Financial Strategy ALL Merged

Illustration : 01
X Ltd is considering acquisition of a Machinery which would require an investment of Rs. 20

Lakh comprising of asset cost of Rs. 15 Lakh and a net working capital of Rs. 5 Lakh.
The Fixed asset has an economic life of 14 years and a salvage value of Rs. 1,00000. At the end
of 14 years the asset is estimated to be replaced at Rs. 18,00000. The company follows SLM of
depreciation for its accounting records. It is projected that the machine would generate a ROIC
of 20%, measured by NOPAT on Invested capital. You are required to calculate the CFROI,
CVA and EVA of the company for first three years.
The cost of capital (Kc) is 10%.
(The FVIFA 14years 10% is 27.975)
Solution:
Accounting Dep = (15 lakh- 1 lakh)/ 14 = 1 lakh p.a.
FVIFA 14years 10% = ((1+i)n -1)/i) = ((1+0.10)14 -1)/0.10) = 27.975

Eco Dep * 27.975 = 1800000 – 100000
Hence, Eco Dep = 17 lakh / 27.975 = 60, 769 p.a.
ROIC is 20% of Invested Capital.

Year Invested Capital Depreciation NOPAT
1 20 Lakh 1 Lakh 4 Lakh
2 19 Lakh 1 lakh 3.8 Lakh
Yr 1 Yr 2 Yr 3
NOPAT 400000 380000 360000
Accounting Depreciation 100000 100000 100000
Operating Cash Flow 500000 480000 460000
Economic Depreciation 60769 60769 60769
Invested Capital 20 Lakh 19 Lakh 18 Lakh
CFROI = (Operating Cash Flow – Economic Depreciation)/ Cash Invested

Yr 1 Yr 2 Yr 3
1. Operating Cash Flow 500000 480000 460000
2. Economic Depreciation 60769 60769 60769
3. Cash Invested 20 Lakh 20 Lakh 20 Lakh
CFROI (1-2)/3 21.96% 20.96% 19.96%
CVA= Operating Cash Flow – Economic Depreciation – Capital charge on Gross
Investment
Yr 1 Yr 2 Yr 3
3. Capital Charge on Gross 2 Lakh 2 Lakh 2 Lakh
investment @ 10%
CVA (1-2-3) 239231 219231 199231
EVA = (ROIC – Kc) * OIC.

OR, EVA = NOPAT – Capital Charge on invested Capital
Yr 1 Yr 2 Yr 3
1. NOPAT 400000 380000 360000
2. Capital Charge on Invested 2 Lakh 1.9 Lakh 1.8 Lakh
Capital @10%
EVA (1-2) 200000 190000 180000
Illustration: 02 (similar to Illustration 6, Pg- 12.47, SFM by Dr. PC)
A company has an investment of Rs.630 million (Rs.480 million in fixed assets and Rs.150
million in net working capital). The company assets have an economic life of 8 years and
are expected to produce a NOPAT of Rs.80 million every year. After 8 years, the net
working capital will be realised at par, but fixed assets will fetch nothing. The cost of
capital for the project is 12 percent. Assume that the straight-line method of depreciation
is used for tax as well as shareholder reporting purposes.
(i) What will be the ROIC for year 3? Assume that the capital employed is measured at
the beginning of the year.
(ii) What will be the EVA (Rs. in million) for year 3?
(iii) What will be the ROGI for year 3?
(iv) What will be the CVA (Rs.in million) for year 3?
(v) What will be the CFROI for year 3?
(vi) Comment on value creation of the company.
Solution:
(Rs. in million)
1 2 3
1. Net fixed assets (beginning) 480 420 360
(=480-60) (=420-60)
2. Accounting Depreciation (= 480 / 8) 60 60 60

3. Net working capital (given) 150 150 150
4. Invested Capital (1+3) 630 570 510
5. NOPAT (given) 80 80 80
6. Economic depreciation (=480/ FVIFA12%, 8yr) 39.02 39.02 39.02
7. Cash investment (=480 + 150) 630 630 630
8. Cost of capital 12% 12% 12%
9. Capital charge (12%*Invested Capital) 75.6 68.4 61.2
Economic depreciation = 480/ FVIFA12%, 8yr = 480/ 12.30 = 39.02

FVIFA12%,8yr = [ (1 + 𝑖)𝑛 – 1] / i = [1.128 – 1]/ 0.12 = 12.30
ROIC3 = NOPAT3/OIC3 = 80/510 = 15.69%

EVA3 = NOPAT3 – WACC x OIC3 = 80 – 0.12 x 510 = 18.8
ROGI3 = (NOPAT3 + DEP3) / CASH INVESTMENT = (80 + 60) / 630 = 22.22%

CVA3 = Operating cash flow3 – Eco. depreciation – Capital charge on Gross Investment
= (80 + 60) – 39.02 – 0.12 x 630 = 25.38
𝑂𝐶𝐹3−𝐸𝑐𝑜 𝐷𝑒𝑝 (80+60)−39.02
CFROI3 = = = 16.03%
𝐶𝑎𝑠ℎ 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 630
Illustration: 3 (based on unsolved Q. No.5, pp- 12.50, SFM by Dr. PC)
Acme ltd. Is considering a capital project for which the following information is available;
Investment outlay = 1000 Project Life = 5 years
Salvage value = 0 Method of depreciation = SLM
Annual revenue = 2000 Annual out of pocket cost = 1400
Cost of equity = 18% Cost of Debt (after tax) = 10%
Debt-Equity Ratio = 1:1
Tax Rate = 40%
i. Calculate EVA for the Project.
ii. Calculate NPV of the Project.
iii. Calculate PV of the project EVAs.
iv. What is the relationship between Cash flows and NPV and EVA and MVA?
Solution:
Since, Debt-Equity ratio is 1:1; the Wd and We = 0.5
Hence, Cost of capital = Wd * Kd (1-t) + We * Ke = 0.5 x 0.10 + 0.5 x 0.18 = 0.14 or 14 %
Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
1. Revenues (given) 2,000 2,000 2,000 2,000 2,000
2. Out of pocket cost (given) 1,400 1,400 1,400 1,400 1,400
3. EBDIT (1 - 2) 600 600 600 600 600
4. Depreciation [=(1000- 0)/5] 200 200 200 200 200
5. EBIT (3 - 4) 400 400 400 400 400
6. NOPAT [=EBIT (1 – t)] 240 240 240 240 240
7. OCF (6+4) 440 440 440 440 440
8. Invested Capital (Reduces by Accn. Dep.) 1000 800 600 400 200
9. Capital Charge on Invested Capital (@14%) 140 112 84 56 28
10. EVA (6 – 9) 100 128 156 184 212
i. NPV =[ 440/(1.14)1 + 440/(1.14)2 + 440/(1.14)3 + 440/(1.14)4 + 440/(1.14)5 ] – 1000

= 510.5
ii. PV of EVAs= 100/(1.14)1 + 128/(1.14)2 + 156/(1.14)3 + 184/(1.14)4 + 212/(1.14)5 = 510.5
iii. NPV of cash flows = PV of EVAs
iv. Theoretically, MVA = PV of EVAs;
Therefore, NPV of cash flows = PV of EVAs = MVA
FINANCIAL
STRATEGY
An Introduction
Chapter 2, 3 (3.3 BSC) & 4, SFM
What Is Financial Strategy?
■ Strategy to manage a company's finances with the intention to

succeed in attaining the company's goals & objectives, and maximize
shareholder value over time.
■ NOTE: However, a company first needs to define its objectives precisely, identify and
quantify its available and potential resources, and devise a specific plan to use its
finances and other capital resources toward achieving its goals.
Strategy & Business Model
■ Strategy is a plan to attain Goals.
■ Business Model is the way the strategy is pursued.
■ NOTE: Financial Strategy is a part of overall Organisational

strategy.
Formulating Strategy
Internal Analysis: Environmental Analysis:

Technical Knowhow Customers
Manufacturing Capacity Competitors
Marketing & Distribution Capacity Regulations
Logistics Infrastructure
Financial Resources Social / Political Environment
Strengths & Weaknesses Opportunities & Threats
Find the fit between Core Capabilities

and External Opportunities
STRATEGIES
■ Note down ONE Corporate Name engaged in different businesses
■ E.g.
■ Corporate- TATA
■ Different Business Units-
– Tata steel,
– Tata Motors
– TCS
– Tanishq
– Tata Sons
Strategy
■ Strategy is formulated at TWO Levels;

1. Corporate Level Strategy
– Has a Portfolio orientation.
– Is concerned with the selection of businesses the firm wishes to participate in.
2. Business Unit Level Strategy

– Is concerned with how the firm chooses to compete in each of the businesses
it includes in its portfolio.
1. Corporate Level Strategy
■ What Businesses should we be in and

■ How Resources should be allocated?
■ Portfolio Planning Tools help in portfolio planning & resource allocation.

■ BCG Matrix & General Electric’s Stoplight Matrix
Corporate Level Strategy: General
Electric’s Stoplight Matrix
BUSINESS STRENGTH: How strong is the firm vis-à-vis its Competitors
INDUSTRY ATTRACTIVENESS: What is the attractiveness or potential of the
industry.
Business Strength
STRONG AVERAGE WEAK
HIGH INVEST INVEST HOLD

Industry
Attractive
ness MEDIUM INVEST HOLD DIVEST
LOW HOLD DIVEST DIVEST

Corporate Level Strategy: Growth
Strategies_Three Horizons
■ Book titled “The Alchemy of Growth: Kick starting and Sustaining Growth in Your
Company” M. Baghai et al. argued That Companies which have sustained above
average growth managed their portfolios across three horizons;
■ Horizon 1: The Existing core business contributing bulk of the current profits and
cash flows. They provide financial sinews that give the firm strategic freedom.
■ Horizon 2: The Emerging Opportunities that fuel future growth. They have customers
and generate revenues, though they may not yet produce positive cash flows.
■ Horizon 3: the Future Options are the promising opportunities where initial work has
begun, in the form of product development or strategic alliances.
Business Level Strategy
■ Diversified firms don’t compete at the Corporate Level.
– TATA don’t compete with Mahindra.
■ A Biz unit of one firm, compete with a Biz unit of another.
– TCS compete with Tech Mahindra.
■ Porter’s Generic Model:

■ Three Generic Strategies that can be adopted at the Business
Unit Level;
■ Cost Leadership, Differentiation & Focus.
■ NOTE: These strategies are not mutually exclusive.

Porter’s Generic Model: Cost Leadership
■ Cost is engineered to be kept lesser allowing a lesser price.

■ When Profit is a fn (Volume, Margin), this strategy attempts to
increase volume to achieve higher profit.
■ List out two factors that would help in achieving Cost Leadership.
– Exploiting economies of scale, Improving capacity utilisation,
Tight control across the value chain, Simplifying product design
etc…
■ Maruti in passenger vehicles, Big Bazar in Retail, Globally Wal Mart,
Reliance in CDMA Cell Phones
Porter’s Generic Model: Differentiation
■ Product is engineered to be perceived as a differentiator allowing a
premium price.
■ When Profit is a fn (Volume, Margin), with the comfort of a higher
price this strategy attempts to increase margin to achieve higher
profit.
■ List out two factors that would help in achieving Differentiation.

– Product quality, product range, bundled services, brand image,
Delivery convenience, Reputation etc…
■ Intel in microchips, Apple in computers, Apple / Blackberry in cell
phones, Cona in electronics etc…
Porter’s Generic Model: Focus
■ Focus strategy involves concentrating on a narrow line of products or a

limited market segment.
■ The company with a Focus Strategy achieves Competitive advantage by
– Cost leadership (Cost Focus)- McDonalds pursues Cost Focus by

offering limited menus to achieve economies of scale.
– Differentiation (Differentiation Focus)- Nikon endorsing HD Digital

Cameras where it is competing the likes of Sony & Samsung.
CLAY CHRISTENSEN’S
FOUR ELEMENTS OF
BUSINESS MODEL:
A case with TATA Motors
Business Model
■ Clay Christensen suggests
that a Business Model
consists of FOUR Elements;
1. Customer Value Proposition

2. Profit Formula
3. Key Resources
4. Key Processes
Clay Christensen’s Four Elements
of Business Model
1. 1. A company finalizes what
Customer unique experiences to be
imparted to the customers
Value
Proposition
2. A company finalizes the
2. Profit Formula means to earning profit/
wealth.
3 & 4. The company
accordingly acquires
resources and adopts 3. Key Resources
processes to impart
unique experiences to
customers and earn 4. Key Processes
profit.
Clay Christensen’s FOUR ELEMENTS
of Business Model: A case with TATA
Motors
1. Customer Value Proposition Independent teams for
Focus on addressing the requirements
Institutional of institutional customers –
Customers Defense, State Transport
Units
Crash Test Customer Wide

Value Network
Facility Proposition of Service
(unique Stations
experiences)
India’s only certified crash test
facility for cars and hemi Easy availability of spare parts
anechoic chamber for testing of and wide n/w of service stations
noise and vibration.
Clay Christensen’s FOUR ELEMENTS of Business
Model: A case with TATA Motors
2. Profit Formula
Optimal Capacity Large product
Utilization portfolio
Mercedes Benz cars make
Diversification: Nano to Safari,
use of TM’s paint shop
Tata Indica to Volvo, Tata Ace
facilities, Fiat uses TM’s
to 18 Wheel Lorry.
After sales service centers.
Cost Reduction Blue ocean

& Optimisation Profit Strategy
Through Long term Formula
relationship with- channel Focus on Non Customers.
partners, Institutional (means to Serving the Unserved.
Customers, Vendor
Suppliers, Employees.
profit) Identifying Niche Market,
3. Key Resources (tangible, Intangible)
• At Jamshedpur, Pune & Lucknow (14000 Engineers, Investment- 2%
R & D establishments of the annual profits )
• Tata Motors European Technical Centre (TMETC) set up in 2005 –
primarily involved in design engineering and development of products
Capital Equipment
• Machine Tool development capabilities of global standard
Manufacturing
Automated manufacturing • Satellite manufacturing model – Assembly units at South

Africa, Thailand, Bangladesh, Brazil etc.
facilities
Sound Leadership & Group • JRD, Ratan Tata, N. Chandrasekhar; Tata Code of Conduct.
• Group resources – Tata Steel and Tata International
Resources
• Vast pool of technically competent engineers and managers.

Human Talent • Apprentice Trainee Course – ensuring stable source of skilled
manpower.
4. Key Processes
Transparent & Real time Logistic management using SAP.
Kaizen & TPM team –

continuous drive to improve operational efficiencies.
Global Sourcing Team –

China, a key destination for sourcing essential items like tyres, power steering
units etc., Steel procured from Belarus.
Focus on development of technical capabilities –

Technical Training Centers, Alliance with technical Institutes.
Focus on development of managerial capabilities –

MDPs, executive training programs at premier business schools
PERFORMANCE MANAGEMENT AND
BALANCED SCORECARD
Reasons for performance
management system
■ Heightened competition
■ Growing empowerment
■ Greater external demands
■ Power of information technology
Performance Measurement Indices
Financial measures Non-Financial Measures
Return on capital employed Customer satisfaction index
Return on investment Customer retention index
Return on equity Customer Recommendation Index
Return on sales Market share
EBITDA New product introduction
EBIT, NOPAT On time delivery
PAT, EPS Manufacturing cycle time
Total shareholder return Defects percentage
Market capitalization Throughput
Economic profit Employee productivity index
Free cash flow Patents obtained
Dividend yield
EVA, MVA
Balanced scorecard (BSC)…
a performance MANAGEMENT system
■ Pioneered by Robert Kaplan,

David Norton and others in 1996
■ BSC is strategy driven
■ BSC is a strategic management
system to manage strategies
Basic design of a
Balanced Scorecard
 Financial- Is the company
attractive to shareholders?
 Customers- Does the
company provide value to
its customers?
 Business Process- What
must the company excel
in?
 Innovation- Is the company
improving and innovating
continually?
Logistics center – A methodology for implementing BSC
PARADIGM SHIFT IN
FINANCE DECISION AREAS
Enlightened Value Maximization: Creation of shareholders’ wealth
through stakeholder welfare and by creating shared values
Paradigm Shift in Finance Decision
Areas
■ Strategic Financial Management

■ In response to the emerging business environmental opportunities &
challenges, Creation of Shareholder Value has
become the central corporate agenda.
■ Hence the FOCUS is;
■ What is the value of my company?

■ How can value of the company be enhanced?
Value Octagon
1. Strategy & Business Model.

2. Capital Allocation
3. Strategic Financing Decision
4. Organizational Architecture
5. Cost Management
6. Corporate Risk Management
7. M&A and Restructuring
8. Corporate governance.
Guiding Principle
■ What should be the Objective of a Company?

■ *Value Maximisation Theory- Historically prominent among
Anglo-Saxon Countries. Managers must strive to maximise
the Value of Firm/ Equity/SWM.
■ *Stakeholder Theory- Historically prominent among

countries like German n Japan. Managers should make
decisions taking into consideration the interest of all
stakeholders in a firm- claim holders, suppliers, customers,
employees, govt. n community.
Guiding Principle:
Value Maximisation vs. Stakeholder Theory
■ With increasing globalisation of Capital Markets---- importance of
maximising shareholders’ value.
■ In 1990s companies expressed growingly their allegiance
■ Very few questioned this culture as rising stock prices increased wealth
for so many.
■ However in the 1st decade of 21st Century, developments like dot.com
bubble accounting scandals like Enron & Worldcom and Global Financial
Crisis have tempered public attitude towards SWM
■ and kindled interest towards CSR activities, which is a modern day
incarnation of Stakeholder Theory.
Value Maximisation
■ Many Finance Theories are based on the assumption that managers must strive to
maximise the Value of Firm.
■ Vf = Ve + Vd
■ Vd remaining constant, Vf can be maximised if Ve is maximised.
■ The logic of SWM rests on Two basic premises;
■ Legal
■ Economic
Value Maximisation Theory:
Legal premise
■ Managers are appointed by the owners/ shareholders as their agents to run
the biz.
■ All other stakeholders are compensated as per the terms of the contractual
agreement with the firm.
■ Where as shareholders have only the residual claim against the earnings &
assets of the firm.
■ So, managers must maximise the shareholders’ wealth.
■ In 1919, Michigan State Supreme Court pronounced that Business
Corporation is organised and carried on primarily for the profit of the
stockholders and the powers of Directors are to be employed to that end.
Value Maximisation Theory:
Economic premise
■ Adam Smith’s concept of Free Hand.
■ An economic unit employs capital to earn more than what it employs.
■ Hence they must be allowed a free hand in their persuit of wealth
maximisation as long as they remain within the legal framework.
■ Further Social Welfare is maximised when all firms in the economy
maximise their own firm value.
Value Maximisation Theory_
Criticism
■ Though VM is conceptually unquestionable, it lacks emotional
appeal.
■ Michel Jensen:- “as a statement of corporate vision/ mission
VM is not likely to tap into the energy and enthusiasm of
employees and managers to create value….
■ It may not be possible to write complete & enforceable
contracts with all stakeholders.
■ Monopolies pose a problem. SWM is appropriate only when
markets are efficient i.e. MPS represent its Intrinsic Value.
Stakeholder Theory
■ In contrast ST argues that managers should make decisions taking
into consideration the interest of all stakeholders in a firm - claim
holders, suppliers, customers, employees, govt. n community.
■ While Value Maximisation finds its roots in Economics; Stakeholder
Theory emerges from fields like - Sociology, Politics, Organisation
Behaviour.
 BUT, the problem lies with

the fact that Stakeholder
Theory does not provide
clear cut decision criterion
on how to chose among
multiple alternatives with
competing & often
conflicting demands.
Guiding Principle_ VM vs. ST
■ ST seems holistic but does not have well defined objective function.
■ In contrast VM provides a clear guideline, But lacks emotional appeal;
(*“Spend a rupee provided the value added to the firm is a rupee or more”)
■ BUT, meanwhile Can Corporate Managers Succeed by merely

focusing on VM and ignoring other stakeholders??
Guiding Principle_ VM vs. ST
■ To maximise Value managers must satisfy all stakeholders.

■ A company may not create value on a sustainable basis unless
– It meets customer expectations
– Provides satisfactory employment conditions to employees
– Cultivates viable relationship with suppliers
– Treats community fairly
■ Hence it calls for a marriage b/w VM and ST

MARRIAGE B/W VM AND ST
Enlightened Value Maximisation (EVM)
■ Michael Jensen proposes
■ ‘Enlightened Value Maximisation’ or

■ ‘Enlightened Stakeholder Theory’.
EVM uses much of structure of ST but accepts

maximisation of the long run value of firm.
Enlightened Value Maximisation_examples
■ Coca Cola “our mission is to maximise shareowner

value over time. In order to achieve this we must
create value for all the constituents we serve,
including our customers, our employees, our bottler,
and our communities.”
Hindalco “…to relentlessly pursue the creation of

superior shareholder value by exceeding customer
expectations profitably, unleashing employee
potential, and being a responsible corporate citizen.”
Enlightened Value Maximisation_examples
■ TATA MOTORS
■ VISION: To be a world class corporate constantly furthering the interest of
all its stakeholders.
■ MISSION: To consistently create shareholder value by generating Returns
in excess of Weighted Average Cost of Capital (WACC) during the upturn
and at least equal to Weighted Average Cost of Capital (WACC) during the
downturn of the business cycle, by
– Strengthening lasting relationships with customers and providing
them superior value for money
– Incubating & promoting innovation through excellent employee
reward system
– Fostering a mutually beneficial long term relationship with Vendor &
Channel partners
– While proactively reshaping the country’s economic growth and
protecting the environment.
EVM, CSR and TBL
■ While EVM remains the basic Guiding Principle of modern day

companies; few related concepts e.g. CSR and TBL are also worth
mentioning here.
■ While EVM, CSR and TBL are not the same, it is important to bear in
mind that they are not mutually exclusive.
Corporate Social Responsibility: CSR
■ CSR, the modern incarnation of ST, has received great deal of attention
in recent times.
■ The World Business Council defines
■ “CSR is the continuing commitment by business to behave ethically
and contribute to economic development while improving quality of life
of the workforce and their families as well as of the local communities
and society at large.”
CSR: Onus of CSR_ Sch. VII, Indian
Companies Act 2013
■ Advocates of CSR argue that companies, given their vast resources &
capabilities, ought to contribute towards solving societal problems.
■ The Ministry of Corporate Affairs has notified Section 135 and Schedule
VII of the Comp. Act 2013 as well as the provisions of the Companies
(Corporate Social Responsibility Policy) Rules, 2014 to come into effect
from April 1, 2014.
■ With effect from April 1, 2014,
– every company, private limited or public limited,
– which either has a net worth of Rs 500 crore or
– a turnover of Rs 1,000 crore or
– net profit of Rs 5 crore,
■ needs to spend at least 2% of its average net profit for the immediately
preceding three financial years on CSR activities.
CSR: Onus of CSR_ Sch. VII, Indian
Companies Act 2013 contd…
■ The CSR activities should not be undertaken in the normal course of
business and must be with respect to any of the activities mentioned
in Schedule VII of the 2013 Act.
■ Contribution to any political party is not considered to be a CSR
activity, and
■ Only activities in India would be considered for computing CSR
expenditure.
CSR: Effect of CSR
■ However having undertaken CSRs companies may suffer competitive
disadvantage.
■ Empirical Evidence on the effects of CSR programmes on corporate
financial performance has - mixed results.
■ BUT An overview* of 50 different studies in the area has following THREE
CONCLUSIONS;
– CSR programmes generally associated with higher/ improved
financial performance (across various industries & time periods).
– There seems to be a Two-way Causality between CSR programmes
and financial performance.
– CSR programmes improve financial performance mainly because
they enhance firm’s reputation in the eyes of external stakeholders
and not because they improve internal efficiency.
(*Orlitzky, M., Schmidt, F., and Rynes, S. “Corporate social and financial performance: A meta
analysis,” Organisational Studies, Vol. 24, No.3, 2003.)
Effects of CSR_ Creation of Shared
Value
■ Having undertaken CSRs companies may suffer competitive
disadvantage.
■ Is there a Way Out??
■ YES, if companies engage in solving societal problems in which
they have an economic stake.
■ Michael R. Porter & Mark R. Kramer: “When a well run business
applies its vast resources, expertise and management talent to
problems that it understands and in which it has a stake, it can
have greater impact on social good than any other institution…”
STAKEHOLDER ENGAGEMENT FOR
VALUE CREATION
Wonder how to make your employees to work on a
holiday with higher productivity: Not So Difficult
How to make investors OWN the company
ABSTAINING them from being TRANSIENT.
■ COMMUNICATE:
Regular, In time, Direct & Comprehensive
■ Pfizer, Inc. was one of the first U.S. companies to take a proactive
measure to communicate with investors on matters related to the
company’s corporate governance processes and the rationale behind
the design of executive compensation plans (wef 2007).
■ EMC Corp. facilitates shareholder engagement on environmental and
social issues through a voluntary sustainability report (since 2007).
(Investors also look for beyond profit- Contribution to society, pride, etc.)
■ In 2011 approx 40 companies in US, including Microsoft Corp., Applied
Materials, Inc., Rambus, Inc., JetBlue Airways, Intel Corp., and Dynegy,
Inc., held virtual annual meetings using tools that enable online voting
and participation.
NESTLE_ Creating Shared Value
■ In recent years Nestle has helped expand cultivation & quality of Chicory in
different areas of India by developing & guiding specific vendors who are in direct
contact with chicory farmers.
■ Transfer of technology & education helped in expanding area under cultivation and
improved crops.
■ Better knowledge of roasting & processing has increased the yields.
■ During the last 10 years the number of chicory farmers benefiting from this has
increased from 1000 to 7500 and production has gone up by 600% from 2,000
tns. to 12,000 tns.
■ Nestle could also ensure abundant supply of chicory of specified quality.
■ (Source: Nestle creating shared value report 2010)

Creating Shared Values
■ Michael R. Porter & Mark R. Kramer proposed THREE Broad Ways of

Creating Shared Values;
1. Reconceiving Products & markets
2. Redefining Productivity in the Value Chain
3. Building Supportive Industry Clusters at a place where the
company is located.
Creating Shared Value
1. Reconceiving Products & markets

– White Goods- From proper service delivery to Energy Savings.
– Eco Friendly Colours/ Crackers/ Ganesha
– Water health international, using innovative low cost nature
friendly water purification techniques to provide clean water
in rural India/ Ghana.
– Food companies- from Taste/ price to Nutrition.
2. Redefining Productivity in the Value Chain

– HUL’s Mission Shakti- involving rural women (SHG) in production of etables.
– ITC’s Social Forestry Project- supplying high yielding varieties of eucalyptus
plants for free to farmers with attractive buyback schemes to solve raw
material problem.
– Intel spending millions in training school teachers in computer aided
learning packages to improve teaching, usage of computer and Intels’s
business.
– Green Production/ Organic Farming
3. Building Supportive Industry Clusters at a place where the company is
located.
■ No company can grow in isolation.
■ It needs supporting companies and infrastructure around it.
■ Clusters (geographic concentrations) of firms, suppliers, service
providers, logistical infrastructure, related businesses etc. influence
productivity & innovation.
■ IT in Bangalore, Garments in Ludhiana, Diamond cutting in Surat.
■ TATA Motors establishing Vendor Parks and supporting Budding young
entreprenuers at Sanand, Gujrat.
■ RIL constructing roads & connectivity to Jamnagar.
Triple Bottom Line (TBL)
■ A related Notion suggested by John Elkington _ TBL.
■ It seeks to measure organisational performance in terms of three criteria :
■ Economic, Ecological & Social OR
■ People, Planet & Profit
1. People / Society- How fair is the company towards the workforce, customers,
lenders & community.
2. Planet / Ecological – Whether company pursues sustainable environmental
practices.
3. Profit / Economic – Whether company creates economic value beyond all
costs including cost of equity.
CAPITAL
ALLOCATION
Strategic Investment Decision including Real Options
Chapter 5, SFM
Strategic Investment Decision
• An investment is considered strategic if it represents an opportunity
to
• Initiate/ stimulate/ abort & reinvent
• a revenue stream which has a significant bearing on the company’s

total performance.
 Capital Budgeting decision

 Long term asset mix decision
 Big ticket item decision
INVESTMENT DECISIONS:
Importance
1. Significant effect on Cash flows generation
2. Irreversible in nature (Risk)
3. Non- temporal spread
Techniques for Evaluation
A. Traditional techniques
B. Modern techniques
Traditional techniques
I. ARR
II. PBP
Modern Techniques
I. NPV
II. IRR
III. PI
IV. DPBP
Recent Developments
I. AEV (Annual Equivalent Value)
When the investment decisions compared have different life
durations, this Variant of NPV is used.
II. MNPV (Modified Net Present Value)

When Reinvestment rate and Cost of capital are different this
Variant of NPV is used.
III. MIRR (Modified Internal Rate of Return)

MIRR eliminates the shortcomings of IRR –
a) Multiple IRR- Incase of unconventional CFs,
b) Incorrect Project Ranking – Incase of mutually exclusive projects
AEV: Annual Equivalent Value
• When the investment decisions compared have different life durations, NPV
can’t be used.
• Instead AEV can be applied.
• AEVi = NPVi/ PVIFAn,r

• Where; NPVi = NPV of project i.
PVIFA = Present Value Interest Factor Annuity
n = Life of project i in years
r = discount factor Applicable for project i.
Decision Rule:
• . ACCEPT Positive AEV,
Higher The Better
AEV: Example 1
• Consider the following two mutually exclusive project with a discount

rate of 10%;
CASH FLOWS
Year Project X Project Y
0 -150 -75
1 100 80
2 50 40
3 40
4 30
• Find out which project has to be accepted on the basis of AEV?
• SOLUTION: Since both the projects have different life durations NPV Can’t be
applied, rather another variant of NPV i.e. AEV has to be applied.
AEV: Solution 1
YEAR CIF (X) CIF (Y) PVF@10% DCFs of X DCFs of Y
A B C D=A*C E=B*C
1 100 80 1/(1+0.10)^1 90.91 72.73
2 50 40 1/(1+0.10)^2 41.32 33.06
3 40 1/(1+0.10)^3 30.05
4 30 1/(1+0.10)^4 20.49
PV of CIFs = 182.77 105.79

ICO 150.00 75.00
NPV = PV of CIFs - ICO 32.77 30.79
PVIFA 4y, 10% = 1/(1+0.10)^1 + 1/(1+0.10)^2 +1/(1+0.10)^3 + 1/(1+0.10)^4= 3.170
PVIFA 2y, 10% = 1/(1+0.10)^1 + 1/(1+0.10)^2= 1.736
32.77/3.170= 30.79/1.736=
AEV=NPV/PVIFA 10.34 17.74
DECISION: Since AEV(Y) > AEV(X) Reject X Accept Y
AEV: Example 2
• Consider the following two mutually exclusive project;
CASH FLOWS
Year Project A Project B
0 -200 -200
1 100 50
2 100 100
3 120 90
4 100
• The cost of capital for Project A is 10% and for Project B is 12%.
• Find out which project has to be accepted on the basis of AEV?
AEV: Solution 2
YEAR A B PVF@10% PVF@12% DCFs of A DCFs of B
1 2 3 4 5=1*3 6=2*4
1 100 50 1/(1+0.10)^1 1/(1+0.12)^1 90.91 44.65
2 100 100 1/(1+0.10)^2 1/(1+0.12)^2 82.64 79.72
3 120 90 1/(1+0.10)^3 1/(1+0.12)^3 90.16 64.06
4 100 1/(1+0.12)^4 63.55
PV of CIFs = 263.71 251.98

ICO 200 200
NPV 63.71 51.98
PVIFA 3y, 10% = 1/(1+0.10)^1 + 1/(1+0.10)^2 +1/(1+0.10)^3 = 2.4868
PVIFA 4y, 12% = 1/(1+0.12)^1 + 1/(1+0.12)^2 + 1/(1+0.12)^23 + 1/(1+0.12)^4 = 3.0373
63.71/2.4868= 51.97/3.0373=
AEV=NPV/PVIFA 25.62 17.11
DECISION Accept A Reject B
NOTE: The two projects compared had different rates of cost of capital. Is it possible?
Modified Net Present Value
(MNPV)
• NPV assumes that ;
• Reinvestment Rate = Cost of capital
• If this is NOT TRUE, i.e. Reinvestment Rate ≠ Cost of capital

• Then NPV can’t be calculated.
• Rather another variant of NPV i.e. MNPV has to be
calculated.
(MNPV)
1. Calculate Terminal Value (TV), which is the sum of FV of all CIFs at the end of the project life
n
• TV = ∑ CIFt (1+ r’)n – t
t=1
2. Then discount the TV @ Cost of capital and deduct the ‘initial cash outlay’
• MNPV = [TV / (1+r)n] – ICO
• Here r’= reinvestment rate;

r = discount rate Decision Rule:
ACCEPT Positive MNPV,
n = project life in years, Higher The Better
t = year 1, 2, 3
(MNPV): Example 1
• Consider the following cash flows associated with Project X;
Year 1 2 3 4
Cash 31000 40000 50000 70000
Inflows
(in Rs. Mn.)
• The project needs an investment of Rs 110,000 mn. and enjoys a

reinvestment rate of 14%. The cost of capital for the project is
10%.
• Find out the MNPV of the project.
(MNPV):Solution 1
Year CIF (1+ r’)n – t CIFt (1+ r’)n – t
A B C D =B*C
1 31000 (1+0.14)^(4-1)= 1.481544 45928
2 40000 (1+0.14)^(4-2)= 1.2996 51984
3 50000 (1+0.14)^(4-3)= 1.14 57000
4 70000 (1+0.14)^(4-4)= 1 70000
TV= ∑ CIFt (1+ r’)n – t 224,912
MNPV= [TV / (1+r)n] – ICO=
[224,912/(1+0.10)^4] -110,000 = 43,618
DECISION: Since MNPV is positive, ACCEPT.
(MNPV): Example 2
• Consider the previous example 1;

• Say the Reinvestment rate increases to 18% (from previous 14%)
and the cost of capital remains same at 10%.
I. Find out the new MNPV of the project.
II. List out your observation.
(MNPV):Solution 2
Year CIF (1+ r’)n – t CIFt (1+ r’)n – t
1 31000 (1+0.18)^(4-1)= 1.643032 50934
2 40000 (1+0.18)^(4-2)= 1.3924 55696
3 50000 (1+0.18)^(4-3)= 1.18 59000
4 70000 (1+0.18)^(4-4)= 1 70000
TV= ∑ CIFt (1+ r’)n – t 235,630
[TV / (1+r)n] – ICO=

MNPV= [235,630/(1+0.10)^4] -110,000 = 50,938
DECISION: Since MNPV is positive, ACCEPT.

Inferences: 1. MNPV increased from 43,618 to 50,938.
2. It was due to the increased spread between the Reinvestment
rate and Cost of capital (the reinvestment rate increases from 14%
to 18%, while the cost of capital remained same at 10%).
NOTE: Higher the Spread b/w Reinvestment Rate and Cost of Capital => Higher the MNPV
Modified Internal Rate of Return
(MIRR)
• Hence IRR suffers from TWO biggest problems;

• Multiple IRR- Incase of unconventional CFs
• Incorrect Project Ranking – Incase of mutually exclusive
projects
• MIRR eliminates these shortcomings of IRR, and gives a real

rate of return to the practitioners.
(MIRR)
1. Calculate ‘Present Value of Cash Outflows’ (PVC)
• PVC = ∑ COFt / (1+ r)t
2. Calculate Terminal Value (TV), which is the Sum of FV of all CIFs at the
end of the project life
• TV = ∑ CIFt (1+ r)n – t
3. Obtain MIRR by solving following equation

Decision Rule:
• PVC = TV/(1+MIRR)n ACCEPT if MIRR>Kc;
• OR MIRR = (TV / PVC)1/n - 1 Higher the Better
(MIRR): Example 1
• Consider the following cash flows associated with Project Y;
Year 0 1 2 3 4 5 6
Cash Flows -120 -80 20 60 80 100 120
(In Rs. Mn.)
• The cost of capital for the project is 15%.

• Find out the MIRR of the project.
(MIRR): Solution 1
Year CFs PV of COFs FV of CIFs
COFt / (1+ r)t CIFt (1+ r)n – t
0 -120 120/(1+0.15)^0= 120.00
1 -80 80/(1+0.15)^1= 69.57
2 20 20*(1+0.15)^(6-2)= 34.98013
3 60 60*(1+0.15)^(6-3)= 91.2525
4 80 80*(1+0.15)^(6-4)= 105.8
5 100 100*(1+0.15)^(6-5)= 115
6 120 120*(1+0.15)^(6-6)= 120
PVC = ∑ COFt / (1+ r)t = 189.57

TV = ∑ CIFt (1+ r)n – t = 467.0326
MIRR = (TV / PVC)1/n - 1=[(467.033/189.57)^(1/6)] - 1 = 16.22%
DECISION: Since MIRR 16.22% > CoC 15%; ACCEPT.
(MIRR) : Example 2
• Consider the following cash flows associated with Project Y;
Year 0 1 2 3 4 5 6
CFs
In Rs. Mn. -200 -80 100 80 -100 150 200
• The cost of capital for the project is 15%.

• Find out the MIRR of the project.
(MIRR): Solution 2
Year CFs PV of COFs FV of CIFs
COFt / (1+ r)t CIFt (1+ r)n – t
0 -200 200/(1+0.15)^0= 200
1 -80 80/(1+0.15)^1= 69.57
2 100 100*(1+0.15)^(6-2)= 174.90
3 80 80*(1+0.15)^(6-3)= 121.67
4 -100 100/(1+0.15)^4= 57.18
5 150 150*(1+0.15)^(6-5)= 172.50
6 200 200*(1+0.15)^(6-6)= 200
PVC = ∑ COFt / (1+ r)t = 326.75
TV = ∑ CIFt (1+ r)n – t = 669.07

MIRR = (TV / PVC)1/n - 1=[(669.07/326.75)^(1/6)] - 1 = 12.69%
DECISION: Since MIRR 12.69% < CoC 15%; REJECT

MISTAKES COMMITTED IN
APPRAISAL
of Strategic Investment Decisions
Mistakes committed in Appraisal of
• In applying DCF analysis following mistakes are generally committed;
1. Mechanical projection of Cash Flows
Long time duration may not factor effects of competition, inflation, innovations.
2. Optimistic bias in cash flows

Intentional overstatement, lack of experience, myopic euphoria.
3. Emphasis on IRR
IRR is biased against long lived capital intensive projects which may have greater
strategic significance to the firm.
4. Inconsistent treatment of Inflation

As discount rate considered factors all – inflation, rfr, RRR.
5. Unreasonably high RRR benchmark

No idea as to the normal return in cap mkt, Premiums are asked for Diversifiable
risk, Optimism of Project sponsors.
Reflections on Strategic Investment
Decision
• Growth vs. Profits
• Gordon Donaldson “the more the management is preoccupied by

near-term results, the more likely it is to place RONA ahead of
growth; conversely, the more the company emphasizes future
competitive strength and position, the more likely it is to
perceive the sequence of growth, RONA later.”
REFLECTIONS OF
GROWTH vs. PROFITS
ON
Reflections on Strategic Investment
Decision
• DCF analysis provides only a partial discipline
Resource allocation is heavily dominated by Strategic matrix
Rate of Growth, Market Share etc. are also important elements of
resource allocation, which are not adequately considered in DCF
analysis.
• Investment decisions are not individualistic
Most Investment Decisions are not individualistic, it is an
incremental process occurring over a long period of time
REAL OPTION
Valuing Real Options
Real Options
• In case of Real option the underlying asset is a Real Asset (tangible/
projects)
• While financial options are detailed in their contract; the Real Options
are embedded in strategic investments must be identified and
specified.
• Real option approach provides the managers with opportunities for the
planning & managing the strategic investments.
Valuing Options
1. Binomial Model.
a. Option equivalent method
b. Risk neutral method
2. Black Scholes Model (BS Model).

Binomial Option Equivalent Method
• Value of a call option
• C = [(Cu – Cd)/(u – d)] – [(dCu – uCd)/(u – d)R]
• Where;
• Cu = Value of Call option when share price go up = Max (uS – E, 0)
• Cd = Value of Call option when share price go down= Max (dS – E, 0)
• S = Current Market Price of Share
• u = Future possible proportionate higher sales price
• d = Future possible proportionate lower sales price
• uS = Future possible higher sales price
• dS = Future possible lower sales price
• E = Srike or Exercise price of call option
• R = (1+r)n ; where r = risk free rate and n = time period in years till the exercise
date.
Risk Neutral Method
• STEP 1 – Find out the Probability of Rise in stock Price.
 PV of Expected Return form the asset in open market = current price of the
asset in open market
 Or, [(P* future price when rises) + (1 – P)* future price when falls] * 1/(1+r)n =
current price
 Where, P = Probability of Price rise
• STEP 2 – Find out the expected future value of Call Option.

 Cn = P* Cu + (1 – P)* Cd
• STEP 3 – Find out the current value of option.

 C = Cn/(1+r)n EXAMPLE
Black-Scholes Model (BS Model)
• Developed by Fisher Black and Myron Scholes
• Applicable even when stock prices are expected to change continuously.

Black Scholes Model (BS Model)
STEP 1 – Calculate d1 and d2
ln (S0 / E) + [ r + ⸹2/2] * t
d1 =
⸹ √t
d2 = d1 – ⸹√t
Where,
S0 = Current price of the share
E = Exercise price of the option
r = risk free interest rate
t = time till option expires
⸹ = standard deviation of stock returns
STEP 2 – Find out N(d1) and N(d2)
Where N(d1) and N(d2) are the Normal distribution values (Z Scores)
for d1 and d2.
It can be ascertained either with the help of NORMSDIST function of

EXCEL or by referring to Normal Distribution Table.
Where,
N (d) is Value of the cumulative normal density functions
STEP 3 – Find out the value of the option.
C0 = S0 N(d1) - E * N(d )
2
ert
Where,
e = exponential term (2.7183)
E/ert = the present value of exercise price
EXAMPLE
Real Options
• Valuing Real Options (using Black Scholes Model).

Real Options_ Managing Proactively
• KEY GUIDELINES
1. Extend the option duration.
By innovating hold technological lead; signaling the ability to exercise
2. Increase the certainty of cash flows of option

By developing innovative products, extending opportunities to related
market with complementary product
3. Increase the future cash inflows of option

By engaging in new marketing initiatives
4. Reduce the value lost by waiting to exercise the option

By locking up key resources; Alliances with low cost suppliers
5. Reduce Investment
By leveraging economies of scale
SMALL TICKET
ITEMS
Disciplining the Capital Budgeting Process for Small Ticket Items
Disciplining the Capital Budgeting
Process for Small Ticket Items:
• Tom Copland argues that capex can be reduced and sustainable value
can be created by;
• Conducting rigorous evaluation of small ticket items, that are
often unnecessary / wasteful, but usually get rubber stamped by Senior
Managers.
• And, sacrificing evaluation of small ticket items to focus more on big
ticket items is not justified.
Altman Z Score Model
 Named after Edward Altman, the New York
University professor
 Altman Z-Score is a statistical tool used to

measure the likelihood that a company will
go bankrupt.
 He used multivariate analysis to the mix of

traditional ratio-analysis techniques.
 Altman developed the Z-Score after
evaluating 66 companies, half of which had
filed for bankruptcy between 1946 and
1965.
 He started out with 22 ratios classified into
five categories (liquidity, profitability,
leverage, solvency and activity).
 But eventually narrowed it down to Five
ratios and Seven variables.
 Altman's Z-Score determines how likely a
company is to fail.
ProfitabilitySolvencyActivity
Liquidity Leverage
 Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
 Where:
 A = Working Capital/Total Assets

B = Retained Earnings/Total Assets
C = Earnings Before Interest & Tax/Total
Assets
D = Market Value of Equity/Total Liabilities
E = Sales/Total Assets
 INR in Lacs, 2014 FY
 Working capital = 243,833
 Total Assets = 1385,324
 Retained earnings = 508,952
 EBIT = 90,114
 Mkt Value of Equity = 394,369
 Total Liabilities = 871,966
 Sales = 399,969
 Z Score = 1.48
 In general, higher the score the Better is the
Credit Quality; and the lower the score, the
higher the chance of bankruptcy.
 Z score < 1.81 means the company is probably

headed for bankruptcy,
 1.81 < Z score < 2.99 Grey Zone. Can’t say.
 Z scores > 2.99 are not likely to go
bankrupt.
 Now that we know the formula, it's helpful to
examine why these particular ratios are
included. Let's take a look at the significance
of each one.
 This ratio is a good test for corporate
distress.
 A firm with -ve working capital (i.e. CA <CL)
is likely to experience problems meeting its
short-term obligations because there simply
is not enough current assets to cover those
obligations.
 By contrast, a firm with significantly positive
working capital rarely has trouble paying its
bills.
 This ratio measures the amount of reinvested
earnings or losses, which reflects the extent of
the company's leverage.
 Companies with low RE/TA are financing capital
expenditure through borrowings rather than
through retained earnings.
 Companies with high RE/TA suggest a history of
profitability and the ability to stand up to a bad
year of losses.
 The age of a firm is implicitly considered in this
ratio.
 A relatively young firm will probably have a lesser
RE/TA ratio. The incidence of failure is much
higher in a firm’s earlier years.
 This is a version of return on assets (ROA), an
effective way of assessing a firm's ability to
squeeze profits from its assets before factors
like interest and tax are deducted.
 It is a measure of true productivity of the

firm’s assets, abstracting from any tax or
leverage factors.
 A durable market capitalization can be
interpreted as the market's confidence in the
company's solid financial position.
 Equity is measured by the combined market

value of all shares of stock, preferred and
common; while debt includes both current
and long term.
 This tells investors how well management
handles competition and how efficiently the
firm uses assets to generate sales.
 Failure to grow market share translates into a

low or falling S/TA.
 It is one measure of management’s capability

in dealing with competitive condition.
 Edward I. Altman. “Financial ratios,
discriminant analysis and the prediction of
corporate bankruptcy”, The Journal of
Finance, Vol. 23, No. 4. (Sep., 1968), pp.
589-609.
STRATEGIC FINANCING
DECISION
Dividend and Share Repurchase, Chapter 6, SFM
Strategic Financing Decision
 Financial Distress lead to greater importance to Capital
Structure & Distribution (by Dividend & Share Buy back)
 Referred as SFD, it seeks to discuss the impact of Cap
Structure and suggests guidelines for taking these
decisions.
 Value conscious companies seek to;
 Choose a capital structure that reduces the WACC of the firm,
while preserving the financial flexibility
 Return cash to shareholders by way of dividend & share buy

backs when the firm lacks credible value creating
opportunities to invest in biz.
Dividend Policy and Firm Value
 MM Dividend Irrelevance model
 Value of firm depends solely on its Earnings Power
and not how earnings is divided between retained
earnings and dividends.
 Assumptions taken;
 Capital Mkts are perfect & Investors are rational
 Floatation costs are nil
 No taxes
 Investment & Dividend Decisions are Independent.

Dividend Policy and Firm Value
 But in reality imperfections exist and they make
earnings distribution policy relevant to decide
firm value.
 Imperfections;
 InvestorPreference for Dividends
 Transaction Costs
 Information Asymmetry
 Agency Costs
Investor Preference for Dividends
 Although taxes & transaction costs are ignored,

dividends and capital appreciation can not be
considered as perfect substitutes.
 Preference for Dividend still exists.
 Hersh Shefrin & Meir Statman- Investors prefer
dividends due to behavioural reasons;
 ‘principles of self control’ – limit spending to dividends and
the capital amount is maintained.
 ‘aversion to regret’- if no dividend is received one has to
sell shares to get income, which would result in more regret
if the share prices rise sharply subsequently.
 HENCE, there is a Demand of DIVIDEND.
Information Asymmetry
 Management often has significant info about the

prospects of the company that it can not/ prefers
not to share with investors.
 Hence the stock prices may be lesser than what it
should have been.
 Solution??
 Signaling Theory_ Companies do pay Dividends to
signal that it is confident of paying same / higher
dividends in future.
 Hence there is also a Supply of DIVIDEND.
Top dividend paying companies in
India @ 2016-17
TOP 10 WEALTH CREATORS
(2012-2017)
TCS is the Biggest Wealth Creator for the

fifth time in a row
TCS has emerged as the biggest Wealth
Creator for the period 2012-17, retaining
the top spot it held in the previous four study
periods (2011-16, 2010-15, 2009-14 and
2008-13).
DIVIDEND PAY
OUT HISTORY OF
TCS
Agency Costs
 If dividend is not paid then capital appreciation is
expected.
 But then the shareholders are concerned about the
fact that Managers do so diligently rather than
resorting to uneconomic projects for their personal
gain.
 Further regular payment of dividend requires
managers to be at their best of performance.
 Hence Payment of DIVIDEND can resolve the
agency cost.
Formulating Dividend Policy: Factors
to be Considered
 Don’t pay Dividends at the expense of +NPV Projects.
 External Equity is rather expensive than Internal Equity.
Minimise the need to issue ext. equities.
 Distribute cash when firms lack credible investment
opportunities.
 Consider share buyback if dividend can’t be paid
regularly.
 Define Target DPR along with Target D/E ratio
considering other factors. (with acceptable deviations)
 Avoid reduction in Dividend Payments.
SHARE BUYBACK
Share Buyback: Rationale
 Effective allocation of resources- Excess cash may
be spent uneconomically if not used effectively.
 Warren Buffett “ When companies purchase their
own stock they often find it easy to get $2 of
present value for $1.
Corporate acquisition programs almost never do as
well and, in a discouragingly large number of
cases, fail to get anything close to $1 of value for
each $1 expended”
Share Buyback: Rationale
 Positive Signal- shares are undervalued. Mangers
are committed to creation of SWM.
 An instrument of Price Stabilisation.
 An instrument of alteration to Capital Structure.
 Control-ship enhancement.
 Voluntary character- dividend is imposed while
share buyback is optional for investors.
 No implied commitment (against dividends)
Share Buyback: Objections
 Unfair advantage to Non participating investors.
 If companies are allowed to buyback and reissue
shares then it may resort to unhealthy manipulation
of share prices.
 Promoters to increase their control stake may offer
excess amount for share buyback. (corporate
resources get used for personal entrenchment)
 Share buyback does not create any extra
enterprise value (as it does not increase the Cash
Inflows to the firm)
Thank You….
STRATEGIC FINANCING
DECISION
Chapter 6, SFM
Strategic Financing Decision
 Financial Distress lead to greater importance to Capital
Structure & Distribution (by Dividend & Share Buy back)
 Referred as SFD, it seeks to discuss the impact of Cap
Structure and suggests guidelines for taking these
decisions.
 Value conscious companies seek to;
 Choose a capital structure that reduces the WACC of the firm,
while preserving the financial flexibility
 Return cash to shareholders by way of dividend & share buy

backs when the firm lacks credible value creating
opportunities to invest in biz.
Imperfections & Capital Structure
 The leverage irrelevance theorem of MM is valid if
the perfect mkt assumptions underlying their
analysis are satisfied.
 However in the face of imperfections characteristics
of the real world, the capital structure of the firm
may affect its valuation.
 The major imperfections of the real world are;
Taxes, Financial Distress and Agency Cost.
 Taxes: when corporate income is liable to taxation,

debt financing is advantageous.
 While dividend is not deductible for taxes, interest
on debt is tax deductible, which leaves the firm with
higher residual income than an unlevered firm.
 Financial Distress: when a firm is unable to meet its

obligations it results in financial distress that can
lead to bankruptcy.
 The greater the level of debt, the larger is the debt
servicing burden and the higher the probability of
Financial Distress.
 Agency Costs:
 There is a agency relationship b/w the share
holders & creditors of firms that have huge debts.
 In such firms shareholders have little incentive to
limit losses in the event of bankruptcy.
 Hence managers acting in the interest of
shareholders may invest in potentially high risk &
volatile projects to increase the wealth of investors,
but at the expense of creditors.
Tools for developing effective capital
structure
 ROI- ROE analysis.

 Leverage Analysis.
 Ratio Analysis.
ROI-ROE Analysis
 ROE = [ROI + (ROI – r)* D/E] (1 – t)
 Where;
 ROE = PAT/ Shareholders Funds
 ROI = EBIT/ Capital Employed
 D/E = financial leverage ratio = LTD/ Shareholders Funds
 r = cost of debt
 t = tax rate
ROI-ROE Analysis
 Say, D/E = 1.5, ROI = 20%, r = 10%, t = 50%
 Then , ROE = ?
 ROE = [ROI + (ROI – r)* D/E] (1 – t)

 ROE = [20 + (20 – 10)* 1.5] (1- 0.5)
 ROE = 17.5 %
Leverage Analysis
 Degree of Operating Leverage (DOL)
 DOL- Sensitivity of EBIT to changes in Sales.
 DOL = % Change in EBIT/ % Change in Sales
 OR, DOL = Contribution/ EBIT
 Degree of Financial Leverage (DFL)
 DFL- Sensitivity of PBT to changes in EBIT.
 DFL = % Change in PBT/ % Change in EBIT
 OR, DFL = EBIT/ PBT
 Degree of Total or Combined Leverage (DTL)
 DTL – Sensitivity of PBT to changes in sales quantity.
 DTL = % Change in PBT/ % Change in Sales Qty.
 OR, DTL = DOL * DFL
 OR, DTL = (Contribution/EBIT) * (EBIT/PBT)
 OR, DTL = Contribution / PBT
Ratio Analysis
 D/E = Debt / Shareholders’ funds
 Interest Coverage Ratio (ICR) = EBIT/ Interest on debt
 Fixed Assets Coverage Ratio = Fixed Assets/ Debt
 Cash Flow Coverage Ratio = (EBIT + Depreciation + Other

Non Cash Charges) / [Interest on debt + (Loan repayment
installment/1- t)]
 Debt Service Coverage Ratio = OCF/ Debt Service

Guidelines for Capital Structure
Planning
 Avail tax advantage
 Preserve Flexibility
 Ensure total risk exposure in reasonable
 Subordinate financial policy to corporate strategy
 Finance proactively at favourable time
 Know the norms of lenders and CRAs
 Issue innovative securities
 Take up the problems for better
understanding….
SIGNALING THEORY
Signaling Theory
 Gordon Donaldson, 1961

 Firms rely on internal accruals, debt financing and
equity financing; in descending order of preference
(called pecking order of financing).
SIGNAL VALUE OF DIVIDEND PAYMENT:
 Dividend payout is a residual financing decision.
 Dividend are paid only when firms are confident
that higher dividend can be paid and dividends are
not lowered unless things are very bad.
Signaling Theory
 If firm’s Internal Accruals exceed its capex need, it
would invest in marketable securities, retire debt,
raise dividends, resort to acquisitions or buyback
shares.
 If firm’s Internal Accruals fall short of its capex
need, it would sell mktbl securities, then seek
external finance; debt, convertible debt and at last
equity.
Question:
Pioneer stocks are currently selling at Rs. 200. The call option of the stock exercisable a year from
now has a strike price of Rs. 220. it is predicted that either the share price can rise by 40% or fall
by 10%. If the risk free return is 10%, what is the value of call option as per Option equivalent
method? What is the recommendation price to buy this option?
Solution:
C = [(Cu – Cd)/(u – d)] – [(dCu – uCd)/(u – d)R]
uS = Future possible higher sales price = 200 X 140% = 280
dS = Future possible lower sales price = 200 X 90% = 180
E = Srike or exercise price of call option = 220
Cu = Value of Call option when share price go up= Max (uS – E, 0) = Max (280 – 220, 0) = 60
Cd = Value of Call option when share price go down= Max (dS – E, 0) = Max (180 – 220, 0) = 0
S = Current Market Price of Share = 200
u = Future possible higher sales price in proportion = 1.4
d = Future possible lower sales price in proportion = 0.9
n= 1 year
R = (1+r)n= (1 + 0.10)1 = 1.10
C = [(Cu – Cd)/(u – d)] – [(dCu – uCd)/(u – d)R]
Or, C = [(60 – 0)/(1.4 – 0.9)] – [(0.9*60 – 1.4*0)/(1.4 – 0.9)*1.10] = Rs. 21.82
Recommendation price to buy this option= Below Rs. 21.82
Question:
Pioneer stocks are currently selling at Rs. 200. The call option of the stock exercisable a year from
now has a strike price of Rs. 220. it is predicted that either the share price can rise by 40% or fall
by 10%. If the risk free return is 10%, what is the value of call option as per Risk Neutral method?
Solution:
Cu = Value of Call option when share price go up= Max (uS – E, 0) = Max (280 – 220, 0) = 60
Cd = Value of Call option when share price go down= Max (dS – E, 0) = Max (180 – 220, 0) = 0
• STEP 1 – Find out the Probability of Rise in stock Price.

Present value of expected return = current price
Or, [(P* future price when rises) + (1 – P)* future price when falls] * 1/ (1+r)n = current price
Where, P = Probability of Price rise
Or, [(P* 280) + (1 – P)*180] * 1/ (1+0.1)1 = 200;
Or, P = 0.4
• STEP 2 – Find out the expected future value of Call Option.

Cn = P* Cu + (1 – P)* Cd
Cn = 0.4* 60 + 0.6 * 0 = 24
C = Cn/(1+r)n
C = 24/ (1+0.1)1 = Rs. 21.82
APPLICATION of Binomial Model: Valuing a Real Option
Question: A builder owns a plot of land that can be used for either 9 or 15 apartment units. The
current price per apartment is 1.2 million. The construction costs of these two alternatives are 9
million and 17 million respectively.
Alternatively the builder may wait for 1 year to construct and sell the apartment. If the market for
apartments is buoyant next year, each apartment will sell for 1.5 million; if the market is sluggish
each apartment unit will sell for 1.1 million. The yearly rental of vacant land (net of expenses) per
unit is estimated at 0.10 million and the risk free interest rate is 10% p.a.
i. What is the profit from best alternative if the builder is to construct and sell now?
ii. If builder waits for one year what is the payoff from best alternative if the market
turns out to be buoyant?
iii. If builder waits for one year what is the payoff from best alternative if the market
turns out to be sluggish?
iv. What are the risk neutral probabilities that the market for apartments will be buoyant
and sluggish respectively?
v. What is the value of vacant land? Should the builder wait for one year?
Solution:
PRESENTLY,
Profits from 9 apartment building = 1.2 * 9 – 9 = 1.8 million
Profits from 15 apartment building = 1.2 * 15 – 17 = 1 million
What is the profit from best alternative if the builder is to construct and sell now?
Hence 9 apartments is the best option now with a value of 1.8 million.
However, if the builder waits for 1 year;

Options Pay off When Prices Rise Pay off When Prices Fall
9 apartment building 1.5*9 – 9 = 4.5 1.1*9 – 9 = 0.9
15 apartment building 1.5*15 – 17 = 5.5 1.1*15 – 17 = - 0.5
Pay off of the options(Max)
Value of Option when prices go up = Cu = Max (4.5, 5.5) = 5.5 million
Value of Option when prices go down = Cd = Max (0.9, - 0.5) = 0.9 million
• STEP 1 – Find out the Probability of Rise.

Say, P = Probability of Price rise of apartment
Present Value of expected return from apartment = current price of the apartment Or,
[{P* (future price when price rises + rent)} + (1 – P)*(future price when price falls + rent)] * 1/ (1+r)n
= current price of apartment
Or,[{P* (1.5+ 0.1)} + (1 – P)*(1.1+0.1)] * 1/ (1+0.1) 1= 1.2;
Or, P = 0.3
Hence, P = 0.3 and (1-P) = 0.7.
• STEP 2 – Find out the expected future value of the Option.
Rn = P* Cu + (1 – P)* Cd
Rn = 0.3* 5.5 + 0.7 * 0.9 = 2.28

R = Rn/(1+r)n
R = 2.28/ (1+0.1) = 2.07 million
THE BEST PAYOFF NOW IS 1.8 MN, WHEREAS THE VALUE OF WAITING FOR ONE YEAR IS 2.07MN (AS
VALUED BY RISK NEUTRAL METHOD) WHICH IS MORE. HENCE THE BUILDER MUST WAIT.
Question:
A stock is currently selling at Rs. 60, with a standard deviation of continuously
compounded annual returns of 0.3. The call option on the stock exercisable 6 months
from now is having an exercise price of Rs. 56. If the risk free rate is 14% find out the value
of the option as per BS Model.
Solution:
S0 = Current price of the share= 60

E = Exercise price of the option = 56
r = risk free interest rate = 0.14
t = time till option expires = 0.5 year
⸹ = standard deviation of stock returns = 0.3
d1 = [ln (So/E) + (r + ⸹2/2) * t] / ⸹ √t

or, d1 = [ln (60/56) + (0.14 + 0.32/2)* 0.5] / (0.3)(√0.5) = 0.7614
d2 = d1 – ⸹ √t
or, d2 = 0.7614 – (0.3)(√0.5) = 0.5493
N (d1) = N (0.7614) = 0.7768

N (d2) = N (0.5493) = 0.7086
(NORMSDIST value from excel is referred, alternatively Normal distribution table has to be
referred)
N(d1) = N (0.7614) = ?
0.7614 lies between 0.76 and 0.77.
N (0.76) = 0.7764; N(0.77) = 0.7794. (Z Table Values)
For a difference of 0.01 (=0.77 – 0.76) the cumulative probability increases by 0.003
(=0.7794 - 0.7764).
The difference between 0.7614 to 0.76 is 0.0014.
So, N (0.7614) = N (0.76) + (0.003/0.01) * (0.0014)
Or, N (0.7614) = 0.7764 + 0.00042 = 0.7768
Similarly, N(d2) = N (0.5493) can be calculated.

0.5493 lies between 0.54 and 0.55
N(0.54) = 0.7054; N (0.55) = 0.7088 (Z Table Values)
For a difference of 0.01 the cumulative probability increases by 0.0034 (=0.7088 -0.7054).
The difference between 0.5493 to 0.54 is 0.0093.
So, N(0.5493) = N(0.54) + (0.0034/0.01) *(0.0093)
Or, N (0.5493) = 0.7054 + 0.0032 = 0.7086
Finally:
C0 = S0 N(d1) – (E/ert) N(d2)
C0 = 60 (0.7768) – [56/2.7183(0.14)(0.5)] (0.7086) = 9.61
Question:
Your firm is reviewing a proposal to manufacture a certain computer called Comp- 1. The
projected cash flows of this proposal are as follows;
Rs. In Millions
Year 0 Year 1 Year 2 Year 3 Year 4
Initial outlay (100)
Cash flows 20 50 50 20
Terminal Cash flow 10
The discount rate applicable to the project is 20%.

Though the cash flows do not appear very attractive, if Comp-1 project is taken it will be in
a position to make a follow on investment in an advanced version, Comp-2, four years
from now.
Comp-2 will be double the size of Comp-1 in terms of investment outlay and cash inflows.
The cash inflows of Comp-2 will have a standard deviation of 30% per year.
a. What is the NPV of the cash flow of Comp-1?
b. What is the value of the option to invest in Comp-2?
(Assume that the risk free rate is 12% for valuation of Comp-2 option)
Solution:
a. NPV of Comp-1 = - 100 + [20/1.21 + 50/1.22 + 50/1.23 + (20+10)/1.24] = - 100 + 94.77
= - 5.23 million
b. The present value of cash inflows of Comp-2 proposal, 4 years from now will be
Rs.189.54 million (= 94.77* 2).
S0 = Present value of the asset = P.V. of CIFn/ert
S0 = 189.54/2.7183(0.2)(4) = 85.17
E = exercise price of the option OR the initial outlay for Comp-2 = 100* 2 = 200 million
⸹ = 0.3
t = 4 years
r = 0.12
STEP-1 Calculate d1 and d2.

d1 = [ln(So/E) + (r + ⸹2/2) * t]/ ⸹ √t = [ln (85.17/200) + (0.12 + 0.3 2/2)* 4] / (0.3)(√4) = -0.323
d2 = d1 – ⸹ √t = - 0.323 – (0.3)(√4) = - 0.923
STEP-2 Calculate N(d1) and N(d2).

N (d1) = N (- 0.323) = 0.3733
N (d2) = N (- 0.923) = 0.1780
N (-0.323) =? It lies between -0.32 to -0.33
N (-0.32) =0.3745; N (-0.33) = 0.3707
For a difference of 0.01 the cumulative probability reduces by 0.0038.
The difference between -0.32 to -0.323 is 0.003.
So, N (-0.323) = N (-0.32) - (0.0038/0.01) *(0.003)
Or, N (-0.323) = 0.37448 - (0.0038/0.01) *(0.003) = 0.3733
N (- 0.923) =? It lies between -0.92 and -0.93

N (-0.92) = 0.1788; N (-0.93) = 0.1762
For a difference of 0.01 the cumulative probability reduces by 0.0026.
The difference between -0.92 to -0.923 is 0.003.
So, N (-0.923) = N (-0.92) - (0.0026/0.01) *(0.003)
Or, N (-0.923) = 0.1788 - (0.0026/0.01) *(0.003) = 0.1780
STEP-3 Find out the value of the option.

C0 = S0 N(d1) – (E/ert) N(d2)
C0 = 85.17 (0.3733) – [200/2.7183(0.12)(4)] (0.1780) = 9.76million
ROI-ROE ANALYSIS
1. Xpress transport has an average cost of 9 per cent for debt financing. The financial leverage ratio is 0.6and
the ROI is 12 per cent. What is the ROE of the company, if its tax rate is 30 per cent?
2. A company has a target ROE of 18%. The financial leverage ratio is 0.7 and the tax rate is 40%. If the cost of
debt is 12%, what ROI should the company plan to earn.
3. A company has a ROI of 15%, but it needs a ROE of 20%. The tax rate is 40%, and total capital employed is
Rs. 5,00,000 consisting only equity. Illustarte how it can achieve the same by altering its capital structure?
Assume that debt financing costs 10%.
ROI-ROE and LEVERAGE ANALYSIS

4. Which company has better credit quality? What is the current ROE for both the companies? What
alterations in the capital structure would enable the companies to maintain an ROE of 30%? Assume
tax rate 50%.
Equity
Debt @10%
EBIT
Industry average Debt equity
Industry average ICR
5. Following data are for X Ltd. and its competitor Y Ltd.
Selling Price per unit

Variable cost per unit
Fixed operating cost
Equity
Debt @ 10%
(Both the companies are currently producing & selling 10,000 units.)
i. Calculate DOL, DFL and DTL for both the companies.
ii. If sales are expected to grow in future then identify which company is likely to perform better? Why?
iii. If sales are expected to decline in future then identify which company is likely to perform better? Why?
iv. When would you like a company to have more leverages and when less of it?
v. Compare the revenue and cost of both companies and list out your inferences related to leverages.
vi. How can you alter the degree of leverages for a company?
Company A Company B
300000 400000
200000 100000
100000 100000
0.5
4 times
X Ltd. (INR) Y Ltd. (INR)

100 100
25 50
500,000 250,000
3 lakh 8 lakh
5 lakh Nil
ROE = [ROI + (ROI – r)* D/E] (1 – t)
1. Xpress transport has an average cost of 9 per cent for debt financing. The
financial leverage ratio is 0.6and the ROI is 12 per cent. What is the ROE of the
company, if its tax rate is 30 per cent?
ROE = [ROI + (ROI – r)* D/E] (1 – t)
ROE= [12 + (12-9)*0.6]*(1-0.3)
ROE= 9.66 %
EXCEL APPLICATION
ROE = 9.66
ROI = 12
r= 9
D/E = 0.6
t= 0.3
2. A company has a target ROE of 18%. The financial leverage ratio is 0.7 and
the tax rate is 40%. If the cost of debt is 12%, what ROI should the company
plan to earn.
ROE = [ROI + (ROI – r)* D/E] (1 – t)
18 = [X + (X-12)*0.7]*(1-0.4)
18/0.6 = X + 0.7X - 8.4
1.7X = 30+ 8.4
X = 22.59 %
EXCEL APPLICATION (Goal Seek Function)

ROE = 18
ROI = 22.59
r= 12
D/E = 0.7
t= 0.4
3. A company has a ROI of 15%, but it needs a ROE of 20%. The tax rate is 40%,
and total capital employed is Rs. 5,00,000 consisting only equity. Illustarte how
it can achieve the same by altering its capital structure? Assume that debt
financing costs 10%.
ROE = [ROI + (ROI – r)* D/E] (1 – t) EXCEL APPLICATION
20 =[ 15 + (15-10)* X]*(1-0.4) ROE =
20/0.6 = 15+ 5X ROI =
X = (33.33 - 15)/5 r=
X = (33.33 - 15)/5 D/E =
X = 3.67 t=
so, D/E = 3.67

hence, D = 3.67 E
Since, D + E = 500000
Therefore, 3.67 E + E = 500000
or, 4.67 E = 500000
or, E = 500000/4.67 = 107067
and, D = 500000 - 107067 = 392933
It needs to take Debt to the extent of 392933 and use the amount to buyback
equity. Thus the equity will reduce to 107067 (=500000-392933) and D/E shall
be 3.67 (=392933/107067).
4. Which company has better credit quality? What is the current ROE for
both the companies? What alterations in the capital structure would enable
the companies to maintain an ROE of 30%? Assume tax rate 50%.
Company A
Equity 300000
Debt @10% 200000
EBIT 100000
Industry average Debt-equity Ratio 0.
Industry average ICR 4 tim
Solution: Company A
Debt Equity Ratio = D/E 0.67

Interest on Debt 20000
ICR = EBIT/Interest 5
Which company has better credit quality?Ans: Company B has a lesser

D/E (0.25) than Company A and Industry Average, so it has lesser risk.
Further, Company B has a higher ICR than Company A and Industry
Avarage, so its EBIT covers its interest expense with a higher spread.
Hence the credit quality of Comp B is better.
What is the current ROE for both the companies?

ROE = [ROI + (ROI – r)* D/E] (1 – t) Company A
Equity 300000
Debt @10% 200000
EBIT 100000
ROE = 0.1333
ROI =EBIT/Capital Employed 0.2
r= 0.1
D/E = 0.667
t= 0.5
What alterations in the capital structure would enable the companies to

maintain an ROE of 30%?
ROE =
ROE = [ROI + (ROI – r)* D/E] (1 – t) ROI =
30 = [20 + (20-10)*X](1-0.5) r=
30/0.5 = 20+10X D/E =
X = (60-20)/10= 4 t=
Hence, both the companies need to transit to a D/E of 4 to achieve the ROE of
30%.
Transiting to D/E of 4:
D/E = 4; or D = 4E
So, D + E = 500000
or, 4E + E = 500000;
or, E = 100000; then D = 500000 -100000 = 400000
Currently, A has Equity of 3,00,000 and Debt 2,00,000.

So A has to take Debt of 2,00,000 more and use it to buyback Equity.
Similarly, B has Equity of 4,00,000 and Debt of 1,00,000.

So, B has to take Debt of 3,00,000 more and use it to buyback Equity.
5. Following data are for X Ltd. and its competitor Y Ltd.

X Ltd. (INR)
Selling Price per unit 100
Variable cost per unit 25
Fixed operating cost 500,000
Equity 300,000
Debt @ 10% 500,000
(Both the companies are currently producing & selling 10,000 units.)
i. Calculate DOL, DFL and DTL for both the companies. X Ltd. (INR)
Sales Units 10,000
SALES 1,000,000
(-) Variable cost 250,000
CONTRIBUTION 750,000
(-) Fixed Cost 500,000
EBIT 250,000
(-) Interest on Debt@10% 50,000
PBT 200,000
DOL = Contribution/EBIT 3
DFL = EBIT/PBT 1.25
DTL = DOL*DFL 3.75
ii. If sales are expected to grow in future then identify which company is X, with a
likely to perform better? Why? higher DTL.
iii. If sales are expected to decline in future then identify which company is
likely to perform better? Why?
Strategic Learning: During upturn a higher leverage and during downturn a

lesser leverage is preferred.
iv. When would you like a company to have more leverages and when less
of it?
v. Compare the revenue and cost of both companies and list out your
inferences related to leverages.
vi. How can you alter the degree of leverages for a company?
6. Consider the following information;

Depreciation= Rs. 30,000
EBIT= Rs. 1,00,000
Interest on Debt= Rs. 50,000
Tax Rate= 40 per cent
Loan Repayment instalment= Rs. 1,00,000
i. Find out Interest coverage ratio and Cash flow coverage ratio.
ii. What purpose these two ratios serve?
iii. Which of these two ratio better serves the purpose and why?
Solution:
Interest on Debt 50000
EBIT 100000
ICR=EBIT/ Interest 2
Depreciation 30000
Tax Rate 0.4
Loan Repayment Installment 100000
Cash Flow Coverage Ratio = (EBIT + Depreciation + Other Non Cash Charges) /
[Interest on debt + (Loan repmt installment/1- t)] 0.6
7. If a term loan of Rs 10 lakh @12% is to be repaid in five equal installments

and the OCFs for year 1 through 5 are Rs 8 lakh, 9 lakh, 9 lakh, 10 lakh and 11
lakh; then find out the DSCR and CFCR for each year and interprete the result.
(assume tax rate 30%)
PVFA 5y, 12%
Annual Installment = 10 lakh/ PVFA 5, 12% 277,410
Year
1
2
3
4
5
Loan Aamortisati
year
1
2
3
4
5
Cash Flow Coverage Ratio = OCF / [Interest on debt + (Loan repmt installment/1-
t)] year
1
2
3
4
5
ICATION (Goal Seek Function)
20
15
10
3.667
0.4
Company B
400000
100000
100000
0.5
4 times
Company B Industry
Average
0.25 0.5
10000
10 4
Company B
400000
100000
100000
0.1125
0.2
0.1
0.250
0.5
Company A Company B
30.00 30
20 20
10 10
4 4
0.5 0.5
Y Ltd. (INR)
100
50
250,000
800,000
0
Y Ltd. (INR)
10,000
1,000,000
500,000
500,000
250,000
250,000
-
250,000
2
1
2
Y, with a lesser
DTL.
3.605 3.605
OCF DS OCF/DS
800,000 277,410 2.884
900,000 277,410 3.244
900,000 277,410 3.244
1,000,000 277,410 3.605
1,100,000 277,410 3.965
DSCR 3.388
rtisation Table
Pricipal
repaymen
Beginnig Value Installment Interest t Ending Value
1000000 277,410 120000.0 157,410 842,590
842,590 277,410 101110.8 176,299 666,291
666,291 277,410 79955.0 197,455 468,837
468,837 277,410 56260.4 221,149 247,687
247,687 277,410 29722.5 247,687 0
[Interest on debt +
Interest on (Loan repmt
OCF Debt Repayment (1-t) installment/1- t)] CFCR
800,000 120000 157,410 0.7 344871.05 2.32
900,000 101110.8322 176,299 0.7 352966.40 2.55
900,000 79954.96419 197,455 0.7 362033.20 2.49
1,000,000 56260.39206 221,149 0.7 372188.02 2.69
1,100,000 29722.47128 247,687 0.7 383561.42 2.87
Corporate Valuation
Chapter 1: Corporate Valuation: Primer, SFM
Outline
• Approaches to Valuation
• FCFF and FCFE
• Enterprise DCF Valuation
• Intangible Valuation
Approached to Valuation
• Means to ascertain Enterprise Value (EV):
1. Book Value Approach
2. Stock and Debt Approach
3. Discounted Cash Flow Approach
4. Relative Valuation Approach
5. Option Valuation Approach
Book Value Approach
Book Value Approach
• Valuing a company based on the information found on its Balance
Sheet
• EV = BV of FA + NCA or
• EV = BV of Investors’ Claims
• LOGIC:
i. BV’s are adjusted to reflect replacement value or liquidation
value/ fair value, and
ii. Since in most cases a firm’s BV < MV, it allows the EV to be
conservative (but sometimes far below the real valuation).
Book Value Approach
EXAMPLE: Consider the balance sheet given below;
Balance sheet of XYZ Ltd.
Liabilities Rs. In mn. Assets Rs. In mn.

Equity 860 Fixed assets 1050
Capital work in
Reserves 280 Progress 230
Debt 250
Total Investor's Total Fixed
claim 1390 Assets 1280
Current liabilities 310 Current Assets 420
TOTAL 1700 TOTAL 1700
Find out the value of XYZ ltd. Based on book value approach.
Solution: EV = BV of FA + NCA = 1280 + (420-310) = 1390
OR, EV =BV of Investors Claim = Net Worth + Debt
= (860 + 280) + 250 = 1390
Book Value Approach
• Divergence between BV and MV is because conventional Balance
Sheet does not reflect valuable intangibles like Brand equity,
Technical & Managerial knowhow, vendor relations and so on.
• More in intangible intensive Sectors like IT and Pharma
• Less in tangible sectors like Real Estate and Banking.
Stock and Debt Approach
• This method assumes market efficiency.
• Where market price of a security is unbiased estimate of its
intrinsic value.
• Errors in the market price are unbiased, and
• Price deviations are random and uncontrolled with any observable
variable.
• Value can be obtained by adding the Market Value of all
outstanding securities
• Also referred as the Market approach
• Example: Outstanding equity shares of a company on 31st march,
2018 is 1.5 crores which had a closing price of Rs.20 each on that
day. Outstanding debt was valued at Rs. 21 crore on the same day.
Find out the value of the enterprise as per stock and debt
approach.
• EV = MV of debt + MV of Shares
• EV = 21,00,00,000 +150,00,000*20 = Rs. 51 Crore
Discounted Cash Flow
Approach
Discounted Cash Flow Approach
• Similar to valuing a capital project using the NPV
• Forecasting firm’s future cash flows and discounting them to
present point of time using a Cost of capital (Kc).
• In the words of Warren Buffett “Intrinsic value (DCF) can be

defined simply as the discounted value of cash that can be taken
out of a business during it’s lifetime.”
• Although informationally intensive, this approach has gained in

popularity from the early 1990s.
• Models of DCF:
I. Enterprise DCF model

II. Equity DCF Model
III. Adjusted PV Model
IV. Economic Profit Model
I. Enterprise DCF model – Forecasting the Free Cash Flow to the
Firm(FCFF) and discounting the same at the Weighted Average
Cost Of Capital(WACC).
• FCFF represents the cash flow available for distribution to all

investors after CAPEX & WC need.
• FCFF = Net Income + Amortizations + Interest (1 – t) + Depreciation

– Capex – Increase in WC [+ if Decrease]
• OR FCFF = Cash flow from operations + Interest (1 – t) – Capex
II. Equity DCF Model – Focuses on the valuation of firm’s equity.
• There are two variants of Equity DCF Model;
a. Dividend discount model (DDM)
It involves forecasting future dividends and discounting the same at the
Cost of equity (Ke)
b. Free Cash Flow to Equity Model (FCFE)
It involves forecasting free cash flow available for distribution to equity
holders after the firm has met its obligations towards other investors and
provided for its capex and net working capital needs.
Then discounting the same at the cost of equity (Ke).
FCFE = Net Income + Amortizations + Depreciation – Capex – Increase in WC
[+ if Decrease] + Debt Issued – Debt Repayments
III. Adjusted PV Model – Enterprise value as sum of unlevered
equity free cash flow and financing side effects.
Value of the Unlevered Value of the financing
Enterprise value = +
equity free cash flow side effects
IV. Economic Profit Model – an aggregate of current invested

capital and the PV of the future economic profit streams
Current Invested PV of future

Enterprise value = +
capital economic profits
streams
Invested Return on Weighted Average

Where, Economic Profit = X -
Capital Invested Capital Cost of Capital
• FCF: Free cash flow refers to the cash available to investors after
paying for operating and investing expenditure.
• The two types of free cash flow measures used in valuation are: FCFF
& FCFE. Usually, when we talk about free cash flow we are referring
to FCFF.
• FCFF = Net Income + Interest (1 – t) + Amortisations +
Depreciation – Capex – Increase in WC [+ if Decrease]
• FCFF = EBIT (1 – t) + Amortisations + Depreciation – Capex –
Increase in WC [+ if Decrease]
• FCFF = Cash flow from operations + Interest (1 – t) – Capex
• FCFF = FCFE + Interest (1 – t) – New Debt Issues + Principal
Repayments
• Example: a company earned a PAT of Rs. 37 mn, after deducting depreciation of Rs.
12 mn, interest on debt Rs. 10 mn and amortising intangibles worth Rs.7 mn. The CA
of the company is Rs. 80 mn for current year and Rs. 70 mn for last year. Similarly,
the CL of the company is Rs. 50 mn for current year and Rs. 60 mn for last year.
Further the company has additionally invested Rs. 25 mn in capital projects in current
year by sourcing it equally from equity and debt. Tax rate of the firm is 30%.
• You are required to find out;
I. FCFF of the company for the current year.
II. Cash flow from operations for the current year.
III. FCFE for the current year.
• SOLUTION:
• Net Income = 37; Depreciation = 12; Interest = 10; Amortisation = 7; CA cy =80: CA
ly=70; CL cy = 50; CL ly = 60; Capex = 25; Equity Issued = Debt taken = 25/2 = 12.5
• WC current year = CA – CL = 80-50 = Rs. 30 mn
• WC last year = CA – CL = 70-60 = Rs. 10 mn
• Hence WC increased by = 30-10 = Rs. 20 mn
I. FCFF = Net Income + Interest (1 – t) + Amortisations + Dep – Capex –
I. FCFF = 37 + 10(1-0.3) + 7 + 12 – 25 – 20 = Rs.18 mn.
II. FCFF = Cash flow from operations + Interest (1 – t) – Capex
I. 18 = CFO + 10(1-0.3) – 25; Hence CFO = Rs. 36 mn
III. FCFE = PAT + Dep + Amortisations – Capex – Inc in WC + New Debt
Issues - Principal Repayments
FCFE= 37 + 12 + 7 - 25 - 20 + 12.5 – 0 = 23.5 mn
Discounted Cash Flow Approach: FCFF
and FCFE
A. FCFF: The cash flows before payments to debt investors and after
reinvestment needs (capex & Increase in WC) are called free cash flows to the
firm
FCFF = Net Income + Amortizations + Interest (1 – T) + Depreciation – Capex –

B. FCFE: The cash flows after payments to debt investors and after
reinvestment needs are called free cash flows to equity.
FCFE = Net Income + Amortizations + Depreciation – Capex – Increase in WC [+ if

Decrease] + Debt Issued – Debt Repayments
FCFE and FCFF: Example
• Diebold Incorporated manufactures, markets, and services automated teller machines in the
United States. The following are selected numbers from the financial statements for 2018
and 2019 (in Crores):
2019
Revenues 620.0
(Less) Operating Expenses (528.5)
(Less) Depreciation (14.0)
= Earnings before Interest and Taxes 77.5
(Less) Interest Expenses (0.0)
(Less) Taxes (29.5)
= Net Income 48.0
Working Capital 240.0
• The firm had capital expenditures of 18 million in 2019. The WC in 2018 was 175 mn.
• Required:
• (a) FCFE for 2019
• (b) Find FCFF for 2019
• (c) Explain the difference between FCFF and FCFE if any with reasons.
FCFE and FCFF: Solution
• (a) FCFE = Net Income + Amortizations + Depreciation – Capex – Increase in WC + Debt
Issued – Debt Repayments
FCFE 2019 = 48 + 14 – 18 – (240 – 175) = - 21 Crore
(b) FCFF = NI + Dep + Int (1 – t) – Capex- Increase in WC
FCFF 2019 = 48 + 14 + nil – 18 – (240 – 175) = - 21 crore
As there is no interest on debt, debt capital is nil and no data on any debt inflow or
outflow is there FCFF = FCFE.
2019
Revenues 620.0
(Less) Operating Expenses (528.5)
(Less) Depreciation (14.0)
= Earnings before Interest and Taxes 77.5
(Less) Interest Expenses (0.0)
(Less) Taxes (29.5)
= Net Income 48.0
Working Capital 240.0
FCFF vs. FCFE
FCFF FCFE
It is available to all investors of the firm It is available to Equity investors only
Includes impact of leverage by subtracting

Excludes impact of leverage & hence
interest and repay to debt holders and
called unlevered CF
called levered CF
Computes Enterprise Value Computes Equity Value
WACC is base for PV computation Ke is base for PV computation

FCFE and FCFF : Example
The financial information's extracted from Leopard Steel Limited as on 31.3.2018:
(Rupees in Crore)
• EBITDA = Rs. 1000
• Depreciation = Rs.400
• Interest Expenses = Rs.150
• Tax Rate = 30%
• Purchase of Fixed Assets = Rs.500
• Changes in Working Capital = Rs. 50
• Net Borrowings = Rs.80
• Common Dividends = Rs.200
Required to Calculate FCFF and FCFE for Leopard Steel Limited
FCFE and FCFF
• Solution: FCFF using Net Income Approach
• NI = (EBITDA – Depreciation – Interest) (1- Tax rate)
• NI = (1000-400-150) (1-30%) = 315
• FCFF = NI+ Dep +Interest(1-Tax Rate) – Capex - ∆ WC

• FCFF = 315 + 400 + 150(1 - 30%) – 500 - 50 = 270
• FCFE = NI + Dep - Capex – ∆ WC + (Debt Taken – Debt Repayments)

• FCFE = 315 + 400 – 500 -50 + 80 = 245
FCFE and FCFF
• Solution: FCFF using EBIT and EBITDA
• EBIT = EBITDA – Dep = 1000 – 400 = 600
• FCFF = NI+ Dep + Interest(1-Tax Rate) – Capex - ∆ WC

• FCFF = EBIT(1-t) + Dep - Capex - ∆ WC
• FCFF = 600(1- 30%) + 400 – 500 – 50 = 270
• FCFF = NI+ Dep + Interest(1-Tax Rate) – Capex - ∆ WC

• FCFF = EBITDA(1-t) + Dep(t) – Capex - ∆ WC
• FCFF=1000(1-30%) + 400(30%) – 500 - 50 = 270
FCFE and FCFF
• Solution: FCFF using CFO
• CFO = NI + Dep - ∆ WC
• CFO = 315 + 400 - 50 = 665
• FCFF = NI+ Dep + Int (1- t) – Capex - ∆ WC

• FCFF = CFO + Int(1-t) – Capex
• FCFF = 665+150(1-30%)-500 = 270
FCFE and FCFF
• Solution: FCFE using FCFF, Net Income and CFO
• FCFE = FCFF – Int (1-t) + (Debt Taken – Debt Repayments)

• FCFE = 270 -150 (1-30%) +80 = 245
• FCFE = NI + Dep - Capex – ∆ WC + (Debt Taken – Debt Repayments)

• FCFE = 315 + 400 – 500 -50 + 80 = 245
• FCFE = CFO – Capex + (Debt Taken – Debt Repayments)

• FCFE = 665 – 500 + 80 = 245
Example: FCFF & FCFE
From the balance sheet and income statement given below calculate FCFF
and FCFE for 20X2
Balance sheet INCOME Rs. In

20X1 20X2 20X1 20X2 STATEMENT mn.
Rs. In Rs. In Rs. In Rs. In Revenue 831.1
Liabilities mn. mn. Assets mn. mn. Less: Operating
Equity 860 860 Fixed assets 980 1050 Expenses 374.0
Reserves 130 280 Less: Depreciation 150.0
10% Preference Capital work EBIT 307.1
Capital 50 10 in Progress 120 230 Less: Interest 24.0
Debt 200 240 EBT 283.1
Total Investor's Total Fixed less: Tax @ 25% 70.8
claim 1240 1390 Assets 1100 1280 Net Income (PAT) 212.3
Current
Current liabilities 180 310 Assets 320 420
TOTAL 1420 1700 TOTAL 1420 1700
Solution:
Calculation of FCFF and FCFE.
FCFF = Net Income + dep + Int (1-t) - Capex - increase in WC
Net Income 212.3
Depreciation 150.0 WC 20X1 = 320-180= 140
Interest(1-t)= 24(1-0.25) 18 WC 20X2 = 420 -310= 110
Capex=(1280+150)-1100 330
Decrease In WC =140-110 30
FCFF =212.3+150+18-330+30= 80.3
FCFE = Net Income + Dep - Capex - Increase in WC + Debt or Pref Issued - Debt or Pref
Repayment - Pref Dividend
Net Income 212.3
Depreciation 150.0
Capex=(1280+150)-1100 330.0
Decrease In WC =140-110 30.0
Debt Issued= 240-200 40.0
Preference Dividend = 50*0.1 5.0
Preference Repayment = 50 - 10 40.0
FCFE=212.3+150-330+30+40-5-40= 57.3
Enterprise DCF Valuation
Enterprise DCF Valuation: based on FCFE and FCFF

• Value of Equity = Equity Value  
FCFE t
t 1 (1  r )t
Discount Factor = Ke
• Enterprise Value or Value of Firm =
Discount Factor = WACC

Enterprise Value _ Example
The following are the projected cash flows to equity and to the firm over the next
five years:
Year CF to Equity Int (1-t) CF to Firm
1 250.00 90.00 340.00
2 262.50 94.50 357.00
3 275.63 99.23 374.85
4 289.41 104.19 393.59
5 303.88 109.40 413.27
Terminal Values 3,946.50 6,000.00
(The terminal values is the value of the equity or firm respectively at the end of
year 5.)
The firm has a cost of equity of 12% and a cost of capital of 9.94%.
Required: (a) What is the value of the equity in this firm?
(b) What is the value of the firm?
FCFE and FCFF: Enterprise Value_Solution
• Solution: 

FCFE t
• (a) Value of Equity = Equity Value 
t 1 (1  r )t
Discount Factor = Ke= 12%

Value of Equity = 250/1.12 + 262.50/1.122 + 275.63/1.123 + 289.41/1.124 +
(303.88+3946.50)/1.125 = 3224
• (b) Value of Firm =
Discount Factor = Kc = 9.94%

Value of the Firm= 340/1.0994 + 357/1.09942 + 374.85/1.09943+393.59/1.09944+
(413.27+6000)/1.09945 = $5149
Key Terms used in Enterprise DCF Valuation
• INVESTED CAPITAL, also referred as capital Employed
• INVESTED CAPITAL = Net Fixed Assets + Net Current Assets
• INVESTED CAPITAL = Equity + Long term Debt
• NOPAT, Net Operating Profit After Taxes
• NOPAT = PBIT (1 – t)
• ROIC, Return On Invested Capital
• ROICt = NOPATt / Invested Capital t-1
• Net Investment, means net investment (i.e. Capex & Increase in W/Cap) made
during the year.
• Net Investment = Invested Capital t – invested Capital t-1
• Net Investment = (NFA+NCA) t - (NFA+NCA) t-1
• FCF, Free cash flow is the excess of NOPAT over Net Investment
• FCF = NOPAT – Net Investment
Enterprise Value: Estimating PV of FCFs
• Estimate FCFs for each of the year of initial planning period when
the enterprise enjoys a high growth rate for each year.
• Estimate the Continuing Value (or Terminal Value) of the enterprise
at the end of initial planning period (n years).
• (After n years the growth rate becomes a ‘steady rate’)
FCF1 + FCF2 +…+ FCFn + CVn
EV0=
(1+WACC) (1+WACC)2 (1+WACC)n (1+WACC)n
Present value of the FCF during the Present value of

Initial planning period continuing value
𝐹𝐶𝐹 𝑛+1
Where, CVn=
𝑊𝐴𝐶𝐶 −𝑔
Enterprise DCF Value: Example
Ram ltd is interested in acquiring the cement division of Shyam
Ltd. The planning group at Ram Ltd. Has developed the following
forecast for the cement division of Shyam Ltd. (Rs. In Million)
YEAR 1 2 3 4 5 6
Growth rate 30 25 20 14 14 10
Asset Value
(Beginning) 100 130 162.5 195 222.3 253.4
NOPAT 14 18.2 22.8 27.3 31.1 35.5
Net Investment 30 32.5 32.5 27.3 31.1 25.3

The growth rate from year 7 onwards will be a constant 10%. The
discount rate (WACC) to be used for this acquisition is 13%.
What is the value of this acquisition?
Enterprise DCF Value: Solution
YEAR 1 2 3 4 5 6 7
Growth rate 30 25 20 14 14 10 10
Asset Value
(Beginning) 100 130 162.5 195 222.3 253.4 278.7 (=253.4*1.10)
NOPAT 14 18.2 22.8 27.3 31.1 35.5 39.1 (=35.5*1.10)
Net Investment 30 32.5 32.5 27.3 31.1 25.3 27.8
(ASSET t+1 – ASSET t) (=130-100) (=162.5- 130) (=195-162.5) (=222.3-195) (=253.4-222.3) (=278.7-253.4) (=278.7*1.1-278.7)
FCF
(=NOPAT-Net
Inv) -16 -14.3 -9.7 0 0 10.2 11.3 (=39.1 - 27.8)
WACC= 13%; Beyond 6 years, g = 10%
TV6 = FCF7/WACC - g = 11.3/0.13-0.10 = Rs. 377 mn
EV0 = -16/(1.13^1) – 14.3 /(1.13^2) – 9.7 /(1.13^3) + 0/(1.13^4) + 0 /(1.13^5) + 10.2

/(1.13^6) + 377 /(1.13^6) = Rs. 154 mn
Hence value of this acquisition is Rs. 154 mn.
Estimating Weighted Average Cost of Capital (WACC)
• WACC = re (S/V) + rp (P/V) + rd (1-t) (B/V)

• Where;
re= cost of equity capital
rp= cost of preference capital
rd= pre-tax cost of debt capital
S = market value of equity capital
P = market value of preference capital
B = market value of debt capital
V = market value of firm
t = tax rate
Estimating Weighted Average Cost of Capital (WACC): Example
• The market value of equity and debt of Rio tech is $300 mn and
$120 mn respectively. Besides it has preference capital valued at $
80 mn. The cost of equity, debt and preference capital is 15%, 10%
and 12% respectively. Find out Rio’s cost of capital. The marginal
tax rate of Rio is 30%.
• SOLUTION:
S = $300mn; B = $120mn; P = $80mn
V = market value of firm = 300+120+80 = $500mn
re= 0.15; rd= 0.10; rp= 0.12; t = 0.3
WACC = re (S/V) + rp (P/V) + rd (1-t) (B/V)
WACC = 0.15(300/500) + 0.12(80/500) + 0.10(1-0.3)(120/500)
Hence; WACC = 0.09 + 0.0192 + 0.0168 = 0.126 or 12.6%
Estimating Return On Invested capital (ROIC) : Example
From the balance sheet and income statement below find out the
(i) ROIC for 20X2. (ii) FCF for 20X2.
(iii) Estimate WACC for 20X2; when re= 14%; rd= 10%; rp= 10% and in 20X2 market value
of equity, debt & preference is Rs 1500 mn, Rs 360 mn and Rs. 50 mn respectively.
(iv) Estimate the enterprise value if the cash flows post 20X2 are to grow at 8% perpetually.
Balance sheet INCOME 20X2
20X1 20X2 20X1 20X2 STATEMENT Rs. In mn.
Debt 200 240 EBT 283.1
Current
TOTAL 1420 1700 TOTAL 1420 1700
Estimating Return On Invested capital (ROIC) : Solution
Balance sheet INCOME 20X2
20X1 20X2 20X1 20X2 STATEMENT Rs. In mn.
Debt 200 240 EBT 283.1
Current
TOTAL 1420 1700 TOTAL 1420 1700
(i) ROIC= NOPAT / Invested Capital.

NOPAT 20X2 = EBIT (1-t) = 307.1 (1-0.25) = 230.3 mn
Invested Capital 20X2 = NFA + NCA = 1280 + (420-310) = 1390 mn
Or Invested Capital 20X2 = Equity + Preference + Debt = (860+280) + 10 + 240 = 1390 mn
ROIC 20X2 = 230.3 / 1390 = 0.1657 or 16.57%
Balance sheet
20X2
20X1 20X2 20X1 20X2
INCOME STATEMENT Rs. In mn.
Rs. In Rs. In Rs. In Rs. In
Revenue 831.1
Liabilities mn. mn. Assets mn. mn.
Less: Operating
Equity 860 860 Fixed assets 980 1050
Expenses 374.0
Reserves 130 280
Less: Depreciation 150.0
10% Preference Capital work in
EBIT 307.1
Capital 50 10 Progress 120 230
Less: Interest 24.0
Debt 200 240
EBT 283.1
Total Fixed
Total Investor's claim 1240 1390 Assets 1100 1280 less: Tax @ 25% 70.8
Net Income (PAT) 212.3
Current liabilities 180 310 Current Assets 320 420
TOTAL 1420 1700 TOTAL 1420 1700
(ii) FCF = NOPAT – Net Investment

Net Investment 20X2 = Invested capital 20X2 – Invested Capital 20X1
Invested capital 20X2 = NFA + NCA = 1280 + (420-310) = 1390 mn
Invested capital 20X1 = NFA + NCA = 1100 + (320-180) = 1240 mn
Net Investment 20X2 = 1390 – 1240 = 150 mn
NOPAT 20X2 = EBIT (1 –t) = 307.1 (1- 0.25) = 230.3 mn
FCF 20X2 = 230.3 – 150 = 80.3 mn
(iii) Given; re= 14%; rd= 10%; rp= 10%; t = 0.25;
S = 1500 mn; P = 50 mn; B = 360 mn;
V = 1500 + 50 + 360 = 1910 mn
WACC = re (S/V) + rp (P/V) + rd (1-t) (B/V)
WACC = 0.14 (1500 /1910) + 0.1(50 /1910) + 0.1(1-0.25)(360 /1910)
Hence, WACC 20X2 = 0.1267 or 12.67%
(iv) Enterprise Valuen = FCFn+1 / (WACC- g)

Given, g = 0.08; Estimated, WACC= 0.1267 and FCF 20X2 = 80.3 mn;
Post 20X2 CFs shall grow @ 8% perpetually.
Hence, FCF 20X3 = 80.3 mn *1.08 = 86.7 mn;
So, EV20X2 = FCF20X3/ (WACC – g) = 86.7/(0.1267 – 0.08) = 1856.5 mn
Enterprise Value: Example
• The following information is available for Magna ltd.
Invested Capital = 20 bn; Return on Invested capital = 14%
Growth rate = 9%; Weighted Average Cost of Capital = 12%
What is the Enterprise Value of Magna ltd.?
• Solution:
ROIC = NOPAT/ Invested Capital
 0.14 = NOPAT/20
 NOPAT = 0.14*20 = 2.8 bn
Growth Rate is 9%, hence Invested Capital will also grow by 9% leaving
Net investment = 20*0.09 = 0.18 bn
FCF = NOPAT – Net Investment = 2.8 – 0.18 = 2.62 bn
FCFn+1 = 2.62*1.09 = 2.86 bn
EVn = FCFn+1/(WACC- g) = 2.86/ (0.12 – 0.09) = 95.33 bn
Enterprise Value: Example
• The following information has been gathered for Phoenix Ltd.
Invested Capital = 50 bn; Return on Invested capital = 12 %
Growth rate = 7%; Weighted Average Cost of Capital = 11%
What is the ratio of Enterprise value to Invested Capital?
• SOLUTION:
ROIC = NOPAT/ Invested Capital
 0.12 = NOPAT/50
 NOPAT = 0.12*50 = 6 bn
Growth Rate is 7%, hence Invested Capital will also grow by 7% leaving
Net investment = 50*0.07 = 3.5 bn
FCF = NOPAT – Net Investment = 6 – 3.5 = 2.5 bn
FCF n+1 = 2.5 *1.07 = 2.675
EVn = FCFn+1/(WACC- g) = 2.675/ (0.11 – 0.07) = 66.875 bn
Ratio of EV to IC = 66.875 / 50 = 1.34 times
Relative Valuation
Relative Valuation
• This approach involves valuing a company by comparing it with the
valuation of other companies in the same industry.
• Also referred to as the direct comparison approach or the multiples

approach
• This comparison is done using two approaches :
(a) Comparison with industry averages
(b) Comparison with comparable companies
Relative Valuation
𝑽𝒄
VT =XT *
𝑿𝒄
• Where;
VT = Value of the Target Firm
Vc = Observed value of the comparable firm
XT = Observed Variable (Such as Profit before Interest and Taxes)
Xc= Observed variable for the comparable company
Relative Valuation
• Two kinds of Multiples in Relative Valuation
A) Enterprise Multiples
B) Equity Multiples
Relative Valuation
A) Enterprise Multiples
• It expresses the value of the company or enterprise value (EV), in
relation to the whole company.
• The Most common enterprise multiples are

EV/EBITDA
EV/BV and
EV/S
Relative Valuation
B). Equity Multiples
• It expresses the value of equity in relation to an
equity static.
• The most common equity multiples are:
P/E Ratio and
P/B Ratio
Relative Valuation: Example
(Enterprise Multiples: Example)
• Find out the Enterprise Value of Target which has an EBIT of
$4500 bn; when the EBIT and Enterprise value of a comparable
firm Walmart is $6250 bn and $81250 bn.
• Solution:
• XT = EBIT of Target = $4500 bn
• XC = EBIT of Walmart = $6250 bn
• VC= Enterprise Value of Walmart = $81250 bn
• Hence; Enterprise Value of Target,
𝑽𝒄
VT =XT * =4500*(81250/6250) = $58500 bn
𝑿𝒄
(Enterprise Multiples : Example)
• Find out the enterprise value of P&G which has an Invested Capital of
Rs. 87500 million, when the Enterprise Value of a comparable
business HUL is Rs. 160 billion with an Invested Capital of Rs. 1600
million.
• Solution:
• XP&G = Invested Capital of P&G = $87500 million
• XHUL = Invested Capital of HUL = $1600 million
• VHUL= Enterprise Value of HUL = $160,000 million
• Hence; Enterprise Value of P&G,
𝑽
VP&G =XP&G *𝑿𝑯𝑼𝑳=87500*(160,000/1600)= $8750,000 million
𝑯𝑼𝑳
Or $8750 billion
(Equity Multiples : Example)
• Find out the equity value of Infy Ltd. that has an EPS of Rs 11, if the
EPS and Equity value of a comparable firm Ticies Ltd. Is Rs. 12 and
Rs. 1500 respectively. Infy has 10,000 no. of outstanding equity
shares.
• Solution:
• For Ticies; MPS = 1500 and EPS = 12
• Hence P/E TICIES = 1500/12 = 125 times
• For Infy; EPS = 11 and Assuming Infy P/E to be as same as that of
Ticies P/E, the Infy MPS shall be = 11*125 = Rs.1375
Hence, the Equity Value of Infy = MPS* No. of Outstanding Shares
=1375*10,000= Rs.13,750,000
or Rs. 13.75 mn
(Equity Multiples : Example)
• The Price to Sales multiple for pharma sector averages at 11
times. If Arvind pharmaceuticals has registered a sales of Rs. 2500
bn for 2019 FY, what would be its relative valuation based on Price
to Sales ratio.
• Solution:
• Industry Avargae P/S = 11 times.
• Assuming a P/S of 11 for Arvind, the Equity Value of Arvind would
be = 2500*11 = Rs 27500 bn
Option Valuation
Option Valuation
• It is special contract under which the option owner enjoys the
right to buy or sell without obligation.
• Option pricing valuation is actually a kind of absolute valuation
• It derives asset value based on the risk and return of the asset
(the option)
• Financial option
• Real option
Intangibles Valuation
• Intangible asset is that it is an asset that we can neither see nor feel.
• Broad range of intangible assets:

Franchises, copy rights and trademarks
Patents
Brand names
Goodwill
• Invisible assets including:

Top-notch management
Loyal and well-trained workforce
Technological know-how
• The needs for intangible assets are :
i) Business Value addition

ii) Distinguish product from similar products
iii) Improve Value for Stake holders
iv) Create a Business Image
Process of Valuation of Intangible Assets
• Valuation of intangible assets is a complex exercise.
• The non-physical form of intangible assets makes it difficult to
identify the future economic benefits
• Many intangible assets do not have alternative use and cannot be
broken down into components or parts for resale.
• There are three approaches used in valuing intangible assets:
(i) Cost approach,
(ii) Market value approach and
(iii) Economic value approach.
• Valuation of Goodwill
• Valuation of Brand
• Trademarks
• Patents
• Royalty
• Copy rights etc.
• Let’s see Valuation of Goodwill and Brand Valuation

Valuation of Goodwill
• Goodwill is the value of the reputation of a firm built over time with respect
to the expected future profits over and above the normal profits.
• Goodwill is an intangible real asset which cannot be seen or felt but exists
in reality and can be bought and sold.
• Valuation of Goodwill:
i. Average Profit method
ii. Super Profit method
iii. Capitalization method
• Average Profit Method
• In this method, the profits of the past few years are averaged and
adjusted for any change that is expected to occur in the near future.
• The adjusted average is multiplied by a certain agreed number (say, 2

or 3 or 5).
• It is expressed, for example, as 3 years’ purchase of five years’ average
profits.
• Average Profit Method – Example
• If, for example, the profits for the last five years have been Rs 80,000, Rs
90,000, Rs 70,000 Rs 85,000 and Rs 1, 00,000; what shall be the value of
goodwill if it is norm to value goodwill as 3 years’ purchase of five years’
average profits.
• SOLUTION: If, goodwill is to be valued at 3 years’ purchase of average
profits for 5 years,
• Avg. Profit for 5 years =
• Goodwill will be 3 years purchase of 5 years average profit = Rs 85,000 x

3 = Rs 2,55,000.
• Hence, Goodwill is valued at Rs. 2,55,000.
• Average Profit Method – Example 2
Majumdar & Co. decides to purchase the business of ABC Ltd. on
31.12.2003. Profits for the last 6 years were: Rs. 10,000; Rs. 8,000; Rs.
12,000; Rs. 16,000, Rs. 25,000 and Rs. 31,000 from year 1998 through
2003 respectively.
Compute the value of Goodwill on the basis of 3 years’ purchase of the
average profit for the last 4 years.
• Solution: Goodwill = 3 years’ purchase of last 4 years’ average profit.
• Average Profit for last 4 year = (12000+16000 + 25000+31000) /4
= 21000
Therefore Goodwill (at 3 years’ purchase) = 21000 * 3 = 63,000
• Super Profit Method
• In every industry, there is a rate which is considered to be the normal rate

at which profits are expected to be earned on the capital employed.
• If a firm is able to earn more than the normal expected profit, the
excess is called super profits which can be attributed to the special
advantages of firm.
• Super Profit Method – Example
The capital of the firm is Rs 4, 00,000 and that 15% is reasonable return in
the industry. The reasonable or normal profits are Rs 60,000. If the average
profits are Rs 85,000. Calculate goodwill value for 3 years’ purchase agreed
upon.
• Solution:
Normal Profit = 400000*15% = 60,000
Average Profit = 85,000
SUPER PROFIT = 85,000 – 60,000 = 25,000
Goodwill = Super Profit x Number of years’ agreed to purchase
Goodwill = Rs.25,000 x 3 = Rs. 75,000
• Super Profit Method – Example2
ABC Limited earns a profit of Rs.50,000 by employing a capital of
Rs.2,00,000, The normal rate of return of a firm is 20 %.
Calculate value of Goodwill using super profit method.
• Solution:
Capital Employed = Rs. 200,000 and the Rate of Return = 20%
Hence, Normal Profit = 2,00,000 * 20% = Rs.40,000
But the company earns an Actual Profit = 50,000 meaning a SUPER
PROFIT of = Rs.50,000 – Rs.40,000 = Rs.10,000
Assuming that goodwill is the base for earning super profit of Rs.
10,000, the Goodwill is valued at = Rs.10,000 x 100/20 = Rs.50,000
• Capitalisation Method
• In this method, the value of the whole business is found out by the
formula,
Capitalised Value
of Profits (CVP) =
• The net assets (excluding goodwill) of the firm are deducted and the
remainder is goodwill.
So, Goodwill = CVP – Net Assets

• Capitalisation Method – Example 1
• The capital of the firm is Rs 4,00,000 and that 15% is reasonable return in
the industry. The reasonable or normal profits are Rs 60,000. If the
average profits are Rs 85,000, Net assets (excluding goodwill) or capital
is Rs 4, 00,000. Calculate Value of Goodwill.
• Solution:
• Profit = 85,000; Reasonable return = 15%; Net Assets = 4,00,000
85000
• Hence, CVP = (Profits/ Normal rate of Return)*100 = * 100 = 5,66,667
15
• Goodwill = CVP – Net Assets = 5,66,667 – 4,00,000 = 1,66,667
• Capitalisation Method – Example 2
• A firm earns profits of Rs.2,00,000. The normal rate of return in a similar
type of business is 10% of total assets (excluding goodwill) and external
liabilities, which stood at Rs.22,00,000 and Rs.5,60,000 respectively as
on that of valuation of goodwill. Calculate the value of goodwill using
Capitalization of Profit method.
• Solution
Profits = 2,00,000; Normal Return = 10%;
200,000
CVP = (Profits/ Normal Rate of Return)*100 = * 100 = 20,00,000
10
Net Assets = Total Assets – Current Liabilities
= 22,00,000-560,000 = 16,40,000
Therefore, Goodwill= CVP – Net Assets= 20,00,000 -16,40,000 = 3,60,000
Brand Valuation
Brand
• Brand means a name, term, sign, symbol or design or group of
sellers and to differentiate them from those of competitors.
- American Marketing Association
• Brand is that intangible assets which is acquired from outside

source while acquiring business or may also be nurtured internally
by a company, which are known as home grown brands.
• Brands greatly determine the corporate market value.
• Brands have major influence on takeover decisions as a strong
brand portfolio calls for a fat premium.
Brand Valuation
• Brand valuation is a process to ascertain the value of a brand. The value
of a brand depends on the corporate’s philosophy, culture, positioning,
messages, promises, deliverables, legal protection and value proposition.
• Approaches for determining the financial value of a home-grown brand:
i. The Historical Cost Model
ii. Replacement Cost Model
iii. Market Price Model
iv. Present Value Model
v. Royalty Relief Model
Brand Valuation: Historical Cost Model
• In historical cost model actual expenses incurred in creation,
maintenance and growth of corporate brands are taken into
consideration.
• The value of corporate brands is computed as follows:
• Brand Value = Brand Development Cost + Brand marketing and

Distribution Cost + Brand promotion cost including advertising
and other costs.
Brand Valuation: Replacement Cost Model
• Under replacement cost model brands are valued at the costs
which would be required to recreate the existing brands.
• It is the opportunity cost of investment made for the replacement of

the brand.
• Brand Value = Replacement Brand Cost.

Brand Valuation: Market Price Model
• Probable value that a company would fetch by selling its brand is
taken as the value of the brand.
• Brand value is given by ;
Brand Value=Net Realisable Value
• As there is no readymade market for many brands, the value is

determined on the basis of expected benefit to be derived by the
purchaser by purchasing the brand.
Brand Valuation: Present Value Model
• According to present value model (DCF model), the value of a brand is
the sum total of present value of future estimated flow of brand revenues
for the entire economic life of brand plus the residual attached to the
brand.
𝒏 𝑹𝒕 𝑹𝒆𝒔𝒊𝒅𝒖𝒂𝒍 𝑽𝒂𝒍𝒖𝒆
• 𝑩𝒓𝒂𝒏𝒅 𝑽𝒂𝒍𝒖𝒆 = 𝒕=𝟏 𝟏+𝒓 𝒕 +
𝟏+𝒓 𝒏
• Where, Rt = Anticipated revenue in year t, attributable to the brand
r = Discounting rate i.e. WACC
• The model is used by considering the year wise revenue attributable to
the brand over a period of 5,8 or 10 years.
• The residual value is estimated on the basis of a perpetual income,
assuming that such revenue is constant or increased at a constant rate.
Brand Valuation: Royalty Relief Model
• In this method the brand is valued as ‘Present Value
of Future Royalty Benefits of Brand’.
Brand Value = AR* PVIFA n,r

• Where,
AR = Annual Royalty on Brand
PVIFA = Present Value Interest Factor Annuity
n = Number of years for which brand shall earn economic benefit
r = risk free rate
Problem No.1
• RS Ltd furnishes the following information relating to the
previous three years, and requests you to compute the value
of the brand of the Company — [Rs` in Lakhs]
• Inflation was 9% for 2012 and 15% for 2013. If the capitalization
factor considering internal and external value drivers to the brand
is 14, determine the brand value. (Assume an all-inclusive future
tax rate of 35%.)
Particulars 2011 2012 2013
Profits Before Interest and Tax (PBIT) 75.00 85.25 150.00
Loss on Sale of Assets* 3.00 --- 18.00
Non-Operating Income* 12.00 7.25 8.00
(*Included in PBIT)
Problem No.1: Solution
Particulars 2011 2012 2013
Profits Before Interest and Tax 75.00 85.25 150.00
Add: Loss on Sale of Assets (Since included in PBIT) 3.00 -- 18.00
Less: Non-Operating Income (12.00) (7.25) (8.00)
Branded Earnings (Adjusted Operating Earnings) 66.00 78.00 160.00
Inflation Adjustment Factor 1.15 1.00
1.25
(1.09 x 1.15x1.00) (1.15 x 1.00)
Inflation Adjusted Earnings as at 31.03.2013 82.50 89.70 160.00

(=66 x 1.25) (=78 x 1.15) (=160 x 1.00)
Weights 1 2 3
Weighted Earnings 82.50 179.40 480.00
(=82.50x 1) (=89.70x 2) (=160.00x 3)
Weighted Average Earnings Before Tax [(82.50 + 179.40 +480)/(1+2+3)] 123.65
Less: Taxes at 35%(=123.65*0.35) (43.28)
Weighted Average Brand Earnings After Tax 80.37
Capitalization Factor 14
BRAND VALUE (Return / Capitalization Rate = 80.37/0.14) 574.07
Problem No.2
• The following financials are pertaining to TECHNO LTD an IT
company:
• You are required to calculate the Brand Value for Techno Ltd.
Year ended March 31st 2014 2013 2012
EBIT(Rs in Crores) 696.03 325.65 155.86
Non-branded Income(Rs in Crores)* 53.43 35.23 3.46
Inflation compound factor @ 8% 1.000 1.08 1.17
Remuneration of Capital 5% of average
capital
employed
Average capital Employed(Rs IN CRORES) 1112.00
Corporate Tax Rate 35%
Capitalization Factor 16%
(*Included in PBIT)
Problem No.2: Solution
TECHNO LTD.
Computation of Brand Value (Amount in Rs. Crores)
Year ended March 31st 2014 2013 2012
A EBIT (Rs) 696.03 325.65 155.86
B Less : Non-brand income (Rs) 53.43 35.23 3.46
C Adjusted Profits (Brand Income= A – B) (Rs) 642.60 290.42 152.40
D Inflation Compound Factor @ 8% 1.000 1.08 1.17
(1x1.08) (1x1.08x1.08)
E Present Value of Profits for the brand(C*D) (Rs) 642.60 315.65 178.31
F Weight age Factor 3 2 1
G Weighted Profits (E*F) (Rs) 1927.80 631.30 178.31
H 456.24
Weight Average Profits = (1927.80 + 631.30+ 178.31)/ (3 + 2 + 1) (Rs)
I Remuneration of Capital 55.60

[5% of Average capital employed i.e. 1112×5%]
J Brand Related Returns (H – I) 400.64
K Corporate tax @ 35% (J*0.35) 140.22
L Brand Earning (J – K) 260.42
M Capitalization Factor 16%
N BRAND VALUE(Return / Capitalization Rate = 260.42/0.16) 1627.63
Problem 3:
• It is estimated that a home grown brand in telecom sector would yield a
revenue of Rs. 125 mn in the initial year-end and it would grow at a rate
10%, 8% and 6% for next three years before it finally starts growing at 3%
for ever. Find out the value of Brand as per present value model. The
weighted average cost of capital is 11%.
Year Revenue Revenue
• SOLUTION: Growth (Rt)
1 -- 125.00
2 10% 137.50
Residual Value5 = = R6/(WACC – g) = 167.00/(0.11 – 0.03) = 2087.5 3 8% 148.50
Brand Value0 = (125/1.111) + (137.5/1.112) + (148.5/1.113) + 4 6% 157.41
5 3% 162.13
(157.41/1.114) + (162.13/1.115) + [ 2087.5/1.115)]
6 3% 167.00
= 112.61 + 111.59 + 108.58 + 103.69 + 96.21 + (2087.5* 0.5934)
= 1771.53 mn.
Problem. 4
• Find out the brand value under royalty relief method, when the
annual royalty for acquiring a similar brand would cost Rs.
200,000 and the Brand would accrue benefits for next 10
years. The relevant rate is 12%.
• Solution:
Brand Value = Annual Royalty * PVIFA y,r
= 200,000*PVIFA 10y, 12%
= 200000* 5.650 = 11,30,000
OR = 200000*(1/0.12) - [1/0.12(1.12^10)] = 1130,000
Thank you
Mergers and Acquisitions
Module 4
There are so many mergers and acquisitions that happen every
year. As per the IMAA institute, more than 45,000 transactions
took place in the M&A landscape in 2015. The valuation of these
stands at $4.5 trillion or more.
Source: Institute for Mergers, Acquisitions & Alliances (IMAA)
Why Merger and Acquisitions?
Primarily value creation or value enhancement is the goal of any merger.
These are business combinations, and the reasons are based on pecuniary
elements.
Module 4
• Merger and Acquisitions - Introduction

• Reasons for merger or acquisitions (e.g. synergistic benefits).
• Valuation of synergy
• Anti Take over Defense
• Forms of consideration & terms for acquisitions (e.g. cash, shares, convertibles &
earn-out arrangements), & their financial effects.
• The post-merger or post-acquisition integration process (e.g. management transfer &
merger of systems)
• The implications of regulation for business combinations.
MERGERS AND ACQUISITIONS
• TERMINOLOGY
• The term ‘merger’ is usually used to describe the joining together of two or more entities.
• Acquisition: One entity acquires a majority shareholding in another, the second is said to
have been acquired (or ‘taken over’) by the first.
• Merger: Two entities join together to submerge their separate identities into a new entity
• In fact, the term ‘merger’ is often used even when an acquisition/takeover has actually
occurred, because of the cultural impact on the acquired entity – the word merger makes
the arrangement sound like a partnership between equals.
• TYPES OF MERGER/ACQUISITION
1. Horizontal integration
2. Vertical integration
3. Conglomerate integration
TYPES OF MERGER/ACQUISITION
• Horizontal integration
• Two companies in the same industry, whose operations are very closely
related, are combined
• Walmart’s acquisition of Flipkart.
• Tata Motors acquisition of luxury car maker Jaguar Land Rover.
• Vodafone-Idea: India’s largest Telecom merger.
• The entire story of Ongoing Banking Consolidation.
• Consolidation of Bank of Baroda (BoB), Vijaya Bank and Dena Bank.
• Vertical integration
• Two companies in the same industry, but from different stages of the
production chain merger
• Axis Bank’s acquisition of digital payment company FreeCharge from
Snapdeal for Rs 385 crore.
• GVK Power acquired out Australia’s Hancock Coal for about 1.26 billion
dollars.
• Conglomerate integration
• A combination of unrelated businesses, there is no common thread and
the main synergy lies with the management skills and brand name
• E.g. L&T and Voltas
• L&T’s acquisition of Mindtree.
• Dr. Reddy's Laboratories Limited’s acquisition of Imperial Credit Private
Limited, a non-banking finance company based in Kolkata
• KEY REASONS FOR ACQUISITION
• Increased market share/power
• Economies of scale
• Combining complementary needs
• Improving efficiency
• A lack of profitable investment opportunities (surplus cash)
• Tax relief
• Reduced competition
• Asset-stripping
• Diversification – to reduce risk
• Shares of the target are undervalued.
BUT the Larger Question is…
• Does Diversification Create Value?
• 1960s n1970s Conglomerates started emerging due to diversification.

• 1980s n1990s Conglomerates were dismantled & restructured to
achieve greater focus.
• During Global Financial Crisis, the coinsurance effect is

realised by diversified companies and Conglomerates are reemerging.
Value Growth of Conglos > Value Growth of Single Biz Firms

• METHODS OF MERGERS AND ACQUISITIONS
Transfer of Assets Transfer of Shares
Acquisition B acquires trade and assets from A for B acquires shares in A from A’s
(B takes over A) cash. shareholders in exchange for
A is then liquidated, and the proceeds cash.
received by the old shareholders of A. A, as a subsidiary of B, may
subsequently transfer its trade
and assets to its new parent
company (B).
Merger Z acquires trade and assets from both X Z acquires shares in X and Y in
(X and Y merge and Y in return for shares in Z. return for its own shares.
to form Z)
X & Y are then liquidated X and Y subsequently transfer
their trade and assets to their
new parent company (Z)
• Steps in Acquisition
• Strategic steps
– Step 1: Appraise possible acquisitions.
– Step 2: Select the best acquisition target.
– Step 3: Decide on the financial strategy, i.e. the amount and the structure of the consideration.
• Tactical steps
– Step 1: Checklist delineation for relevant regulation.
– Step 2: Make a public offer for the shares not held.
– Step 3: Success will be achieved if more than 50% of the target company’s shares are acquired.
• SYNERGY
• Two or more entities coming together to produce a result not independently obtainable
• Importance of synergy in mergers and acquisitions for a successful business combination
• HLL-Brooke Bond Lipton merger is also a good example of mergers for synergistic motives.
Operating synergies resulted in cutting down employee costs by 10 per cent, resulting in a
post-merger increase of eight per cent in net profit.
• MV of combined company (AB) > MV of A + MV of B
• Sources of synergy
• There are several reasons why synergistic gains arise. These break down into the following:
1. Revenue synergy, such as market power and combining complementary resources
2. Cost synergy, such as economies of scale.
3. Financial synergy, such as elimination of inefficiency.
• THE FORM OF CONSIDERATION FOR A TAKEOVER
• Cash offer
• Share exchange
• Earn out
• CASH OFFER
• The target company shareholders are offered a fixed cash sum per share.
• This method is likely to be suitable only for relatively small acquisitions, unless
the bidding entity has an accumulation of cash.
• Advantages:
• Quick and at low cost.
• Less risk compared to accepting shares in the bidding company.
• Increased liquidity to target company shareholders
• This reduces the overall cost of the bid to the bidding company.
• CASH OFFER
• Disadvantages:
• In larger acquisitions – borrowing/ capital issue in the capital markets
will increase, and cost of capital may also increase due to the increased
financial risk.
• Target company shareholders – Gain on sale of shares will be taxable
• Target company shareholders may be unhappy with a cash offer, since
they are 'bought out' and do not participate in the new group.
• SHARE EXCHANGE
• The bidding company issues some new shares and then exchanges them with
the target company shareholders.
• Large acquisitions almost always involve an exchange of shares, in whole or in
part.
• SHARE EXCHANGE
• Advantages:
• The bidding company does not have to raise cash to make the payment.
• The bidding company can ‘boot strap’ earnings per share if it has a higher P/E
ratio than the acquired entity.
• A share exchange can be used to finance very large acquisitions.
• SHARE EXCHANGE
• Disadvantages:
• The bidding company’s shareholders have to share future gains with the
acquired entity.
• Price risk – there is a risk that the market price of the bidding company's
shares will fall during the bidding process, which may result in the bid
failing.
• EARN-OUT
• A procedure whereby sellers will receive a portion of their consideration linked
to the financial performance of the business during a specified period after the
sale.
• The arrangement gives a measure of security to the new owners, if risk
associated in the purchase.
• The purchase consideration is sometimes structured so that there is an initial
amount paid at the time of acquisition, and the balance deferred.
• Some of the deferred balance will usually only become payable if the target
entity achieves specified performance targets.
• KEY ISSUES RELATING TO FORMS OF CONSIDERATION
• Considerations of different stakeholders

• Position of the target company's shareholders
• Position of the bidding company and its shareholders
• Methods of financing a cash offer
• Cash Surplus
• Debt
• Rights issue
• EVALUATING A SHARE FOR SHARE EXCHANGE
• Value the predator company as an independent entity and hence calculate the value of a share
in that company.
• Repeat the procedure for the victim company.
• Calculate the value of the combined company post-integration. This is calculated as:
Value of predator company as independent company xxx
Value of victim company as independent company xxx
Value of any synergy xxx
Total Value of combined company xxx
Calculate the number of shares post-integration :

Number of shares originally in the predator company xxx
Number of shares issued to victim company xxx
Total shares post-integration xxx
Exchange Ratio - MERGERS AND ACQUISITIONS
Exercise 1: Exchange Ratio – No. of Shares Post Merger

Kelloggs Ltd is taking over Corn Flakes Ltd. The shareholders of Corn Flakes Ltd would
receive 0.8 share of Kelloggs Ltd for each share held by them. No. of shares of Kelloggs
Ltd before Merger is 250,000 and No. of shares of Corn Flakes Ltd pre-merger is 175000.
Calculate the post-merger no. of shares
Solution:
New Shares to be issued to Target
= Exchange Ratio X Existing No. of shares of Target
Hence, New shares to be issued to Corn Flakes = 0.8 X 175,000 = 140,000
Existing Shares of Kelloggs = 250,000
Post-Merger Number of Shares of Kelloggs = 250,000 + 140,000 = 390000
Exercise 2: Exchange Ratio – Net Asset value Method
Based on the information given below ascertain the exchange ratio based on Net Assets Value:
S Ltd (Acquirer) M Ltd (Target)
Total Assets 1000 Lacs 500 Lacs
External Liabilities 400 Lacs 200 Lacs
Solution:
Net Assets = Total Assets – Liabilities
Net Assets of S Ltd = 1000 – 400 = 600 Lacs
Net Assets of M Ltd = 500 – 200 = 300 Lacs
Net Assets Ratio = Net Assets of Target Co./Net Assets of Acquiring Co. = 300/600 = 0.5
Exchange Ratio = 0.5:1
Shareholders of M Ltd. will get 0.5 share of S Ltd. for every share held in M Ltd.
Exercise 3: Exchange Ratio – EPS Method
Determine the exchange ratio in case of below Merger, based on EPS proportion:
Thump Ltd(Acquirer) Mount Ltd(Target)
PAT Rs. 67,00,000 Rs. 54,50,000
No. of shares 100,000 50,000
Solution: EPS = Profit after Tax / No. of Shares
EPS of Thump Ltd = 6700000 / 100000 = Rs. 67
EPS of Mount Ltd = 5450000 / 50000 = Rs. 109
Exchange Ratio based on EPS proportion = EPS of Target Co / EPS of Acquiring Co
Exchange Ratio based on EPS proportion = 109 / 67 = 1.63
Hence, Shareholders of Mount will get 1.63 share of Thump for every share held in Mount.
Exercise 4: Exchange Ratio – Market Price Method
Determine the Exchange Ratio in case of below takeover based on Market price
D Ltd(Acquirer) Id Ltd(Target)
P/E Ratio 5 Times 10 Times
Profit after Tax Rs. 20 Lacs Rs. 1250000
No. of Shares 100000 50000
Solution: Market Price = P/E Ratio X EPS
Market Price = P/E Ratio X (Profit after Tax/No. of Shares)
Market Price of D Ltd (Acquiring Co) = 5 X (2000000/100000) = 5 X 20 = 100
Market Price of Id Ltd (Target Co) – 10 X (1250000/50000) = 10 X 25 = 250
Exchange Ratio based on Market Price = Market Price of Target / Market Price of Acquiring
Exchange Ratio based on Market Price = 250 / 100 = 2.5
Shareholders of Id Ltd. will get 2.5 share of D Ltd. for every share held in Id Ltd..
Exercise 5: Exchange Ratio
Shanthisagar Ltd wishes to takeover Maheshprasad Ltd. The financial details of the two companies are as under:
Particulars Shanthisagar Maheshprasad
Equity Shares (Rs. 10 per share) 100,000 50,000
Share Premium Account ---- 2,000
Profit and Loss Account 38,000 4,000
Preference Shares 20,000 ---
10% Debentures 15,000 5,000
Total 173,000 61,000
Fixed Assets 122,000 35,000
Net Current Assets 51,000 26,000
Maintainable Annual Profit After
Tax For Equity Shareholders 24,000 15,000
Market Price per Equity Share 24 27
Price Earnings Ratio 10 9
What offer do you think Shanthisagar Ltd could make to Maheshprasad Ltd in terms of
exchange ratio, based on
(i)Net Assets Value
(ii)Earnings Per Share
(iii) Market Price?
(iv) Which method would you prefer from Shanthisagar Ltd’s point of view?
Solution 5:
i) Exchange Ratio based on Net Assets Value
Shanthisagar Maheshprasad
Fixed Assets 122000 35000
Net Current Assets 51000 26000
Total Assets 173000 61000
Solution 5:
Total Assets 173000 61000
Less: 10% Debentures 15000 5000
Less: Preference Shares 20000 ----
Net Assets 138000 56000
No. of Shares 10000 5000
Net Assets per share 13.8 11.2
Exchange Ratio based on Net Assets = 11.2/13.8 = 0.81
Solution 5:
ii) Exchange Ratio based on EPS
Profit 24000 15000
No. of Shares 10000 5000
Earnings per share 2.4 3
Exchange Ratio based on EPS = 3/2.4 = 1.25

Solution 5:
iii) Exchange Ratio based on Market Price per share
Market Price 24 27
Exchange Ratio based on MPS = 27/24 = 1.125
iv) Which method would you prefer from Shanthisagar Ltd’s point of view?
From Shanthisagar’s point of view Net Asset Value based Exchange Ratio is the best as therein,
only 0.81 share in Shantisagar has to be given for every share held in Maheshprasad.
EPS Bootstrapping - MERGERS AND ACQUISITIONS
Exercise 6: MPS Management and EPS Bootstrapping
Based on the below data, of Acquiring company – Iyangars Ltd and Target Company – SLV Ltd
answer the following questions;
Iyangars (Acquiring) SLV (Target)
Profit after Tax of Iyangars Rs. 25,00,000 Rs. 45,00,000
No. of outstanding equity shares 250,000 180,000
Market Price of Shares Rs. 100 Rs. 100
Required:
i. If the exchange ratio is decided on the basis of market price of shares then find out the
expected market value of the merged entity.
ii. Calculate the Pre-merger EPS of both the companies and Post-merger EPS of Iyangars.
iii. Also illustrate the effect of EPS bootstrapping.
EPS Bootstrapping - MERGERS AND ACQUISITIONS
Solution 6: Exchange ratio = MPS of Target/ MPS of Acquiring = 100/100 = 1
Pre-merger Post-merger
Iyangars SLV Iyangars
PAT Rs. 25,00,000 Rs. 45,00,000 70,00,000 (=25,00,000+45,00,000)
No. Of Shares 250,000 180,000 430,000 (=250,000+ 1*180,000)
EPS Rs. 10 Rs. 25 16.28
P/E = MPS/EPS 10 times (=100/10) 4 times (=100/25) 10 times (assumed to maintain pre-merger P/E)
MPS 100 100 16.28*10 = 162.80 (=EPS*P/E)
Market Value (=162.80* 430,000) Rs. 70,004,000
• Pre Merger Market Value of Both = 250,000*100 + 180,000*100 = Rs. 43,000,000
• Post merger Market Value = 70,004,000
• Benefit of EPS Bootstrapping = 70,004,000 – 43,000,000 = Rs. 27,004,000 (Possible when
Acquiring company has a higher P/E than Target Company P/E).
EVALUATION - MERGERS AND ACQUISITIONS
• Problem No. 1
• Company A intends to acquire Company B. Summary of company
information:
Particulars Company A Company B
Market price per share (Rs.) 75 15
Number of shares 1,00,000 60,000
Market Value 75,00,000 9,00,000
• Required:
• If Company A intends to pay Rs.12,00,000 cash for B, what is the cost premium if:
• (a) the share price does not anticipate the takeover
• (b) the share price of the company B includes a ‘speculation’ element of Rs.2 per share?
• Solution:
• (a) The share price accurately reflects the true value of the entity.
• The cost premium for the bidder (A) is = Rs.12,00,000 – Rs.9,00,000 = Rs.3,00,000
• Company A is paying Rs.3,00,000 premium for the identified benefits of the
take over.
• (b) when the share price includes a speculation element of Rs. 2, the accurate
price should be = 15 -2 = 13 per share.
• The cost premium for the bidder (A) is = Rs.12,00,000 – 780,000 (=13 * 60000)
= Rs. 420,000
• Company A is paying Rs.4,20,000 premium for the identified benefits of the
take over.
• Problem No. 2
• Company A has 200m shares with a current market value of $4 per share. Company B has 90m
shares with a current market value of $2 per share. A makes an offer of 3 new shares for every 5
currently held in B. A has worked out that the present value of synergies will be $40m.
• Required:
• Calculate the expected value of a share in the combined company (assuming that the given share prices
have not yet moved to anticipate the takeover), and advise the shareholders in company B whether the
offer should be accepted.
• Solution 2
• Market Value of A = 800; Market Value of B = 180;
• Present Value of Synergies = 40
• No. of shares of A post issue of “3 new shares of A for every 5 shares (held in B)”
= 200 Existing Shares + (3/5 x 90) New Shares = 254
Merged Entity(A)’s No. Of Shares Post-Acquisition Pre-Acquisition Change in Value
Market Value value
Shares with (3/5 * 90 =) 54 216 180 36 (216 -180)
Shareholders of B [=(1020/254)*54] (Shareholders of B)
Shares with 200 804 800 4 (=804 – 800)
Shareholders of A [=(1020/254)*200] (Shareholders of A)
Value of Merged Entity Post Acquisition 1020
= MV of A+ MV of B + Synergy = (=800+180+40)
• The wealth of the shareholders in company B will increase by 36 as a consequence of

the takeover. This is a 20% increase in wealth (36/180).
• Company B’s Shareholders should be advised to accept the 3 for 5 share for share offer.
• Problem No. 3
• Mayer’s Company Ltd and Power Company Ltd are listed on the Stock Exchange.
Relevant information is as follows:
Mayer’s Company Ltd Power Company Ltd
Share Price today (Rs.) 3.05 6.80
Shares in issue 48,00,000 13,00,000
• Mayer’s Company Ltd wants to acquire 100% of the shares of Power Company Ltd.
The directors are considering offering 2 new Mayer’s Company Ltd shares for every 1
Power Company share.
• Required:
• Evaluate whether the 2 for 1 share for share exchange will be likely to succeed.
• If necessary, recommend revised terms for the offer which would be likely to succeed.
• Solution 3
• Value of Mavers Co = Rs.3.05 × 48,00,000 shares = Rs.1,46,40,000
• Value of Power Co = Rs.6.80 × 13,00,000 shares = Rs.88,40,000
• Total value Post Integration (assuming no synergistic gains)
= Rs.1,46,40,000 + Rs.88,40,000 = Rs.2,34,80,000
• Number of shares post-integration = 48,00,000 + (2 × 13,00,000) = 74,00,000
• So the post-integration share price will be: Rs.2,34,80,000/74,00,000 = Rs.3.173
• Evaluation: Whether the 2 in Mavers for 1 share in Power for share exchange
will be likely to succeed.
• Value of 1 share in Power (Pre-integration) = Rs. 6.80
• Value of 2 Shares in Mavers (Post-integration) = 3.173*2 = Rs. 6.35
• Since, Pre-integration 1 Share (6.80) > Post-integration 2 shares (6.35), this will
NOT work.
• Solution 3
• Inference : The Power Co shareholders will not accept a 2 for 1 share for share exchange
since it causes their wealth to reduce.
• Recommendation
• The value of the offer needs to be (Rs.6.80 × 13,00,000 shares) = Rs.88,40,000.
• Also, the post-integration share price will be: Rs.2,34,80,000/74,00,000 = Rs.3.173
• Hence No. of shares to be offered to Power shareholders in post integrated firm =
88,40,000/ 3.173 = 27,86,007
• Exchange of 27,86,000 Mayer’s Co shares for the 13,00,000 Power Co shares represents a
ratio of 27,86,000 to 13,00,000 or 2.14 to 1.
• However, it is not possible to offer 2.14 shares in integrated company against 1 share in
Power.
• Advice : Therefore, perhaps 2 shares in integrated company and cash of Rs. 0.44
(=0.14*3.173) against 1 share in Power or even favourable offer will workout.
• Problem No. 4
• X Ltd. is considering the proposal to acquire Y Ltd. and their financial information is given
below :
Particulars X Ltd. Y Ltd.

No. of Equity shares 10,00,000 6,00,000
Market price per share (Rs.) 30 18
Market Capitalization (Rs.) 3,00,00,000 1,08,00,000
• X Ltd. intends to pay Rs. 1,40,00,000 in cash for Y Ltd., if Y Ltd.’s market price reflects only its
value as a separate entity.
• Required: Calculate the cost of merger:
• (i) When merger is financed by cash
• (ii) When merger is financed by stock (Assume number of shares for exchange is 5, 00,000).
• (iii) In second case, whether the Y Ltd’s shareholders sell the shares as they get or should they
remain invested in merged entity?
• Solution 4
(i) Cost of Merger, when Merger is Financed by Cash.
Then, Cost of Merger to X Or Value that Sh. Holders of Y get in cash
= Cash paid to acquire Y – MV of Y
= (1,40,00,000 – 1,08,00,000) = Rs. 32,00,000
(ii) Cost of Merger when Merger is financed by Exchange of Shares in X Ltd. to the
shareholders of Y Ltd.
• X Ltd. gives 5, 00,000 shares of itself in exchange of shares in Y Ltd.
• Cost of merger or Value that Sh. Holders of Y get instantly (if they sell these shares)
= Value in X Ltd. that Y Ltd.’s shareholders get. instantly – MV of Y
= (5, 00,000 × Rs. 30) – Rs. 1, 08,00,000 = Rs. 42,00,000
• Solution 4
• BUT:
• Value of firm post integration = MV of X + MV of Y = 300,00,000 + 108,00,000 = 408,00,000
• Proportion that Y Ltd.’s shareholders will get in X Ltd.’s Capital structure will be :
𝟓, 𝟎𝟎, 𝟎𝟎𝟎
= = 0.333
𝟏𝟎, 𝟎𝟎, 𝟎𝟎𝟎 + 𝟓, 𝟎𝟎, 𝟎𝟎𝟎
• Cost of merger or Value that Sh. Holders of Y get if they remain invested in X post-merger
= Value in X Ltd. that Y Ltd.’s shareholders get. post-merger – MV of Y
= (0.333 × 4,08,00,000) - 1,08,00,000 = Rs. 28,00,000
• Hence, the shareholders of Y would be better off if they sell the shares of X ltd. Post merger
where they can make a gain of 42,00,000 rather than remaining invested in X post merger
where they can make only Rs. 28,00,000.
• THE REGULATION OF TAKEOVERS/BUSINESS COMBINATIONS
• General principles of takeover regulation

• At the most important time in the company’s life - the best interest of their shareholders, and
should disregard their personal interests.
• All shareholders must be treated equally.
• Shareholders must be given all the relevant information to make an informed judgement.
• The board must not take action without the approval of shareholders, which could result in the
offer being defeated.
• All information supplied to shareholders must be prepared to the highest with standards of
care and accuracy.
• The assumptions on which profit forecasts are based and the accounting polices used should
be examined and reported on by accountants.
• An independent valuer should support valuations of assets.
Leveraged Buyout Management Management Buy-in
(LBO) Buyout (MBO) (MBI)
where a company’s where an external

an M&A in which a
management team management team
company is acquired
purchases the assets acquires a company
using borrowed
and operations of the and replaces the
money. existing management.
company.
• The primary reason for a management buyout (MBO) is so that a company can go
private in an effort to streamline operations and improve profitability.
• Because the management team typically has a limited amount of cash available, in
most cases it needs to procure a loan to acquire the business. Therefore, an MBO
frequently takes the same form as an LBO.
Post Merger Integration (PMI):
There are four typical types of post acquisition integration.
• is when the acquiring company completely absorbs the target,

Absorption including all processes, organizations, and procedures.
• only occurs in certain areas to help meet the goals of the merger
Symbiosis or acquisition.
• The target company is mostly kept at self-governing, however,

Preservation some integration may occur with financial information.
• This is when the acquiring company holds ownership of the

Holding target company, but they don’t integrate with each other.
UNBUNDLING
• UNBUNDLING: Disposal or Sale of a division, a business unit, a
product line or a subsidiary.
• Unbundling is discussed in terms of Divestments and Divestitures.
• These terms are often used as synonyms, but they are, in fact, distinct
strategic options.
• A divestment is the partial or complete sale or disposal of physical and
organizational assets, the closing of facilities and the reduction of the
workforce.
• A divestiture, on the other hand, is the partial or complete sale or
disposal of a business unit, product line, subsidiary or division.
• HOSTILE TAKEOVER BIDS
• If a negotiated takeover of another company is impossible, a hostile bid may be
needed.
• In a hostile bid, management of the targeted company is bypassed, and the
stockholders are approached directly.
• The acquirer argues that management is not maximizing the potential of the
company and is not protecting the interest of shareholders.
• Hostile takeovers are typically quite costly because they usually involve a
significant price incentive, and antitakeover measures.
• They can be disruptive to both buyer and seller because of “slur” campaigns.
• It is rare that smooth transitions of management take place.
• HOSTILE TAKEOVER BIDS
• Tender Offer
• In a tender offer, the buyer goes directly to the stockholders of the target
business to tender (buy) their shares, typically for cash.
• The tender in some cases may be shares in the acquiring company rather
than cash.
• If the buyer obtains enough stock, it can gain control of the target
company and force the merger.
• Stockholders are induced to sell when the tender price substantially
exceeds the current market price of the target company stock.
DEFENSES AGAINST HOSTILE TAKEOVER BIDS
• Listed company needs to be aware that a bid might be received at any time.
• If the board of directors of a target company decides to fight a bid that appears to
be financially attractive to their shareholders, then they should consider one of the
following defenses:
• PRE-BID DEFENSES
I. Communicate effectively with shareholders: This includes having a public relation
officer specialising in financial matters liaising constantly with the entity’s
stockbrokers, keeping analysts fully informed, and speaking to journalists.
II. Revalue non-current assets: To ensure that shareholders are aware of true and
prevailing asset value per share
III. Poison pill: To make itself less attractive to a potential bidder.
IV. Change the Articles of Association (super majority): The Articles of Association are
altered to require that a higher percentage (say 80%) of shareholders have to vote for
the takeover.
DEFENSES AGAINST HOSTILE TAKEOVER BIDS
• POST-BID DEFENSES
I. Appeal to their own shareholders: Aggressive publicity & Direct
communication with the shareholders stressing the financial and strategic
reasons for remaining independent.
II. Attack the bidder: Defaming the bidder’s management style, overall
strategy, methods of increasing earnings per share, dubious accounting
policies and lack of capital investment
III. White Knight: The directors of the target company offer themselves to a
friendlier /preferable bidder. This tactic should only be adopted in the last
resort.
IV. Counterbid ('Pacman'): Attempt to acquire the bidding company.
V. Refer the bid to the Competition authorities: The target entity could seek
government intervention by bringing in the Competition authorities citing
the takeover as against the public interest.
DIVESTITURE
• It is only with a divestiture, and not with a divestment, that the parent
organization creates a new company, able to operate more or less autonomously
in the market.
• The divestiture of business segments by corporations has become an accepted
strategy for growth rather than diversification.
• A business segment may be subject to divestiture if they:
I. Do not produce an acceptable return on invested capital.
II. Do not generate sufficient cash flow.
III. Fail to meet management goals for growth in profits, sales or in other respects.
BCG Matrix for better investment decisions
VALUE BASED
MANAGEMENT
Chapter 3 & 12, SFM
Value Measures
■ Return on Invested Capital ■ ROIC
■ Economic Value Added ■ EVA
■ Market Value Added ■ MVA
■ Cash Flow Return On Investment ■ CFROI
■ Cash Value Added ■ CVA
■ Market – to – Capital Ratio ■ MCR
■ Total Return to Shareholders ■ TRS
■ Future Growth Value ■ FGV
■ Wealth Added Index ■ WAI
RETURN ON INVESTED
CAPITAL (ROIC)
ROIC is an indicator of Operating performance of the company.
Return on Invested Capital (ROIC)
■ ROIC is a indicator of Operating performance of the company.
■ ROIC = NOPLAT / Invested Capital
■ Where,
■ NOPLAT or NOPAT = Net EBIT – Taxes on Net EBIT
■ Net EBIT = EBIT – NOI* + NOE*
■ (*EBIT need to be adjusted for NOI/E if they are already included in EBIT)
■ ‘Invested Capital’ is also called as ‘Operating Invested Capital’
■ OIC = Total Operating Assets
■ Or, OIC = Total Assets – Non Operating Assets – Excess Cash & Mktbl. Secs.
■ Or, OIC = NFA + NCA
Return on Invested Capital (ROIC)
■ ROIC = NOPLAT / Invested Capital
■ A company has an EBIT of Rs. 2 cr. It included interest income Rs. 0.1
cr. And non operating expenses of Rs. 0.2 cr. The total assets of the
company is Rs. 5 cr. The company has capital work in progress worth
Rs. 1 cr; Marketaable securities of Rs. 0.5 cr. and Cash worth Rs. 0.25
cr. in excess of working capital requirement. Tax 30%. Find out ROIC.
■ Net EBIT = 2 – 0.1 + 0.2 = Rs. 2.1 cr.

■ NOPLAT = 2.1 – (2.1*0.3) = Rs. 1.47 cr.
■ OIC = 5 – 1 – 0.5 – 0.25 = Rs. 3.25 cr.
■ ROIC = 1.47 / 3.25 = 45%
ECONOMIC VALUE
ADDED (EVA)
Economic Value Added is a measure of economic profit.
Economic Value Added (EVA)
■ Economic Value Added is a measure of economic profit.
■ It is calculated as the difference between the Net Operating Profit After
Tax and the (opportunity) cost of invested Capital.
This opportunity
cost is determined
by the weighted
average cost of
Debt and Equity
Capital ("WACC")
times to the amount
of Capital
employed.
■ EVA
■ EVA = (ROIC – Kc) * OIC.
■ Or EVA = NOPAT – Capital Charge on Invested Capital
■ If EVA is +ve, the firm’s unlevered pool of profits

(NOPAT) available for all investors is in excess of
what the firm has to pay for employing funds in the
business (Capital Charge).
■ Say; EBIT = 1.5 Lakh, Tax rate = 30%, Net Fixed Assets = 5 lakh, Net Current
Assets = 2 Lakh; WACC = 9%. Find out EVA.
■ NOPAT = EBIT (1-t) = 1.5 (1 – 0.3) = 1.05 Lakh

■ OIC or Invested Capital = NFA + NCA = 5 + 2 = 7 Lakh
■ EVA = 105000 – (0.09 * 700000) = 42000
MARKET VALUE
ADDED (MVA)
MVA is the value addition through capital market operations.
Market Value Added (MVA)
■ Market Value Added measures the difference between the market value
of the firm (Mkt Value of Debt and Equity) and the amount of Capital
invested.
■ MVA is the excess of market value of capital over and above the book
value of capital (as sourced from equity and debt providers).
Equivalently,
MVA equals
the present
value of future
expected EVA
when
discounted @
wacc.
Market Value Added (MVA)
■ MVA = Market Value of Equity & Debt – Invested Capital
■ If MVA is +ve, Business has created a market value of firm more
than what it sourced from the equity & debt holders
■ The Book Value of Equity and Debt are 5 Cr. And 4 Cr. respectively.
The market price of equity is Rs. 2100 and there are 30,000 equities
outstanding. Find out the MVA of the Company.
MVE = 2100 * 30000= 6.3 Cr.

MVA = (6.3 + 4) – (5 + 4) = 1.3 Cr
Link between MVA and EVA
■ Equivalently, MVA equals the present value of future expected EVA when
discounted @ wacc.
■ MVA = EVA1/(1+wacc)1 + EVA2/(1+wacc)2 + …
CASH FLOW RETURN
ON INVESTMENT
(CFROI)
CFROI is a relative measure of sustainable value creation by the
business.
Cash Flow Return on Investment
(CFROI)
■ CFROI = (Operating Cash Flow – Economic Depreciation) / Cash
Invested
■ Where, Operating Cash Flow = NOPAT + Accounting Depreciation

■ And Economic Depreciation is the amount of annual contribution to
sinking fund earning cost of capital to replace the asset.
■ OR, Replacement fund Needed =
Eco Dep * FVIFA (Replacement time years, at cost of capital)
OR, Replacement fund Needed =
1+𝑖 𝑛 −1
Eco Dep * 𝑖
Cash Flow Return on Investment
(CFROI)
■ If CFROI > Kc, the business is earning cash in excess of capital charge,
■ even after making provision for asset replacement at the end of asset life
■ i.e. Business seems to be sustainable for long time.
CASH VALUE ADDED
(CVA)
CVA is an absolute measure of sustainable value creation by the
business.
Cash Value Added (CVA)
■ CVA= Operating Cash Flow – Eco Dep. – Capital charge on Gross Investment
■ Where,
Operating Cash Flow = NOPAT + Accounting Depreciation
■ Eco Dep * FVIFA (Replacement time years, at cost of capital) = Replacement fund Needed
■ Capital charge on Gross Investment = WACC * Cash Invested Originally.
Cash Value Added (CVA)
■ If CVA is +ve, the business is earning cash in excess of capital charge, even
after making provision for asset replacement at the end of asset life i.e.
Business seems to be sustainable for long time.
■ While CFROI is a relative measure, CVA is an absolute measure of Business
sustainability.
■ EXAMPLE
MARKET-TO-CAPITAL
RATIO (MCR or MBR)
MCR measures value added to equity through capital market
operations.
Market-to-Capital ratio (MCR or MBR)
■ MCR = Mkt Value of Equity / Book Value of Equity
■ If MCR > 1 , Business has created a market value of equity more
than what it sourced from the equity holders.
■ The Shareholders Funds stands at Rs 5 Lakh. The market price of

equity is Rs. 250 and there are 1,000 equities outstanding. Find out
the MCR of the Company.
MVE = 250 * 1000= 2.5 Lakh.

MCR = 2.5 / 5 = 0.5
TOTAL RETURN TO
SHAREHOLDERS (TRS)
TRS is a comprehensive measure of returns earned by the
shareholders.
Total Return to Shareholders (TRS)
(End Mkt Value of Equity - Beginning Mkt Vlaue of
Equity) + Dividends & Share Buybacks During the
Year
TRS =
Beginning Mkt Value of Equity + Additional equity
raised during the year
If TRS ≥ Ke,
than a business could live up to the equity holders’

expectations.
Total Return to Shareholders (TRS)
 What would have been the total return to the shareholder having 1000 shares in
a company if the DPR of the company is 40% having a face value of Rs.10 with
earnings per share of Rs.7.50 . The Opening price is Rs.141 and the closing is
Rs.150.
■ PAT= 7.5*1000 = 7500

■ Dividend = 7500*40% = 3000
■ Capital Appreciation = 150*1000 – 141*1000 = 9000
■ TRS = (9000 + 3000) / (141*1000) = 8.51%
FUTURE GROWTH
VALUE (FGV)
FGV measures the portion of market value attributed to EVA
growth.
Future Growth Value (FGV)
■ FGV = Mkt Value of Firm – Current Operation Value of Firm
■ Where,
■ Crnt. Oprn. Value of Firm = Capitalised Value of Equity –
Invested Capital
■ Where, Capitalised Value of Equity = EVA / WACC

Future Growth Value (FGV)
■ Calculate the Future Growth Value of a company given that the EVA is
Rs.180 Cr; Invested Capital is Rs.700 Cr (equity 500 cr & Debt 200 cr);
Market Capitalisation Rs. 750 Cr and WACC of 12%.
■ Crnt. Oprn. Value of Firm = (EVA/WACC) – Invested Capital = (180/0.12) –

700 = 800 Cr.
■ FGV = Mkt Value of Firm – Current Operation Value of Firm = (750 + 200) –
800 = 150 Cr.
FGV_Future Growth Value
■ Future Growth Value measures the portion of market value attributed to

EVA growth.
WEALTH ADDED
INDEX (WAI)
WAI measures the excess wealth generated above expectations
Wealth Added Index_ WAI
■ WAI is the excess wealth generated above expectations based on the perceived
risk of the shares.
■ It is important to recognize that Wealth Added reflects returns for all equity investors,
no matter when they bought their shares.
■ WAI = (Total Return to Shareholders - Required Return) x Opening Market Cap

Wealth Added Index_ WAI
■ What would have been the Wealth Added Index in a company if the DPR of
the company is 60% with earnings of Rs.75000. The Opening Market
Capitalisation is Rs.2 Lakh and the closing is Rs.2.5 Lakh. Assume Ke @
9%.
■ WAI = (Total Shareholder Return - Required Return) x Opening Market Cap
■ TSR = [(250000 – 200000) + (75000*0.60)] / 200000
■ TSR = 47.5%
■ WAI = (47.5 – 9)% * 200000 = 77000
APPROACHES TO
VBM
Value Based Management : Stimulants
■ Pressure from Institutional Investors.

■ Peer Pressure.
■ Performance Rating Pressure.
■ Abolition of Agency Cost
Various Approaches to VBM
1. MARAKON
APPROACH
Marakon approach
■ Marakon associates – UK based management consulting firm

– Specify the financial determinants of value
– Understand the strategic drivers of value
– Formulate higher value strategies
– Develop superior organizational capabilities
■ Charles River Associates (legally CRA International, Inc.) is a global consulting firm
headquartered in Boston acquired Marakon in June 2009
Marakon approach….contd
■ The Book value of equity, measures approximately the capital
contributed by the shareholders
■ The Market value of equity reflects how productively the firm has
employed the capital contributed by the shareholders, as assessed by
the stock market
– Hence if M > B value is created and
– if M < B value is destroyed
■ M/B = (r-g)/(k-g)
■ M/B > 1, if and only if r > k
i.e. only if Return On Equity(r) > Cost Of Equity(k)
■ Also when r > k, higher the g, higher is M/B
■ M to B is a function of
– Return on equity (r )
– Growth rate of dividends (and earnings)(g)
– Cost of equity(k)
■ M/B = (r-g)/(k-g)
■ M/B > 1 if and only if r > k i.e. only if return on equity is > cost of
equity
■ Also when r > k, higher the g, higher is M/B
■ When the spread is positive, a higher growth rate contributes more
to value creation
Marakon approach….contd (illustration)
1. If the ROE is 20%, cost of equity is 12% and growth rate of dividends is 7%
then find out the M/B.
i. If the ROE increases to 25% what would be the new M/B?
ii. If the growth rate of dividend increases to 10%, what would be the new M/B?
iii. How does the cost of equity and Growth rate of dividends affect the Value of
the firm?
■ r =20%; k =12%; g =7%

■ M/B = (20-7) / (12-7)= 2.6
■ Iff r =25%;
■ M/B = (25-7) / (12-7)= 3.6
Value of the firm increased from 2.6 to 3.6 as measured by M/B.
Hence;
if the firm can increase the positive spread between r & k
then the Value of firm will also increase & vice versa.
■ When r =20%; k =12% and g =7%, Value of firm was

(M?B)= 2.6
■ If g =10%; M/B =(20-10) / (12-10) = 5
■ Value of the firm increased from 2.6 to 5 as measured by
M/B.
■ Hence;
■ With a positive spread between r and k; if the firm can
increase the value of g then the Value of firm also
increases & vice versa.
■ Limitations of Marakon approach

– The spread between ROE and Ke are not comparable as one
is an accounting measure and the other is market based.
– The positive spread may be due to accounting policies.
■ Advantages of Marakon approach
– ROE, Ke are widely used parameters.
– Intuitively appealing valuation theory
– MV of the firm is an external scorecard
2. MCKINSEY
APPROACH
Mckinsey Approach
■ Founded in 1926, McKinsey is a New York, US based management consulting firm.
■ A company can maximize its value by focusing decision making on the

key drivers of value.
■ Value Thinking: to make value happen, a company’s actions should be
based on a foundation of value thinking. It has two dimensions;
1. Value metrics: The value metrics that reflects the
i. economic results of the company,
ii. the stock market valuation of the company, and
iii. the opportunity cost.
2. Value Mindset: The management must care about shareholder value creation
above others.
Mckinsey Approach: Creating SHARE
HOLDERS VALUE
SHAREHOLDER
VALUE
Aspirations and
targets
Portfolio management
Organizational design
Value driver definition
Business performance Individual performance
management management
Value Metrics Value Thinking Value Mindset
3. STERN STEWART
APPROACH
EVA® Approach
Stern Stewart (EVA®) approach
■ First proposed by Stern Stewart & Co., EVA is now a very popular idea.
■ Fortune Magazine- “Today’s hottest financial idea and getting hotter”
■ Peter Ducker – “it is a measure of total factor productivity”
■ EVA is essentially surplus left after making an appropriate charge for the capital
employed in business.
 EVA = NOPAT – WACC * CAPITAL
 EVA = CAPITAL (ROC – WACC)
 EVA = PAT – COE * EQUITY
 Stern Stewart & Co. is a consulting company founded in New York in 1982 by Joel M.
Stern and G. Bennett Stewart III.
Stern Stewart (EVA®) approach:
Drivers of EVA
■ Increasing efficiency (or productivity)- increasing operating profit from the
same investment in operating assets. (better asset utilization, turning idle asset
into earning assets)
■ Profitable Growth - marginal growth in operating profit should be higher than
marginal growth in investment in operating assets. (Additional investment in
assets only if New ROIC is more than current ROIC)
■ Wiping out unproductive capital – disinvest from segments where ROIC and
WACC spread is negative or fragile than overall average.
■ Reducing WACC – altering financing strategy to reduce WACC.
4. BCG APPROACH
BCG Approach
■ Boston Consulting Group (BCG) is a Boston, Massachusetts, U.S.

based management consulting firm founded in 1963
■ Two Corner concepts;
– Total Return to Shareholder(TRS)
– Total Business Return (TBR)
■ For applying these concepts Two performance matrices are developed;
– Cash Flow Return on Investment (CFROI)
– Cash Value Added (CVA)
Total Return to Shareholders
■ TRS = [Dividend & Share Buyback + (Ending Mkt Value – Beginning Mkt Value)]
/ [Beginning Mkt Value + Additional equity raised during the period]
TRS: Credibility
■ It is comprehensive - dividends and capital gain.

■ It is widely used by investment community and also required by SEC.
■ TRS can be easily benchmarked against the mkt or peer groups
■ TRS is not biased by size
■ TRS is difficult to manipulate
Total Business Return
■ What TRS is to investors, TBR is to internal management.
■ TBR = (Free Cash Flow / Begn. Value) + (Endg Value – Begn Value) / Begn
Value]
BCG approach…contd.
■ CFROI and CVA

(Operating Cash Flow – Economic Depreciation)
■ CFROI =
Cash Invested
■ Drivers of CFROI- Efficiency, Profitable growth and wiping

out unproductive capital.
BCG approach…contd.
■ CVA= Operating Cash Flow – Economic Depreciation –

Capital charge on Gross Investment
■ While CFROI is a relative measure, CVA is an absolute
measure of Business sustainability.
– BCG advocates Cash Value Added as superior to EVA.

– Drivers of CVA - Efficiency, Profitable growth and wiping
out unproductive capital.
BCG approach:
Resource Allocation decision
TBR – Target TBR =
CFROI – WACC =
Negative Positive
Positive QUESTION (?) INVEST (High Priority)
Negative DO NOT FUND (X) QUESTION (?)

Drivers of Value
■ BUT it is interesting to note that drivers of CFROI/ CVA / EVA are same and
they are;
 Efficiency,
 Profitable growth and
 Wiping out unproductive capital.
Illustration : 01
X Ltd is considering acquisition of a Machinery which would require an investment of Rs. 20

Lakh comprising of asset cost of Rs. 15 Lakh and a net working capital of Rs. 5 Lakh.
The Fixed asset has an economic life of 14 years and a salvage value of Rs. 1,00000. At the end
of 14 years the asset is estimated to be replaced at Rs. 18,00000. The company follows SLM of
depreciation for its accounting records. It is projected that the machine would generate a ROIC
of 20%, measured by NOPAT on Invested capital. You are required to calculate the CFROI,
CVA and EVA of the company for first three years.
The cost of capital (Kc) is 10%.
(The FVIFA 14years 10% is 27.975)
Solution:
Accounting Dep = (15 lakh- 1 lakh)/ 14 = 1 lakh p.a.
FVIFA 14years 10% = ((1+i)n -1)/i) = ((1+0.10)14 -1)/0.10) = 27.975

Eco Dep * 27.975 = 1800000 – 100000
Hence, Eco Dep = 17 lakh / 27.975 = 60, 769 p.a.
ROIC is 20% of Invested Capital.

Year Invested Capital Depreciation NOPAT
1 20 Lakh 1 Lakh 4 Lakh
Yr 1 Yr 2 Yr 3
NOPAT 400000 380000 360000
Accounting Depreciation 100000 100000 100000
Operating Cash Flow 500000 480000 460000
Economic Depreciation 60769 60769 60769
Invested Capital 20 Lakh 19 Lakh 18 Lakh
CFROI = (Operating Cash Flow – Economic Depreciation)/ Cash Invested

Yr 1 Yr 2 Yr 3
3. Cash Invested 20 Lakh 20 Lakh 20 Lakh
CFROI (1-2)/3 21.96% 20.96% 19.96%
CVA= Operating Cash Flow – Economic Depreciation – Capital charge on Gross
Investment
Yr 1 Yr 2 Yr 3
3. Capital Charge on Gross 2 Lakh 2 Lakh 2 Lakh
investment @ 10%
CVA (1-2-3) 239231 219231 199231
EVA = (ROIC – Kc) * OIC.

OR, EVA = NOPAT – Capital Charge on invested Capital
Yr 1 Yr 2 Yr 3
1. NOPAT 400000 380000 360000
2. Capital Charge on Invested 2 Lakh 1.9 Lakh 1.8 Lakh
Capital @10%
EVA (1-2) 200000 190000 180000
Illustration: 02 (similar to Illustration 6, Pg- 12.47, SFM by Dr. PC)
A company has an investment of Rs.630 million (Rs.480 million in fixed assets and Rs.150
million in net working capital). The company assets have an economic life of 8 years and
are expected to produce a NOPAT of Rs.80 million every year. After 8 years, the net
working capital will be realised at par, but fixed assets will fetch nothing. The cost of
capital for the project is 12 percent. Assume that the straight-line method of depreciation
is used for tax as well as shareholder reporting purposes.
(i) What will be the ROIC for year 3? Assume that the capital employed is measured at
the beginning of the year.
(ii) What will be the EVA (Rs. in million) for year 3?
(iii) What will be the ROGI for year 3?
(iv) What will be the CVA (Rs.in million) for year 3?
(v) What will be the CFROI for year 3?
(vi) Comment on value creation of the company.
Solution:
(Rs. in million)
1 2 3
1. Net fixed assets (beginning) 480 420 360
(=480-60) (=420-60)
2. Accounting Depreciation (= 480 / 8) 60 60 60

3. Net working capital (given) 150 150 150
4. Invested Capital (1+3) 630 570 510
5. NOPAT (given) 80 80 80
6. Economic depreciation (=480/ FVIFA12%, 8yr) 39.02 39.02 39.02
7. Cash investment (=480 + 150) 630 630 630
8. Cost of capital 12% 12% 12%
9. Capital charge (12%*Invested Capital) 75.6 68.4 61.2
Economic depreciation = 480/ FVIFA12%, 8yr = 480/ 12.30 = 39.02

FVIFA12%,8yr = [ (1 + 𝑖)𝑛 – 1] / i = [1.128 – 1]/ 0.12 = 12.30
ROIC3 = NOPAT3/OIC3 = 80/510 = 15.69%

EVA3 = NOPAT3 – WACC x OIC3 = 80 – 0.12 x 510 = 18.8
ROGI3 = (NOPAT3 + DEP3) / CASH INVESTMENT = (80 + 60) / 630 = 22.22%

CVA3 = Operating cash flow3 – Eco. depreciation – Capital charge on Gross Investment
= (80 + 60) – 39.02 – 0.12 x 630 = 25.38
𝑂𝐶𝐹3−𝐸𝑐𝑜 𝐷𝑒𝑝 (80+60)−39.02
CFROI3 = = = 16.03%
𝐶𝑎𝑠ℎ 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 630
Illustration: 3 (based on unsolved Q. No.5, pp- 12.50, SFM by Dr. PC)
Acme ltd. Is considering a capital project for which the following information is available;
Investment outlay = 1000 Project Life = 5 years
Salvage value = 0 Method of depreciation = SLM
Annual revenue = 2000 Annual out of pocket cost = 1400
Cost of equity = 18% Cost of Debt (after tax) = 10%
Debt-Equity Ratio = 1:1
Tax Rate = 40%
i. Calculate EVA for the Project.
ii. Calculate NPV of the Project.
iii. Calculate PV of the project EVAs.
iv. What is the relationship between Cash flows and NPV and EVA and MVA?
Solution:
Since, Debt-Equity ratio is 1:1; the Wd and We = 0.5
Hence, Cost of capital = Wd * Kd (1-t) + We * Ke = 0.5 x 0.10 + 0.5 x 0.18 = 0.14 or 14 %
Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
1. Revenues (given) 2,000 2,000 2,000 2,000 2,000
2. Out of pocket cost (given) 1,400 1,400 1,400 1,400 1,400
3. EBDIT (1 - 2) 600 600 600 600 600
4. Depreciation [=(1000- 0)/5] 200 200 200 200 200
5. EBIT (3 - 4) 400 400 400 400 400
6. NOPAT [=EBIT (1 – t)] 240 240 240 240 240
7. OCF (6+4) 440 440 440 440 440
8. Invested Capital (Reduces by Accn. Dep.) 1000 800 600 400 200
9. Capital Charge on Invested Capital (@14%) 140 112 84 56 28
10. EVA (6 – 9) 100 128 156 184 212
i. NPV =[ 440/(1.14)1 + 440/(1.14)2 + 440/(1.14)3 + 440/(1.14)4 + 440/(1.14)5 ] – 1000

= 510.5
ii. PV of EVAs= 100/(1.14)1 + 128/(1.14)2 + 156/(1.14)3 + 184/(1.14)4 + 212/(1.14)5 = 510.5
iii. NPV of cash flows = PV of EVAs
iv. Theoretically, MVA = PV of EVAs;
Therefore, NPV of cash flows = PV of EVAs = MVA
1. Stellar Ltd. has an ROIC of 16%, EBIT of RS. 100000 and interest income of Rs. 15000.
The WACC of the company is 12% and the effective tax rate is 20%. If the company wants
to obtain an EVA of Rs. 30000 by increasing ROIC, then find out what should be the new
ROIC?
Solution:
NOPAT = (100000 – 15000) *(1 – 0.2) = 68,000
IC = 68000 / 0.16 = 425,000
30000 = (ROIC – 0.12) *425000
So, new ROIC = 19.06%
2. During the calendars year 20X1 the PAT earned is Rs. 300000, DPR is 50% and shares
bought back worth Rs. 200000 for Xania ltd. If the company had a market capitalization of
Rs. 18 Lakh on 31 December 20X1 and its TSR during the year was 50%, find out its
Market Capitalisation on 1st Jan 20X1.
Solution:
Dividend Paid = 50% of 300000 = 1.5 Lakh
Ending Mkt Value of Equity = 18 Lakh
TSR = [End Mkt Value of Equity- Beginning Mkt Value of Equity) + Dividends &
Share Buybacks During the Year] / Beginning Mkt Value of Equity
Or, 0.5 = (18 – Beginning Mkt Value of equity + 1.5+2)/ Beginning Mkt Value of equity
Or, Begn Mkt Value of Equity = 14.33 Lakh
3. Viduyt ltd has a Kc = 12%, NOPAT = Rs. 30000 and ROIC = 15%, then what is the value
of FGV?
Solution:
ROIC = NOPAT / Invested Capital
Or, Invested Capital = 30000 / 0.15 = 2 Lakh
EVA = (ROIC – WACC) * Invested Capital
Or, EVA = (15% – 12%)* 2 Lakh = 6000
Crnt. Oprn. Value of Firm = (EVA/WACC) – Invested Capital
Or, Crnt. Oprn. Value of Firm = (6000 /0.12) – 2 lakh = 50000
FGV = Mkt Value of Firm – Current Operation Value of Firm
Or, FGV = 200000 – 50000 = 150000
4. Biotech international earns a return on equity of 20%. The dividend payout ratio is 0.25.
Equity holders required rate of return is 16%. The book value per share is Rs. 60. What is
the market price per share as per Marakon model?
Solution:
M/ B = r –g / k-g
g = (1-b) r = 0.75 * 0.2 = 0.15
M/ 60 = (0.2 – 0.15)/ (0.16 – 0.15); Hence, M = 300
5. In the above question (Biotech), if the return on equity falls to 19%, what should be the
payout ratio to ensure that the market price remains unchanged?
Solution:
300/60 = 0.19-g / 0.16-g
Or, g = 0.1525
Or, (1-b) r = 0.1525
Or, (1 – b) * 0.19 = 0.1525
Or, b = 0.1974 or 19.74%
6. Sintax Ltd. has an EBIT of Rs. 200000, Interest Income of Rs. 20000. Depreciation as
charged in income statement is Rs. 70000, cash invested is Rs. 150000 and CFROI is 30%.
What is its Operating Cash Flow? (Assume a tax rate of 35%)
Solution:
Operating Cash Flow = NOPAT + Accounting Depreciation = [(200000 - 20000) – 35%
of 180000] + 70000 = [180000 – 63000] + 70000 = 187000
7. In the above question (Sintax), What is the value of Economic Depreciation?

Solution:
CFROI = (Operating Cash Flow – Economic Depreciation) / Cash Invested
Or, 0.30 = (187000 – ED) / 150000
Or, ED = 142000
8. Mitra & Co. has these financials- EVA is Rs.200 mn; Invested Capital is Rs.800 mn at a
debt-equity ratio of 1:3; market capitalisation (of equity) Rs. 1,050 mn and a WACC of
12%. Find out the MVA of the company?
Solution: BV of Debt = 800*1/4 = 200; BV of equity = 800*3/4 = 600;
MVA = (1050+200) – 800 = 450 mn.
9. Find out the FGV of the above company (Mitra & Co.).
Solution:
FGV = (1050+200) – [(200/0.12) – 800] =383 mn.
10. For a reporting period a company has an OCF of Rs 30,000; economic depreciation of Rs
10,000; NOPAT of Rs 20,000 at a ROIC of 10%. If the company’s WACC is 12% and the
accumulated depreciation is Rs 100,000; then find out the CVA.
Solution:
IC = 20000/0.10 = 200000; GI = 200000 + 100000 = 300000;
CVA = 30000 – 10000 – 0.12*300000 = (16000)
NAME:_____________________________________ USN____________________________
1. “Revenue growth under a particular condition can increase the value of the company”.
Which condition is referred here?
a. ROI should be more than ROIC
b. ROI should be less than ROIC
c. ROIC should be more than WACC
d. WACC Should be more than growth rate.
e. None of the above. ANS._________
2. The Book Value of Equity and Debt are 10 Cr. And 5 Cr. respectively. The market price of
equity is Rs. 2100 and there are 50,000 equities outstanding. Find out the MVA of the
Company.
Solution:
MVE = 2100*50000 = 10.5 cr. ; MVF = 10.5 + 5 = 15.5 cr.; IC = 10+5 = 15 Cr
MVA= 15.5 -15 = 0.5 cr or 50,00,000
3. Calculate the Future Growth Value of a company given that the EVA is Rs.255 Cr; Market
Capitalization of equity is Rs.2000 Cr; Invested Capital is Rs.568 Cr; and WACC is 14%?
Solution:
COVF = EVA/WACC – IC = 255/0.14 – 568 = 1253.43 cr ; Debt assumed to be Nil;
FGV = MVF – COVF = 2000 – 1253.43 = 746.57 Cr
4. What would have been the total return to the shareholder (TRS) having 200 shares in a
company if the retention ratio policy of the company is 40% having a face value of Rs.5 with
earnings per share of Rs.7. Stock price: Intra year high is Rs.132; intra year low is Rs.47;
Opening is Rs.96 and closing being Rs.108.
Solution:
Dividend = (7*200)*60% = 840; Cap appreciation = (108 – 96)* 200 = 2400
TRS = 2400+840 / (96*200)= 16.875 %
5. The Shareholders Funds stands at Rs 10 Lakh. The market price of equity is Rs. 1250 and
there are 10,000 equities outstanding. Find out the MCR of the Company and give your one
liner comment.
Solution:
MCR = MVE/ BVE = (1250*10000) /10,00000= 12.5; MVE is 12.5 t imes to BVE.
6. For a reporting period a company has an OCF of Rs 30,000; economic depreciation of Rs
10,000; NOPAT of Rs 20,000 at a ROIC of 10%. If the company’s WACC is 12% and the
accumulated depreciation is Rs 100,000; then find out the CVA.
Solution:
IC = NOPAT/ ROIC = 20000/0.10 = 200000
Gross Investment = Invested Capital + Accumulated Depreciation
= 200000+100000 = 3,00,000
CVA = OCF – ED – Cap Charge on GI
= 30000 – 10000 – 12% * 300000 = - 16,000
7. Biotech International earns a return on equity of 25%. The dividend payout ratio is 30%.
Equity shareholders of Biotech require a return of 18%. The book value per share is Rs.80.
What is the market price per share, according to Marakon model?
Solution:
M/B = (r-g)/ (k-g)
r = 25; k = 18; DPR or b = 0.30; Retention Ratio or (1-b) = 1-0.30 = 0.70
g = (1-b) *r = 0.70*0.25 = 17.5;
M/B = (25-17.5)/(18-17.5)= 15 times; Hence, M= 80*15 = Rs. 1200
8. During the calendar year 20X1 the PAT earned is Rs. 300000, Dividend Payout Ratio is
50% and shares bought back is worth Rs. 200000 for Xania ltd. If the company had a
market capitalization of Rs. 18 Lakh on 31 December 20X1 and its TSR during the year
was 50%, find out its Market Capitalisation on 1st Jan 20X1.
Solution:
0.5 = (1.5 + 2 + 18 - BMC) / BMC
Or, 1.5 BMC = 21.5, hence BMC = 21.5/1.5 = 14.33 lakh or 14,33,333
9. A ltd. has an WACC of 20%. What should be the minimum ROIC of A ltd. so that it can
create value?
Solution:
More than 20%
10. A company pays a dividend of Rs 500,000. The opening market capitalisation is Rs.25 Lakh and
the closing is Rs.30 Lakh. Assume cost of equity at 9%. Find out the WAI.
Solution:
TRS = (5 + 5) / 25 = 40%
WAI = (0.40-0.09)*25 = Rs. 7.75 Lakh or Rs. 7,75,000

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Illustration : 01

X Ltd is considering acquisition of a Machinery which would require an investment of Rs. 20

The cost of capital (Kc) is 10%.

(The FVIFA 14years 10% is 27.975)

Accounting Dep = (15 lakh- 1 lakh)/ 14 = 1 lakh p.a.

FVIFA 14years 10% = ((1+i)n -1)/i) = ((1+0.10)14 -1)/0.10) = 27.975

ROIC is 20% of Invested Capital.

CFROI = (Operating Cash Flow – Economic Depreciation)/ Cash Invested

EVA = (ROIC – Kc) * OIC.

Illustration: 02 (similar to Illustration 6, Pg- 12.47, SFM by Dr. PC)

2. Accounting Depreciation (= 480 / 8) 60 60 60

Economic depreciation = 480/ FVIFA12%, 8yr = 480/ 12.30 = 39.02

ROIC3 = NOPAT3/OIC3 = 80/510 = 15.69%

ROGI3 = (NOPAT3 + DEP3) / CASH INVESTMENT = (80 + 60) / 630 = 22.22%

Illustration: 3 (based on unsolved Q. No.5, pp- 12.50, SFM by Dr. PC)

Since, Debt-Equity ratio is 1:1; the Wd and We = 0.5

Hence, Cost of capital = Wd * Kd (1-t) + We * Ke = 0.5 x 0.10 + 0.5 x 0.18 = 0.14 or 14 %

i. NPV =[ 440/(1.14)1 + 440/(1.14)2 + 440/(1.14)3 + 440/(1.14)4 + 440/(1.14)5 ] – 1000

■ Strategy to manage a company's finances with the intention to

■ Strategy is a plan to attain Goals.

■ Business Model is the way the strategy is pursued.

■ NOTE: Financial Strategy is a part of overall Organisational

Internal Analysis: Environmental Analysis:

Strengths & Weaknesses Opportunities & Threats

Find the fit between Core Capabilities

■ Strategy is formulated at TWO Levels;

2. Business Unit Level Strategy

■ What Businesses should we be in and

■ Portfolio Planning Tools help in portfolio planning & resource allocation.

HIGH INVEST INVEST HOLD

LOW HOLD DIVEST DIVEST

■ Porter’s Generic Model:

■ NOTE: These strategies are not mutually exclusive.

■ Cost is engineered to be kept lesser allowing a lesser price.

■ List out two factors that would help in achieving Differentiation.

■ Focus strategy involves concentrating on a narrow line of products or a

■ The company with a Focus Strategy achieves Competitive advantage by

– Cost leadership (Cost Focus)- McDonalds pursues Cost Focus by

– Differentiation (Differentiation Focus)- Nikon endorsing HD Digital

1. Customer Value Proposition

Crash Test Customer Wide

Cost Reduction Blue ocean

Automated manufacturing • Satellite manufacturing model – Assembly units at South

• Vast pool of technically competent engineers and managers.

Transparent & Real time Logistic management using SAP.

Kaizen & TPM team –

Global Sourcing Team –

Focus on development of technical capabilities –

Focus on development of managerial capabilities –

■ Pioneered by Robert Kaplan,

■ Strategic Financial Management

■ Hence the FOCUS is;

■ What is the value of my company?

1. Strategy & Business Model.

■ What should be the Objective of a Company?

■ *Stakeholder Theory- Historically prominent among

 BUT, the problem lies with

■ BUT, meanwhile Can Corporate Managers Succeed by merely

■ To maximise Value managers must satisfy all stakeholders.

■ Hence it calls for a marriage b/w VM and ST

■ Michael Jensen proposes

■ ‘Enlightened Value Maximisation’ or

EVM uses much of structure of ST but accepts