BUSINESS VALUATION

CHAPTER – 14
BUSINESS VALUATION

QUESTION – 01
Tender Ltd has earned a net profit of ₹ 15 lacs after tax at 30%. Interest cost
charged by financial institutions was ₹10 lacs. The invested capital is ₹ 95 lacs
of which 55% is debt. The company maintains a weighted average cost of
capital of 13%.
Required:

(a) Compute the operating income.

(b) Compute the Economic Value Added (EVA).

(c) Tender Ltd. has 6 lac equity shares outstanding. How much dividend can
the company pay before the value of the entity starts declining?

(Study MaterialTYK – 11 & PM)

SOLUTION:-

Taxable Income = ₹ 15 lac/(1 0.30)

= ₹ 21.43 lacs or ₹ 21,42,857

Operating Income = Taxable Income Interest

= ₹ 21,42,857 ₹ 10,00,000

= ₹ 31,42,857 or ₹ 31.43 lacs

EVA = EBIT (1-Tax Rate) – WACC Invested Capital

= ₹ 31,42,857(1 – 0.30) – 13% ₹ 95,00,000

= ₹ 22,00,000 – ₹ 12,35,000 = ₹ 9,65,000

EVA Dividend = = ₹ 1.6083

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QUESTION – 02
Herbal Box is a small but profitable producer of beauty cosmetics using the
plant Aloe Vera. Though it is not a high-tech business, yet Herbal’s earnings
have averaged around ₹ 18.50 lakhs after tax, mainly on the strength of its
patented beauty cream to remove the pimples.
The patent has nine years to run, and Herbal Box has been offered ₹ 50 lakhs
for the patent rights. Herbal’s assets include ₹ 50 lakhs of property, plant and
equipment, and ₹ 25 lakhs of working capital. However, the patent is not
shown on the books of Herbal Box. Assuming Herbal’s cost of capital being 14
percent, calculate its Economic Value Added (EVA).

(Exam November - 2018, 2020 &RTP May-2022)

SOLUTION:-

EVA = Income Earned – (Cost of Capital Total Investment)

Total Investment

Amount (₹ in lakhs)
Working Capital 25.00
Property, Plant &Equipments 50.00
Patent Rights 50.00
Total 125.00

EVA = Profit Earned – WACC Invested Capital

= ₹ 18.50 Lakhs – 14% ₹ 125 Lakhs

= ₹ 1.00 Lakhs

QUESTION – 03
An established company is going to be de merged in two separateentities. The
valuation of the company is done by a well-known [Link] has estimated a
value of ₹ 5,000 lakhs, based on theexpected freecash flow for next year of ₹
200 lakhs and an expected growth rate of 5%. While going through the
valuation procedure, it was found that theanalyst has made the mistake of
using the book values of debt andequity in his calculation. While you do not
know the book value weightshe used, you have been provided with the
following information:

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(i) The market value of equity is 4 times the book value of equity, while the
market value of debt is equal to the book value of debt,

(ii) Company has a cost of equity of 12%,

(iii) After tax cost of debt is 6%.

You are required to advise the correct value of the company.

(Exam May – 2018)

SOLUTION:-

Value of the Company = ,

Where,

Kc = weighted average cost of capital.

Value of the company = 5000 =

Kc – 5 = 200/5000 = 4%

Kc = 4% 5% = 9%

We do not know the weights the analyst had taken for arriving at the cost of
capital. Let w be the proportion of equity. Then, (1 w) will be the proportion of
debt.

Kc = 9 = w 12 (1 w) 6

9=6 6w

6w = 3.

Hence w = 3/ 6 = 0.5 = 50 % or 1:1

The weights are equal i.e. 1:1 for equity and debt.

The correct weights should be market value of equity : market value of debts.
i.e. 4 times book value of equity : book value of debts. i.e. 4:1 equity : debt

Revised Kc = 4/5 12 1/5 6= 10.8 %

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Revised value of the company = = 200/5.8% = 3448.28 lacs.

QUESTION – 04
A valuation done of an established company by a well-known analyst has
estimated a value of ₹ 500 lakhs, based on the expected free cash flow for next
year of ₹ 20 lakhs and an expected growth rate of 5%.
While going through the valuation procedure, you found that the analyst has
made the mistake of using the book values of debt and equity in his
calculation. While you do not know the book value weights he used, you have
been provided with the following information:

(i) Company has a cost of equity of 12%,

(ii) After tax cost of debt is 6%,

(iii) The market value of equity is three times the book value of equity, while
the market value of debt is equal to the book value of debt.

You are required to estimate the correct value of the company.

(RTP May – 2020)

SOLUTION:-

Cost of capital by applying Free Cash Flow to Firm (FCFF) Model is as follows:-

Value of Firm = V0 =

Where –

FCFF1 = Expected FCFF in the year 1

Kc = Cost of capital

gn = Growth rate forever

Thus, ₹ 500 lakhs = ₹ 20 lakhs /(Kc g)

Since g = 5%, then Kc = 9%

Now, let X be the weight of debt and given cost of equity

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= 12% and cost of debt = 6%, then 12% (1 – X) 6% X = 9%

Hence, X = 0.50, so book value weight for debt was 50%

∴ Correct weight should be 150% of equity and 50% of debt.

∴ Cost of capital = Kc = 12% (0.75) 6% (0.25) = 10.50%

And correct firm’s value = ₹ 20 lakhs/(0.105 – 0.05) = ₹ 363.64 lakhs.

QUESTION – 05
Following information is available pertaining to ABC Ltd. which is expected to
grow at a higher rate for 3 years after which growth rate will stabilize at a lower
level.

Base year information is –

Revenues EBIT Capital Depreciation

(After Depreciation) Expenditure
₹ 1,000 Cr. ₹ 150 Cr. ₹ 140 Cr. ₹ 100 Cr.

Information for high growth and stable growth period are as follows:

Stable Growth

Particulars High Stable Growth

Growth
Growth in Revenue & EBIT 20% 10%
Growth in Capital 20% Capital Expenditure are offset by
Expenditure and Depreciation
Depreciation
Risk free rate 10% 9%
Equity Beta 1.15 1.00
Market Risk Premium 6% 5%
Pre Tax cost of Debt 13% 12.86%0
Debt Equity Ratio 1:1 2:3

Working capital is 25% of Revenue for all time.

Corporate Tax Rate is 30%.

You are requested to find out the value of ABC Ltd.

(Exam May-2022)

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SOLUTION:

High growth phase: Stable growth phase:

Ke 0.10 1.15 0.06 = 0.169 0.09 1.0 0.05 = 0.14 or
or 16.9%. 14%.

Kd 0.13 (1 0.3) = 0.091 or 0.1286 (1 0.3) = 0.09 or

9.1%. 9%.
Cost of 0.5 0.169 0.5 0.091 = 0.6 0.14 0.4 0.09 =
capital
0.13 or 13%. 0.12 or 12%.

Determination of forecasted Free Cash Flow of the Firm (FCFF)

(₹ in crores)
Year 1 Year 2 Year 3 Terminal
Year
Revenue 1,200.00 1,440.00 1,728.00 1,900.80
EBIT 180.00 216.00 259.20 285.12
EAT 126.00 151.00 181.44 199.58
Capital Expenditure 48.00 57.60 69.12 -
Less Depreciation
Working Capital 50.00 60.00 72.00 43.20
Free Cash Flow (FCF) 28.00 33.60 40.32 156.38

Alternatively, it can also be computed as follows:

(₹ in crores)
Year 1 Year 2 Year 3 Terminal
Year
Revenue 1,200.00 1,440.00 1,728.00 1,900.80
EBIT 180.00 216.00 259.20 235.12
EAT 126.00 151.20 181.44 199.58
Add: Depreciation 120.00 144.00 172.80 190.08
246.00 295.20 354.24 389.66
Less: Capital Exp. 168.00 201.60 241.92 190.08
Working Capital 50.00 60.00 72.00 43.20
28.00 33.60 40.32 156.38

Present Value (PV) of FCFF during the explicit forecast period is:

FCFF (₹ in crores) PVF @ 13% PV (₹ in crores)

28.00 0.885 24.78
33.60 0.783 26.31

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40.30 0.693 27.94

₹ 79.03

Terminal Value of Cash Flow = = ₹ 7,819 Crores

PV of the terminal, value is = ₹ 7,819 Crores

= ₹ 7,819 Crores 0.693 = ₹ 5418.57 Crore

The value of the firm is = ₹ 79.03 Crores ₹ 5,418.57 Crores

= ₹ 5497.60 Crores

QUESTION – 06
Mantra Ltd. is planning to buy Alay Ltd. Following information is given is
respect of Alay Ltd. which is expected to grow at a rate of 18% p.a. for the next
three years, after which the growth rate will stabilize at 8% p.a. normal level, in
perpetuity:

Particulars For the year ended

March 31, 2022
Revenues ₹ 6,800 Crores
Cost of Goods Sold (COGS) ₹ 2,800 Crores
Operating Expenses ₹ 2,100 Crores
Capital Expenditure ₹ 750 Crores
Depreciation (included in Operating Exp.) ₹ 600 Crores

During high growth period, Revenues & Earnings Before Interest & Tax (EBIT)
will grow at 18% p.a. and capital expenditure net of depreciation will grow at
12% p.a. From 4th year onwards, i.e. normal growth period revenues and EBIT
will grow at 8% p.a. and incremental capital expenditure will be offset by the
depreciation. During both high growth & normal growth period, net working
capital requirement will be 25% of revenues.

Corporate Income Tax rate is 30%.

The Weighted Average Cost of Capital (WACC) for both the companies is 15%.

You are required to estimate the value of Alay Ltd. using Free Cash Flows to
Firm (FCFF) & WACC methodology.

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The PVIF for the three years are as below:

Year t1 t2 t3
PVIF @ 15% 0.870 0.756 0.658

(Exam Nov-2022)
SOLUTION:-

Determination of forecasted Free Cash Flow of the Firm (FCFF)

(₹ in crores)

Year 1 Year 2 Year 3 Terminal

Year
Revenue 8,024.00 9,468.32 11,172.62 12,066.43
COGS 3,304.00 3,898.72 4,600.49 4,968.53
Operating Expenses* 1,770.00 2,088.60 2,464.55 2,661.71
(Excluding
Depreciation) 708.00 835.44 985.82 1,064.68
Depreciation 2,242.00 2,645.56 3,121.76 3,371.51
EBIT 672.60 793.67 936.53 1,011.45
Tax @ 30% 1,569.40 1,851.89 2,185.23 2,360.06
EAT 168.00 188.16 210.74 -----
Capital Exp. – Dep. 306.00 361.08 426.07 223.45
Working Capital 1,095.40 1,302.65 1,548.42 2,136.61
Free Cash Flow (FCF)

Terminal Value is :

= ₹ 30, 523 Crore

Present Value (PV) of FCFF:

FCFF (₹ in crores) PVF @ 15% PV (₹ in crores)

1,095.40 0.870 953.00
1,302.65 0.756 984.80
1,548.42 0.658 1,018.86
30,523 0.658 20,084.13
23,040.79

The value of the firm is ₹ 23,040.79 Crores

Note: The answer may vary due to rounding off difference.

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QUESTION – 07
Excellent Ltd. reported a profit of ₹ 154 lakhs after 30% tax for the financial
year 2019- 20. An analysis of the accounts revealed that there is an
extraordinary loss of ₹ 20 lakhs and the income included extraordinary items of
₹ 16 lakhs. The existing operations, except for the extraordinary items, are
expected to continue in the future. In addition, the results of the launch of a
new product are expected to be as follows:
₹ in lakhs

Sales 140

Material costs 40

Labour costs 24

Fixed costs 20

You are required to:

(i) Calculate the value of the business, given that the capitalization rate is
14%.

(ii) Determine the market price per equity share, with Excellent Ltd.'s share
capital being comprised of 2,00,000 at 13% preference shares of ₹ 100
each and 100,00,000 equity shares of ₹ 10 each and the P/E ratio being
12 times. (Ignoring Corporate Dividend Tax).

(Exam July – 2021)

SOLUTION:

(i) Computation of Business Value

(₹ Lakhs)
220
Profit before tax
(16)
Less: Extraordinary income 20
Add: Extraordinary losses 224

Profit from new product (₹ Lakhs)

Sales 140

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Less: Material costs 40

Labour costs 24
Fixed costs 20 (84) 56
280.00
Less: Taxes @ 30% 84.00
Future Maintainable Profit after taxes 196.00
Relevant Capitalization Factor 0.14
Value of Business (₹ 196/0.14) 1400

(ii) Determination of Market Price of Equity Share

Future maintainable profits (After Tax) ₹ 1,96,00,000

Less: Preference share dividends 2,00,000 shares of ₹ 26,00,000
₹ 100 @ 13%
Earnings available for Equity Shareholders ₹ 1,70,00,000
No. of Equity Shares 1,00,00,000
₹ 1.70
Earnings per share = =

PE ratio 12
Market price per share ₹ 20.40

QUESTION – 08
The closing price of LX Ltd. is ₹ 24 per share as on 31st March, 2019 on NSE
Ltd. The Price Earnings Ratio was 6. It was found that an amount of ₹ 24
Lakhs as income and an extra ordinary loss of ₹ 9 lakhs were included in the
books of accounts. The existing operations except for the extraordinary items
are expected to continue in future. Further the company has launched a new
product during the year with the following expectations:

(₹ in Lakhs)
Sales 150
Material Cost 40
Labour Cost 34
Fixed Cost 24

The company has 500,000 equity shares of ₹ 10 each and 100,000 9%

Preference Shares of ₹ 100 each. The Price Earnings Ratio is 6 times. Post tax
cost of capital is 10 per cent per annum. Tax rate is 34 per cent. You are
required to determine:

(i) Existing Profit from old operations

(ii) The value of business

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(Exam May – 2019)

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SOLUTION:-

Price Earnings Ratio 6

Market Price Per Share 24
EPS 4
Number of Shares 5,00,000
Profit After Pref. Dividend ₹20,00,000
Pref. Dividend ₹9,00,000
Profit After Tax ₹29,00,000
Profit before tax ₹43,93,939

Less: Extraordinary income ₹24,00,000

Add: Extraordinary losses ₹9,00,000
Existing Profit from Old Operations ₹28,93,939
Profit from new product (₹ Lakhs)
Sales 150
Less: Material costs 40
Labour costs 34
Fixed costs 24 (98) ₹52,00,000
₹80,93,939
Less: Taxes @ 34% ₹27,51,939
Future Maintainable Profit after taxes ₹53,42,000
Relevant Capitalization Factor 0.10
Value of Business (₹ 53,42,000/0.10) ₹5,34,20,000
Or ₹5.342 crore

QUESTION – 09
T Ltd. Recently made a profit of ₹ 50 crore and paid out ₹ 40 crore (slightly
higher than the average paid in the industry to which it pertains). The average
PE ratio of this industry is 9. As per Balance Sheet of T Ltd., the shareholder’s
fund is ₹ 225 crore and number of shares is 10 crore. In case company is
liquidated, building would fetch ₹ 100 crore more than book value and stock
would realize ₹ 25 crore less.
The other data for the industry is as follows:

Projected Dividend Growth 4%

Risk Free Rate of Return 6%

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Market Rate of Return 11%

Average Dividend Yield 6%

The estimated beta of T Ltd. is 1.2. You are required to calculate value of T Ltd.
using

(i) P/E Ratio

(ii) Dividend Yield

(iii) Valuation as per:

(a) Dividend Growth Model

(b) Book Value

(c) Net Realizable Value

SOLUTION:-

(i) ₹ 50 crore 9 = ₹ 450 crore

(ii) ₹ 50 crore = ₹ 666.67

(iii)

(a) Ke = 6% 1.2 (11% - 6%) = 12%

Value of Firm = = ₹ 520 crore

(b) ₹ 225 crore

(c) ₹ 225 crore ₹ 100 crore – ₹ 25 crore = 300 crore

Value of Equity on The Basis of FCFE

QUESTION – 10
Calculate the value of share from the following information:
Profit after tax of the company ₹ 290 crores

Equity capital of company ₹ 1,300 crores

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Par value of share ₹ 40 each

Debt ratio of company (Debt/ Debt + Equity) 27%

Long run growth rate of the company 8%

Beta 0.1; risk free interest rate 8.7%

Market returns 10.3%

Capital expenditure per share ₹ 47

Depreciation per share ₹ 39

Change in Working capital ₹ 3.45 per share

(RTP May – 2020)

SOLUTION:-

No. of Shares = = 32.5 Crores

EPS =

EPS = = ₹ 8.923

FCFE = Net income [(1 b) (capex – dep) (1 b) ( ΔWC )]

FCFE = 8.923 [(1 0.27) (47 39) (1 0.27) (3.45)]

= 8.923 [5.84 2.5185] = 0.5645

Cost of Equity = Rf (Rm – Rf)

= 8.7 0.1 (10.3 – 8.7) = 8.86%

PO = = = = ₹ 70.89

QUESTION – 11
Calculate the value of share from the following information:

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Profit of the Company (After Tax) ₹ 560 crores

Equity share capital of the Company ₹ 1,900 crores
Par value of share ₹ 50 each
Debt ratio (Debt/Debt Equity) 43%
Long run growth rate of the Company 7%
Beta 0.1 (Risk free Interest rate) 9.5%
Market return 12.6%
Capital expenditure per share ₹ 53
Depreciation per share ₹ 45
Increase in working capital ₹ 4.62 per share

(Exam May-2022)

SOLUTION:-

No. of shares = = 38 crores

EPS =

EPS = = ₹ 14.737

Cost of Equity = Rf ß (Rm – Rf)

= 9.5 0.1 (12.6 – 9.5) = 9.81%

FCFE = Net income – [(1 b) (capex – dep) (1 b) ( ΔWC )]

FCFE = 14.737 – [(1 0.43) (53 45) (1 0.43) (4.62)]

= 14.737 – [4.56 2.6334] = 7.5436

Po = = = = ₹ 287.25

Chop Shop Approach or Breakup Value Approach

QUESTION – 12

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Using the chop-shop approach (or Break-up value approach), assign a value for
Cranberry Ltd. whose stock is currently trading at a total market price of €4
million. For Cranberry Ltd, the accounting data set forth three business
segments: consumer wholesale, retail and general centers. Data for the firm’s
three segments are as follows:
Business Segment Segment Segment Segment
Sales Assets Operating Income
Wholesale €225,000 €600,000 €75,000
Retail €720,000 €500,000 €150,000
General € 2,500,000 €4,000,000 €700,000

Industry data for “pure-play” firms have been compiled and are summarized as
follows:
Business Capitalization Capitalization Capitalization/
Segment /Sales /Assets Operating Income
Wholesale 0.85 0.7 9
Retail 1.2 0.7 8
General 0.8 0.7 4

(Practice Manual)

SOLUTION:

Business Capital-to- Segment Sales Theoretical Values

Segment Sales
Wholesale 0.85 €225,000 € 191250
Retail 1.2 €720,000 € 864000
General 0.8 € 2,500,000 € 2000000
Total Value € 3055250

Business Capital-to- Segment Theoretical Values

Segment Assets Assets

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Wholesale 0.7 € 600000 € 420000

Retail 0.7 € 500000 € 350000
General 0.7 € 4000000 € 2800000
Total Value € 3570000

Business Capital- Operating Theoretical Values

Segment toOperating Income
Income
Wholesale 9 € 75000 € 675000
Retail 8 € 150000 € 1200000
General 4 € 700000 € 2800000
Total Value € 4675000

Average theoretical value = = 37,66,750

Average theoretical value of Cranberry Ltd. = €37,66,750

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