PREFACE. Dear All, Thanks and Regards, Rajesh C. Khairajani

Transcription

1 VALUATION UPDATES

2 DISCLAIMER This publication contains general information only, and none of KNAV International Limited, its member firms, or their related entities (collectively, the KNAV Association ) is, by means of this publication, rendering professional advice or services. Before making any decision or taking any action that may affect the financial related aspects of your business, you should consult a qualified professional advisor. No entity in the KNAV Association shall be responsible for any loss whatsoever sustained by any person who relies on this publication.

3 PREFACE Dear All, Valuation, as we know is a complex subject involving several estimates, judgements, concepts and analytics. With the advent of Ind AS, valuation as a subject gains considerable importance. Ind AS introduces the concept of fair value, which requires application of various estimates and concepts which are relatively alien to the accounting professionals in our country. The need for valuation arises not only for financial reporting as mentioned above, but also for various regulatory purposes, mergers and acquisitions as well ascertaining the fairness of an existing valuation. We at KNAV through our member firm, Indé Global Advisory Private Limited bring over 17 years of experience in business valuations and intangible asset valuation to help you with your requirements. What follows in the next few pages are some valuation concepts that I have attempted to present to you in a simplified form. These are subjects and topics that I have discussed and debated with my clients and professional colleagues over the past few months. Every topic covered in this compendium is unique in a way that it addresses practical issues that me and my team faced over the course of our business valuation engagements in the recent past. Issues such as how to value an S corporation or how to compute the cost of equity and WACC or how to compute the beta or how to factor in past tax losses in a valuation are practical issues faced by our clients while putting together their DCF valuation worksheets either for management presentation or for the auditor. Certain topics are conceptual in nature but are important from an Indian standpoint as these are new concepts that are gaining significant importance with the advent of Ind AS. These are certain discussions on discount for lack of marketability or applicability and the concept behind control premiums or the applicability of Ind AS 103: Business Combinations Learning is a continuous process and while I have spent over 12 years in practising valuation I still consider myself a student of this ever evolving art form that we call valuations and as I say the practice is evolving every day as we speak. It would be great if you as readers and clients and practitioners could share your valuable inputs and suggestions by writing to me at rck@igapl.com. Thanks and Regards, Rajesh C. Khairajani

4 TABLE OF CONTENTS Ind AS 103 Business Combination Valuation Considerations under Section 409A of the IRC Valuation of an S CORP Building Blocks of WACC Control Premium BETA: An Indispensible Measure of Security Analysis Discount for Lack of Marketability Valuation of Tax Attributes Valuation for IRC 382 Valuing Intercorporate Investments Insights into Real Options Valuation of Contingent Consideration Valuation of Synergies Is Valuation under FEMA Restricted to DCF? Size Adjustments of Multiples In Process Research and Development ( IPR&D ) Assets Aquired in Business Combination

5 01 IND AS 103 BUSINESS COMBINATION This thought leadership paper provides insights on the impact of Ind AS on business combination.

6 A SEA CHANGE ON ACCOUNTING FOR ACQUISITIONS Under the current standards, the difference between the purchase price and the net assets acquired is either recognized as goodwill or capital reserve, as applicable. Going forward, with the advent of Ind AS, all acquired assets, including identifiable intangible assets and liabilities will be re-measured and recorded at fair value. This process, more commonly referred to as purchase price allocation involves identification, valuation and recognition of such identifiable intangibles that have been acquired. Purchase price allocation can be challenging due to the specific principles and method promulgated under Fair Value accounting standards emphasizing the need of boots on the ground experience. Identifying and valuing intangible asset(s) is a broad endeavor and requires careful consideration of factors specific to each business, the transaction structure, identifying the primary income generating asset, determining the discount rates, estimating the useful lives of identified intangibles. Examples of such intangibles include customer contracts, trademarks, brands, etc. India GAAP Ind AS 20% 50% 50% 10% 50% 5% 15% Goodwill Net Assets Intangible X Net Assets Net Assets Intangible Z Net Assets The professionals at Indé Global have been a part of numerous complex domestic and cross border transactions and related purchase price allocations involving leading corporates across different industries. We work closely with the client s management team in identification of core intangibles resulting out of the transaction and adopt appropriate valuation model and strategies for valuing such intangible assets. Financial reporting valuation is subject to in-depth scrutiny by company auditors. At Indé Global, each engagement is built upon our extensive prior and continuing experience, which is reflected in our well-reasoned and thoroughly documented valuation opinions. Our work has been reviewed and accepted by the major agencies of the federal government charged with regulating business transactions, as well as the largest accounting and law firms in connection with engagements involving their clients. 02

7 02 VALUATION CONSIDERATIONS UNDER SECTION 409A OF THE IRC This thought leadership paper provides insights on the requirements and applicability of section 409A valuations.

8 APPLICABILITY OF SECTION 409A Section 409A (the section ) applies to compensation that employees earn in one year but is paid in a future year. It sets forth specific requirements that the valuation of deferred compensation should meet. For closely held corporations whose stocks are not readily tradeable, the section requires a reasonable application of a reasonable valuation method to value the subject stock. According to Section 409A regulations, the Internal Revenue Service ( IRS ) may rebut the presumption of reasonableness only if the stock valuation method or the stock valuation conclusion is grossly unreasonable. Thus, the burden of proof is passed on to the IRS that the exercise price was not at or above the fair market value when the valuation method used is reasonable. GENERAL CONDITIONS According to Section 409A regulations, a valuation method is not reasonable if: It is more than 12 months old; It does not take into consideration any material & recent developments regarding the taxpayer corporation regardless of age. SAFE HARBORS A safe harbor is a provision of a statute or a regulation that specifies that certain conduct will be deemed not to violate a given rule. In context of the section regulations, a safe harbor is a closely held stock valuation method which is presumed reasonable according to IRS. Following is the summary of closely-held corporation stock valuation methods provided in the safe harbor: STOCK APPRAISAL BY AN INDEPENDENT APPRAISER GUIDELINES GUIDELINES 99 The independent appraiser should value the optioned stock using the same valuation standards applicable to the corporation stock. The valuation standards mentioned in Section 401(a)(28)(C) state that the company stock valuation should be performed by an independent appraiser. 99 The valuation should be as at a date which is within the past 12 months before the date of grant. 04

9 STOCK FAIR MARKET VALUATION FORMULA GUIDELINES This safe harbor provision can be used only if the following conditions are met: 99 If an employee wants to sell the corporation stock, then he or she must offer to sell the stock to the prospective buyer only at the formula value; 99 The party that buys the corporation stock from the employee must also offer to sell the stock to the next prospective buyer only at the formula value; & 99 If anyone else (other than employee) holds shares in the same or similar class of corporation stock, then that individual must also use the formula value whenever he or she sells the corporation stock (1) to the corporation or (2) to someone who owns more than 10 percent of the total combined voting power of all classes of the corporation stock. These conditions need not be considered in the event of an arm s length transaction involving the sale of all or substantially all of the outstanding stock of the closely-held corporation. Thus, this provision will be applicable even if the above conditions are not satisfied. STOCK APPRAISAL BY A NON-INDEPENDENT APPRAISER (APPLICABLE ONLY TO START-UPS [1] ) GUIDELINES As the name suggests, the individual performing the valuation need not be independent of the closely held corporation. Hence, this provision allows a start-up to avoid the cost of an independent stock appraisal. This safe harbor provision is not applicable if the corporation or the employee reasonably estimates that the corporation will undergo: 99 A change in ownership/control event in the next 90 days; OR 99 An IPO of the corporation stock in the next 180 days. This provision may not be used if the taxpayer corporation stock is subject to any put, call or other right to purchase the company stock [2] Under this provision, the person performing the valuation must be qualified to perform such a stock valuation based on significant knowledge, experience [3], education or training. The regulations also clarify that the standard to be applied is whether a reasonable individual, upon being apprised of such person s relevant knowledge, experience, education and training, would reasonably rely on the advice 05

10 of such person with respect to valuation in deciding whether to accept an offer to purchase or sell the stock being valued. The final regulations adopt a presumption in specified circumstances that, for purposes of section 409A, a valuation of stock reflects the fair market value of the stock, rebuttable only by a showing that the valuation is grossly unreasonable. The presumption applies where the valuation is based upon an independent appraisal, a generally applicable repurchase formula (applicable for both compensatory and non-compensatory purposes) that would be treated as fair market value under section 83, or, in the case of liquid stock of a start-up corporation, a valuation by a qualified individual or individuals applied at a time that the corporation did not otherwise anticipate a change in control event or public offering of the stock. FOOTNOTES 1] According to Section 409A, a start-up is a corporation that has conducted its trade or business for less than ten years. 2] These stock transfer restrictions exclude a right of first refusal to purchase the corporation stock by an unrelated third party or a non-permanent right to sell or buy the corporation stock at formula value. 3] According to the regulations, significant experience means at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the taxpayer corporation operates. 06

11 03 VALUATION OF AN S CORP This thought leadership paper provides insights on valuation of S corporations.

12 WHAT IS AN S CORP? S corporation can be defined as a form of corporation that meets the IRS requirements to be taxed under Subchapter S of the Internal Revenue Code. Under this structure, the corporation s profits are not taxed at the corporate level, but rather at the level of the shareholders. The following requirements must be met for a corporation to qualify as an S corporation: Must be a domestic corporation; Must not have more than 100 shareholders; Must have only one class of stock; & Must include only eligible shareholders. The purpose of S corporation include: The prevention of double taxation of earnings received by a small business corporation ; & The avoidance of complex adjustments made necessary by instances of such double taxation. WHAT IS THE CHALLENGE IN VALUING AN S CORP? It is implied by the definition, that S corporations have tax benefits over C corporations. The issue of whether an S corporation s earnings should be tax affected or not continues to be controversial issue. In the past, valuators applied a corporate income tax rate of 40%, thus undervaluing the S corporation. However in the 1991 case of Gross vs. Commissioner, the tax court permitted no tax affecting at all. This approach would push up the value of the S corporation. To overcome these issues of underestimating or overestimating the value of S corporations, courts are now heading to a middle ground: a.k.a Kessler method of valuation. KESSLER METHOD OF VALUATION The Kessler approach of valuing an S corporation is one of the popular methods of valuation. This approach is rooted in the 2006 case of Delaware Open MRI Radiology Associates, vs. Kessler. In this case, the Delaware Chancery Court adopted a hybrid approach. This approach was designed to capture the economic advantages enjoyed by an S corporation shareholder who receives dividends free of corporate taxes. Under this approach, a corporation tax rate applicable to S corporations is imputed so as to arrive at an after tax amount available to shareholders of the S corporation as dividend assuming a highest tax bracket of 40%. The tax rate so arrived is 29.4%. Thus a clear analysis was established for dealing with valuation of S corporations. 08

13 Particulars C Crop S Crop S Corp Valuation Income before tax Corporate tax rate % % Available earnings Dividend or Personal income tax rate % % % Available after taxes This approach is based on the assumption that an S corporation is not likely to lose its S status. If there is a likelihood to the contrary, the application of a different approach is warranted. 09

14 04 BUILDING BLOCKS OF WACC This thought leadership paper provides insights on the concept of WACC in valuation.

15 INTRODUCTION The income approach is one of the common ways of determining the value of a business by considering expected returns on an investment, which are then discounted at an appropriate rate of return to reflect the risks and potential rewards associated therewith. The measurement is based on the value indicated by current market expectations about those future amounts. To determine the value of current market expectations, one needs to discount each year s forecast of cash flows for time and risk. The level of cash flows to be discounted depends upon the purpose of valuation. An enterprise valuation requires cash flows available to all stakeholders of the company (equity and debtholders) to be discounted to present value, while an equity valuation required cash flows available to only equity holders to be discounted to present value. The discount factor must represent the risk faced by the investors who has the right over the subject cash flows. For of an enterprise valuation, the discounted factor is represented by the weighted average cost of capital ( WACC ), whereas for any equity valuation, the discount factor is represented by cost of equity ( Ke ) The WACC blends the rates of return required by all investor capital i.e. debt holders as well as equity holders. For a company financed solely with debt and equity, the WACC is defined as follows: WACC =Wd * Kd (1 t) + We * Ke Wd= Weight of debt component in the total capital structure of the subject company; Kd= Cost of debt (Basically the rate at which the subject company can currently borrow, it reflects not only default risk but also the level of interest rate in the market); We = Weight of equity component in the total capital structure of the subject company; Ke = Cost of equity (Basically the return which the equity investors expect to compensate for the risk taken by investing their capital); & t = Tax rate. The cost of equity is the rate of return that investors require to make an equity investment in a firm. There are two approaches to estimating the cost of equity a dividend-growth model; & a risk and return model. The dividend growth model (which specifies the cost of equity to be the sum of the dividend yield and the expected growth in earnings) is based upon the premise that the current price is equal to the value. It cannot be used in valuation, if the objective is to find out if an asset is appropriately valued. 11

16 Under risk and return model, the cost of equity is derived using a build-up method and modified capital assset pricing model ( CAPM ) method. The basic building blocks for the build-up and the modified CAPM are: Risk free rate ( Rf ); Equity risk premium ( RPm ); Beta ( ß ) (in CAPM); Industry risk premium ( RPi ) (in build-up method); Size risk premium ( RPs ); & Company specific risk premium ( RPc ). The basic building blocks of WACC are summarised as follows: CAPM Risk free rate Equity risk premium Beta Modified CAPM Risk free rate Equity risk premium Beta Size risk premium Company-specific risk Build-up method Risk free rate Equity risk premium Industry risk premium Size risk premium Company-specific risk The following chart summarises the various approaches in risk and return model: Risk free rate (Rf) The risk free rate of return includes the investors required rate of return for the riskless use of their funds and a factor of inflation. The risk-free rate is the rate available on instruments considered to have virtually no possibility of default and thus the rate of return on a long term sovereign bond is considered a good proxy for the risk free rate of return. Equity risk Risk free rate premium (Rf) (RPm) The equity risk premium is the extra return that investors demand in excess of the risk free rate to compensate them for investing in a diversified portfolio of large common stocks rather than investing in risk free securities. It represents additional risk, or the degree of uncertainty, that the expected future equity returns will not be realized. It is a forward-looking concept in that the discount rate should reflect what investors think the risk premium will be going forward. Risk Beta free rate (Rf) (β) Beta is a measure of systematic risk of a stock, the tendency of a stock's price to correlate with changes in the market. It is used as a modifier to the ERP in the context of the CAPM. Beta is a sole measure of equity capital of the pure CAPM and refers to the volatility of a security or portfolio relative to the market. 12

17 Industry risk premium (RPi) The industry risk premium is one of the components used while estimating cost of equity under the build-up method The industry risk premium measures how risky the industry is in relation to the market as a whole. In other words, it is a special form of beta that has been adjusted so that it can be employed as a simple up or down adjustment in estimating the cost of capital. Size risk Risk free rate premium (Rf) (RPs) The size risk premium compensates for the size effect which is based on the empirical observation that companies of small size are associated with greater risk and therefore have a greater cost of capital. The size risk premium represents the difference between the actual historical excess return and the excess return predicted by beta. Company Risk specific free rate risk premium (Rf) (RPc) The company specific risk premium is an unsystematic risk (risk that can be diversified) specific to a company s operation and reputation. It depends on the judgement of the valuer based on assessment of various factors. The factors considered for evaluating the addition of a company specific risk premium include; stability of industry in which the company operates, diversification of product lines, stability of earnings, earnings margins, financial structure, management depth and achievability of projections. FAQS Question: Is there any difference between WACC and the discount rate? Answer: It depends on what is being discounted. If one wants to know how much cash is available to all the firm s providers of capital (namely stockholders, bondholders and other claimholders) he/she would consider the WACC as the discount rate, because WACC includes the risk component of equity as well as debt. If one wants to know how much cash can be distributed to the equity shareholders of a company, the discount rate in this situation would be the cost of equity. The cost of equity represents the risk component of equity only. Question: Which amongst the two, the modified CAPM or the build-up method is better? Answer: Depending on the valuation and the company, both models may be relied upon. However, the modified CAPM is often a better model when one believes he/she has good industry comparability with guideline public company betas. If there are no reliable guideline public company betas, analysts will usually apply and rely upon the acceptable build-up model. This often happens in the valuation of small business. GLOSSARY FAQs - Frequently asked questions 13

18 05 CONTROL PREMIUM This thought leadership paper provides insights on the various issues relating to the usage of control premium in valuation.

19 PERSPECTIVE ON CONTROL PREMIUM The amount that a buyer pays to acquire control of a company typically exceeds the current market value of the company based on its market capitalization. The amount in excess that the buyer offers is commonly referred to as the control premium, as it gives the buyer a controlling interest in the company. The issue of shareholder control is illustrated by the following example: Suppose Mr B acquires 10 shares of Z Ltd, a publicly listed company, at the market price of US$10 each. Here, Mr B is one of the many minority shareholders of Z Ltd and by virtue of his ownership of 10 shares he would have little influence in the decision-making of the Company. The US$10 per share market price of Z Ltd in this scenario is reflective of the inability of Mr B (a minority shareholder) to influence those decisions. However, if Mr B acquires 60% share in Z Ltd, which will enable him to influence the decision-making of the company, he may be willing to pay US$15 instead of US$10 paid in the erstwhile case. The additional US$5 paid over the market price reflects the premium paid to obtain a controlling stake in the company. The rights and benefits granted to a control shareholder makes their share more valuable than minority shares. CONTROL PREMIUM IS DEFINED AS An amount or percentage by which the pro-rata value of controlling interest exceeds the pro-rata value of non-controlling interest in a business enterprise, to reflect the power of control. In practice, control premium is generally expressed as a percentage of minority value. CONTROL AND PREROGATIVES OF CONTROL Control is the power to direct the management, dominate the decision making process, and set the policies of a business enterprise. Control and the impact of control (or lack thereof) are important considerations in any valuation. An appraiser must ascertain the extent to which the subject interests being valued contain elements of ownership control. Of all the intrinsic characteristics related to the subject interest, arguably, the element of control may be the most important characteristics. Widely accepted theory within the business valuation community holds that an investment in a privately held company is worth the present value of all of the future benefits inuring to the holder of that investment. Clearly, then, if the investor has a control position, he or she can accelerate the receipt of those future benefits and through management and operational initiatives, take direct steps to enhance the future benefits, or at least the probability that such benefits will be generated. To conclude, a controlling ownership interest will sell at a higher price than an equivalent non-controlling ownership interest. 15

20 THE EXPECTED VALUE OF CONTROL IS A PRODUCT OF TWO VARIABLES: The change in value from changing the way a firm is operated; & The probability that the change will occur. PREMIUM CONTROL MINORITY APPLYING CONTROL PREMIUMS When dealing with discounts and premiums it is essential to specify the level of value to which they are applied. Levels of value are conceptual points at which the value of subject interest can be calculated. There are three basic levels of marketability and control: The controlling interest (a controlling share in a public company or private company); The marketable minority interest (a minority share in a public company); & The non-marketable minority interest (a minority share in a private company). Control Value Discount for lack of control Minority value Control premiums are only applicable in valuations where one is starting with lack of control value and is trying to arrive at control value. Therefore, when approaches and methods applied during a valuation exercise result in a control value, a control premium may not be applied. On the contrary, when a noncontrolling value is the result of the business valuation approaches and methods applied, a control premium may be applied. 16

21 The following table summarises the application of control premium at various levels of value obtained using different valuation approaches: Approach/ Method Assumption Resulting level of value Whether to apply control premium Discounted cash flow method - DCF Control cash flows Minority cash flows Control Minority Guideline public company method - GPCM Multiple applied to control cash flows Multiple applied to minority cash flows Control Minority Guideline transaction method - GTM Transactions represent sales of controlling interests Transactions represent sales of minority interests Control Minority QUANTIFICATION OF CONTROL PREMIUMS One of the most common practices of arriving at control premiums involves relying on the data from actual transactions based on differences between prices at which publicly traded companies are acquired and the pre-acquisition announcement prices of the same stock. Date Price per share Days before transaction Day 1 Monday US$ Day 2 Tuesday US$ Day 3 Wednesday US$ Day 4 Thrusday US$ Day 5 Friday Day 9 Tuesday US$ US$ Date of announcement Control premium = ( ) / = 31.8% The above methodology does not provide for quantification of buyer differences - specific transactions result from specific buyers with alternating motives. As such, transactions amongst synergistic buyers and transactions amongst financial buyers are not segregated. 17

22 REGULATORY ACCEPTANCE CONTROL PREMIUM IN UNITED STATES Control premiums have enjoyed wide acceptance in the United States federal tax system. The IRS ruling on valuation of closely held shares, Revenue Ruling 59-60, clarifies this aspect. The ruling states: Although it is true that a minority interest in an unlisted corporation s stock is more difficult to sell than a similar block of listed stock, it is equally true that control of a corporation, either actual or in effect, representing as it does an added element of value, may justify a higher value for a specific block of stock. Court decisions and rulings employing control premiums have become the standard over the years, applying these principles not only to stocks, but other types of property as well. The business valuation community in non-estate/gift tax venues also broadly accepts the application of these discounts. CONTROL PREMIUM IN INDIA Although the Indian scenario lacks the legal guidance in respect of control premium, there have been significant instances of control premium being considered. Historically, control premiums were observed in more than 90 per cent of the transactions analysed thereby, reinforcing the relevance of control premiums in the Indian context. For example, almost a year ago, Sun Pharma acquired Ranbaxy for an implied value of INR 457 for each Ranbaxy share, which was acquired at a premium of 18% to Ranbaxy s 30-day volume-weighted average share price and a premium of 24.3% to Ranbaxy s 60-day volume-weighted average share price. The quantification of control premium in India is a tedious task due to lack of transactional databases for public as well as private companies. Research has shown that the control premium in India has ranged from 20% to 37% in the past few years. As per CCI guidelines, 15% discount for lack of control has been prescribed which is further subject to the appraiser s judgements. One of the most common questions that appraisers face from their clients is how does the valuation methodology affect control premium? The applicability of control premium does depend on the methodology used to arrive at the base value. Both income and market approach can produce value that may be either minority or control, and the appraiser must decide which level of value model best fits the specific case at hand and whether the cash flow that is being discounted ( DCF ) or is being multiplied with a multiple ( GPCM/ GTM ) is a control cash flow or a minority cash flow in order to determine whether control premium is to be applied or not. GLOSSARY IRS - Internal Revenue Service CCI - Controller of Capital Issues 18

23 06 BETA: AN INDISPENSABLE MEASURE OF SECURITY ANALYSIS This thought leadership paper provides insights on the various issues relating to the usage of control premium in valuation.

24 INTRODUCTION In the world of finance, the capital asset pricing model ( CAPM ) is the most widely used method for computation of cost of equity ( Ke ). The formula for Ke based on pure CAPM is: Ke = Rf + (Rm-Rf) * As can be observed from the above formula, the factor beta is used as a modifier to the equity risk premium ( ERP ). It is the sole risk factor of the pure CAPM, the form most often shown in textbooks. A pre-requisite for understanding beta is to understand the difference between systematic and unsystematic risk. Systematic risk Unsystematic risk Inherent to the entire market or market segment Specific to company Diversification cannot eliminate these risks Diversification can greatly reduce unsystematic risk Examples: inflation, war, fluctuating interest rates Examples: fire, slumping sales WHAT IS BETA? Beta is a measure of the systematic risk of a stock, the tendency of a stock s price to correlate with changes in the market. The market is typically represented by a broad-based equity index that includes a wide range of industries and arguably behaves like the market as a whole. 20

25 ESTIMATION OF BETA The formula for computation of beta is: Beta = covariance (stock, market)/ variance of market Where: Covariance= Correlation (stock, market) * standard deviation (stock) * standard deviation (market) A beta estimate for a public company comes by regressing excess returns of the public company s stock on the excess returns of a market portfolio over a look back period. (Top-down beta estimate) A question often faced by valuation practitioners is that how is a beta estimate arrived at for a non-public company? A proxy beta is estimated by identifying guideline public companies and estimating their betas. A proxy beta needs to be used when the subject business is a division, reporting unit, or a closely held business. (Bottom-up beta estimate) INTERPRETATION OF BETA The market s beta is 1.0 by definition. A company with a beta equal to 1 has the same risk as the market. Theoretically it moves up and down with the market in tandem. A company with a beta greater than 1 is riskier than the market and a company with a beta less than 1 is less risky than the market. Example, if a stock s beta value is 1.3, it means, theoretically this stock is 30% more volatile than the market. 21

26 What does beta tell you about the movement of security crisis? Value of beta Interpretation β = 0 Movement of security is uncorrelated with the movement of market β = 1 Security moves proportionately with the market (same direction and equal magnitude) β > 1 Security moves in the same direction with the market but with higher magnitude 0 < β < 1 Security moves in the same direction with the market but with lower magnitude IMPACT OF BETA ON SHARE VALUATION Beta Discount rate Share Valuation ADJUSTMENTS TO BETA Following are some of the adjustments that financial analysts make to the beta based on subject company/industry characteristics: A. UNLEVERING AND RELEVERING BETA Betas published for public stocks reflect the capital structure of the companies and are known as levered betas. They incorporate two risk factors: business (or operating) risk and financial (or capital structure) risk. Removing the effect of financial leverage i.e. unlevering the betas is desirable to eliminate the impact of the varying capital structures of the comparable companies on the beta. The formula for unlevering beta is as follows: Bu = I/[1+(1-t)*( Wd/ We)] 22

27 Where; ßu: unlevered beta; ßlv: levered beta; t: tax rate for the company; Wd: proportion of debt in the capital structure; & We: proportion of equity in the capital structure. The unlevered beta is then relevered based on an appropriate capital structure applicable to the subject company. B. BLUME ADJUSTMENT Based on the assumption that betas tend to move toward the market s beta (1.00) over time, a weighted average beta may be computed by weighing the historical betas by 2/3rd and the market beta by 1/3rd. C. OPERATING LEVERAGE The unlevered beta may also be adjusted for operating leverage as the operating leverage of the guideline public companies may differ from that of the subject company. The unlevered beta is adjusted for operating leverage by applying the following formula: o = u/(1 + FC/VC) Where; ßo: Beta adjusted for operating leverage; FC: Weight of fixed cost in operating expense structure; & VC: Weight of variable cost in operating expense structure. D. EXCESS CASH AND INVESTMENTS The unlevered betas of the guideline public companies may be adjusted for excess cash and marketable securities held by the companies. Non-inclusion of the surplus assets (assets that can be sold or distributed without impairing company operations) leads to an incorrect estimate of the beta. The adjustment is based on the principle that the beta of the overall company is the market-value weighted average of the business or assets (including excess cash comprising the overall firm). The formula is as follows: ßu= [Asset beta for operations*(operating assets/total assets)]+[asset beta for surplus assets*(surplus assets/total assets)]. 23

28 LIMITATIONS Beta is an indicator of short term risk and fails to capture longer term fundamental risk, where big-picture risk factors are more indicative. High betas may mean price volatility over the near term, but they don t always rule out long-term opportunities; Computation of beta involves a great deal of estimation regarding the period, the periodicity of the return interval (i.e. daily, weekly, monthly, and annual), the appropriate market index, the use of a smoothing technique, and adjustments for small company stocks; & Beta on its own is somewhat deceptive. It is a historical statistic, and a stock, bond or fund is not always going to behave like its beta predicts. It is useful to pair it with R 2 i.e. the coefficient of determination, which indicates the proportion of a security s total variance related to the market, and which illustrates the reliability of the beta. This is computed by comparing the market s variance with the security s variance. A higher R 2 represents a greater confidence in the beta s information. A low R 2 may mean that the instrument s return is more affected by events other than market-related risk. CAN BETAS BE NEGATIVE? The concept of negative beta goes against the intuition that if a beta of 1 represents average risk and a beta of zero represents no risk, then how can an investment have negative risk? However the answer to this question is in the affirmative. Beta should be viewed as the risk added by an investment to a well-diversified portfolio. Accordingly, any investment when added to a portfolio which makes the overall risk of the portfolio go down, is said to have a negative beta. A standard example that is offered for a negative investment is gold, which acts as a hedge against higher inflation. By the definition of beta, the prices of security with a negative beta move in the opposite direction of the market. 24

29 07 DISCOUNT FOR LACK OF MARKETABILITY This thought leadership paper provides insights on the various issues relating to the usage of DLOM in valuation..

30 THE CONCEPT OF MARKETABILITY The concept of marketability centers on the ease with which the stockholder can convert his ownership interest to cash in terms of timing, the reliability of the quoted proceeds, and transaction costs. From a valuation perspective, the concept of marketability relates to a shareholder`s ability to transform its interest easily into cash. According to International Glossary of Business Valuation terms, the marketability is defined as the ability to quickly convert property to cash at minimal cost. PERSPECTIVE ON THE DISCOUNT FOR THE LACK OF MARKETABILITY ( DLOM ) The discount for lack of marketability is an adjustment enabling professional business valuers to relate the marketable level of value with the non-marketable level. The International Glossary of Business Valuation Terms defines DLOM as an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. Thus, DLOM is a downward adjustment to the value of an ownership interest to reflect its reduced level of marketability. Studies have shown that because investors are risk averse, they apply a certain discount to stocks that are not freely traded, as the inability to readily sell an ownership interest significantly reduces its value. To sum up, this discount is meant to act as a means of equalizing an ownership interest in closely held stock with an interest in publicly traded stock. THE RATIONALE FOR DLOM The marketability of an ownership interest in a private company is affected by two factors: the transaction time and the transaction costs. The transaction time refers to the period of time spent to sell the subject ownership interest. This situation is due to the fact that there is not a ready market for such interest to facilitate prompt sale. The unknown time for a sale is considered the fundamental rationale for discounts for lack of marketability. Secondly, the transaction involves incurrence of significant costs associated to selling. These costs are of two types: direct costs of the sale and, the opportunity costs. The direct costs of the sale are represented by legal, accounting and transaction fees. The opportunity costs are represented by the cash-flows on alternative investments that are given up by the seller as a result of his incapacity to sell in short time. 26

31 APPLYING DLOM DLOM is applicable under the following circumstances: DLOM is appropriate when the subject interest is non-marketable, and the valuation approaches and methods result in a marketable value; & DLOM is not appropriate when the approaches and methods have already taken marketabilityoncerns into consideration. Marketable value Discount for lack of marketability DLOM should be determined considering the factors affecting the marketability of the subject ownership interest and should not be combined with other discounts such as discount for lack of control, blockage discount and so on. Non-marketable value QUANTIFICATION OF DLOM Valuation practitioners utilize numerous studies, methods and models as the source for quantifying DLOM. These studies, methods and models can be complex, indicating widely diverse conclusions, and may be appropriate in only certain limited situations. DLOM is most commonly developed by reference to or analysis of restricted stock of public companies, or analysis of pre-ipo transactions in private companies that later went public, or other public stocks. Each of these methods are discussed below: RESTRICTED STOCK OF PUBLIC COMPANIES The transfer of restricted stock is subject to restrictions laid out by the issuing company. These stocks have a limited private market, and their selling price can be readily compared to the price of the unrestricted stock sold in the open market. The difference between prices at which restricted stocks, that are identical in all rights and powers except for their ability to be freely marketed, are issued relative to freely traded stocks of the same company is considered a proxy for DLOM. DLOM = Price of unrestricted - Price of stock restricted stock 27

32 PRE-IPO STOCK PRICE COMPARISONS This study analyses the stock prices of companies before and after they become public. The difference between these prices is attributed to the stock s marketability. DLOM = Price of stock post - Price of stock pre IPO IPO For DLOM, empirical evidence suggests discounts in the range of 20% to 50% may be appropriate. In practice, as the quantum is highly dependent on the valuation circumstances, the discount applied can fall within a much broader range. While these empirical studies provide some support, the selection of an appropriate marketability discount remains one which requires significant professional judgement, analysis of the circumstances and the outcome of a full marketability assessment. REGULATORY ACCEPTANCE DLOM IN THE UNITED STATES DLOM have enjoyed wide acceptance in the United States federal tax system. The IRS addressed the issue of discounts for lack of marketability in Revenue Ruling , stating: Securities traded on a public market generally are worth more to investors than those that are not traded on a public market. The IRS Valuation Training for Appeals Officers, 1998 page 4-9, lists two primary court cases as the basis for discounts for lack of marketability. In Central Trust Co. vs. United States, 305 F 2d 292 (Ct. Cl., 1962) the Court of Claims stated: It seems clear, however, that an unlisted closely held stock of a corporation, in which trading is infrequent and which therefore lacks marketability, is less attractive than a similar stock which is listed on an exchange and has ready access to the investing public. In Estate of Andrews, 79 T.C. 938, page 953, the Court stated: Even controlling shares in a nonpublic corporation suffer from lack of marketability because of the absence of a ready private placement market and the fact that flotation costs would have to be incurred if the corporation were to publicly offer its stock. DLOM IN INDIA DLOM in India is not backed by any statutory or regulatory base. However, as per erstwhile CCI guidelines, 15% discount has been prescribed. It is recommended that the valuer should apply his own discretion in this matter. GLOSSARY IPO - Initial public offer IRS - Internal Revenue Service CCI - Controller of Capital Issues 28

33 08 VALUATION OF TAX ATTRIBUTES This thought leadership paper provides insights on the impact of tax attributes - NOLs in particular, on valuation..

34 APPROACHES TO VALUATION In any business valuation the subject matter being valued is the business along with its operational net assets. For example, the operating level of working capital and the operating assets that are required to produce those cash flows that are eventually discounted to a present value forms a part and parcel of the valuation. Often, as appraisers, we need to look at the non-operating assets and liabilities that sit on the balance sheet as at the valuation date and add the fair value of such assets or liabilities to the value of the business to arrive at the enterprise value or equity value as the case may be. Several tax attributes such as net operating losses (NOLs), future amortization of intangibles, future depreciation of property, plant and equipment, research and development credits, foreign tax credits existing as of the valuation date present themselves as a critical element while arriving at the value of businesses that have these accumulated losses or credits from prior years. This article addresses the rationale that we as appraisers use to measure the value of tax attributes while valuing a business. VALUATION OF TAX ATTRIBUTES Tax attributes are an asset of a company, just as property, plant and equipment are assets. However, tax attributes are an asset that many buyers do not automatically consider. Demonstrating the real and reliable tax savings that can be generated by the utilization of the corporation s tax attributes increases the value of a corporation, and thus, the negotiating leverage. By modelling the projected utilization of a corporation s tax attributes, one can demonstrate that the corporation s tax attributes have significant value, which should be included in the valuation of the corporation. It is important to seek advice from experienced mergers and acquisitions tax professionals who can provide an expedient, yet thorough, analysis of the present value of the corporation s tax attributes. TREATMENT OF NOLS One of the most common tax attributes that an appraiser deals with are NOLs. Subject companies being valued have past losses which need to be incorporated in the valuation model to derive the appropriate value. NOLs can either be valued by considering the tax savings while computing the free cash flows, or can be separately added to the value derived from operating activities. 30

35 ILLUSTRATION ABC International Inc. ( ABC ) needs to determine the enterprise value of its business as of December 31, ABC has accumulated losses of approximately US$ 20 million, which are set to retire on December 31, ABC has provided detailed projections and expects to be profitable from FY The value derived using the discounted cash flow approach (not considering the effect of NOLs) is US$ 25 million. Since the company has accumulated losses, which will result in a lower tax outflow in future years, such accumulated losses need to be assigned some value. The value derived is then to be added to the US$ 25 million computed using the free cash flows of ABC. The following table illustrates the computation of value of the NOLs: Particulars Projected (amounts in $ mn) Profit before tax NOL utilized (A) Unutilized NOL as at the year end Tax out flow avoided (Ax40%) Present value factor Present value of tax savings Sum of present value of tax savings 4.8 Since, the NOLs expire in FY 2019, the company does not get the benefit of tax savings FY 2020 onwards. The present value of tax savings amounting to US$ 4.8 million will be added to US$ 25 million computed using the discounted cash flow approach. Whether the present value of tax savings need to be added to a value derived using a market based valuation model would depend upon the existence of NOLs in the comparable companies being considered in the market based valuation approach. If the comparable companies have NOLs, it is assumed that the market based valuation approach takes into consideration the value of the NOLs and thus the subject companies valuation need not be adjusted for the present value of tax savings. However, if the comparable companies do not have any NOLs, it may be appropriate to add the present value of the tax savings to the value derived. The illustrations explain the importance of assigning values to the tax attributes of the subject entity. The computation of other tax attributes would be very similar to the computation of tax savings on NOLs, and thus should not be ignored in a valuation exercise. 31

36 09 VALUATION FOR IRC 382 This thought leadership paper provides insights on valuation requirements under IRC 382.

37 IRC AN UNDERSTANDING Acquisitions are motivated by various factors some of them being operating synergies with existing businesses, foray into new business segments, as a part of a turn-around strategy etc. However, many a time acquisitions are effected to capitalize on the tax attributes of a loss making target corporation which have the consequence of reducing the future tax liabilities of the acquirer. Based on this understanding, a corporation with accumulated tax loss carry-overs is theoretically more valuable than an otherwise similar corporation without loss carry-overs. Assuming the two corporations project the same future stream of pre-tax income, the corporation with loss carry-overs will anticipate higher after-tax yields. An acquirer should be willing to pay an additional amount for the loss corporation, up to the present value of the projected future tax savings resulting from the anticipated use of loss carry-overs to offset future income. One of the many perils of acquisitions effected with such intent is defeating the principle of tax neutrality, which posits that tax implications should neither impede nor induce business transactions. The US Congress enacted IRC 382 to prevent taxpayers from such trafficking in tax losses. The tax benefits that can be limited through this section include net operating losses ( NOLs ), net capital losses ( NCLs ), and net unrealized built-in losses and depreciation deductions attributable to those built-in losses, thereby increasing the corporation s corporate tax liability. Based on this understanding, a corporation with accumulated tax loss carry-overs is theoretically more valuable than an otherwise similar corporation without loss carry-overs. VALUATION CONSIDERATION UNDER IRC 382 Valuation consideration stems from the definition of value per IRC 382(k) (5) to be Fair Market Value ( FMV ). Internal Revenue Service ( IRS ) revenue ruling defines FMV as, the price at which the property would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of relevant facts. Limitations under IRC 382 are enforced by capping the annual net operating losses that can be utilized by a loss corporation against future taxable income in an event of an ownership change. 33

38 The annual limitation of net operating losses that may be utilized is computed as under: Limitation under IRC 382 = Value of old loss corporation ( FMV ) x Long-term tax exempt rate Some key tax based concepts and definitions are included that explain the triggering event and applicability of IRC 382. WHEN IS IRC 382 TRIGGERED? IRC 382 is triggered when an ownership change occurs in a loss corporation. Ownership change Change in ownership of more than 50% of the stock of loss corporation during the testing period. Occurs through Owner shift: Change in aggregate stock ownership of one or more 5 percent shareholders. Equity shift: Re-organization transactions Loss corporation: The term loss corporation means a corporation entitled to use a net operating loss carry-over or having a net operating loss for the taxable year in which the ownership change occurs; 5-percent shareholder: A 5-percent shareholder includes any person holding (including indirect holding) 5% or more of the loss corporation s stock during the testing period ; & Testing period: The testing period is generally the 3-year period ending on the date of ownership change. 34

39 ILLUSTRATION 1 An individual that previously did not own stock of the loss corporation acquires 52 percent of the stock via a tender offer. Following the tender offer, the individual is a 5-percent shareholder whose percentage ownership has increased by more than 50 percentage points, triggering an ownership change. ILLUSTRATION 2 Company is a loss corporation. Ten unrelated individuals that previously did not own any company stock each acquire 6% of company s stock. Following the acquisitions, each individual is a 5-percent shareholder and each has separately caused a 6 percentage point increase. In the aggregate, they have caused a 60 percentage point increase, triggering an ownership change. As per IRC 382(e)(1), Except as otherwise provided in this subsection, the value of the old loss corporation is the value of the stock of such corporation (including the value of any plain vanilla preferred stock) immediately before the ownership change. The limitation under IRC 382 is similar though less restrictive than the provisions of section 79 of the Income Tax Act, 1961 of India. According to this section, in case of a change in shareholding of a private company, carry forward and set off of losses incurred in any prior year shall not be allowed for any future period barring a few exceptions. The value of a loss corporation: Includes Excludes Capital contribution made primarily to decrease the impact of annual limitation Common stock of loss corporation, convertible preferred stock, voting preferred stock of loss corporation Substantive non-business assets (exceeding 1/3rd of total value of loss corporation s assets) Capital contributions made 2 years prior to an ownership change Determining the value of the stock involves a consideration of the following: For publicly traded companies the IRS has acknowledged that the stock value does not necessarily equal the trading value on an exchange, i.e., certain blocks of stock may have higher value due to control rights; For privately held companies, different classes of stock may have different rights and vary in value; & In non-public corporations, where there are no recent sales, the corporation may wish to acquire an independent appraisal to support the value. 35

40 TAXATION AND VALUATION IN SYNC IRC 382 is one of the few provisions of the IRS that require a professional appraisal to be made to satisfy the regulator s requirements as the value conclusion is a significant determinant of the limitation under the section. This is a striking example of how the diverse practices of the corporate world harmonize in sync for better reporting practices and enhanced regulatory compliances. CASE STUDY - IRC 382 Company A acquires 75% stake in Company B. Company B is a loss corporation having NOLs of US$ 10 million that can be carried forward for 4 years. This is an ownership change of a loss corporation triggering IRC 382. Company B has a FMV of US$ 100 million as of the ownership change date. Annual limitation of NOLs under IRC 382 will be computed as follows: Particulars i. FMV of Company B USD 100 million ii. Long term federal rate(assumed) 2% Annual IRC 382 deduction limit (i) * (ii) USD 2 million Scenario 1: Without limitation of IRC 38 Particulars i. Earnings before NOLs ii. NOLs deduction* iii. Earnings after NOLs (i)-(ii) iv. 20% Earnings after tax (iii)- (iv) (All amounts in USD millions) (2.0) (3.0) (4.0) (1.0) (0.8) The NOLs of US$ 10 million have been utilized by

41 Scenario 2: With limitation under IRC 382 Particulars i. Earnings before NOLs ii. NOLs deduction* iii. Earnings after NOLs (i)-(ii) iv. 20% Earnings after tax (iii)- (iv) (All amounts in USD millions) (2.0) (2.0) (2.0) (2.0) (0.2) (0.4) (0.6) *Per limitation under IRC 382 The annual deduction of NOLs has been restricted to US$ 2 million. As the NOLs can be carry forwarded for 4 years, the balance NOLs US$ 2 million shall lapse beyond

42 10 VALUING INTERCORPORATE INVESTMENTS This thought leadership paper provides insights on the various issues relating to intercorporate investments in valuation..

43 INTRODUCTION Multinational, multi-business companies often have complicated structures, with intercorporate investments (i.e., investments in other companies) across various geographies and across various business lines. Companies commonly make equity or debt investments in other companies. Ownership can be minority (less than 50%) or majority (greater than 50%) and the degree of operational influence can be passive or active. ACCOUNTING CATEGORIZATION Investment Category Level of investor influence Invester ownership level Accounting treatment Investment in financial assets Not material Less than 20% 1) FVTPL 1 ; 2) FVOCL 2 ; & 3) Amortized cost Investment in Significant 20%- 50% Equity method associates Business Control More than 50% Consolidation combinations 1 2 Fair value through profit and loss Fair value through other comprehensive income 39

44 ACCOUNTING TREATMENT Based on the categorization as discussed above, for valuation purposes, the intercorporate investments are: 1. NON-CONTROLLING INTEREST Investments in financial assets and investments in associates are classified as non-controlling interest. Such investments are companies in which the parent company holds less than 50% equity stake or the degree of influence over the investee company is non-controlling. 2. CONSOLIDATED INVESTMENTS Non- Consolidated investments Intercorporate investments Consolidated investments Business combinations are classified as consolidated investments. Here the parent subsidiary relationship arises whereby the parent company exercises formal control over these subsidiaries. VALUATION CONSIDERATIONS The alternatives to value intercorporate investments vary depending upon their classification as well as on the availability of full or partial information. Intercorporate investments Non-controlling investments Controlling investments Public Private Disaggregate Aggregate 40

45 1. NON CONTROLLING INTEREST The primary consideration in the process of valuing non-controlling interest is the trading nature (i.e., publicly traded or privately held) of the investment as well as the availability of information. Non- Consolidated investments Public Private Publicly traded investments For publicly traded investments, the market value of the investment is preferably used as the value estimate. However, before relying on this methodology the market value must be verified as to whether any indicator exists that might suggest that the share price does not reflect current information. In a case, where the share price does not reflect current information but full access to the financial information of invested company is available, a separate DCF valuation is performed to arrive at the value of equity shares of the invested company. Subsequently, the value of the investment is arrived at by applying the percentage proportionate stake of the holding company in the invested company. Privately held investments If the invested company is not listed but full access to its financial statements is available, a separate DCF valuation of the equity stake as discussed above is considered for valuation purpose. However, where full access to information is not available and holding company s accounts are the only source of financial information for the investment, then the following alternatives are relied upon: Capitalization approach: This is a feasible approach in case of minority active investments as only the net income and book equity of the invested company are generally disclosed. All that is required is an estimate of net operating income for the subject company being valued and an estimate of the overall capitalization rate relevant to that company. Multiples valuation: Under this approach, multiples are extrapolated from publicly traded guideline company data to derive the value estimation for the subject company being valued.since typically net income and book value are available, the multiple of book value or net income at which companies in the same business (as the private business in which you have holdings) trade at, are applied to the book value or net income of the invested company being valued. 41

46 2. CONSOLIDATED INVESTMENTS The primary consideration in the process of valuing consolidated investments is perhaps the most critical, since it will determine how to approach the valuation process. It involves deciding, at the start of the process, whether to value the company as a whole (aggregated) or value its individual businesses separately (disaggregated). Consolidated investments Disaggregate Aggregate Disaggregate valuation The viable way to deal with consolidated investments is to value the equity in such holding separately using either an income or market approach to estimate the final value of the proportionate holding. The reason for separate valuations is that the parent and the subsidiaries may have very different characteristics costs of capital, growth rates and reinvestment rates. E.g.: Company A is a steel company and Company C is a chemical company. Valuing them on a combined basis under these circumstances may yield misleading results. Following steps are involved in valuing a consolidated parent company with intercorporate investments: STEP 1: Value the parent on standalone basis To arrive at the value estimate, the standalone financial statements of the parent company are used. If only consolidated statements are available, adjustments to the income, assets and debt of the subsidiary from the parent company s financials is required as failure to do so may double count the value of the subsidiary. STEP 2: Value the subsidiaries independently Applying the crux of disaggregate approach, here each of the subsidiaries that the parent company has holdings in are valued as independent companies, using risk, cash flow and growth assumptions that reflect the businesses that the subsidiaries operate in. The value estimate is arrived at by applying the percent stake of parent in subsidiary to estimate the proportionate value owned by the parent. E.g. if Company A holds 60% of Company C, then value of subsidiary C that would be considered for valuation of Company A = % owned in Company C * (Value of Company C Debt of Company C) STEP 3: Consolidation of value Once the value of parent and subsidiary is separately arrived (estimated in step 1 & 2), they are added up to determine the final value of the equity in the parent company with the cross holdings. 42

47 Aggregate valuation Aggregate valuation is relied when the characteristics costs of capital, growth rates and reinvestment rates, of the parent and subsidiary do not vary. This might be the case when both the companies belong to the same industry or are similar in operations. When valuing the company as an aggregated whole, the portion of the equity in the subsidiary that the parent company does not own i.e. non-controlling interest should be subtracted. The important issue that needs to be addressed is that how to value these non-controlling interest. One way of doing this is to convert the minority interest from book value to market value by applying a price to book ratio (based upon the sector average for the subsidiary) to that minority interest. Estimated market value of minority interest = Minority interest on balance sheet * Price to book ratio for sector (of subsidiary). USING THE ACCOUNTING ESTIMATES In many cases, the information that is provided on the investments, especially in the context of minority holdings, is not enough to value them. These companies often report an estimated value for the holdings on the balance sheet, though that estimated value is not necessarily a market value or even a fair value. When faced with multiple minority holdings, analysts often use these accounting values as estimates of the intrinsic value of the holdings. Although using the accounting estimates of the holdings is the most commonly used approach in practice it should be the last resort especially when the values of the intercorporate investments are substantial. 43

48 11 INSIGHTS INTO REAL OPTIONS This thought leadership paper provides insights on real options valuations.

49 INTRODUCTION Traditional approaches to capital budgeting, such as discounted cash-flows ( DCF ), cannot capture entirely the project value, for various reasons: it is assumed that investment decisions are irreversible, interactions between today s decisions and future decisions are not considered and investment in assets seems to be a passive one (management doesn t interfere during the life of the project). Managerial flexibility generates supplementary value for an investment opportunity because of managerial capacity to respond when new information arises, while the project is operated. Investment in real assets includes a set of real options that management can exercise to increase investment s value (under favorable circumstances) or limit losses (under unfavorable situations). From this perspective, a project has a standard value, determined through traditional techniques like DCF, but also a supplementary value, coming from operational and strategic real options held by an active management. REAL OPTIONS VALUATION WHAT ARE THE KEY TESTS FOR REAL OPTIONS? Is there an option embedded in the asset/ decision? Can you identify the underlying asset? Can you specify the contingency under which you will get pay off? EXAMPLE: If the company has a patent to manufacture a product, does it have the choice to hold the patent in its name without using the patent to manufacture? Is there exclusivity? If yes, there is option value. If no, there is none. If in between, you have to scale value. EXAMPLE: It needs to be assessed whether is it only your company or other companies as well that have a right to manufacture a similar product. Can you use option pricing model to value the real option? Is the underlying asset traded? Can the option be bought or sold? Is the cost of exercising the option known and clear? EXAMPLE: Assess whether you can assign values to the inputs in the option pricing models pertaining to the underlying asset. Real option analysis applies option pricing techniques to capital budgeting decisions. Real options do not refer to a derivative financial instrument, but to actual choices or opportunities of which a business may take advantage or realize. For example, investing in a new manufacturing facility may provide a company with real options of producing new products, consolidating operations or making other adjustments to changing market conditions. Another non-business example would be giving up a job to attend graduate school. The scope of this discussion will be confined to capital budgeting decisions i.e., investments. There are three types of options embedded in investments: The option to delay, expand or abandon. A pertinent point to keep in mind is that not all investment decisions exhibit characteristics of real options. There are certain criteria which must be tested before treating an investment decision as a real option. 45

50 INPUT ESTIMATION IN REAL OPTION VALUATION The challenge in real option valuation is the application of an option pricing model designed for valuing financial instruments to a capital budgeting decision. There is plenty of estimation involved as one has to assign a proxy to each of the inputs of the purely mathematical formula. The table below discusses such estimation: INPUT ESTIMATE Value of underlying asset Present value of cash inflows from taking project now Strike price on the option Option is exercised when investment is made; Cost of making investment on the project; assumed to be constant in present value dollars Variance in cash flows of underlying asset Variance in cash flows of similar assets or firms or; Variance in present value from capital budgeting simulation Dividend yield Cost to delay Each year of delay translates into one year less of value-creating cash flows Annual cost of delay = 1/n Expiration of the option Life of the patent ILLUSTRATION Biogen, a bio-technology firm, has a patent on Avonex, a drug to treat multiple sclerosis, for the next 17 years, and it plans to produce and sell the drug by itself. The key inputs on the drug are as follows: PV of cash flows from introducing drug now ( S ) PV of cost of developing drug for commercial use ( K ) Patent life ( t ) Risk-free rate ( r ) Variance in expected present value ( σ2 ) Expected cost of delay ( y ) Value of Avonex based on traditional DCF US$ billion (a) US$ billion (b) 17 years 6.7% (17-year T-bond rate) (Industry average firm variance for bio-tech firms) 1/17 or 5.89% US$ 547 million (a-b) 46

51 INTERPRETATION Biogen has an exclusive patent to develop the drug Avonex. This patent can be viewed as a call option and the drug as the underlying asset. To analyze whether producing the drug would be profitable or not and if yes, what would be the optimal time to exercise the patent during its entire life, option pricing analysis can be used. COMPUTATION D N(D1) D N(D2) Call value US$ 907 million IMPLICATION The value of Avonex using DCF was around US$ 547 million. This is simply the difference between the present value cash inflows from commercializing the product now and cost of developing the patent. However, the present value of the patent at the same time based on option pricing is US$ 907 million. This implies that the patent i.e. without commercializing the product is valued at US$ 907 million vis-à-vis the product being valued at US$ 547 million i.e., the NPV of the project. As the option pricing analysis is performed every year with the term and cost of delay changing, the option to wait continues to be more valuable than the option of exercising the option i.e., beginning commercial production. Such option continues to be profitable upto the point in time the value of the patent is above US$ 547 million. Thus commercial production should begin when the value of the patent is equal to the value of the product i.e., US$ 547 million. Source: Aswath Damodaran: Valuation: Real Options, Acquisition Valuation and Value Enhancement 47

52 12 VALUATION OF CONTINGENT CONSIDERATION This thought leadership paper provides insights on valuation of contingent consideration..

53 INTRODUCTION Contingent considerations are typically employed in transactions to bridge the valuation gap between buyer and seller arising from differences of opinion regarding the target company s future economic prospects. It helps to get the buyer and seller on the same page when it comes to valuation. Let s examine the basic concept by way of an example: Company A intends to acquire company B. Company B has just introduced a new product line that is expected to generate significant sales. Company B s owners have projected significant amount of sales from the proposed product line and is considering the same to influence the deal size. The buyer on the other hand believes that, there is a risk of uncertainty in the achievement of targets contemplated by the acquiree and hence a disagreement in the deal valuation. By incorporating a contingent consideration clause in the purchase agreement, the seller accepts part of the business risk along with the buyer, and also participates in any upside post-transaction. If Company B, post-acquisition is able to generate the revenue and margins as projected from the new product line, there shall be additional payments made to the owners on account of the same. On the other hand, if the product line fails to get the desired results, Company A need not make the additional payment. In other words, a contingent consideration clause gives the parties to the transaction, additional time in ironing out the uncertainties that exist at the time of deal closure by looking at actual performance post the closing. Contingent consideration, also referred to as earn-out payment is an obligation of the acquiring entity to transfer additional assets or equity interests to the former owners of a target company. The consideration will only be paid if specified future events occur or conditions are met. ASC 805, Business Combinations, IFRS 3 and Ind AS 103 require that contingent consideration assets and liabilities be recorded at fair value on the acquisition date. Moreover, they also require the revaluation of most contingent consideration instruments at each subsequent reporting period until the final settlement of the obligation. Changes in the fair value of the instruments are then typically recognized in earnings. Thus, it is important to understand how to fair value contingent consideration and the different valuation models used. Contingent consideration, also referred to as earn-out payment is an obligation of the acquiring entity to transfer additional assets or equity interests to the former owners of a target company. The consideration will only be paid if specified future events occur or conditions are met. 49

54 VALUATION MODELS The materiality of the earn-out estimate may influence the model s complexity. Some methods may be risk-adjusted while others are risk-neutral. Risk-adjusted methods consider a discount rate to be the risk free rate plus an additional risk premium. In risk-neutral methods, the discount rate considered is the risk-free rate. Following are various methods to fair value earn-outs: DISCOUNTED CASH FLOW ( DCF ) ANALYSIS Framework: Risk-adjusted method Steps: 1] The target company s prospective financial information ( PFI ) is forecasted and analyzed over the term of the earn-out; & 2] Expected payments and timing of the payment are determined which are then discounted to their present-value equivalent as of the acquisition date. Pros: Approach is simplistic. Cons: Limited to the analysis of a single scenario and is not well suited to capture multiple scenarios. ILLUSTRATION The earn-out is payable if EBITDA in year 1 is US$ 5 million. The selected PFI assumes the EBITDA to be only US$ 4 million, then the single PFI approach would conclude the fair value of the earn-out to be US$ 0. PROBABILITY WEIGHTED EXPECTED RETURN METHOD ( PWERM ) OR SCENARIO METHODS Framework: Risk-adjusted method Steps: 1] Scenarios or outcomes with their respective probabilities are estimated; & 2] Expected pay-offs are computed and discounted to their present value equivalent as of the acquisition date. Pros: 1] It is straightforward and intuitive; 2] More robust than the DCF analysis regarding future outcomes; & 3] Suitable when volatility of PFI is high or where contingent payments are based on future events that will result in vastly different cash flows for the target company. Cons: Difficulty in estimating appropriate discount rate, projecting the timing and occurrence of future events, as well as the associated cash flows. 50

55 ILLUSTRATION US$ 100 million is contingent upon obtaining FDA approval. Approval is expected to be received in year 1. Particulars Payment Probability Probability weighted payment Approval obtained US$ % US$ 75 Approval denied US$ 0 25% US$ 0 Total 100% US$ 75 Discount rate 10% Present value factor 0.91 FV of contingent consideration US$ 68 MONTE CARLO METHOD Framework: Risk-adjusted method Steps: 1] Random numbers are used to measure possible outcomes and the likelihood of occurrence; 2] Assumptions must be made regarding the range of likely growth rates and earnings margins, as well as inputs related to minimum and maximum pay-outs under the earn-out terms; 3] If data is unavailable for multiple scenarios, then probability distributions related to key variables may be used; & 4] Simulation software may provide the expected value of the earn-out, range of earnout payments, the frequency at which earn-out is paid, etc. Pros: Numerous outcomes related to future company performance can be contemplated that may otherwise not be considered. BLACK-SCHOLES MODEL Framework: Risk-adjusted method Steps: 1] The earnout represents a call option on the future performance of a target company; & 2] The price of a traditional call option is calculated by analyzing the volatility and opportunity cost of investing in the underlying asset. Pros: Numerous outcomes related to future company performance can be contemplated that may otherwise not be considered. Cons: 1] It is complex and time consuming as it becomes difficult to convert cash flows to a risk-free basis and estimate certain inputs (E.g. volatility); & 2] The model does not consider early exercise of an American option. 51

56 ILLUSTRATION Earn-outs are contingent upon target achieving a benchmark EBIT of US$ 1,125,000 within 3 years. EBIT is currently US$ 1,000,000. At the end, acquirer will pay additional consideration equal to the excess EBIT over the benchmark. The discount rate is 10% and the risk-free rate is 3%. Volatility of earnings is 14% based on historic EBIT. The inputs to the Black-Scholes Model for this example are: 1] The current US$ 1 million level of earnings is the value of the underlying; 2] The benchmark of US$ 1,125,000 serves as the exercise price; 3] The term is 3 years; 4] The volatility is 14%; 5] The risk-free rate is 3%; & 6] The dividend rate is 0%. Based on the above inputs, calculations for the Black-Scholes Model can be incorporated into an excel spreadsheet. The resulting call option value of US$ 84,413 will be the value of contingent consideration. LATTICE MODELS Framework: Risk-adjusted method Steps: 1] Lattice model utilizes a pricing tree whereby future movement in a target variable is estimated based on a volatility factor; 2] In each time period, the model assumes that at least two movements are possible (up or down) representing the evolution in the value of the target variable; & 3] In the case of an earn-out, the strike price would be equal to the earnout hurdle and the underlying asset would represent acquisition date asset value (i.e., the trailing 12 months sales prior to the acquisition date). Pros: Allows a multi-period view and probabilities can be incorporated. Cons: The model is complex and includes an enormous number of calculations and variables over a long period of time. CONCLUSION Understanding the future accounting and valuation implications of earn-out arrangements prior to the transaction can be critical to evaluating alternative transaction terms to support negotiations, and can avoid unnecessary surprises down the road. 52

57 13 VALUATION OF SYNERGIES This thought leadership paper provides insights on valuation of synergies.

58 INTRODUCTION Synergy is the increase in value that is generated by combining two entities to create a new and more valuable entity. It is that magic ingredient allowing acquirers to pay billions of dollars in premiums during acquisitions. In other words, synergy is the additional value that is generated by two combining firms, that create opportunities that would not have been available to these firms operating independently. A colloquial one plus one which on combining equals three, best defines what synergy is. The table below, though not exhaustive, lists out synergies from various aspects considered in a typical M&A transaction. Synergy Operational Financial Debt capacity Tax benefits Diversification Economies of scale Greater pricing power Combination of different functional strengths Higher growth in new or existing markets Operational synergies in form of cost Operational synergies in form of growth 54

59 OPERATIONAL SYNERGY V/S FINANCIAL SYNERGY Operational synergy Financial synergy Allows firms to increase their operating income from existing assets, increase growth or both. It is a combination of growth and cost synergies. Includes new products/competencies, access to new markets, decreased capital expenditure, higher growth potential etc. Payoff can take the form of either higher cash flows or a lower cost of capital (discount rate) or both. Includes lower cost of debt, opportunity to optimize capital structure, tax benefit, diversification etc. VALUING SYNERGY Valuing synergy requires appraisers to make assumptions about future cash flows and growth. The synergy can be valued by answering two fundamental questions. Q. WHAT FORM IS THE SYNERGY EXPECTED TO TAKE? Synergy, to have an effect on value, has to influence one of the four inputs into the valuation process: Higher cash flows from existing assets (cost savings and economies of scale); Higher expected growth rates (market power, higher growth potential); A longer growth period (from increased competitive advantages); or A lower cost of capital (higher debt capacity, lower beta, lower size risk premium). Q. WHEN WILL THE SYNERGY START AFFECTING CASH FLOWS? Synergies seldom show up instantaneously, but they are more likely to show up over time. Since the value of synergy is the present value of the cash flows created by it, the longer it takes for it to show up, the lesser its value. STEPS IN VALUING SYNERGY 1] Value each firm separately, using free cash flow projections and terminal value; 2] Add up the present values for the two firms estimated in step 1; 3] Prepare a free cash flow projections for the combined firm by adding items on the individual firms cash flow projections; 55

60 4] Identify areas which can be impacted by synergies (Higher revenue growth or lower costs); 5] Translate the identified synergies into numbers in the combined free cash flow projections. If revenues are expected to grow faster as a result of synergy, a fast growth rate can be applied, whereas, if costs are expected to be reduced, exhibit the reduced cost in the combined free cash flow projections; 6] Calculate the value of the combined firm with synergies using the revised free cash flow projections as mentioned in Step 5; & 7] Compare the values derived in Step 5 with the value derived is Step 2. The difference in value is the value of synergy. Value of synergy = Value of the combined firm, with synergy - Value of the combined firm, without synergy DISCOUNT RATE The discount rate must be consistent with the risk of the synergy stream. It is widely denoted that cost synergies are less risky than growth synergies. Tax synergy is less risky than both cost synergies and growth synergies. For example: If one has an NOL carry forward of a substantial amount of money and one has substantial cash flows of the acquirer that this NOL carry forward can be utilized, it is likely that it will be, so that would be discounted at the risk-free rate. The next level up with respect to the discount rate and the risk of the attainment of synergies is the variability of the cash flows to earnings before income taxes. The question would be if the risk is low but not risk-free so one would utilize the cost of debt. The next level up would be cash flows that are as risky as the free cash flows of the enterprise then it will be discounted at the firm s integrated weighted average cost of capital. MIXING CONTROL AND SYNERGY In many acquisition valuations, the value of control and synergy are assessed together and it is difficult to determine where one ends and the other begins. By combining the two, appraisers also run the risk of using the wrong discount rates to value each component. Synergy requires two entities (firms, businesses, projects) for its existence and is created by combining the two entities. Control, on the other hand, resides entirely in the target firm and does not require an analysis of the acquiring firm (or its valuation). It is important that appraisers keep the value of synergy apart from the value of control so that we accomplish two objectives. First, ensure that there is no double counting. Second, devise strategies for acquisition bidding that can differentiate between control and synergy value. COMMON ERRORS IN VALUING SYNERGY Acquiring firms often subsidize target firm stockholders by misidentifying sources of synergy or using the wrong discount rate on savings from synergy; It is also common to see a mixing up and double counting of synergy and control values; & Finally, over optimism about when synergy gains will show up often lead to too high a value being attached to synergy. 56

61 ILLUSTRATION Particulars Firm A Firm B Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 Revenues ,000 1,100 1,210 EBIT FCFF Present Value of FCFF Terminal Value Enterprise Value Particulars Combines value of Firm A and B (without synergy) Combines value of Firm A and B (without synergy) Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 Revenues 1,500 1,650 1,815 1,600 1,792 2,007 EBIT FCFF Present Value of FCFF Terminal Value Enterprise Value 926 1,025 Value of Firm A (A) 295 Value of Firm B (B) 631 Combined Value of firm A and B (without synergy) Combined Value of firm A and B (with synergy) (AB) Synergy {(AB)-(A)+(B)} 926 1,

62 14 IS VALUATION UNDER FEMA RESTRICTED TO DCF? This thought leadership paper provides insights on valuation under FEMA regulations.

63 Back in July 2014, FEMA updated the valuation guidelines and mandatorily required the use of internationally accepted valuation methodology for determining value of securities of un-listed companies. However, in our experience, even post the revised guidelines, we continue to see a lot of valuations solely relying on the discounted cash flow approach to derive the fair value of securities. This thought leadership, summarizes the revised regulations and valuation requirements in existence post BACKGROUND The Foreign Exchange Management Act, issued by the Reserve Bank of India, lists down valuation guidelines that need to be followed at the time of transfer of securities to non-residents. The erstwhile valuation guidelines required use of the discounted cash flow method to determine the value of securities to be transferred. The use of the discounted cash flow approach method, meant dependency on the accuracy of information, namely financial projections received from the company to derive the fair value of securities. Such financial projections include assumptions relating to potential working capital, capital expenditure and other information, which may not always be available. The RBI revised these guidelines in July 2014 and stated that, the issue/ transfer price of unlisted equity instruments, shall be determined as per internationally accepted valuation methodology for valuation of shares on an arm s length basis, duly certified by a chartered accountant or a SEBI registered merchant banker. The introduction of internationally accepted valuation methodology implies that, a practitioner is free to use market based approaches to determine the fair valuation. Such modification helps reduce the subjectivity required for conducting the valuation using the discounted cash flow approach. Internationally accepted valuation methodology includes: I. Income approach 1] Discounted cash flow approach; 2] Relief from royalty approach; & 3] Capitalized cash flow approach. II. Market based approach 1] Guideline public comparable company method; & 2] Guideline transaction method. III. Asset/Cost based approach 59

64 The flexibility with respect to the use of the above approaches is left with the practitioner. The following table summarizes valuation guidelines for various scenarios. Scenario Valuation guidelines and methodology Valuation by whom Issue of Equity Shares by an Indian Company to a Non-Resident Issue by Listed Companies Price worked out in accordance with the ICDR Regulations issued by the Securities and Exchange Board of India ( SEBI guidelines ). Can be determined by a Merchant Banker or a CA. Issue by Unlisted Companies The shares must be issued at price not less than the fair value as per any Internationally accepted pricing methodology for valuation of shares on arm s length basis. Can be determined by a Merchant Banker or a CA. Issue of Compulsorily Convertible Preference Shares ( CCPS )/ Compulsorily Convertible Debentures ( CCDs ) by an Indian Company to a Non-Resident Issue by Listed Companies The securities can be issued at price determined based on the valuation guidelines prescribed under the SEBI (ICDR) Regulations. Can be determined by a Merchant Banker or a CA. Issue by Unlisted Companies The securities can be issued at price not less than the fair value of shares as per the Internationally accepted pricing methodology. The conversion formula has to be determined or fixed upfront. The price at the time of conversion should not be less than the fair value worked out at the time of issuance of these securities. Can be determined by a Merchant Banker or a CA. Transfer/ Sale of Shares by a Resident Indian to a Non-Resident Shares of Listed Companies The shares can be transferred at a price not less than the price determined as per the Preferential Allotment Guidelines of the SEBI (ICDR) Regulations, The price should be certified by a Merchant Banker or a CA. Shares of Unlisted Companies Transfer price to be not less than fair value worked out as per any internationally accepted pricing methodology for valuation of shares on arm s length basis. Fair value of shares to be determined by a SEBI Registered Merchant Banker or a CA. Transfer/ Sale of Shares by a Non-Resident to a Resident Indian - Transfer covers sale, buyback, reduction of capital. Thus, an exit to a private equity investor, buy-out by the promoters, etc., would be covered within these guidelines. Shares of Listed Companies The shares can be transferred at a price not more than the price determined as per the Preferential Allotment Guidelines of the SEBI (ICDR) Regulations, The price should be certified by a Merchant Banker or a CA. 60

65 Scenario Valuation guidelines and methodology Valuation by whom Shares of Unlisted Companies Transfer price to be not less than fair value worked out as per any internationally accepted pricing methodology for valuation of shares on arm s length basis. Fair value of shares to be determined by a SEBI Registered Merchant Banker or a CA. Downstream Investment by an Indian Company in another Indian Company Downstream investment means indirect foreign investment, by one Indian company, which is not owned and/ or controlled by resident Indian entities, into another Indian company. Issue/ transfer/ pricing/ valuation of capital shall be in accordance with applicable SEBI/RBI guidelines. The share investment, even in such a case, must comply with the valuation guidelines explained above for an FDI investment. Thus, the downstream is put on par with an FDI investment. Overseas investment for acquiring existing companies Any internationally accepted methodology Investment is > USD 5 million, valuation of the shares of the company shall be made by a Category I Merchant Banker registered with SEBI or an Investment Banker / Merchant Banker outside India registered with the appropriate regulatory authority in the host country; and, in all other cases by a Chartered Accountant or a Certified Public Accountant. Overseas investment through stock swap Determination of share prices of both entities using any internationally accepted methodology Valuation of the shares by a Category I Merchant Banker registered with SEBI or an Investment Banker outside India registered with the appropriate regulatory authority in the host country. Approval of the Foreign Investment. Disinvestment Transfer of shares of joint venture/ wholly owned subsidiary Shares of listed company Traded share price N/A Shares of unlisted company Any internationally accepted methodology for pricing Certified public accountant or Chartered accountant. 61

66 15 SIZE ADJUSTMENT OF MULTIPLES This thought leadership paper provides insights on size adjustment of multiples.