CWA/ICWA Final :: Valuation Management and Case Study : December 2002

*F-20(VMC)* *Revised Syllabus*
Time Allowed : 3 Hours		Full Marks : 100
Answer Question No. 1 which is compulsory carrying 20 marks and any five from the rest.
Marks

(a)

Discounted Cash Flow (DCF) valuation is based on the principle that the fair value of the asset is the present value of the expected cash flows arising from that asset, discounted at the rate that takes into account the riskness of those cash flows, the prevailing rate of interest and the rate if inflation. In the light of the above, specify whether the following statements about DCF valuation are true or false, assuming that all other variables except the one mentioned in each question remain constant:

(i) As the discounting rate increases, the value of the asset increases.

(ii) As the expected rate of growth of cash flows increases, the value of an asset increases.

(iii) As the productive life of an asset is lengthened, the value of the asset increases.

(iv) As the uncertainty about the expected returns- cash flows- from the asset increases, the value of the asset increases.

1x4=4

(b)

In an efficient market the market price is an “unbiased estimate” of the true value of the stocks (shares). This implies that ----(select any one)

(i)	The market price always equals the true value.
(ii)	The market value has no relation to the true value.
(iii)	Markets make mistakes about true value, which can be exploited b investors to earn profit.
(iv)	Market price contain errors, but these being random cannot be exploited by investors.
(v)	No investor will beat the market in any period.

(c)

State whether the following actions by regulatory authorities/ government will increase stock market efficiently, decrease it or leave it unchanged.

(i)	A transaction tax of 1% is imposed on all stock transactions.
(ii)	SEBI imposes a blanket restriction on all short sales to prevent speculation in stocks.
(iii)	An options market, enabling exercise of call and put options on stocks (share) is opened up, with options being regularly traded on many of the stocks listed on the stock exchange.
(iv)	All restrictions in foreign investors acquiring and holding shares in companies are removed.
(v)	The tax rate on dividends is lowered on 20% to 10%.
(vi)	The tax on capital gains arising from trading in shares on the stock exchange is removed.

6x1=6

(d)

State whether the following statements relating to the dividend discount model (Gordon growth model) are true or false:

(i)	The dividend discount model cannot be used to value a high growth company that pays low or no dividends.
(ii)	The dividend discount model is extremely sensitive to the estimate of growth rate and can give misleading or abused result for relatively small errors in estimating growth rates.
(iii)	The dividend discount model generally tends to under value stocks when the overall market is depressed.
(iv)	Stocks that pay high/ dividends and have low price earnings ratios are more likely to come out as undervalued using the dividend discount method.

1x4=4

(e)

Fill in the blanks:

(i)	An investment is risk free when actual returns are always ______ the expected returns. (less than, equal to, more than)
(ii)	In valuing a firm, the ______ tax rate should be applied to earnings of every period. (marginal, effective, average)
(iii)	In valuing firms for take over or in cases where corporate control is being obtained, the value form the ______ model provides a better estimate of value. (Dividend Discount Model(DDM), Free Cash Flows to equity (FCFE) model).
(iv)	Tobin’s Q is more a measure of the perceived quality of a firm’s management than of its mis -valuation. It is estimated by dividing the market value of a firm’s assets by the ______ of these assets. (market value, realizable value, replacement cost, book cost, original cost)

1x4=4

(a)

Discuss the different methods of brand valuation.

(b)

What are the possible causes of horizontal and vertical marges?

(c)

What factors are considered for selecting a target in a business acquisition strategy?

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F-20(VMC)
Revised syllabus

Marks

(a)

Is hostile take over legally allowed in India? If yes, what are bases of arriving at the public offer price? Are these bases applicable for acquisition of an unlisted target company?

(b)

The promoters of Shyam Pharma Ltd. had pledged their shares with GE capital Services as part if the collateral security for a loan. Shyam Pharma reportedly defaulted about Rs.10 crore of loan repayment, which enabled GE Capital Services attracted by the SEBI (Substantial Acquisition of Shares and Take overs) Regulation 2002, and therefore will they have to make public offer?

(c)

TLL has brought the brands and some plants of Takme Ltd., with out buying a single share of Takme. Will the SEBI (Substantial acquisition of Shares and Takeover) Regulation 2002, be trigged if assets are bought and not the shares?

(a)

What is Economic Value Added (EVA)? What does EVA show? When will EVA increase? Calculate the EVA from the following data:

	Rs. Crores 2001
Average debt Average Equity Cost of Debt, post tax % Cost of Equiry % Weighted average cost of capital % Profit after tax, before exceptional item Interest, after taxes	50 2766 7.72 16.70 16.54 1541 5

(b)

Explain in brief the uses of the following group of ratios and give their formulae:

(i)
(ii)
(iii)
(iv)

Earnings per share;
Price earnings ratio;
Dividend- payout ratio;
Dividend –yield ratio.

1x4=4

(a)

Discuss the major aspects assumptions and decision rules of the Discounted Cash Flow (DCF) model.

(b)

What is an efficient market? What are the different levels of market efficiency? Discuss some of the lessons that follow from market efficiency hypothesis.

(a)

A textile company is contemplating to diversify into cement business. It has decided to set up a cement plant at a total cost of Rs.200 crore. The project cost is to be financed as below:

Equity
12% Debt

Rs.75 crore
Rs. 125 crore

The managing director of the company has asked the Director (Finance) to estimate the net present value of the cement business using Discounted Cash Flow (DCF) method. The Director (Finance ) was facing problem in estimating cost if equity for the cement business. He collected the following information with respect to a comparable cement company:

Long term debt
Paid up Share Capital
Reserves & surplus
Equity beta

Rs. 115crore
Rs. 85 crore
Rs.116 crore
0.90

Help the Director (Finance) to estimate the cost of equity and hence the weighted average cost of capital for the cement business. The tax rate for the companies is 35%. Use a risk-free rate of 7.5% and expected risk premium of 8%.

(b)

XY Pvt Ltd. a retail florist, is for sale at an asking price of Rs.31,00,000. you have been contracted by a potential buyer who has asked you to give him opinion as to whether the asking price is reasonable. The potential buyer has only limited information about XY Pvt Ltd. he does not know that annual gross sales of X|Y Pvt Ltd. is about Rs.41,00,000 and that last year’s tax return reported an annual profit of Rs.4,20,000 before tax.
You have collected the following information from the financial details of several retail florists that were up for sale in the past:

Table I

	Price-to-sale (P/S) Ratio	Price-to-earnings (P/E)
Number of firms Mean Ratio Coefficient of variation Maximum Ratio	38 0.55 0.65 2.35	33 3.29 1.52 6.29

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F-20(VMC)
Revised syllabus

Marks

Table 2: Top 10 players (in descending P/S order)
Firm	(P/S) Ratio	(P/E) Multiple
1 2 3 4 5 6 7 8 9 10	2.35 1.76 1.32 1.17 1.09 1.01 0.96 0.85 0.72 0.68	5.65 6.29 5.31 4.60 3.95 3.25 3.10 2.96 2.90 2.75

Offer your opinion on the reasonableness of the asking price.

(a)

A company invested in a 5-year bond issue of another company in 2000 carrying a coupon rate of 10% per annum. The interest payable at half-yearly rests and the principal repayable after 5 years in 2004-end.the current market yield has fallen to 9% during 2001. the investor- company wanted to take advantage of the fall in market yield by selling the bond to any willing buyer. Compute the value of the bond at the end of 2001. assume par value of each bond Rs.1,000.

(b)

ABC Ltd. is run and managed by an efficient team that insists on reinvesting 60% of its earnings in projects that provide an ROE (Return on Equity) of 10%, despite the fact that the firm’s capitalization rate (K) is 15%. The firm’s current years earnings is Rs.10 per share.
At what price will the stock ABC Ltd sell? What is the present value of growth opportunities? Why would such a firm be a takeover target?

Mr. Jatin started at the paper in front of him. He has just finished projection for his stratup company. Export dotcom Pvt Ltd. He was in need of money and intend to use his valuations for this purpose. He was almost convinced that he would be able to influence leaders about the potential of this start up firm in online- export documentation. However, he was not sure about whether the lenders would accept his valuations. He considered the options in front him.

He considered his projections to be reasonable, although he guessed that he only had a 30% chance of hitting those numbers and an equal 30% chance of achieving half of the projected cash flows. He is also aware that there is a relatively high probability (40%) of not getting any cash flow at all.

In estimating cash flow, Jatin thought that he would only need 5 million in cash to run the business. Anything above Rs.5 million would be considered as excess cash. Because the firm was just getting off the ground, there was no working capital and no fixed assets at the beginning of 2002. Any working capital and net fixed at the end of the year 2002 would be a net investment.

Mr. Jatin has made projections for the next six years (Exhibit I) and he thought that after sixth year the net earnings firm is expected to grow at round 7% per year, although he wondered what a somewhat more modest growth rate is of 4% would do the expected value of the firm.

Mr. Jatin thought if approaching venture capitalists too for raising money. He is fully aware that traditional lending institutions are averse to lending in his kinds of business. But he was aware that venture capitalists are always skeptical about any projections made by the prospective borrower and hence he has decided to show only the best case projections to the venture capitalists. He approached one venture capitalist with his cash flow projections and the venture capitalists has flatly said that they would require a 51% rate if return on their investment in his type of firm.

Mr. Jatin knew that he would not be taking on any debt for the foreseeable future. However, he was wondering how being an all equity firm would affect his cost of capital. The long-term equity risk premium is around 7.5%. However , illiquid stocks carry 100 basis point more premium. Current 364-day treasury bills yield 7% on an effective annual rate. A friend of Jatin has suggested that Export Doctom might be able to take on debt later once it has stabilized.

Jatin knew that in order to value a startup, he has to gather information on existing pure players or at least comparable firms. He found that three publicity traded firms directly comparable to his kind of business (pure players) (Exhibit 2). He wondered how he should use this information in determining value of his firm. The following questions came to his mind:

(a)

Should he use beta of these publicity trade firms? What about the fact that he was still private?

(b)

What is the value of the firm based on discounted cash flows. (use market value weighted beta of the pure players )

(c)

Does venture capital method valuation give any better insight? (Use average P/E multiple-equity weighted)

Help Mr.Jatin find answer to these questions. (Refer Exhibits 1&2 given below):

Exhibit 1: Projected Financials (best case) of Export Doctom Pvt. Ltd. (Figs in ‘000s)
	2000	2003	2004	2005	2006	2007
Income Statement Net Sales Cost of goods sold Selling and general admn. Exp R & D expenses EBIT Tax (35%) Net earnings	42,500 16,000 17,500 5,500 3,500 1,225 2,275	75,000 28,000 27,050 12,500 7,450 2,607.5 4,842.5	1,77,500 70,000 32,000 20,500 55,000 19,250 35,750	2,30,000 90,500 26,500 27,000 86,000 30,100 55,900	2,60,000 1,00,500 36,000 32,500 91,000 31,850 59150	3,00,000 1,22,500 39,000 35,000 1,03,500 36,225 67275
Balance Sheet Cash Accounts receivable Inventories Other Net fixed assets Total assets Accounts payable Accrued expenses Net worth Total liabilities and net worth	5,000 7,085 2,000 1,770 4,530 20,385 2,665 3,035 14,685 20,385	5,000 12,500 3,500 3,125 11,500 32,625 4,665 5,355 25,605 35,625	23,965 29,585 8,750 7,400 16,000 85,700 11,665 12,680 61,355 85,700	69,535 38,335 11,315 9,585 20,000 1,48,770 15,085 16,430 1,17,255 1,48,770	1,23,495 43,335 12,562 10,835 21,500 2,11,730 16,750 185.70 1,76,405 2,11,725	1,85,210 50,000 15,315 12,500 22,500 2,85,525 20,415 21,430 2,43,680 2,85,525

Exhibit 2: Financial details of pure players for the year 2001 (firs. in Rs.lakhs)
	Player 1	Player 2	Player 3
Net earnings Debt Net worth Equity beta P/E Ratio	26.35 35.9 60.5 1.4 20	108.75 34 1056 1.3 37	7.5 0.85 187.8 1.2 20

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