Professional Documents
Culture Documents
Research (PIMSR),
New Panvel
1
MMS – Semester - III
Subject : Corporate Valuation and
Mergers & Acquisitions (CV & MA)
by
Dr. K.G.S. MANI
2
Lecture date : 16.11.2023
Chapter – 6 : Special Cases of Valuation
3
Chapter – 6 : Special Cases of Valuation
(1) Valuation of Intangible Assets :
(i) Meaning of Intangible Assets :
An asset is a resource controlled by a company (firm), as a result
of past events, which is expected to generate future net
economic benefits to the company. Applying this concept, we
may define an intangible asset as a resource controlled by a
company (firm) as a result of past events, market reputation for
its products, which has the following attributes: (i) it is non-
physical in nature, (ii) it is capable of generating future
economic benefits, and (iii) it is protected legally or through a
registered right (patent rights). For measuring the value of a
specific intangible asset (goodwill), as distinct from the company
as a whole, it must necessarily be valued separately. Otherwise,
it is not possible to define the ‘boundaries’ of the asset for the
purpose of valuation.
4
(ii) Classification of Intangible Assets :
While it may be difficult to define all types of intangible assets,
the following are the most common intangible assets :
(1) Goodwill (Reputation of a company in the market) (TATA,
Birla),
(2) Brands (Colgate, Horlicks, Bata),
(3) Trade marks, Patents (monogram) (Tata group, Birla, Adani,
Goenka, TVS, Murugappa group),
(4)Intellectual property (research-based products – pharmaceutical,
ayurvedic property medicines – Zandu Pharmaceuiticals,
Baidyanath products, Kottakal Kerala Ayurvedic products)
(5) Copy Rights (book publishing) (Tata Mc Graw, Himalaya Publish
(6) Licences (Taxi Aggregators-UBER, OLA, Coaling Mining, Pharma)
(7) Formulas (Coca Cola, Parle, Coke, Fruit Recipes, etc)
(8) Computer Software (Microsoft)
6
(i) Cost Approach :
Cost approach aggregates the costs incurred in developing the
intangible asset to its present condition(value). There are two
variants of the cost approach, historical cost approach and
replacement cost approach. The historical cost approach is
apparently objective, reliable and consistent. But the value of
intangible asset depends on the future economic benefits
expected from it and not on the cost incurred on its
development. For example, a poorly implemented advertising
campaign or an unsuccessful research and development
programme have very little value, however costly they may have
been. The replacement cost approach seeks to quantify the cost
of replacing the intangible asset or recreating an equivalent
asset. For example, the replacement cost of a brand is the total
cost required to create an equivalent brand which offers, similar
turnover, contribution margin, customer loyalty, market image
and future growth prospects.
7
(ii) Market Approach :
According to market approach, the value of an intangible asset
is determined on the basis of the prices obtained for
comparable assets in recent merger and acquisition deals. This
approach is credible, objective and relevant. However, the level
of activity in the market for intangible assets is limited. Further,
information concerning such transactions may not be publicly
available.
(iii) Economic approach :
The economic approach to the valuation of an intangible asset
involves two broad steps :
(1) Estimate the cash flow / earnings approach :
(a) Direct identification method
(b) Brand contribution method
(c ) Royalty method
8
(2) Capitalise the cash flow / earnings approach :
(i) Discounted cash flow method
(ii) Earnings multiple method
(iii) Dividend Yield method
Note :
(i) Tangible Fixed Assets are depreciated (by depreciation),
(ii) Intangible Fixed Assets like Goodwill, Brand, are amortised
(amortisation over a number of years),
(iii) Fictitious assets like preliminary expenses, advertisement suspense
account are written-off over a number of years
9
(2) Valuation of Goodwill :
(a) Definition of ‘Goodwill’ :
‘Goodwill’ is an important intangible asset in the business. It
presents an aggregation of all the advantages that a
firm/company enjoys with respect to its reputation,
relationships with various stakeholders, location and so on.
Since goodwill is generally inseparable from a business, it can
fetch a price only if the business is sold as a going concern.
Generally, the value of a business as a whole on a going
concern basis is greater than the sum of the values of its assets
when they are sold separately. The difference represents
goodwill. In a way, goodwill is the capacity of a business to earn
a rate of return higher than a fair rate of return.
10
‘Goodwill’ generally does not appear in the balance sheet of the
firm/company, except when one company acquires another and
pays more than the fair market value of the net assets (total
assets – total liabilities). Goodwill is represented on the balance
sheet as an intangible fixed asset. According to International
Financial Reporting Standard (IFRS), “goodwill” is not
amortised. The management however, is responsible to value
goodwill every year and determine whether an impairment is
required. If the fair value falls below historical cost (the purchase
price of goodwill), an impairment must be recorded and the fair
market value lowered. An increase in the fair market value,
however, is not accounted for in the financial statements.
11
(i) Average profits method,
(ii) Super profits method.
(iii) Capitalisation method : (1) Capitalisation of Average Profit
method, (2) Capitalisation of Super Profit method.
12
(ii) Super Profits Method : According to the method, the
calculation is done as under :
Formula :
Goodwill = Super profits x number of years of purchase
13
(iii) Capitalistion method : There are two ways of calculating
goodwill under the capitalisation method namely (i) capitalisation of
average profits and (ii) capitalisation of super profits.
15
(2) Capitalisation of Super Profit method : Under this method,
Goodwill is calculated as under :
Formula :
Goodwill = (Super profits / Normal rate of
return in percentage ) x 100
Note : Super profits are profits in excess of normal profits
18
(iv) Fictitious assets (also known as Deferred Expenditure or
Miscellaneous expenditure) are written-off gradually over a
number of years) (example : preliminary expenses, pre-operative
expenses, advertisement suspense account, discount on issue of
shares, issue expenses (for shares and debentures).
19
Calculation of goodwill paid on take-over of company :
Example :
A co is acquiring company,
B co. is target company
B co. Value of tangible assets = Rs 5 cr.
(-) Equity of B Co.= Rs 1 cr.
Net Assets value = Rs 4 cr.
Purchase consideration paid = Rs 5 cr.
Goodwill :
Purchase consideration paid by A co to B Co = Rs 5 cr.
(-)Net assets taken over by A Co = Rs 4 cr.
Goodwill = Rs 1 cr.
Question : Which company will record the goodwill in its book ?
A Co. will record in its book : goodwill Rs 1 cr.
20
Valuation of Goodwill
Problem - 1 :
X purchased business from Y on 30th June 2008. Profits
earned by Y for the preceeding years ended on 31st
December each year were 2005 Rs 41,000, 2006
Rs 40,000 and 2007 Rs 42,000. It was certain that
profits of 2006 included a non-recurring item of
Rs 1,500 and profit of 2007 was reduced by Rs 2000 due
to extaordinary loss on account of theft. The properties
were not insured and it was thought prudent to insure
the business in future. The premium was estimated at
Rs 200 per annum. X, at the time of purchasing business
was employed with Rama Bros Ltd and was getting
Rs 500 p.m. He intends to remove the manager of the
business who at present is getting Rs 350 p.m. The
goodwill is estimated at 2 years' purchase of average
profits. You are required to calculate goodwill of
the business. Write
comments.
21
Solution - 1 : Amount Rs
Profit for 2005 41,000
Profit for 2006 : 40,000
Less : Non-recurring profit 1,500 38,500
Profit for 2007: 42,000
Add : Extraordinary loss 2,000 44,000
Total profits 1,23,500
Average profits ( 123500 / 3) 41,167
Less Expenses to be paid in
future :
Insurance premium 200
Salary : 12 x 500 6,000 6,200
34,967
Add : Expenses not be paid
in future :
Salary of manager : 12 x 350 4,200
Net average profit to come in 39,167
future :
22
Problem - 2 :
With the help of following Balance Sheet, you are required to
calculate (i) capital employed, (ii) average capital employed :
Liabilities Amount Rs Assets Amount Rs
Pref. share capital 1,00,000 Goodwill 20,000
Equity share capital 2,00,000 Land & Bldg 70,000
Reserves (including 60,000 Plant 1,20,000
profit of current year
Rs 40,000)
Workmens’ 85,000 Current Assets 3,00,000
compensation fund
Depreciation fund : Investments 90,000
Land & Bldg : 20,000 Investments for 20,000
replacement of
plant
Plant : 30,000 50,000 Preliminary exp. 5,000
Debentures 70,000
Creditors 60,000
6,25,000 6,25,000
23
Solution-2
Note : 1/2 of the profits is deducted on the basis that they are
earned evenly throughout the year and also that when profits
are earned every day. Profit earned on 31 st December cannot be
re-employed (during the same year) but the profits earned on
1st January is re-employed for the whole year. Thus, on an
average basis 1/2 of the profit is employed throughout the year.
24
Problem -3 :
Refer to problem -2 above. What will be the (i) Capital employed
and (ii) Average capital employed, if the market value of land
and building is Rs 90,000 and that of plant and
machinery is
Rs 70,000. Investment other than those for replacement of plant,
may be treated as non-business investments.
Solution - 3 :
Asset side approach Amount Liabilities side Amount Rs
Rs approach
Land & Bldg (market 90,000 Pre. Capital 1,00,000
value)
Plant (market value) 70,000 Equity capital 2,00,000
Current Assets 3,00,000 Reserves 20,000
Investments for 20,000 Profits 40,000
replacement of plant
Total (A) 4,80,000 Workmen 85,000
compensation fund
Less : Creditors 60,000 4,45,000
Debentures 70,000 Less :
Total (B) 1,30,000 Goodwill : 20,000
(i) Total Capital 3,50,000 Prel. Exp : 5,000
Employed (A) minus
(B)
Less : 1/2 of profit 20,000 Invstments : 90,000 1,15,000
(ii) Average Capital 3,30,000 3,30,000
Employed
Less : Loss onplant 20,000
(1,20,000 - 30,000 -
70,000)
3,10,000
Add : Gain on 40,000
revaluation of land
and bldg (90,000 -
(70,000 - 20000)
(i) Capital Employed 3,50,000
Less : 1/2 of profit 20,000
(ii) Average Capital 3,30,000
Employed
25
Problem -4 :
Balance Sheet of Manufacturing Co. Ltd disclosed the following
financial position as on 31st March 2012.
Liabilities Amount Rs Assets Amount Rs
Paid up capital : Goodwill 30,000
30,000 shares of Rs 10 3,00,000 Land & Bldg at cost 1,75,000
each fully paid up (less depreciation)
Capital reserve 20,000 Pland and machinery 90,000
at cost (less
depreciation)
Sundry creditors 71,000 Stocks at cost 1,15,000
Provision of taxation 55,000 Book Debts : 98,000
Profit & Loss a/c 66,000 Less : Provision for 95,000
bad debts : 3,000
Cash at bank 7,000
5,12,000 5,12,000
You are asked to value the goodwill of the company on the basis of
5 years' purchase of super profits for which purpose the following
information is supplied :
(i) Adequate provision has been made in the accounts for income-tax
and depreciation.
(ii) The rate of income tax may be taken at 50%
(iii) Average rate of dividend declared by the company for the past
5 years was 15%
(iv) The reasonable return on capital invested in the class of
business done by the company is 12%
26
Solution - 4 :
Valuation of Goodwill according to purchase of
Super Profit Method'
Land & Bldg 1,75,000
Plant and machinery 90,000
Stocks 1,15,000
Book Debts 95,000
Cash at bank 7,000
4,82,000
Less :
Sundry Creditors : 71,000
Provision for tax : 55,000 1,26,000
Capital Employed 3,56,000
27
Problem - 5 :
Ascertain the value of goodwill of Sheen Ltd from the following
information :
Balance Sheet as on 30.6.2010
Liabilities Amount Assets Amount Rs
Rs
Paid-up Capital - 25000 25,00,000 Goodwill at cost 2,50,000
shares of Rs 100 each
fully paid
Bank overdraft 4,80,000 Land & bldg at cost 11,00,000
Sundry creditors 8,05,000 Plant & machinery at 10,00,000
cost less
depreciation
Provision for tax 4,25,000 Stock-in-trade 15,00,000
P & L Appropriation 6,00,000 Book debts less 9,60,000
a/c provision for bad
debts
48,10,000 48,10,000
The company started operations in 2005 with a paid up capital as
aforesaid of Rs 25,00,000. Profit earned before providing for taxation
have been as follows :
Year ended 30th June Amount
Rs
2006 6,00,000
2007 7,50,000
2008 8,50,000
2009 9,50,000
2010 8,50,000
Income tax at 50% has been payable on these profits. Dividends
have been distributed from the profits of the first 3 years at 10%
and from those of the next two years at 15% of paid up capital
28
Solution - 5 :
(i) Computation of Net Tangible Assets :
Particulars Amount
Rs
Net Tangible assets :
Land & Building 11,00,000
Plant and machinery 10,00,000
Stock-in-trade 15,00,000
Sundry debtors less provision for 9,60,000
bad debts
45,60,000
Less : Liabilities :
Bank overdraft : 4,80,000
Sundry creditors : 8,05,000
Provision for tax : 4,25,000 17,10,000
Net Tangible assets : 28,50,000
29
(iii) Computation of Goodwill : Amount Rs
Average dividend paid = (10 x 3) + (15 x 2) / 5 = 12%
It is assumed that the fair returnon capital of this type of
business is also 12%.
Capitalised value of business is computed as follows :
( 4,00,000) / 12) x 100 = 33,33,333
Less : Net Tangible Assets = 28,50,000
Goodwill = 4,83,333.33
30
Problem - 6 :
The following particulars are available in
respect of the business carried on by
Wisehead & Co. Amount Rs
(i) Capital employed 50,000
(ii) Trading Results :
Profit for 2009 12,200
Profit for 2010 15,000
Loss for 2011 2,000
Profit for 2012 21,000
(iii) Market rate of interest on investment : 8%
(iv) Rate of risk return on capital invested in
business : 2%, and
(v) Remuneraton from alternative employment
of the proprietor (if not engaged in business)
Rs 3,600 per annum.
You are required to compute the value of
goodwill on the basis of 3 years' purchase of
super profits of the business, calculated on the
average profits of the last 4 years.
31
Solution - 6 : Amount Rs
Average profit (12,200 + 15,000 - 11,550
2,000 + 21,000) / 4 =
Less : Remuneration for the 3,600
proprietor
Average maintainable profits 7,950
Normal profit, 10% on capital 5,000
employed (50,000 x (8% + 2%) ***
Super Profits 2,950
Goodwill at 3 years' purchse of 8,850
super profits = ( 2,950 x 3) =
32
Problem - 7 :
State with reasons whether the following
statement is correct or not :
Sunil - Sonal's financial position is as follows:
Particulars Amount Rs
(i) Sundry assets : 9,27,342
(ii) Current liabilities : 52,492
(iii) Averge net profit of last 4 years 1,20,500
(iv) Average capital employed 9,00,000
(v) Partner's average annual 18,000
remuneration
(vi) Goodwill valued at 4 years 50,000
purchase of super profit :
Therefore the expected rate of return is 15%
33
Solution - 7 :
Goodwill being 4 years' purchase of 50,000
super profits :
Super profit per year (average) 12,500
(50,000 / 4) =
Average net profit for last 4 years 1,20,500
Less : Average remuneration : 18,000
Adjusted net profits : 1,02,500
Super Profit = Adjusted net profit
(-) Normal profits
Normal Profits = Adjusted Net
profit (-) Super profits =
Rs 1,02,500 - Rs 12,500 = Rs 90,000
Since average capital employed is Rs 9,00,000
normal profit of Rs 90,000 worked out to
10% return.
Hence the expected rate of return is 10% and
not 15% as stated in the problem.
34
Problem - 8 :
The net profit of business after providing for taxation
for the past five years are Rs 40,000, Rs 42,500,
Rs 46,000, Rs 52,000 and Rs 59,000. The capital
employed in the business is Rs 4,00,000. The normal
rate of return expected in this type of business is
10%. It is expected that the copany will be able to
maintain its super profit for the next 5 years.
Calculate the goodwill on the basis of :
(i) 5 years' purchase of super profits
(ii) Annuity method, taking present value of annuity
of Re 1 for 5 years at 10% as 3.78
(iii) Capitalisation of super profits method
35
Solution - 8 :
(i) Calculation of super profits : Amount Rs
Total profit for 5 years (40,000 + 42,500 + 2,40,000
46,000 + 52,500 + 59,000) =
Average profit (2,40,000 / 5) = 48,000
Less : Normal profit (4,00,000 x 10 / 100) 40,000
Super profit (Average profit - normal profit) 8,000
36
Problem - 9 :
Mr Kishan Goyal has invested a sum of Rs 3,00,000
in his own business which is a very profitable one. The
annual profit earned from his business is Rs 60,000
which includes a sum of Rs 10,000 received as
compensation for acquisition of a part of his business
premises.
The money could have been invested in deposits for
a period of 5 years and over with interest at 10% and
himself could earn Rs 7,200 per annum in alternative
employment.
Considering 2% as fair compensation for the risk
involved in the business, calculate the value of
goodwill of his business on capitalisation of
super profits method at a normal rate of return.
37
Solution - 9 :
Calculation of Goodwill Amount Rs
Profits earned from business : 60,000
Less : Compensation from premises not
being business income : 10,000
Less : Reasonable remumeration: 7,200 17,200
Expected future profit : 42,800
Less : Normal profits at 12% on 3,00,000 36,000
capital employed) (3,00,000 x 12% ) =
Super Profit = 6,800
Goodwill on capitalisation of profits on the basis of
normal rate of return of 12% =
6,800 x 100 / 12 = Rs 56,667
38
(3) Valuation of Brands :
(a) Concept and Meaning of Brand :
“The Brand is a special intangible assets in many businesses, it is
the most important assets” Brand means a name, term, sign,
symbol or design or combination of these intended to identify the
goods or services of one seller or group of sellers and to
differentiate them from those of competitors. Brands may be that
which is acquired from outside source while acquiring business or
may also be nurtured internally by a company, which are known as
‘home-grown brands’.
By assigning a brand name to the product the manufacturer
distinguishes it from rival products and helps the customers to
identify it while going in for it. (examples: Colgate, Horlicks,
Boost, Garlic Pearl, etc). The necessity of branding its products
has increased enormously due to influence of various factors like
growing competition, increasing importance of advertising, etc.
This is due to the economic impact of the brand.
39
(b) Need for brand valuation :
Companies find brand valuation helpful for the following :
(i) To make decision on business investment.
(ii) To measure the return on brand investments
(iii) To allocate marketing expenditure according to the benefit of
cash, the company derives from the brand assets.
(iv) To organise and optimise the use of different brands in the
business.
(v) To manage a large number of brands across a variety of
markets.
(vi) To assess fair transfer prices for the use of brands in subsidiary
companies.
(vii) To determine brand royalty rates for optimal use of the brand
assets through licensing the brand to third parties.
(viii)To capitalise brand assets on the balance sheet according to US
GAAP.
40
(vi) Brand Valuation is used for both the initial valuation and the
periodical impairment tests for the derived values. (Maggi’s brand
value impaired on account of more zinc content) (court case).
(vii) To know how much the brands have contributed towards value
creation for shareholders.
41
Examples :
(1) ‘Horlicks’ (health drink) brand of Glaxo Company (Unit and
Brand were purchased by Hindustan Unilever Limited (HUL). It
is a classic example of ‘brand’ purchase.
(2) ‘Garlic Pearl’ (Heart health capsule) of Ranbaxy
Pharmaceuticals was purchased by Sun Pharma Company along
with take-over deal of Ranbaxy by them.
(3) Coca-Cola paid Rs 170 crores to Parle Company Limited, to
acquire its soft drinks brands namely, Thumps-UP, Limca, Gold
Spot.
(4) Erstwhile Hindustan Lever Limited (HLL) (now Hindustan
Unilever Limited (HUL), bought the brands of ‘Lakme’ Company.
(5) Tata Motors acquired Jaguar and Land Rover brand cars (JLR)
from Ford Motor Company, for USD 2.3 billion.
(6) Tata Tetley (tea), Girnar tea, Society tea are the reputed
brands in Tea product.
42
(g) Valuation of Brands :
(i) Valuation of Purchased/Acquired Brands :
(1) Where the Acquiring Company purchases only the brand
name(s)
Formula : Brand Value = Price paid for acquisition
(2) Where the Acquiring Company purchases an existing
business concern along with its brands.
Formula : Brand Value = Purchase Consideration (-) Net
Assets taken over.
43
Formula :
Brand Value = Brand Development Cost (+) Brand Marketing
and Distribution Cost + Brand Promotion Costs including
Advertising and other costs.
Merits : It is based on the actual costs which are objectively
verifiable. It facilitates easy computation of brand values.
45
(h) Variables affecting the methods of Valuation of Brands:
The variables affecting the methods of brand valuation are as
follows :
(i) Exclusive earning power of brand.
(ii) Product as a brand and hence, product life cycle.
(iii) Separating a brand from other less important value drivers.
(iv) Cost of acquisition of brand.
(v) Expenses incurred on nurturing a ‘home-grown’ brand.
(vi) Impact of other brands as new entrants to the market.
(vii) Intrinsic strength of the people and process handling the
brand.
(viii)Accuracy in projecting the super or extra earnings offered by a
brand and rate of discounting such cash flows.
(ix) The cost of withdrawing or replacing the brand.
(x) Internationalisation of a brand and therefore, local earning
power of a brand in various countries or markets.
46
(4) Valuation of Patents, Trademarks, Copyrights, Licences
(intangible assets) :
The Company owning the Patent, Trademark, Copyright or
Licence enjoys the exclusive right to produce a product or
provide a service. So the value of a patent, trademark,
copyright or licence is derived from the cash flows that can be
produced from the exclusive right. If there is a cost relating to
the production of goods or provision of services, the value
stems from the excess returns generated by the exclusive right.
The analyst can value these intangible assets in two ways. The
cashinflows from owning the intangible asset can be estimated.
48
(iii) Copyrights : Copyright for publishing books. Authors obtain
copyright registration and get certificate, which provides the
authors exclusive rights on the contents of the books published
by them. Any one copying the contents from the books
(without written permission from the authors, are liable for
level action. (It is also known as ‘Intellectual Properties right’).
(other examples : Dr Prasanna Chandra’s books on Finance,
ICFAI study notes, and other books).
49
(5) Human Resources Valuation :
(a) Meaning of Human Resources Valuation :
Human Resources Accounting (valuation) can be defined as the
process of identifying, measuring and communicating
information about human resources in financial statements in
order to facilitate identifying the skills employees and effective
management. Human Resources Accounting (HRA) is an
attempt to identify, quantify and report investments made in
human resources of an organisation. Leading Companies like
OIL, BHEL, NTPC and SAIL have been reporting human
resources in their Annual Reports as additional information.
Although human beings are considered as the prime mover for
achieving productivity the conventional accounting practice
does not assign significance to the human resource Human
resources. Human resources are not thus recognised as ‘assets’
in the Balance Sheet of the Companies. While investments in
human resources are not considered as ‘assets’ and not
amortised over the economic service life, the result is that
50
the income statement comprising Current Revenue and
Expenses gives a distorted picture of the real affairs of the
company. Human resources accounting provides scope for
planning and decision-making in relation to proper manpower
planning.
51
(iii) It is difficult to measure expected Future Benefits due to the
continuous nature of skill formation/ utilisation.
(iv) It is difficult to measure qualitative aspects of an individual.
(v) Determination of replacement Cost/Opportunity Cost of an
individual is highly subjective.
52
cover the qualitative aspects (such as Employee Attitude, Loyalty,
Commitment, Job Satisfaction, etc) of human beings since
employee attitude loyalty, commitment, job satisfaction etc may
also influence the way in which human resource skills are utilised.
(iii) Behavioural Factors :
Behavioural factors should also be considered after assigning
respective weightage to behavioural factors but care should be
taken to avoid excessive subjectiveness (personal bias and
inaccuracies should be avoided).
(d) HRA Models for Valuation of Human Assets :
Human Resources Accounting are yet in the preliminary stage in
India. A few large companies are only adopting Human
Resources Accounting for the purpose of reporting in their Annual
Report. Mostly in western countries, Human Resources
Accounting (HRA) models for Valuation of human assets are
adopted.
(Example : Recently YES Bank has offered additional salary and
Stock Option to its highly skilled officials in order to retain them in
the bank).
53
(6) Real Estate Valuation :
The following are the methods of valuation of Real Estates.
(i) Cost Method :
(a) The price someone should pay for a piece of property should
not exceed what someone would have to pay to build an
equivalent building.
(b) Market Price = Cost of land (+) Cost of construction (-)
depreciation
(c) Most accurate when property is new.
54
(d) Used as a quick snapshot of what property may be worth.
Does not take into account specific features of a piece of
property (condition, exact neighbourhood).
55
(7) Valuation of Warrants :
A Warrant is an option issued by a Company to buy a stated
number of stocks at a specified price. Warrants are generally
distributed with debt or preference shares, to induce investors
to buy those securities at lower cost. A detachable warrant is
one that can be detached and traded separately from the
underlying security. Most warrants are detachable. A warrant is
similar to a long term right, in that it is merely an option to
purchase equity share at a stated price. The minimum price of
a warrant is equal to zero until the price of share rises above
the warrant’s exercise price. After that, the warrant’s minimum
price takes on positive values. Investors are willing to pay a
premium for warrants because only a small loss is possible in
that the warrant price is less than that of the share price and
has large return possibilities. The warrants can be detached
and traded separately on the stock exchange. Most Warrants
are detachable Warrants are issued for their following
advantages.
56
(i) Warrants are attached to debt issue, thus acting as sweeteners
to increase the marketability of these debt instruments.
(ii) Warrants provide additional cash inflow when they are
exercised.
(iii) Warrants enables companies to raise cheaper debt in the local
market as they are generally attached to debt instruments.
(iv) Warrants delay loss of control in the company, as equity shares
are issued later on exercise of option under warrant.
(v) Warrants are favoured at times when raising money in the
market gets tougher.
(vi) This hybrid instrument (warrants) allows investors to separate
the embedded equity option from the bond and trade it
separately.
57
(8) Valuation of Convertible Securities :
(i) Meaning :
A convertible security is a bond or debenture or preference
shares (preferred stock) that can be converted into equity of a
company. The original security is a debt instrument, which
can be converted into an ownership instrument after a
specified period of time. The period of holding necessary for
conversion, the ratio of conversion and other terms including
the price are to be laid down in the beginning itself. Once the
conversion terms are stated, they cannot be altered by the
company unilaterally. The SEBI guidelines cover all the
categories of convertible instruments and new financial
products like convertibles. As per the guidelines, a company
can issue three types of debentures as debt instruments with
convertible options. The convertible option shall be of two
types ‘Call Option’ (by the company) or ‘Put Option’ by the
investor.
58
(ii) Valuation of Convertible Securities :
The value of the bond or debenture with option for conversion,
(into equity) is related to the value of equity into which it can be
converted. Secondly, the value of residual non-convertible portion
of the debenture instrument will remain as a debt instrument.
Both the above components vary with the market conditions, time
to expiry of the bond, prevailing interest rates or yields, etc.
59
For the first 3 years Rs 100, the face value of the bond carries
an interest return of 12% per bond. At the end of 3 years, Rs
75 is converted into 5 equity shares. If the market price is Rs
20 and exercise price for conversion is Rs 15, the convertible
portion gains by Rs 5 per share, (say) total gain is Rs 25 (5 x
5). Besides for the next two years, equity shares may show
capital gains or losses plus dividends, if any declared for the
rest of the period to maturity. The non-convertible portion of
the Bond earns 12% per year namely, Rs 4 on Rs 25 (residual
portion) of the bond of Rs 100.
60
(9) Valuation of High Growth Companies:
The rise and fall of some companies (IT companies) suggest
that the valuing the high-growth and high-uncertainty
companies, is challenging task. The best way to value such
companies is to use scenario-based Discounted Cash Flow
(DCF) analysis method, supported by micro-economic
fundamentals. To value a well established company, an
analysis of historical performance has to be done. But a new
company with a few years existence, the valuation should be
based on expected growth in future (and work backward to link
it to the present period) as per the methods explained in DCF
chapter.
61
(10)Valuation of Private Limited Companies :
Valuation of private companies is difficult for several reasons:
(i) Many private companies are in a low growth level and low level
of operations. They are expected to grow slowing over a period
of time. They also generate negative cashflow (loss) at times
because of lack of market in the face of competition. Hence,
making an appropriate forecast cash inflows is difficult.
(ii) For most private companies, the number of years for which
past information is available is limited due to short period of
historical data (on account of short period of existence just like
MSMEs). Further, the quality of this information is generally
less reliable than that of public limited companies.
(iii) In the absence of stock price data, it is difficult to estimate the
equity beta (which is required for computing the cost of equity)
for private limited companies.
(iv) These companies are not listed on the Stock Exchange and the
Market Price of Share (MPS) is not avaiable.
62
(v) As such, for the valuation of Private Limited the price available in
records of the Over-the-Counter (OTC) stock exchange shall only be
adopted for calculation of valuation. Also book value method (i.e. Net
Assets Valuation) of calculation of Private Limited company can be
applied for valuation.
64
THANK YOU
65