Responsibility of a Registered Valuer under Section 247(2) of the Companies Act, 2013.


The Ministry of Corporate Affairs (MCA) vide its notification dated October 18, 2017, brought into force the provisions of Section 247 of the Companies Act, 2013, which deals with the Valuation of, inter alia, property, stocks, shares, debentures or net worth of a company by the Registered Valuers.

The distinguishing feature is that the subject of Valuation and the regulation of the profession of Valuation is covered under Section 247 of the Companies Act, 2013 which is a single section in one chapter of the Act. Any important decision to be taken by a banker, businessman, shareholder, investors any stakeholder is dependent on the report of the valuer.

The Valuation as a practice and as a profession is being regulated now to improve Corporate Governance and better transparency in the corporate sector which is imperative to infuse confidence amongst investors in Indian market and abroad.

Valuation of a business requires understanding and analysis of various complex factors and has a major impact on all type of businesses whether big or small.

As we all know that the Valuation assignment is distinctive and there are no uniform practices that are being adopted by the valuers in carrying Valuation.So, tailoring a Valuation about the most suitable and appropriate procedures to be relevant to each assignment is somewhat a very technical issue.

The intention of bringing the Rules is to make the valuers more accountable as Valuation plays a significant role in the capital growth of the country. It is the economic and social activity. Valuation denotes the worth of the underlying assets as on a particular date. Better Corporate Governance is likewise prompting requirement of independent Business Valuations.

The introduction of these Rules would not only ensure a streamlined methodology but would also ensure an increase in the standard of professional judgment utilized in Valuation process. This would also lead to Valuation being a specialized profession and offer a host of opportunities to the existing professionals including Chartered Accountants, Company

Secretaries, Cost Accountants and MBA/ PGDBM in finance, however it is a very onerous endeavour and has come with lot of responsibilities as it now stands regulated.

The Rules also provide that the Insolvency and Bankruptcy Board of India ("IBBI") should be established to be the "Authority" which will hold examinations and grant certifications of the designation of a "Registered Valuer".




 
   

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
   

 

 

 
   

 

 

 
   

 

 

 

 

 

 

 

Valuation: Professionals’ Insight

Series -3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
   

 

Valuation Standards Board

ICAI Registered Valuers Organisation

The Institute of Chartered Accountants of India

(Set up by an Act of Parliament)

New Delhi

 

 

 

 

 

© The Institute of Chartered Accountants of India

 
   


All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form, or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior permission,  in writing, from the publisher.

 

 

 

 

 

First Edition                  :          July 2019

 

Committee/Department          :    Valuation Standards Board E-mail                           :          Valuationstandards@icai.in

Website                         :          www.icai.org

 

Price                             :          ` 150 /-

 

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

 

Published by                 :          The Publication Department on behalf of

the Institute of Chartered Accountants of India, ICAI Bhawan, Post Box No. 7100, Indraprastha Marg, New Delhi - 110 002.

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

July/2019/500

 

 

 

 

 

                                          Message

 

The success of an institutional framework depends on the well-organized, efficient and effective working of the institutions involved in it. As per the  Companies (Registered Valuers and Valuation) Rules, 2017, the Registered Valuers Organsiations are the frontline Regulators to regulate and promote  the continuous education of the registered valuers who derive value on which the economic growth of a country depends.

Value is always influenced by a variety of factors: the  preconceptions  and  bias of the asset’s owner, the valuer’s understanding of the market, the methodology that is being used, and the complexity of the underlying  business. These influences impact the assumptions being made by valuers. Decision makers must be confident that the assumptions applied are appropriate, and that they are not overly optimistic or needlessly pessimistic. This is why it is essential to know, and understand, the basis of the assumptions made by a valuer.

To continuously upgrade the knowledge of the Valuers, the ICAI Registered Valuers Organisation is working jointly with the Valuation Standards Board of the Institute of Chartered Accountants of India and bringing out various publications, organizing the webcasts, training programmes, workshops etc apart from conducting 50 hours educational course.

I am extremely happy that in continuing with the joint endeavours,  the Valuation Standards Board of ICAI and ICAI Registered Valuers Organisation (ICAI RVO) are bringing out this Third Series of publication on ‘Valuation: Professionals’ Insight’ to give a thoughtful insight of the practices followed by other valuers and professionals.

I would like to put on record my appreciation to the Institute of Chartered Accountants of India for all the joint initiatives with  ICAI RVO. My  thanks to  the Valuation Standards Board (VSB) of ICAI under the Chairmanship of CA.

  1. C. Hegde and Vice Chairmanship of M. P. VijaKumar and to the members of the Board of ICAI RVO, Shri I. Y. R Krishna Rao, Shri Samir Kumar Barua, Shri Ashok Haldia for this joint initiative. I convey my heartfelt thanks to CA. Prafulla P. Chhajed, CA. Atul Kumar Gupta and CA. Nilesh S. Vikamsey– the Directors of ICAI RVO, for their support in this initiative.

I would like to thank CA. Sarika Singhal, Secretary Valuation  Standards  Board who is involved in compiling and contributing the articles.

 

 

 

 

 

I sincerely believe that  this Educational Material will be  of  immense use to  the valuer members and others stakeholders.

 

 

 

 

 

Date: June, 2019 Place: New Delhi

 

Justice Anil R.  Dave (Retd.)

Chairman, ICAI Registered Valuers Organisation

 

 

 

 

 

                                         Foreword

 

With globalisation and dismantling of trade barriers, corporates are increasingly making international forays- be it accessing capital or making acquisitions abroad. This has led to increase in the demand for valuation experts as Companies are seeking accurate valuations for their businesses. The Valuation profession got further recognition with the introduction of the concept Registered Valuers in the Companies Act, 2013

In the valuation process, valuation expert values the organisation by using technology, applying specific methods of valuation (which can be termed as Science) and by his own experience in taking various assumptions. The importance of Valuation cannot be undermined as understanding what  an asset is worth, and what drives that value, is very essential, when both management and stakeholders need to make informed  and  effective  business and investment decisions.

I appreciate the efforts of the Valuation  Standards  Board  and  ICAI Registered Valuers Organisation in taking the joint initiatives  for upgradation of knowledge of valuers. In continuation of these endeavours, the publication titled - ‘Valuation: Professionals’ Insight’ containing the views in the form of Articles capturing the varied practices of valuation is been brought out.

I sincerely appreciate the dedicated efforts put in by CA. N. C. Hedge, Chairman, Valuation Standards Board and CA. M. P. Vijay Kumar, Vice- Chairman, Valuation Standards Board and other members of the VSB for bringing out this publication in the form of Series.

I am hopeful that this this Series of the publication will further enhance the knowledge and wisdom of valuers and at the same time ensure quality work being done by the valuers.

 

 

 

 

 

Date: June 2019 Place: New Delhi

 

CA.  Prafulla P. Chhajed

President ICAI Director ICAI RVO

 

 

 

 

 

 

 

                                            Preface

 

An important aspect of valuation is that the value often depends on the intended purpose of the valuation. Therefore, the same business often has different values depending on the purpose of valuation. Nonetheless, placing the right value on a particular business which is necessary for a number of reasons, is the ultimate purpose of a valuation.

It’s more than a year since the valuation spectrum has  been  formally regulated by the Government as a professional practice. The Companies (Registered Valuers and Valuation) Rules, 2017 provides an institutional set- up comprising of four main pillars. The pillars are Registered Valuers, Registered Valuers Organisation the Insolvency and Bankruptcy Board  of India and the Ministry of Corporate Affairs which has the most important role  of administering the entire framework of valuation as per Section 247 of the Companies Act, 2013 and Rules thereunder.

The Implementation of any system does not only depend on the law, but also on the institutions involved in administration and execution of the same. It depends on the effective functioning of all the institutions but a very critical role is played by the Registered Valuers who have a vital role to play in the entire valuation process.

As part of the continuous efforts towards upgradation of knowledge and to bring to the fore the practices followed by the registered valuers,  the  Valuation Standards Board jointly with ICAI Registered Valuers Organisation has decided to bring out Third Series of the publication titled “Valuation: Professionals’ Insights” covering practical insights on valuation.

This publication like the other two series, is a compilation of  articles  on varied valuation topics written by experts in this field. The objective of the publication is to make available the knowledge of the valuers of the professional practices followed by them in the field of valuation.

We may clarify that  the views expressed in this publication are the views of  the authors and are not the views of the Institute.

In this connection, we take this opportunity in thanking  the  President  ICAI and Director ICAI RVO CA. Prafulla P. Chhajed, and the Vice President ICAI and Director ICAI RVO CA. Atul Kumar Gupta for their moral support and encouragement in bringing out the publication.

 

Responsibility of a Registered Valuer under Section 247(2) of the Companies Act, 2013.

  • Make an impartial, true and fair Valuation of assets which may be required to be valued;
  • Exercise due diligence while performing the functions of a valuer;
  • Make the Valuation in accordance with such rules as may be prescribed; and
  • Not undertake Valuation of any assets in which he has a direct or indirect interest or becomes so interested at any time during or after the Valuation of

Applicability of the Rules

  1. The Companies Act, 2013
  2. Insolvency and Bankruptcy Code, 2016
  3. Any other Authority which provides for adoption of the same

framework as that of Companies (Registered Valuers and Valuation) Rules, 2017.

Institutional Set up under the Companies (Registered Valuers and Valuation) Rules, 2017

The Companies (Registered Valuers and Valuation), Rules, 2017 provides an institutional set-up comprising of five pillars:

  • Registered Valuers- To conduct the Valuation under the Companies Act, 2013 and the Insolvency and Bankruptcy Code, 2016, the role  of the Registered Valuer encompasses a wide range of functions, which

include adhering to procedure of the law, as well as accounting and finance related functions.

  • Registered Valuers Organsiation- To enrol and regulate Registered Valuers as its members in accordance with the Section 247 of the Companies Act, 2013 and read with Companies (Registered Valuers and Valuation), Rules,
  • Insolvency and Bankruptcy Board of India- An authority who will oversee these organsiations and to perform legislative, executive and quasi-judicial functions with respect to the Registered Valuers and Registered Valuers
  • The Ministry of Corporate Affairs- The Ministry is a Regulator which is primarily concerned with administration of the Companies Act 2013, and rules & regulations framed there-under mainly for regulating the functioning of the corporate sector in accordance with
  • Adjudicating Authority- The National Company Law Tribunal (NCLT), established under the Companies Act, 2013 would function as an

The implementation of any system does not only depend on the law, but also on the institutions involved in administration and execution of the same. It depends on the effective functioning of all the institutions but the Registered Valuers have a vital role to play in the entire process.

Recognition of Registered Valuers Organisations

A company registered under section 8 of the Companies Act,  2013  (or  section 25 of the erstwhile Companies Act, 1956), with the sole object of dealing with matters relating to regulation of valuers of an asset class or classes and professional institutes established by  an  Act  of  Parliament.  They are eligible to be registered as Registered Valuers Organisations, provided they meet the following key requirements:

  • Conducts educational courses /training in Valuation, in accordance  with the syllabus as prescribed by the
  • Grants memberships to individuals who possess qualifications and experience as prescribed under the Registered Valuers and Valuation Rules,
  • Reviews and monitors the functioning, including quality, of services, of valuers who are its

ICAI Registered Valuers Organisation formed by the Institute of  Chartered Accountants of India- Journey so far.

ICAI Registered Valuers Organisation (RVO) is a Section 8 private company formed by the Institute of Chartered Accountants of India which has been recognized by the IBBI to enroll and regulate registered valuers or valuer member as its members in accordance with the Companies (Registered Valuers and Valuation) Rules, 2017, and functions incidental thereto. ICAI RVO is registered for Securities or Financial Assets Class.

Some of the important roles of ICAI RVO are as follows-

  • ensure compliance with the Companies Act, 2013 and rules,  regulations and guidelines issued thereunder governing the conduct of Registered Valuers Organisation and Registered Valuers;
  • employ fair, reasonable, just, and non-discriminatory practices for the enrolment and regulation of its members;
  • be accountable to the authority in relation to all  bye-laws  and directions issued to its members;
  • develop the profession of registered valuers;
  • promote continuous professional development of its members;
  • continuously improve upon its internal regulations and guidelines to ensure that high standards of professional and ethical conduct are maintained by its members; and
  • provide information about its activities to the

Rule 5 (1) of the Companies (Registered Valuers and Valuation) Rules, 2017 provides that the authority shall, either on its own or through a designated  agency, conduct Valuation examination for one or more asset classes, for individuals, who possess the qualifications and experience as  specified  in Rule 4, and have completed their educational courses as member of a Registered Valuers Organisation, to test their professional knowledge, skills, values and ethics in respect of Valuation:

Rule 5 (2) provides that the authority shall determine the syllabus for various Valuation specific subjects or assets classes for the Valuation examination on the recommendation of one or more Committee of experts constituted by the authority in this regard.

IBBI has notified the syllabus and mandated a 50 hours training by the Registered Valuers Organisation which is a precondition to take examination  to become Registered Valuer and revised the same.

Training Conducted

In this direction, from June, 2018 onwards, ICAI RVO has conducted the 50 hours training across the country and batches have been held at Delhi (3), Mumbai (3), Kolkata(2), Chennai (2), Bangalore(2), Ahmedabad, Jaipur, Gurugram, Coimbatore, Hyderabad, Salem, Ernakulam, Pune, Indore, Jaipur, Vasai, Ludhiana, Chandigarh, Baroda.

Valuer Members trained:

As on date 1300+ members have been trained by ICAI RVO at  its   Educational course of 50 hours.

Registered valuers registered as on 25th June, 2019

ICAI RVO has the highest number of registration of Registered Valuers under the Asset Class- ‘Securities or Financial Asset’. As on 25th June, 2019, 555 Registered Valuers have been registered by the Insolvency and Bankruptcy Board of India under the Asset Class Securities or Financial Assets. Out of which, 322 Registered Valuers (58%) are ICAI RVO members.

Conclusion

The real fair value is when the same is calculated by stepping in the shoes of the stakeholder for whom the value is calculated. Further, regulation brings in discipline but the self- regulation is most important.

The increased transparency and fairness in the Valuation system would also boost stakeholder confidence by bringing uniformity.

History of Valuation

For a big part of the 20th century, tangible assets, which include fixed assets such as buildings, land, and machinery, were considered to be the main source of the commercial value for any business. They were usually recorded in the financial statement based on their cost and/or outstanding value. The company’s assessment on profitability and performance  focused  on  all assets except intangible assets. Intangibles were generally excluded as the specific value of such assets wasn’t always clear.

The Original methodology used for Valuation was Assets minus Liabilities, or just the equity. Later, the regulatory requirements for better tax accountancy, prohibition, the tax breaks and compensation paid to some businesses by the Governments formed a new viewpoint. This revolutionary concept was that a company was actually worth far more than simply its assets minus  its  liabilities or only its equity. Since then, the methodology has seen significant changes. The inputs, risk factors and range of information which are used to calculate the final company Valuation based on their current circumstances has also evolved to become more robust and complete. This development brought about new concepts including the value of future profit  and  goodwill in calculating company Valuation.

In the past couple of decades, as the awareness of creating value for the shareholders increased dramatically, the significance of  intangible  assets  and their Valuation changed. Although several stakeholders  paid  little attention to the benefits from intangible assets, the management of the company was aware of the importance of such assets.  Intangible  assets  often give businesses their competitive advantage. Most businesses were successful due to effective corporate management of intangible assets such as brands, patents, technology and employees. However, because they have no physical characteristics, their value can be hard to determine.

Shifting Paradigm

Business Valuation focus has shifted from just the value of tangible assets to become more comprehensive. It also includes Earnings capability, Intangible assets, Innovative capabilities and Management capabilities which are now considered critical in the Valuation of any business. With several companies becoming service oriented rather than product oriented, the proportion of intangibles to the entire business has increased. This led to the serious realization of the need for some guidelines in valuing the intangible assets. Several standard setting bodies developed guidelines for Valuation of various kinds of assets using various approaches like:

  • Market approach - based on market evidence of what third parties have paid for comparable assets
  • Income approach – based on the present value of future  earnings from the asset
  • Cost approach - based on the costs of developing or acquiring a new asset that is of similar use as the existing one

These methods look at things like comparable transactions, excess earnings, relief from royalty, replacement or reproduction  costs  and  simulation analysis. As for Goodwill, value is based on the calculation of a  residual  value, by subtracting the net value of assets from the enterprise value of the business.

Need for Regulation and Valuation Standards

Corporate Valuation is necessary for the purpose of corporate finance activities, accounting and regulatory requirements or  for  internal  management reporting. However, Valuation is not an exact science, it  depends on various factors such as purpose, size of business, industry, location of business, risk, management assumptions, promoter strength, etc. The wide variation in Valuation methodologies and approaches  across markets has made it difficult to compare Valuations.

Further, international investors require greater levels of transparency and confidence in the Valuations to enable them to make sound investment decisions.

Valuations also form a key part of audited financials which should provide transparency and comparability in relation to the value of companies and therefore impact share prices. This is important for the purpose of financial market stability and ultimately, a stable economy.

Considering the above, Government has enacted Section 247 of the Companies Act, 2013 (“the Act” or “Companies Act”). Further, the MCA also issued the Companies (Registered Valuation and Valuation) Rules, 2017.

Section 247

As per Section 247, where a  Valuation is required to be made in respect of  any property, stocks, shares, debentures, securities, goodwill or any other assets or liabilities or net worth of a company under the provisions of the Act.  It shall be valued by a person, registered as  a valuer and being a member of   a recognised organisation.

The valuer appointed shall:

  • make an impartial, true and fair Valuation of any assets which may be required to be valued;
  • exercise due diligence while performing the functions as valuer
  • make the Valuation in accordance with prescribed rules
  • not undertake Valuation of any assets in which he has a direct or indirect interest or becomes so interested at any time during or  after the Valuation of assets

Onus on Valuer

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

Companies (Registered Valuation and Valuation) Rules, 2017

The Companies (Registered Valuation and Valuation) Rules, 2017 prescribe the rules for eligibility, qualification and registration of valuers and Valuation professional organizations.

Further, the said rules also state that a Registered Valuer shall make Valuations as per the Valuation Standards notified by the  Central  Government. However, until such time as the Valuation  Standards  are  notified by the Central Government, a valuer shall make Valuations as per

  • internationally accepted valuation standards;
  • Valuation standards adopted by any registered valuers organisation;

It must be noted that the Central Government has not issued such Valuation Standards at this point of time.

Valuation Standards issued by the ICAI

The Institute of Chartered Accountants of India (ICAI) has  issued  the  following Valuation Standards:

  • Preface to the ICAI Valuation Standards
  • Framework for the Preparation of Valuation Report in accordance with the ICAI Valuation Standards
  • ICAI Valuation Standard 101 - Definitions
  • ICAI Valuation Standard 102 - Valuation Bases
  • ICAI Valuation Standard 103 - Valuation Approaches and Methods
  • ICAI Valuation Standard 201 - Scope of Work, Analyses and  Evaluation
  • ICAI Valuation Standard 202 - Reporting and Documentation
  • ICAI Valuation Standard 301 - Business Valuation
  • ICAI Valuation Standard 302 - Intangible Assets
  • ICAI Valuation Standard 303 - Financial Instruments

Positive impact of ICAI Valuation Standards on Valuers

While the Valuation Rules have put the onus on valuers in terms of increased liability and responsibility, the Valuation Standards have the  following positives for valuers:

  • Valuation standards ensure consistency and reduce discretionary ‘judgement calls’ taken by
  • They increase comparability between different valuers and Valuation firms by promoting use of consistent Valuation
  • The Standards ensure that ‘best practices’ of Valuation are followed and there is fairness in Valuation
  • They promote credibility, relevancy & transparency of Valuation information.
  • The Standards cover Valuation of all assets, liabilities and businesses (cash flows). Accordingly, there is more guidance available on Valuation of complex financial instruments as well as unusual
  • The Standards specify usage and give direction on various items such as discount rates to be used, illiquidity discounts, discount for lack of control
  • The Standards help Valuer in preparing information checklist, choosing Valuation method and finalising Valuation

In conclusion, the field of Valuation is witnessing a revolution and conduct of Valuations by quality Valuation professionals  will  improve public  confidence in Valuations.

 

 Valuation-Through the Judicial Lens

One of the parameters for evaluating a Valuation outcome is  its  ability  to stand the rigors of scrutiny by the various stakeholders. With Valuation outcomes impacting tax revenues of the country, the Government too is interested in the correctness of the Valuation results and hence, amongst others, the Indian tax authorities have been closely scrutinizing Valuation reports on the basis of which transactions have been carried out. The past  year has witnessed a flurry of judicial rulings on a variety of Valuation related aspects by various tax courts across the country. As professionals in the field of Valuation, we cannot help but take note of this.

This Chapter accordingly takes us through some of the relevant observations made by courts in judgements and orders pronounced by them. While these may, at times, be more pertinent in the specific facts  of  the case,  they  do also provide guidance to the practitioners in general and may aid in the Valuation process.

Sanctity of Choice of Selection of Method

Section 56(2)(vii)(b) of the Income-Tax Act, 1961 (Act) aims at taxing excess share premium received by a closely held company from resident investors. This provision read with Rule 11UA of the Income-tax Rules, 1962 (Rules) inter alia grants the taxpayer a choice to determine the Fair Market Value of the shares using the Discounted Cash Flow (DCF) method in addition to the Net Asset Value Method. This option to use DCF as the Valuation method is important as it allows the taxpayer to demonstrate the appropriateness of the pricing based on future cash flows (and not just book the value of the net assets), which is also often the basis for pricing of actual  transactions  between parties.

Taxpayers have faced challenges on this front where the actual operating results have differed from the cash flow projections/ estimates or where there have been differences in the underlying assumptions adopted by  the valuer as compared to those considered by the Assessing Officer (AO) during the scrutiny process. The AO has, in certain cases, not only challenged the DCF

computation but also rejected the method and asked the taxpayer to  determine the share price as per the Net Asset Value Method, which would throw up a very different (and lower) share price thereby leading to a greater tax outflow.

However, the Courts have come to the rescue of the taxpayers. The Bombay High Court in the case of Vodafone M-Pesa Ltd1 held that the AO can scrutinize the Valuation report and determine a fresh Valuation either by himself or by calling a final determination from an independent valuer to confront the taxpayer. But the basis has to be DCF method and he cannot change the method of Valuation which has been adopted by  the  taxpayer. This view has also been upheld amongst others by the Bangalore Bench of  the Income Tax Appellate Tribunal (ITAT) in the case of Innoviti Payment Solutions Ltd2 and by the Jaipur Bench of the ITAT in the case of Rameshwaram Strong Glass (P) Ltd3. This is indeed a welcome relief.

Here, it is pertinent to note that a contrary view has been taken by the Delhi Bench of the ITAT in the case of Agro Portfolio Pvt Ltd4 wherein, on perusing the long disclaimer appended by the merchant banker of not undertaking any independent examination of the financial  data,  the  Tribunal concluded that the valuer did not do anything reflecting his expertise except by applying the formula. Further, the ITAT held that if the taxpayer does not provide any evidence to substantiate the data on which the DCF Valuation is based and does not provides reasonable connectivity between those projections in cash flow with the reality evidences by the material, it is not possible even for the Departmental Valuation Officer to conduct any exercise of verification of the acceptability of the value determined by the merchant banker, the  AO  has  the power to reject the DCF method and value the shares using the NAV method.

Following this, the Bangalore Bench of the ITAT, in the case of  TUV  Rheinland NIFE Academy Pvt Ltd5 held that since the taxpayer was unable to substantiate the projections on the basis of which the value was determined using the DCF Method, the AO could proceed with the NAV method.

While the above judgements appear to be conflicting, there is still a common thread running through them – in order to stand the test of scrutiny, it is imperative for the taxpayer to consider the best estimate drawn up on a scientific basis and considering the relevant economic factors. Similarly, it is imperative that the valuer maintains robust documentation and gives a sound reasoning for underlying inputs and assumptions made while drawing up the projections. This would help defend in case of a challenge even where the actual numbers vary significantly from the projections.

The above is also supported by the observations of the Jaipur Bench of the ITAT in the case of Rameshwaram Strong Glass (P) Ltd, (supra) which gave due cognizance to the ground work done by the Chartered Accountant (CA) while undertaking the Valuation exercise. The ITAT observed that the CA had considered the plant capacity, industry and market conditions as prevailed in the state, the sanctioning of the loan by the bank which factors formed a reasonable basis of projections and that the Valuation reports were prepared by the CA as per the guidelines given by the ICAI. The AO had not found any fault. Accordingly, the ITAT did not find any rational or sound basis  in  the order of the AO rejecting the Valuation report submitted by  the  taxpayer based on DCF Method.

Guidelines for Application of the DCF Method

The Bangalore Bench of the ITAT in the case of Innoviti Solutions discussed above, while examining the application of the DCF  method, emphasized on the importance of appropriateness of the cash flows, which forms the foundation of the Valuation. Taking note of the Technical Guide on Share Valuation (issued in 2009) by the Research Committee of The Institute of Chartered Accountants of India (ICAI) and other rulings6, the ITAT stated that the Cash Flow projection based on which the Valuation report is prepared by the Chartered Accountant needs to be estimated with reasonable certainty.  The taxpayer needs to demonstrate that the projections are a  reliable  estimate achievable with reasonable certainty on the basis of facts available


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

on the date of Valuation and actual result of future cannot be a  basis for saying that the estimates of the management are not  reasonable  and  reliable.

The ITAT recognised that in the case of a start-up where no past data is available, it should not be insisted upon that the cash flow projection should  be on the basis of reliable future estimate. It rules that in such cases, the projections may be on the basis of expectations as long as it is shown that  such expectations are reasonable after considering various macro and micro economic factors affecting the business.

The ITAT further observed that the primary onus to prove the correctness of the Valuation Report is on the taxpayer as he has special knowledge and he   is a privy to the facts of the company and only he has opted for this method. Hence, he has to satisfy about the correctness of the projections, discounting factor and terminal value etc. with the help of  empirical data or industry norm  if any and/or scientific data, scientific method, scientific study and applicable guidelines regarding DCF Method of Valuation. If the taxpayer cannot  establish that the cash flow is achievable with reasonable  certainty,  the  future cash flow cannot be recognized and the DCF method is not workable.

Substance of The Security – Preference Versus Equity

Recently, the Bangalore Bench of the ITAT in the case of 2M Power Health Management Services Pvt Ltd7, while examining  the  dispute  around Valuation of preference shares directed that the substance of the securities  being issued needed to be looked at while undertaking  the  Valuation exercise.

In this case, the taxpayer allotted compulsorily convertible preference shares at a premium. The holders of these shares had the right to attend the general meetings of the company and vote on resolutions directly affecting their interest. After examining the facts of  the case, the ITAT held that the nature   of the issued share was that of an equity share and not preference share. It further stated that it was important to decide, based on the evidence, if the share premium is received for equity shares to be issued later or  for preference shares issued now, the prescribed Valuation methodology should be applied.

7 ITA No.2880/Bang/2018

For the purposes of calculating FMV under Section 56, Rule 11UA of the  Rules provides Valuation methodology for equity shares as  well  as  preference shares. Rule 11UA(1)(c)(c) provides that the FMV of preference shares should be the price the shares would fetch if sold in the open market  on the Valuation date. Based on the above, it may be  possible that  the  AO  will value the shares as equity (per Rule 11UA) and not as preference shares (i.e. applying the price fetched if they are sold on the open market), if depending on the nature and terms of its issue, the instrument fails to satisfy the test of being preference shares. Accordingly, just going by the nomenclature of the security would not suffice therefore, it  would  be  important to examine the terms thereof.

In the following case too, the Mumbai Bench of the ITAT  gave  due  importance to the features of the security being valued. The ruling was pronounced in the case of Golden Line Studio Pvt. Ltd8. In this  case,  the  ITAT ruled that for the purposes of determining whether excessive premium has been charged on the issue of redeemable non-cumulative preference shares, its fair market value (FMV) should not be calculated on  the basis of  the Net Asset Value (NAV) of the issuing company as there was a difference   in equity and preference shares and they both could not be valued the same way.

The taxpayer argued that considering that the return on preference shares is fixed whether in terms of dividend or at the time of  winding  up,  the preference shareholders get a preference over equity shareholders on  payment of dividend and repayment of capital.  Accordingly,  preference shares are akin to quasi debt instruments and should be valued based on the returns they fetch and not the company’s NAV. The Tribunal appreciated the above arguments while deciding in favour of the taxpayer.

Conclusion

In the past, there have been judgements e.g. in the case of G. L. Sultania9 where the Supreme Court (SC) has held that unless it is shown to the court  that some well accepted principles of Valuation have been departed from without any reason or that the approach adopted is patently erroneous or that relevant factors have not been considered by the valuer or that the Valuation was made on a fundamentally erroneous basis or that the valuer adopted a demonstrably wrong approach or a fundamental error going to the root of the matter, the court cannot interfere with the Valuation of an expert. However, considering that appropriateness of a Valuation result depends on the facts  and underlying assumptions, the issue is more fact driven than by law. Similarly, the SC in the case of Hindustan Lever10 and Miheer Mafatlal11 had observed that Valuation of shares is a technical and complex problem which can he appropriately left to the consideration of experts in the field of accountancy and that even courts are not equipped to question the assumptions made by a valuer.

As regards approach towards  Valuation, it is known that there are bound to   be differences in the Valuations undertaken by two valuers and hence, even the value determined by the AO could differ from that undertaken by the professional valuer but does that vitiate the Valuation done by  the  latter  needs to be pondered over. In the book “Study on Share  Valuation”,  published by the ICAI, the following observation has been made in the Foreword to the first edition:

"The subject of Valuation of shares has always been controversial in the accounting profession. No two accountants have ever agreed in the past or  will ever agree in the future on the Valuation of shares of a company, as inevitably they involve the use of personal judgment on which professional  men will necessarily differ ..."

The above was acknowledged by the Gujarat High Court in the case of Kiritbhai Hiralal Patel and Ors. vs Arvind Intex Ltd.12

Inspite of the above guidance by the highest courts of the country, one of the fundamental questions that keeps coming up is whether the AO can question

/ revisit the assumptions followed while preparing the projections and the various inputs / variables considered to arrive at the Valuation. This is on account of the fact that Valuation is a fact and judgement driven process and the likelihood of a challenge cannot be ruled out.

 

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

 

Valuation-Peculiarities of Valuing a Private Business

Background

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

Given the Indian scenario, it is all the more necessary for a practicing valuer  to understand the nuances that form part of the Valuation exercise  of  a  private business.

Setting the Context

Fundamentally, the approaches that are considered for valuing a private business are similar to those used for valuing publicly listed companies. However, it is crucial to consider that the expectations of the investors are different in each transaction depending on the facts of each transaction. Broadly speaking, it is convenient to value publicly traded  companies  because of some assumptions that are inherently considered by the valuer. However, it is crucial to understand the outlook of the investors towards the target business being valued. It is certain that for the same business having the same financial practices, an investor shall have separate outlook for the one which is a publicly traded business vis-à-vis the one which is a private business. Considering the varying outlook of the investors, it is crucial to evaluate the impact this outlook is likely to have on the cost of capital for the private business.

Diversification

Two entities having the same business and same financial practices  shall have the same risk. However, two people looking at the same business can have different perspectives on the risk in the business. A very important assumption that underlies in the Valuation  of a  publicly traded company is  that the investor in the publicly traded company is adequately diversified. The assumption supposes that the Investor is rational and attempts to maximise expected returns, given the risk taken. In the process, the investor ends up with diversified portfolios and uses information to make reasoned judgments  on value. In the scenario of a private business, it is not always correct to assume that the investor has adequate diversification. To the extent that the investor in a business is not diversified, the investor may like to incorporate some or all firm-specific risk into its discount rates, thus reducing the value. This may be called lack of diversification discount. Accordingly, the cost of equity and the resultant cost of capital shall be  different  for  a  private business when compared to a publicly traded company.

When we use a beta to measure risk, we are measuring only that portion of  the risk that cannot be diverted away. We are assuming that  the  remaining risk is ignored because it can be diverted. Hence, when valuing private business, this factor needs to be considered and addressed by a valuer while determining the discounting rate.

Liquidity and Control

What is lack of liquidity? Illiquidity can be simply put as a  characteristic of asset of not easily getting converted into cash. Illiquidity for a market can be defined as one with few participants and a low volume of activity. Private businesses, when compared to publicly traded businesses, tend to be more illiquid. The ideal manner to look at this is that all  assets are illiquid, with  some assets being more liquid than others. There is no single yardstick to measure the liquidity of any asset. However, availability of a marketplace and participants in the marketplace can be considered to be a reasonable  yardstick for the liquidity of the asset. Having said that, it is to be understood that publicly traded companies amongst themselves also have varying  degrees of liquidity. Treasury bonds and bills may be considered to be most liquid assets, whereas stock in publicly traded company with small float may be more illiquid than the stock in publicly traded company having  wide  trading. Real estate may be more liquid than a private business. Moreover, private business amongst themselves may also have varying degrees of liquidity, especially private businesses offering control (more liquid) vis-à-vis private businesses without control (less liquid).

This brings us to the next important characteristic of control in a transaction. Generally, while valuing a publicly traded business, the transactions are frequent and the intention of the buyer may not be to obtain control, and hence, the control characteristic in such transactions is not of paramount importance. However, when a private business is being valued, more often than not, the intention  may always include control. Lack of  obtaining control  in a transaction involving a private business generally calls for suitable adjustment by factoring a discount for lack of control.

Addressing

It is  important to  understand that each characteristic is  separate and needs  to be treated as such. The degree and magnitude of each discount will vary  not only across firms but also for the same firms, across time  and  for different transactions. Without valuing each one separately, one cannot estimate the correct discount. It is also crucial to understand that each  needs to be counted separately. Trying to consolidate these discounts into one number is a dangerous exercise and can lead to miscounting and double counting of risks.

While valuing a target entity, the valuer needs to understand that each of the characteristic is negotiable. The fact that one can value something (lack of diversification, lack of control or lack of liquidity) does not  mean  that  the same shall be included in the price too. While concluding on each  of  the above factors/characteristic, the valuer needs to exercise judgment and decide as per the facts of the case in a pragmatic manner.

The following can be the guiding principles for the valuer to take into account before addressing each of the above characteristic:

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

Best Buyer

This brings us to the next important characteristic in valuing  a  private business namely the buyer. The characteristic of the buyer also plays an important role in the Valuation exercise of a private business. The long-term buyer for a profitable cash flow generating business may not have the same illiquidity factor for the business as would a cash-constrained  short  term  buyer have for the same business. Discount rate for the profitable cash flow generating business may not also be the same as that for  unprofitable negative cash flow businesses.

Buyer Synergy: If the buyer is confident that the buyer can dramatically improve his/its own overall earnings by ownership of the target,  he/it  can afford to pay more. Synergy may come from  simple cross sale of capabilities  to a greater breadth of customers (buyer to seller and vice versa). It  may  come from ability to reduce overhead in the combination. It may come from dozens of possible benefits of combination. Regardless of specific source or reason, the buyer has value in synergy when he/it knows that he/it can add  more to his/its overall performance than just the simple addition of combining his/its earnings with those of the seller.

Market positions and sentiment: This also plays an important role in determining the value. One cannot be away from the market while valuing a business. Discount at the time of the 2008 crisis and the one sometime later when things looked better, would not be the same. Even established businesses have trouble in raising funds in an  economically  negative situation. For private businesses, it is even worse. The  discount  varies  across companies, buyers and time.

Moreover, in private businesses, sometimes, the choice to sell the business may not be to the best buyer. This can be understood with the help of an example. A general medical practitioner who has been practising as such for the past many years may want to retire and sell off her practice. For such a private business, the best available buyer shall be in the form of another medical practitioner. The choice for the seller to sell the business may not be  to the best buyer. This is due to the inherent limitation of certain private businesses of not being able to approach the best buyer. Amongst the available choices for any transaction, the owner of  a  private business may not be able to approach all the possible options and carry out a ‘price discovery’ unlike a publicly traded company, which can generally afford to do so. In a transaction wherein Valuation of a publicly traded  company’s  business is done, the underlying assumption is always there that the seller shall sell the business to the buyer who is likely to offer the highest price.

The exploration continues amongst various parties including:

  • A private owner
  • A private equity fund/venture capital fund
  • A publicly traded company

Different buyers shall have a different measure of  risk that is seen in the  same business, resulting into different value.

Inherent Issues in Valuing Private Businesses

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

Absence of market value of equity and debt: Generally, in valuing a business, especially that relating to publicly traded companies, for calculating the weighted average cost of capital (WACC), market values of equity and  debt are taken into consideration for assigning weights and deriving the WACC. This serves as a good benchmark and reliable information while working on value of publicly traded companies. Generally, private businesses do not have market value of either equity or debt, leading to  the  valuer to  have to rely on the limited information that is  available. Private businesses are generally funded significantly with promoter’s  money.  The promoter of  the private business may or may not be charging any interest on the said funding. Lack of even credit rating of the private businesses leads to a  situation where significant judgment has to be exercised while deciding on various aspects.

Disclosure problems with private companies: Generally, publicly traded companies are subject to  stringent corporate governance standards leading to adequate, timely and correct disclosures  of  financial  information. Generally, there are significant disclosure problems with private firms as they have a limited historical period as well as lack of discipline in appropriate reporting of financial information.

Absence of market price: Inherent in a Valuation exercise is the fall back of the valuer on the market price of the asset. This can be called  the inherent bias of the valuer. In case of a private company, there is no established stock price and hence, validation of the derived value with the market price is not available. Lack of market information plays a key role in Valuation  of  a  private business.

Larger issues with the cash flow: Generally, private firms are  not  habituated with complex predictions considering multiple eventualities. Such exercises have hardly been undertaken by such firms. In such a case, the valuer has to consider the larger issues with the cash flow prediction and forecast, especially considering historical performance and prudence in achievability of the projected cash flow.

Shorter history: Generally, private firms have been in business for shorter periods of time as compared to publicly traded companies.

Accounting standards: Differences in Accounting Standards plays  a  key role in decision making about reliability of financial information. Periodic accounting is prevalent largely in our country where people account for  various items at periodic intervals.

Intermingling of personal and business expenses: While valuing a transaction, it is imperative for the valuer to broadly  consider  the intermingling of personal and business expenses. In our country, for private businesses, it is very common to have an overlap of personal and business  expenses. Largely, selling promoters represent a larger  than  reality  proportion of expenses to be personal in nature, trying to prove higher operating cash flows, which may result in a higher value to them. The valuer has to exercise adequate care in addressing this sensitive area.

Separating salaries from dividends: Generally, sole owners do not charge their salary. Moreover, sole owners do a lot of chores which may not be continued by them after a particular transaction. It is extremely important to understand that while projecting cash flows for a business, it should be considered as to which expenses shall continue beyond and which expenses shall add up if the owner is no longer the sole owner. Various roles such as accountant, marketing, etc. by owner can add up to costs after a particular transaction. What would cost one to replace the owner is important while valuing a private company as one may need multiple people to do what the owner did previously.

Key person value - Mainly CAs, Doctors, dentists, chefs,  other  professionals, have key person value. Key person value is the variable which can lead to loss of revenue due to the key person’s absence. It can be understood by way of an example: If a dentist sells her practice to another dentist, a patient visiting after the transaction on not seeing the previous dentist may choose to walk out of  the clinic rather than  getting attended by  the new dentist. Key person value mostly affects businesses having personal services. A valuer may have to clean up the financial statements for the purpose of Valuation. Cleaning up of financial statements includes adjusting cash flows for items such as expenses  which shall increase/decrease post  the transaction. Generally, in real life, the key person assists in transition.  Also, non-compete needs to be factored into Valuation if it is factored into the transaction.

Related party transactions: Indian private businesses have a tendency to enter into multitude of  related party transactions. More often than  not, the  said related party transactions are entered into at a price which may be calculated on the basis of some ulterior motive of the promoters of the private business. The valuer should exercise due care while considering the quantum, implication and importance of the related party transactions on the business being valued. If adjustments are required to be made, appropriate adjustments after exercising due care must be done.

Royalty payments: Some private businesses might charge  royalty on  the  use of the trademark of  the promoter of  the private business  registered in  any other personal’s entity’s/name. A valuer should consider such royalty payments and its implication on the value.

Different Purposes of Valuing Private Firms

The purpose of Valuation is also crucial for the private business’ Valuation. There are multiple reasons for which a private business might require a Valuation:

  • Regulatory requirement: Preferential issue, rights’ issue, employee stock option, as per the requirement of the Companies Act, 2013.
  • Private businesses might sometimes ask for a Valuation out  of  curiosity to know what the business is worth?
  • Sometimes, for split or family settlements, the Valuation is
  • Sometimes, fair value accounting, does not lead to any
  • Sale of one partner’s interest to the other partner, and so

Knowing the purpose of Valuation is crucial for the valuer for considering the relevant factors affecting the transaction purported and reliance of the said transaction on the value derived.

Conclusion

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

 

Computing Beta — The Most Critical Input to the CAPM

Valuers/analysts across the globe adopt Capital Asset Pricing Model (CAPM) as one of the methodologies to arrive at the cost of equity and consequently  the cost of capital. One of the most critical inputs to  the CAPM is ‘Beta’ i.e.  the sensitivity of the subject company/asset to the market. In this article we look at the ways to compute beta for listed as well as unlisted entities.

The method to arrive at beta is by taking the company’s returns over a time period and compare the Index returns say Sensex or Nifty for  the  same period. Now, we have both data sets, we take the co-variance of the stock returns and the index returns for the same period and divide it  by  the  variance of  the index returns. This gives you a  coefficient which measures  the relative risk of your company with respect to the market, for example if    the coefficient you arrive is at is 1.5, then if the index moves by 1%  up  or down then your company moves 1.5% in the respective direction.

This is basically running a regression on both the data sets - returns on the  stock and returns of the index, the slope of  the line is  your beta, this gives  you a statistical answer to what is the beta for the company. This coefficient (beta) could come with a standard error and is just an estimate.

Let us try and compute beta  with the help of  an  illustration. Given below is  the data pertaining to Tata Steel’s stock price and Nifty 50  for the period Oct  1, 2015 to September 30, 2016.

Tata Steel

 

 

 

 

 

 

Date

Open

High

Low

Close

Volume

Adj Close

01-10-2015

215

215.5

210.25

212.25

4872900

212.25

05-10-2015

214.9

225.8

214.2

225

8121300

225

06-10-2015

227.7

229

223.15

227.5

7359800

227.5

07-10-2015

225

237.7

223.6

236.8

9838500

236.8

08-10-2015

237.9

242.7

236.2

240.8

8915500

240.8

09-10-2015

242.4

253

242.2

251.1

10520000

251.1

12-10-2015

255.1

261.95

249.8

250.85

10570000

250.85

13-10-2015

248

248.65

243.25

245

5821200

245

14-10-2015

244

253

243.55

248.35

6290100

248.35

15-10-2015

249.15

257.2

248.05

255.25

7008000

255.25

16-10-2015

255.9

256.7

248.4

252.9

5326500

252.9

19-10-2015

253.1

254.1

246.75

248.4

4478300

248.4

20-10-2015

247.05

248.9

240

240.8

5248500

240.8

21-10-2015

241.7

246.45

238.25

244.4

8042200

244.4

23-10-2015

247.4

251.6

244.15

246

5005800

246

26-10-2015

247.35

251.55

246.25

249.65

4188000

249.65

27-10-2015

248.85

250.3

244.05

245.95

3403600

245.95

28-10-2015

244.5

248.5

244

247.15

3436900

247.15

29-10-2015

246.3

251.45

244.7

247.6

4589000

247.6

30-10-2015

248.4

254.8

245.15

246.6

6173200

246.6

02-11-2015

246.5

246.6

236.3

238.9

4909500

238.9

03-11-2015

241.7

243

234.9

235.7

4492700

235.7

04-11-2015

239.15

240

233.85

235.4

4861300

235.4

05-11-2015

236

236

224.3

225.4

8801600

225.4

06-11-2015

218.9

221.85

215.1

220.25

9906300

220.25

09-11-2015

215

224.4

212.65

222.25

6272600

222.25

10-11-2015

220.8

222.25

217.15

218.05

4536400

218.05

11-11-2015

218.05

218.05

218.05

218.05

0

218.05

13-11-2015

218.7

223.6

216.6

222.65

4426900

222.65

 

 

16-11-2015

222.85

231.9

220.2

230.6

6923300

230.6

17-11-2015

231.9

235.75

230.9

234.55

5240900

234.55

18-11-2015

234.1

235

225.2

225.85

5283600

225.85

19-11-2015

227.5

229.7

225.6

228.75

3661100

228.75

20-11-2015

228.1

232.75

228.1

230

3859400

230

23-11-2015

230.85

230.85

223.1

224.45

4102300

224.45

24-11-2015

223.35

226.4

222.5

224.35

4179000

224.35

26-11-2015

225.5

230

224.2

227.9

4588000

227.9

27-11-2015

227.9

235

227.55

231.25

5393000

231.25

30-11-2015

232.4

234.4

228.8

229.6

4556700

229.6

01-12-2015

230.8

238.5

230.3

237.55

6586500

237.55

02-12-2015

239.95

245.9

238.1

243.85

8858300

243.85

03-12-2015

240.15

243.5

236.8

240.15

7107800

240.15

04-12-2015

238.05

244.25

237.1

240.25

5538100

240.25

07-12-2015

244.8

247.5

242.45

243.55

4936400

243.55

08-12-2015

242.05

243.05

233.5

234.75

4545900

234.75

09-12-2015

234

235.85

224.9

226.85

4727600

226.85

10-12-2015

227.25

234.75

226.5

233

4804800

233

11-12-2015

235.1

243.9

235.1

240.9

11922400

240.9

14-12-2015

239

248.9

238.45

245

11314400

245

15-12-2015

247

247.25

241.25

244.35

5218800

244.35

16-12-2015

246.55

248.6

242.1

244.7

5759800

244.7

17-12-2015

246.9

257.95

246.05

257.1

12112200

257.1

18-12-2015

256.5

257.95

254

255.65

6944200

255.65

21-12-2015

255.5

261.4

254.65

258.45

6195200

258.45

22-12-2015

259

261.8

256.55

257.4

4544200

257.4

23-12-2015

262.25

266.4

262.25

264.45

7702900

264.45

24-12-2015

266

266

260.6

263.35

3843700

263.35

28-12-2015

263.95

264.3

253

254.1

5317600

254.1

29-12-2015

255.8

257.15

253.35

255.3

3800500

255.3

30-12-2015

256.4

261.8

255.1

258.7

6812700

258.7

 

 

31-12-2015

260

260.8

256.95

259.8

4446600

259.8

04-01-2016

255

263.2

253.1

256.9

6981400

256.9

05-01-2016

257.55

276.4

257.55

274.3

15008900

274.3

06-01-2016

272.8

274.6

266

268.75

7454700

268.75

07-01-2016

263

263.3

248.2

249.9

9503700

249.9

08-01-2016

252

256.3

249.05

253.6

6299400

253.6

11-01-2016

247

253.35

244.25

251.65

6085300

251.65

12-01-2016

253.05

255.3

243.15

245.75

5425300

245.75

13-01-2016

248.5

251.8

237

246.6

7482400

246.6

14-01-2016

235

242.55

231.5

238.75

8884800

238.75

15-01-2016

242.5

243

228.1

229.7

5991600

229.7

18-01-2016

229.8

244

225.2

235.9

8417400

235.9

19-01-2016

237.55

240.95

231.25

238

6304100

238

20-01-2016

232.8

234

226.5

232

5486800

232

21-01-2016

234.7

239.35

231.25

235.6

6245300

235.6

22-01-2016

238.3

250.8

237.65

247.8

6510700

247.8

25-01-2016

249

256.4

248.8

254.9

5576500

254.9

27-01-2016

255

259.9

253.4

257.6

6235600

257.6

28-01-2016

257

258.45

252.4

254.2

6016700

254.2

29-01-2016

254.65

258.8

247.45

249.7

6747900

249.7

01-02-2016

248.9

254.95

246.5

249.3

4420700

249.3

02-02-2016

250.25

251

230.1

231.45

8388400

231.45

03-02-2016

227.9

233.9

221.45

224

7791500

224

04-02-2016

224.4

228.6

219

225.95

11709400

225.95

05-02-2016

216

238.3

216

233.85

25803300

233.85

08-02-2016

238.6

243.95

232.05

234.1

10332400

234.1

09-02-2016

230.9

237.3

230.1

235.5

7562800

235.5

10-02-2016

234.85

237.75

227.1

235.7

7616000

235.7

11-02-2016

235.95

237.3

220.85

224.5

6151600

224.5

12-02-2016

226

229.35

211.15

217.5

9373700

217.5

15-02-2016

222

248

222

246.7

13602300

246.7

 

 

16-02-2016

249.6

251.6

243.15

244.85

9146800

244.85

17-02-2016

245

252.9

238

251.25

8295400

251.25

18-02-2016

255

256.5

243.2

250.85

9459300

250.85

19-02-2016

248.5

254.45

246.85

253.25

6770600

253.25

22-02-2016

253.6

257.5

251.7

255.25

4810300

255.25

23-02-2016

255.8

261.6

252.1

253.55

8452300

253.55

24-02-2016

250.6

253.75

246.95

247.9

4743800

247.9

25-02-2016

247.1

249.85

244.6

248.15

5588100

248.15

26-02-2016

249.5

251.7

243.15

248.45

5336800

248.45

29-02-2016

246.9

263.65

245.1

249.1

9850400

249.1

01-03-2016

250

258.15

246.55

257.05

7111200

257.05

02-03-2016

260

269.5

259.5

267.55

7645600

267.55

03-03-2016

273

289

272.1

287.05

17533000

287.05

04-03-2016

289

291.2

284.5

288.55

9170100

288.55

08-03-2016

287.8

296.7

287

291.8

9281500

291.8

09-03-2016

283.5

296.5

281.3

295.4

10158400

295.4

10-03-2016

296.3

301.25

293.3

296.7

8556900

296.7

11-03-2016

296

298.2

290.35

294.05

7633600

294.05

14-03-2016

295.95

300.25

295.25

296.7

4445300

296.7

15-03-2016

297

302

294.1

300.45

6978000

300.45

16-03-2016

300

302.75

294.2

299.5

7039300

299.5

17-03-2016

304.5

305.65

294.9

295.9

8005500

295.9

18-03-2016

299.7

302.75

296.95

302.2

7314400

302.2

21-03-2016

302

305.95

300.65

303.55

5651700

303.55

22-03-2016

303.1

311.8

301.35

309.8

6579000

309.8

23-03-2016

311.8

317.9

310.55

317.2

6377700

317.2

28-03-2016

318.4

318.4

297.4

299.15

9069700

299.15

29-03-2016

300

307.75

300

303.85

5937100

303.85

30-03-2016

309.45

325.75

305.3

324.3

12438800

324.3

31-03-2016

324.9

324.9

314.4

319.7

13349900

319.7

 

 

Nifty 50

 

 

 

 

 

 

Date

Open

High

Low

Close

Volume

Adj Close

01-10-2015

7992.05

8008.25

7930.65

7950.9

156900

7950.9

05-10-2015

8005.1

8128.8999

8005.1

8119.3

183100

8119.3

06-10-2015

8180.45

8180.9502

8096.5

8152.9

178500

8152.9

07-10-2015

8146.2

8188.8999

8132.9

8177.4

193900

8177.4

08-10-2015

8196.75

8196.75

8105.85

8129.35

171700

8129.35

09-10-2015

8186.35

8232.2002

8139.65

8189.7

199700

8189.7

12-10-2015

8231.5

8244.5

8128.2

8143.6

199100

8143.6

13-10-2015

8121.95

8150.25

8088.6

8131.7

145900

8131.7

14-10-2015

8102.4

8139.2998

8096.35

8107.9

138900

8107.9

15-10-2015

8134.35

8190.5498

8129.8

8179.5

167200

8179.5

16-10-2015

8193.65

8246.4004

8147.65

8238.15

156400

8238.15

19-10-2015

8262.55

8283.0498

8239.2

8275.05

124500

8275.05

20-10-2015

8280.3

8294.0498

8229.2

8261.65

155100

8261.65

21-10-2015

8258.35

8294.4004

8217.15

8251.7

144800

8251.7

23-10-2015

8308.25

8328.0996

8280.75

8295.45

152000

8295.45

26-10-2015

8333.65

8336.2998

8252.05

8260.55

133900

8260.55

27-10-2015

8230.35

8241.9502

8217.05

8232.9

156700

8232.9

28-10-2015

8188.9

8209.0996

8131.8

8171.2

188900

8171.2

29-10-2015

8175.45

8179.6001

8098

8111.75

217500

8111.75

30-10-2015

8123.55

8146.1001

8044.4

8065.8

199500

8065.8

02-11-2015

8054.55

8060.7002

7995.6

8050.8

136100

8050.8

03-11-2015

8086.35

8100.3501

8031.75

8060.7

132500

8060.7

04-11-2015

8104.9

8116.1001

8027.3

8040.2

122100

8040.2

05-11-2015

8030.35

8031.2002

7944.1

7955.45

132100

7955.45

06-11-2015

7956.55

8002.6499

7926.15

7954.3

219500

7954.3

09-11-2015

7788.25

7937.75

7771.7

7915.2

211800

7915.2

10-11-2015

7877.6

7885.1001

7772.85

7783.35

165200

7783.35

11-11-2015

7838.8

7847.9502

7819.1

7825

21700

7825

13-11-2015

7762.45

7775.1001

7730.9

7762.25

160900

7762.25

16-11-2015

7732.95

7838.8501

7714.15

7806.6

149500

7806.6

 

 

17-11-2015

7848.75

7860.4502

7793

7837.55

145000

7837.55

18-11-2015

7823.15

7843.3999

7725.05

7731.8

143600

7731.8

19-11-2015

7788.5

7854.8999

7765.45

7842.75

132600

7842.75

20-11-2015

7841.9

7906.9502

7817.8

7856.55

151900

7856.55

23-11-2015

7869.5

7877.5

7825.2

7849.25

127000

7849.25

24-11-2015

7837

7870.3501

7812.65

7831.6

130600

7831.6

26-11-2015

7837.15

7897.1001

7832

7883.8

219800

7883.8

27-11-2015

7910.6

7959.2998

7879.45

7942.7

150300

7942.7

30-11-2015

7936.25

7966

7922.8

7935.25

216300

7935.25

01-12-2015

7958.15

7972.1499

7934.15

7954.9

138600

7954.9

02-12-2015

7976.7

7979.2998

7910.8

7931.35

126300

7931.35

03-12-2015

7902.3

7912.2998

7853.3

7864.15

125700

7864.15

04-12-2015

7817.6

7821.3999

7775.7

7781.9

152500

7781.9

07-12-2015

7816.55

7825.3999

7746.05

7765.4

137600

7765.4

08-12-2015

7738.5

7771.25

7685.45

7701.7

135100

7701.7

09-12-2015

7695.5

7702.8501

7606.9

7612.5

140000

7612.5

10-12-2015

7643.3

7691.9502

7610

7683.3

140800

7683.3

11-12-2015

7699.6

7703.0498

7575.3

7610.45

167800

7610.45

14-12-2015

7558.2

7663.9502

7551.05

7650.05

148900

7650.05

15-12-2015

7659.15

7705

7625.1

7700.9

134300

7700.9

16-12-2015

7725.25

7776.6001

7715.75

7750.9

154300

7750.9

17-12-2015

7783.05

7852.8999

7737.55

7844.35

175900

7844.35

18-12-2015

7828.9

7836.1499

7753.35

7761.95

191400

7761.95

21-12-2015

7745.65

7840.75

7733.45

7834.45

126300

7834.45

22-12-2015

7829.4

7846.2998

7776.85

7786.1

125700

7786.1

23-12-2015

7830.45

7871.4502

7826.1

7865.95

117900

7865.95

24-12-2015

7888.75

7888.75

7835.5

7861.05

93500

7861.05

28-12-2015

7863.2

7937.2002

7863

7925.15

122900

7925.15

29-12-2015

7929.2

7942.1499

7902.75

7928.95

113000

7928.95

30-12-2015

7938.6

7944.75

7889.85

7896.25

106800

7896.25

31-12-2015

7897.8

7955.5498

7891.15

7946.35

150900

7946.35

04-01-2016

7924.55

7937.5498

7781.1

7791.3

134700

7791.3

 

 

05-01-2016

7828.4

7831.2002

7763.25

7784.65

145200

7784.65

06-01-2016

7788.05

7800.9502

7721.2

7741

147100

7741

07-01-2016

7673.35

7674.9502

7556.6

7568.3

188900

7568.3

08-01-2016

7611.65

7634.1001

7581.05

7601.35

157400

7601.35

11-01-2016

7527.45

7605.1001

7494.35

7563.85

189000

7563.85

12-01-2016

7587.2

7588.2998

7487.8

7510.3

163900

7510.3

13-01-2016

7557.9

7590.9502

7425.8

7562.4

215200

7562.4

14-01-2016

7467.4

7604.7998

7443.8

7536.8

200800

7536.8

15-01-2016

7561.65

7566.5

7427.3

7437.8

197500

7437.8

18-01-2016

7420.35

7463.6499

7336.4

7351

233600

7351

19-01-2016

7381.8

7462.75

7364.15

7435.1

188300

7435.1

20-01-2016

7357

7470.8999

7241.5

7309.3

225600

7309.3

21-01-2016

7376.65

7398.7002

7250

7276.8

240700

7276.8

22-01-2016

7355.7

7433.3999

7327.6

7422.45

229200

7422.45

25-01-2016

7468.75

7487.1499

7421.2

7436.15

163156900

7436.15

27-01-2016

7469.6

7477.8999

7419.7

7437.75

187600

7437.75

28-01-2016

7426.5

7468.8501

7409.6

7424.65

274500

7424.65

29-01-2016

7413.35

7575.6499

7402.8

7563.55

298700

7563.55

01-02-2016

7589.5

7600.4502

7541.25

7555.95

200400

7555.95

02-02-2016

7566.65

7576.2998

7428.05

7455.55

230200

7455.55

03-02-2016

7392.45

7419.3999

7350.3

7361.8

192000

7361.8

04-02-2016

7411.45

7457.0498

7365.95

7404

222700

7404

05-02-2016

7418.25

7503.1499

7406.65

7489.1

249800

7489.1

08-02-2016

7489.7

7512.5498

7363.2

7387.25

171500

7387.25

09-02-2016

7303.95

7323.4502

7275.15

7298.2

212100

7298.2

10-02-2016

7264.3

7271.8501

7177.75

7215.7

246900

7215.7

11-02-2016

7203.6

7208.6499

6959.95

6976.35

292300

6976.35

12-02-2016

7023.65

7034.7998

6869

6980.95

333900

6980.95

15-02-2016

7057.35

7182.7998

7056.8

7162.95

354200

7162.95

16-02-2016

7201.25

7204.6499

7037.7

7048.25

253800

7048.25

17-02-2016

7058.85

7123.7002

6960.65

7108.45

260000

7108.45

18-02-2016

7177.4

7215.1001

7127.85

7191.75

246700

7191.75

 

 

19-02-2016

7170.55

7226.8501

7145.95

7210.75

192300

7210.75

22-02-2016

7208.85

7252.3999

7200.7

7234.55

154400

7234.55

23-02-2016

7240.3

7241.7002

7090.7

7109.55

194400

7109.55

24-02-2016

7075

7090.7998

7009.75

7018.7

199700

7018.7

25-02-2016

7029.85

7034.2002

6961.4

6970.6

283100

6970.6

26-02-2016

7039.3

7052.8999

6985.1

7029.75

206700

7029.75

29-02-2016

7050.45

7094.6001

6825.8

6987.05

473400

6987.05

01-03-2016

7038.25

7235.5

7035.1

7222.3

275100

7222.3

02-03-2016

7321.7

7380.3501

7308.15

7368.85

338500

7368.85

03-03-2016

7429.55

7483.9502

7406.05

7475.6

278600

7475.6

04-03-2016

7505.4

7505.8999

7444.1

7485.35

281700

7485.35

08-03-2016

7486.4

7527.1499

7442.15

7485.3

257000

7485.3

09-03-2016

7436.1

7539

7424.3

7531.8

245100

7531.8

10-03-2016

7545.35

7547.1001

7447.4

7486.15

224700

7486.15

11-03-2016

7484.85

7543.9502

7460.6

7510.2

198700

7510.2

14-03-2016

7542.6

7583.7002

7515.05

7538.75

166900

7538.75

15-03-2016

7535.85

7545.2002

7452.8

7460.6

193700

7460.6

16-03-2016

7457.05

7508

7405.15

7498.75

195400

7498.75

17-03-2016

7557.4

7585.2998

7479.4

7512.55

239600

7512.55

18-03-2016

7534.65

7613.6001

7517.9

7604.35

237400

7604.35

21-03-2016

7619.2

7713.5498

7617.7

7704.25

196800

7704.25

22-03-2016

7695.55

7728.2002

7643.8

7714.9

208900

7714.9

23-03-2016

7717.45

7726.8501

7670.6

7716.5

199600

7716.5

28-03-2016

7741

7749.3999

7587.7

7615.1

242400

7615.1

29-03-2016

7606.55

7652.8999

7582.25

7597

216800

7597

30-03-2016

7651.1

7741.9502

7643.45

7735.2

232600

7735.2

31-03-2016

7727.65

7777.6001

7702

7738.4

380100

7738.4

For computing the beta using the above information, we need to compute the daily returns both for the stock i.e. Tata Steel and the index i.e. Nifty 50 by applying the following formula:

 

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

Tata Steel

 

 

 

 

 

 

 

Date

Open

High

Low

Close

Volume

Adj Close

Daily Returns

01-10-2015

215

216

210

212

48,72,900

212

 

05-10-2015

215

226

214

225

81,21,300

225

6%

06-10-2015

228

229

223

228

73,59,800

228

1%

07-10-2015

225

238

224

237

98,38,500

237

4%

08-10-2015

238

243

236

241

89,15,500

241

2%

09-10-2015

242

253

242

251

1,05,20,000

251

4%

12-10-2015

255

262

250

251

1,05,70,000

251

0%

13-10-2015

248

249

243

245

58,21,200

245

-2%

14-10-2015

244

253

244

248

62,90,100

248

1%

15-10-2015

249

257

248

255

70,08,000

255

3%

16-10-2015

256

257

248

253

53,26,500

253

-1%

19-10-2015

253

254

247

248

44,78,300

248

-2%

20-10-2015

247

249

240

241

52,48,500

241

-3%

21-10-2015

242

246

238

244

80,42,200

244

1%

23-10-2015

247

252

244

246

50,05,800

246

1%

26-10-2015

247

252

246

250

41,88,000

250

1%

27-10-2015

249

250

244

246

34,03,600

246

-1%

 

 

28-10-2015

245

249

244

247

34,36,900

247

0%

29-10-2015

246

251

245

248

45,89,000

248

0%

30-10-2015

248

255

245

247

61,73,200

247

0%

02-11-2015

247

247

236

239

49,09,500

239

-3%

03-11-2015

242

243

235

236

44,92,700

236

-1%

04-11-2015

239

240

234

235

48,61,300

235

0%

05-11-2015

236

236

224

225

88,01,600

225

-4%

06-11-2015

219

222

215

220

99,06,300

220

-2%

09-11-2015

215

224

213

222

62,72,600

222

1%

10-11-2015

221

222

217

218

45,36,400

218

-2%

11-11-2015

218

218

218

218

-

218

0%

13-11-2015

219

224

217

223

44,26,900

223

2%

16-11-2015

223

232

220

231

69,23,300

231

4%

17-11-2015

232

236

231

235

52,40,900

235

2%

18-11-2015

234

235

225

226

52,83,600

226

-4%

19-11-2015

228

230

226

229

36,61,100

229

1%

20-11-2015

228

233

228

230

38,59,400

230

1%

23-11-2015

231

231

223

224

41,02,300

224

-2%

24-11-2015

223

226

223

224

41,79,000

224

0%

26-11-2015

226

230

224

228

45,88,000

228

2%

27-11-2015

228

235

228

231

53,93,000

231

1%

30-11-2015

232

234

229

230

45,56,700

230

-1%

01-12-2015

231

239

230

238

65,86,500

238

3%

02-12-2015

240

246

238

244

88,58,300

244

3%

03-12-2015

240

244

237

240

71,07,800

240

-2%

04-12-2015

238

244

237

240

55,38,100

240

0%

 

 

07-12-2015

245

248

242

244

49,36,400

244

1%

08-12-2015

242

243

234

235

45,45,900

235

-4%

09-12-2015

234

236

225

227

47,27,600

227

-3%

10-12-2015

227

235

227

233

48,04,800

233

3%

11-12-2015

235

244

235

241

1,19,22,400

241

3%

14-12-2015

239

249

238

245

1,13,14,400

245

2%

15-12-2015

247

247

241

244

52,18,800

244

0%

16-12-2015

247

249

242

245

57,59,800

245

0%

17-12-2015

247

258

246

257

1,21,12,200

257

5%

18-12-2015

257

258

254

256

69,44,200

256

-1%

21-12-2015

256

261

255

258

61,95,200

258

1%

22-12-2015

259

262

257

257

45,44,200

257

0%

23-12-2015

262

266

262

264

77,02,900

264

3%

24-12-2015

266

266

261

263

38,43,700

263

0%

28-12-2015

264

264

253

254

53,17,600

254

-4%

29-12-2015

256

257

253

255

38,00,500

255

0%

30-12-2015

256

262

255

259

68,12,700

259

1%

31-12-2015

260

261

257

260

44,46,600

260

0%

04-01-2016

255

263

253

257

69,81,400

257

-1%

05-01-2016

258

276

258

274

1,50,08,900

274

7%

06-01-2016

273

275

266

269

74,54,700

269

-2%

07-01-2016

263

263

248

250

95,03,700

250

-7%

08-01-2016

252

256

249

254

62,99,400

254

1%

11-01-2016

247

253

244

252

60,85,300

252

-1%

12-01-2016

253

255

243

246

54,25,300

246

-2%

13-01-2016

249

252

237

247

74,82,400

247

0%

 

 

14-01-2016

235

243

232

239

88,84,800

239

-3%

15-01-2016

243

243

228

230

59,91,600

230

-4%

18-01-2016

230

244

225

236

84,17,400

236

3%

19-01-2016

238

241

231

238

63,04,100

238

1%

20-01-2016

233

234

227

232

54,86,800

232

-3%

21-01-2016

235

239

231

236

62,45,300

236

2%

22-01-2016

238

251

238

248

65,10,700

248

5%

25-01-2016

249

256

249

255

55,76,500

255

3%

27-01-2016

255

260

253

258

62,35,600

258

1%

28-01-2016

257

258

252

254

60,16,700

254

-1%

29-01-2016

255

259

247

250

67,47,900

250

-2%

01-02-2016

249

255

247

249

44,20,700

249

0%

02-02-2016

250

251

230

231

83,88,400

231

-7%

03-02-2016

228

234

221

224

77,91,500

224

-3%

04-02-2016

224

229

219

226

1,17,09,400

226

1%

05-02-2016

216

238

216

234

2,58,03,300

234

3%

08-02-2016

239

244

232

234

1,03,32,400

234

0%

09-02-2016

231

237

230

236

75,62,800

236

1%

10-02-2016

235

238

227

236

76,16,000

236

0%

11-02-2016

236

237

221

225

61,51,600

225

-5%

12-02-2016

226

229

211

218

93,73,700

218

-3%

15-02-2016

222

248

222

247

1,36,02,300

247

13%

16-02-2016

250

252

243

245

91,46,800

245

-1%

17-02-2016

245

253

238

251

82,95,400

251

3%

18-02-2016

255

257

243

251

94,59,300

251

0%

19-02-2016

249

254

247

253

67,70,600

253

1%

 

 

22-02-2016

254

258

252

255

48,10,300

255

1%

23-02-2016

256

262

252

254

84,52,300

254

-1%

24-02-2016

251

254

247

248

47,43,800

248

-2%

25-02-2016

247

250

245

248

55,88,100

248

0%

26-02-2016

250

252

243

248

53,36,800

248

0%

29-02-2016

247

264

245

249

98,50,400

249

0%

01-03-2016

250

258

247

257

71,11,200

257

3%

02-03-2016

260

270

260

268

76,45,600

268

4%

03-03-2016

273

289

272

287

1,75,33,000

287

7%

04-03-2016

289

291

285

289

91,70,100

289

1%

08-03-2016

288

297

287

292

92,81,500

292

1%

09-03-2016

284

297

281

295

1,01,58,400

295

1%

10-03-2016

296

301

293

297

85,56,900

297

0%

11-03-2016

296

298

290

294

76,33,600

294

-1%

14-03-2016

296

300

295

297

44,45,300

297

1%

15-03-2016

297

302

294

300

69,78,000

300

1%

16-03-2016

300

303

294

300

70,39,300

300

0%

17-03-2016

305

306

295

296

80,05,500

296

-1%

18-03-2016

300

303

297

302

73,14,400

302

2%

21-03-2016

302

306

301

304

56,51,700

304

0%

22-03-2016

303

312

301

310

65,79,000

310

2%

23-03-2016

312

318

311

317

63,77,700

317

2%

28-03-2016

318

318

297

299

90,69,700

299

-6%

29-03-2016

300

308

300

304

59,37,100

304

2%

30-03-2016

309

326

305

324

1,24,38,800

324

7%

31-03-2016

325

325

314

320

1,33,49,900

320

-1%

 

 

 

 

Nifty 50

 

 

 

 

 

 

 

Date

Open

High

Low

Close

Volume

Adj Close

Daily Returns

01-10-2015

7,992

8,008

7,931

7,951

1,56,900

7,951

 

05-10-2015

8,005

8,129

8,005

8,119

1,83,100

8,119

2%

06-10-2015

8,180

8,181

8,097

8,153

1,78,500

8,153

0%

07-10-2015

8,146

8,189

8,133

8,177

1,93,900

8,177

0%

08-10-2015

8,197

8,197

8,106

8,129

1,71,700

8,129

-1%

09-10-2015

8,186

8,232

8,140

8,190

1,99,700

8,190

1%

12-10-2015

8,232

8,245

8,128

8,144

1,99,100

8,144

-1%

13-10-2015

8,122

8,150

8,089

8,132

1,45,900

8,132

0%

14-10-2015

8,102

8,139

8,096

8,108

1,38,900

8,108

0%

15-10-2015

8,134

8,191

8,130

8,180

1,67,200

8,180

1%

16-10-2015

8,194

8,246

8,148

8,238

1,56,400

8,238

1%

19-10-2015

8,263

8,283

8,239

8,275

1,24,500

8,275

0%

20-10-2015

8,280

8,294

8,229

8,262

1,55,100

8,262

0%

21-10-2015

8,258

8,294

8,217

8,252

1,44,800

8,252

0%

23-10-2015

8,308

8,328

8,281

8,295

1,52,000

8,295

1%

26-10-2015

8,334

8,336

8,252

8,261

1,33,900

8,261

0%

27-10-2015

8,230

8,242

8,217

8,233

1,56,700

8,233

0%

28-10-2015

8,189

8,209

8,132

8,171

1,88,900

8,171

-1%

29-10-2015

8,175

8,180

8,098

8,112

2,17,500

8,112

-1%

30-10-2015

8,124

8,146

8,044

8,066

1,99,500

8,066

-1%

02-11-2015

8,055

8,061

7,996

8,051

1,36,100

8,051

0%

03-11-2015

8,086

8,100

8,032

8,061

1,32,500

8,061

0%

04-11-2015

8,105

8,116

8,027

8,040

1,22,100

8,040

0%

05-11-2015

8,030

8,031

7,944

7,955

1,32,100

7,955

-1%

06-11-2015

7,957

8,003

7,926

7,954

2,19,500

7,954

0%

09-11-2015

7,788

7,938

7,772

7,915

2,11,800

7,915

0%

10-11-2015

7,878

7,885

7,773

7,783

1,65,200

7,783

-2%

11-11-2015

7,839

7,848

7,819

7,825

21,700

7,825

1%

 

 

13-11-2015

7,762

7,775

7,731

7,762

1,60,900

7,762

-1%

16-11-2015

7,733

7,839

7,714

7,807

1,49,500

7,807

1%

17-11-2015

7,849

7,860

7,793

7,838

1,45,000

7,838

0%

18-11-2015

7,823

7,843

7,725

7,732

1,43,600

7,732

-1%

19-11-2015

7,789

7,855

7,765

7,843

1,32,600

7,843

1%

20-11-2015

7,842

7,907

7,818

7,857

1,51,900

7,857

0%

23-11-2015

7,870

7,878

7,825

7,849

1,27,000

7,849

0%

24-11-2015

7,837

7,870

7,813

7,832

1,30,600

7,832

0%

26-11-2015

7,837

7,897

7,832

7,884

2,19,800

7,884

1%

27-11-2015

7,911

7,959

7,879

7,943

1,50,300

7,943

1%

30-11-2015

7,936

7,966

7,923

7,935

2,16,300

7,935

0%

01-12-2015

7,958

7,972

7,934

7,955

1,38,600

7,955

0%

02-12-2015

7,977

7,979

7,911

7,931

1,26,300

7,931

0%

03-12-2015

7,902

7,912

7,853

7,864

1,25,700

7,864

-1%

04-12-2015

7,818

7,821

7,776

7,782

1,52,500

7,782

-1%

07-12-2015

7,817

7,825

7,746

7,765

1,37,600

7,765

0%

08-12-2015

7,739

7,771

7,685

7,702

1,35,100

7,702

-1%

09-12-2015

7,696

7,703

7,607

7,613

1,40,000

7,613

-1%

10-12-2015

7,643

7,692

7,610

7,683

1,40,800

7,683

1%

11-12-2015

7,700

7,703

7,575

7,610

1,67,800

7,610

-1%

14-12-2015

7,558

7,664

7,551

7,650

1,48,900

7,650

1%

15-12-2015

7,659

7,705

7,625

7,701

1,34,300

7,701

1%

16-12-2015

7,725

7,777

7,716

7,751

1,54,300

7,751

1%

17-12-2015

7,783

7,853

7,738

7,844

1,75,900

7,844

1%

18-12-2015

7,829

7,836

7,753

7,762

1,91,400

7,762

-1%

21-12-2015

7,746

7,841

7,733

7,834

1,26,300

7,834

1%

22-12-2015

7,829

7,846

7,777

7,786

1,25,700

7,786

-1%

23-12-2015

7,830

7,871

7,826

7,866

1,17,900

7,866

1%

24-12-2015

7,889

7,889

7,836

7,861

93,500

7,861

0%

28-12-2015

7,863

7,937

7,863

7,925

1,22,900

7,925

1%

29-12-2015

7,929

7,942

7,903

7,929

1,13,000

7,929

0%

30-12-2015

7,939

7,945

7,890

7,896

1,06,800

7,896

0%

 

 

31-12-2015

7,898

7,956

7,891

7,946

1,50,900

7,946

1%

04-01-2016

7,925

7,938

7,781

7,791

1,34,700

7,791

-2%

05-01-2016

7,828

7,831

7,763

7,785

1,45,200

7,785

0%

06-01-2016

7,788

7,801

7,721

7,741

1,47,100

7,741

-1%

07-01-2016

7,673

7,675

7,557

7,568

1,88,900

7,568

-2%

08-01-2016

7,612

7,634

7,581

7,601

1,57,400

7,601

0%

11-01-2016

7,527

7,605

7,494

7,564

1,89,000

7,564

0%

12-01-2016

7,587

7,588

7,488

7,510

1,63,900

7,510

-1%

13-01-2016

7,558

7,591

7,426

7,562

2,15,200

7,562

1%

14-01-2016

7,467

7,605

7,444

7,537

2,00,800

7,537

0%

15-01-2016

7,562

7,567

7,427

7,438

1,97,500

7,438

-1%

18-01-2016

7,420

7,464

7,336

7,351

2,33,600

7,351

-1%

19-01-2016

7,382

7,463

7,364

7,435

1,88,300

7,435

1%

20-01-2016

7,357

7,471

7,242

7,309

2,25,600

7,309

-2%

21-01-2016

7,377

7,399

7,250

7,277

2,40,700

7,277

0%

22-01-2016

7,356

7,433

7,328

7,422

2,29,200

7,422

2%

25-01-2016

7,469

7,487

7,421

7,436

16,31,56,900

7,436

0%

27-01-2016

7,470

7,478

7,420

7,438

1,87,600

7,438

0%

28-01-2016

7,427

7,469

7,410

7,425

2,74,500

7,425

0%

29-01-2016

7,413

7,576

7,403

7,564

2,98,700

7,564

2%

01-02-2016

7,590

7,600

7,541

7,556

2,00,400

7,556

0%

02-02-2016

7,567

7,576

7,428

7,456

2,30,200

7,456

-1%

03-02-2016

7,392

7,419

7,350

7,362

1,92,000

7,362

-1%

04-02-2016

7,411

7,457

7,366

7,404

2,22,700

7,404

1%

05-02-2016

7,418

7,503

7,407

7,489

2,49,800

7,489

1%

08-02-2016

7,490

7,513

7,363

7,387

1,71,500

7,387

-1%

09-02-2016

7,304

7,323

7,275

7,298

2,12,100

7,298

-1%

10-02-2016

7,264

7,272

7,178

7,216

2,46,900

7,216

-1%

11-02-2016

7,204

7,209

6,960

6,976

2,92,300

6,976

-3%

12-02-2016

7,024

7,035

6,869

6,981

3,33,900

6,981

0%

15-02-2016

7,057

7,183

7,057

7,163

3,54,200

7,163

3%

16-02-2016

7,201

7,205

7,038

7,048

2,53,800

7,048

-2%

 

 

17-02-2016

7,059

7,124

6,961

7,108

2,60,000

7,108

1%

18-02-2016

7,177

7,215

7,128

7,192

2,46,700

7,192

1%

19-02-2016

7,171

7,227

7,146

7,211

1,92,300

7,211

0%

22-02-2016

7,209

7,252

7,201

7,235

1,54,400

7,235

0%

23-02-2016

7,240

7,242

7,091

7,110

1,94,400

7,110

-2%

24-02-2016

7,075

7,091

7,010

7,019

1,99,700

7,019

-1%

25-02-2016

7,030

7,034

6,961

6,971

2,83,100

6,971

-1%

26-02-2016

7,039

7,053

6,985

7,030

2,06,700

7,030

1%

29-02-2016

7,050

7,095

6,826

6,987

4,73,400

6,987

-1%

01-03-2016

7,038

7,236

7,035

7,222

2,75,100

7,222

3%

02-03-2016

7,322

7,380

7,308

7,369

3,38,500

7,369

2%

03-03-2016

7,430

7,484

7,406

7,476

2,78,600

7,476

1%

04-03-2016

7,505

7,506

7,444

7,485

2,81,700

7,485

0%

08-03-2016

7,486

7,527

7,442

7,485

2,57,000

7,485

0%

09-03-2016

7,436

7,539

7,424

7,532

2,45,100

7,532

1%

10-03-2016

7,545

7,547

7,447

7,486

2,24,700

7,486

-1%

11-03-2016

7,485

7,544

7,461

7,510

1,98,700

7,510

0%

14-03-2016

7,543

7,584

7,515

7,539

1,66,900

7,539

0%

15-03-2016

7,536

7,545

7,453

7,461

1,93,700

7,461

-1%

16-03-2016

7,457

7,508

7,405

7,499

1,95,400

7,499

1%

17-03-2016

7,557

7,585

7,479

7,513

2,39,600

7,513

0%

18-03-2016

7,535

7,614

7,518

7,604

2,37,400

7,604

1%

21-03-2016

7,619

7,714

7,618

7,704

1,96,800

7,704

1%

22-03-2016

7,696

7,728

7,644

7,715

2,08,900

7,715

0%

23-03-2016

7,717

7,727

7,671

7,717

1,99,600

7,717

0%

28-03-2016

7,741

7,749

7,588

7,615

2,42,400

7,615

-1%

29-03-2016

7,607

7,653

7,582

7,597

2,16,800

7,597

0%

30-03-2016

7,651

7,742

7,643

7,735

2,32,600

7,735

2%

31-03-2016

7,728

7,778

7,702

7,738

3,80,100

7,738

0%

By applying the formula Beta (β) = Covariance (X, Y)/ Variance (Y) where, X

= Stock Return and Y = Index Return, we get the Beta as 1.72.

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

After we have collated the unlevered beta for all the comparable companies, we compute the industry average/median unlevered beta. The industry average/median unlevered beta is then re-levered using the unlisted company’s debt-equity ratio to arrive at the beta  of  the unlisted  company. The formula for re-levering the beta is mentioned below:


Now that, we have walked  through the process of  computing beta for listed as well as unlisted entities, the input needs to be inserted  in  the  CAPM model, to arrive at the cost of equity using the below mentioned formula:

 

 Valuation of Preference Shares

With the Indian accounting requirements moving from Indian Generally Accepted Accounting Principles (‘I-GAAP’) to Indian Accounting Standards (‘Ind AS’), a critical change is the requirement to recognize financial instruments at their fair value (albeit with few exceptions) in the financial statements as at the reporting date. This Chapter attempts to discuss  Valuation of preference shares, a common financial instrument appearing in the financial statements. The following Ind AS standards apply to them:

  • Ind AS 32: Presentation and classification of financial instruments;
  • Ind AS   109:   Recognition,  de-recognition, classification  and measurement of financial instruments;
  • Ind AS 113: Principles of fair value measurement that would be applicable to financial instruments;
  • Ind AS 107: Disclosures required with respect to financial instruments.

With respect to fair value measurement of preference share, we rely primarily on the principles discussed in Ind AS 113 and terms of its measurement as indicated in Ind AS 109.

Key Characteristics of Preference Shares

There are 3 main characteristics which define and drive a preference share Valuation – nature of coupon, redemption terms and conversion terms.

  1. Coupon: Coupon can be zero, cumulative or non-cumulative. Additionally, one might see instances involving moratorium in accrual/ payment of coupon for a part of the preference share
  2. Redemption: Redemption is the settlement in cash, either at maturity or in an amortizing fashion over multiple  redemption  Redemption may be defined in terms of a fixed  redemption premium, but far more popular option is to define it by an effective IRR requirement, with redemption premium quantum getting adjusted for coupon payments already made prior to redemption.
  3. Conversion: Conversion indicates settlement in equity shares of the Conversion may be defined in terms of a fixed or  formula  driven conversion ratio/ price.

Combinations of the above characteristics lead to various types of preference shares and this Chapter discusses Valuation of the following:

  1. Redeemable preference shares (‘RPS’);
  2. Compulsorily convertible preference shares (‘CCPS’);
  3. Optionally convertible preference shares (‘OCPS’);

Valuation

Before we discuss Valuation of preference shares, it will be useful to have a quick look at three classical Valuation approaches and some thoughts on Valuation approach,  which are typically applied in business  Valuation and  can be extended to financial instruments as well.

Income Approach: The discounted cashflow (DCF) analysis is the primary methodology used for Valuation of preference shares. Two inputs to the DCF model are cash-flows and the discount factor. Cash-flows are defined as per coupon, redemption and conversion terms of the underlying  preference  share. A Valuer must assess the achievability of the cash-flows required to service the coupon and redemption premiums indicated in the term sheet of preference shares. For the purpose of our discussions in this Chapter  we  have assumed that the company issuing the preference shares would have access to sufficient cash-flows. Discount factor is  based on market yield that  a comparable instrument will need to offer to raise funds as at the Valuation Date.

Market Approach: Convertible preference shares issued in  the time vicinity  of the Valuation date can be used as indicators of price, especially in case of redeemable preference shares. However, our quick assessment of the listed preference shares market in India indicates that the market lacks the depth. Most of the preference shares are privately placed and full feature disclosure  is not available in the public domain. Further, trade information/ frequency in case of listed preference shares is low. This poses a  challenge to  carrying  out any meaningful analysis based on comparable transaction method.

Cost Approach: Ind AS 109 allows recognizing financial asset/ liabilities through the amortized cost method, under specific circumstances, when the concept of SPPI (Solely held to collect principal and interest) is fully satisfied. This approach is not discussed further here.

Also, it would be relevant to observe that Valuation of certain  preference shares (especially those involving conversion) could require business/ equity Valuations, which is outside the scope of this Chapter. We assume that the reader is aware of business/ equity Valuation principles and the required Valuation numbers are available with the Valuer. Secondly, this Chapter discusses Valuations largely from the perspective of investor who  has  invested in to the preference shares.

Valuation of Preference Shares

Redeemable Preference Share (RPS)

Three variations can be noted on the basis of the nature of the coupon and redemption premium:

  1. Zero coupon redeemable preference share;
  2. Non-cumulative redeemable preference share;
  3. Cumulative redeemable preference

We have provided hereunder the illustrative workings on how  each  type, listed above, can be fair valued.

  1. Company A has issued a redeemable preference share to Company The RPS is zero coupon, with redemption IRR of 0%. It was issued on 31 March 2017 and will mature 5 years from the Issue date, i.e., 31 March 2022. A fair Valuation is required as at 29 March 2019.

In order to estimate the fair value of  the RPS on  29  March 2019, the fair  value yield as on 29 March 2019 has to be re-estimated.  Further,  as discussed earlier, it is assumed that the Company A has sufficient cash-flows to honor these preference shares.

Re-assessment of the yield can be done from two starting points:

Option 1: If comparable preference shares (w.r.t. features) has been issued close to the Valuation date, then the yield indicated by the transaction can be referred. The Valuer must ensure that the aforesaid preference share transaction should be recent, should be at arm’s- length and in the same currency as those issued by Company A.

In INR

Option 2: If Option 1 cannot be applied (due to  non-availability  of data), bond yields for comparable credit rating as that of Company  A can be used as a starting point. Bond yield can be based on  comparable bonds (of similar credit rating as Company A), if recently traded data as at the Valuation date is available. However, if sufficient/ reliable data is not available, the Valuer may choose to compute the bond yield based on methodology prescribed in the FIMMDA Valuation of Investments circular dated 29 March 2019. The bond yield is thereafter grossed up for the tax benefit (dividend  on  preference  shares is tax free in the hands of the investor), in accordance with the guidance presented for tax free bonds in the FIMMDA Valuation of Investments circular dated 29 March 2019, in the case where there is  no redemption premium13. The bond yield is thereafter adjusted for subordinated status to bonds14 to arrive at the yield that can be  used  for the fair Valuation of the Company A RPS as at the Valuation date.

Dates                                 Cashflows

31-Mar-17                                           (100.0)

29-May-19                                               -

31-Mar-22                                            100.0

 

IRR                                                                      0.0%

Valuation date                                                     29-Mar-19

Re-assessed yield*                                                  10.2%


 Fair value of RPS 76.0  

* Valuer re-assessed yield as at the Valuation Date

13 In cases where there is a redemption premium, the bond yield will need to be assessed in view of long term capital gains tax applicability.

14 In our experience, the Valuers have made an addition of 1-2% to discount rate to adjust for subordinated status of preference shares to bonds/ debt instruments.

  1. The RPS has a non-cumulative coupon of 15%. It was issued on 31 March 2017 and will mature 5 years from the Issue date, i.e., 31 March 2022. A fair Valuation is required as at 29 March

It would be relevant to observe that  dividend on  preference shares, if not paid, does not accrue. Depending on cash-flows generation in the business, it is possible to argue that dividend for certain years may not be paid. In such a case, dividend not expected to be paid, should be excluded from the RPS cash-flows, as no compensatory payment can  be made in the future years.

The yield assessment is in-line with the options available to ZCRPS as mentioned above. The key point of difference is the usage of the par yield (i.e. bonds which have regular coupon payment frequency)  instead of the zero coupon yield data. The zero coupon yield curve will be at a premium to the par yield curve, mainly because the absence of regular coupon payment increases the credit risk of the instrument and hence, the choice of curve is important to note.

Dates                                        RPS Contractual

 

In INR

Cashflows if  dividend not

 

Cashflows   expected to be  received for FY19

31-Mar-17

(100.0)

(100.0)

31-Mar-18

15.0

-

29-Mar-19

-

-

31-Mar-19

15.0

-

31-Mar-20

15.0

15.0

31-Mar-21

15.0

15.0

31-Mar-22

115.0

115.0

IRR

Valuation date

Re-assessed yield

15.0%

29-Mar-19

10.0%

 

Fair value estimates

127.3

112.3

 

  1. The RPS has a cumulative coupon of 15%. It was issued on 31 March 2017 and will mature 5 years from the Issue date, i.e. 31 March   A fair Valuation is required as at 29 March 2019.

The yield assessment is in-line with the options available to non- cumulative yield. The table below presents the contractual cash-flows and cash-flows considering FY18 dividend, which is expected to be received together with FY19 dividend.

 

 

 

In INR

Dates

Contruactual

cashflows

Cashflows - FY18 cashflows

expected to  come  in FY19

31-Mar-17

(100.0)

(100.0)

31-Mar-18

15.0

-

29-Mar-19

-

-

31-Mar-19

15.0

30.0

31-Mar-20

15.0

15.0

31-Mar-21

15.0

15.0

31-Mar-22

115.0

115.0

IRR

Valuation date

Re-assessed yield

15.0%

29-Mar-19

10.0%

 

 Fair value estimates                                                                   

127.3                                                              

142.3

Compulsorily Convertible Preference Shares (CCPS):

The variation in the nature of coupons – i.e., zero, non-cumulative and cumulative remains relevant in the case of CCPS as well and should be assessed in line with the discussions presented in the RPS section of this  note.

A further step in the CCPS fair Valuation is the factoring in of the conversion terms. Conversion terms could be of the following types:

  1. Conversion price is equal to fair value of the underlying share;
  2. Conversion ratio is 1:1;
  3. Either conversion ratio or conversion price is based on a formula (generally linked to revenue or profit achieved at maturity)

We have provided below illustrative working on how each type, listed above, can be fair valued.

  1. Company A has issued a Compulsorily Convertible Preference Share (‘CCPS’) to Company The CCPS has a cumulative compounding coupon of 0.1%. The CCPS will be compulsorily convertible into equity shares of Company A at the maturity date. The Conversion price is equal to the fair value of the equity share of Company A. CCPS was issued on 31 March 2017 and will mature 5 years from the Issue date,

i.e. 31 March 2022. A fair Valuation is required as at 29 March 2019.

In this example, the accrued dividend and principal  on  the maturity  date would be divided by  the then  fair value per share of  Company A  to arrive at the number of shares. The fair value of the CCPS is  therefore nothing but the rolled up (for coupon) principal amount as at the Valuation date.

  1. Company A has issued a Compulsorily Convertible Preference Share (‘CCPS’) to Company The CCPS has a cumulative coupon of 0.1%. The CCPS will be compulsorily convertible into equity shares of Company A at the maturity date. Conversion ratio is 1:1, i.e., each preference share shall convert into one equity share of Company A. CCPS was issued on 31 March 2017 and will mature 5 years from the Issue date, i.e., 31 March 2022. A fair Valuation is required as at 29 March 2019.

The above instrument is considered quasi equity. Since the conversion ratio is fixed at 1:1, the fair value of each CCPS is nothing but the fair value per share of Company A as at the Valuation date. There is an argument to consider discount to  the fair value per share of  Company  A to reflect the lack in marketability till the maturity date.

  1. Company A has issued a Compulsorily Convertible Preference Share (‘CCPS’) to Company The CCPS has a cumulative compounding coupon of 0.1%. The CCPS will be compulsorily convertible into equity shares of Company A at the maturity date. Conversion ratio is linked to achievement of actual performance (say, EBITDA) by Company A at maturity date, i.e., each preference share shall convert to X equity shares of Company A. And, X is based on EBITDA at maturity date. CCPS was issued on 31 March 2017 and will mature 5 years from the Issue date, i.e. 31 March 2022. A fair Valuation is required as at 29 March 2019.

Expected conversion ratio as at the maturity date, needs to be estimated on the Valuation date. There are two solutions (while many other variants may be considered) on how the EBITDA at maturity should be determined

Solution 1: Deterministic: EBITDA based on future projections as prepared by the management of Company A. The expected conversion ratio is worked out based on this expected EBITDA in FY22. The fair value of the CCPS on the Valuation date is the aforementioned  expected conversion ratio multiplied with fair value per share of Company A as at the Valuation date.

Solution 2: Simulated: Possible equity values of Company A  as  at  the maturity date can be simulated using Monte Carlo simulations – Black Scholes framework. For each EBITDA, a simulated conversion ratio is computed. The fair value of the CCPS on the Valuation Date is the average of the aforementioned expected conversion  ratios multiplied with fair value per share of Company A as at the Valuation Date.

Note: Sensitivity of the end result to the profitability multiple should be assessed and quantified.

The usage of either solutions enumerated above is debatable. One might argue that Solution 1 is easy to implement and regular re- Valuation exercise takes it closer to the payoff achieved at maturity. Solution 1 however does not consider probability of occurrence weighted scenarios for the EBITDA values at maturity and therefore is generally further away from the true price than Solution 2 on a given Valuation Date. Solution 2 requires technical knowledge w.r.t implementation of the Monte Carlo simulation.

The examples above make a simplistic assumption w.r.t the conversion being allowed only at maturity. There might be cases of conversion at the option of the Investor, which adds to the complexity of the fair Valuation of the CCPS. Option models which allow for scenario analysis such as Binomial model and Monte Carlo models can be used to model these complexities.

Optionally convertible redeemable preference shares (OCRPS)

The variations in the nature of coupons – i.e zero, non-cumulative and cumulative remain relevant in the case of OCRPS as well and should be assessed in line with the discussion presented in the RPS section of this Chapter.

A further step in the OCRPS fair Valuation is the factoring in of the choice between redemption and conversion that the investor is faced with. The following are the types:

  1. Redemption value at maturity date is assessed at the accrued unpaid value, conversion is at fair value of the underlying share;
  2. Redemption value at maturity date is assessed at the accrued unpaid value, conversion ratio is 1:1;
  3. Redemption value at maturity date is assessed at the accrued unpaid value, either conversion ratio or conversion price is based on  a  formula (generally linked to revenue or profit achieved at maturity)

We have provided hereunder illustrative working on how each type, listed above, can be fair valued

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

 

The call option captures the upside that the investor might get to participate over and above the value accrued through the redemption route.

  1. Company A has issued an optionally convertible redeemable  preference share (OCRPS) to Company The OCRPS has a cumulative compounding coupon of 10%. The OCRPS will be can be either redeemed or converted at the option  of  Company  B.  Redemption value at the maturity date is the accrued value of the investment. Conversion ratio is linked to achievement of a particular EBITDA by Company A at maturity, i.e each preference share shall convert to X equity shares of Company A. And X is defined based on EBITDA at maturity date. OCRPS was issued on 31  March 2017 and  will mature 5 years from the Issue date, i.e 31 March 2022. A fair Valuation is required as at 29 March 2019.

The solutions offered in CCPS (3) are available fora Valuation of a financial instrument of this type. However the introduction of the redemption feature payout acts as a floor against which the payout of the conversion feature needs to be tested against. Option models such as binomial model and Monte  Carlo model, with  provision for defining   a floor (based on redemption value) can be considered in carrying out the fair Valuation exercise.

Fair Value Measurement-Ind AS 113 :
 Definition

Fair value is the mantra of today in financial reporting  across  borders.  In India also, the Institute of Chartered  Accountants of  India  (ICAI) converged its accounting standards with IFRSs and accordingly, corporate financial statements beginning accounting year 2016-17 started disclosing financial figures based on fair value measurement. One of the purposes of fair value measurement is to narrow the gap between the balance sheet value and market value of a company. Fair value measurement aims at fair recording of  a business transaction so that the financial statements are able  to  show a  true and fair view of the profitability and financial position.

Indian Accounting Standard (Ind AS) 113 is a dedicated standard which provides guidance on Fair Value Measurement (FVM). In this Chapter we will discuss about the objective, scope, key concepts and definitions, as prescribed in Ind AS 113 on Fair Value Measurement.

A. Objective of Ind AS 113

This Ind AS:

  • Defines Fair Value
  • Sets out a Framework for measuring Fair Value
  • Requires Disclosures about fair value measurements

B. Scope

This Ind AS applies when another Ind AS requires or permits fair value measurements or disclosures about fair value measurements

The measurement and disclosure requirements of this Ind AS do not apply to the following:

  • Share based payment transactions within the scope of Ind AS 102, Share based Payment
  • Leasing transactions within the scope of Ind AS 17, Leases
  • Measurements that have some similarities to fair value but are not fair value, such as net realisable value in Ind AS 2, Inventories, or value in use in Ind AS 36, Impairment of Assets

The disclosure requirements by this Ind AS do not apply to the following:

  • Plan assets measured at fair value in accordance with Ind AS 19, Employee Benefits
  • Assets for which recoverable amount is fair value less costs  of  disposal in accordance with Ind AS 36, Impairment of

C. Definitions

1.    Fair Value (FV)

“Fair Value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between Market participants at the Measurement Date.

 

1

FV is Exit Price

Fair Value is the price to sell an asset or  transfer a liability, and therefore represents an exit price, not an entry price

2

FV is Not Transaction Price

The transaction price is NOT presumed to represent the fair value of an asset or liability on its initial recognition

3

FV in Principal Market

Fair value is an exit price in  the  principal market (or in absence of a principal market, the most advantageous market) in which reporting entity would transact

4

FV is Market based measurement

Fair Value is a market  based  measurement, not an entity specific measurement

5

FV                    excludes

Transaction Costs

Fair Value measurements should not be adjusted for transactions costs

Note: The definition of fair value focuses on assets and liabilities because  they are a primary subject of accounting measurement. In addition,  this Ind  AS shall be applied to an entity's own equity instruments measured at fair value.

2.    Active Market

A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.

3.    The Asset or Liability

A fair value measurement is for a particular asset or liability. An entity shall  take into account the characteristics of the asset or liability at the time of measurement of fair value as if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Such characteristics include, for example, the following:

  • the condition and location of the asset; and
  • restrictions, if any, on the sale or use of the asset

4.    Entry Price

When an asset is acquired or a liability is assumed in an  exchange  transaction for that asset or liability, the transaction price is the price paid to acquire the asset or received to assume the liability.

5.    Exit Price

The fair value of the asset or  liability is the price that would be  received to  sell the asset or paid to transfer the liability.

D. Key Concepts

Transfer of Liability versus. Settlement of Liability

  1. When liability is transferred to market participants then  it  continues and not
  2. “Transfer” reflects market-based measurement & excludes  firm  specific efficiencies or inefficiencies

Fair Value may not be equal to Transaction Price

  1. When transaction is between related parties
  2. Where transaction occurs under duress or force
  3. Unit of account represented by the transaction is different from that of the asset or liability
  4. Market in which the transaction occurs is different from the principal or most advantageous market

Fair value for Financial Reporting vs. Fair Market Value (FMV)

  1. Fair value has a hierarchy of inputs for Valuation but FMV does not have it
  2. Fair Value uses HABU for non – financial assets Valuation resulting in maximising value against consensus value under FMV
  3. DLOM adjustments may be required in certain cases under Fair Value but DLOC is doubtful
  4. Fair value disregards blockage discount (decline in value due to size)

Particular asset or liability that is the subject of measurement

A fair value measurement is for a particular asset or liability. The characteristics of the asset or liability that market participants would take into account when pricing the asset or liability at the measurement date shall be taken into account. Such characteristics include:

  • the condition and location of the asset
  • restrictions, if any, on the sale or use of the asset

The asset or liability measured at fair value might be either of the following:

  • a stand-alone asset or liability (e.g. a financial instrument or a non- financial asset); or
  • a group of assets, a group of liabilities or a group of assets and liabilities (e.g. a cash-generating unit or a business).

Principal (or most advantageous) market

The transaction to sell the asset or transfer the liability takes place either:

  • in the principal market or
  • in the absence of a principal market, in the most  advantageous 

Highest and best use for a non-financial asset

A fair value measurement of a non-financial asset takes into account  a  market participant’s ability to generate economic benefits by using  the asset  in its highest and best use. The highest and best use of a non-financial asset takes into account the use of the asset that is

  1. Physically Possible
  2. Legally Permissible
  3. Financially feasible

Highest or best use is usually (but not always) the current use – if for competitive reasons an entity does not intend to use the asset at its highest and best use, the fair value of asset still reflects its highest and best use by market participants (defensive value).

Fair Value Hierarchy

To increase the consistency and comparability in fair value assignments and related disclosures, fair value hierarchy  categorises inputs into three levels   as defined below.

·             Input Level 3 (Unobservable)

Inputs that reflect management’s own assumptions about the assumptions that a market participant would  make  (E.g.  Projected cash flows used to value a business or non-controlling interest in an unlisted entity)

·             Input Level 2 (Indirectly Observable)

  1. Prices in active markets for similar assets / liabilities
  2. Quoted prices for identical / similar items in markets that are not
  3. Inputs other than quoted prices (E.g. Interest Rates and yield curves, implied volatilities )

·             Input Level 1 (Directly Observable)

Quoted prices in active markets for identical assets / liabilities (E.g. Quoted prices for an equity security on the BSE/ NSE).

 

 

Cost of Capital in Goodwill

 Impairment

Impairment means the state of being diminished, weakened, or damaged. Goodwill impairment is a charge that companies record when goodwill's carrying value on financial statements exceeds its fair value. In accounting, goodwill is recorded after a company acquires assets and liabilities, and pays  a price in excess of their identifiable value. Goodwill impairment arises when there is deterioration in the capabilities of acquired assets to generate cash flows, and the fair value of the goodwill dips below its book value.

Indian Accounting Standard (Ind AS) 36, Impairment of Assets (the standard) sets out the requirements to account for and report impairment of most non- financial assets. As a result, goodwill impairments have inevitably increased and companies have placed an additional focus on their impairment testing procedures.

One of the key inputs while performing the impairment test is the cost of  capital or discount rate. Determining the appropriate cost of capital is  often  like a pandora box, but in uncertain economic conditions, its difficulty even compounds due to volatile share prices affecting betas; risk free rates  reaching record lows; and reduction in debt liquidity affecting the cost of debt for many companies.

Indian Accounting Standards require the annual impairment  testing  of goodwill and other assets in accordance with Ind AS 36. Ind AS 36 specifies when an entity needs to perform an impairment test, how to perform it, recognition of any impairment losses and the related disclosures.

Ind AS 36 deals with impairment testing for all tangible and intangible assets, except for assets that are covered by other Ind AS. Ind AS 36 requires that assets should be carried at no more than their recoverable amount. To meet this objective, the standard requires entities to  test all assets that  are within  its scope for potential impairment when indicators of impairment exist or, at least, annually for goodwill and intangible assets with indefinite useful lives.

The process for measuring and recognising impairment loss under Ind AS 36 could be presented in a flowchart:

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

Key Requirements of IND AS 36

The entity assesses, at each reporting date, whether there is any indication that an asset may be impaired.

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

Indicators of impairment

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

Recoverable amount

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

Fair value less cost to sell

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

Value in use

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

Estimating the Future Cash Inflows and Outflows

The starting point for estimating future cash flows is the most recent financial budget or forecast approved by management. From this starting point, the budget or forecast typically needs to be both adjusted and extrapolated. Ind  AS 36 specifically requires that these budgets/forecasts are adjusted to:

  • exclude any estimated future cash inflows/outflows expected to arise from future restructuring or improving or enhancing the asset’s performance (Para 33)
  • exclude cash inflows or outflows from financing activities or income tax receipts/payments (Para 50)
  • include costs for day-to-day servicing, future directly attributable overheads (Para 41) and cash flows necessary to maintain the level of economic benefits expected to arise from the asset in its current condition (Para 49)
  • cover a maximum period of five years (unless a longer period can be justified). Cash flow projections needed beyond the period covered must be estimated by extrapolating the budget/ forecast projections using a steady or declining growth rate  for subsequent years (unless  an increasing rate can be justified) (Para 33)
  • incorporate net cash flows, if any, to be received (or paid) for the disposal of the asset at the end of its useful life (Para 39).

This list of adjustments is not exhaustive. The specific adjustments required    in each case will naturally vary depending upon the basis of the budgets or projections used as  a starting point and the nature of expected cash flows. It  is also essential to ensure that the estimates and projections are based on reasonable and supportable assumptions.

Applying the Appropriate Discount Rate

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

Pre-tax versus post-tax discount rate

While Ind AS 36 requires the use of ‘a pre-tax discount rate’ for the  discounting of cash flows, it has long been accepted  by  Valuation practitioners that the direct determination of a pre-tax cost  of  capital  is difficult if not impossible to derive.

When valuing a firm or business, the most widely used method  for  determining a discount rate is the weighted average  cost  of  capital (“WACC”). In theory, this is calculated by weighing the costs of debt  and equity capital at a target or optimal capital structure. The capital asset pricing model (“CAPM”) is most often used as the basis for determining the cost of equity. The data needed to build up the cost of equity using  CAPM  is generally based on observable market-based information. As companies pay tax in the real world, the equity market data observable to  derive inputs such as beta, gearing, etc. is all based on post-tax observations. Pre-tax equivalents are not directly observable.

How to calculate Pre-Tax Rate

One solution to this problem could be simple grossing up your  post-tax market rate and tax rate, like in the following formula:

PRE-TAX RATE = POST-TAX RATE / (1 – TAX RATE)

Although this method is very simple, it should be used rarely.. For example, when the asset or CGU is not that material to your company, or variance in a discount rate does not cause any material errors in value in use.

Why not use this simple method as the basic one? The main reason is that in most cases, the timing of your tax payments is never the same as  the timing  of your tax base (income and expenses). Many entities pay taxes one year after obtaining taxable revenues and expenses. And that might cause significant difference in your real pre-tax rate and pre-tax rate calculated this way. You should bear in mind that pre-tax rate must take not only assets’ / CGU’s post-tax rate and relevant tax rate into account, but also assets’ /  CGU’s useful life and timing of future cash flows.

So how to calculate pre-tax rate more precisely? If you have obtained market rate that is post-tax and you have pre-tax cash flow projections for your asset

/ CGU under review, you can try to use this method. It’s kind of other way  round and involves the following 3 steps:

Step 1: Estimate post-tax cash flows

First of all, we shall calculate asset’s / CGU’s value in use with application of post-tax rate. But hang on for a minute – we have post-tax rate and pre-tax cash flows and this inconsistency would not give us the answer even close to correct. Therefore, we need to do the following:

  • Estimate future tax payments from our pre-tax cash flow Do it on a year-by-year basis. But be careful here. If you want to be really precise, you should take various tax issues into account – for example, future tax allowances related to asset / CGU, utilization of future tax losses, temporary differences, etc. Simply – try to estimate tax payments as realistic as possible, not by multiplying tax base and tax rate.
  • Deduct estimated future tax payments from pre-tax cash flows. And  also do it on a year-by-year

Step 2 – Calculate value in use on post-tax basis

That is clear. You have post-tax cash flows in your table and you also have post-tax discount rate. So, using discounting technique, get present value of your post-tax cash flows.

When calculating value in use, you should be consistent to avoid double counting. And, you should arrive to the same result. So, when you calculate value in use using post-tax cash flows and post-tax discount rate, that rate shall be the same as calculated from pre-tax values. In other words:

= post-tax cash flows discounted by post-tax rate

= pre-tax cash flows discounted by pre-tax rate

= value in use

Step 3 – Calculate pre-tax rate from value in use and pre-tax cash flows

We just need to work out the rate at which the present value of pre-tax cash flows equals the value in use. This is not as easy as it seems, because it requires using certain iteration technique. But all is doable!

Conclusion

Generally, companies and their advisors have accepted that the practical solution to this problem is to determine the value in use using post-tax cash flows and a post-tax WACC. The pre-tax WACC needed for disclosure as required by Ind AS 36 can then be determined by eliminating tax from  the  cash flows and back solving (an iterative process) to determine the pre-tax WACC that equates to the same value in use.

It should be noted that simply grossing up the post-tax WACC based on the marginal tax rate will not, in most circumstances, result in the same pre-tax WACC.

Further, International Accounting Standard 36 Para BCZ 85 states that in theory, discounting post tax cash flows at a post-tax discount rate and discounting pre-tax cash flows at a pre-tax discount rate should give the same result, as long as the pre-tax discount rate is the post-tax discount rate adjusted to reflect the specific amount and timing of the future tax cash flows. The pre-tax discount rate is not always the post-tax discount rate grossed up by a standard rate of tax. The same paragraph in the “Basis for Conclusions” provides an example as to how both approaches might differ and result in different indications for value in use.

As a result, a supportable impairment review requires that the discount rate and the long-term growth rate are both technically correct and also consistent with each other and the forecast cash flows. Industry norms can therefore provide a benchmark, but a rigorous review of the specific circumstances of the asset being valued and the risk associated with  the expected cash flows  is still required.

 

Brand Valuation

“If this business were to be split up, I would be glad to take the brands, trademarks and goodwill and you could have all the bricks and mortar - and I would fare better than you”

-John Stuart, Former Quaker Oats Chairman

“Your brand is what people say about you when you are not in the room”

Jeff Bezos, CEO Amazon

Introduction

Brands and their underlying trademarks are an important element  of  the  value of a business. They are intangible assets that contribute to the increasing gap between observed market capitalizations versus  reported  book values of companies. In today’s world of new age technology and consumer awareness, the scope of brand for an organization is not  just  limited to a name or a logo but much more than  that. This is  all because of  the impact a brand can have on the customer choices, investors, company’s image etc.

The term ‘brand’, refers to names, signs, symbols, colors, logos etc. that help to identify goods, services or companies. It is something which a consumer associates itself with and considers as a promise by the brand that they will conform to the expectations that they have created over time in the minds of their customers.

World’s five most valuable brands as recognized by Forbes magazine  for  2018 are :

  • Apple: $182.8 billion
  • Google: $132.1 billion
  • Microsoft: $104.9 billion
  • Facebook: $94.8 billion
  • Amazon: $70.9 billion

Reasons/ Need For Brand Valuation

A study by Interbrand in association with JP Morgan concluded that on an average brands account for more than one-third of shareholder value. Thus, brands are one of the most important strategic assets of an organization and may require Valuation under following circumstances:

  • Financial Reporting - Purchase Price Allocation
  • M&A Decisions
  • Licensing
  • Tax Planning
  • Dispute Resolution
  • Liquidation
  • Litigations
  • Raising Funds

Brand Valuation Approaches/ Methods

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

Popular brand Valuation methods and approaches include:

A.   Cost Approach

This approach is primarily concerned with  the cost in  creating or  replacing  the brand. It comprises of following two methods:

1.    Reproduction Cost Method

This method aggregates all the historical marketing costs as the value of the brand. In other words, the method involves historical cost of  creating  the brand as the actual brand value. It is often used at the initial stages of brand creation when specific market application and benefits cannot yet be  identified.

2.    Replacement Cost Method

This method values the brand by considering the expenditures and investments necessary to replace the brand with a new one that has an equivalent utility to the company. Although this method is easy in terms of calculation, it neglects the success of an established brand. The first brand in the market has a natural advantage over the other brands as  they  avoid clutter and with each new attempt, the probability of success diminishes.

This approach is generally not considered because there is no direct correlation between cost incurred in creating the brand and market value of  the brand.

B.   Market Approach

In this approach a comparison with the other brands in  the market is done. For example, if a person wishes to buy a property in place A, it is quite likely that the price at the neighborhood would be checked before arriving at a conclusion on the existing property, leading to an approach based on the market. This Valuation method relies on the estimation of value based on similar market transactions (e.g. similar license agreements) of comparable brand rights.

This approach contains two methods namely:

  1. Sales Comparison Method
  2. Market Multiples Method

Both of these methods involve Valuation of the brand by looking at the recent transactions involving similar brands in the same industry and referring to comparable multiples.

This approach is generally not considered due to non-availability of reliable data for comparable brands. Also, the price paid for a similar brand includes the synergies and the specific objectives of the buyer and it may vary leading to the value of similar brand not being directly comparable to the brand being valued.

C.   Income Approach

It is the most common approach to measure the value of a brand. This approach estimates the price an asset could be sold for in an arm’s length  transaction on the basis of the asset’s expected future income stream. This involves estimating the present value of future economic benefits attributable to the owner of an asset and incorporating as much observable market data into the Valuation as possible. In the Income Approach, expected future  returns from an investment in the form of cash flows are  discounted  to  present value at an appropriate rate of return  for  the  investment.  The selected discount rate or rate of return should reflect  the  degree  of uncertainty or  risk associated with the future returns and returns available  from alternative investments. Higher uncertainty or risk leads to higher expected rate of return, which produces a lower value for the investment.

This approach can be characterized by six methods which are explained below:

1.    Relief from Royalty Method

This is the most widely resorted method used to determine the value of the brand. This method assumes that the brand is not owned by the branded business but is licensed from a third party. If brand has to be licensed from a third-party, a royalty rate on turnover will be charged for privilege of using the brand. Thus, the brand value is deemed to be the present value of the royalty payments saved by virtue of owning the brand.

2.    Relative Discounted Cash Flow Method

The incremental cash flow method identifies all cash flows generated by the brand in a business, by comparison with comparable  businesses  with  no such brand. Cash flows are generated through both increased revenues and reduced costs. However it is rare to find  conditions for this method  to  be  used since finding similar unbranded companies can be difficult.

3.    Residual Value Method

The method entails segregation of the value of the total tangible assets from the total business value. The residual value after deducting the value of tangible assets from the business value is attributable to the  intangible  assets.

4.    Premium Price Method/ Profit Differential Method

Under this method, the asset is valued by considering the premium profit generated by a company, using intangible assets and comparing it with a business not utilizing a comparable intangible asset. The resultant figure is then capitalized to form a value for the intangible assets.

5.    Multi-Period Excess Earnings Method (MEEM)

The Multi-Period Excess Earnings Method is commonly used when a reliable direct measurement of future economic benefits generated by an intangible asset is not possible. However, revenue and earnings to those assets can be readily determined. The method adopts a ‘residual approach’ for estimating the income that an intangible is expected to generate. The premise of the excess earnings method is that the value of an asset is represented by the discounted future earnings specifically attributed to that asset, that is, in  excess of returns for other assets that contributed to those earnings. The excess earnings method examines the economic returns contributed by all assets utilized in generating earnings, and then  isolates the excess return   that is attributed to the specific asset being valued.

MEEM is applied to a wide variety of intangible assets, especially those that are close to the ‘core’ of the business model. Customer relationship assets, technology, and IPR&D are among the intangible assets which are frequently valued using MEEM.

Under this method, the value of an asset is a function of:

  • Projected revenue and earnings generated by the asset;
  • Expected economic life of the asset;
  • Contributory asset charges that would be paid to the requisite operating assets; and
  • A discount rate which reflects risk associated with receiving  future  cash

6.    Favourable Contract Method

A favourable contract arises from an arrangement that affords one of the parties a below-market rate for a good or service. This may be from paying  rent for a building at below-market rates or being granted the use of a trademark for a royalty rate  that is lower than  the going market rate. Similar to the “with and without” method to value the arrangement, cash flows are  computed using market rates and also under the present arrangement. The difference between these values is the value of the asset.

In the next section, Royalty Relief Method is explained in detail which is the most widely used method to determine the value of the brand.

Relief from Royalty Method (RRF)

This is the most widely used method to determine brand cash flows, the  reason being that it is grounded in commercial reality and can be easily benchmarked against real world transactions. This method is a  combination of market and income approach where value is determined on the basis of avoided cost.

Key factors to be considered while using this method are:

  1. Appropriate Royalty Rate
  2. Revenue Projections
  3. Discount Rate

Various steps involved in RRF are as presented below:

Step 1: Ascertaining the Brand Specific Financial and Revenue Data

For brand Valuation via RRF, firstly we need to  ascertain the brand revenue  to be generated from utilizing the brand over its projected  life.  Projected brand revenue is generally estimated after considering the historical revenue trends of the company, doing industry analysis and discussion with the management. Further market demand of  the  company’s products in  relation to its competitors should also be taken into account  along  with  long  term GDP growth of the country.

Step 2: Ascertaining the Royalty Rate in Relation to the Brand

Royalty rates cannot be evaluated in vacuum. Arm’s length licensors and licensee negotiate royalties within a dynamic matrix of strategic, economic  and legal considerations, each term and condition in a  license  agreement may shift the risk from one party to the other and therefore shall  be  considered in determining the appropriate royalty rate or range thereof.

There are various sources, both internal and external which help the valuer in the determination of royalty rate.

  • Some of external sources are listed below:
    • License agreement covering a similar patent or trademark granted by the licensor owning the subject property to a third party

These agreements can be extracted from various royalty data bases such as: Royaltystat, Royalty source, ktMINE etc.

  • News articles and magazines such as Financial World which provide  an annual survey of some top value Brands

Royalty rates extracted above need to be adjusted (up or down) to  fit  the particular facts and circumstances. For this, their compatibility is evaluated on various factors such as:

  • Industry/ Subject Business
  • Nature of Product/ Service
  • Geography
  • Exclusivity- exclusive arrangements may command higher rates
  • Market Positioning – brands with better market positioning may command higher rates
  • Internal source includes using the price premium method for  calculating the royalty
    • In this Royalty rates are computed based on the price premium commanded by company in each product category/ segment. In order to calculate the price premium, prices for company’s product is compared with the prices of similar products of other Please note, prices to be considered here should be the price at which product is  sold to  the first party and nor the retail price of the product which are generally adjusted for  discounts. Further, to get a better understanding of prices and to confirm the price premium, discussion with the various industry participants such as wholesalers, retailers etc. should be done if possible.
    • Further an effective product premium for each product segment is calculated by multiplying the price premium with the sales proportion of the respective
    • The price premium calculated above can’t be entirely  attributable to There are various other factors which contribute to this price premium. Accordingly, based on various factors associated with the industry such as customer reach, distribution, scale of operations etc. and on the basis of the discussion with the management and industry participants (wholesalers & retailers) an appropriate weightage for brand is  assumed and final royalty rate is selected.

Step 3: Ascertainment of Net Royalty Saving Post Tax

Royalty rates computed above is applied on the brand revenue to  calculate  the royalty savings on  account of  owning the brand. This royalty saving is  then reduced by the estimated brand promotion and marketing  expenses which are incurred by the owner of the brand. These expenses are generally considered on the basis of percentage of sales  on  account  of  historical trends of the company, to calculate the net royalty savings.

Net royalty savings are further reduced by the marginal income tax, to calculate net royalty savings post tax.

Step 4: Ascertainment of Appropriate Discount Rate

An appropriate discount rate needs to be  ascertained which can be  applied  on the post-tax royalty savings to calculate their present value

The calculation of the appropriate discount rate to estimate an intangible asset’s fair value requires certain considerations which are as follows:

  • The discount rate should be determined considering the market- participant assumption
  • The discount rate should reflect the risks commensurate with the intangible asset’s individual cash flows

In general, the risk profile of each asset category should be considered when estimating the appropriate rates of return. The valuer should consider the liquidity of the assets on the balance sheet on a spectrum  from  working capital (most liquid) to the intangible assets (least liquid). In addition,  the valuer can consider the assets based on  their ability to be  financed by  debt or equity.

Therefore, the weighted average cost of capital (WACC) is calculated and  further an appropriate risk premium is adjusted to calculate the discount rate.

Step 5: Ascertainment of Brand Value

The discount rate calculated as above is applied on the net royalty savings to calculate their net present value. These net present values for explicit years are added to calculate the value of the brand. Further notional benefit of tax amortization benefit (“TAB”) is added to calculate the final value of the brand.

 

Other Points to be Considered

1.    Tax Amortization Benefit

In the Valuation exercise of individual intangible assets, the future amortization of an individual intangible asset must be considered as a component of the aggregate value of the subject intangible asset. In the context of valuing intangible assets, the tax amortization benefit is an uplift to reflect the value of the tax-shield afforded by the amortization of capitalized intangible assets.

This exercise assumes that a hypothetical buyer could capitalize the  intangible asset and reduce future taxable income through amortization over   a certain period pursuant to the applicable tax regulations. This tax shield is discounted to present value and added to the pre-amortization value to determine the fair value.

2.    Remaining Useful Life

Economic and useful lives are key inputs to Valuation and generated income  of acquired assets. The key considerations include:

  • Longevity: The period over which the asset is expected to be used and contributing to the cash flows

 

 

  • Typical product life cycle of the asset: Any legal, regulatory or contractual provisions that may limit the useful life must also be considered
  • Historical experience of using a similar acquired asset
  • The impact of anticipated changes in consumer demands, preferences and tastes along with the impact of other economic and industry changes
  • The level of expenditures (including ongoing marketing  and advertising) required to maintain the asset
  • The life of other related assets
  • Technical, technological, commercial or any other type  of obsolescence

Factors that impact the amortization period of an asset should also be considered in determining the period of cash flows to be used in valuing the asset. For this reason, companies typically look  for the period over which  cash flows used in the asset’s Valuation are forecasted in order to determine an appropriate amortization period or reach to an indefinite-life classification.

 

Valuation of Intangibles

What is an Intangible Asset?

The International Glossary of Business Valuation Terms describes intangible assets as non-physical assets such as franchises, trademarks, patents, copyrights, mineral rights, customer contracts or relationships, etc. that grant rights and privileges, and have value for the owner.

Intangible assets are assets in addition to financial and tangible assets and working capital. Under Ind AS 38 an intangible asset is defined as An identifiable non-monetary asset without physical substance. From an accounting perspective, it has the following key attributes:

  • Identifiability - they are separable or may arise from contractual  or other legal rights,
  • Future economic benefits – their existence depends on expectation of future benefit such as revenue or cost savings or other benefits resulting from their use; and
  • Control - the owner can control the use or restrict the access to the future economic benefit

Need for Valuation of Intangibles

Intangibles are an increasingly key component in determining the value of an enterprise. In industries such as pharmaceuticals, technology, fashion and consumer goods, to name a few, intellectual property is a major enterprise value driver.

Furthermore, the convergence of Indian Accounting Standards with IFRS has brought Valuation of intangible assets to the fore as they comprise a  significant asset class in the allocation of the purchase price in case of Business Combinations under Ind AS 103 and Ind AS 38 which deal with the accounting treatment of intangible assets.

Besides financial reporting, intangible assets such as patents, brands, technical know-how, etc. are also bought and sold / transferred; albeit through usually confidential agreements; which obscures the basis on which  its value is determined. How then, is the value of such an asset determined?

Principle for Measurement

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

Valuation Approaches and Methodologies

The generally accepted Valuation approaches comprise of Market Approach, Income Approach, and Cost Approach. Each approach has its  own advantages and disadvantages. Thus, depending on the circumstances of each case; for instance, asset type, information availability and  quality  thereof, risk characteristics, etc. a particular approach might be used. The selection of the approach and methodology is a process of elimination and often the valuer will use more than one method under different approaches to corroborate or set a guideline for an estimate of the fair value. Moreover, depending on the approach and methodology used, the Valuation may be predicated on either historical or prospective financial information along with contemporaneously available market data.

The Valuation approaches and key methodologies under each are briefly discussed hereunder:

  • Market Approach: This approach uses market-based indicators of It is based on the premise of efficient markets and supply & demand. It estimates fair value by reference to observable  market  price data or transactions of comparable intangible assets. However, given that there is no active market for trading in intangible assets, comparable transactions may be used under this approach.

Comparable Transaction Method: Transactions occurring in a  free and open market between knowledgeable and willing buyers  and  sellers conducted on an arm’s length basis can be used to determine benchmark metrics for the purpose of valuing the  comparable  intangible asset. While evaluating comparability, factors such as  age   of the asset, applicability of use, locational / geographical access  or use, risk and expected return characteristics, etc. are considered. Typical benchmarks include multiples of revenue or profitability.

However, while an ideal method, it has limited practical applicability.  For one, observable market-based transactions of identical or substantially similar intangible assets are often difficult to obtain. Such transactions are generally confidential and often involve other negotiated terms with respect to marketing, financing, use restrictions, etc. which influence price but the existence of such arrangements  is  not publicly known. A further limitation is a lack of comparability - by nature, intangible assets usually enjoy unique characteristic, which almost always necessitates adjustments to be made to the benchmark metric.

Consequently, depending on the quality of data, if available,  the  method is generally used as a means to  corroborate the value arrived  at under other Valuation methods.

  • Income Approach: The income approach uses estimates of future estimated economic benefits or cash flows and discounts them for the associated time and risks involved to a present The method is founded on the principal of anticipation – whether of  revenue streams or cost savings or other economic benefit. Thus, it finds maximum applicability in the Valuation of intangible assets such as brands, customer relationships, copyrights, patents, etc. which generate a  future income or cash inflow stream. However, a key area of difficulty under this approach lies in separating the cash flows exclusively pertaining to the asset under Valuation from that of the enterprise as a whole.

The discount factors typically used in such instances are the weighted average cost of capital (WACC), or weighted average return on assets (WARA), or the Internal Rate of Return (IRR) of the investor specific to the asset being valued. Thus, depending on the risk and return profile of the asset, a suitable discount factor would be applied to  the cash  flow stream to arrive at the present value.

This approach includes the following commonly used methods:

  • Relief from Royalty Method: The Relief from Royalty method is based on the principle that, if the business did not own the asset, it would have to in-license it in order to earn the returns that it is  Alternatively, the business could out-license the asset if it did not wish to use it. Thus, the value of  the  asset is calculated based on the present value of the royalty  stream that the business is saving by owning the asset.

Under this method, a royalty that could be expected to be obtained in normal commercial practice is applied to  an  estimated level of future maintainable sales and the resultant after-tax royalty stream is computed. Such computed after-tax royalty stream is discounted using a relevant discount factor to arrive at the value of the asset.

The method is popularly employed in the Valuation of intangible assets such as brands, licences and technical know-how, where transacted royalty rates for similar assets are often available. These rates are then adjusted for asset  specific  risks  and returns such as geographical use restrictions, brand recall, etc.  to arrive at a suitable royalty rate.

Pitfalls with rules of thumb: It may be the case that  past  or current transactions for royalty rates for similar  assets may not be available. In such instances, a generally accepted heuristic is the “25%-profit split” method. The 25% Rule as defined by Goldscheider et al (2002) suggests that a licensee should pay a royalty rate equivalent to about 25 % of the expected profits for the product that incorporates the subject IP. The genesis of the 25 % rule was an observation by Robert Goldscheider that the average royalty from a small sample of licensing agreements for  a bundle of IP from one company, Philco, reached in the 1950s was about 25 % of operating profit. However, this is not backed by reliable evidence. Empirical evidence suggests extremely  wide variation depending on the industry. Nevertheless, it still enjoys wide-spread acceptance. Thus, the valuer should be cautious in its use, and should employ it as a cross-check with suitable up/down adjustment and in addition to other data  sources to arrive at an appropriate royalty rate.

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

The approach is best used in valuing intangible assets such  as technical drawings or internally developed software that do  not generate a direct cash inflow stream, or assembled workforce; which although not separately recognized on the balance sheet, is used to arrive at the fair value of other assets). There are two commonly used methodologies under this approach:

  • Historical Method: This method considers the historic or suck cost or purchase price to value the This method does not consider future benefits arising out of the use of assets. Hence, it usually is not a good indicator of the true value of the intangible asset.
  • Replacement Cost Method: The method considers estimating the costs to recreate / replace an asset with equivalent  functionality at current prices and costs, including adjustments for factors like physical deterioration and functional / economic obsolescence, wherever applicable. It is based on the premise  that a prudent third-party would pay no more for an asset than its replacement

Tax Amortization Benefit (TAB)

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

Conclusion

Generally, the valuer will use more than one method for determining the fair value depending on the nature of the intangible asset and data availability. A summary of the commonly used approaches in Valuation of intangible assets is as follows:

 

Asset

Primary

Secondary

Tertiary

Patent, Brand, Technical know-how, Copyright

Income

Market

Cost

Customer relationship

Income

Cost

Market

Internally developed software

Cost

Market

Income

Assembled workforce

Cost

Income

Market


ILLUSTRATIVE EXAMPLES OF STAND-ALONE INTANGIBLE ASSET VALUATION

Assembled Workforce - Replacement Cost Method

Particulars

INR Mn

Current Annual CTC of Assembled Workforce

215

Hiring Cost (1 month’s CTC)

18

Training Cost (1.5 month’s CTC)

27

Inefficiency Cost (50% for 2 month’s CTC)

18

Replacement Cost of Workforce

278

 

Brand Valuation - Royalty Relief Method                        (INR Mn)

Particulars

 

2020

2021

2022

2023

2024

Terminal

Net Sales

 

400

750

1,100

1,400

1,600

1,680

Pre-Tax Relief from Royalty

5.00%

20

38

55

70

80

84

Income Tax

34.94%

7

13

19

24

28

29

After Tax Royalty

 

13

24

36

46

52

55

Discounting Factor

19.50%

0.84

0.70

0.38

0.22

0.16

0.16

Growth Rate

5.00%

 

 

 

 

 

 

PV of Cash Flows

 

11

17

14

10

8

9

Sum of PV of Cash Flows

60

 

 

 

 

 

 

PV of Perpetuity

61

 

 

 

 

 

 

Fair Value of Brand

121

 

 

 

 

 

 

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

 

Non-Compete Valuation - With and Without Method                     INR Mn

Particulars

 

2020

2021

2022

2023

2024

Cash flows (with Non-compete)

 

19

24

32

35

40

Cash flows (without Non-compete)

 

2

5

17

25

33

Difference in Cash flows

 

17

19

15

10

7

Discount factor

17.50%

0.85

0.72

0.39

0.23

0.16

PV of Differential Cash Flows

 

14

14

6

2

1

Sum of Differential Cash Flows

38

 

 

 

 

 

Probability of competing

50%

 

 

 

 

 

Fair Value of Non-compete

19

 

 

 

 

 

Cash flow with Non-compete

 

Particulars

 

2020

2021

2022

2023

2024

EBIT

 

 

34.94%

50

58

65

70

74

Less: Income Tax

17

20

23

24

26

Net Income

33

38

42

46

48

Add: Dep

2

2

2

2

1

Less: Capex

12

12

10

10

8

Less: Increase in Working Capital

4

4

3

2

2

Cash flows with non-compete

19

24

32

35

40

Cash flow without Non-compete

 

Particulars

 

2020

2021

2022

2023

2024

EBIT

 

 

34.94%

20

32

49

56

70

Less: Income Tax

7

11

17

20

24

Net Income

13

21

32

36

45

Add: Dep

2

2

2

2

1

Less: Capex

12

12

10

10

8

Less: Increase in Working Capital

2

6

7

3

6

Cash flows without Non-compete

2

5

17

25

33


  • Cash
    -flows are considered for the period of non-compete
  • The dependency ratio on the non-compete has been considered to arrive at cash flows with non-compete, which reduces with time as follows:

Particulars

2020

2021

2022

2023

2024

Dependency Ratio

60%

45%

25%

20%

5%

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

 

Nuances on Valuation of Intangible

Assets

 

As investment in intangible assets continues to grow globally  across industries, investment in intangibles often matches or exceeds investment in traditional capital such as plant and equipment, machinery and buildings. Intensified global competition, emergence of new business models in  the world of startups and increasing importance of the services sector have amplified the prominence of intangibles. Global gaints such as Apple, Microsoft, Starbucks, Prada, Gucci, BMW etc. rely heavily on  intangible  assets to drive firm value. In Indian context it has also been seen that certain brands despite having zero or  no  sales have still been  transacted  at  a value,

e.g. Dalda, Cibaca, Ambassador

Ind AS 38-Intangible Assets, defines an intangible asset as “an identifiable non-monetary asset without physical substance”. Intangible assets represent  a company’ right or claim to future benefits arising from their use. Brands,  trade names and trademarks, customer relationships, franchises, patents, copyrights, contracts and goodwill etc. are commonly recognised intangible assets. Examples of some of the generally considered intangibles in various industries include:

  • IT industry: Patents, technical know-how, internet domain names, technology, software codes ;
  • Pharmaceutical industry: Product molecules, in-process research & development, licensing agreements, trade names and trademarks ;
  • Telecommunication industry: spectrum licenses, software, customer relationships, trademarks ;
  • Business services industry: customer/ vendor relationships, order backlogs, non-compe agreements

The adoption of Ind AS in India has also increased the importance of  intangible assets on a company’s  reported financials. Intangible assets have to be fair valued in case the Ind AS 103-Business Combinations is applicable  in a controlling transaction. Furthermore, financial statement implications associated with amortization and impairment testing (under Ind AS 36- Impariment of Assets) have to be carefully accessed with respect to the intangible assets of a company.

The recent advances in the Indian Valuation landscape, has warranted a greater emphasis on the accurate Valuation of intangible assets, as these assets become critical drivers of corporate value. The common approaches considered in Valuation of intangible assets are:

  • Income approach – considers the future expected cash flows derived from the asset;
  • Market approach – based on market based metrics, such as  prices paid in actual transactions with similar characteristics and functionality; and
  • Cost approach – based on cost to purchase or replace an asset of  equal

Among these  Valuation approaches, the Income approach is widely utilized as it considers the future benefits from use of  the subject intangible asset.  Due to the paucity of market data that would form a reliable proxy of the  specific attributes of a subject intangible asset, the Market approach, though utilized often, has limited application in the Valuation of  intangible  assets.  The Cost approach assumes that the value of an intangible can  be  determined based on its replacement cost. As such the Cost  approach  is often utilized in valuing specific intangibles such as assembled workforce and internally developed software. However, the Cost approach  also  assumes that intangible assets can be rapidly recreated and a market participant will  not be willing to pay a significant premium for the ability to use the subject asset immediately. Thus this approach is normally used to value intangible assets that are not primary or significant in nature from market participants' point of view.

While there is variability in the nuances of application, depending on the subject intangible that needs to be valued, three common  methods  for  valuing intangibles using the Income approach are:

  • Relief-from-royalty method – This method is based on a hypothetical royalty (typically calculated as a percentage of the forecasted revenue) that the owner will otherwise be willing to pay in  order to  use the asset assuming  it was not already owned. Thus, the royalty savings are considered as the expected future cash flows from the subject intangible 

Valuation: Professionals’ Insight

  • With and without method – The fundamental concept underlying this method is that the value of the subject intangible asset is the difference between an established, ongoing business and one where the subject intangible asset does not exist. This results in a stream of incremental cash flows in terms of either incremental revenue (on account of charging a premium by the owner of the subject intangible  asset), and/or cost  savings (as the subject intangible asset allows its owner to lower  the  cost).  Key inputs of this method are the assumptions to what extent and how long the cash flows of the business get affected (adversely) in the absence of the subject intangible
  • Excess earnings method – This method calculates the value of an asset based on the expected revenue and profits related to that particular asset, adjusted for the portion of profits attributable to other assets (tangible and intangible) that contribute to the generation of cash flow (for example, working capital, fixed assets, assembled workforce, etc.). This method is typically used in order to determine the value of the primary cash generating intangible of the

While valuing intangible assets, consideration needs to be given to  key aspects such as:

  • Isolating future cash flows associated exclusively with the subject intangible assets which are independent of the other assets and liabilities of the company. This can often be challenging to ascertain given that a company’s management usually provides overall cash flows of the company as a starting The Valuation professional has to work closely with the management of the company to isolate the cash flows pertaining to the subject asset including assumptions such  as obsolescence/ attrition rates, add backs with respect to sales and marketing/ research and development expenses yet to be incurred based on the nature of the subject intangible asset.
  • Charges for supporting/ contributory assets – how do the company’s other assets help contribute to the cash flow generation of the subject intangible? Identifying these supporting assets and separating them from the other assets/ liabilities is critical in the application of the excess earnings method. A return for these ‘supporting assets’ should be reflected in the Valuation of the primary Additionally, the excess earnings method is not typically used to value both the primary intangible as well as other supporting intangibles due to the potential double counting of cash flows as well as issues related with ‘cross charging’. Furthermore, the supporting assets should also be  considered at fair value while assessing the fair value of the subject intangible.
  • The discount rate applied to estimate the present value of future cash flows of an intangible asset should be considered based on the stage, type and nature of the asset, and an assessment of the inherent risks embedded in the future cash flows of the subject
  • The economic life of an intangible asset plays a crucial role in Valuation, as the future cash flows from the asset are considered over its economic life. Thus, the Valuation appraiser needs to analyse the company’s assumption regarding the future use of the subject intangible, market participants’ view point on the potential future use  and should corroborate the fact pattern with an industry benchmark

In conclusion it can be said that intangible assets play an increasingly pivotal role in enhancing firm value. As such it is imperative to correctly estimate the value of intangible assets utilizing globally accepted Valuation methodologies in order to protect and enhance shareholder value.

 

Practical Solutions to Situations faced

 while carrying out Valuation Exercises

APPROACH TO FOLLOW

The simpler approach to Valuations, typically, is to compute enterprise value, apportion the value to debt like instruments, and thereafter  apportion  the value to equity like instruments. For this purpose, one needs to identify the instruments as debt and equity, to allocate values. To ascertain the nature of the instruments the following characteristics need to be assessed:

  • Rate of interest payable on the instrument
  • Rate of dividend payable on the instrument, and whether cumulative
  • Liquidation preference
  • Anti-dilution protection
  • Right to vote on major decisions taken by the company, whether restricted to the class of instruments or in expanded form and combination with other classes
  • Right to board seats / board observer seats / advisor status
  • Right to have their prior approval for certain
  • Right to convert into equity shares, drag along and tag along
  • Treatment of such instruments by regulatory bodies such as RBI, and accounting treatment as per

After assessing these characteristics, we could identify instruments as being near equity, if the rate of interest or dividend payable on the instrument is marginal, meaning that the return to the investor comes out of the other characteristics; if there is anti-dilution protection, right to  vote  similar  to equity shares, rights to board seats in proportion to fully diluted status of  equity, etc. In fact, based on the proportion of shareholding of such instruments, one can even assess whether there is a controlling interest residing in such instruments.

Instruments to be considered as part of the pre-money number of  equity shares outstanding on a fully diluted basis, are likely to be the following –

  • CCDs
  • Convertible portion of PCDs
  • OCDs, if the likelihood of conversion is greater than 50%
  • CCPS
  • The option pool under ESOP, whether granted or not
  • Options attached to other instruments
  • Share warrants, assuming that the likelihood of calling for equity  shares is greater than 50%
  • Convertible notes, if they are likely to be converted and  terms  are

Instruments more likely to be considered as debt are as follows –

  • NCDs
  • Non-convertible portion of PCDs
  • OCDs if unlikely to be converted
  • Redeemable preference shares
  • Other instruments that are unlikely to be converted, including convertible

While computing the weighted average cost of debt, it is necessary to identify the cost of debt for each of the instruments assessed as debt, as above. For instance, the cost of RPS would be higher on post-tax basis as compared to NCDs on post-tax basis, as dividends are not tax deductible.

Allocation of enterprise value to each of the debt instruments outstanding on the Valuation date can be done, by computing the value of each instrument, given its characteristics

  • In the case of NCDs, PCDs, OCDs treated as debt –  the cash flows  due to the instruments can be computed, net of tax, comprising the interest payouts, and the premium, if any,  on  redemption of debentures
  • In the case of RPS, the rate of dividend can be used as the capitalization rate to arrive at the value of the RPS, and suitably increased for the premium on redemption, if

The Valuation model should also factor in the time at which redemption is  likely to take place. Once the value of each debt instrument is computed and reconciled with the value of debt, from the enterprise Valuation, one can deduct and arrive at the value of the equity instruments.

Allocation of Values to Equity-Like Instruments

  • CCPS - If the rate of dividend on CCPS is negligible (say 01%), the value attribution to this dividend is marginal. Value attribution to liquidation preference is also likely to be small, if the cash flows show low probability of liquidation. In this situation, the real value is attributable to the rights that are very similar to the rights of the equity shares. Value of the CCPS  is  dependent on  the ratio at  which the CCPS will convert into equity shares,   and the value per equity share, is likely to be very similar to the value of  CCPS, subject to a marginal adjustment for dividend.
  • CCD – Here again, if the rate of interest on CCD is negligible (say 01%), the value attribution to the interest is marginal. Similarly, value attribution to liquidation rights will be as above. Value per CCD is likely to be very similar to the value of equity shares, subject to a  marginal adjustment for interest.
  • ESOP – There is an interesting question to be addressed, namely whether value attribution should be given to options earmarked for grant to employees, but not yet

The option pool is typically adjusted by investors from the pre-money Valuation, rather than from the post-money Valuation. Similarly, whether options granted but not vested, or vested but not exercised, will  have  a similar value as equity shares outstanding.

Also, in the Valuation of options, one should consider the fair value of options or the intrinsic value of options. The suggested approach to Valuation is to consider the entire option pool in the pre-money computation of  the  number  of shares outstanding. The value of the ESOP can be adjusted for the grant price/expected grant price of unexercised options, with  suitable discounting  for the time at which options are likely to be exercised.

The value of the option itself, will be the intrinsic value, in case this method is used, and the fair value of the options (which should typically be higher than the intrinsic value).

In order to handle the issue of fair Valuation of options – let’s look at the perspective from which the Valuation of options is done.

“Fair Valuation of options is done from the perspective of arriving at an accounting value for stock option grants. However, from the viewpoint of the enterprise, it is to be kept in mind that it is writing the options that are being granted. The Valuation from this perspective is  therefore  what  we  have stated above, i.e., the option pool has value which is  similar to  the value of  the other shares of the enterprise, less the amount receivable for the grant price of the options.”

Applicability of Legal Framework

  • Section 61(1)(b) of Companies Act, 2013 and Rule 12 of  the Companies (Share Capital and Debentures) Rules, 2014 cover the  issue of employee stock A reference is also to be made to  SEBI regulations under sub-rule (11), in the case of listed companies.
  • SEBI (Share based Employee Benefits) Regulations, 2014 cover issue of employee stock options by listed
  • Section 17(2)(vi) of the Income Tax Act, 1961 and Rule 3(8) of the Income tax (perquisite )
  • Ind AS 102 on Share-Based Payment and Guidance Note on Accounting for Employee share-based payments (2005).

It would be a good practice for a company to get  a  Valuation  of  the company’s equity shares and its option grants done every year, for the  purpose of determining the intrinsic value/ fair value of options. This serves  the purposes of substantiating the accounting treatment  of  stock  option costs, and computation of the perquisite value on exercise of options. In the latter case, the Valuation may have to be done by a merchant banker, rather than a registered valuer, in the case of unlisted companies.

The valuer needs to collate basic data such as  -

  • Volatility of the stock
  • Risk free rate
  • Expected dividend yield
  • Expected option life
  • Market price of the stock
  • Exercise price of the

A choice has to be made between the appropriate Valuation model to be followed –

  • Binomial Model or
  • Black Scholes Model (BSM)

Theoretically, the value derived under either model should converge, if  multiple steps are assumed in the binomial model. The Binomial Model is preferable for valuing American options, though, as stated, with sufficient number of steps, the value under the BSM should converge with the BSM model Valuation.

Obtaining Data

  • Volatility of the stock – The measure of volatility used in option pricing models is the annualized standard deviation of the continuously compounded rates of return on the stock over a period of In some circumstances, historical data may not be available, e.g., in the case of a start-up enterprise. It may not be appropriate to choose overall market volatility for a start-up enterprise, since it is likely suppress the estimation of volatility. A sectoral average or the volatility for similar enterprises may be more appropriate. The historical volatility of the stock over the most recent period that is commensurate with the expected life of the option being valued, could be  used.
  • Risk free rate – Current yield on government securities with similar residual maturity could be
  • Exercise price and Expected dividend yield will be provided by management
  • Expected option life – While estimating the expected option life, it is sensible to segregate employees into homogenous groups if possible, since there could be a difference in behavior between   Thereafter, estimating the life of the options could be kept simple (e.g., (min life plus max life)/2 to arrive at the average life).


The next step is computing the value of the option, for which we may even   use any option calculator, that is available online. It is important that the Valuation report outlines the scope of work, the methodology followed, parameters used, the references to public  databases,  assumptions  made, and suitable disclaimers.

It is possible that an acquisition transaction is based on the  premise  that  there will be cost synergies in the acquisition. As a part of the assessment of the synergy, the selling enterprise may share information that major cost optimization drives have been identified and initiated, and the enterprise Valuation correspondingly is higher, assuming that benefits of these cost savings accrue to the selling enterprise.

An independent valuer is faced with assessing the situation where huge enterprise value is created by assuming large incremental cash flows from these cost savings. There has to be a critical analysis of the enterprise in comparison to others in the industry, and the performance of the enterprise over time. This requires approaching the enterprise using the EIC model, i.e., assessing the economy, the industry and then the company.


A common size analysis would enable comparison of  the  enterprise  with other enterprises in the same industry and against itself over time. Based on the analysis, we get insights about the industry growth rates  vs  the  company’s growth rate, the high performers and laggards in the industry, the cost structures in the industry, industry segmentation, customer segmentation, assessment of product features and positioning in relation to competition. Once we have common size analysis of the company’s cost structure, we would be better placed to assess the likelihood of cost optimization initiatives resulting in savings. Thereafter, an assessment of management’s capability in delivering on these initiatives needs to be done, and a probability assigned to the likelihood of success of these initiatives.

Post-acquisition, it would be essential for an enterprise to obtain a purchase price allocation (PPA) report, which provides an independent assessment of the values at which the purchase price is to be allocated to the  various tangible and intangible assets that have been acquired, and the resulting goodwill. Since the auditors need to frame an  independent  viewpoint  on  these reports and the values at which assets and liabilities are  stated, the  PPA report would be done by independent valuers. Hence, there are likely to be multiple viewpoints with significant differences in approach, to  the Valuation of the business being acquired.

Management’s Valuation includes synergies that could result from the acquisition. The expert involved in the PPA may not  have been involved in the acquisition process and may have been brought in solely for the PPA report. The auditors need to assess  that  financial statements are true and  fair. In this situation, if the PPA report allocates significant values to goodwill,


there would have to be an assessment of whether the goodwill is impaired, from the outset, however improbable. The allocation of goodwill to the cash generating units to which the goodwill is attributable would be done  in  the  PPA report. Impairment testing of the goodwill can  be  done in accordance with Ind AS 36, at the cash generating unit level, and if the testing indicates that there is an impairment, the asset values need to be written down.

  1. Section 62(1)(a) of Companies Act, 2013 requires any further issue of shares to be made to the existing shareholders in proportion to their existing holdings and shall be deemed to include a right to  renounce the shares in favor of any other
  2. Section 56(2)(vii) of the Income Tax Act applies to a rights issue only if it is not a bona  fide business transaction, and if  the rights issue is not  in proportion to the existing
  3. FEMA regulations state that the rights issue to a person outside India should not be at a price that is less than the price offered to a person resident in

Hence, based on the existing legislative framework, there is no need for a Valuation report in the case of a rights issue.

Investment Terms vis-a-vis Valuation

 

Generally, any discussion on Valuation would be mostly concentrated on the Valuation or its concepts as relatable to a  large corporations/ listed entities  the only exception being the recent buzz about the start up Valuation. The Valuation of a closely held company with few investors (whether professional  or otherwise) is a completely different play where few generally accepted norms of Valuation do not work, some essential requirements would not be at the reach in the right way and so on. In this Chapter, we would try to understand one of the areas of closely held company’s Valuation namely the Investment Terms.

Private Equity/ Venture Capital funding will be bound by specific set of terms and conditions which form the basis of investment decision making and price negotiation, of course apart from the core business considerations and the business environment. This is in contrast to the investment in publicly traded securities which would be guided by regulated market prices. These investment terms and conditions would be agreed upon by and amongst the shareholders (including promoters) and the company through Shareholder’s Agreement or Share Purchase Agreement or Investment Agreement, as may be relevant.

Herein, impact of the Investment Terms on the Valuation of the Company/ Shares, along with background and intent of such terms and all aspects to be considered while undertaking the Valuation exercise are discussed.

Firstly, we will see certain adjustments to be made for determining the value   of closely held companies including for PE, VC and Angel investments. Amongst them, Discount for Lack of Marketability (DLOM), Control Premium and DLOC are most important and have a play in almost every closely held company Valuation. Ensuing few paragraphs discuss the meaning, need and impact of DLOM and DLOC in Valuation exercise.

DLOM is based on the premise that an asset which is readily marketable commands a higher value than an asset which requires longer marketing period to be sold or an asset having restriction on its ability to sell (Para 38, ICAI Valuation Standard – 103: Valuation Approaches and Methods).

Traded price of a publicly traded stock would usually reflect Value of a Marketable Minority Share. Application of DLOM on such value would derive Value of a Non-Marketable Minority Share – which is relevant in case of an unlisted closely held company.

Control premium is an amount that a buyer is willing to pay over the current market price of a publicly traded company to acquire a controlling interest in  an asset. It is opposite of DLOC to be applied in case of Valuation of a non controlling/minority interest (Para 43, ICAI Valuation Standard –  103: Valuation Approaches and Methods).

Control premium would usually be applied in cases where the Investor acquires ability to control operational decision making and/or financial  decision making of the company. In converse situations, DLOC would be applied to derive value of minority shareholding from value of control stake.

In addition to the general considerations given for determination of DLOM, Control Premium and DLOC as above, specific consideration is to be given to the terms of investment as per the Investment  Agreements and  their impact on Valuation.

Key Investment Terms and Valuation Considerations

Following are the investment terms which are generally sought after by the Investors/ preferred by the promoters.

A.       Conversion Rights

Most of the private equity and venture capital investors prefer to invest in dilutive securities such as compulsorily or optionally convertible preference shares/ debentures to pure equity shares for investment in early stage and start-up companies for various reasons including flexibility and down-side investment protection which these instruments offer.

Conversion ratio for a dilutive  security can be  agreed upon upfront (say, in  the ratio of 1:1) or it may be  linked to  the Valuation  that instruments can  claim in the future investment rounds (say, 30% discount to the next round of investment) or any other business performance linked conditions. It may be noted that none of the  regulations in India  provide for any specific  direction on treatment of these terms of investment, except for the rules to Companies Act, 2013 as discussed herein.

Rule 13 of Companies (Share Capital and Debentures)  Rules,  2014 prescribes that where convertible securities are offered on  a  preferential  basis with an option to apply  for and get equity shares allotted,  the price of  the resultant shares pursuant to conversion shall be determined-

  • either upfront at the time when the offer of convertible securities is made, on the basis of Valuation report of the registered valuer given at the stage of such offer, or
  • at the time, which shall not be earlier than thirty days to the date when the holder of convertible security becomes entitled to apply for shares, on the basis of Valuation report of the registered valuer given  not earlier than sixty days of the date when the holder of convertible  security becomes entitled to apply for shares

It is important to note that the company shall take a decision on the above at the time of offer of convertible security itself and make appropriate disclosure of the same.

Further, conversion of the instrument can be either compulsory or optional at the will of investor. However, you may see in many instances that investment terms shall be drafted in such a manner to mandate conversion at the end of an agreed time period, with an option of conversion at the will of investor at  any time during such agreed time period. This offers down-side investment protection to investors for any happening of liquidation events during the agreed time period.

While Optionally Convertible Securities are generally treated on  par  with  Debt Securities, application of Option Pricing  Models  appropriately  factors the impact of optionality clauses and conversion terms on Valuation. Though none of the regulations in India, including ICAI Valuation Standards mandate application of Option Pricing Model, it is the most preferred methodology of valuing hybrid securities.

B.       Distribution Rights

Proportionate claim to dividend and liquidation proceeds can differ from instrument to instrument based on face value, paid-up value, conversion and differential rights of respective instruments.

Distribution rights may also differ from Investor to Investor based  on liquidation preference and minimum return claim held by such Investor (as deliberated further). These are the rights relating to the special treatment to be provided to one or more of the investors or classes of instruments in comparison to the rest with respect to claim in dividend and liquidation distribution.

The valuer, while determining dilution effect of each class of instrument and thereby the value of instrument, should duly consider and factor in specific distribution rights of such instruments or investors holding such instruments.

C.       Minimum Guaranteed Return

Venture capital and private equity funds procure funds from investors offering minimum guarantee return (IRR) on investment. In order to achieve  the agreed IRR and for few other reasons, such venture capital  and  private  equity funds in turn set minimum IRR benchmarks to companies for every investment made (this is to put it in very simple terms and only to provide a context – though the constraints and aspects to be considered here are numerous).

In certain instances, achievement/ non-achievement of such minimum guaranteed IRR by the investee company may lead to automatic alteration of any specific terms of investment, including conversion  ratio,  distribution rights, voting rights or liquidation preference.

Minimum guaranteed IRR restriction can have two-way  impact on  Valuation  of the instruments:

  • Minimum guaranteed IRR reflects risk rating of the equity investment made from investor’s perspective and thereby the return expectations. Such IRR may act as a better indicator of  cost of capital (of course  after duly adjusting for investor specific considerations or aspects relating to the investee company), than a market determined cost of
  • Upon achievement or otherwise of minimum guaranteed IRR by the investee company, the conversion, distribution or  liquidation preference terms would get altered. This would in-turn have the impact on the enterprise value and also the proportionate instrument value. In such a scenario, option pricing models needs to  be  adopted to  factor  in the probability impact of minimum guaranteed  IRR  on  Valuation, with scenarios built for both down-side and up-side

D.       Voting Rights:

As per the regulatory framework under Companies Act, 2013, equity

shareholders alone shall be vested with voting rights in proportion to respective holding of paid-up equity share capital. However, when it is approved by the shareholders, a company can issue equity shares with differential voting rights, i.e higher, lower or nil voting rights.

Dilutive securities, i.e. convertible preference shares or  convertible debentures shall not have voting rights as per the Regulatory framework unless in instances where rights of such instruments are directly impacted.

In order to gain decision making powers and bridge the control gap, investors who generally prefer Dilutive Securities for investment may subscribe to and hold nominal equity shares with differential (higher) voting rights and holding  of such equity shares can be tied to holding of Dilutive Securities.

While determining value of any Dilutive Instrument, to which holding of equity shares with differential voting rights is tied up to, DLOC is to be determined considering voting rights and control held by respective holding of Equity Shares.

E.        Lock-in, Drag along, Tag along and related restrictions

One of the major considerations for Angel or VC or PE Investors  for investment in any  early-stage or start-up entity is  strength and reliability of  the management, i.e., the promoter group. Value propositions of  an investment might change based on continuance or discontinuance of such promoters with the company and in most cases there may not be any value  left in the company if the promoters are not there.

In order to ensure continuing of management of the investee company, as a part of investment terms usually lock-in restrictions will be  placed  on  promoter shareholding, i.e., promoter cannot dispose/transfer their shareholding in the company until completion of an agreed period or unless approved by the investors and restrictions would impact liquidity of the instruments part of promoter shareholding. The Valuer should consider the same appropriately for determining DLOM specific to such instruments.

In addition to lock-in restrictions on promoter holding, investors in general would be provided with  tag along, drag along  rights and right of  first refusal.  If promoters or any other shareholders of the company are undertaking any transactions involving sale of their respective shareholding. Tag along right gives option to investor or holder of respective instrument to  participate in such sale transaction along with promoter or selling shareholder and offer  their shareholding for sale. If such option is exercised, promoter or selling shareholder shall ensure that the instruments with tag along rights are sold at the same value that is offered to their shareholding and as per same terms.

Conversely, drag along right gives right to the investor or holder of respective instrument to force the promoters or other shareholders of the company, as may be agreed upon, to sell their shareholding to a third-party buyer in a sale transaction through which holder of drag along instruments is selling respective shareholding.

If any of the shareholders are intending to undertake a transaction involving sale of their respective shareholding, the right of first refusal provides an opportunity to the Investors or holders of such right to purchase the shares of transferring shareholders at the same price and terms as that would  be  offered under the intended transaction with third party. This would benefit the investors by helping them to retain control over the company and protect against potential dilution.

Holders of tag along, drag along rights and right of first refusal would have liquidity benefit over other shareholders whose holding is subject to such tag along or drag along rights and same is to be appropriately considered while determining DLOM for respective instruments.

F.        Liquidation Preference

Liquidation preference is one of the primary considerations  for  venture  capital and private equity investment. Liquidation preference  terms  summarise the sequence of preference of various classes of instruments or investors over the liquidation proceeds of the company.

As per general regulatory framework under Companies Act, 2013, in case of liquidation of company, liquidation proceeds of the company shall be first distributed to debenture holders along with other creditors/borrowers. Thereafter, balance proceeds shall be distributed to preference shareholders any leftover proceeds shall be distributed to equity shareholders. Here the claims of debentures and preference shareholders shall be limited to their nominal value and unsettled interest or dividend, unless otherwise provided.

However, in majority of the instances venture capital and private equity investors acquire dilutive instruments at a premium and  would  seek liquidation preference even for the component of premium, along with agreed return if any. To accommodate this, liquidation preference as a part of investment terms would be set in following manner:

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

Liquidation preference significantly affects proportionate value of instruments held by investors and shareholders/ other non-preference holders. In these situations, option pricing model – waterfall distribution approach needs to be adopted for allocation of equity value for appropriately factoring in the impact  of liquidation preference.

Option Pricing Model

In multiple places above we have discussed about option pricing model  – so   it would be pertinent to look at this and understand it. Following paragraphs summarise the basic understanding of key methodologies of OPM and how  the same can be implemented.

A.       Binomial Model

Binomial call option pricing model (American/ European as may be relevant) can be applied for factoring the impact of investment terms on Valuation, including:

  • Conversion of optionally convertible instruments;
  • Conversion linked to future conditions;
  • Achievement/non-achievement of minimum guaranteed IRR and resultant alternation of terms of investment;

Under Binomial option pricing model, scenarios can be built for probability of upside or downside movement of underlying asset value for multiple periods and iterations.

Final outcome under this model is based on iterations of such upside and downside probability, where in probability is in-turn dependent on underlying risk (volatility) and risk-free return.

Key Inputs for Binomial call option pricing model

Time to Expiry

Time period between Valuation date and date of lapse of optionality condition

Number of Nodes

Number of Iterations

Time   Interval   of           Node (DeltaT)

Time to Expiry/Number of Nodes

Risk Free Return (r)

Benchmark Risk Free Rate

Volatility (v)

Volatility of underlying Equity

Uptick (u)

e ^ (v* Square-root of DeltaT)

Downtick (d)

1/u

Upside Probability (Pu)

[{e^(r*DeltaT)}-d]/[u-d]

Downside Probability (Du)

(1-Pu)

Current Stock Price (S)

Value of Equity/Instrument on Valuation Date

Exercise Price (E)

Price to be paid to exercise the Option

 

S2aa =

S1a*u

S2ab =

S1a*d

S2ba =

S1b*u

S2bb =

S1b*d

 


B.       Black-Scholes Model

Black-Scholes call option pricing model is widely used for allocation of equity value amongst current value method, probability weighted expected return method and option pricing model.

For allocation of equity value under Black-scholes call option pricing model, breakpoints of distribution of assumed liquidation proceeds is to be  determined in line with conversion, distribution and liquidation preference terms of various dilutive instruments of the company. Breakpoint is where the distribution proportion of assumed incremental liquidation proceeds changes.

Implied value of each such breakpoints is then determined using Black- Scholes call option pricing model considering transition values of the break points as strike prices and equity value as spot price. Incremental of implied value of  breakpoints so determined above represents equity value allocated to each of such breakpoint, which shall further  be  allocated  to  various classed of dilutive instruments based on their respective distribution claims at such breakpoints. Value of each of class of Instrument is equivalent to equity Value so allocated to such instruments divided by number of Dilutive Instruments under such class.

Key Inputs for Black-option pricing model for Equity Allocation

Time to Liquidity (T)

Time period between Valuation Date and Likely Date of Liquidity Event as per Investment Terms

Risk Free Return (r)

Benchmark Risk Free Rate

Volatility (v)

Volatility of underlying Equity

Spot Price (S)

Current Equity Value

Strike Price (K)

Transition Value of Breakpoint

 Tax Amortisation Benefit

 

The term ‘Tax amortisation benefit’ has not been explicitly defined anywhere but as a concept is widely accepted by all global professional bodies. In India too, TAB is commonly applied, especially by valuers who regularly carry out Valuations for the purpose of financial reporting. TAB in a layman’s term is a benefit that is availed by claiming amortisation of an acquired asset as an allowable expense under tax laws. As an expert however, one would define TAB as a hypothetical benefit arising from future amortisation of an acquired intangible asset that could be available to an acquiring entity which is  recording such an intangible asset in its books of accounts. The Indian Valuation Standard 302 on Intangible Assets issued by The Institute of Chartered Accountants of India in 2018 explains TAB as  a  hypothetical  benefit available to a market participant by way of amortisation  of  the acquired intangible asset, thereby reducing the tax burden.

The points below are relevant to correctly understand, apply and calculate TAB.

1.        TAB is a hypothetical concept

The premise of TAB arises from the assumption that while  acquiring  the asset, hypothetically the acquirer would have factored in the determination of the acquisition price, such amortisation benefit that would be available on acquisition of the asset in the future. The premise of TAB is thus hypothetical and is applied irrespective of  whether such amortisation is actually claimed  or not. While its premise is hypothetical, its applicability is not. If there is  reason to believe that the structure of a transaction or the purpose of the Valuation or the tax laws are such that there may not be any amortisation  benefit available, then TAB would not be available.

2.        The asset should be seen to be acquired in isolation and not as  part of a business

TAB is based on the premise that the benefit would be available on amortisation of an asset, and hence it is implied that only if the asset can be isolated and recorded separately, it can be amortised. If the asset is taken as part of a business, the asset loses its identity and cannot be recorded

 

 

separately and will not be amortised and the question of  TAB  would  not arise. There is some confusion among valuers as to whether this implies that TAB would be applicable only on asset purchase transactions and  not  on stock purchase transactions. However it has been settled that TAB should be applied irrespective of whether the transaction is an asset  purchase  or  a stock purchase, as long as the asset is being accounted and recorded separately.

3.        The applicability of TAB depends on the purpose of the Valuation

Just like any other Valuation, the purpose of Valuation is also important to assess when TAB should be applied. TAB being a hypothetical benefit, it is important that TAB is not arbitrarily applied as it would erroneously inflate the value of the asset. TAB is therefore applied only  if the intangible asset is  being valued separately which generally it is when a  purchase  price  allocation has been carried out (either to account for a business combination for the purpose of financial reporting or at the time of a slump / group sale for tax reporting) or when the intangible is been sold / acquired separately. For financial reporting, the inherent assumption under which the Valuation is carried out assumes a hypothetical sale of the intangible asset; in case of a purchase price allocation for a slump / group sale, the very reason the purchase price allocation is carried out is to claim tax amortisation.

4.        The applicability of TAB depends on the Valuation approach followed

When the cost or market approach is used to value an asset, it is understood that the estimated cost to create / replace the subject asset and the market price used to realise the value of the subject asset respectively takes into account the value of all benefits and therefore there is no reason  to  additionally add the value of TAB when valuing an asset under these approaches. However when an income approach is used to value an asset, because the cash flows / earnings / cost savings  pertain only  to  the use  of the subject asset, the amortisation benefit does not get captured in the calculation and hence the need to add TAB separately when valuing an asset under the income approach.

As amortisable tangible assets are valued using either the cost approach or  the market approach or both, it is by implication clear that TAB is applicable only when valuing intangible assets and that too only if they are valued using the income approach.

5.        TAB applicability depends on the tax amortisation laws of the country in which the asset is used

Although the amortisation is claimed in the books of the acquirer entity, it is  the location where the asset is used that determines the applicability and the amount of TAB. For eg. if an acquirer in India buys an  intangible asset used   in Europe, if the European tax laws do not allow for amortisation of the acquired intangible asset, TAB should not be applied even if the acquired intangible asset is allowed to be amortised as per Indian tax laws.

6.        The value of TAB is calculated as per the amortisation method allowed by the laws of the country in which the asset is used

As mentioned earlier, once it is established that TAB is  applicable,  the method of amortisation to calculate TAB would also depend on the location where the asset is used. For eg. if an intangible asset used in India, is acquired, as per the tax laws of India, such an intangible asset would be amortised at the rate of 25% per annum based on the written down value method. However if the asset was being used in the US, the amortisation method would be the straight line method and the number  of  years  over which the asset could be amortised would be different. The value of TAB  would hence be different in different countries for the same intangible asset.

7.        Calculation of TAB

The four primary inputs that go in the calculation of TAB are the amortisation rate, the discounting rate, the tax rate and the duration.

Amortisation Rate

As mentioned earlier, the amortisation rate is dependent on the situs where  the intangible asset is used. Depending on the amortisation laws, the amortisation policy and the amortisation method, the amortisation rate should be decided.

Discounting Rate

Intangible assets are perceived to be riskier than the company as  a  whole  and hence the discounting rate used to value an intangible asset is  higher than that used to value a company. There is hence some debate over which discounting rate should be used to present value the tax savings for calculating TAB.

While some valuers use  the company’s discount rate  commonly referred to   as the weighted average cost of capital (‘WACC’) to discount the tax savings to calculate the present value of TAB, some others discount the tax savings using the discounting rate of the intangible asset. The  school  of  thought which uses WACC to calculate TAB is of the view that as the amortisation benefit can be used to reduce the tax burden of the entire company, it is appropriate to use the WACC of the company. Proponents  of  the  other  school of thought believe that as the amortisation benefit is calculated on an intangible asset which is valued based on its own attributable cash flows

/earnings / cost savings which are separate from the business, the intangible asset specific discounting rate should be used.

Both approaches are followed and are in vogue. The Valuation Standards  issued by the Institute of Chartered Accountants of India as well the International Valuation Standards issued by the International Standards Valuation Council allow the use of both  approaches. However one needs to  be careful that the same is applied consistently in the  entire  Valuation process. For example, where an intangible asset specific discounting rate is being used to calculate TAB, the tax rate used to  calculate TAB also should  be the one pertaining to the intangible asset and not the business as a whole and vice versa.

Tax Rate

As mentioned earlier, depending on what discounting rate is being used for calculation of TAB, the tax rate should be considered so as to be consistent with the logic.

Duration

The duration for which TAB is calculated is  directly  related  to  the amortisation rate. Where the amortisation method followed is the straight line method, the duration would be inversely proportionate to  the  amortisation rate. For eg. if the amortisation rate prescribed is 10%, then the duration over which the benefit would accrue would be 10 years. In some countries, the life itself is prescribed such as the US where the amortizable life prescribed is 15 years. In countries like India, the amortisation rate prescribed is 25% per annum and the method prescribed is the written down value method. As the method prescribed is a reducing balance method, TAB is generally calculated for a duration by which the present value of the tax savings becomes negligible.

Although transactions involving intangible assets  have increased, Valuation of intangible assets is not as widely accepted or understood as say a business or an equity Valuation and because the information available  in public domain about intangible assets exchanging hands is limited. In India, it is easy to err. In India, the value of TAB can constitute almost 25% to 30% of the value of the intangible asset and hence it is a double edged sword that should be understood and applied with caution depending on the purpose of the Valuation, the Valuation approach and the tax laws of the relevant jurisdiction.

Valuation of a Financial Service Company

India has a diversified financial sector undergoing rapid expansion, both in terms of strong growth of existing Financial Service Companies and new entities entering the market. The sector comprises of Commercial Banks, Insurance Companies, Non-Banking Financial Companies, Co-operatives, Pension Funds, Mutual Funds and other smaller Financial Entities. The Government of India has introduced several reforms  to  liberalise,  regulate and enhance this industry. But valuing such companies has its own challenges.

The two major challenges in valuing a Financial Service Company are:

Debt: The debt of a Financial Service Company is difficult to define and measure, making it difficult to estimate firm value or cost of capital. In a non- Financial Service Company, funds are raised through equity as well as from debts to make its investment. When we value the firm, we value the assets owned by the firm and not just the equity value of the firm. But for most of the Financial Service Companies, debts are raw material rather than a source of capital. The Financial Service Company raises debt to fund its operation and earn operating revenue. Thus, defining debt in a Financial Service Company  is extremely difficult.

Estimating cash flow: Financial Service companies are  highly  regulated. The regulatory authority governs where they can invest their fund and how much they can invest. Two major reinvestment items are net capital expenditure and change in working capital. However, financial company has  its own challenges. Unlike a non-financial company which invests  in  plant  and machinery, land and building and other fixed assets, a Financial Service Company primarily invests in marketing, human capital and other intangible assets like brand name. Such investments are often categorized as operating expenses and are expensed out in books. With, working capital we face a different problem i.e. to categorise debt and investment into current or non- current, inter-changing such number can give a bizarre Valuation.

Thus, due to the above mentioned challenges in debt and cash flow, “Discounted Cash Flow Method” – the method which is most commonly used for valuing a firm is not suitable for valuing a Financial Service Company.

Under “Discounted Cash Flow Method” we value firms by discounting  expected After Tax Cash Flows prior to debt payments at the weighted  average cost of capital and we value equity by discounting cash flows  to  equity investors at the cost of equity. Estimating cash flows prior to debt payments at weighted average cost of capital is problematic as the nature of debt cannot be easily identified. To value equity, we have to estimate free cash flow to equity, defined as follows:

Free Cash flow to Equity = Net Income available to Equity Shareholders +

Depreciation –  Change in non-cash working capital – Net Capital  Expenditure

– Net Debt repayment.

Since we cannot estimate capital expenditure, working capital and nature of debt in a Financial Service Company as discussed before, we cannot clearly estimate the Free Cash flow to Equity.

We now look at the different Valuation methodology which can be used to  value a Financial Service Company.

  • Excess Return Model: The Value of Equity under the “Excess Return Method” can be derived as the sum of Value of Equity as on the date of Valuation and the present value of expected excess returns to the Equity

The given model focuses on just the value of equity in a firm, thus eliminating the difficulty in defining the nature of debt in a financial company.

Value of Equity = Value of Equity as on the date of Valuation + Present Value of Expected Excess Returns to the Equity Investors.

The model focuses on  its excess returns earned by  the equity investors of   the company over the fair market rate of return on such investments. A firm that earns below the market return on its equity investment will see its equity value dip below the equity capital currently invested and vice versa.

The Value of Equity as on the date of Valuation is usually the Book Value of Equity of the company. The Book Value of Equity of the Financial Service  Company is more reliable measure to consider as the Value of Equity for various reasons. First, unlike in a Non-Financial Service Company where depreciation plays a major role in determining the Book Value of Firm, depreciation is often negligible in a  Financial Service Company. Secondly,  the assets of a Financial Service Company are often financial assets and hence are marked up to market, thus eliminating the deviation between book value and market value of such assets.

The Excess Returns can  be  stated as  the difference between Profit after tax to equity shareholders and equity cost.

Excess returns = Profit after tax to Equity Shareholders – Equity Cost

The profit after tax to Equity Shareholders can be derived based  on  mutli- year forecast, similar to the projections as required for “The Discounted Cash Flow Method”.

The equity cost shall be determined by the general market  expectation for such investments. To ascertain the equity cost, cost of equity shall be multiplied by the average book value of equity.

Cost of Equity shall be derived based on Capital Assets Pricing Model and is computed as under:

Cost of Equity = Risk Free Rate of Return + Beta (Market Risk Premium)

Equity Cost = Cost of Equity * Average Book Value of Equity

The Terminal Value of Excess Returns to Equity Investor can then be computed by applying Gordon Growth Model.

Terminal Value = Expected Excess Return of Explicit forecast period∗(1+g)

CoE−g

Where: CoE = Cost of Equity

g = constant growth rate beyond the forecast horizon

Terminal Value is then discounted to its present value using the discounting factor for the last year of the forecast horizon.

 

  • Assets Based Valuation: In this model, we value assets of the Financial Service Company, netting off the debt and other liabilities and the difference is the value of

The biggest merit of this model while valuing a Financial Service Company is that the assets held by a financial service company are often financial assets and hence are marked up to market, thus eliminating the need to revalue the assets as on the Valuation date.

But this model has its own limitations, in as much as it ignores the growth potential of the company, thereby ignoring the future earning potential of the business. It is also difficult to arrive at the value of intangible  assets,  like brand name, human capital, etc.

  • Relative Valuation: Under the Relative Valuation Approach, series of multiplies are used to value

Multiplies such as “Value to EBITDA” or “Value to EBIT” cannot be  easily  used to value Financial Service Companies, as neither Value nor Operating Income can easily be estimated for Financial Service Companies.

For valuing a Financial Service Company, the multiples which can be used must be equity linked multiplies like price earnings ratio and price to  book value ratios.

Price Earnings Ratio: Also known as the price multiple or the earnings multiples, the ratio for valuing a company that measures its current share  price relative to its per-share earnings.

Price Earnings Ratio = Market Value Per Share

Earnigs Per Share

 

An issue, specific to valuing a Financial Service Company  using P/E ratio is the use of provisions for expected losses: eg provision for non- performing assets by banks. Such provisions reduce the reported income and affect the reporting P/E ratio. Banks which are more  conservative about categorizing  bad loans will report lower earning and have higher P/E ratio, whereas banks that are less conservative will report higher earnings and lower P/E ratio.

Price to Book Value Ratio:  This ratio expresses the relationship between  the price of share to the book value of equity per share.

The higher growth rates in earnings, lower cost of  equity and higher returns  on equity all results in lower price to book ratios. The strength of the relationship between price to book ratios and return on equity should be stronger for Financial Service Company than for Non-Financial Service Company, as the book value of equity of Financial Service Company is much likely to be in line with market value of the equity invested in existing assets.

CONCULSION

Valuation principles for valuing a Financial Service Company are the same    as those of Non-Financial Service Company. However, the methodologies used in both the companies are quite different. This is mainly because, first in a Financial Service Company it is difficult to categorize the nature of debt and secondly estimating cash flow has it’s own challenges with capital expenditure and working capital, which are not easily estimated in Financial Service Company. Excess Return Method which focuses on excess return earned by equity investor on the equity investments is by  far  the  most suitable method under income approach for a Financial Service Company.

Under relative Valuation we face challenges in using multiplies like Value to EBITDA or Value to EBIT as neither value nor operating  income  can  be easily estimated for Financial Service Company. Hence, price  to  earnings ratio and price to book value ratio are the most suitable methods under the relative approach.

Source: ICAI


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