Advanced Accounting concepts

Value Based Management

Creating value for shareholders is accepted as a

corporate objective in todays times

Many VBM approaches have been developed to

measure and create value. These are synergies
of various disciplines

Finance – DCF and shareholder value maximisation

Business strategy – Value creation through exploitation of
business oppurtunities
Accounting – Structure of financial statements with modifications
Organisational Behaviour - Incentive plans for creating value
Principal methods of VBM

1.Free cash flow – Mckinsey and Alcar

2.EVA / MVA – Stern Stewart
3.Cash flow return on investment / Cash value added
( CFROI /CVA ) – BCG

Common threads
1. Value of any company = PV of future cash flows
2. Firms should use value metrics and employ them
across all management functions
3. A well designed incentive structure will motivate
employees to create shareholder value.
Economic Value Added
EVA ®
EVA as a concept was developed by
Stern Stewart & Co. EVA is the surplus
over and above the cost of capital.

A company which gives a return more

than the cost of capital creates wealth
or adds shareholder value whereas a
company earning a return less than the
cost of capital destroys value.
EVA = PAT – cost of equity
= PAT – cost of equity rate * equity capital

EVA = Capital * ( return on capital – cost of

capital )

EVA = NOPAT – cost of capital

(PAT + INT(1-t)) – (Capital * WACC)
Illustration
Net sales 300
COGS 258
PBIT 42
Interest 12
PBT 30
Tax @30% 9
PAT 21

Cost of equity = 18%

Cost of debt = 12%
Debt Equity ratio = 1
Equity = 100 , Debt = 100
Components of EVA

 NOPAT
 Cost of capital
 Capital employed
Value creating strategies using EVA

Capital = 10000, NOPAT =2000, c = 15%, r=20%

EVA = 10000* ( 20-15) = 500

I. Improvement of operating performance to 2250

II . Profitable investment of 10000 at a return of 18%
III. Withdrawal of unproductive capital of 1000 thereby
reducing return by 50.
IV. Reduction in cost of capital by altering capital
structure.
EVA and firm valuation

Firm value = economic book value of

assets +PV of EVA associated with it.

Ideally firm value using EVA will be more

or less similar to firm value using DCF
• Global Ltd. is interested in acquiring the food
division of Regional Ltd. They have forecasted
the free cash flow on the basis of following
assumptions :
1. Growth rates in assets, revenues and profits
after tax will be 20% for the first 3 years,
12% for the next 3 years and 8% thereafter.
2. The ratio of PAT to net assets would be 0.12
3. The oppurtunity cost of capital is 11%
 1 2 3 4 5 6
Asset value 50.00 60.00 72.00 86.40 96.77 108.38
NOPAT 6.00 7.20 8.64 10.37 11.61 13.00
Net Invt. 10.00 12.00 14.40 10.37 11.61 8.67

FCF (4.00) (4.80) (5.76) nil nil 4.33

Terminal value 4.33 ( 1+0.8) =156

0.11 -0.08

PV ( FCF+TV) = (9.39 ) + 83.46 = 74.07

EVA projection
1 2 3 4 5 6
Op. capital 50.00 60.00 72.00 86.40 96.77 108.38
NOPAT 6.00 7.20 8.64 10.37 11.61 13.00
Cost of capital 11% 11% 11% 11% 11% 11%
Capital charge 5.50 6.60 7.92 9.50 10.64 11.92
EVA 0.50 0.60 0.72 0.87 0.97 1.08
TV 1.08 * 1.08 = 1.17 = 39
0.11-0.08 0.03
Firm value = 50 + PV ( EVA + TV )
= 50 + 24.05 = 74.05
Mergers and Acquisitions
 Economic rationale of a merger is that the
value of the combined entity will be more
than that of individual entities.

Realistic reasons in favour of mergers

1. Strategic benefit
2. Economies of scale
3. Economies of scope
4. Economies of vertical integration
5. Complementary resources
6. Tax shields
Mechanics of a merger
I. Legal Procedure – Sec 391-394 of the Companies
Act 1956

 Examination of object clause

 Intimation to stock exchanges
 Approval of draft amalgamation proposal by the
Boards
 Application to High courts
 Notice to shareholders and creditors
 Meetings of shareholders and creditors
 Passing of High court orders
 Filing the order with Registrar
 Transfer of assets and liabilities
 Issue of shares and debentures
II . Tax aspects

Tax concessions are available to amalgamated company only if

the amalgamating company is a Indian company.

Following deductions remaining unabsorbed by the

amalgamating company will be allowed to the amalgamated
company.

 Capital expenditure on scientific research

 Expenditure on acquisition of patents / knowhow etc.
 Expenditure for obtaining license to operate telecom services
 Amortisation of preliminary expenses
 Carry forward of losses and unabsorbed depreciation
Accounting for amalgamations AS -14

Pooling method - merger

Purchase method - acquisition
Illustration
Beta Ltd. has agreed to merge with Alpha Ltd.
The swap ratio of 3:5 has been fixed. The face
value per share of both companies is
Rs.10/-.The assets & liabilities of Beta Ltd. are
revalued as :

Net fixed assets 3200

Investments 400
Current assets 2900
Current liabilities 1600
Loan funds 2400
 Before merger After merger
Pooling Purchase
Liabilities A Ltd. B Ltd. Alpha Ltd. Alpha
Ltd.
Share capital 4000 1000 4600 4600
Capital reserve - - 400 1900
Share premium 2000 500 2500 2000
G. Reserve 6000 1500 7500 6000
Loan funds 4000 2500 6500 6400
C.Liab & Prov. 2000 1500 3500 3600
18000 7000 25000 24500
Assets
Net fixed assets 7000 3000 10000 10200
Investments 3000 500 3500 3400
Current assets 7000 3000 10000 9900
Misc. expenses 1000 500 1500 1000
18000 7000 25000 24500
Exchange ratio in a merger

Basis

Book value per share

Earnings per share
Dividend discounted value per share
Discounted cash flow value per share
 Book value per share

If BV per share of acquiring company is Rs.25

and that of target company is Rs.15, the
exchange ratio will be 15/25 = 3/5

for every 5 shares in target company 3 shares in

acquiring company.

Drawback of this method

 Book values do not reflect economic
values
 Earnings per share : If the EPS of the target company
is Rs. 5.00 and the EPS of acquiring company is Rs.5
exchange ratio = 2/5

Drawbacks of this method

This method is based on current earning per share. It

fails to take into account :

 The growth rate of the companies

 Improvement in earnings due to merger
 Risks associated with the earnings of the two
companies.
Market price per share

The exchange ratio is based on the relative market

price of the shares of the company.

If the shares of the company are actively traded then

the market prices indicate current earnings, growth
prospects and risks. If the shares are not actively
traded market price may not be a realistic indicator

Share prices may be manipulated by vested interests.

Dividend discounted value per share

The dividend discounted value is the present

value of expected dividends

This method is useful only if the dividend

streams can be predicted with reasonable
surety
Discounted cash flow value per share

DCF value per share

= Firm value by DCF method – debt value
Number of equity shares

This method is useful if the companies

business plans and cash flow projections are
available for 5 – 10 years.