10%.

2. Additions are taken to qualify for full depreciation in the year of
additions.

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Note for BLR Unit:

3. The average depreciation rate for the period of projections is taken to
be 24%.

4. Additions are taken to qualify for full depreciation in the year of
additions.

5. Tax WDV of the assets as at March 31, 2017 (INR mn): 35.01

SEZ UNIT

Calculation of Tax Depreciation Amount (in Mn Rs.)

Particulars 2017-18 2018-19 2019-20 2020-21 2021-22

Opening - 431.19 412.01 370.81 333.73
WDV

Additions 479.10 26.60 - - -

WDV before 479.10 457.79 412.01 370.81 333.73
Depreciation

Less: IT (47.91) (45.78) (41.20) (37.08) (33.37)

Depreciation 10%

Closing 431.19 412.01 370.81 333.73 300.36
WDV

SEZ Unit

Computation of Profits before Tax Amount (in Mn Rs.)
2020-21 2021-22
Particulars 2017-18 2018-19 2019-20 369.68 387.09

PBT 20.34 187.25 286.00

Add:

Depreciation 11.85 37.52 37.52 37.52 37.52
407.20 424.62
Total 32.19 224.77 323.52
Inflows
(PBDT)

Less: IT 47.91 45.78 41.20 37.08 33.37
Depreciation

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PBT for Tax (15.72) 178.99 282.32 370.12 391.24
Purposes - - - 58.69

Normal Tax 0%/ 15% -

BLR Unit

Calculation of Tax Depreciation Amount (in Rs.)

Particulars 2017- 2018- 2019-20 2020- 2021-22
18
19 21

Opening WDV 35.01 26.61 20.22 15.37 11.68

Additions - - - - -

35.01 26.61 20.22 15.37 11.68

Less: IT (8.40) (6.39) (4.85) (3.69) (2.80)
Depreciation 24%

Closing WDV 26.61 20.22 15.37 11.68 8.88

BLR Unit

Computation of Tax Provision Amount (in Mn Rs.)

Particulars 2017- 2018- 2019-20 2020-21 2021-

18 19 22

PBT 11.78 14.51 17.51 20.81 24.44

Add:

Depreciation 12.10 12.10 12.10 12.10 12.10

Total Inflows 23.88 26.61 29.61 32.91 36.54
(PBDT)

Less: IT 8.40 6.39 4.85 3.69 2.80
Depreciation

PBT for Tax 15.48 20.22 24.76 29.22 33.74
Purposes

Normal Tax 33.22%/30% 5.14 6.07 7.43 8.77 10.12

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Case Studies

BLR UNIT

WDV as at 31.03.22 8.88

Particulars 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 28

Opening WDV 100.00 76.00 57.76 43.90 33.36 25.36 19.27 14.65 11.13 8.46 6.43 4.89 3.71 2.82 2.14 1.63 1.24 0.94 0.72 0.54 0.41 0.31 0.24 0.18 0.14 0.10 0.08 0.06 0.05

Depreciation 24% 24.00 18.24 13.86 10.54 8.01 6.09 4.62 3.51 2.67 2.03 1.54 1.17 0.89 0.68 0.51 0.39 0.30 0.23 0.17 0.13 0.10 0.08 0.06 0.04 0.03 0.03 0.02 0.01 0.01

Closing WDV 76.00 57.76 43.90 33.36 25.36 19.27 14.65 11.13 8.46 6.43 4.89 3.71 2.82 2.14 1.63 1.24 0.94 0.72 0.54 0.41 0.31 0.24 0.18 0.14 0.10 0.08 0.06 0.05 0.03

Tax Savings on Depreciation 30.00% 7.20 5.47 4.16 3.16 2.40 1.83 1.39 1.05 0.80 0.61 0.46 0.35 0.27 0.20 0.15 0.12 0.09 0.07 0.05 0.04 0.03 0.02 0.02 0.01 0.01 0.01 0.01 0.00 0.00

Discounting Factor 12.56% 0.89 0.79 0.70 0.62 0.55 0.49 0.44 0.39 0.34 0.31 0.27 0.24 0.21 0.19 0.17 0.15 0.13 0.12 0.11 0.09 0.08 0.07 0.07 0.06 0.05 0.05 0.04 0.04 0.03

Present Value of Tax Savings 6.40 4.32 2.92 1.97 1.33 0.90 0.61 0.41 0.28 0.19 0.13 0.09 0.06 0.04 0.03 0.02 0.01 0.01 0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Total PV of Tax Benefit 19.69

SEZ UNIT 300.36
WDV as at 31.03.22 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 28
Particulars
100.00 90.00 81.00 72.90 65.61 59.05 53.14 47.83 43.05 38.74 34.87 31.38 28.24 25.42 22.88 20.59 18.53 16.68 15.01 13.51 12.16 10.94 9.85 8.86 7.98 7.18 6.46 5.81 5.23
Opening WDV 10% 10.00 9.00 8.10 7.29 6.56 5.90 5.31 4.78 4.30 3.87 3.49 3.14 2.82 2.54 2.29 2.06 1.85 1.67 1.50 1.35 1.22 1.09 0.98 0.89 0.80 0.72 0.65 0.58 0.52
Depreciation
Closing WDV 90.00 81.00 72.90 65.61 59.05 53.14 47.83 43.05 38.74 34.87 31.38 28.24 25.42 22.88 20.59 18.53 16.68 15.01 13.51 12.16 10.94 9.85 8.86 7.98 7.18 6.46 5.81 5.23 4.71
Tax Savings on
Depreciation 30.00% 3.00 2.70 2.43 2.19 1.97 1.77 1.59 1.43 1.29 1.16 1.05 0.94 0.85 0.76 0.69 0.62 0.56 0.50 0.45 0.41 0.36 0.33 0.30 0.27 0.24 0.22 0.19 0.17 0.16
Discounting Factor 12.56% 0.89 0.79 0.70 0.62 0.55 0.49 0.44 0.39 0.34 0.31 0.27 0.24 0.21 0.19 0.17 0.15 0.13 0.12 0.11 0.09 0.08 0.07 0.07 0.06 0.05 0.05 0.04 0.04 0.03
Present Value of Tax
Savings 2.67 2.13 1.70 1.36 1.09 0.87 0.70 0.56 0.45 0.36 0.28 0.23 0.18 0.15 0.12 0.09 0.07 0.06 0.05 0.04 0.03 0.02 0.02 0.02 0.01 0.01 0.01 0.01 0.01
Total PV of Tax 13.28

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IV Income Tax under normal provisions vs MAT

After computing the Normal Tax the next step is to compare it with Minimum
alternate Tax

Income-tax & MAT

Computation of Normal Taxes Amount (in Mn Rs.)

Particulars 2017-18 2018-19 2019-20 2020-21 2021-22

BLR Unit 5.14 6.07 7.43 8.77 10.12

SEZ Unit - - - - 58.69

Total 5.14 6.07 7.43 8.77 68.81
Normal Tax

Computation of MAT & MAT Credit Amount (in Mn Rs.)

Particulars 2017-18 2018-19 2019-20 2020-21 2021-22

Book
Profits

BLR Unit 11.78 14.51 17.51 20.81 24.44

SEZ Unit 20.34 187.25 286.00 369.68 387.09

Total Book 32.12 201.75 303.51 390.49 411.53
Profits

MAT 20.00% 6.42 40.35 60.70 78.10 82.31
Payable
(note)

Tax Payable and MAT Credit Amount (in Mn Rs.)

Particulars 2017-18 2018-19 2019-20 2020-21 2021-22 Total

Total 5.14 6.07 7.43 8.77 68.81 96.21

Normal Tax

MAT 6.42 40.35 60.70 78.10 82.31 267.88

Actual Tax 6.42 40.35 60.70 78.10 82.31 267.88
Outflow

MAT Credit 1.28 34.28 53.27 69.33 13.50 171.67
Entitlement

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V Present Value of Cash Flows during Explicit Period

The next input is to determine the present value of cash flows for equity
shareholders using 16.86% discounting factor and cash flow as per projected
financials.

Cash Flows to firm - Explicit Period Amount (in Mn Rs.)

Particulars 2017-18 2018- 2019- 2020- 2021-
19 20 21 22
201.75
PBT 32.12 16.28 303.51 390.49 411.53
49.62
Add: Interest 8.77 267.66 16.28 13.06 6.62

Add: Depreciation 23.95 104.25 49.62 49.62 49.62
26.60
Total Inflows 64.84 3.26 369.41 453.17 467.78
40.35
Less: Outflows 174.46

Incremental Working 111.48 280.70 297.71 284.89
Capital - - -

Capital Expenditure 415.03 3.26 2.61 1.32
60.70 78.10 82.31
Tax on interest 1.75 344.66 378.42 368.52

Tax Provision 6.42

Total Outflows 534.68

Free Cash Flows (469.84) 93.20 24.76 74.75 99.26

Discount rate 12.56% 12.56% 12.56% 12.56% 12.56%
Discounting factor 0.89 0.79 0.70 0.62 0.55

Discounted Cash (417.40) 73.56 17.36 46.56 54.93
Flows

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VI Computation of Terminal Value for ABC India Pvt. Ltd.

Perpetuity Value Amount (in Mn Rs.)
Particulars Amount Amount

PBDIT of 2021-22 30.00% 467.78
Adjustments
Less: Tax (123.46)
Terminal capex (50.00)
Incremental Working Capital
Net Cash Flow for Perpetuity (109.27)
Growth Rate 185.04
perpetuity value
Discounting Factor 2.00%
Present Value of Perpetuity 1,786.84

0.55
988.79

VII Discounted Cash Flow Value

After computing all the necessary inputs the final step is to compute the value
per share as required by XYZ Ltd.

Discounted Cash Flow Value

Value per Share Amount (in Mn Rs.)

Particulars Amount Amount

NPV of Explicit Period (224.99)

Present Value of Perpetuity 988.79

Enterprise Value 763.80

Add/(Less): Adjustments

Contingent Liability -

MAT Credit at the end of 2021-22 171.67

Discounting Factor 0.55 95.00

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756.80
ECB outstanding at the end of 2016-17
Total Value attributable to the Current Equity 42,40,694
Shareholders of the company 178.46
No. of Equity Shares (note)
Value per Equity Share

Conclusion

Hence it is suggested that XYZ ltd shall consider purchasing ABC India
Pvt Ltd. for not more than Rs 178.46/share.

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Chapter-10

Detailed Case Study of an automobile
company to recommend ‘buy or not to

buy decision’ with Monte Carlo
Simulation

This detailed case study of Automobile Company is a scenario based case
study wherein Valuer is appointed to recommend 'buy or not-to-buy decision'.
Case study explains analysis of historical financial statements, and uses
compounded average growth rates to develop prospective financial
information. The valuation under DCF is further stress tested on 2 (two) critical
inputs - Revenue & Cost as a % of Revenue. Finally, Monte Carlo Simulation
is applied to identify confidence level and conclude the decision.

Introduction

You are a Manager in M/s. Valuer Associates and your partner has designated
you to perform a valuation of a Peace Auto Pvt. Ltd. (Hence forth to be called
as Peace), leading Indian automobile manufacturer for potential strategic
Investor – Bull Investor Ltd. Due diligence of the Peace is carried by L.A.W.
Lawyers & Associates and have identified no material mis-statements which
are significant for considerations under Equity Valuation Exercise. Hence, you
can place full reliance on historical financial statements and critically analyse
prospective financial information developed by the management. Bull Investor
Ltd. and Peace have principally agreed to acquire Controlling stake in the
company priced at Rs. 183.70 per share. You are expected to analyse the
value proposition to Bull Investor Ltd. You have been requested to use Income
Approach and market participant assumptions in deriving the fair value of
equity share without assuming any synergy/ acquisition benefits. You have
also been asked not to apply discount for lack of marketability as few more
strategic buyers are bidding for the complete acquisition and hence investor -
Bull Investor Ltd. - believes that the active market for such purchase is
available. As the existing investor of Peace Ltd. is looking for exit for personal
reason, Bull Investor Ltd. believes that it may not be required to pay controlling
premium and hence, for a limited purpose assessment, has requested you to
ignore both Controlling Premium and Discount for Lack of Marketability.

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About Investee Company

Peace Auto Pvt. Ltd. (Peace) is an automobile company. It offers the world a
wide and diverse portfolio of cars, sports utility vehicles, trucks, buses and
defence vehicles. Equipped with strong fundamentals, future-ready products,
operational excellence, innovation and technological expertise – the company
is prepared to navigate the liquidity challenges post FY 2020.

In FY20, challenges facing the automotive industry were aplenty, much before
the outbreak of the coronavirus pandemic. A slowing domestic economy,
muted demand across other geographies, regulatory transitions (emissions,
safety and axle load), pricing pressures and geo-political conflicts put its
resilience to test. However, anchored to its core purpose of providing
innovative mobility solutions, the company has leveraged its strategic
strengths to become more lean, agile and operationally fit amidst the
intensifying storm.

Company prioritised its capital expenditures towards immediately value-
accretive projects, reduced working capital and curtailed overhead costs. Its
new launches and strong pipeline reflect the choices it is making to consolidate
its core capabilities by streamlining products, architectures and new-age
technologies. Company is exploring strategic alliances to ensure steady
access to capital, deleverage its balance sheet and step up its play as a
leading automobile manufacturer.

No matter how perfect the storm is and the magnitude of its impact, Peace
Auto Pvt. Ltd. is confident of emerging stronger on the other side. Company
aims to achieve this by keeping its costs low and ecosystem viable.

Assumptions

After management interviews and review of prospective financial information
developed by the company, you have noted that the company’s entire sale is
a domestic sale and hence, cash flows are solely in Indian Rupees. Capital
composition of the company is moderately geared. The Debt Equity Ratio is
2.134 & Debt to total Capital Ratio is 0.681. Peace has issued various bonds
(debt instruments) in last 5 years and average cost of debt is 6.5% vis-a-vis
comparable market bond cost of 6.75%. Company specific 6.5% cost of debt
can be an acceptable cost of debt level for the valuation. Company has only
one class of equity shares. Preferred stock is never issued by the company.
Peace has average tax cost of 25.17% and management assumes no material
changes in tax laws of the country.

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10 year Indian Government Bond Yield Curve as at Valuation Date was
5.89%.
Calculation of Levered Beta
Beta is a measure of systematic risk. It captures the volatility in stock prices of
the company vis-à-vis volatility in the market. Peace Auto Pvt. Ltd. is unlisted
entity. Hence, you identified 6 comparable listed entities in order to derive
levered beta of Peace.
Identified Listed Comparable Companies are as follows:
1. Maruti Suzuki India Limited
2. Mahindra & Mahindra Limited
3. Hero MotoCorp Limited
4. Bajaj Auto Limited
5. BAIC Motor Corporation Limited
6. TVS Motor Company Limited
Management of Peace Auto Pvt. Ltd. and your partner – both have agreed to
use above companies as comparable companies and a representative of the
auto industry in India for calculating entity specific beta.
Consequently, the average industry unlevered beta can be identified by
assuming above 6 companies’ sample as a representative of Auto Industry of
Peace Auto Ltd. Consequently, unlevered beta is calculated as below:
The unlevered beta of the industry is calculated as follows.

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Peace Auto Ltd.’ Debt Equity Ratio is 2.134. Hence, Levered Beta of the
company can be calculated as follows:

Calculation of ke, kd, & WACC
Discount Rate is the return expected by a market participant from a particular
investment and shall reflect not only the time value of money but also the risk
inherent in the asset being valued as well as the risk inherent in achieving the
future cash flows. You have adopted FCFF approach. Hence, WACC is to be
used as a discounting rate.
Cost of Equity is calculated using Capital Asset Pricing Model. Contracted
bond yield is assumed to be a cost of debt. Book values are used as weights
in calculating weighted average cost of capital.

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Pre-tax cash flows need to be discounted by pre-tax discount rate and post-
tax cash flows to be discounted by post-tax discount rate. Consequently, in
composition of WACC, cost of debt needs to be netted with tax rate. Further
adjustment to discount is not necessary as all company specific risks are
captured in management developed prospective financial information.
WACC Sensitivity
Sensitivity towards Pre-tax Cost of Debt

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Sensitivity towards Cost of Equity

Historical Analysis
2020 will be remembered for the COVID-19 pandemic, which has devastated
lives and disrupted livelihoods. However, Peace was fortunate to quickly
respond to challenging times. The company has reacted quickly and decisively
to the pandemic, with an accelerated focus on improving cashflow and
strengthening liquidity to pave the way for long-term EBIT margin
improvement. The company has been innovating relentlessly to create exciting
and inherently diverse products with a compelling market proposition. Through
collaboration and continuous investment into R&D, Peace is leading the
transition to connected, seamless and integrated mobility. Peace is now
preparing for a post-virus future in which private vehicles could play a far
greater role than previously imagined. It has charted a path towards long-term
sustainable growth, with a lean cost base, disciplined capital allocation, a
highly skilled workforce and world-class R&D. Following is the analysis of
historical financial statements of the company.

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Working Capital Assessment

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Management Developed Prospective Financial Statements
Performance in immediate 5 (five) years can be assumed to be reasonable
basis for developing prospective financial information. Consequently, average
growth rates and margins have been used to build the estimations as follows.

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The management has assumed accrual basis of accounting in developing the
projections. Management is not anticipating significant change from the
historical performance to be reflected in the estimations.
You have performed ratio analysis and trend analysis of the historical financial
statements and found prospective information in line with such trends.
Interviews with the management have revealed that such projections are
achievable. You have also referred to few independent research reports on the
auto industry and the growth rate in cash flows assumed by the management
is found to be within acceptable range.
Future projections of 5 years can be assumed to be a reflection of one entire
business cycle and can be assumed to be sufficient explicit forecast period.
Key DCF Assumptions

Fair Value
Terminal Value can be calculated using various methods such as Gordon’s
Growth Model, Variable Growth model, Exit Multiple, and Salvage or
Liquidation Value. In a given case, Bull Investor Ltd. has specifically asked you
to use Exit Multiple of 5.5 onto EBITDA level of FY 2025 as a basis for
calculation of terminal value. The estimation of terminal value under this
method involves application of a market-evidence based capitalisation factor
or market multiple.
However, you believe that terminal value can significantly influence the fair
value of equity share and hence, decided to perform sensitivity analysis on
EBITDA Multiple Input.

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Fair Value Sensitivity Analysis
EBITDA Exit Multiple Sensitivity to Equity Value per share

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EBITDA Exit Multiple Sensitivity to Enterprise Value

EBITDA Exit Multiple Sensitivity to Premium/ (Discount) on Buy Price
available to Investor.

Interim Conclusion
Peace Auto Pvt. Ltd. has achieved operational excellence, benchmark
performance, continuous innovation and improvement in automotive
manufacturing processes which laid the foundation of its growth. In keeping
with the changing customer preferences and evolving regulatory environment,
Peace has delivered products that are world class and are technologically
advanced. Its research, design and engineering centres collaborate with
expert bodies globally in the process of developing future-ready products.
Implied Fair Value is Rs.213.46 per share. Potential transaction price of Rs.
183.70 reflects discount of Rs.16.20. Hence, for Bull Investor Ltd. it is a good
value proposition to acquire controlling stake at bid price of Rs. 183.70 per
share.

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Investor’s Take on Uncertainty
Bull Investment Ltd. believes that expected transaction price of Rs. 183.70 is
a good deal in one of the scenario assumed by the management (and reflected
in its developed prospective financial statements). The outcome post
acquisition is subject to two critical inputs – Revenue, which is often driven by
purchasing power, fiscal budgets, changing demands etc., and Cost as a % of
Revenue. Bull Investment Ltd. is happy with your sensitivity analysis for
EBITDA multiple input, but has requested you to carry stress testing and
identification of confidence level by further studying these two critical inputs. It
believes that in a best possible scenario, revenue can be 10% up from current
level of projections but can be at 80% level in worst case scenario. Similarly,
cost as a % of sale can be less by 5% from current margin % in a best case
scenario but could be 10% higher than current margin % in a worst case
scenario.
Monte Carlo Simulation
Consequently, you have carried a Monte Carlo Simulation by stress testing
two inputs – Revenue and Cost as a % of Revenue as below:

You have decided to carry 3 simulations –
Simulation 1 – 100 iterations,
Simulation 2 – 1000 iterations, and
Simulation 3 – 10,000 iterations
After carrying the first simulation, you calculated average fair value of equity
share at Rs. 198.14. In a best-case scenario, equity share has a simulated fair
value of Rs. 249.87. In a worst-case scenario, equity share has a simulated

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fair value of Rs. 136.23. The mode for fair value of equity share under 100
iterations is Rs. 195.70 (i.e., the value which appears most). The median fair
value per equity share is Rs. 200.91. Standard deviation in fair value is of Rs.
27.13. Stress testing has thrown following results for 90% confidence level.

Similarly, in Simulation 2 – 1000 iterations, you concluded fair value per equity
share of Rs.198.10. In a best-case scenario, equity share has a simulated fair
value of Rs.257.30. In a worst-case scenario, equity share has a simulated fair
value of Rs. 128.58. The mode for fair value of equity share under 1000
iterations is Rs. 220.10 (i.e., the value which appears most). The median fair
value per equity share is Rs. 200.96. Standard deviation in fair value is of Rs.
27.16. Stress testing has thrown following results for 90% confidence level.

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Finally, you have carried 10,000 iterations and calculated average fair value
per equity share of Rs. 198.11.. In a best-case scenario, equity share has a
simulated fair value of Rs.263.57. In a worst-case scenario, equity share has
a simulated fair value of Rs. 120.53. The mode for fair value of equity share
under 10,000 iterations is Rs. 212.44 (i.e., the value which appears most). The
median fair value per equity share is Rs. 200.71. Standard deviation in fair
value is of Rs. 27.09.
The summary of 3 simulations is as follows:

You have prepared a detail summary for Simulation 3 – iterations under 10,000
scenarios as under. It concludes your stress testing assessment for two critical
inputs – Revenue & Cost as a % of Revenue.

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Note – Valuers are expected to use Monte Carlo Simulations to handle
valuations in uncertain times such as pandemic, wars, or catastrophe.
Final Conclusion
You have concluded that interim fair value calculation of Rs. 213.46 per share
is very close (within acceptable range of 90% level) to mean fair values under
Monte Carlo Simulation for all 3 (three) simulations. Considering the
uncertainty around revenue and Cost as a % of Revenue, the mean fair value
of Rs. 198.11 can be best estimate under 10,000 iterations. Potential offer
price of Rs. 183.70 is still lower than the mean value under Monte Carlo
Simulation i.e., at a discount of 7.27%. Hence, it is recommended to ‘buy’ the
stake in Peace Auto Pvt. Ltd.

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APPENDIX “A”

ICAI Valuation Standard- 301
Business Valuation

CONTENTS PARAGRAPH

OBJECTIVE 1-5

SCOPE 6-8

SIGNIFICANT ELEMENTS 9-11

VALUATION METHIDOLOGY 12-52

Premise of the value 13-16

Analysis of Asset to be valued 17-24

Adjustment to information from financial statements 25-28

Valuation Approaches And Methods 29-37

Market approach 32-33

Income approach 34-35

Cost approach 36-37

Value under liquidation 38-41

Rule of Thumb or Benchmark Value 42-46

Treatment of non-operating assets and inter-company 47-48
investments

Consideration of the Capital Structure of company 49

Value 50-52

EFFECTIVE DATE 53

(The ICAI Valuation Standard includes paragraphs set in bold type and plain
type, which have equal authority. Paragraphs in bold type indicate the main
principles. (This ICAI Valuation Standard should be read in the context of
Framework for the Preparation of Valuation Report in accordance with ICAI
Valuation Standards)
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Objective
1. This Standard provides guidance for business valuers who are

performing business valuation or business ownership interests valuation
engagements.
2. The objective of this Standard is to establish uniform concepts,
principles, practices and procedures for valuers performing valuation
services.
3. Valuations of businesses, business ownership interests may be
performed for a wide variety of purposes including the following:
(a) valuation of financial transactions such as acquisitions, mergers,

leveraged buyouts, initial public offerings, employee stock
ownership plans and other share-based plans, partner and
shareholder buy-ins or buy-outs, and stock redemptions;
(b) valuation for dispute resolution and/ or litigation/pending litigation
relating to matters such as marital dissolution, bankruptcy,
contractual disputes, owner disputes, dissenting shareholder and
minority ownership oppression cases, employment disputes, etc;
(c) valuation for compliance oriented engagements, for example:
(i) financial reporting; and
(ii) tax matters such as corporate reorganisations, ; purchase

price allocations etc.
(d) valuation for other purposes like the valuation for planning,

internal use by the owners etc;
(e) valuation under Insolvency and Bankruptcy Code.
4. This Standard provides a broad framework of generally accepted
principles, theories and procedures.
5. The principles enunciated in this Standard shall be applied in
conjunction with the principles prescribed and contained in the
Framework for the Preparation of Valuation Report in accordance
with ICAI Valuation Standards.

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Scope

6. A valuer shall follow all applicable requirements of this Standard in the
valuation of a business.

7. This Standard describes the basic principles which govern the valuer’s
professional responsibilities and which shall be complied with whenever
an engagement to estimate value is carried out.

8. A valuer shall not apply this Standard, where any requirement of this
Standard is inconsistent with

(a) the requirements prescribed under; or

(b) valuation procedures specified by

any law, regulations, rules or directions of any government or regulatory
authority, or Court order.

In such cases, the valuer shall follow the requirements prescribed by
any law, regulations, rules or directions of any government or regulatory
authority, or Court order.
Significant Elements

9. Business Valuation is the act or process of determining the value
of a business enterprise or ownership interest therein.

10. A valuer shall apply valuation approaches and valuation methods, as
described in ICAI Valuation Standard 103 Valuation Approaches and
Methods, and also use his professional judgment which is an essential
component of estimating value.

11. When valuing a business or business ownership interest, a valuer may
express either an exact number or a range of values. There could be
different benchmarks at which the estimate of value of an entity could
be expressed by the Valuer. For example:

(a) Enterprise Value: Enterprise Value is the value attributable to the
equity shareholders plus the value of debt and debt like items,
minority interest, preference share less the amount of non-
operating cash and cash equivalents.

(b) Business Value: Business value is the value of the business
attributable to all its shareholders

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(c) Equity Value: Equity Value is the value of the business
attributable to equity shareholders

Valuation Methodology
12. In performing a valuation assignment, a valuer shall:

(a) define the premise of the value;
(b) analyse the asset to be valued and collect the necessary

information;
(c) identify the adjustments to the financial and non-financial

information for the valuation;
(d) consider and apply appropriate valuation approaches and

methods;
(e) arrive at a value or a range of values; and
(f) identify the subsequent events, if any
Premise of the value
13. Premise of the value refers to the conditions and circumstances
how an asset is deployed.
14. The premise shall always reflect the facts and circumstances underlying
each valuation engagement.
15. Determining the business value depends upon the situation in which the
business is valued, i.e., the events likely to happen to the business as
contemplated at the valuation date.
16. Premises of value are explained in detail in ICAI Valuation Standard 102
Valuation Bases.
Analysis of asset to be valued
17. The analysis of the asset to be valued shall assist the valuer in
considering, evaluating, and applying the various valuation approaches
and methods to the valuation engagement.
18. The nature and extent of the information required to perform the
analysis shall depend on the following:
(a) nature of the asset to be valued;

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(b) scope and purpose of the valuation engagement;

(c) the valuation date;
(d) the intended use of the valuation;

(e) the applicable ICAI Valuation Standard;

(f) the applicable premise of value;
(g) assumptions and limiting conditions; and

(h) applicable governmental regulations or regulations prescribed by
other regulators or other professional standards;

19. In analysing the asset to be valued, the valuer shall gather, analyse and
adjust the relevant information necessary to perform a valuation,
appropriate to the nature or type of the engagement. Such information
shall include:

(a) non-financial information;

(b) ownership details;
(c) financial information; and

(d) general information.
The detailed guidance in this respect is laid down in ICAI Valuation
Standard 201 Scope of Work, Analyses and Evaluation.

20. A valuer shall read and evaluate the information to determine the
reasonableness of information.

21. Even though the above mentioned procedure is presented in a manner
that suggests a sequential valuation process, valuations involve an
ongoing process of gathering, updating, and analysing information.
Accordingly, the sequence of the requirements and guidance in this
Standard may be implemented differently at the option of the valuer.

22. If the historical financial statements of the business to be valued are not
considered to be reflective of its future business performance, the valuer
should understand the rationale for the same and document the same.

23. The conditions, rights and obligations of ownership right are usually
mentioned in the legal document such as articles of association, bye-
laws, shareholders agreement, partnership agreements, etc. of the

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asset to be valued. These documents may consider certain restrictions
or give certain benefits for ownership rights for certain groups of
stakeholders. A valuer shall consider and incorporate the same in the
valuation of the ownership interest of the business.

24. The type, availability, and significance of such information may vary with
the asset to be valued.

Adjustment to information from financial statements

25. Adjustment shall be made to information available from the historical
financial statements, if appropriate, to reflect the appropriate asset
value, income, cash flows and/or benefit stream, as applicable, to be
consistent with the valuation method(s) selected by the valuer.

26. Financial information adjusted to be analysed include those of the
underlying company and any entities used as comparable entities to the
extent available in public domain.

27. Adjustments to financial information are modifications to reported
financial information which is relevant and significant to the valuation
process. Adjustments may be appropriate for the following reasons,
amongst others:

(a) to present financial data of the underlying and comparable
companies on a consistent basis;

(b) to adjust revenues and expenses to levels that are reasonably
representative of continuing operations;

(c) to adjust for non-operating/non-recurring assets and liabilities,
and any revenues and expenses related to the non-operating
items.

28. Adjustments to the financial information are made for the sole purpose
of assisting the valuer in reaching a value.

Valuation Approaches and Methods

29. Generally, the following three main valuation approaches are adopted
to perform the business valuation in correlation with the valuation
approaches and methodologies prescribed under ICAI Valuation
Standard 103 Valuation Approaches and Methods :

(a) Market approach;

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(b) Income approach; and

(c) Cost approach.

30. A valuer shall select and apply appropriate valuation approaches,
methods and procedures to the extent relevant for the engagement.

31. The requirements of this Standard shall be followed consistently in
addition to the requirements as contained in ICAI Valuation Standard
103 while selecting and applying the valuation approach.

Market approach

32. Market approach is a valuation approach that uses prices and other
relevant information generated by market transactions involving
identical or comparable (i.e., similar) assets, liabilities or a group
of assets and liabilities, such as a business

33. The following are the common methodologies for the market approach:

(a) Market Price Method;

(b) Comparable Companies Multiple Method; and

(c) Comparable Transaction Multiple Method.
Income approach

34. Income approach is the valuation approach that converts
maintainable or future amounts (e.g., cash flows or income and
expenses) to a single current (i.e. discounted or capitalised)
amount. The fair value measurement is determined on the basis of
the value indicated by current market expectations about those
future amounts.

35. The most commonly used income approach is Discounted Cash Flow
(DCF) Method.

Cost approach

36. Cost approach is a valuation approach that reflects the amount that
would be required currently to replace the service capacity of an
asset (often referred to as current replacement cost).

37. The following are the commonly used valuation methods under the cost
approach:

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(a) Replacement Cost Method; and

(b) Reproduction Cost Method.
Value under liquidation

38. Liquidation value is the amount that will be realised on sale of an
asset or a group of assets when an actual/hypothetical termination
of the business is contemplated/assumed.

39. The value under liquidation would be relevant in case the basis of
valuation is liquidation value

40. In the event of valuation of ownership interest under the premise of
liquidation, it may be relevant to consider the realisable values of assets
of the entity after considering transaction costs.

41. Liabilities could be considered at their settlement values.
Rule of Thumb or Benchmark Value

42. Rule of thumb or benchmark indicator is used as a reasonable
check against the values determined by the use of other valuation
approaches in a valuation engagement.

43. Rule of thumb may provide insight into the value of a business or
business ownership interest. Some of the examples of rule of thumb or
benchmark valuation would be value based on transaction multiples for
capacity or turnover.

44. It shall not be used as the only method to determine the value of the
asset to be valued.

45. Value indications derived from the use of rules of thumb method shall
not be given substantial weight unless they are supported by other
valuation methods and it can be established that knowledgeable buyers
and sellers place substantial reliance on them.

46. A valuer shall set forth in the report the rationale and support for the
valuation methods used.

Treatment of non-operating assets and inter-company investments

47. Apart from operating assets, entities hold non-operating assets. Such
assets should be valued based on their realisable values net of costs
and outgoes and added to the value arrived under the various
approaches to derive the value for ownership interest.

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48. Inter-company adjustments or substantial cross holdings between
companies in the business valuations should be considered at fair value.

Consideration of Capital Structure of the business

49. A business is usually financed by a combination of investments such as
equity interests, debt (including redeemable preference shares) and
quasi equity instruments. Certain engagements may require the valuer
to allocate the enterprise value of the business into (a) value allocable
to equity and (b) value allocable to debt. In deriving the above allocation,
the valuer should give due consideration to the capital structure of the
business including the terms of instruments used to finance the
business. The value allocable to equity interests is usually the residuary
value after reducing the debt from enterprise value.

Value

50. Value is an estimate of a business or business ownership interest,
arrived at by applying the valuation procedures appropriate for a
valuation engagement and using professional judgment as to the
value or range of values based on those procedures.

51. The value shall be based upon the applicable bases of value, the
purpose and intended use of the valuation, and all relevant information
available as of the valuation date in carrying out the value for the
valuation engagement and on value indications resulting from one or
more valuation methods performed under the valuation process.

52. In arriving at the value, the valuer shall:

(a) assess the reliability of the results under the different approaches
and assign weights to value indications reached on the basis of
various methods;

(b) the selection of and reliance on appropriate methods and
procedures depends on the judgment of the valuer and not on
any prescribed formula. One or more approaches may not be
relevant to a particular situation, and more than one method
under an approach may be relevant;

(c) the valuer must use informed judgment when determining the
relative weight to be accorded to indications of value reached on
the basis of various methods, or whether an indication of value

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from a single method shall be conclusive. In any case, the valuer
shall provide the rationale for the selection or weighting of the
method or methods relied on in reaching the conclusion;

(d) in assessing the relative importance of indications of the value
determined under each method, or whether an indication of value
from a single method shall be the value, the valuer shall consider
factors such as:
(i) the applicable premise of value;
(ii) the purpose and intended use of the valuation;
(iii) whether the underlying business is an operating company,
a real estate or investment holding company, or a company
with substantial non-operating or excess assets;
(iv) the quality and reliability of data underlying the value;
(v) such other factors that in the opinion of the valuer, are
appropriate for consideration.

Effective Date
53. ICAI Valuation Standard 301 Business Valuation, shall be applied for

the valuation reports issued on or after 1st July, 2018.

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