Valuation and corporate restructuring

It is important for the finance managers, in general, and other managers in particular, to
understand the process and methods of valuing a business firm. The term business is more
comprehensive than the assets deployed in it. The reason is that the valuation of business is to
reckon all types of assets (tangible and intangible) as well as all liabilities (recorded and
contingent).

Irrespective of the difference in scope, the business valuation exercise is a key to the valuation
of an asset or a security and is dependent on financial concepts of the time value of money, risk
and return, and future cash flows.

The subject of business valuation assumes special significance in the case of mergers and
acquisition with a view to, firstly, determining the price that the acquiring firm should be
willing to pay for the acquisition of a business, and secondly, deciding fair exchange ratio
between the shareholders of the two companies.

 Unit One focuses on business valuation, and

 Unit Two focuses on corporate restructuring.

1
 Unit One
BUSINESS VALUATION

Learning objectives:

1. Explain the basic valuation framework in terms of different concepts of value – book
value, market value, intrinsic/economic value, liquidation value, replacement value,
salvage value, fair value, and value of goodwill.
2. Describe the four major approaches to valuation of business – asset based, earning based,
market value based, and fair value based.
3. Discuss market value added (MVA) and economic value added (EVA) approaches to
measure value with focus on shareholders.

Introduction
Section I: Conceptual Framework of Valuation
The term valuation implies the task of estimating the wealth/value of an asset, a security or a
business. The price an investor or a firm (buyer) is willing to pay to purchase a specific
asset/security would be related to this value. Obviously, two different buyers may not have the
same valuation for an asset/business as their perception regarding its worth/value may vary; one
may perceive the asset/business to be of higher worth (for whatever reason) and hence may be
willing to pay a higher price than the other. A seller would consider the negotiated selling price
of the asset/business to be greater than the value of the asset/business he/she is selling.
Evidently, there are unavoidable subjective considerations involved in the task of business
valuation is more comprehensive than that of an asset or an individual security. In the case of
business valuation, the valuation is required not one of tangible assets (such as plant and
machinery, land and building, office equipment, and so on) but also of intangible assets (like,
goodwill, brands, patents, trademarks and so on) as well as human resources that run/manage the
business. Likewise, there is an imperative need to take in to consideration recorded liabilities as
well as unrecorded/contingent liabilities so that the buyer is aware of the total sums payable,
subsequent to the purchase of business. Thus, the valuation process is affected by subsequent
considerations. In order to reduce the element of subjectivity, to a marked extent, and help the
financial manager to carry out a more credible valuation exercise in an objective manner, the
following concepts of value are explained in this section.

2
 1. Book Value
The book value of an asset refers to the amount at which an asset is shown in the balance sheet of
a firm. Generally, the sum is equal to the initial acquisitions cost of an asset less accumulated
depreciation. Accordingly, the mode of valuation of asset is as per the going concern principle of
accounting. In other words, book value of an asset shown in balance does not reflect its current
sale value.
Book value of a business refers to total book value of all valuable assets (excluding fictitious
asset, such as accumulated losses and differed revenue expenditure, like advertisement,
preliminary expenses, cost of issue of securities not written off) less all external liabilities
(including preference share capital). It is also referred to as net worth.

2. Market Value
In contrast to book value, market value refers to the price at which an asset can be sold in the
market. The market value can be applied with respect to tangible asset only, (intangible asset in
isolation more often than not, do not have any sales value). Market value of a business refers to
the aggregate market value (as per stock market quotation) of all equity shares outstanding. The
market value is relevant to listed companies only.

3. Intrinsic/Economic Value
The intrinsic value of an asset is equal to present value of incremental future cash inflows likely
to occur due to the acquisition of the asset, discounted at the appropriate required rate of return
(applicable to the specific asset intended to purchase). It represents the maximum price the buyer
would be willing to pay for such an asset. The principle of valuation based on the discounted
cash flow approach (economic value) is used in capital budgeting decision.
In the case of business intended to be purchased, its valuation is equivalent to the present value
of incremental future cash inflows after taxes, likely to accrue to the acquiring firm, discounted
at the relevant risk adjusted discount rate as applicable to the acquired business. The economic
value indicates the maximum price at which business can be acquired.

4. Liquidation Value
As the name suggests, liquidation value represents the price at which each individual asset can be
sold if business operations are discontinued in the wake of liquidation of the firm. In operational

3
terms, the liquidation value of a firm is equal to the sum of (1) the realizable value of assets and
(2) cash and bank balances minus the payment required to discharge all essential liabilities. In
general, among all measures of value, the liquidation value of an asset / or business is likely to be
the least.

5. Replacement Value
The replacement value is the cost of acquiring a new asset of equal utility and usefulness. It is
normally useful in valuing tangible assets such as office equipment and furniture and fixtures
which do not contribute towards the revenue of the business firm.

6. Salvage Value
Salvage value represents realizable/scrap value on the disposal of assets after the expiry of their
economic useful life. It may be employed to value assets such as plant and machinery. Salvage
value should be considered net of removal costs.

7. Value of Goodwill
The valuation of goodwill is conceptually the most difficult. A business firm can be said to have
real goodwill in case it earns a rate of return (ROR) on invested funds higher than the ROR
earned by similar firms (with the same level of risk). In operational terms, goodwill results when
the firm earns excel (supper) profits. Defined in this way, the value of goodwill is equivalent to
the present value of supper profits (likely to accrue, say for a number of years in the future), the
discount rate being the ROR applicable to such firms.
The value of goodwill in terms of the present value of supper profit method can serve as a useful
benchmark in terms of the amount of good will the term would be willing to pay for the required
business. In the case of mergers and acquisitions decisions the value of goodwill paid is equal to
the net difference between the purchase price paid for acquired business and the value of asset
acquired net of liabilities the acquiring firm has undertaken to pay for.

8. Fair Value
The concept of fair value draws heavily on the value concepts discussed above, in particular,
book value, intrinsic value and market value, i.e. the average of these. The fair value is hybrid in
nature and often is the average of these three values.

4
In brief, the financial manager, will find it useful to know business valuation from different
perspectives. For instance, the book value may be relevant for accounting/tax purposes, the
market value may be useful in determining share exchange ratio and liquidation value may be
provided on insight in to the maximum loss, if the business is to be wound up.

Approaches / Methods of Business Valuation

The various approaches to valuation of business will focus on equity share valuation are
examined in this section. They should be viewed as providing a range of values,
catering/providing to varied needs depending on the circumstances. The major approaches
namely, (1) the asset based approach to valuation, (2) earning based approach to valuation, (3)
market value based approach to valuation, and (4) the fair value method to valuation are
described below:

I. Asset based Approach to Valuation

Asset based approach to valuation focuses on determining the value of net assets from the
perspective of equity share valuation. What should the basis of assets valuation be, is the
central issue of this approach. It should be determined whether the assets should be valued at
book, market, and replacement or liquidation value. More often than not, they are (and
should be) valued at book value, (i.e. original acquisition cost minus accumulated
depreciation, as assets are normally acquired with the intent to be used in business and not
for resale. Thus, the valuation of assets is based on the going concern concept. Some other
value measure may be used depending on circumstances of the case.
Apart from tangible assets, intangible assets, such as good will, patents, trademarks, brands,
know how, and so on, also need to be valued satisfactorily. It may be useful to adopt the
supper profit method to value some of these assets.
To arrive at the net assets value, total external liabilities (including preference share capital)
payable are deducted from total assets (excluding fictitious assets).
The company’s net assets are computed as per equation 1.1.

Equation 1.1

Net Assets = Total Assets – Total External Liabilities

5
 The value of net assets is also known as net worth or equity/ordinary shareholders’ funds.
Net assets per share can be obtained dividing net assets by the number of equity shares issued
and outstanding. Thus,
Equation 1.2

Net assets per share = Net assets / number of equity shares issued and outstanding

The value of net assets is contingent up on the measure of value adopted for the purpose of
valuation of assets and liabilities. In the case of book value, assets and liabilities are taken at
their balance sheet values. In the market value measures, assets shown in the balance sheet
are revalued at the current market prices.
For the purpose of valuing assets and liabilities it will be useful for a finance manager/valuer
to accord special attention to the following points:
1) While valuing tangible assets he should consider aspects related to technological
obsolescence and capital improvements made in the recent years. Depreciation
adjustment may be needed in case the company is following unusual depreciation policy
in this regard.
2) Is the valuation of good will satisfactory, given the amount of profits, capital employed
and average rate of return available on such businesses?
3) With respect to current assets, are additional provisions required for unreliability of
debtors? Likewise, are adjustments required for unsalable stores and stocks?
4) With respect to liabilities, there is a need for careful examination of contingent liabilities.

The net assets valuation based on book value is in tune with the going concern principle of
accounting. In contrast, liquidation value measure is guided by the realizable value available on
the winding up/liquidation of a corporate firm. Liquidation value is the final net asset value (if
any) per share available to the equity shareholder. The value is given as per equation 1.3.

Equation 1.3

Net assets per share = liquidation value of assets minus liquidation expenses minus total
external liabilities divided by the number of equity shares issued and outstanding.

The net asset value (NAV) per share will be the lowest under the liquidation value measure
(example 1.1.).

6
Activity 1.1
Following is the balance sheet of X- company private limited Company as on Dec. 31, 2020.

Amounts (in thousands)

LIABILITIES AND OWNERS’ EQUITY
40,000 11% preference shares of $100 each, fully paid up --------------------------------------$4,000
120,000 equity shares of $100 each, fully paid up ------------------------------------------------12,000
Retained earnings (P&L A/C) -------------------------------------------------------------------------2,300
10% Debentures -----------------------------------------------------------------------------------------2,000
Trade creditors -------------------------------------------------------------------------------------------7,100
Provision in income tax -----------------------------------------------------------------------------------800
Total liabilities & Owners Equity------------------------------------------------------------------$28,200
ASSETS
Fixed assets-----------------------------------------$15,000
Less depreciation -------------------------------------3,000 ------------------------------------------12,000
Current assets:
Stocks -----------------------------------------------10,000
Debtors -----------------------------------------------5,000
Cash and bank --------------------------------------1,000 --------------------------------------------16,000
Preliminary expenses -------------------------------------------------------------------------------------200
Total assets--------------------------------------------------------------------------------------------$28,200

Additional information:
(1) A firm of professional valuers has provided the following market estimates of its
various assets: fixed assets of $13,000; stocks of $10,200, debtors $4,500. All other
assets are to be taken at their balance sheet values.
(2) The company is yet to declare and pay dividend on preference shares.
(3) The valuers also estimate the current sale proceeds of the firm’s assets in the event of its
liquidation: fixed assets $10,500, stock $9,000, debtors $4,000. Besides, the firm is to
incur $15,000 as liquidation costs.
(4) All figures are in thousands.

Required:
You are required to compute the net asset value per share as per book value, market value
and liquidation value bases?

7
Solution
Determination of Net Asset Value per Share

(1) Book value bases:

Amount (in thousands)
Fixed assets (net) ------------------------------------------------------------------------------$12,000
Current assets:
Stock --------------------------------------------------------$10,000
Debtors --------------------------------------------------------5,000
Cash and bank ------------------------------------------------1,000 ---------------------------16,000
Total assets --------------------------------------------------------------------------------------28,000
Less: external liabilities:
10% Debentures -------------------------------------------2,000
Trade creditors ---------------------------------------------7,100
Provision for taxation ---------------------------------------800
11% Preference share capital ----------------------------4,000
Dividend on preference shares (0.11x4,000) ------------440 -----------------------------14, 340
Net assets available for equity shareholders ------------------------------------------------13,660
Divided by the number of equity shares (in ‘thousands) -------------------------------------120
Net assets value per share ($) ------------------------------------------------------------------ $113.83

(2) Market value bases:

Fixed assets (net) -------------------------------------------------------------------------------13,000
Current assets:
Stock ------------------------------------------------------10,200
Debtors -----------------------------------------------------4,500
Cash and bank ---------------------------------------------1,000 ------------------------------15,700
Total assets --------------------------------------------------------------------------------------28,700
Less: external liabilities (as given above) ---------------------------------------------------14,340
Net assets available for equity shareholders ------------------------------------------------14,360
Divided by the number of shares (in’ thousands) ---------------------------------------------120
Net assets value per share ($) ------------------------------------------------------------------ $119.67

8
 (3) Liquidation value bases:
Fixed assets (net) -----------------------------------------------------------------------------------10,500
Current assets:
Stock ----------------------------------------------------------9,000
Debenture ----------------------------------------------------4,000
Cash and bank -----------------------------------------------1,000 --------------------------------14,000
Total assets ------------------------------------------------------------------------------------------24,500
Less: External liabilities (as listed above) -------------------------------------------------------14,340
Less: liquidation costs -------------------------------------------------------------------------------1,500
Net assets available for equity shareholders ------------------------------------------------------8,660
Divided by the number of equity shares (‘thousands) --------------------------------------------120
Net assets value per equity share ($) ----------------------------------------------------------------$72.17

The asset based approach is appealing in that it indicates the net assets backing per equity
share. However, the approach ignores the future earnings cash flow generating ability of the
company’s assets. The earnings based approach reckons/considers this perspective.

9
 II. Earnings based Approaches to Valuation

The earnings approach is essentially, guided by the economic proposition that business valuation
should be related to the firm’s potential future earnings of cash flow generating capacity. This
approach overcomes the limitation of asset based approach; which ignores the firm’s prospects
of future earnings and ability to generate cash in business valuation. Earnings can be expressed
on the sense of accounting as well as financial management. Accordingly, there are two major
variants of this approach. (1) Earnings measure on accounting basis and (2) earnings measure
on cash flow (financial management) basis.

A) Earnings Measure on Accounting – Capitalization Method

As per this method, the earnings approach of business valuation is based on two major
parameters, that is, the earnings of the firm and the capitalization rate applicable to such
earnings (given the level of risk) in the market. Earnings in the context of this method are the
normal expected annual profits. Normally, to smoothen out the fluctuations in earnings, the
average of the past earnings (say, of the last three to five years) is computed.

The determination of the capitalization factor is not an easy task in practice. A few
guidelines/principles may, however, be helpful to the valuer in its qualification. First, the
capitalization factor for a business firm should be higher than that of a government security
(normally considered riskless). Secondly, the capitalization factor should match/stay close
around the one that is used for other firms operating in similar types of businesses. In case the
valuer wants to apply different capitalization rate, there should be weighty and convincing
reasons to do so.

Having determined the two major inputs, equation 1.4 can be used to compute the value of
business (VB) from the perspective of shareowners.

Equation 1.4

VB = Future Maintainable Annual Profits after Taxes

Relevant Capitalization Factor

10
Activity 1.2
In the current year, a firm has reported a profit of $6,500,000, after paying taxes at 35 per cent.
On close examination, the analyst ascertains that the current year’s income includes: (1)
extraordinary income of $1,000,000 and (2) extraordinary loss of $300,000. A part from
existing operations, which are normal in nature and likely to continue in the future, the company,
expects to launch a new product in the coming year:
Revenues and cost estimates in respect of the new product are as follows:
Sales ------------------------------------------------------------------------------------------------$6,000,000
Material cost ----------------------------------------------------------------------------------------1,500,000
Labor cost (additional) ----------------------------------------------------------------------------1,000,000
Allocated fixed costs ---------------------------------------------------------------------------------500,000
Additional fixed costs --------------------------------------------------------------------------------800,000
Required:
From the given information compute the value of the business, given that capitalization rate
applicable to such business in the market is 15 per cent.
Solution

Valuation of Business
Profit before tax ($6,500,000/ (1 – 0.35) -----------------------------------------------------$10,000,000
Less: Extraordinary income (not likely to accrue in future) ------------------------------- (1,000,000)
Add: Extraordinary loss (non-recurring in nature) -----------------------------------------------300,000
Add: Incremental income expected from the launch of the new product:
Sales ----------------------------------------------------------------------------$6,000,000
Less: Incremental costs:
Material costs --------------------------------$1,500,000
Labor costs -------------------------------------1,000,000
Fixed costs (additional) -------------------------800,000------------------- (3,300,000) ------2,700,000
Expected profits before taxes -------------------------------------------------------------------12,000,000
Less: taxes (0.35) -------------------------------------------------------------------------------- (4,200,000)
Future maintainable profits after taxes ----------------------------------------------------------7,800,000
Divided by relevant capitalization factor------------------------------------------------------------ ÷ 0.15
Value of business (7,800,000 ÷ 0.15) -------------------------------------------------------$52,000,000

Some useful insight in to estimate of capitalization rate can be made by referring to the price
earnings (P/E) ratio. The reciprocal of the P/E ratio is indicative of the capitalization factor
employed for the business by the market. In Activity 1.2, the P/E ratio is approximately 6.67
(1/0.15). The product of future maintainable profits after taxes, $7,800,000 and the P/E multiple
of 6.67 times, yields $52,000,000. Given the fact, that P/E ratio is a widely used measure, it is
elaborated below.

11
 Price Earnings (P/E) Ratio
The price earnings ratio (also known as the P/E multiple) is the method most widely used by
finance managers, investment analysts and equity shareholders to arrive at market price of an
equity share.
The application of this method primarily requires the determination of earnings per equity share
(EPS). The EPS is computed as per equation 1.5.

Equation 1.5

EPS = Net Earnings Available to Equity Share Holders

Number of Equity Shares Outstanding During the Period

The net earnings/profits are after deducting taxes, preference dividends, and after adjusting for
exceptional and extraordinary items (related to both income and expenses/losses). Likewise,
appropriate adjustments should be made for new equity shares issues or buy backs equity shares
made during the period to determine the number of equity shares.
The EPS is to be multiplied by the P/E ratio to arrive at the market price (based on future
earnings) of equity shares (MPS).

MPS = EPS x P/E Ratio

The price earnings ratio may be derived given the MPS and EPS.

P/E Ratio = MPS/ EPS

The future maintainable earnings/projected future earnings should also be used to determine
EPS. It makes economic sense in that investors have access to future earnings only. There as a
financial and economic justification to compute forward or projected P/E ratios with reference to
projected future earnings, apart from historic P/E ratios. This is all the more true of present
businesses that operate in a highly turbulent business environment.

Activity 1.3
Required:
For facts in Activity1.2, determine the market price per equity share (based on future earnings).
Assuming:
i) The company has 100,000, 11% preference shares of $100 each, fully paid up.
ii) The company has 400,000 equity shares of $100 each, fully paid up.
iii) P/E ratio is 6.67 times.

12
Solution

Determination of Market Price of Equity Shares

Future maintainable profits after taxes --------------------------------------------------------$7,800,000

Less: Preference dividend (100,000 x $100x11%) --------------------------------------------1,100,000
Earnings available to equity shareholders ------------------------------------------------------6,700,000
Divided by number of equity shares ------------------------------------------------------------ ÷400,000
EPS ($6,700,000/400,000) -----------------------------------------------------------------------------16.75
Multiplied by P/E ratio (times) ---------------------------------------------------------------------- x 6.67
Market price per share ($16.75 x 6.67) MPS -----------------------------------------------------$111.72

To conclude, the P/E ratios should be used/ interpreted with caution and care. In particular, the
investors should focus on perspective/ future P/E ratios, risk and growth attributes of business
and comprehensive analysis with a view to have more authentic and credible valuation.

B) Earnings Measure on Cash Flow Basis (DCF Approach)

DCF approach is used to evaluate capital expenditure proposals in terms of their potential for
creating net present value for the firm. The DCF approach is applied to the entire business, which
may consist of individual capital budgeting projects.
Accordingly, the value of business firm is equal to the present value of expected future cash
flows (FCF) to the firm discounted at the rate that reflects the riskiness of the cash flows (ko).
In equation terms:

Equation 1.6
n
∑
Value of firm0 = t =1 CF to firm t
(1+ko) t

To use the DCF approach accounting earnings (as shown by the firm’s income statement) are to
be converted to cash flow figures as shown in format 1.1.

Format 1.1 Computations of Cash Flows:

After tax operating earnings
Plus: Depreciation
Plus: Other non-cash items (say amortization of non-tangible assets such as
patents and loss on sale of long term assets)

13
Another variant of cash flow approach is to discount estimated future free cash flows to the firm
(FFCF) instead of operating cash flows. The FFCFs are computed by deducting incremental
investments in long term assets as well as investment in working capital from operating cash
flows. The value of the firm is given by Equation 1.7.
Equation 1.7
∞
∑
Valuation of Firm0 = t=1 FFCF to All Investors t
(1+k0) t
The value of equity can be determined by subtracting the total external liabilities (debt holders
and preference shareholders) from the value of the firm. Alternatively, the value of equity can be
determined directly by discounting the future free cash flows available to equity shareholders
(FFCF) after meeting interest, preference dividends and principal payments, the discount rate
being rate of return required by equity investors, that is, cost of equity ( Ke).
Equation 1.8
∞
∑
Valuation of Equity0 = t=1 FFCF to Equity Holders t
(1+ke) t
Thus, there are varying connotations of FFCF to serve different needs. However, while the
valuation of a firm and equity use different definitions of FFCF as well as of discount rates, they
provide identical answers as long as the same set of assumptions is used in both the equations.

Activity 1.4
Suppose a firm has employed a total capital of $1,000,000 (provided equally by 10 percent debt
and 5 thousands equity share of $100 each), its cost of equity is 14 percent. The projected cash
flows to all investors of the firm for 5 years are given below:
Year End 1 $300,000
2 200,000
3 500,000
4 150,000
5 600,000
Required:

14
Compute (1) valuation of firm, based on K0, and (2) valuation from the perspective of equity
shareholders, based on ke. Assume 10 per cent debt is repayable at the year 5 and interest is paid
at each year-end.

Solution
i) Computation of Overall Cost of Capital
Source of capital After tax cost (%) Weights Total
Equity 14 0.50 7
Debt 6* 0.50 3
Weighted average cost of capital (ko) --------------------------------10%
Note: 10% (1- 0.40 tax rate) = 6%*

ii) Valuation of Firm, Based on ko

Year-end FFCF PV factor (0.10) Total Present value
1 $300,000 0.909 $272,700
2 200,000 0.826 165,200
3 500,000 0.751 375,500
4 150,000 0.683 102,450
5 600,000 0.621 372,600
Total present value/ valuation of firm -------------------------1,286,450
Less: Value of debt--------------------------------------------------500,000
Value of equity----------------------------------------------------$788,450

iii) Valuation of Equity, Based on ke

Year-end FFCF to all After tax FCFF to PV factor Total PV

investors payment to equity (0.14) (5) =(3) x (4)
(1) debt holders holders (4)
(2) (3)= (1) – (2)

1 $300,000 $30,000* $270,000 0.877 $236,790

2 200,000 30,000 170,000 0.769 130,730
3 500,000 30,000 470,000 0.675 317,250
4 150,000 30,000 120,000 0.592 71,040
5 600,000 530,000** 70,000 0.519 36,330

15
 Total present value $792,140
Note:
*
Interest on $500,000 @ 10% = $50,000 (1-0.40) = $30,000
**
Inclusive of debt repayment of $500,000 at year-end 5.
Thus, the valuation of equity by both the methods is virtually the same ($788,450 and
$792,140). The minor difference of $3,690 can be attributed primary to rounding-off the present
value figures.
Total present value of the projected free cash flows to equity shareholders can be used to
compute free cash flows per equity share FFCF as per equation 1.9.
Equation 1.9
FFCF per equity share = PV of FFCF to Equity Holders
Number of Equity Shares Outstanding
FFCF per equity share is = $792,140 = $158.428
5,000

III. Market Value Based Approach to Valuation

The market value is reflected in the stock market quotations, is another method for estimating the
value of a business. The market value of securities used for the purpose can be either (1) twelve
months average of the stock exchange price or (2) the average of the high and low values of
securities during a year. The justification of market value as an approximation of the true worth
of a firm is derived from the fact that market quotations by and large indicate the consensus of
investors as to the firm’s earning potentials and the corresponding risk. The market value
approach as one of the most widely used in determining value, in particular of large listed firms.
The major problem with this method is that market value of a firm is influenced not only by
financial fundamentals but also by speculative factors. Another limitation of this approach is
that this approach cannot be applied if the shares are unlisted or are not actively traded.
Apart from the limited applicability of this method only to listed corporate enterprises, whose
shares/securities are actively traded, the valuation of a business is not in tune with the going-
concern approach.

IV. Fair Value Based Approach

The fair value method is not an independent method of share valuation like those discussed
above. This method uses the average/ weighted average of two or more of the above methods.

16
Since this method uses the average concept, its virtue is that it helps in smoothing out wide
variations in estimated valuations as per different methods. In other words, this approach
provides, in a way, the ‘balanced’ figure of valuation. In general, this method has limited
application for business valuation.

Other Approaches to Value Measurement

In recent years a number of approaches/methods to measure value (with focus on shareholders)

have been developed and practiced. The two major approaches are market value added (MVA)
and Economic Value Added (EVA). They are explained in this section.

V. Market Value Added Approach (MVA)

The MVA approach measures the change in the market value of the firm’s equity vis-à-vis equity
investment (consisting of equity share capital and retained profits). Accordingly;

Equation 1.10

MVA = Market Value Firm’s Equity – Equity Capital Investment/ Funds

Though, the concept of MVA is normally used in the context of equity investment (and, hence, is
of greater relevance for equity shareholders), it can also be adopted (like other previous
approaches) to measure value from the perspective of providers of all invested funds (i.e.,
including preference share capital and debt).

Equation 1.11

MVA = (Total market value of firm’s securities – (Equity shareholders funds +

Preference share capital +Debentures))

The MVA approach cannot be used for all types of firms. It is appropriate and applicable to only
firms whose market prices are available. In that sense, the method has limited application.
Besides, the value provided by this approach may exhibit wide fluctuations, depending on the
state of the capital market/ stock market in the country.

Activity 1.5

17
Suppose Supreme Industries has an equity market capitalization of $3,400,000 in current year.
Assume further that its equity share capital is $2,000,000 and its retained earnings are $600,000.

Required:

Determine the MVA and interpret it?

Solution

MVA = ($3,400,000 - $2,600,000) = $800,000

The value of $800,000 implies that the management of Supreme Industries has created wealth/
value to the extent of $800,000 for its equity shareholders.
Well managed companies (engaged in sunrise businesses), having good growth prospects and
perceived so by the investors, have positive MVA. Investors may be willing to pay more than the
net worth. In contrast, companies relatively less known or engaged in businesses that do not hold
future growth potentials may have negative MVA.

Activity 1.6
Suppose X-company has equity market capitalization of $900,000 in the current year. Its equity
share capital and accumulated losses are of $1,200,000 and $200,000 respectively.

Required:
Determine the MVA of the firm?

Solution

MVA = ($900,000 - $1,000,000) = (-$100,000)

The firm has negative MVA of $100,000. The investors discount its value/ worth, as it is loss
incurring firm.
The market value added approach reflects market expectations and is essentially a future oriented
and forward looking approach. The investors, willing to pay a different price (other than one
suggested by the book value), are guided by the individual company’s future prospects, future
growth rates, risk complexion of the firm, industry to which the firm belongs, required rate of
return and so on.

VI. Economic Value Added (EVA)

18
The EVA method is based on the past performance of the corporate enterprise. The underlying
economic principle in this method is to determine whether the firm is earning a higher rate of
return on the entire invested funds than the cost of each funds (measured in terms of the
weighted average cost of capital, WACC). If the answer is positive, the firm’s management is
adding to the shareholders value by earning extra for them. On the contrary, if the WACC is
higher than the corporate earning rate, the firm’s operations have eroded the existing wealth of
its equity shareholders. In operational terms, the method attempts to measure economic value
added (or destroyed) for equity shareholders, by the firm’s operations, in a given year.
Since WACC takes care of the financial costs of all sources of providers of invested funds in a
corporate enterprise, it is imperative that operating profits after taxes (and not net profits after
taxes) should be considered to measure EVA. The accounting profits after taxes, as reported by
the income statement, be the net operating profits after taxes and the cost of funds will be
product of the total capital supplied (including retained earnings) and WACC.

Equation 1.12
EVA = (Net Operating Profits after Taxes – (Total Capital x WACC))

The computation of EVA is illustrated in activity 1.7.

Activity 1.7
Following is the condensed income statement of a firm for the current year.
Sales revenue ------------------------------------------------------------------$5,000,000
Less: Operating costs ----------------------------------------------------------3,000,000
Less: Interest costs ---------------------------------------------------------------120,000
Earnings before taxes ----------------------------------------------------------1,880,000
Less: Taxes (0.40) ----------------------------------------------------------------752,000
Earnings after taxes -----------------------------------------------------------$1,128,000

The firm’s existing capital consists of $1,500,000 equity funds, having 15 percent cost and of
$1,000,000 12 percent debt.
Required:
Determine the economic value added (EVA) during the year.
Solution
i) Determining of Net Operating Profit after Taxes

Sales revenue ----------------------------------------------------------------------------$5,000,000

19
 Less: Operating costs --------------------------------------------------------------------3,000,000
Operating profit (EBIT) -----------------------------------------------------------------2,000,000
Less: taxes (0.40) ---------------------------------------------------------------------------800,000
Net operating profit after taxes (NOPAT) -------------------------------------------$1,200,000

Alternatively, (EAT, $1,128,000 + interest $120,000 – (tax savings on interest, $120,000 x

0.40 = 48,000)).
ii) Determination of WACC

Equity ($1,500,000 x 15%) --------------------------------------$225,000

12% debt ($1,000,000 x 7.2%) -------------------------------------72,000
Total cost------------------------------------------------------------$297,000
WACC ($297,000 ÷ $2,500,000) -----------------------------------11.88%
Where: Cost of debt = 12% (1- 0.40 tax rate) = 7.2%*

iii) Determination of EVA

EVA = NOPAT – (Total Capital x WACC)
= 1,200,000 – ($2,500,000 x 11.88%)
= $1,200,000 - $297,000
= $903,000

During the current year, the firm has added an economic value of $903,000 to the existing
wealth of the equity shareholders. Essentially, the EVA approach is a modified accounting
approach to determine profits earned after meeting all financial costs of all providers of capital.
Its major advantage is that this approach reflects the true profit position of the firm.

Activity 1.8

For Activity 1.7, assuming sales revenues are $3,300,000, compute the earnings after taxes?
Solution
Income Statement (Conventional)
Sales revenue ------------------------------------------------------------------$3,300,000
Less: Operating costs ----------------------------------------------------------3,000,000
Less: Interest costs ---------------------------------------------------------------120,000
Earnings before taxes ------------------------------------------------------------180,000
Less: Taxes (0.40) -----------------------------------------------------------------72,000

20
 Earnings after taxes -------------------------------------------------------------$108,000

The firm has registered profits of $108,000 during the current year on the equity funds of
$1,500,000 which has financial costs of $225,000. Therefore, the firm has suffered a loss of
($117,000) as the opportunity costs of equity funds invested by equity shareholders is more than
what has been earned by the firm from them. This point is brought to the fore by EVA approach.
It is for this reason that the EVA approach is going more attention. It is superior to the
conventional approach of determining profits.

Determining of EVA
(a) Sales revenue-------------------------------------------$3,300,000
Less: Operating costs----------------------------------------3,000,000
Operating profits-----------------------------------------------300,000
Less: Taxes (0.40) ---------------------------------------------120,000
Net operating profits after taxes-----------------------------180,000

(b) EVA = NOPAT – (Total capital x WACC)

= $180,000 – ($297,000, already computed above)
= -$117,000

Activity 1.8 demonstrates that there may be a substantial difference between profits
determined as per accounting approach and the EVA approach. In no way, the firm can be
said to have earned profits without meeting financial costs of all sources of finance. The EVA
approach is in tune with the basic financial tenet of cost-benefit analysis; financial benefits have
to be more than financial costs to have true profits.

Summary:

The term valuation implies the estimated worth of an asset or a security or a business.
The alternative approaches to value a firm/an asset are: (1) book value, (2) market value,
(3) intrinsic value, (4) liquidation value, (5) salvage value, (6) replacement value, and (7)
fair value.
While book value refers to the amount at which an asset is shown in the balance sheet of
a firm, market value is the price at which an asset can be sold in the market, intrinsic

21
value is equal to the present value of incremental future cash inflows likely to accrue due
to the acquisition of an asset, discounted at an appropriate discount rate. The fair value is
the average of the book value, market value and intrinsic value.
There are four approaches to valuation of business (with focus on equity share valuation):
(1) asset based, (2) earning based, (3) market value based, and (4) the fair market value
method.
Asset based method focuses on determining the value of net assets = (Total assets – Total
external obligations).
Net assets per share can be obtained by dividing total net assets by the number of equity
shares outstanding. It indicates the net assets backing per equity share (also known as net
worth per share).
Earning based method relates the firm’s value to its potential future earnings or cash flow
generating capacity. Accordingly, there are two major variants of this approach: (1)
earnings measured on accounting basis and (2) earnings measure on cash flow basis. As
per the first method, the value of business = future maintainable profits, excluding
extraordinary items related to income and losses relevant capitalization factor.
The second method makes use of the discounting cash flow technique to value the
business. According to the DCF approach, the value of business/firm is equal to the
present value of expected future operating cash flows (CF) to the firm, discounted at a
rate that reflects the riskiness of the cash flows (Ko), that is:
∞
∑
Valuation of firm = t=1 CF to firmt
(1+ko)t
The market value (reflected in the stock market quotation) is the most widely used
approach to determine the value of a firm, in particular of large listed firms. The market
value indicates the price the investors are willing to pay for the firm’s earning potentials
and the corresponding risk. This method is particularly useful in deciding swap ratios in
the case of merger decisions.
Fair value method is not an independent method of share valuation. The method uses the
average/weighted average of two or more of the above methods. Therefore, such a

22
method helps in smoothening out wide variations caused by different method and
indicates the balanced figure of valuation.
The market value added (MVA) approach measures the change in the value of the firm
from the perspective of all the providers of funds (that is, shareholders as well as
debenture-holders).
MVA = (total market value of firm’s securities – (equity shareholders’ funds + preference
share capital +debentures)).
The MVA from the point of view of equity shareholders is = (Market value of firm’s
equity – equity funds)
The EVA method measures economic value added (or destroyed) for equity-owners by
the firm’s operations in a given year. The underlying economic principle in this method is
to determine whether the firm is earning a higher rate of return on the entire invested
funds than the cost of such funds.
EVA = (Net Operating Profits after Taxes – (Total Capital x WACC))
Thus, the EVA approach measures the true profit position of the firm.

-----ENDS------

23