strategic financial management

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Strategic Financial Management

By

Binoy john varghese

Strategic Financial ManagementStrategic financial management refers to both, financial implications or aspects of various business strategies, and strategic management of finance.

It is an approach to management that relates financial techniques, tools and methodologies to strategic decisions making to have a long-term futuristic perspective of financial well being of the firm to facilitate growth, sustenance and competitive edge consistently.

Strategic Financial ManagementAn approach to management that applies financial techniques to strategic decision making.

Definition: “the application of financial techniques to strategic decisions in order to help achieve the decision-maker's objectives”

Strategy: a carefully devised plan of action to achieve a goal, or the art of developing or carrying out such a plan

Strategic Financial Management

Strategic Financial Management refers to both, financial implications or aspects of various business strategies, and strategic management of finances.

Strategic Financial DecisionsStrategic Financial Management Deals with:

1. Investment decisions Long Term Investment Decisions Short Term Investment Decision

1. Financing Decisions Best means of financing- Debt Equity Ratio

1. Liquidity Decisions Organization maintain adequate cash reserves or

kind such that the operations run smoothly

1. Dividend Decisions Disbursement of Dividend to Share holder and

Retained Earnings

5. Profitability Decisions

Strategic Financial DecisionsStrategic Financial Management also Deals with:

1. Valuation of the firm

2. Strategic Risk Management

3. Strategic investments analysis and capital budgeting

4. Corporate restructuring and financial aspects

5. Strategic financial evaluation

6. Strategic capital restructuring

7. Strategic international financial management

8. Strategic financial engineering and architecture

9. Strategic market expansion planning

10.Strategic compensation planning

11.Strategic innovation expenditure

12.Other business challenges

Investment decisionsThe investment decision relates to the selection of assets in which funds will be invested by a firm. The assets which can be acquired fall into two broad groups: (a) long-term assets (Capital Budgeting) (b) short-term or current assets (Working Capital Management).

(a) Long Term Investment Decisions

Capital Budgeting Capital budgeting is probably the most crucial financial decision of a firm. It relates to the selection of an asset or investment proposal or course of action whose benefits are likely to be available in future over the lifetime of the project.

Capital Budgeting decisions

Use Pay Back period, NPV, IRR, etc. for evaluation

Investment Decisions

(b)Short Term Investment DecisionWorking Capital Management : Working capital management is concerned with the management of current assets. It is an important and integral part of financial management as short-term survival is a prerequisite for long-term success.

Fixed Part of working capital –managed from long term funds

Fluctuating Part of Working Capital –managed from short term funds

Financing DecisionsThe second major decision involved in financial management is the financing decision. The investment decision is broadly concerned with the asset-mix or the composition of the assets of a firm. The concern of the financing decision is with the financing-mix or capital structure or leverage. There are two aspects of the financing decision.

First, the theory of capital structure which shows the theoretical relationship between the employment of debt and the return to the shareholders. The second aspect of the financing decision is the determination of an appropriate capital structure, given the facts of a particular case. Thus, the financing decision covers two interrelated aspects: (1) the capital structure theory, and (2) the capital structure decision.

Dividend DecisionsTwo alternatives are available in dealing with the profits of a firm.

(1)They can be distributed to the shareholders in the form of dividends or

(2)They can be retained in the business itself.

It depends on the dividend-pay out ratio, that is, what proportion of net profits should be paid out to the share holders.

It depends upon the preference of the shareholders and investment opportunities available within the firm

Profitability Management

The source of revenue has to be pre-decided to obtain profits in future.

It is closely related to investment decisions as revenue generation will be from operations, investments and divestments.

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Working Capital Decision

Gross working capital (GWC) GWC refers to the firm’s total investment in current assets.

Current assets are the assets which can be converted into cash within an accounting year (or operating cycle) and include cash, short-term securities, debtors, (accounts receivable or book debts) bills receivable and stock (inventory).

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Concepts of Working Capital

Net working capital (NWC).NWC refers to the difference between current

assets and current liabilities. Current liabilities (CL) are those claims of

outsiders which are expected to mature for payment within an accounting year and include creditors (accounts payable), bills payable, and outstanding expenses.

NWC can be positive or negative. Positive NWC = CA > CLNegative NWC = CA < CL

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Concepts of Working CapitalGWC focuses on

– Optimization of current investment – Financing of current assets

NWC focuses on – Liquidity position of the firm– Judicious mix of short-term and long-tern

financing

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Operating CycleOperating cycle is the time duration required to convert sales, after the conversion of resources into inventories, into cash. The operating cycle of a manufacturing company involves three phases:– Acquisition of resources such as raw material, labour,

power and fuel etc.– Manufacture of the product which includes conversion

of raw material into work-in-progress into finished goods.– Sale of the product either for cash or on credit. Credit

sales create account receivable for collection.

Working Capital ManagementReceivables Management

Investment in receivable• volume of credit sales• collection period

Credit policy• credit standards• credit terms• collection efforts

Cash Management

Working Capital ManagementInventory Management

Stocks of manufactured products and the material that make up the product.

Components:

• raw materials

• work-in-process

• finished goods

• stores and spares (supplies)

Working Capital Management

Cash Management

Cash management is concerned with the managing of:– cash flows into and out of the firm,– cash flows within the firm, and– cash balances held by the firm at a point of

time by financing deficit or investing surplus cash

Functions of Financial Manager

1. Financial Forecasting and Planning

2. Acquisition of funds

3. Investment of funds

4. Helping in Valuation Decisions

5. Maintain Proper Liquidity

Financial PolicyCriteria describing a corporation's choices regarding its debt/equity mix, currencies of denomination, maturity structure, method of financing investment projects, and hedging decisions with a goal of maximizing the value of the firm to some set of stockholders.Hedging: A strategy designed to reduce investment risk using call options, put options, short-selling, or futures contracts. Its purpose is to reduce the volatility of a portfolio by reducing the risk of loss.

Strategic planningStrategic planning is an organization's process of defining its strategy, or direction, and making decisions on allocating its resources to pursue this strategy, including its capital and people. Various business analysis techniques can be used in strategic planning, including SWOT analysis (Strengths, Weaknesses, Opportunities, and Threats ), PEST analysis (Political, Economic, Social, and Technological), STEER analysis (Socio-cultural, Technological, Economic, Ecological, and Regulatory factors), and EPISTEL (Environment, Political, Informatic, Social, Technological, Economic and Legal).

Strategic planning Strategic planning is the formal consideration of an organization's future course.

All strategic planning deals with at least one of three key questions:

"What do we do?"

"For whom do we do it?"

"How do we excel?"

In business strategic planning, some authors phrase the third question as "How can we beat or avoid competition?". (Bradford and Duncan, page 1). But this approach is more about defeating competitors than about excelling.

Strategic planning In many organizations, this is viewed as a process for determining where an organization is going over the next year or - more typically - 3 to 5 years (long term), although some extend their vision to 20 years.

In order to determine where it is going, the organization needs to know exactly where it stands, then determine where it wants to go and how it will get there. The resulting document is called the "strategic plan."

It is also true that strategic planning may be a tool for effectively plotting the direction of a company; however, strategic planning itself cannot foretell exactly how the market will evolve and what issues will surface in the coming days in order to plan your organizational strategy. Therefore, strategic innovation and tinkering with the 'strategic plan' have to be a cornerstone strategy for an organization to survive the turbulent business climate.

Characteristics of Strategic planning

Successful Strategic planning constitutes the following features. It should:

1. Exhibit impacts in daily routine

2. Facilitate dynamic, forward and backward thinking process

3. Counters repetitive patterns of mistakes, especially human tendencies

4. Remain clear and simple

5. Ensure planning is complete only when it is properly implemented

6. Designate a core planning team with a level of autonomy

7. Constitute collective leadership and involvement of key stakeholders in decision making

Mission and VisionMission: Defines the fundamental purpose

of an organization or an enterprise, succinctly describing why it exists and what it does to achieve its Vision

A Vision statement outlines what the organization wants to be, or how it wants the world in which it operates to be. It concentrates on the future. It is a source of inspiration. It provides clear decision-making criteria.

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Finance FunctionsInvestment or Long Term Asset Mix

Decision

Financing or Capital Mix Decision

Dividend or Profit Allocation Decision

Liquidity or Short Term Asset Mix Decision

Strategic Financial PlanningA Financial Plan is statement of what is to be done in a future time.

Most decisions have long lead times, which means they take a long time to implement.

In an uncertain world, this requires that decisions be made far in advance of their implementation

Strategic Financial PlanningIt formulates the method by which financial goals are to be achieved.

There are two dimensions:

1. A Time Frame– Short run is probably anything less than a year.

– Long run is anything over that; usually taken to be a two-year to five-year period.

2. A Level of Aggregation– Each division and operational unit should have a plan.

– As the capital-budgeting analyses of each of the firm’s divisions are added up, the firm aggregates these small projects as a big project.

Strategic Financial PlanningScenario AnalysisEach division might be asked to prepare three

different plans for the near term future:1. A Worst Case- This plan would require making the worst

possible assumptions about the companies products and the state of the economy

2. A Normal Case- This plan would require making the most likely assumptions about the company and the economy

3. A Best Case- Each divisions would be required to work out a case based on optimistic assumptions. It could involve new products and expansion.

Components of Financial StrategyStart-Up Costs

A new business venture, even those started by existing companies, has start-up costs. An existing manufacturer looking to release a new line of product has costs that may include new fabricating equipment, new packaging and a marketing plan. Include your start-up costs in your financial strategy.

Competitive Analysis

Your competition affects how you make money and how you spend money. The products and marketing activities of your competition should be included in your financial strategy. An analysis of how the competition will affect revenue needs to be included in your planning.

Ongoing Costs

Revenue

Components of Financial Strategy

Ongoing CostsThese include labor, materials, equipment maintenance, shipping and facilities costs, such as lease and utilities. Break down your ongoing cost projections into monthly numbers to include as part of your financial strategy.

RevenueIn order to create an effective financial strategy, you need to forecast revenue over the length of the project. A comprehensive revenue forecast is necessary when determining how much will be available to pay your ongoing costs, and how much will remain as profit.

Objectives and Goals

Goal: The Financial Goal of the firm should be shareholder’s wealth maximization, as reflected in the market value of the firm’s share.

Firms’ primary objective is maximizing the welfare of owners, but, in operational terms, they focus on the satisfaction of its customers through the production of goods and services needed by them

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Objectives Of Financial ManagementThe term objective is used to in the sense of a goal or decision criteria for the three decisions involved in financial managementThe goal of the financial manager is to maximise the owners/shareholders wealth as reflected in share prices rather than profit/EPS maximisation because the latter ignores the timing of returns, does not directly consider cash flows and ignores risk. As key determinants of share price, both return and risk must be assessed by the financial manager when evaluating decision alternatives. The EVA is a popular measure to determine whether an investment positively contributes to the owners wealth.

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Objectives Of Financial Management

However, the wealth maximizing action of the finance managers should be consistent with the preservation of the wealth of stakeholders, that is, groups such as employees, customers, suppliers, creditors, owners and others who have a direct link to the firm.

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Finance Manager’s Role• Raising of Funds

• Allocation of Funds

• Profit Planning

• Understanding Capital Markets

Financial Goals• Profit maximization (profit after tax)

• Maximizing Earnings per Share

• Shareholder’s Wealth Maximization

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Profit Maximization

Maximizing the Rupee Income of Firm – Resources are efficiently utilized

– Appropriate measure of firm performance

– Serves interest of society also

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Objections to Profit MaximizationIt is VagueIt Ignores the Timing of ReturnsIt Ignores RiskAssumes Perfect CompetitionIn new business environment profit

maximization is regarded as UnrealisticDifficultInappropriate Immoral.

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Maximizing EPS

Ignores timing and risk of the expected benefit

Market value is not a function of EPS. Hence maximizing EPS will not result in highest price for company's shares

Maximizing EPS implies that the firm should make no dividend payment so long as funds can be invested at positive rate of return—such a policy may not always work

39

Shareholders’ Wealth Maximization

Maximizes the net present value of a course of action to shareholders.

Accounts for the timing and risk of the expected benefits.

Benefits are measured in terms of cash flows.

Fundamental objective—maximize the market value of the firm’s shares.

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Risk-return Trade-offRisk and expected return move in tandem;

the greater the risk, the greater the expected return.

Financial decisions of the firm are guided by the risk-return trade-off.

The return and risk relationship: Return = Risk-free rate + Risk premium

Risk-free rate is a compensation for time and risk premium for risk.

41

Managers Versus Shareholders’ GoalsA company has stakeholders such as employees, debt-holders, consumers, suppliers, government and society.

Managers may perceive their role as reconciling conflicting objectives of stakeholders. This stakeholders’ view of managers’ role may compromise with the objective of SWM.

Managers may pursue their own personal goals at the cost of shareholders, or may play safe and create satisfactory wealth for shareholders than the maximum.

Managers may avoid taking high investment and financing risks that may otherwise be needed to maximize shareholders’ wealth. Such “satisfying” behaviour of managers will frustrate the objective of SWM as a normative guide.

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Financial Goals and Firm’s Mission and Objectives

Firms’ primary objective is maximizing the welfare of owners, but, in operational terms, they focus on the satisfaction of its customers through the production of goods and services needed by themFirms state their vision, mission and values in broad terms

Wealth maximization is more appropriately a decision criterion, rather than an objective or a goal.

Goals or objectives are missions or basic purposes of a firm’s existence

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The shareholders’ wealth maximization is the second-level criterion ensuring that the decision meets the minimum standard of the economic performance.

In the final decision-making, the judgement of management plays the crucial role. The wealth maximization criterion would simply indicate whether an action is economically viable or not.

What Will the Planning Process Accomplish?

InteractionsThe plan must make explicit the linkages between

investment proposals and the firm’s financing choices.

OptionsThe plan provides an opportunity for the firm to weigh its

various options.

Feasibility- The different plans must fit into the overall corporation objective of maximizing shareholder wealth

Avoiding SurprisesOne of the purpose of financial planning is to avoid surprise.

Strategic Planning Process

Strategic Planning

Strategic Planning relates to planning in advance for a long period of time.

This facilitates predicting the future and devising a course of action well in advance.

It deals with future course of action consistent with the business environment changes.

Components of Strategic Planning 1. Vision- Organization visualizes what it would like to in

future

2. Mission- Deals with distinctive purpose which an organization is striving for. It declares the main concerns or priorities and principles of the business firm.

3. Goals – They are concrete aims which enhance the motivation of organization teams which prepare themselves in specific aspects.

4. Objectives- intend to put forward in precise terms what an organization wants to achieve, where it wants to be in future, what are the tasks that needs to be achieved in short spans of time.

Process of Strategic Planning 1.Visualizing ideal future

2.Identifying critical success factors

3.Analyzing the present status of the company both internal and external

4.Identifying core areas and core competencies and opportunities available in the environment

5.Focusing on core areas and devising strategy accordingly

6.Designing of long-range plan

7.Implementing plans and transition management

8.Reviewing and redesigning and updating and checking discrepancies

9.Achieving desired outcomes

Benefits of Strategic Planning 1. Development and articulation of the vision into mission

2. Standardization and innovation in the dimensions get included for the analysis for decision making

3. More acceptance throughout the organization and from stakeholders

4. Results into a more tolerant, enduring and dynamic organization

5. Opportunities in external environment can be tapped

6. Identifies competitive position and enables competitive advantage through growth and sustenance

Benefits of Strategic Planning 7. Cross functional approach integrates the systems for

implementation

8. Flow of vision and its orientation to all levels and departments in an organization

9. Well-directed inputs to reduce wastage are encouraged

10. Facilities prioritization and utilization of resources

11.Empowerment leads to commitment and contribution of ideas at all levels

12. The broad view of strategic level is transferred to narrower levels of the organization

Financial Planning Model:The Ingredients

1. Sales forecast

2. Pro forma statements

3. Asset requirements

4. Financial requirements

5. Plug

6. Economic assumptions

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1. Sales Forecast All financial plans require a sales

forecast. Perfect foreknowledge is impossible

since sales depend on the uncertain future state of the economy.

Businesses that specialize in macroeconomic and industry projects can be help in estimating sales.

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2. Pro Forma Statements

The financial plan will have a forecast balance sheet, a forecast income statement, and a forecast sources-and-uses-of-cash statement.

These are called pro forma statements or pro formas.

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3. Asset Requirements

The financial plan will describe projected capital spending.

In addition it will the discuss the proposed uses of net working capital.

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4. Financial Requirements

The plan will include a section on financing arrangements.

Dividend policy and capital structure policy should be addressed.

If new funds are to be raised, the plan should consider what kinds of securities must be sold and what methods of issuance are most appropriate.

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5. Plug Compatibility across various growth targets will

usually require adjustment in a third variable. Suppose a financial planner assumes that

sales, costs, and net income will rise at g1. Further, suppose that the planner desires assets and liabilities to grow at a different rate, g2. These two rates may be incompatible unless a third variable is adjusted.

For example, compatibility may only be reached if outstanding stock grows at a third rate, g3.

Compatibility across various growth targets will usually require adjustment in a third variable.

Suppose a financial planner assumes that sales, costs, and net income will rise at g1. Further, suppose that the planner desires assets and liabilities to grow at a different rate, g2. These two rates may be incompatible unless a third variable is adjusted.

For example, compatibility may only be reached if outstanding stock grows at a third rate, g3.

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6. Economic Assumptions

The plan must explicitly state the economic environment in which the firm expects to reside over the life of the plan.

Interest rate forecasts are part of the plan.

The plan must explicitly state the economic environment in which the firm expects to reside over the life of the plan.

Interest rate forecasts are part of the plan.

Matt H. Evans, [email protected]

Strategic Planning Model

9S Model of SFMNine S Model combines the quantitative and qualitative skills of a strategist.

1.Sanctity

2.Selectivity

3.System

4.Strategic Cost Management

5.Sensitivity

6.Sustainability

7.Superiority

8.Structural Flexibility

9.Soul Searching

9S Model of SFM1. Sanctity refers to the ‘ethical economics’ of

business. This approach offers a long-term, sustainable ‘brand-equity’ to the enterprise which ultimately reduces every cost at every stage of a product life cycle.

2. Selectivity refers to the most appropriate business choices based on an enterprise's core competence. SFM should concentrate on building up a most flexible core competence together with strategic cost mangement.

9S Model of SFM3. System- emphasizes the need for a supportive mechanism to make ‘SFM’ a continued success. It refers to the technological, accounting, information and operational systems of an enterprise.

4. Strategic Cost Management- is the micro-level strategic analysis of various cost-structure and cost implications. Some of costing methods are; Activity Based Costing (or Objective Based Costing), Life Cycle Costing, Notional Cost Benefit Analysis, Cost analysis for establishing the validity of a certain value-chain of an enterprise, etc.

9S Model of SFM5.Sensitivity- It is to know the strategic use of every piece of information. It convert technical data into commercial data. Sensitivity depends on the capacity to transform ‘x’ information into ‘y’ in minimum possible amount of cost and time.

6. Sustainability- of performance is a matter of long-term strategic planning. Strategic plan requires a very careful combination of ‘business strategy ‘ and ‘business funding strategy’. It also means ‘managing new competitors’ with extra cost on sustenance’.

Superiority

Structural Flexibility

Soul Searching

9S Model of SFM7. Superiority- refers to the position of ‘Leadership’ that an enterprise must attain in the market. SFM should aim at maintaining both positions in the same market and little paradoxical.

8. Structural Flexibility- It is the sum total of the qualitative and quantitative adaptability and adjustability of an organization. Sunk cost, Committed cost, Engineered cost, Capacity Costa, Burden costs and corrective cost could be huge if structural flexibility is absent.

9S Model of SFM9. Soul Searching- It is based on continuous bench marking and requires a tremendous amount of financial alertness, innovation and total exposure to new variables and parameters.

It also refers to establishing new heights of achievement and newer core-competences.

The 9 references of SFM ultimately aim for, ‘Wealth Maximization through the accelerating Effect’.

Strategic planningStrategic planning is an organization's process of defining its strategy, or direction, and making decisions on allocating its resources to pursue this strategy, including its capital and people.

Strategic planningVarious business analysis techniques can be used in strategic planning, including SWOT analysis (Strengths, Weaknesses, Opportunities, and Threats ), PEST analysis (Political, Economic, Social, and Technological), STEER analysis (Socio-cultural, Technological, Economic, Ecological, and Regulatory factors), and EPISTEL (Environment, Political, Informatic, Social, Technological, Economic and Legal).

Strategic planning Strategic planning is the formal consideration of an organization's future course.

All strategic planning deals with at least one of three key questions:

"What do we do?"

"For whom do we do it?"

"How do we excel?"

In business strategic planning, some authors phrase the third question as "How can we beat or avoid competition?". (Bradford and Duncan, page 1). But this approach is more about defeating competitors than about excelling.

Strategic planning In many organizations, this is viewed as a process for determining where an organization is going over the next year or - more typically - 3 to 5 years (long term), although some extend their vision to 20 years.

In order to determine where it is going, the organization needs to know exactly where it stands, then determine where it wants to go and how it will get there. The resulting document is called the "strategic plan."

It is also true that strategic planning may be a tool for effectively plotting the direction of a company; however, strategic planning itself cannot foretell exactly how the market will evolve and what issues will surface in the coming days in order to plan your organizational strategy. Therefore, strategic innovation and tinkering with the 'strategic plan' have to be a cornerstone strategy for an organization to survive the turbulent business climate.

Characteristics of Strategic planningSuccessful Strategic planning constitutes the following features. It should:

1. Exhibit impacts in daily routine

2. Facilitate dynamic, forward and backward thinking process

3. Counters repetitive patterns of mistakes, especially human tendencies

4. Remain clear and simple

5. Ensure planning is complete only when it is properly implemented

6. Designate a core planning team with a level of autonomy

7. Constitute collective leadership and involvement of key stakeholders in decision making

Vision Goals

Components of Strategic planning or

Strategic Intent

Mission Objectives

Components of Strategic Planning 1. Vision- Organization visualizes what it would like to in

future

2. Mission- Deals with distinctive purpose which an organization is striving for. It declares the main concerns or priorities and principles of the business firm.

3. Goals – They are concrete aims which enhance the motivation of organization teams which prepare themselves in specific aspects.

4. Objectives- intend to put forward in precise terms what an organization wants to achieve, where it wants to be in future, what are the tasks that needs to be achieved in short spans of time.

VisionA Vision statement outlines what the organization wants to be, or how it wants the world in which it operates to be. It concentrates on the future. It is a source of inspiration. It provides clear decision-making criteria.Every organization visualizes what it would like to be in future.Vision describes a wishful long-term desire of the company with out mentioning the steps or plans to be used in order to set the target.

MissionMission: Defines the fundamental purpose of an organization or an enterprise, describing why it exists and what it does to achieve its Vision.

Mission deals with a distinctive Purpose which a organization is striving for. A well defined mission statement declares the main concerns or priorities and principles of the business firm

ObjectivesObjectives intend to put forward in precise terms what an organization wants to achieve where it wants to be in future, what are the tasks that needs to be achieved in short spans of time to achieve the future objectives and goals.

GoalsGoals are the concrete aims or targets which enhance the motivation of the organizational teams which prepare themselves in specific aspects.

Goals provide the benefit of breaking down or fragmenting the broader mission into more concert and clear tasks that are understandable, and responsibilities are allocated to individuals and teams in the organization.

Financial Objectives and Goals

Goal: The Financial Goal of the firm should be shareholder’s wealth maximization, as reflected in the market value of the firm’s share.

Firms’ primary objective is maximizing the welfare of owners, but, in operational terms, they focus on the satisfaction of its customers through the production of goods and services needed by them

1-77

Objectives Of Financial ManagementThe term objective is used to in the sense of a goal or decision criteria for the three decisions involved in financial managementThe goal of the financial manager is to maximise the owners/shareholders wealth as reflected in share prices rather than profit/EPS maximisation because the latter ignores the timing of returns, does not directly consider cash flows and ignores risk. As key determinants of share price, both return and risk must be assessed by the financial manager when evaluating decision alternatives. The EVA is a popular measure to determine whether an investment positively contributes to the owners wealth.

1-78

Objectives Of Financial Management

However, the wealth maximizing action of the finance managers should be consistent with the preservation of the wealth of stakeholders, that is, groups such as employees, customers, suppliers, creditors, owners and others who have a direct link to the firm.

79

Finance Manager’s Role• Raising of Funds

• Allocation of Funds

• Profit Planning

• Understanding Capital Markets

Financial Goals• Profit maximization (profit after tax)

• Maximizing Earnings per Share

• Shareholder’s Wealth Maximization

Strategic Financial PlanningA Financial Plan is statement of what is to be done in a future time.

Most decisions have long lead times, which means they take a long time to implement.

In an uncertain world, this requires that decisions be made far in advance of their implementation

Strategic Financial PlanningIt formulates the method by which financial goals are to be achieved.

There are two dimensions:

1. A Time Frame– Short run is probably anything less than a year.

– Long run is anything over that; usually taken to be a two-year to five-year period.

2. A Level of Aggregation– Each division and operational unit should have a plan.

– As the capital-budgeting analyses of each of the firm’s divisions are added up, the firm aggregates these small projects as a big project.

Strategic Financial PlanningScenario AnalysisEach division might be asked to prepare three

different plans for the near term future:1. A Worst Case- This plan would require making the worst

possible assumptions about the companies products and the state of the economy

2. A Normal Case- This plan would require making the most likely assumptions about the company and the economy

3. A Best Case- Each divisions would be required to work out a case based on optimistic assumptions. It could involve new products and expansion.

Components of Financial StrategyStart-Up Costs

A new business venture, even those started by existing companies, has start-up costs. An existing manufacturer looking to release a new line of product has costs that may include new fabricating equipment, new packaging and a marketing plan. Include your start-up costs in your financial strategy.

Competitive Analysis

Your competition affects how you make money and how you spend money. The products and marketing activities of your competition should be included in your financial strategy. An analysis of how the competition will affect revenue needs to be included in your planning.

Ongoing Costs

Revenue

Components of Financial Strategy

Ongoing CostsThese include labor, materials, equipment maintenance, shipping and facilities costs, such as lease and utilities. Break down your ongoing cost projections into monthly numbers to include as part of your financial strategy.

RevenueIn order to create an effective financial strategy, you need to forecast revenue over the length of the project. A comprehensive revenue forecast is necessary when determining how much will be available to pay your ongoing costs, and how much will remain as profit.

85

Objections to Profit MaximizationIt is VagueIt Ignores the Timing of ReturnsIt Ignores RiskAssumes Perfect CompetitionIn new business environment profit

maximization is regarded as UnrealisticDifficultInappropriate Immoral.

86

Maximizing EPS

Ignores timing and risk of the expected benefit

Market value is not a function of EPS. Hence maximizing EPS will not result in highest price for company's shares

Maximizing EPS implies that the firm should make no dividend payment so long as funds can be invested at positive rate of return—such a policy may not always work

87

Shareholders’ Wealth Maximization

Maximizes the net present value of a course of action to shareholders.

Accounts for the timing and risk of the expected benefits.

Benefits are measured in terms of cash flows.

Fundamental objective—maximize the market value of the firm’s shares.

88

Risk-return Trade-offRisk and expected return move in tandem;

the greater the risk, the greater the expected return.

Financial decisions of the firm are guided by the risk-return trade-off.

The return and risk relationship: Return = Risk-free rate + Risk premium

Risk-free rate is a compensation for time and risk premium for risk.

89

Managers Versus Shareholders’ GoalsA company has stakeholders such as employees, debt-holders, consumers, suppliers, government and society.

Managers may perceive their role as reconciling conflicting objectives of stakeholders. This stakeholders’ view of managers’ role may compromise with the objective of SWM.

Managers may pursue their own personal goals at the cost of shareholders, or may play safe and create satisfactory wealth for shareholders than the maximum.

Managers may avoid taking high investment and financing risks that may otherwise be needed to maximize shareholders’ wealth. Such “satisfying” behaviour of managers will frustrate the objective of SWM as a normative guide.

90


Firms’ primary objective is maximizing the welfare of owners, but, in operational terms, they focus on the satisfaction of its customers through the production of goods and services needed by themFirms state their vision, mission and values in broad terms

Wealth maximization is more appropriately a decision criterion, rather than an objective or a goal.

Goals or objectives are missions or basic purposes of a firm’s existence

91


The shareholders’ wealth maximization is the second-level criterion ensuring that the decision meets the minimum standard of the economic performance.

In the final decision-making, the judgement of management plays the crucial role. The wealth maximization criterion would simply indicate whether an action is economically viable or not.

What Will the Planning Process Accomplish?

InteractionsThe plan must make explicit the linkages between

investment proposals and the firm’s financing choices.

OptionsThe plan provides an opportunity for the firm to weigh its

various options.

Feasibility- The different plans must fit into the overall corporation objective of maximizing shareholder wealth

Avoiding SurprisesOne of the purpose of financial planning is to avoid surprise.

Costs and BenefitsFinancial executives do financial cost benefit analysis. IRR is a method of cost analysis in certain cases and Economic Rate of Return (ERR) should replace the IRR for adequate and rational appraisal of the same project in both the economy.

Indicative Cost –Benefit-Analysis may be useful for highly subjective decisions or judgments.

The indicative or relative significance of various variables deciding the ultimate outcome of the decision making process can be used for approximate cost benefit analysis.

Costs and BenefitsOngoing business processes require a quick ‘incremental Cost-Benefit analysis’ for quick conclusions.

As long as incremental profit exceeds incremental costs, the project is worth while.

Sustainable Net incremental Benefit is very often a strategic decision. It also require a lot of strategic analysis based on a long-tem appraisal of the uncertainty involved.

Costs and BenefitsThe long term project will have to be assessed with an average Cost Benefit Analysis (CBA) for the project’s life cycle.

CBA with strategic perspective is of vital significance.

Multi-product or multi-locational enterprises always makes use of CBA in totality.

LIFE CYCLE COASTING (LCC) is commonly used of the ‘life-cycle strategy formulations of a project.

LIFE CYCLE COASTING (LCC)LCC involve the analysis of the following cost:

1.Cost of Launching

2.Cost of early corrections

3.Cost of take of

4.Cost of consolidation

5.Cost of leadership

6.Cost of Sustainance

7.Cost of Revival

8. Cost of withdrawal from market

97

RISK AND UNCERTAINTY There are two types of expectations individuals may have about the future- – Certainty, and – uncertainty

Risk describes a situation where there is not just one possible outcome, but an array of potential returns. Also there are various probabilities for each of the probable returns.Risk refers to a set of unique outcomes for a given event which can be assigned probabilities while uncertainty refers to the outcomes of a given event which are too unsecure to be assigned probabilities.

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Risk and UncertaintyRisk refers to the variability in the actual returns vis-à-vis the estimated returns, in terms of cash flows.

Risk is an integral part of investment decision. The uncertainty related with the returns from an investment brings risk into an investment.The possibility of variation of actual return from the expected return is known as risk.

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Definition of RiskRisk may be defined as “ the chance of future loss that can be foreseen”Risk is the potential for variability in return.

Risk involved in capital budgeting can be measured in absolute as well as relative terms. The absolute measures of risk include sensitivity analysis, simulation and standard deviation. The coefficient of variation is a relative measure of risk.

100

Nature of RiskRisk exists because of the inability of the decision-maker to make perfect forecasts.In formal terms, the risk associated with an investment may be defined as the variability that is likely to occur in the future returns from the investment.Three broad categories of the events influencing the investment forecasts:

– General economic conditions – Industry factors – Company factors

101

Types of Risk

Risk

1. Business Riska) Internal Business Risk

b) External Business Risk

2. Financial Risk

Unsystematic Risk

1. Interest Rate Risk

2. Market Risk

3. Purchasing Power Risk

4. Exchange Rate Risk

Systematic Risk

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Types of RiskIt is classified into mainly two types.1. Systematic Risk2. Unsystematic Risk

Systematic Risk is the risk which is directly related with overall movement in general market or economy. This type of risk covers factors which are external to a particular company and are uncontrollable by the company.

Unsystematic Risk refers to variability in returns caused by unique factors relating to that firm or industry like management failure, labor strikes, and shortage of raw material. There are two source of unsystematic or unique risk –business risk and financial risk.

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Unsystematic Risk 1. Business Risk2. Financial Risk

1. Business Risk is the variability in operating income due operating conditions of the company. This can be divided into two types

a. Internal Business RiskFactors affecting Internal Business Risk are:Fluctuation in SaleResearch and developmentPersonnel managementFixed costSingle product

b. External Business RiskResult of operating conditions imposed on the firm circumstances beyond its control.Social and regulatory factorsPolitical RiskBusiness cycle

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Unsystematic Risk 2. Financial RiskIt refers to the variability in return due to capital structure.The use of debt with owned funds to increase the return of shareholders is known as financial leverage.If the earnings are low, it may lead to bankruptcy to equity shareholders.Financial risk considers the difference between EBIT and EBT Business risk causes the variation between revenue and EBIT. Financial risk can be avoided by management by reducing borrowed funds

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Risk and UncertaintyRisk refers to situation in which the decision maker knows the possible consequences of an investment decision whereas Uncertainty involves a situation about which the likelihood of possible outcome is not known.

Risk is the consequence of making wrong decision and due to this, the decision that is made is uncertain.The bigger the risk, the greater the uncertainty.

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Types of UncertaintyUncertainty can be classified into the following categories.1.Market Uncertainty- caused by factors which are external to the economy.2.Technical Uncertainty- caused by technical factors like size of production or change in technology3.Competitive Uncertainty- due to action of competitors4.Technological Uncertainty- non availability of technology5.Political Uncertainty- Due to Unstable political system

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Source of Uncertainty1.Information incomplete2.Reliability of source of Information3.Variability- Parameters which change over time4.Linguistic imprecision- People using imprecise terms and expression in communication

Causes or Reasons of Risk and Uncertainty

1. Nature of investment2. Maturity period3. Amount of investment4. Bias in data and its

assessment5. Misinterpretation of data6. Non-availability of

managerial talents7. Method of investment

8. Nature of Business9. Terms of lending10. Wrong timing of investment11. Nature of calamities (disasters)

12. Wrong investment decision13. Creditworthiness of issuer14. Obsolescence15. Salvage ability of investment

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Investment Decision Under Risk and Uncertainty

Types of Investment Decision1.Certainty (No Risk)-The estimated returns are equal to the actual return2.Uncertainty- An uncertain situation in one when probabilities of occurrence of a particular event are not known. In the case of uncertainty, future loss cannot be foreseen. So, it cannot be planned in advance by management3.Risk- A risky situation is one in which the probabilities of a particular event’s occurrence are known. In the case of risk, chance of future loss can be foreseen due to past experiences.

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TECHNIQUES OF INVESTMENT DECISIONS

Investment decision techniques refer to the choice by several decision makers of possible outcomes and probabilities of their occurrence under risk and uncertainty.An investment decision always involve a trade-off between risk and return.Assessing risk and incorporating the same in the final decision is an integral part of financial analysis.

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TECHNIQUES OF INVESTMENT DECISIONS

The main techniques of decision making under the conditions of risk and uncertainty:1.Risk-adjusted discount rate2.Certainty equivalent method or approach3.Statistical Methods

a) Standard deviation methodb) Coefficient of variation methodc) Sensitivity analysisd) Simulation methode) Probability and expected value methodf) Decision Tree analysis

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Risk Adjusted Discount Rate

In this approach a risk premium is added to the risk free discount rate. Risk adjusted discount rate is than used to calculate net present value in the normal manner.

Drawbacks of risk-adjusted discount rate method : Risk-adjusted discount rate method relies on accurate assessment of the riskiness of a project. Risk perception and judgment are subjective and susceptible to personal bias.

112

Risk-Adjusted Discount RateRisk-adjusted discount rate, will allow for both time preference and risk preference and will be a sum of the risk-free rate and the risk-premium rate reflecting the investor’s attitude towards risk.

Under CAPM, the risk-premium is the difference between the market rate of return and the risk-free rate multiplied by the beta of the project.

= 0

NCFNPV =

(1 )

nt

tt k+∑

f rk = k + k

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Risk Adjusted Discount Rate (RADR)A project is required to invest Rs. 1,10,000 and is expected to generate cash flows after tax over its economic life of 5 years of Rs. 20,000, Rs. 30,000, Rs. 35000, Rs. 55,000 and Rs. 10,000. Risk free interest rate is 7%, and risk premium 3%. Calculate NPV using RADR method.RADR=Risk free rate + risk premium=7+3=10%

Years CFATDiscount Factor

(10%) PV1 20000 0.909 18181.822 30000 0.826 24793.393 35000 0.751 26296.024 55000 0.683 37565.745 10000 0.621 6209.21

Total Present Value of Cash Inflow 113046.18110000.00

3046.18Cash Out Flow

NPV

114

Evaluation of Risk-adjusted Discount RateThe following are the advantages of risk-adjusted discount rate method:

– It is simple and can be easily understood.– It has a great deal of intuitive appeal for risk-averse businessman.– It incorporates an attitude (risk-aversion) towards uncertainty.

This approach, however, suffers from the following limitations:

– There is no easy way of deriving a risk-adjusted discount rate. As discussed earlier, CAPM provides for a basis of calculating the risk-adjusted discount rate. Its use has yet to pick up in practice.

– It does not make any risk adjustment in the numerator for the cash flows that are forecast over the future years.

– It is based on the assumption that investors are risk-averse. Though it is generally true, there exists a category of risk seekers who do not demand premium for assuming risks; they are willing to pay a premium to take risks.

115

Certainty EquivalentCertainty-equivalent is a common procedure for dealing with risk in capital budgeting to reduce the forecast the cash flows to some conservative levels.There is a certainty-equivalent cash flow for all projects.

Certainty-equivalent approach may be expressed as:

Where NCF= the forecasts of net cash flow with out risk-adjustmentα= the risk adjustment factor or certainty equivalent coefficient k- risk free rate assumed to be constant for all period

= 0

NCFNPV =

(1 )f

nt t

tt k

α+

∑

116 Financial Management, Ninth Edition © I M Pandey

Vikas Publishing House Pvt. Ltd.

Certainty-equivalent coefficient α assumes a value between 0 and 1

If the investor feels that only 80% of expected cash flow is certain, the Certainty-equivalent coefficient will be .80

Certainty-equivalent coefficient can be determined as a relationship between the certain cash flows and risky cash flows. That is

If expected cash flow is 80,000 and certain cash flow is 60,000 the

Certainty-equivalent coefficient α= 60,000/80,000=0.75

*NCF Certain net cash flow =

NCF Risky net cash flowt

tt

α =

Certainty Equivalent

117

Reduce the forecasts of cash flows to some conservative levels.The certainty—equivalent coefficient assumes a value between 0 and 1, and varies inversely with risk. Decision-maker subjectively or objectively establishes the coefficients.The certainty—equivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows.

= 0

NCFNPV =

(1 )f

nt t

tt k

α+

∑

*NCF Certain net cash flow =

NCF Risky net cash flowt

tt

α =

Certainty Equivalent

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Certainty EquivalentSky Way Ltd. is considering an investment proposal which requires 20 lakhs. The expected cash inflow and certainty coefficients are given below: Risk Free interest rate is 6%. Determine NPV of proposal

Year Cash InflowCertainty Coefficient

1 600000 0.90

2 300000 0.85

3 700000 0.80

4 800000 0.75

5 900000 0.65

119

Certainty Equivalent (NPV)Sky Way Ltd. is considering an investment proposal which requires 20 lakhs. The expected cash inflow and certainty coefficients are given below: Risk Free interest rate is 6%. Determine NPV of proposal

YearCash Inflow

Certainty Coefficient

Certain Cash In Flow

Discount Factor (6%)

Present Value

1 600000 0.90 540000 0.94 509433.962 300000 0.85 255000 0.89 226949.093 700000 0.80 560000 0.84 470186.804 800000 0.75 600000 0.79 475256.205 900000 0.65 585000 0.75 437146.03

2118972.082000000.00

118972.08

Present Value of Cash InflowPresent Value of Cash OutflowNet Present Value

120

Certainty Equivalent (IRR)A company is considering an investment proposal whose cost is Rs. 10000 and its economic life is 4 years. Expected cash flow and certainty factor is given. Determine IRR.


1 6667 0.902 2500 0.803 2000 0.504 12500 0.40

121

Certainty Equivalent (IRR)

(10841-10000) 841

IRR=12+ ------------------- x 2= 12 + ----- x 2

(11274-10841) 432.92

=12+3.886=15.886%


Certain Cash In Flow

D.F (10%) P V

D.F (12%) P V

1 6667 0.90 6000 0.909 5454.82 0.893 5357.412 2500 0.80 2000 0.826 1652.89 0.797 1594.393 2000 0.50 1000 0.751 751.31 0.712 711.784 12500 0.40 5000 0.683 3415.07 0.636 3177.59

11274.09 10841.17Present Value of Cash Inflow

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Evaluation of Certainty—Equivalent

This method suffers from many dangers in a large enterprise:

– First, the forecaster, expecting the reduction that will be made in his forecasts, may inflate them in anticipation.

– Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecast or to make it ultra-conservative.

– Third, by focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some good investments.

123 Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.

Risk-adjusted Discount Rate Vs. Certainty–Equivalent

The certainty—equivalent approach recognises risk in capital budgeting analysis by adjusting estimated cash flows and employs risk-free rate to discount the adjusted cash flows. On the other hand, the risk-adjusted discount rate adjusts for risk by adjusting the discount rate. It has been suggested that the certainty—equivalent approach is theoretically a superior technique.The risk-adjusted discount rate approach will yield the same result as the certainty—equivalent approach if the risk-free rate is constant and the risk-adjusted discount rate is the same for all future periods.

© Tata McGraw-Hill Publishing Company Limited, Financial Management 12 - 124

Statistical MethodsStatistical techniques are analytical tools for handling risky investments. This enable the decision-maker to make decisions under risk or uncertainty.

The concept of probability is fundamental to the use of the risk analysis techniques.

Probability may be described as a measure of someone’s opinion about the likelihood that an event will occur .

Most commonly used method is to use high, low and best guess estimates

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Measurement of Risk

Statistical Methodsa) Standard deviation methodb) Coefficient of variation methodc) Sensitivity analysisd) Simulation methode) Probability and expected value methodf) Decision Tree analysis


Measurement of RiskRisk involved in capital budgeting can be measured in absolute as well as relative terms. The absolute measures of risk include Sensitivity analysis, Simulation, and standard deviation.

The coefficient of variation is a relative measure of risk.


Sensitivity AnalysisSensitivity analysis provides information as to how sensitive the various estimated project parameters, namely selling price, cash flows, cost of capital, unit sold, and project’s economic life about estimation errors. Sensitivity analysis is essentially a ‘what if’ analysis.

For example what if labor costs are 5% lower? What if raw material double its price?, etc.

By carrying out a series of calculations it is possible to build up a picture of the nature of the risks facing the project and their impact on project profitability.


Sensitivity AnalysisAdvantageous of Sensitivity analysis:Information for decision makingTo direct search – sensitivity analysis points to some variables being more crucial than othersTo make contingency plans –managers can make contingency plans if the key parameters differ significantly from the estimates

Drawbacks of Sensitivity analysis:

The absence of any formal assignment of probabilities to the variations of the parameters is a potential limitation of sensitivity analysis

Another criticism of sensitivity analysis is that each variable is changed in isolation while all other factors remain constant. In practice factors change simultaneously


Sensitivity AnalysisSensitivity analysis provide information about cash flows normally made under three assumptions:

1) The most pessimistic – the worst2) The most likely – the expected3) The most optimistic- the best the outcomes associated with the project

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Example 1 From the under mentioned facts, compute the net present values (NPVs) of the two projects for each of the possible cash flows, using sensitivity analysis.

Particulars Project X Project Y

(’000) (’000)

Initial cash outlays (t = 0) Rs 40 Rs 40

Cash inflow estimates (t = 1 – 15)

Worst 6 0

Most-likely 8 8

Best 10 16

Required rate of return 0.10 0.10

Economic life (years) 15 15

Solution

The NPV of each project, assuming a 10 per cent required rate of return, can be calculated for each of the possible cash flows. Table A-4 indicates that the present value interest factor annuity (PVIFA) of Re 1 for 15 years at 10 per cent discount is 7.606. Multiplying each possible cash flow by Present Value Interest Factor Annuity (PVIFA), we get, (Table 1):


Table 1: Determination of NPV

Project X Project Y

Expected cash inflows

PV NPV PV NPV

WorstMost likely

Best

Rs 45,63660,84876,060

Rs 5,63620,84836,060

NilRs 60, 848

1,21,696

(Rs 40,000)20,84881,696

Table 1 demonstrates that sensitivity analysis can produce some very useful information about projects that appear equally desirable on the basis of the most likely estimates of their cash flows. Project X is less risky than Project Y. The actual selection of the project (assuming that the projects are mutually exclusive) will depend on the decision maker’s attitude towards risk. If the decision maker is conservative, he will select Project X as there is no possibility of suffering losses. On the other hand, if he is willing to take risks, he will choose Project Y as it has the possibility of paying a very high return as compared to project X. Sensitivity analysis, in spite of being crude, does provide the decision maker with more than one estimate of the project’s outcome and, thus, an insight into the variability of the returns.


Assigning Probability

It has been shown above that sensitivity analysis provides more than one estimate of the future return of a project. It is, therefore, superior to single-figure forecast as it gives a more precise idea regarding the variability of the returns. But it has a limitation in that it does not disclose the chances of occurrence of these variations. To remedy this shortcoming of sensitivity analysis so as to provide a more accurate forecast, the probability of the occurring variations should also be given. Probability assignment to expected cash flows, therefore, would provide a more precise measure of the variability of cash flows. The concept of probability is helpful as it indicates the percentage chance of occurrence of each possible cash flow.

For instance, if some expected cash flow has 0.6 probability of occurrence, it means that the given cash flow is likely to be obtained in 6 out of 10 times (i.e. 60 per cent). Likewise, if a cash flow has a probability of 1, it is certain to occur (as in the case of purchase–lease capital budgeting decision that is, the chances of its occurrence are 100 per cent). With zero probability, the cash flow estimate will never materialise. Thus, probability of obtaining particular cash flow estimates would be between zero and one.

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The procedure for assigning probabilities and determining the expected value is illustrated in Table 2 by using the NPVs for projects X and Y of Example 1.

TABLE 2 Calculation of Expected Values

Possible NPV Probability of the NPV occurrence

NPV (×) Probability

Project X

Rs 5,636 0.25 Rs 1,409

20,848 0.50 10,424

36,060 0.25 9,015

1.00 Expected NPV 20,848

Project Y

(40,000) 0.25 (10,000)

20,848 0.50 10,424

81,696 0.25 20,424

1.00 Expected NPV 20,848

The mechanism for calculating the expected monetary value and the NPV of these estimates is further illustrated in Example 2.


Example 2

The following information is available regarding the expected cash flows generated, and their probability for company X. What is the expected return on the project? Assuming 10 per cent as the discount rate, find out the present values of the expected monetary values.

Year 1 Year 2 Year 3

Cash flows Probability Cash flows Probability Cash flows Probability

Rs 3,0006,0008,000

0.250.500.25

Rs 3,0006,0008,000

0.500.250.25

Rs 3,0006,0008,000

0.250.250.50

Solution

TABLE 3 (i) Calculation of Expected Monetary Values


Cash flows

Probability

Monetary values

Cash flows

Probability

values

Monetary

Cash flows

Probability

values

Monetary

Rs 3,0006,0008,000Total

0.250.500.25

Rs 7503,0002,0005,750

Rs 3,0006,0008,000

0.500.250.25

Rs 1,5001,5002,0005,000

Rs 3,0006,0008,000

0.250.250.50

Rs 750

1,5004,0006,250


(ii) Calculation of Present Values

Year 1 Rs 5,750 × 0.909 = Rs 5,226.75

Year 2 5,000 × 0.826 4,130.00

Year 3 6,250 × 0.751 4,693.75

Total 14,050.50


Sensitivity analysis Sensitivity analysis can also be used to ascertain how change in key variables (say, sales volume, sales price, variable costs, operating fixed costs, cost of capital and so on) affect the expected outcome (measured in terms of NPV) of the proposed investment project.

For the purpose of analysis, only one variable is considered, holding the effect of other variables constant, at a point of time.

Example 6.1

Acmart plc has developed a new product line called Marts. The likely demand is 1,00,000 per year at a price of Rs. 1 for the 4 year period. Cash Flows of Mart

Initial Investment Rs. 800,000

Cash Flow per unit Rs. Sale Price 1.00

CostsLabourMaterialOverhead

Cash Flow Per unit

0.200.400.10

0.700.30

Required rate of return is 15%Solution

Annual Cash Flow =.30x1,00,000=Rs. 300,000Present Value of annual cash flows=300,000xannuity factor for 4 years @ 15% =300,000x2.855 =856,500 -Initial Investment =800,000Net Present Value =+56,500

Sensitivity Analysis

What if the price is only 95 ps

Annual Cash flow= .25x1,00,000=Rs. 250,000Present Value of annual cash flows=250,000x2.855 =713,750-Initial Investment =800,000Net Present Value =-86,250

What if the price rose by 1%Annual Cash flow= .31x1,00,000=Rs. 310,000Present Value of annual cash flows=310,000x2.855 =885,050-Initial Investment =800,000Net Present Value =+85,050

What if the quantity demanded is 5% moreAnnual Cash flow= .30x1,05,000=Rs. 315,000Present Value of annual cash flows=315,000x2.855 =899.325-Initial Investment =800,000Net Present Value =+99,325

What if the quantity demanded is 10% less than expectedAnnual Cash flow= .30x 90,000=Rs. 270,000Present Value of annual cash flows=270,000x2.855 =770,850-Initial Investment =800,000Net Present Value =-29,150

Sensitivity Analysis

What if discount rate is 20% more than what is originally expected ( 15*1.2=18%)

Annual Cash Flow =.30x1,00,000=Rs. 300,000

Present Value of annual cash flows=300,000xannuity factor for 4 years @ 18%

=300,000x2.6901 =807,030 -

Initial Investment =800,000

Net Present Value =+ 7,030

What if discount rate is 20% lower than what is originally expected ( 15*.8=13.5%)

Annual Cash Flow =.30x1,00,000=Rs. 300,000

Present Value of annual cash flows=300,000xannuity factor for 4 years @ 13.5%

=300,000x2.9438 =883,140 -

Initial Investment =800,000

Net Present Value =+ 83,140

Break-Even NPV

The Break-Even point is where NPV is zero. If the NPV is below zero the project is rejected, if it is above zero, it is accepted

Scenario Analysis

With Sensitivity Analysis we change one variable at a time and look at the result.

Managers are often interested in situation where a number of factors change.

They are interested in worst-case and best-case scenario. That is, what NPV will result if all the assumptions made initially turned out to be too optimistic? And what would be the result if, in the event, matters went extremely well on all fronts.

SimulationSimulation is a statistically based behavioral approach used in capital budgeting to get a feel for risk by applying predetermined probability distributions and random numbers to estimate risky outcomes.

A Simulation Model is akin (similar) to sensitivity analysis as it attempts to answer ‘what if’ question. Advantage of simulation is that it is more comprehensive.Instead of showing impact on NPV for change in one key variable, simulation enables the distribution of probable values for change in all key variables.Simulation requires sophisticated computing

143

Simulation Analysis• The Monte Carlo simulation or simply the simulation

analysis considers the interactions among variables and probabilities of the change in variables. It computes the probability distribution of NPV. The simulation analysis involves the following steps:– First, you should identify variables that influence cash inflows and

outflows.– Second, specify the formulae that relate variables. – Third, indicate the probability distribution for each variable.– Fourth, develop a computer programme that randomly selects one

value from the probability distribution of each variable and uses these values to calculate the project’s NPV.

144

Techniques for Risk Analysis• Statistical Techniques for Risk Analysis

– Probability

– Variance or Standard Deviation

– Coefficient of Variation

• Conventional Techniques of Risk Analysis

– Payback

– Risk-adjusted discount rate

– Certainty equivalent


Statistical MethodsStatistical techniques are analytical tools for handling risky investments. This enable the decision-maker to make decisions under risk or uncertainty.

The concept of probability is fundamental to the use of the risk analysis techniques.

Probability may be described as a measure of someone’s opinion about the likelihood that an event will occur .

Most commonly used method is to use high, low and best guess estimates


Probability• A typical forecast is single figure for a period. This is

referred to as “best estimate” or “most likely” forecast:– Firstly, we do not know the chances of this

figure actually occurring, i.e., the uncertainty surrounding this figure.

– Secondly, the meaning of best estimates or most likely is not very clear. It is not known whether it is mean, median or mode.

• For these reasons, a forecaster should not give just one estimate, but a range of associated probability–a probability distribution.

• Probability may be described as a measure of someone’s opinion about the likelihood that an event will occur.


Assigning Probability • The probability estimate, which is based on a

very large number of observations, is known as an objective probability.

• Such probability assignments that reflect the state of belief of a person rather than the objective evidence of a large number of trials are called personal or subjective probabilities.

148

Expected Net Present Value• Once the probability

assignments have been made to the future cash flows the next step is to find out the expected net present value.

• Expected net present value = Sum of present values of expected net cash flows.

= 0

ENPV = (1 )

n

tt

ENCF

k+∑

ENCF = NCF × t jt jtP

149

Variance or Standard Deviation • Simply stated,

variance measures the deviation about expected cash flow of each of the possible cash flows.

• Standard deviation is the square root of variance.

• Absolute Measure of Risk.

2 2

=1

(NCF) = (NCF – ENCF)n

j jj

Pσ ∑


Independent Cash Flows Over Time The mathematical formulation to determine the expected values of the probability distribution of NPV for any project is:

The above calculations of the standard deviation and the NPV will produce significant volume of information for evaluating the risk of the investment proposal. The calculations are illustrated in Example 6.

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Example 6

Suppose there is a project which involves initial cost of Rs 20,000 (cost at t = 0). It is expected to generate net cash flows during the first 3 years with the probability as shown in Table 7.

TABLE 7 Expected Cash Flows


Probability Net cash

flows


flows


flows

0.10 Rs 6,000 0.10 Rs 4,000 0.10 Rs 2,000

0.25 8,000 0.25 6,000 0.25 4,000

0.30 10,000 0.30 8,000 0.30 6,000

0.25 12,000 0.25 10,000 0.25 8,000

0.10 14,000 0.10 12,000 0.10 10,000

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SolutionTable 8 Calculation of Expected Values of Each Period

Time period

Probability(1)

Net cash flow(2)

Expected value (1 × 2)(3)

Year 1

Year 2

Year 3

0.100.250.300.250.10

0.100.250.300.250.10

0.100.250.300.250.10

Rs 6,0008,000

10,00012,00014,000

4,0006,0008,000

10,00012,000

2,0004,0006,0008,000

10,000

Rs 6002,0003,0003,0001,400

= 10,000400

1,5002,4002,5001,200

= 8,000200

1,0001,8002,0001,000

= 6,000

(3) NPV = Rs 10,000 (0.909) + Rs 8,000 (0.826) + Rs 6,000 (0.751) – Rs 20,000 = Rs 204.

12 - 153

Solution

1 . Expected Values: For the calculation of standard deviation for different periods, the expected values are to be calculated first. These are calculated in Table 8.

154

Coefficient of Variation

Relative Measure of Risk

It is defined as the standard deviation of the probability distribution divided by its expected value:

Coefficient of Variation (CV)=

Standard deviation/Expected Value

155

Coefficient of Variation

• The coefficient of variation is a useful measure of risk when we are comparing the projects which have– (i) same standard deviations but different expected

values, or

– (ii) different standard deviations but same expected values, or

– (iii) different standard deviations and different expected values.

156

Scenario Analysis

• One way to examine the risk of investment is to analyse the impact of alternative combinations of variables, called scenarios, on the project’s NPV (or IRR).

• The decision-maker can develop some plausible scenarios for this purpose. For instance, we can consider three scenarios: pessimistic, optimistic and expected.


Shortcomings

• The model becomes quite complex to use.

• It does not indicate whether or not the project should be accepted.

• Simulation analysis, like sensitivity or scenario analysis, considers the risk of any project in isolation of other projects.

158

Capital Asset Pricing ModelCAPM deals with how the assets or securities should be priced in capital market. CAPM attempts to understand the behavioural aspects of the capital markets. It is a conservative but balanced approach.

It provides theoretical linear relationship between risk return trade-offs of individual securities/assets to market returns.

CAPM relates returns on individual stock and stock market returns over a period of time.

Capital Asset Pricing Model

• Risky asset i:

• Its price is such that:

E(return) = Risk-free rate of return + Risk premium specific to asset i

= Rf + (Market price of risk)x(quantity of risk of asset i)

CAPM tells us 1) what is the price of risk?

2) what is the risk of asset i?

11-160

CAPITAL ASSET PRICING MODEL (CAPM) APPROACH

The CAPM describes the relationship between the required rate of return or the cost of equity capital and the non-diversifiable or relevant risk of the firm as reflected in its index of non-diversifiable risk, that is, beta. Symbolically,

Ke = Rf + b (Km – Rf ) (14)

Rf = Required rate of return on risk-free investment

b = Beta coefficient**, andKm = Required rate of return on market portfolio, that is, the average rate or return on all assets

M = Excess in market return over risk-free rate,J = Excess in security returns over risk-free rate,MJ = Cross product of M and J andN = Number of years

( )∑∑

−

−= 22 MNM

JMNMJb


Introduction• Corporate restructuring includes

mergers and acquisitions (M&As), amalgamation, takeovers, spin-offs, leveraged buy-outs, buyback of shares, capital reorganisation etc.

• M&As are the most popular means of corporate restructuring or business combinations.

Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.

Motives and Benefits of Mergers and Acquisitions

Utilise under-utilised resources–human and physical and managerial skills.

Displace existing management.Circumvent government regulations.Reap speculative gains attendant upon new

security issue or change in P/E ratio.Create an image of aggressiveness and

strategic opportunism, empire building and to amass vast economic powers of the company.

163Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.

Benefits of Mergers and Acquisitions

The most common advantages of M&A are:Accelerated GrowthEnhanced Profitability

Economies of scale Operating economies Synergy

Diversification of Risk



Reduction in Tax Liability Financial Benefits

Financing constraint Surplus cash Debt capacity Financing cost

Increased Market Power


Costs of Mergers and Acquisitions External growth could be expensive if the

company pays an excessive price for merger. Price may be carefully determined and negotiated so that merger enhances the value of shareholders.

166

29-166

A Cost to Stockholders from Reduction in Risk

In a firm with debt, the gains are likely to be shared by both bondholders, and stock holders. The benefit gained by bond holders are on the expense of stock holders.

The gains to the creditors are at the expense of the shareholders if the total value of the firm does not change.

An acquisition can create an appearance of earnings growth, which may fool investors into thinking that the firm is worth than it really is.


29-167

A Cost to Stockholders from Reduction in Risk

The Base Case If two all-equity firms merge, there is no transfer of

synergies to bondholders, but if…

One Firm has Debt The value of the levered shareholder’s call option

falls.

How Can Shareholders Reduce their Losses from the Coinsurance Effect? Retire debt pre-merger.


Benefits of Mergers and AcquisitionsThe most common advantages of M&A are:

Accelerated Growth

A company can achieve its growth objective by: Expanding its existing markets Entering into new markets

Mergers results into accelerated growth Enhanced Profitability

Combination of two or more companies may result in more than the average profitability due to cost reduction and efficient utilization of resources. This may happen because of the following reasons:

Economies of scale Operating economies Synergy



Economies of scaleEconomics of scale arises when increase in the volume of production

leads to the decrease in cost of production per unit. Mergers may help to expand volume of production without a corresponding increase in fixed cost. It also helps in

Optimum utilization of management resources and systems and planning

Budgeting Reporting and control

Operating economies A combine firm may avoid or reduce overlapping functions and

facilities

It can consolidate functions such as manufacturing, marketing, R&D and reduce operating costs

Vertical integration (backward integration or forward integration) leads to better business operations- purchasing, manufacturing, and marketing.


Benefits of Mergers and AcquisitionsSynergy

Synergy implies a situation where the combined firm is more valuable than the sum of the individual combining firms. Operating economics are one form of synergy benefit. There is also

enhanced managerial capabilities, Creativity, Innovativeness R&D and market coverage capacity


Benefits of Mergers and Acquisitions Diversification of Risk

Diversification implies growth through the combination of firms in unrelated businesses. Such mergers are called conglomerate mergers. Such mergers results in

reduction in non- systematic risks –company related risks with out taking any efforts by the investors to diversify their portfolio.

Reduction in Tax –liability

A company is allowed to carry forward their accumulated loss. The combined company can make use of this carry forward facility of the loss of loss making company after merger.


Benefits of Mergers and AcquisitionsFinancial Benefits

A merger may help in : Eliminating the financial constraint Deploying surplus cash Enhancing dept capacity Lowering the financial cost

Increased Market Power A merger can increase the market share of the merged

firm that will improve the profitability The bargaining power vis-a-vis labour, suppliers, and

buyers is also increased Exploit technological advantage

Corporate Restructuring

Corporate restructuring implies activities related to

expansion/ contraction of a firm’s operations or

changes in its assets or financial or ownership

structure.

The most common forms of corporate restructuring are

mergers/amalgamations and acquisitions/takeovers,

financial restructuring, divestitures/demergers and

buyouts.

FORMS OF EXPANSION

Internal Expansion

Gradual increase in the activities of the concern – expand production capacity by adding m/c etc.

External Expansion or Business Combinations

Two or more companies combine and expand their business activities. The ownership and control of the combining concerns may be undertaken by single agency.

FORMS OF COMBINATIONS

Merger or AmalgamationA merger is a combination of two or more companies into one company. It may be in the form of one or more companies being merged into an existing company or a new company may be formed to merge two or more existing companies. Absorption

A combination of two or more companies into an existing company is known as absorption. Consolidation

A consolidation is a combination of two or more companies into a new company.

Acquisition and Take-overAcquiring company takes over the ownership of one or more other companies and combine their operations. The control over management of another company can be acquired through either a ‘friendly take-over’ or through ‘forced’ or ‘unwilling acquisition’.Holding CompaniesA holding company is a form of business organization which is created for the purpose of combining industrial units by owning a controlling amount of their share capital.

FORMS OF COMBINATIONS ..

Acquisition

A transaction where one firm buys another firm with the intent of more effectively using a core competence by making the acquired firm a subsidiary within its portfolio of businesses


Takeover vs. Acquisitions Takeover – The term takeover is understood to connote hostility. When an acquisition is a ‘forced’ or ‘unwilling’ acquisition, it is called a takeover.A holding company is a company that holds more than half of the nominal value of the equity capital of another company, called a subsidiary company, or controls the composition of its Board of Directors. Both holding and subsidiary companies retain their separate legal entities and maintain their separate books of accounts.


Takeover vs. Acquisitions Acquisition may be defined as an act of acquiring effective control over assets or management of a company by another company without any combination of businesses or companies. A substantial acquisition occurs when an acquiring firm acquires substantial quantity of shares or voting rights of the target company.


Types of Business Combination

Merger or Amalgamation– Merger or amalgamation may take two forms:

• Absorption is a combination of two or more companies into an existing company.

• Consolidation is a combination of two or more companies into a new company.

– In merger, there is complete amalgamation of the assets and liabilities as well as shareholders’ interests and businesses of the merging companies. There is yet another mode of merger. Here one company may purchase another company without giving proportionate ownership to the shareholders’ of the acquired company or without continuing the business of the acquired company.


Types of Business CombinationForms of Merger:

– Horizontal merger - Combination of two or more firms in similar type of production, distribution, or area of business

– Vertical merger - Combination of two or more firms involved in different stages of production or distribution.

– Conglomerate merger - Combination of firms engaged in unrelated lines of business activity.

Mergers and Takeovers

When two companies join to form one new firm, it can be:

voluntary, also known as a ‘merger’

orforced, when it is known

as a ‘takeover’

Merger

A transaction where two firms agree to integrate their operations on a relatively coequal basis so they have resources and capabilities that together may create a stronger competitive advantage

Merger activity is an example of ‘integration’ taking place within industries.

Mergers

While a merger is a combination of two or more firms in which the resulting firm maintains the identity of one of the firms only, an amalgamation involves the combination of two or more firms to form a new firm. In the case of merger/absorption, the firm that has been acquired/absorbed is known as the target firm and the firm that acquires is known as the acquiring firm. There are three types of mergers:

1) Horizontal,

2) Vertical and

3) Conglomerate.

Horizontal merger is a merger when two or

more firms dealing in similar lines of activity

combine together.

Vertical merger is a merger that involves two

or more stages of production/distribution that

are usually separate.

Conglomerate merger is a merger in which

firms engaged in different unrelated activities

combine together.

Why Integrate?

Firms are sometimes keen to merge when:

they can make savings from being bigger this is known as gaining ‘economies

of scale’ they can compete with larger firms

or eliminate competition they can spread production over

a larger range of products or services

Economics of MergerThe major economic advantages of a merger are:

1) Economies of scale,

2) Synergy,

3) Fast growth,

4) Tax benefits and

5) Diversification.

Synergy takes place as the combined value of the merged firm is likely to be greater than the sum of individual business entities.

The combined value = value of acquiring firm, VA + value of target firm, Vt + value of synergy, ΔVAT. (1)

In ascertaining the gains from the merger, costs associated with acquisition should be taken into account. Therefore, the net gain from the merger is equal to the difference between the value of synergy and costs:

Net gain = ΔVAT – costs (2)

Economies of ScaleThere are several types of economy

of scale: technical economies, when producing the good by

using expensive machinery intensively managerial economies,

by employing specialist managers financial economies, by borrowing

at lower rates of interest commercial economies,

by buying materials in bulk marketing economies, spreading the cost of

advertising and promotion

research and development economies, from developing better products

Economies of ScaleThere are sometimes problems

that can affect integrated firms. These are known as ‘diseconomies of scale’

firms are too big to operate effectively

decisions take too long to make poor communication occurs

Mergers, Acquisition and Takeovers

The two terms - ‘mergers’ and ‘acquisition’ represent the ways by strategies used by companies to buy, sell and recombine businesses. In the present day when there exists cut throat competition in every sphere, not all mergers and acquisitions are consensual and peaceful.

The concept of takeovers without consent have, therefore been ideally termed “hostile takeovers”. no consented.

Legal and Regulatory Framework for Takeovers in India

The term “acquirer” means any person who, directly or indirectly, acquires or agrees to acquire control over the target company, or acquires or agrees to acquire control over the target company, either by himself or with any person acting in concert with the acquirer

Tender Offer and Hostile Takeover

A tender offer is a formal offer to purchase a given number of a company’s shares at a specific price.

Tender offer can be used in two situations. First, the acquiring company may directly

approach the target company for its takeover. If the target company does not agree, then the acquiring company may directly approach the shareholders by means of a tender offer.

Second, the tender offer may be used without any negotiations, and it may be tantamount to a hostile takeover.

Permission for merger Information to the stock exchange Approval of board of directors Application in the High Court Shareholders’ and creditors’ meetings Sanction by the High Court Filing of the Court orderTransfer of assets and liabilities Payment by cash or securities

Legal Procedures for merger

1. Permission for mergerTwo or more companies can amalgamate only when

amalgamation is permitted under their memorandum of association. Also, the acquiring company should have the permission in its object clause to carry on the business of the acquired company.

2. Information to the stock exchange The acquiring and the acquired companies should inform

the stock exchanges where they are listed about the merger

3. Approval of board of directors The board of directors of the individual companies should

approve the draft proposal for amalgamation and authorize the management of companies to further persue the proposal.

Legal Procedures for merger

Legal Procedures for merger .. 4. Application in the High Court An application for approving the draft amalgamation proposal duly approved by the boards of directors of the individual companies should be made to the high court. High court would convene a meeting of the shareholders and creditors to approve the amalgamation proposal.5. Shareholders’ and creditors’ meetings At least 75% of shareholders and creditors in separate meeting, voting in person or by proxy, must accord their approval to the scheme6. Sanction by the High Court After the approval of shareholders and the creditors, on the petitions of the companies, the High court will pass order sanctioning the amalgamation scheme after it is satisfied that the scheme is fair and reasonable.

Legal Procedures for merger .. 7. Filing of the Court orderAfter the court order, its certified true copies will be filed with the Registrar of companies.

8. Transfer of assets and liabilitiesThe assets and liabilities of the acquired company will be transferred to the acquiring company in accordance with the approved scheme, with effect from the specified date

9. Payment by cash or securitiesAs per the proposal, the acquiring company will exchange shares and debentures and/or pay cash for the shares and debentures of the acquired company. These securities will be listed on the stock exchange.


Accounting for Mergers and Acquisitions

Pooling of Interests Method In the pooling of interests method of accounting, the

balance sheet items and the profit and loss items of the merged firms are combined without recording the effects of merger. This implies that asset, liabilities and other items of the acquiring and the acquired firms are simply added at the book values without making any adjustments.

Purchase Method Under the purchase method, the assets and liabilities of

the acquiring firm after the acquisition of the target firm may be stated at their exiting carrying amounts or at the amounts adjusted for the purchase price paid to the target company.


The term “acquirer” means any person who, directly or indirectly, acquires or agrees to acquire control over the target company, either by himself or with any person acting in concert with the acquirer.

The Takeover Code makes it difficult for the hostile acquirer to just sneak up on the target company. It forewarns the company about the advances of an acquirer by mandating that the acquirer make a public disclosure of his shareholding or voting rights to the company if he acquires shares or voting rights beyond a certain specified limit. The Takeover Code also imposes a prohibition on the certain actions of a target company during the offer period, such as transferring of assets or entering into material contracts and even prohibits the issue of any authorized but unissued securities during the offer period. However, these actions may be taken with approval from the general body of shareholders.



The regulation provides for certain exceptions such as the right of the company to issue shares carrying voting rights upon conversion of debentures already issued or upon exercise of option against warrants, according to pre-determined terms of conversion or exercise of option. It also allows the target company to issue shares pursuant to public or rights issue in respect of which the offer document has already been filed with the Registrar of Companies or stock exchanges, as the case may be. Further the law does not permit the Board of Director, of the target company to make such issues without the shareholders approval either prior to the offer period or during the offer period as it is specifically prohibited under Regulation 23.


The Takeover Code is required to be read with the SEBI (Disclosure & Investor Protection) Guidelines, which are the nodal regulations for the methods and terms of issue of shares/warrants by a listed Indian company.

Under the DIP guidelines, issuing shares at a discount and warrants which convert to shares at a discount is not possible as the minimum issue price is determined with reference to the market price of the shares on the date of issue or upon the date of exercise of the option against the warrants.


Also, the FDI policy and the FEMA Regulations have provisions which restrict non-residents from acquiring listed shares of a company directly from the open market in any sector, including sectors falling under automatic route. There also exist certain restrictions with respect to private acquisition of shares by non-residents. This has practically sealed any hostile takeover of any Indian company by any non-resident

Reasons for strategic failures of merger/acquisition

1. The strategy is misguided- Strategic plans which turned out to be value destroying rather creating

2. Over optimism - Acquiring managers have to cope with uncertainty about the future potential of their acquisition. It is possible for them to be over optimistic about the market economics, the competitive position and the operating synergies available

3. Failure of Integration Management- One problem is the over-rigid adherence to prepared integration plans. Usually the plans require dynamic modification in the light of experience and altered circumstances. The integration programme may have been based on incomplete information and may need post-merger adaptation to the new perception of reality.

Reasons for strategic failures of merger/acquisition

Most common causes of failure Most common causes of success

Target management attitudes and cultural difference

Little of no post-acquisition planning

Lack of knowledge of industry or target

Poor management and poor management practices in the acquired company

Little or no experience of acquisitions

Detailed post-acquisition plans and speed of implementation

A clear purpose for making acquisitions

Good cultural fit

High degree of management co-opertion

In-depth knowledge of the acquiree and his industry

Reasons for failures of merger/acquisition

There are several reasons merger or an acquisition failures. Some of the prominent causes are summarized below:

If a merger or acquisition is planned depending on the (bullish) conditions prevailing in the stock market, it may be risky.

There are times when a merger or an acquisition may be effected for the purpose of "seeking glory," rather than viewing it as a corporate strategy to fulfill the needs of the company.

Regardless of the organizational goal, these top level executives are more interested in satisfying their "executive ego."

Failure may also occur if a merger takes place as a defensive measure to neutralize the adverse effects of globalization and a dynamic corporate environment.

Failures may result if the two unifying companies embrace different "corporate cultures.“

The primary issue to focus on is how realistic the goals of the prospective merger are

207

Financing a Merger Cash or exchange of shares or combination of cash, shares and debt can finance a merger or acquisition.The means of financing may change the debt-equity mix of the combined or acquired firm after merger.

208

Financing a Merger Cash Offer:A cash offer is a straightforward means of financing a merger. The share holders of the target company get cash for selling their shares to the acquiring company.It does not cause any dilution in the earnings per share and the ownership of the existing shareholders of the acquiring company.Share Exchange:A share exchange offer will result into the sharing of ownership of the acquiring company between its existing shareholders and new shareholders (that is, shareholders of the acquired company). The earnings and benefits would also be shared between these two groups of shareholders. The precise extent of net benefits that accrue to each group depends on the exchange ratio in terms of the market prices of the shares of the acquiring and the acquired companies.

Swap Ratio

The ratio in which an acquiring company will offer its own

shares in exchange for the target company's shares during a

merger or acquisition. To calculate the swap ratio, companies

analyze financial ratios such as book value, earnings per

share, profits after tax and dividends paid, as well as other

factors, such as the reasons for the merger or acquisition.

For example, if a company offers a swap ratio of 1:1.5, it will provide one

share of its own company for every 1.5 shares of the company being

acquired.

This can also be applied as a debt/equity swap, when a company wants

investors to trade their bonds with the company being acquired for the

acquiring company's own shares.

Swap Ratio

Example: SFC would be offering 18.34 crore share for

25 crore outstanding shares of Excell, which means

0.734 share of SFC for one share of Excell or

Swap ratio of 0.734:1.


Share Exchange Ratio

The mergers and acquisitions decisions are also evaluated in terms of EPS, P/E ratio, book value etc.Share Exchange RatioThe share exchange ratio (SER) would be as follows:

The exchange ratio in terms of the market value of shares will keep the position of the shareholders in value terms unchanged after the merger since their proportionate wealth would remain at the pre-merger level.

Share price of the acquired firmShare exchange ratio

Share price of the acquiring firmb

a

P

P= =

Swap Ratio

Example: If the share price of acquired firm is 24.00 and

that of acquiring firm is 96.00, the Share Exchange Ratio

(SER) is calculated as:

SER= 24.0/96.0 = 0.25

If the pre-merger number of shares of acquired firm is

4,000, then

Share price of the acquired firmShare exchange ratio

Share price of the acquiring firmb

a

P

P= =

No. of shares exchanged SER Pre-merger number of shares of the acquired firm

( / ) 0.25 4,000 1,000b a bP P N

= ×= = × =

PAT PATPost-merger combined PATPost-merger combined EPS =

Post-merger combined shares (SER)a b

a bN N

+=

+


Earnings Growth

The formula for weighted growth in EPS can be expressed as follows:Weighted Growth in EPS = Acquiring firm’s growth × (Acquiring firm’s pre-merger PAT/combined firm’s PAT) + Acquired firm’s growth × (Acquired firm’s pre-merger PAT/combined firm’s PAT).

PAT PAT

PAT PATa b

w a bc c

g g g= × + ×


Corporate restructuring is the process of redesigning one or more aspects of a company. The process of reorganizing a company may be implemented due to a number of different factors, such as positioning the company to be more competitive, survive a currently adverse economic climate, or poise the corporation to move in an entirely new direction. Restructuring a corporate entity is often a necessity when the company has grown to the point that the original structure can no longer efficiently manage the output and general interests of the company.


For example, a corporate restructuring may call for spinning off some departments into subsidiaries as a means of creating a more effective management model as well as taking advantage of tax breaks that would allow the corporation to divert more revenue to the production process. In general, the idea of corporate restructuring is to allow the company to continue functioning in some manner.

Financial Restructuring

Financial restructuring may take place in response to a drop in sales, due to a sluggish economy or temporary concerns about the economy in general.When this happens, the corporation may need to reorder finances as a means of keeping the company operational through this rough time. Costs may be cut by combining divisions or departments, reassigning responsibilities and eliminating personnel, or scaling back production at various facilities owned by the company. With this type of corporate restructuring, the focus is on survival in a difficult market rather than on expanding the company to meet growing consumer demand.

Distress Restructuring

Distress Restructuring is used to indicate the corporate turnaround from severe financial distress through methods such as Debt/Equity Restructuring, Working Capital Management and corporate Valuation.Distress causes due to illiquidity due to poor structuring or working capital at various levels (vix work-in-progress, bills receivables etc.) of business. Such companies must undertake restructuring strategies (incentives for early payment, delaying in payments to creditors etc.) and activities to come out of this situation.

Financial Distress

Financial distress arises when a firm is not able to meet its obligations (payment of interest and principal) to debt-holders. The firm’s continuous failure to make payments to debt holders can ultimately lead to the insolvency of the firm.With higher business risk and higher debt, the probability of financial distress become much greater. The degree of business risk of a firm depends on the degree of operating leverage (the proportion of fixed costs).

219

BUSINESS VALUTIONThe term ‘valuation’ implies the estimated worth of an asset or a security or a business. The alternative approaches to value a firm/an asset are:

Book value, Market value, Intrinsic value, Liquidation value, Replacement value, Salvage value Value of Goodwill Fair value.

32 - 220

Book ValueThe book value of an asset refers to the amount at which an asset is shown in the balance sheet of a firm. Generally, the sum is equal to the initial acquisition cost of an asset less accumulated depreciation. Accordingly, this mode of valuation of assets is as per the going con-cern principle of accounting. In other words, book value of an asset shown in balance does not reflect its current sale value.Book value of a business refers to total book value of all valuable assets (excluding fictitious assets, such as accumulated losses and deferred revenue expenditures, like advertisement, preliminary expenses, cost of issue of securities not written off) less all external liabilities (including preference share capital). It is also referred to as net worth.

© Tata McGraw-Hill Publishing Company Limited, Financial Management 25-221

LeaseLease is a contractual arrangement under which the owner of an asset (lessor) allows the use of the asset to the user (lessee) for an agreed period of time (lease period) in consideration for the periodic payment (lease rent). At the end of the lease period, the asset reverts back to the owner, unless there is a provision for the renewal of the lease contract.


Essential Elements

Parties to the Contract

There are essentially two parties to a contract of lease financing, namely, the owner and the user, called the lessor and the lessee, respectively.

Lessor is the owner of the assets that are being leased.

Lessee is the receiver of the services of the assets under a lease contract.

Assets

The assets, property or equipment to be leased is the subject matter of a lease financing contract. The asset may be an automobile, plant and machinery, equipment, land and building, factory, a running business, an aircraft and so on. The asset must, however, be of the lessee’s choice, suitable for his business needs.

Ownership Separated from User

The essence of a lease financing contract is that during the lease tenure, ownership of the asset vests with the lessor and its use is allowed to the lessee. On the expiry of the lease tenure, the asset reverts to the lessor.


Term of Lease

The term of lease is the period for which the agreement of lease remains in operation. Every lease should have a definite period, otherwise it will be legally inoperative. The lease period may sometimes stretch over the entire economic life of the asset (i.e. financial lease) or a period shorter than the useful life of the asset (i.e. operating lease). The lease may be perpetual, that is, with an option at the end of lease period to renew the lease for the further specific period.

Lease Rentals

The consideration that the lessee pays to the lessor for the lease transaction is the lease rental. Lease rentals are structured so as to compensate (in the form of depreciation) the lessor for the investment made in the asset, and for expenses like interest on the investment, repairs and servicing charges borne by the lessor over the lease period.


Modes of Terminating the Lease :

At the end of the lease period, the lease is terminated and various

courses are possible, namely,.

a) The lease is renewed on a prepetual basis or for a definite

period, or

b) The asset reverts to the lessor, or

c) The asset reverts to the lessor and the lessor sells it to a

third party or

d) The lessor sells the asset to the lessee.

The parties may mutually agree to and choose any of the

aforesaid alternatives at the beginning of a lease term.


Classification

An equipment lease transaction can differ on the basis of

1) the extent to which the risks and rewards of ownership are transferred,

2) number of parties to the transactions,

3) domiciles of the equipment manufacturer, the lessor, the lessee and so on.

Risk, with reference to leasing, refers to the possibility of loss arising on account of under-utilisation or technological obsolescence of the equipment, while reward means the incremental net cash flows that are generated from the usage of the equipment over its economic life and the realisation of the anticipated residual value on expiry of the economic life. On the basis of these variations, leasing can be classified into the following types:

Finance lease and Operating lease,

A. Sales and lease back and Direct lease,

B. Single investor lease and Leveraged lease and

C. Domestic lease and International lease.


(a) Finance Lease and Operating Lease

Finance Lease

According to the International Accounting Standards (IAS-17), in a finance lease the lessor transfers, substantially all the risks and rewards incidental to the ownership of the asset to the lessee, whether or not the title is eventually transferred. It involves payment of rentals over an obligatory non-cancellable lease period, sufficient in total to amortise the capital outlay of the lessor and leave some profit.


The IAS-17 stipulates that a substantial part of the ownership related risks and rewards in leasing are transferred when

1) The ownership of the equipment is transferred to the lessee by the end of the lease firm; or

2) The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair market value at the date the option becomes exercisable and if at the inception of the lease it is reasonably certain that the option will be exercised; or

3) The lease term is for a major part of the useful life of the asset; the title may not eventually be transferred. The useful life of an asset refers to the minimum of its (i) physical life in terms of the period for which it can perform its function, (ii) technological life in the sense of the period in which it does not become obsolete and (iii) product market life defined as the period during which its product enjoys a satisfactory market. The criterion/cut-off point is that if the lease term exceeds 75 per cent of the useful life of the equipment, it is a finance lease or


4. The present value of the minimum lease payment is greater than, or substantially equal to, the fair market value of the asset at the inception of the lease (cost of equipment). The title may or may not be eventually transferred.

The cut-off point is that the present value exceeds 90 per cent of the fair market value of the equipment. The present value should be computed by using a discount rate equal to the rate implicit in the lease, in the case of the lessor, and the incremental rate in the case of the lessee.


According to the Accounting Standard (AS)-19:

Risks include the possibility of losses from the idle capacity or technological obsolescence and of variation in return due to changing economic conditions. Rewards may be represented by the expectation of profitable operation over the economic life of the asset and of gain from appreciation in the value of the residual value that has been realised.

A lease is classified as a finance lease if it transfers substantially all the risk and rewards incidental to ownership. Title may or may not eventually be transferred.


A finance lease is structured to include the following features:

1)The lessee (the intending buyer) selects the equipment according to his requirements, from its manufacturer or distributor;

2)The lessee negotiates and settles with the manufacturer or distributor, the price, the delivery schedule, installation, terms of warranties, maintenance and payment and so on;

3)The lessor purchases the equipment either directly from the manufacturer or distributor (under straight foward leasing) or from the lessee, after the equipment is delivered (under sale and lease back);

4)The lessor then leases out the equipment to the lessee. The lessor retains the ownership while lessee is allowed to use the equipment;

5)A finance lease may provide a right or option, to the lessee, to purchase the equipment at a future date. However, this practice is rarely found in India;


5. The lease period spreads over the expected economic life of the asset. The lease is originally for a non-cancellable period called the primary lease period during which the lessor seeks to recover his investment alongwith some profit. During this period, cancellation of lease is possible only at a very heavy cost. Thereafter, the lease is subject to renewal for the secondary lease period, during which rentals are substantially low;

6. The lessee is entitled to exclusive and peaceful use of the equipment during the entire lease period, provided he pays the rentals and complies with the terms of the lease;

7. As the equipment is chosen by the lessee, the responsibility of its suitability, the risk of obsolescence and the liability for repair, maintenance and insurance of the equipment rest with the lessee.


Operating LeaseAn operating lease is one that is not a finance lease. In a operating lease, the lessor does not transfer all the risks and rewards incidental to the ownership of the asset and the cost of the asset is not fully amortised during the primary lease period. The lessor provides services (other than the financing of the purchase price) attached to the leased asset, such as maintenance, repair and technical advice. For this reason, an operating lease is also called a ‘service lease’.


An operating lease is structured with the following features:

1) An operating lease is generally for a period significantly shorter than the economic life of the leased asset. In some cases, it may be even on an hourly, daily, weekly or monthly basis. The lease is cancellable by either party during the lease period.

2) Since the lease periods are shorter than the expected life of the asset, the lease rentals are not sufficient to totally amortise the cost of assets.

3) The lessor does not rely on the single lessee for recovery of his investment. His ultimate interest is in the residual value of the asset. The lessor bears the risk of obsolescence, since the lessee is free to cancel the lease at any time;

4) Operating leases normally include a maintenance clause requiring the lessor to maintain the leased asset and provide services such as insurance, support staff, fuel and so on.


Examples of operating leases are:

a) Providing mobile cranes with operators;b) Chartering of aircrafts and ships, including the

provision of crew, fuel and support services;c) Hiring of computers with operators;d) Hiring a taxi for a particular travel, which includes

service of the driver, provision for main-tenance, fuel, immediate repairs and so on.


(b) Sale and Lease Back

Sale–Lease Back

Sale-lease back is a lease under which the lessee sells an asset for cash to a prospective lessor and then leases back the same asset, making fixed periodic payments for its use.


Direct Lease

Direct lease is a lease under which a lessor owns/acquires the assets that are leassed to a given lessee. A direct lease can be of two types: bipartite and tripartite lease.

Bipartite Lease

There are two parties in this lease transaction, namely,

1) the equipment supplier-cum-lessor and 2) the lessee. Such a lease is typically structured as an

operating lease with inbuilt facilities like upgradation of the equipment (Upgrade lease), addition to the original equipment configuration and so on.

Direct Lease


Tripartite Lease

Such a lease involves three different parties in the lease agreement:

1) the equipment supplier, 2) the lessor and 3) the lessee. An innovative variant of the tripartite lease is the

sales-aid lease under which the equipment supplier arranges for lease finance in various forms by:

Providing reference about the customer to the leasing company;

Negotiating the terms of the lease with the customer and completing all the formalities on behalf of the leasing company;

Writing the lease on his own account and discounting the lease receivables with the designated leasing company. The effect is that the leasing company owns the equipment and obtains an assignment of the lease rental.


(c) Single Investor Lease and Leveraged LeaseSingle Investor Lease

There are only two parties to this lease transaction: the lessor and the lessee. The leasing company (lessor) funds the entire investment by an appropriate mix of debt and equity funds. The debt raised by the leasing company to finance the asset are without recourse to the lessee, that is, in the case of default in servicing the debt by the leasing company, the lender is not entitled to payment from the lessee.

Leveraged Lease

There are three parties to the transaction: (i) the lessor (equity investor), (ii) the lender and (iii) the lessee. In such a lease, the leasing company (equity investor) buys the asset through substantial borrowing, with full recourse to the lessee and any recourse to it. The lender (loan participant) obtains an assignment of the lease and the rentals to be paid by the lessee as well as first mortgage assets on the leased asset. The transaction is routed through a trustee who looks after the interests of the lender and lessor. On receipt of the rentals from the lessee, the trustee remits the debt-service component of the rental to the loan participant and the balance to the lessor.


To illustrate, assume the Hypothetical Ltd (HLL) has structured a leveraged lease with an investment cost of Rs 50 crore. The investment is to be financed by equity from the company and loan from the Hypothetical Bank Ltd (HBL) in the ratio of 1:5. The interest on loan may be assumed to be 20 per cent per annum, to be repaid in five equated annual instalments. If the required rate of return (gross yield) of the HLL is 24 per cent, calculate (i) the equated annual instalment and (ii) the annual lease rental.


(d) Domestic Lease and International LeaseDomestic Lease

Domestic lease is a lease transaction if all parties to the agreement are domiciled in the same country.

International Lease

International lease is a lease transaction if all parties to the agreement are domiciled in different countries. This type of lease is further sub-classified into (1) the import lease and (2) the cross-border lease.

Import Lease

In an import lease, the lessor and the lessee are domiciled in the same country but the equipment supplier is located in a different country. The lessor imports the asset and leases it to the lessee

Cross-Border Lease

When the lessor and the lessee are domiciled in different countries, the lease is classified as cross-border lease. The domicile of the supplier is immaterial.


Significance

Advantage of Leasing: To the Lessee

Financing of Capital Goods

Lease financing enables the lessee to avail of finance for huge investments in land, building, plant, machinery, heavy equipment, and so on, upto 100 per cent, without requiring any immediate down payment.

Additional Sources of Finance

Leasing facilitates the acquisition of equipment, plant and machinery without the necessary capital outlay and, thus, has a competitive advantage of mobilising the scarce financial resources of a business enterprise. It enhances the working capital position and makes available the internal accruals for business operations.

Less Costly

Leasing as a method of financing is less costly than other alternatives available.

Ownership Preserved

Leasing provides finance without diluting the ownership or control of the promoters.


Flexibility in Structuring of Rentals

Some of the ways to structure lease rentals are illustrated below.

The following data relate to the Hypothetical Leasing Ltd:

(1) Investment outlay/cost, Rs 100 lakh(2) Pre-tax required rate of return, 20 per cent per annum(3) Primary lease period, 5 years(4) Residual value (after primary period), Nil(5) Assumptions regarding alternative rental structures:

(A) Equated/Level(B) Stepped (15 per cent increase per annum),(C) Ballooned (annual rental of Rs 10 lakh for years, 1–4),(D) Deferred (deferment period of 2 years)

The annual lease rentals under the above four alternatives are computed below

Avoids Conditionalities

Lease finance is considered preferable to institutional finance as in the former case there are no strings attached. Lease financing is beneficial since it is free from restrictive covenants and conditionalities, such as representation on the board, conversion of debt into equity, payment of dividend and so on, which usually accompany institutional finance and term loans from banks.


(A) Equated Annual Lease Rental (Y):

Y = Y PVIFA [at 20 per cent for 5 years (20,5) = Rs 100 lakh ×

= (Rs 100 lakh / 2.991) = Rs 33.43 lakh

(B) Stepped Lease Rental (assuming 15 per cent increase annually):

Y = Y PVIF (20,1) + (1.15)Y PVIF (20,2) + (1.15)× × 2Y PVIF (20,3) + × (1.5)3Y PVIF (20,4) + (1.5)× 4Y PVIF (20,5) = Rs 100 lakh×

= 8.33Y + 0.798Y (0.694 1.15Y) + 0.764Y (0.579 1.32Y) + 0.733Y× ×

(0.482 1.52Y) + 0.703Y (0.402 1.75Y)× ×

= (0.482 1.52 Y) + 0.703 (0.402 1.75 Y) = 3.833Y = Rs 100 lakh× ×

Y = Rs 26.10 lakh, where Y denotes the annual rental in year 1.

The lease rentals in different years over the lease term will be: Year 2,

Rs.30.02 lakh; Year 3, Rs 34.52 lakh; Year 4, Rs 39.70 lakh; an Year 5, Rs 45.65 lakh.


C) Ballooned Leased Rental (Rs 10 lakh for years 1–4):

Y = [10 × PVIFA (20,4) + Y × PVIF (20,5)] = Rs 100 lakh

Y = Rs 100 lakh – Rs 25.9 lakh

or Y = (Rs 74.10 lakh ÷ 0.402) = Rs 184.33 lakh, where Y denotes

the ballooned payment in year 5.

(D) Deferred Lease Rental (deferment of 2 years):

Denoting Y as the equated annual rental to be charged between years 3-5,

Y = Y × PVIF (20,3) + Y × PVIF (20,4) + Y × PVIF (20,5) =

Rs 100 lakh

1.463 Y = Rs 100 lakh

Y = Rs 68.35 lakh


Simplicity

A lease finance arrangement is simple to negotiate and free from cumbersome procedures with faster and simple documentation

Tax Benefits

By suitable structuring of lease rentals, a lot of tax advantage can be derived

Obsolescence Risk is Averted

In a lease arrangement, the lessor, being the owner, bears the risk of obsolescence and the lessee is always free to replace the asset with the latest technology.


To the Lessor

Full Security The lessor’s interest is fully secured since he is always the owner of the leased asset and can take repossession of the asset if the lessee defaults.

Tax Benefit The greatest advantage of the lessor is the tax relief by way of depreciation.

High Profitability The leasing business is highly profitable since the rate of return is more than what the lessor pays on his borrowings.

Trading on Equity The lessor usually carrys out his operations with greater financial leverage. That is, he has a very low equity capital and use a substantial amount of borrowed funds and deposits. Thus, the ultimate return on equity is very high.

High Growth Potential The leasing industry has a high growth potential. Lease financing enables the lessees to acquire equipment and machinery even during a period of depression, since they do not have to invest any capital. Leasing, thus, maintains the economic growth even during a recessionary period.


Limitations of Leasing

Restrictions on Use of Equipment A lease arrangement may impose

certain restrictions on use of the equipment, acquiring compulsory

insurance and so on.

Limitations of Financial Lease A financial lease may entail a higher

payout obligation if the equipment is not found to be useful and the

lessee opts for premature termination of the lease agreement.

Loss of Residual Value The lessee never becomes the owner of the

leased asset. Thus, he is deprived of the residual value of the asset

and is not even entitled to any improvements done by the lessee or

caused by inflation or otherwise, such as appreciation in value of

leasehold land.


Consequence of Default If the lessee defaults in complying with any

terms and conditions of the lease contract, the lessor may terminate

the lease and take over the possession of the leased asset.

Understatement of Lessee’s Asset Since the leased asset does not

form part of the lessee’s assets, there is an effective understatement

of his assets, which may sometimes lead to gross underestimation

of the lessee.

Double Sales Tax With the amendment of the sales tax law of

various States, a lease financing transaction may be charged sales

tax twice—once when the lessor purchases the equipment and again

when it is leased to the lessee.


Financial Evaluation of Leaseing

The process of financial appraisal in a lease transaction generally involves three steps:

1) appraisal of the client, in terms of his financial strength and credit worthiness;

2) evaluation of the security/collateral security offered and

3) financial evaluation of the proposal. The most critical part of a leasing transaction, both to the lessor and the lessee, is the financial evaluation of the proposal.


Lessee’s Perspective

Finance lease can be evaluated from the point of view of both the lessee and the lessor. From the perspective of the lessee, leasing should be evaluated as a financing alternative to borrow and buy. The decision-criterion requires comparison of the present value (PV) of cash outflows after taxes under the leasing option vis-á-vis borrowing-buy alternative. The alternative with the lower PV should be selected.

The Net Advantage of Leasing (NAL) approach is the alternate approach to evaluate finance lease. The benefits from leasing are compared with cost of leasing.

The benefits from leasing are:

1) Investment cost of asset (saved), 2) Plus PV of tax shield on lease payment, discounted by kc and

3) Plus PV of tax shield on management fee, discounted by kc.

The cost of leasing are:

1) Present value of lease rentals, discounted by kd,

2) Plus management fee,3) Plus PV of depreciation shield foregone, discounted by kc,

4) Plus PV of salvage value of asset, discounted by kc and

5) Plus PV of interest shield, discounted by kc.

In case NAL is positive (benefits > costs), leasing alternative is preferred.


Equationally NPV(L)/NAL

=Investment cost

Less: Present value of lease payments (discounted by Kd)

Plus: Present value of tax shield on lease payments (discounted by Kc)

Less: Management fee

Plus: Present value of tax shield on management fee (discounted by Kc)

Minus: Present value of depreciation (tax) shield (discounted by Kc)

Minus: Present value of (tax) shield on interest (discounted by Kc)

Minus: Present value of residual/salvage value (discounted by Kc)

where Kc = Post-tax marginal cost of capital

Kd = Pre-tax cost of long-term debt

If the NAL/NPV(L) is positive, the leasing alternative should be used, otherwise the borrowing alternative would be preferable.


Example 1

XYZ Ltd is in the business of manufacturing steel utensils. The firm is planning to diversify and add a new product line. The firm either can buy the required machinery or get it on lease.

The machine can be purchased for Rs 15,00,000. It is expected to have a useful life of 5 years with a salvage value of Rs 1,00,000 after the expiry of 5 years. The purchase can be financed by 20 per cent loan repayable in 5 equal annual instalments (inclusive of interest) becoming due at the end of each year. Alternatively, the machine can be taken on year-end lease rentals of Rs 4,50,000 for 5 years. Advise the company on the option it should choose. For your exercise, you may assume the following:

(1) The machine will constitute a separate block for depreciation purposes. The company follows written down value method of depreciation, the rate of depreciation being 25 per cent.

(2) Tax rate is 35 per cent and cost of capital is 20 per cent.

(3) Lease rentals are to be paid at the end of the year.

(4) Maintenance expenses estimated at Rs 30,000 per year are to be borne by the lessee.


PV of Cash Outflows Under Leasing Alternative

Year-end Lease rent after taxes [R(1 – t)]

[Rs 4,50,000 (1 – 0.35)]

PVIFA at 13%

[20% (1 –

0.35)]

Total PV

1–5 Rs 2,92,500 3.517 Rs 10,28,723

Borrowing/Buying Option:

Equivalent annual loan instalment = Rs 15,00,000/2.991 (PVIFA for 5 years at

20% i.e., 20,5) = Rs 5,01,505.


PV of Cash Outflows Under Buying Alternative

Year-end

Loan intsalment

Tax advantage on Net cash outflows

col. 2 –(col. 3 + 4)

PVIF at13%

TotalPVInterest

(I × 0.35)Depreciation

(D × 0.35)

1 2 3 4 5 6 7

1 Rs 5,01,505 Rs 1,05,000 Rs 1,31,250 Rs 2,65,255 0.885 Rs 2,34,751

2 5,01,505 90,895 98,437 3,12,173 0.783 2,44,431

3 5,01,505 73,968 73,828 3,53,709 0.693 2,45,120

4 5,01,505 53,656 55,371 3,92,478 0.613 2,40,589

5 5,01,505 29,114 41,528 4,30,863 0.543 2,33,959

11,98,850

Less: PV of salvage value (Rs 1,00,000 × 0.543) 54,300

Less: PV of tax savings on short-term capital loss

(Rs 3,55,958 – Rs 1,00,000) × 0.35 = (Rs 89,585 × 0.543) 48,645 ________________

Total 10,95,905

Recommendation

The company is advised to go for leasing as the PV of cash outflows under the leasing option is lower than under the buy/borrowing alternative.


Working notes

Schedule of Debt Payment

Year-end

Loan intsalment

Loan at the beginning of

the year

Payments Loan outstanding at the end of the year

(col. 3 – col. 5)Interest (col. 3 ×

0.20)

Principal repayment

1 2 3 4 5 6

1 Rs 5,01,505 Rs 15,00,000 Rs 3,00,000 Rs 2,01,505 Rs 12,98,495

2 5,01,505 12,98,495 2,59,699 2,41,806 10,56,689

3 5,01,505 10,56,689 2,11,338 2,90,167 7,66,522

4 5,01,505 7,66,522 1,53,304 3,48,201 4,18,321

5 5,01,505 4,18,321 83,184* 4,18,321 —

*Difference between the loan instalment and loan outstanding.

Schedule of Depreciation

Year Depreciation Balance at the end of the year

12345

Rs 15,00,000 × 0.25 = Rs 3,75,00011,25,000 × 0.25 = 2,81,250

8,43,750 × 0.25 = 2,10,9376,32,813 × 0.25 = 1,58,2034,74,610 × 0.25 = 1,18,652

Rs 11,25,0008,43,7506,32,8134,74,6103,55,958


(Annual Lease Rentals)

Example 2

The following details relate to an investment proposal of the Hypothetical Industries Ltd (HIL):

Investment outlay, Rs 180 lakh Useful life, 3 years Net salvage value after 3 years, Rs 18 lakh Annual tax relevant rate of depreciation, 40 per cent

The HIL has two alternatives to choose from to finance the investment:

Alternative I:

Borrow and buy the equipment. The cost of capital of the HIL, 0.12; marginal rate of tax, 0.35; cost of debt, 0.17 per annum.

Alternative II:

Lease the equipment from the Hypothetical Leasing Ltd on a three year full payout basis @ Rs 444/Rs 1,000, payable annually in arrears (year-end). The lease can be renewed for a further period of 3 years at a rental of Rs 18/Rs 1,000, payable annually in arrears.

Which alternative should the HIL choose? Why?


Decision Analysis (Rs lakh)

1.2.3.4.5.6.

Investment outlayLess: Present value of lease rentals (working note 1)Plus: present value of tax shield on lease rentals (2)Minus: present value of tax shield on depreciation (3)Less: Present value of interest shield on displaced debt (4)Less: Present value of net salvage value (5)NAL/NPV(L)

Rs 180.00176.61

67.1941.0118.2912.81(1.53)

Since the NAL is negative, the lease is not economically viable. The HIL should opt for the alternative of borrowing and buying.

Working Notes

1. Present value of lease rentals: = Rs (180 lakh × 0.444) × PVIFA (17,3) = Rs 79.92 lakh × 2.210 = Rs 176.61 lakh

2. Present value of tax shield on lease rentals: = Rs (180 lakh × 0.444 × 0.35) × PVIFA (12,3) = Rs 27.972 lakh × 2.402 = Rs 67.19 lakh

3. Present value of tax shield on depreciation = [72 × PVIF (12,1) + 43.2 × PVIF (12,2) + 25.92 × PVIF (12,3)] × 0.35 = [(72 × 0.893) + (43.2 × 0.797) + (25.92 × 0.712)] × 0.35 = Rs 41.01 lakh


(Displaced) Debt (Present Value of Lease Rentals) Amortisation Schedule(Rs lakh)

Year Loan outstanding Interest content (at 17%)

Capital content Instalment amount

at the beginning* (176.61 ÷ 2.210)

1 176.61 30.03 49.89 79.92

2 126.72 21.54 58.38 79.92

3 68.34 11.61 68.34 79.92

*Equal to the present value of lease rentals5. Present value of net salvage value = 18 × PVIF (12,3) = 18 × 0.712 = Rs 12.81 lakh


(Monthly Lease Rentals)

Example 3

In Example 2, assume a lease rental of Rs 35/Rs 1,000 payable monthly, in advance. Compute the NAL/NPV(L). Should the HIL opt for lease financing?

Solution

Decision Analysis (Rs lakh)

1.2.3.4.5.6.

Investment outlayLess: Present value of lease rentals (working note 1)Plus: Present value of tax shield on lease rentals (2)Less: Present value of tax shield on depreciation (3)Less: Present value of interest shield on displaced debt (4)Less: Present value of net salvage value (5)NAL

Rs 180.00182.10

63.5641.0113.1212.81(5.48)

As the NAL is negative, the lease is not financially advantageous and HIL should not opt for it.


Debt Amortisation Schedule (Rs lakh)

Year Loan outstanding Interest content Capital content Instalment amount[182.10 ÷ 2.409 (1.09

× 2.210)]at the beginning*

1 181.10 24.15 51.45 75.60

2 130.65 15.39 60.21 75.60

3 70.44 5.16 70.44 75.60

*Equal to the present value of lease rentals

5. Present value of net salvage value: No change from annual payment basis (Rs 12.81 lakh)

Working Notes

1. Present value of lease rentals: = Rs (180 × 0.035 × 12) × PVIFAm (17,3) = 75.6 × i/d(12) × PVIFA (I,3), where I = 0.17 = 75.6 × 1.09 (Table A-3) × 2.210 (Table A-2) = Rs 182.10 lakh

2. Present value of tax shield on lease payments: = Rs [(180 × 0.035 × 12) × PVIFA (12,3) × 0.35] = 75.6 × 2.402 × 0.35 = Rs 63.56 lakh

3. Present value of tax shield depreciation: No change from the annual payment (Rs 41.01 lakh)


Break-Even Lease Rental

The break-even lease rental (BELR) is the rental at which the lessee

is indifferent to a choice between lease financing and

borrowing/buying. Alternatively, BELR has a NAL of zero. It reflects

the maximum level of rental that the lessee would be willing to pay.

If the BELR exceeds the actual lease rental, the lease proposal

would be accepted, otherwise it would be rejected. The

computation of the BELR is shown in example 4.


Example 4

For the HIL in Example 2, assume monthly lease payments in advance. Compute the break-even monthly lease rental. Can the HIL accept a lease quote of Rs 35/Rs 1,000 per month, payable in advance?

Solution

The monthly break-even lease rental (BL) can be obtained when NAL = zero. Thus, [180 – (12 BL × 3.27 × 2.210) + (12 BL × 0.35 × 2.402) – 58.59 – [(11.49 × 0.893) + (7.35 × 0.797) + (2.43 × 0.712)] × 0.35 BL – 12.81 = 0. BL = Rs 2.78 lakh

Monthly lease rental payable by HIL = Rs 180 lakh × 0.035 = Rs 6.30 lakhSince the BL is less than the actual rental to be paid, the lease proposal cannot be accepted.

Working notes

Required Amortisation Schedule (Rs lakh)

Year Loan outstanding at the beginning*

Interest content Capital content

Instalment amount

1 86.73 BL 24.51 BL 11.49 BL 12 BL

2 66.22 BL 28.65 BL 7.35 BL 12 BL

3 33.57 BL 33.57 BL 2.43 BL 12 BL


Lessor’s Viewpoint

For the lessor, lease decision is akin to a capital budgeting decision. The leasing is viable when the PV of cash inflows after taxes (CFAT) accruing to him exceeds the cost of asset. The CFAT are discounted at the weighted average cost of capital.

The NAL approach can also be used by the lessor to assess the financial viability of the lease decision. The NAL to a lessor = Present value of lease payment plus (i) Present value of management fee, (ii) Present value of depreciation tax shield, (iii) Present value of net salvage value, (iv) Present value of tax shield on initial direct costs, minus, (i) Initial investment, (ii) Present value of tax on lease payments, (iii) Present value of tax on management fee, and (iv) Present value of initial direct cost.

Example 5

For the firm in our Example 1, assume further that; (i) the lessor’s weighted average cost of capital is 14 per cent. Is it financially profitable for a leasing company to lease out the machine?


Determination of NPV of Cash Inflows

Particulars Years

1 (Rs) 2 (Rs) 3 (Rs) 4 (Rs) 5 (Rs)5 (Rs)

Lease rent Less: DepreciationEarnings before taxes Less: Taxes (0.35)Earnings after taxesCash inflows afterTaxes x PV factor at (0.14)Total

4,50,0003,75,000

75,00026,25048,750

4,23,7500.877

3,71,629

4,50,0002,81,2501,68,750

59,0621,09,6883,90,938

0.7693,00,631

4,50,0002,10,9372,93,063

83,6721,55,3913,66,328

0.6752,47,271

4,50,0001,58,2032,91,7971,02,1291,89,6683,47,872

0.5922,05,940

4,50,0001,18,6523,31,3481,15,9722,15,3763,34,028

0.5191,73,361

Total PV (operations) 12,98,832

Add: PV of salvage value of machine (1,00,000 0.519)× 51,900

Add: PV of tax savings on short-term capital loss (Rs 89,585 0.519)× 46,495 ________________

Gross PV 13,97,227

Less: Cost of machine 15,00,000

NPV (1,02,773)

It is not financially profitable to let out the machine on lease by the leasing company, as NPV is negative.


Solution

(a) Break-even Lease Rental

Cost of machineLess: PV of salvage value to be received at the end of 5 years (Rs 1,00,000 × 0.519)Less: PV of tax savings on short-term capital loss at the end of the 5th year (Rs 89,585 × 0.519)Less: PV of tax shield on depreciation: (Rs 3,75,000 × 0.35 × 0.877) + (Rs 2,81,250 × 0.35 × 0.769) + (Rs 2,10,937 × 0.35 × 0.675) + (Rs 1,58,203 × 0.35 × 0.592) + (Rs 1,18,562 × 0.35 × 0.519)Required total PV of after tax lease rentDivided by PVIFA for 5 years at 0.14After tax lease rentalsBreak-even lease rentals (Rs 3,22,352/(1 – 0.35)

Rs 15,00,000

51,900

46,495

2,94,95511,06,650

÷ 3.4333,22,3574,95,933

Break-Even Lease Rental

From the viewpoint of a lessor, the break-even lease rental represents the minimum (floor) lease rental that he can accept. The NAL/NPV(L) at this level of rental is zero. The discount rate to compute the NAL is the marginal overall cost of funds to the lessor.

Example 6 For facts contained in Example 5, (a) determine the minimum lease rentals at which the lessor would break-even. Also, prepare a verification table. Determine the lease rentals if the lessor wants to earn an NPV of Rs 1 lakh.


Verification Table

Particulars Years

1 2 3 4 5

Lease rent Rs 4,95,933 Rs 4,95,933 Rs 4,95,933

Rs 4,95,933

Rs 4,95,933

Less: Depreciation 3,75,000 2,81,250 2,10,937 1,58,203 1,18,652

Earnings before

taxes 1,20,933 2,14,683 2,84,996 3,37,730 3,77,281

Less: Taxes (0.35) 42,327 75,139 99,749 1,18,206 1,32,049

Earnings after

taxes 78,606 1,39,544 1,85,247 2,19,524 2,45,232

CFAT (EAT +

Depreciation) 4,52,606 4,20,794 3,96,184 3,77,727 3,63,884

×PV factor at (0.14) 0.877 0.769 0.675 0.592 0.519

Total 3,97,812 3,23,591 2,67,424 2,23,614 1,88,856

PV of Lease rent 14,01,297

Add: PV of salvage value 51,900

Add: PV of tax savings on short- term capital loss 46,495

Total PV 15,00,000


(b) Lease-Rentals to be Charged to Earn NPV of Rs 1,00,000

Required total PV of after-tax lease rentals (Rs 11,06,650 for break-even + Rs 1,00,000) Rs 12,06,650

Divided by PVIFA for 5 years at 0.14 ÷ 3.433

After-tax lease rentals 3,51,486

Lease rentals to be charged [Rs 3,51,486/(1 – 0.35)] 5,40,740

Example 7

The under mentioned facts relate to a lease proposal before the Hypothetical Leasing Ltd (HLL):

The initial cost of equipment to be leased out is Rs 300 lakh, on which 10 per cent sales tax would be levied. At the end of the lease term, after 5 years, the salvage value is estimated to be Rs 33 lakh. The other costs associated with the lease proposal payable in advance (front-ended) are initial direct cost, Rs 3 lakh and management fee, Rs 5 lakh. The marginal cost of funds to the HIL is 14 per cent while the marginal rate of tax is 35 per cent.

What is the break-even rental for HLL if the tax relevant rate of depreciation is 25 per cent?


Solution

Computation of Break-even Lease Rental (L)

Particulars Amount (Rs lakh)

1. Equipment cost (including ST) 3,30.000

2. Present value of lease rentals (working note 1) 3.433 L

3. Present value of tax on lease rentals (2) 1.202 L

4. Present value of tax shield on depreciation) 64.900

5. Present value of direct initial cost 3.000

6. Present value of management fee 5.000

7. Present value of tax shield on initial direct cost (4) 0.920

8. Present value of tax on management fee (5) 1.530

9. Present value of salvage value (6) 17.100

The break-even rental (L) can be derived from the equation:3.433 L – 1.202 L + Rs 64.90 lakh – Rs 3 lakh + Rs 5 lakh + Rs 0.902 lakh – Rs 1.53 lakh + Rs 17.10 lakh – Rs 330 lakh = 0L = Rs 123.30 lakh


Working Notes

1) Present value of lease rental = L [PVIFA (14,5)] = 3.433 L

2) Present value of tax on lease rental = 0.35 × L × PVIFA (14,5) = 1.202 L

3) Present value of tax shield on depreciation = [Rs 82.50 lakh × PVIF (14,1) + Rs 61.90 lakh × PVIF (14,2) + Rs 46.40 lakh × PVIF (14,3) + Rs 34.80 lakh × PVIF (14,4) + Rs 26.1 lakh × PVIF (14,5)] × 0.35 =[(Rs 82.50 × 0.877) + (Rs 61.90 × 0.769) + (Rs 46.40 × 0.675) + (Rs 34.80 × 0.592) + (Rs 26.1 × 0.519)] × 0.35 = Rs 64.90 lakh

4) Present value of tax shield on initial direct costs = Rs 3 lakh × 0.35 × PVIF (14,1) = Rs 0.92 lakh

5) Present value of tax shield on management fee = 0.35 × Rs 5 lakh × PVIF (14,1) = Rs 1.53 lakh

6) Present value of salvage value = Rs 33 lakh × PVIF (14,5) = Rs 17.10 lakh


Example 8

The Hypothetical Leasing Ltd (HLL) has a lease proposal under consideration. Its post-tax cost of funds is 14 per cent and it has to pay central sales tax (CST) @ 10 per cent of the basic price of the capital equipment on inter-state purchases. The marginal tax rate of the HLL is 35 per cent. The details of the proposed lease are given below:

Primary lease period, 3 years

Tax relevant depreciation, 40 per cent on written down basis (with other assets in the block)

Residual value, 8 per cent of the original cost.

(a) If the monthly lease rentals are collected in advance, what is the minimum lease rental the HLL should charge for per Rs 1,000 for the lease?

(b) What is the minimum monthly lease rental for a lease proposal costing Rs 660 lakh (including CST at 10 per cent)?


Solution

(a) Minimum Monthly Rental per Rs 1,000

1 Investment cost Rs 1,000.00

2 Present value of lease rentals (working note 1) 29.93 L

3 Present value of tax shield on rentals (2) 9.75 L

4 Present value of tax shield on depreciation (3) 221.48

5 Present value of residumal value (4) 54.00

The break-even level of rental (L) can be derived from the equation (NAL = 0) = Rs 1,000 + 29.93 L – 9.75 L + Rs 221.48 + Rs 54 = 0L = Rs 35.90, that is, Rs 35.90/Rs 1,000/month(b) Minimum monthly lease rental for the proposal costing Rs 660 lakh = Rs 660 lakh 0.03590 = Rs 23.69 lakh×

Working Notes

1. Present value of lease rentals = 12 L × PVIFAm (14,3) = 12L × 2.322 × 1.0743 = 29.93 L

2. Present value of tax shield on lease rentals = 12L × PVIFA (14,3) × 0.35 = 12 L × 2.322 × 0.35 = 9.75 L

3. Present value of tax shield on depreciation = [Rs 400 × PVIF 914,1) + Rs 240 × PVIF (14,2) + Rs 144 × PVIF (14,3)] × 0.35 = (Rs 400 × 0.877) + (Rs 240 × 0.769) + (Rs 144 × 0.675) = Rs 221.48

4. Present value of residual value = Rs 1,000 (0.08) × PVIF (14,3) = Rs 54.


Hire-Purchase FinanceHire-purchase is an agreement relating to a transaction in which goods are let on hire, the purchase price is to be paid in instalments and the hirer is allowed the option to purchase the goods, paying all the instalments. Though the option to purchase the goods is allowed in the very beginning, it can be exercised only at the end of the agreement. It implies ownership is transferred at the time of sale.The ownership of the goods passes on to the purchaser simultaneously with the payment of the initial/first instalment in instalment sale. The hire-purchase also differs from the instalment sale in terms of the call option and right of termination in the former but not in the latter. Hire-purchase and leasing as modes of financing are different in several respects such as ownership of the asset, its capitalisation, depreciation charge, extent of financing, tax treatment, and accounting and reporting.Hire-purchase contract, basically, requires two parties, namely, the intending seller and the intending buyer. When such a sales is executed through the involvement of finance companies, the hire-purchase contracts involve three parties: the financier, the seller and the buyer.


Hire-purchase Vs Instalment Payment

In an instalment sale, the contract of sale is entered into, the goods are delivered and the ownership is transferred to the buyer, but the price of the goods is paid in specified instalments over a definite period.

The first distinction between hire purchase and instalment purchase is based on the call option (to purchase the goods at any time during the term of the agreement) and the right of the hirer to terminate the agreement at any time before the payment of the last instalment (right of termination) in the former while in the latter the buyer is committed to pay the full price. Secondly, in instalment sale the ownership in the goods passes on to the purchaser simultaneously with the payment of the initial/first instalment, whereas in hire purchase the ownership is transferred to the hirer only when he exercises the option to purchase/or on payment of the last instalment.


Lease Financing Vs Hire-purchase

Financing These two modes of financing differ in the following aspects:

Ownership The lessor (finance company) is the owner and the lessee (user/manufacturer) is entitled to the economic use of the leased asset/equipment only in case of lease financing. The ownership is never transferred to the user (lessee). In contrast, the ownership of the asset passes on to the user (hirer), in case of hire purchase finance, on payment of the last instalment; before the payment of the last instalment, the ownership of the asset vests in the finance company/intermediary (seller).

Depreciation The depreciation on the asset is charged in the books of the lessor in case of leasing while the hirer is entitled to the depreciation shield on assets hired by him.

Magnitude Both lease finance and hire-purchase are generally used to acquire capital goods. However, the magnitude of funds involved in the former is very large, for example, for the purchase of aircrafts, ships, machinery, air conditioning plants and so on. The cost of acquisition in hire purchase is relatively low, hence, automobiles, office equipments, generators and so on are generally hire purchased.


Extent Leasing financing is invariably 100 per cent financing. It requires no margin money or immediate cash down payment by the lessee. In a hire-purchase transaction typically a margin equal to 20-25 per cent of the cost of the equipment is required to be paid by the hirer. Alternatively, the hirer has to invest an equivalent amount on fixed deposits with the finance company, which is returned after the payment of the last instalment.

Maintenance The cost of maintenance of a hired asset is to be borne, typically, by the hirer himself. In case of finance lease only, the maintenance of the leased asset is the responsibility of the lessee. It is the lessor (seller) who has to bear the maintenance cost in an operating lease.

Tax Benefits The hirer is allowed the depreciation claim and finance charge and the seller may claim any interest on borrowed funds to acquire the asset for tax purposes. In case of leasing, the lessor is allowed to claim depreciation and the lessee is allowed to claim the rentals and maintenance cost against taxable income.


Parties to a Hire-purchase Contract

There are two parties in a hire-purchase contract, namely, the intending seller and the intending purchaser or the hirer. Nowadays, however, hire-purchase contracts generally involve three parties, namely, the seller, the financier and the hirer. With the acknowledgement of the finance function as a separate business activity and the substantial growth of finance companies in the recent times, the sale element in a hire purchase contract has been divorced from the finance element. A dealer now normally arranges a hire purchase agreement through a finance company with the customer. It is, therefore, a tripartite deal. A tripartite hire-purchase

contract is arranged with following modalities:


1) The dealer contracts a finance company to finance hire-purchase deals submitted by him. For this purpose, they enter into a contract drawing out the terms, warranties that the dealer gives with each transaction and so on.

2) The customer selects the goods and expresses his desire to acquire them on hire purchase. The dealer arranges for a full set of documents to be completed to make a hire-purchase agreement with a customer. The documents are generally printed by the finance company.

3) The customer then makes a cash down payment on completing the proposal form. The down payment is generally retained by the dealer as a payment on account of the price to be paid to him by the finance company.

4) The dealer then sends the documents to the finance company requesting him to purchase the goods and accept the hire purchase transactions.

5) The finance company, if it decides to accept the transactions, signs the agreement and sends a copy to the hirer, along with the instructions as to the payment of the instalments. The finance company also notifies the same to the dealer and asks him to deliver the goods, if they are not already delivered.

6) The dealer delivers the goods to the hirer against acknowledgements and the property in the goods passes on to the finance company.

7) The hirer makes payment of the hire instalment periodically.8) On completion of the hire term, the hirer pays the last instalment and the

property in the goods passes on to him on issue of a completion certificate by the finance company.


Taxation Aspects

The taxation aspects of hire-purchase transactions can be divided into three parts:

1) Income tax, 2) Sales tax and 3) Interest tax


Income Tax

Hire-purchase, as a financing alternative, offers tax benefits both to the hire vendor, (hire-purchase finance company) and the hire purchaser (user of the asset).

Assessment of Hire-Purchaser (Hirer)

According to circular issued by the Central Board of Direct Taxes in 1943 and a number of court rulings, the hirer is entitled to (a) the tax shield on depreciation, calculated with reference to the cash purchase price and (b) the tax shield on the ‘consideration for hire’ (total charge for credit). In other words, though the hirer is not the owner of the asset, he is entitled to claim depreciation as a deduction on the entire purchase price. Similarly, he can claim deduction on account of ‘consideration of hire’, that is, finance charge.

Assessment of Owner (Hire Vendor)

The hire/hire charge/income received by the hire vendor is liable to tax under the head profits and gains of business and profession, where hire-purchase constitutes the business (mainstream activity) of the assessee, otherwise it is taxed as income from other sources. The hire income from house property is generally taxed as income from house property. Normal deductions (except depreciation) are allowed while computing the taxable income.


Tax Planning in Hire-Purchase

First, the net income (finance income less interest on borrowings by the hire vendor) can be inflated at the rear end of the transaction and thereby defer tax liability. The hirer can similarly postpone his tax liability by allocating a finance charge on the basis of a actuarial/rate of return method that implies a higher deduction in the early years.

Secondly, another possible area of tax planning is to use hire-purchase as a bridge between the lessor and the lessee. In other words, instead of direct lease an intermediate financier is introduced.

Suppose, X wants to lease an asset to Z. Instead of going for a direct lease, they adopt a different strategy, wherein Y steps in as an intermediary. Y takes the asset on hire-purchase from X and gives the same asset to Z on lease. There is no prohibition of such arrangement, unless the hire-purchase agreement prohibits the sub-lease. Under this strategy, Y gets the dual advantage of depreciation and finance charge against his income from lease rentals, thereby postponing his taxes. This strategy can be very useful in case Y is a high tax paying entity. Y in consideration for reduction in his tax liability will pass off some income to X in the form of high hire charges and to Z by way of lease rentals. Even if the intermediary Y derives no financial gains, substantial tax savings can be reaped by distributing the income and tax benefits.


Sales Tax Aspect

The salient features of sales tax, pertaining to hire purchase transactions, after the Constitution (Forty sixth Amendment) Act, 1982, are as detailed below

Hire-Purchase as Sale

Hire-purchase, though not sale in the true sense, is deemed to be sale. Such transactions are per se liable to sales tax. The sales tax is payable once the goods are de-livered by the owner (hire vendor) to the hirer (hire-purchaser), even if the transaction does not fructify into a sale. There is no provision for the refund of sales tax on an unpaid instalment. In other words, full tax is payable irrespective of whether the owner gets the full price of the goods or not.

Delivery Vs Transfer of Property: Taxable Event

A hire-purchase deal is regarded as a sale immediately after the goods are delivered and not on the transfer of the title to the goods. That is, the taxable event is the delivery of the goods and not transfer of the title to the goods. For the purpose of levying sales tax, a sale is deemed to take place only when the hirer exercises the option to purchase.

Taxable Quantum

The quantum of sales tax is related to the sales price; it must be determined to be the consideration for the transfer of the goods when the delivery of the goods takes place. The consideration for the sale of the goods is the total amount that is agreed to be paid before the transfer of the goods takes place in a hire-purchase contract.


States Entitled to Impose Tax

When a hire-purchase transaction is entered in the state where the goods are lying, the concerned state is entitled to impose sales tax.Sales tax on hire-purchase is not levied if the state in which goods are delivered has a single point levy system in respect of such goods and if the owner (finance company) had purchased the goods within the same state. Moreover, sales tax is not levied on hire-purchase transactions structured by finance companies if they are not dealers in the type of goods given on hire.The interstate hire-purchase deals attract central sales tax (CST). But in actual practice, no hire-purchase transaction is likely to be subject to CST. Under the CST, the taxable event is not the delivery but the transfer of goods.

Rate of Tax

The rates of tax on hire purchase deals vary from state to state. There is, as a matter of fact, no uniformity even regarding the goods to be taxed. If the rates undergo a change during the currency of a hire-purchase agreement, the rate in force on the date of delivery of the goods to the hirer is applicable.

Interest Tax

The hire-purchase finance companies, like other credit/finance companies, have to pay interest tax under the Interest Tax Act, 1974. According to this Act, interest tax is payable on the deal amount of interest earned less bad debts in the previous year @ 2 per cent. The tax is treated as a tax deductible expense for the purpose of computing the taxable income under the Income Tax Act.


From the Point of View of the Hirer (Hire-Purchaser)

The tax treatment given to hire-purchase is exactly the opposite of that given to lease financing. It may be recalled that in leasing financing, the lessor is entitled to claim depreciation and other deductions associated with the ownership of the equipment, including interest on the amount borrowed to purchase the asset, while the lessee enjoys full deduction of lease rentals. In sharp contrast, in a hire-purchase deal, the hirer is entitled to claim depreciation and the deduction for the finance charge (interest) component of the hire instalment. Thus, hire purchase and lease financing represent alternative modes of acquisition of assets. The evaluation of hire purchase transaction from the hirers’ angle, therefore, has to be done in relation to the leasing alternative.

Decision Criterion

The decision criterion from the point of view of a hirer is the cost of hire-purchase vis-à-vis the cost of leasing. If the cost of hire-purchase is less than the cost of leasing, the hirer (purchaser) should prefer the hire purchase alternative and vice versa.

Financial Evaluation


Cost of Leasing The cost of leasing (COL) consists of the following elements:

1) Lease management fee2) Plus: Present value of lease payments discounted by Kd

3) Less: Present value of tax shield on lease payments, and lease management fee discounted by Kc

4) Plus: Present value of interest tax shield on hire purchase discounted by Kc

Cost of Hire-purchase The cost of hire-purchase to the hirer (CHP) consists of the following:

1) Down payment2) Plus: Service charges3) Plus: Present value of hire purchase discounted by cost of debt (Kd)

4) Minus: Present value of depreciation tax shield discounted by cost of capital (Kc)

5) Minus: Present value of the net salvage value discounted by cost of capital (Kc)


Example 9

The Hypothetical Industries Ltd (HIL) has an investment plan amounting to Rs 108 lakh. The tax relevant rate of depreciation of the HIL is 25 per cent, its marginal cost of capital and marginal cost of debt are 16 per cent and 20 per cent respectively and it is in 35 per cent tax bracket.

It is examining financing alternatives for its capital expenditure. A proposal from the Hypothetical Finance Ltd (HFL), with the following salient features, is under its active consideration:

Hire Purchase Plan: The (flat) rate of interest charged by the HFL is 16 per cent. Repayment of the amount is to be made, in advance, in 36 equated monthly instalments. The hirer/hire-purchaser is required to make a down payment of 20 per cent.

Leasing Alternative: Lease rentals are payable @ Rs 28 ptpm, in advance. The primary lease period can be assumed to be 5 years.

Assume that the SOYD method is used to allocate the total charge for credit under the hire-purchase plan. The net salvage value of the equipment after 3 years can be assumed to be Rs 33 lakh.

Which alternative—leasing or hire-purchase—should the HIL use? Why?


Solution The choice will depend on the relative cost of hire purchase and leasing

Cost of Hire-Purchase (CHP) (Rs lakh)

1 Down payment (working note 1) Rs 21.60

2 Plus: Present value of monthly hire-purchase instalment (working note 2) 99.19

3 Minus: present value of depreciation tax shield (working note 3) 20.44

4 Minus: present value of net salvage value 15.70

Total 84.65

Working Notes

1. Down payment = Rs 108 lakh × 0.20 = Rs 21.6 lakh2. Monthly hire-purchase instalment = [Rs 86.4 lakh (Rs 108 lakh less 20 per cent

down payment) (Rs 86.4 lakh × 0.16 × 3 years)] ÷ 36 = Rs 3.552 lakhPresent value of monthly hire purchase instalment

= Rs 3.552 lakh × 12 × [I/d(12)] × PVIFA (20,3) where I = 0.20= (Rs 3.553 lakh × 12) × 1.105 × 2.106 = Rs 99.19 lakh

3. Present value of depreciation tax shield:= [Rs 27 lakh × PVIF (16,1) + Rs 20.25 lakh × PVIF (16,2) + Rs 15.19

lakh× PVIF (16,3) + Rs 11.39 lakh × PVIF (16,4) + Rs 8.54 lakh × PVIF (16,5)] × 0.35

= [(27 × 0.862) + (20.25 × 0.743) + (15.19 × 0.641) + (11.39 × 0.552) + (8.54 × 0.476)] × 0.35 = Rs 20.44 lakh


Working Notes

1. Present value of lease payments:= [Rs 108 lakh × 0.028 × 12) × [I/d(12)] × PVIFA (20,5)], where I = 0.20= Rs value of tax shield on lease payment = [Rs 108 lakh × 0.028 × 12 × PVIFA (16,5) × 35= (Rs 36.29 lakh × 3.274)] × 0.35 = Rs 41.58 lakh

2. Present value of tax shield on charge for credit:Total charge for credit = Rs 108 lakh × 0.80 × 0.16 × 3 = Rs 41.47 lakh

Cost of Leasing (COL) (Rs lakh)

123

Present value of lease payments (working note 1)Minus present value of tax shield on lease payment (2)Plus present value of tax shield on charge of credit (3)Total

Rs 119.9341.5811.5689.91

4.86666

366

1...3536

1...11123

13.82666

222

1...3536

13...23242

22.79666

366

1...3536

25...35361

lakh) (Rs charge l Annua factor SOYD Year

MethodSODY Credit; for Charge Total of Allocation

=++++++

=+++

+++

=+++

+++


Net Present Value of Hire Purchase Plan [NPV (HPP)] The NPV (HPP) consists of:

1) Present value of hire purchase instalments2) Plus: Documentation and service fee3) Plus: Present value of tax shield on initial direct cost4) Minus: Loan amount5) Minus: Initial cost6) Minus: Present value of interest tax on the finance income 7) Minus: Present value of income tax on finance income (interest)

netted for interest tax8) Minus: Present value of income tax on documentation and service fee

From the Viewpoint of Finance Company (Hire Vendor)

Hire-purchase and leasing represents two alternative investment decisions of a finance company/financial intermediary/hire vendor. The decision criterion, therefore, is based on a comparison of the net present values of the two alternatives, namely, hire-purchase and lease financing. The alternative with a higher net present value would be selected and the alternative having a lower net present value would be rejected.


Present Value of Lease Plan [NPV (LP)] The NPV (LP) consists of the following elements:

1) Present value of lease rentals2) Add: Lease management fee3) Add: Present value of tax shield on initial direct costs and depreciation4) Add: Present value of net salvage value5) Less: Initial investment6) Less: Initial direct costs7) Less: Present value of tax liability on lease rentals and lease

management fee

Example 10

For the HFL in Example 9, assume the following:Front-end (advance) cost of structuring the deal: 0.5 (half) per cent of the

amount financedMarginal cost of debt: 20 per centMarginal cost of equity: 25 per centTarget long-term debt-equity ratio: 4:1Marginal tax rate: 35 per centResidual value under lease plan: 10 per cent of the investment cost

Required Which plan—hire-purchase or lease—is financially more attractive to the HFL? Why?


Solution

A (i) Net Present Value of Hire-Purchase Plan (Rs lakh)

1 Present value of monthly hire-purchase instalment (working note 1) 104.46

2 Plus present value of tax shield on initial direct costs (working note 2) 0.13

3 Less: Amount financed (Rs 108 lakh – Rs 21.60 lakh, down payment) 86.40

4 Less: Initial direct cost (0.5 per cent of Rs 86.4 lakh) 0.43

5 Less: Present value of interest tax on hire purchase-related income (working note 3)

0.67

6 Less: Present value of income tax on net finance income (working note 4)

11.41

Total 5.68


Working Notes

Marginal cost of capital [0.80 × 0.20 × 0.65] + [0.20 × 0.25] = (0.104 + 0.05) = 15.4 per cent

1. Monthly hire-purchase instalment = [(Rs 86.4 lakh + (Rs 86.4 lakh × 0.16 × 3)] ÷ 36 = Rs 3.552 lakh

Present value of monthly hire-purchase instalments:

= Rs 3.552 lakh × PVIFAm (15.4,3)

= Rs 3.552 lakh × 12 × 2.265 × 1.082 = Rs 104.46 lakh

2. Present value of tax shield on initial direct cost:

Initial direct cost (0.5 per cent of Rs 86.4 lakh) = 0.432 lakh

Present value = Rs 0.432 lakh × 0.866 × 0.35 = Rs 0.13 lakh

3. Present value of interest tax on hire purchase related income:

Unexpired finance income (total charge for credit) at inception = Rs 86.4 lakh × 0.16 × 3 = Rs 41.47 lakh


Interest Tax and Income Tax on Annual Finance Income (Rs lakh)

Year Gross Finance Income

Interest tax (2%)

Net finance income

Income tax (0.35)

1 22.79 0.46 22.33 7.82

2 13.82 0.28 13.54 4.74

3 4.86 0.10 4.76 1.67

Present value = (Rs 0.46 lakh 0.866) + (Rs 0.28 lakh 0.751) + (Rs 0.10 lakh × × ×0.648) = Rs 0.67 lakh

86.4lakh47.41Rs666

78

1...3536

1...11123

82.13lakh47.41Rs666

222

1...3536

13...23242

79.22lakh 47.41Rs666

366

1...3536

25...35361

lakh) (Rs charge Annual factor SOYD Year

Method SODY the on Based Income, Finance Unexpired of Allocation

×=++++++

×=+++

+++

×=+++

+++


4. Present value of income tax on net finance income:

= (Rs 7.82 lakh 0.866) + (Rs 7.74 lakh 0.751) + (Rs 1.67 lakh 0.648) = Rs × × ×11.41 lakh

A (ii) Net Present Value of Leasing (Rs lakh)

1 Present value of lease rentals/receipts (working note 1) 130.08

2 Plus: Present value of depreciation tax shield (note 2) 20.62

3 Plus: Present value of tax shield on initial direct cost (note 3) 0.16

4 Plus: Present value of residual value (note 4) 5.21

5 Less: Initial investment 108.00

6 Less: Initial direct cost 0.54

7 Less: Present value of income tax on lease rentals (note 5) 42.09

Total 5.44


Working Notes

1. Present value of lease rentals = Rs 108 lakh × 0.028 × 12 × PVIFA (15.4, 5)= Rs 108 lakh × 0.028 × 12 × 1.082 × 3.313 = Rs 130.08 lakh

2. Present value of depreciation tax shield = [Rs 27 lakh × PVIF (15.4,1) + Rs 20.25 lakh × PVIF(15.4,2) + Rs 15.19 lakh × PVIF (15.4,3) + Rs 11.34 lakh × PVIF (15.4,4) + Rs 8.55 lakh × PVIF (15.4,5)] × 0.35 = [Rs 27 lakh × 0.866) + (Rs 20.25 lakh × 0.751)+ (Rs 15.19 lakh × 0.648) + (Rs 11.34 lakh × 0.562) + ( Rs 8.55 lakh × 0.482)]= Rs 20.62 lakh

3. Present value of tax shield on initial direct cost:= 0.54 lakh (0.5 per cent of Rs 108 lakh) × PVIF (15.4,1) × 0.35 = Rs 0.16 lakh

4. Present value of residual value = Rs 10.80 lakh (0.10 × Rs 108 lakh) × PVIF (15.4,5) = Rs 5.21 lakh

5. Present value of income tax on lease rentals = Rs 108 lakh × 0.028 × 12 × PVIFA (15.4,5) × 0.35= (Rs 36.29 lakh × 3.314) × 0.35 = Rs 42.09 lakh

As the present value of hire-purchase (Rs 5.68 lakh) exceeds the net present value of leasing (Rs 5.44 lakh), the hire purchase plan is financially more attractive to the HFL.


SOLVED PROBLEMS


SOLVED PROBLEM 1

ABC Machine Tool Company Ltd is considering the acquisition of a large equipment to set up its factory in a backward region for Rs 12,00,000. The equipment is expected to have an economic useful life of 8 years. The equipment can be financed either with an 8-year term loan at 14 per cent interest, repayable in equal instalments of Rs 2,58,676 per year, or by an equivalent amount of lease rent per year. In both cases, payments are due at the end of the year. The equipment is subject to the straight line method of depreciation for tax purposes. Assuming no salvage value after the 8-year useful life and 50 per cent tax rate, which of the financing alternatives should it select?

Solution

PV of cash inflows under leasing alternative

Year end Lease payment after taxes(L) (1 – 0.5)

PV factorat 0.07 (Kd)

Total PV

1–8 Rs 1,29,338 5.971 Rs 7,72,277


Determination of interest and principal components of loan instalment

Yearend

Loaninstalment

Loan atthe beginning

of the year

Payment of Principal outstanding at

theend of the

year(Col 3 – Col 5)

interest(Col 3 ×

0.14)

principal(Col 2 – Col 4)

1 2 3 4 5 6

1 Rs 2,58,676 Rs 12,00,000 Rs 1,68,000 Rs 90,676 Rs 11,09,324

2 2,58,676 11,09,324 1,55,305 1,03,371 10,05,953

3 2,58,676 10,05,953 1,40,833 1,17,843 8,88,110

4 2,58,676 8,88,110 1,24,335 1,34,341 7,53,769

5 2,58,676 7,53,769 1,05,528 1,53,148 6,00,621

6 2,58,676 6,00,621 84,087 1,74,589 4,26,032

7 2,58,676 4,26,032 59,644 1,99,032 2,27,000

8 2,58,676 2,27,000 31,676 2,27,000 —


PV of cash outflows under buying alternative

Year Loaninstalment

Tax advantage on Cash outflowsafter taxes

[Col 2 – (Col 3+ Col 4)]

PV factorat 0.07

TotalPV

interest(I t)×

depreciation

(D t)×

1 2 3 4 5 6 7

1 Rs 2,58,676 Rs 84,000 Rs 75,000 Rs 99,676 0.935 Rs 93,197

2 2,58,676 77,652 75,000 1,06,024 0.873 92,559

3 2,58,676 70,416 75,000 1,13,260 0.816 92,420

4 2,58,676 62,167 75,000 1,21,509 0.763 92,711

5 2,58,676 52,764 75,000 1,30,912 0.713 93,340

6 2,58,676 42,043 75,000 1,41,633 0.666 94,328

7 2,58,676 29,822 75,000 1,53,854 0.623 95,851

8 2,58,676 15,838 75,000 1,67,838 0.582 97,682

7,52,088

Recommendation The borrowing (buying) alternative of financing the purchase of the large equipment should be selected.


SOLVED PROBLEM 2

For (Solved Problem 1) compute the net advantage of leasing (NAL) to the lessee assuming (i) The company follows written down value method of depreciation, the deprecation rate being 25 per cent; (ii) The corporate tax is 35 per cent; (iii) Post-tax marginal cost of capital (Kc) is 12 per cent and (iv) The company has several assets in the asset block of 25 per cent.

Solution

Computation of NAL to the lessee

Benefits from lease:

Cost of the equipment (investment saved) Rs 12,00,000

PV of tax shield on lease rentals (working note 2) 4,49,786

Total 16,49,786

Cost of lease:

PV of lease rental (1) 11,99,998

PV of tax shield foregone on depreciation (3) 2,72,333

PV of interest tax shield foregone on debt (4) 2,08,381

Total 16,80,712

NAL (30,926)

Recommendation The lease is not financially viable.


(3) PV of tax shield foregone on depreciation

Year Depreciation Tax shield PV factor (at 0.12) Total PV

1 Rs 3,00,000 Rs 1,05,000 0.893 Rs 93,765

2 2,25,000 78,750 0.797 62,764

3 1,68,750 59,062 0.712 42,052

4 1,26,562 44,297 0.636 28,173

5 94,922 33,223 0.567 18,837

6 71,191 24,917 0.507 12,633

7 53,393 18,688 0.452 8,447

8 40,045 14,016 0.404 5,662

2,72,333

Working Notes

(1) PV of lease rentals: Lease rentals PVIFA (14,8) = Rs 2,58,676 4.639 = Rs × ×11,99,998.

(2)PV of tax shield on lease rentals: Lease rentals tax rate PVIFA (12,8) = Rs × ×2,58,676 0.35 4.968 = Rs 4,49,786× ×


(4) PV of interest tax shield

Year Interest Tax shield PV factor (at 0.12) Total PV

1 Rs 1,68,000 Rs 58,800 0.893 Rs 52,508

2 1,55,305 54,357 0.797 43,322

3 1,40,833 49,292 0.712 35,096

4 1,24,335 43,517 0.636 27,677

5 1,05,528 36,935 0.567 20,942

6 84,087 29,430 0.507 14,921

7 59,644 20,875 0.452 9,436

8 31,676 11,087 0.404 4,479

2,08,381


SOLVED PROBLEM 3

For facts in Solveb Problem 2, determine the break even lease rentals (BELR) for the lessee.

Solution

Computation of BELR

Benefits from lease:

Cost of the equipment Rs 12,00,000

PV of tax shield on lease rentals (working note 2) 1.62365L

Cost of lease:

PV of lease rentals (note 1) 4.639L

PV of tax shield foregone on depreciation 2,72,333

PV of interest tax shield foregone on debt 2,08,381

BELR (L) = 4.639L + Rs 4,80,714 = 1.62365L + Rs 12,00,000

4.639L – 1.62365L = Rs 12,00,000 – Rs 4,80,714

L = Rs 7,19,286/3.01535 = Rs 2,38,541

Working Notes

(i) PV of lease rentals: L PVIFA (14,8) = 4.639 L = 4.639L× ×(ii) PV of tax shield on lease rentals: L PVIFA (14,8) tax rate = 4.639L 0.35 = 1.62365L× × ×


SOLVED PROBLEM 4

HCL Ltd is considering acquiring an additional computer to supplement its time-share computer services to its clients. It has two options:

(i) To purchase the computer for Rs 22,00,000.

(ii) To lease the computer for 3 years from a leasing company for Rs 5,00,000 annual lease rent plus 10 per cent of gross time-share service revenue. The agreement also requires an additional payment of Rs 6,00,000 at the end of the third year. Lease rent are payable at the year end, and the computer reverts to the lessor after the contract period.

The company estimates that the computer under review now will be worth Rs 10 lakh at the end of the third year.

Forecast revenues are:

Year 1 Rs 22,50,000

2 25,00,000

3 27,50,000


Annual operating costs (excluding depreciation and lease rent of computer) are estimated at Rs 9,00,000, with an additional Rs 1,00,000 for start-up and training costs at the beginning of the first year.

HCL Ltd will borrow at 16 per cent interest to finance the acquisition of the computer; repayments are to be made according to the following schedule.

Year-end Principal Interest Total

1 Rs 5,00,000 Rs 3,52,000 Rs 8,52,000

2 8,50,000 2,72,000 11,22,000

3 8,50,000 1,36,000 9,86,000

The company uses the straight line method to depreciate its assets and pays 50 per cent tax on its income.

The management of HCL Ltd approaches you for advice. Which alternative would you recommend? Why?


Solution

PV of cash outflows under leasing alternative

Y

e

a

r

Payment under lease contract Tax shield

@ 50% on

lease

payments

Net cash

outflows

PV

factor

(0.08)

Total

PVLease

rent

10% of

gross

revenue

Lumpsum

payment

1 Rs 5,00,000 Rs2,25,000 — Rs 3,62,500 Rs 3,62,500 0.926 Rs 3,35,675

2 5,00,000 2,50,000 — 3,75,000 3,75,000 0.857 3,21,375

3 5,00,000 2,75,000 Rs 6,00,000 6,87,500 6,87,500 0.794 5,45,875

12,02,925


PV of cash outflows under borrowing alternative

Year Loaninstalment

Tax advantage on Net cash outflows

PV factor(0.08)

TotalPV(I 0.50)× (D 0.50)×

1 Rs 8,52,000 Rs 1,76,000 Rs 2,00,000 Rs 4,76,000 0.926 Rs 4,40,776

2 11,22,000 1,36,000 2,00,000 7,86,000 0.857 6,73,602

3 9,86,000 68,000 2,00,000 7,18,000 0.794 5,70,092

Salvage value (10,00,000) 0.794 (7,94,000)

8,90,470

Assumption The start-up and training costs are to be borne by the lessee even if the computer is acquired on lease basis.

Recommendation The management is advised to buy the computer.

307

BUSINESS VALUTIONThe term ‘valuation’ implies the estimated worth of an asset or a security or a business. The alternative approaches to value a firm/an asset are:

Book value, Market value, Intrinsic value, Liquidation value, Replacement value, Salvage value Value of Goodwill Fair value.

32 - 308

Book ValueThe book value of an asset refers to the amount at which an asset is shown in the balance sheet of a firm. Generally, the sum is equal to the initial acquisition cost of an asset less accumulated depreciation. Accordingly, this mode of valuation of assets is as per the going con-cern principle of accounting. In other words, book value of an asset shown in balance does not reflect its current sale value.Book value of a business refers to total book value of all valuable assets (excluding fictitious assets, such as accumulated losses and deferred revenue expenditures, like advertisement, preliminary expenses, cost of issue of securities not written off) less all external liabilities (including preference share capital). It is also referred to as net worth.

Market Value

In contrast to book value, market value refers to the price at which an asset can be sold in the market. The market value can be applied with respect to tangible assets only; intangible assets (in isolation), more often than not, do not have any sale value. Market value of a business refers to the aggregate market value (as per stock market quotation) of all equity shares outstanding. The market value is relevant to listed companies only.

Intrinsic/Economic Value

Intrinsic/Economic Value is the present value of incremental future cash inflows using an appropriate discount rate.

Liquidation Value

As the name suggests, liquidation value represents the price at which each individual asset can be sold if business operations are discontinued in the wake of liquidation of the firm. In operational terms, the liquidation value of a business is equal to the sum of (i) realisable value of assets and (ii) cash and bank balances minus the payments required to discharge all external liabilities. In general, among all measures of value, the liquidation value of an asset/or business is likely to be the least.

Replacement Value

The replacement value is the cost of acquiring a new

asset of equal utility and usefulness. It is normally useful in valuing tangible assets such as office equipment and

furniture and fixtures, which do not contribute towards the revenue of the business firm.

Salvage Value

Salvage value represents realisable/scrap value on the disposal of assets after the expiry of their economic

useful life. It may be employed to value assets such as plant and machinery. Salvage value should be

considered net of removal costs.

Value of Goodwill

The valuation of goodwill is conceptually the most difficult. A business firm can be said to have ‘real’ goodwill in case it earns a rate of return (ROR) on invested funds higher than the ROR earned by similar firms (with the same level of risk). In operational terms, goodwill results when the firm earns excess (‘super’) profits.

Fair Value

Fair value is the average of book value, market value and intrinsic value. The fair value is hybrid in nature and often is the average of these three values.

In India, the concept of fair value has evolved from case laws (and hence is more statutory in nature) and is applicable to certain specific transactions, like payment to minority shareholders. It may be noted that most of the concepts related to value are ‘stock’ based in that they are guided by the worth of assets at a point of time and not the likely contribution they can make towards earnings/cash flows of the business in the future.


Approaches/Methods of ValuationThere are four approaches to valuation of business (with focus on equity share valuation):

1) Assets based,

2) Earnings based,

3) Market value based and

4) Fair value method.


Asset-Based Approach to ValuationAssets-based method focuses on determining the value

of Net assets = (Total assets – Total external obligations)

(1)

Net assets per share can be obtained dividing total net

assets by the number of equity shares outstanding. It indicates the net assets backing per equity share (also

known as net worth per share).

Net assets per share = Net assets / Number of equity

shares issued and outstanding (2)


For the purpose of valuing assets and liabilities, it will be useful for a finance manager/valuer to accord special attention to the following points :

1. While valuing tangible assets, such as plant and machinery, he should consider aspects related to technological obsolescence and capital improvements made in the recent years. Depreciation adjustment may also be needed in case the company is following unsound depreciation policy in this regard.

2. Is the valuation of goodwill satisfactory, given the amount of profits, capital employed and average rate of return available on such businesses?

3. With respect to current assets, are additional provisions required for “unrealisability” of debtors? Likewise, are adjustments required for “unsaleable” stores and stock?

4. With respect to liabilities, there is a need for careful examination of ‘contingent liabilities’, in particular when there is mention of them in the auditor’s report, with a view to assess what portion of such liabilities may fructify. Similarly, adjustments may be required on account of guarantees invoked, income tax, sales tax and other tax liabilities that may arise.

Liquidation value is the final net asset value (if any) per share available to the equity shareholder. The value is given as per Equation

Net assets per share = (Liquidation value of assets – Liquidation expenses – Total external liabilities)/Number of equity shares issued and outstanding. (3)


Example 1: Following is the balance sheet of Hypothetical Company Limited as on March 31, current year.

Share capital40,000 11% Preference shares of Rs 100 each, fully paid-up 1,20,000 Equity shares of Rs 100 each, fully paid-upProfit and loss account10% DebenturesTrade creditorsProvision for income tax

40

120232071

8282

Fixed assetsLess: DepreciationCurrent assets:StocksDebtorsCash at bankPreliminary expenses

Rs 15030

1005010

120

1602

____282

Additional Information:(i) A firm of professional valuers has provided the following market estimates of its

various assets: fixed assets Rs 130 lakh, stocks Rs 102 lakh, debtors Rs 45 lakh. All other assets are to be taken at their balance sheet values.

(ii) The company is yet to declare and pay dividend on preference shares.(iii) The valuers also estimate the current sale proceeds of the firm’s assets, in the

event of its liquidation: fixed assets Rs 105 lakh, stock Rs 90 lakh, debtors Rs 40 lakh. Besides, the firm is to incur Rs 15 lakh as liquidation costs.You are required to compute the net asset value per share as per book value, market value and liquidation value bases.


Solution : Determination of Net Asset Value per Share (Rs lakh)

(i) Book value basis Fixed assets (net) Current assets: Stock Debtors Cash and bank

Total assetsLess: External liabilities:

10% DebenturesTrade creditorsProvision for taxation11% Preference share capitalDividend on preference shares (0.11 × Rs 40 lakh)

Net assets available for equity holdersDivided by the number of equity shares (in lakh)Net assets value per share (Rs)

Rs 1005010

2071 840

4.4

Rs 120

160 280

143.4 136.6 1.2

113.83

(ii) Market value basis

Fixed assets (net)

Current assets:

Stock

Debtors

Cash and bank

Total assets

Less: External liabilities (as per details given

above):

Net assets available for equityholders

Divided by the number of equity shares (in lakh)

Net assets value per equity share (Rs)

102

45

10

130

157

287

143.4

143.6

1.2

119.67

(iii) Liquidation value basis

Fixed assets (net)

Current assets:

Stock

Debtors

Cash and bank

Total assets

Less: External liabilities (listed above):

Less: Liquidation costs



Net assets value per equity share (in Rs)

90

40

10

105

140

245

143.4

15.0

86.6

1.2

72.17


Earnings Based Approach to Valuation

Earnings based method relates the firm’s value to its potential future earnings or cash flow generating capacity. Accordingly, there are two major variants of this approach (i) Earnings measure on accounting basis and (ii) earnings measure on cash flow basis.

(i) Earnings measure on accounting basis

As per this method, the earnings approach of business valuation is based on two major parameters, that is, the earnings of the firm and the capatilisation rate applicable to such earnings (given the level of risk) in the market. Earnings, in the context of this method, are the normal expected annual profits. Normally to smoothen out the fluctuations in earnings, the average of past earnings (say, of the last three to five years) is computed.

Value of business (VB) = Future maintainable profits ÷ Relevant capitalisation factor (4)


Example 2:

In the current year, a firm has reported a profit of Rs 65 lakh, after paying taxes @ 35 per cent. On close examination, the analyst ascertains that the current year’s income includes: (i) extraordinary income of Rs 10 lakh and (ii) extraordinary loss of Rs 3 lakh. Apart from existing operations, which are normal in nature and are likely to continue in the future, the company expects to launch a new product in the coming year.

Revenue and cost estimates in respect of the new product are as follows:

(Rs lakh)

Sales

Material cost

Labour cost (additional)

Allocated fixed costs

Additional fixed costs

Rs 60

15

10

5

8

From the given information, compute the value of the business, given that capitalisation rate applicable to such business in the market is 15 per cent.

Solution : Valuation of Business (Rs lakh)

Profit before tax (Rs 65 lakh/(1 – 0.35) Less: Extraordinary income (not likely to accrue in future) Add: Extraordinary loss (non-recurring in nature) Add: Incremental income expected from the launch of the new product:Sales Less: Incremental costs: Material costs Labour costs Fixed costs (additional)Expected profits before taxes Less: Taxes (0.35)Future maintainable profits after taxesRelevant capitalisation factorValue of business (Rs 78 lakh/0.15)

Rs 1510 8

60

33

Rs 100(10)

3

27120 42

780.15520

Some useful insights into estimate of capitalisation rate can be made by referring to the Price ear-nings (P/E) ratio. The reciprocal of the P/E ratio is indicative of the capitalisation factor employed for the business by the market. In Example 2, the P/E ratio is approximately 6.67 (1/0.15). The product of future maintainable profits, after taxes, Rs 78 lakh and the P/E multiple of 6.67 times, yield Rs 520 lakh. Given the fact that P/E ratio is a widely used measure, it is elaborated below.


Price Earnings (P/E) RatioThe P/E ratio (also known as the P/E multiple) is the method most widely used by finance managers, investment analysts and equity shareholders to arrive at the market price of an equity share. The application of this method primarily requires the determination of earnings per equity share (EPS). The EPS is computed as per Equation

EPS = Net earnings available to equity shareholders during the period/Number of equity shares outstanding during the period. (5)

The EPS is to be multiplied by the P/E ratio to arrive at the market price of equity share (MPS).

MPS= EPS × P/E ratio (6)

The P/E ratio may be derived given the MPS and EPS.

P/E ratio = MPS/EPS (7)(7)


Example 3

For facts in Example 2, determine the market price per equity share (based on future earnings). Assuming:

(i) The company has 1,00,000 11% Preference shares of Rs 100 each, fully paid-up.(ii) The company has 4,00,000 Equity shares of Rs 100 each, fully paid- up.(iii) P/E ratio is 8 times.

Solution

Determination of Market Price of Equity Share

Future maintainable profits after taxesLess: Preference dividends (1,00,000 × Rs 11)Earnings available to equity-holders Divided by number of equity sharesEarnings per share (Rs 67 lakh/4 lakh)Multiplied by P/E ratio (times)Market price per share (Rs 16.75 × 8)

Rs 78,00,000 11,00,000 67,00,000

4,00,000 16.75 8

134

To use the DCF approach, accounting earnings (as shown by the firm’s income statement) are to be converted to cash flow figures as shown in Format 1.

Format 1: Computation of Cash Flows

After tax operating earnings*

Plus: Depreciation

Plus: Other non-cash items (say, amortisation of non-tangible asset,

such as patents, trade marks, etc and loss on sale of long- term assets)

* The interest costs are included as a part of the discount rate (K0).

Format 2 shows computation of operating free cash flows (OFCF) for the purpose of valuation of a business.

Format 2: Determination of Operating Free Cash Flows (OFCFF)


Plus: Depreciation, amortisation and other non-cash items

Less: Investments in long-term assets

Less: Investments in operating net working capital**

Operating free cash flows (OFCFF)

*Exclusive of income from (i) marketable securities and non- operating investments and (ii) extraordinary incomes or losses.

**Addition is to be made in the event of decrease of net working capital.

Format 3: Determination of Free Cash Flows (FCFF)

Operating free cash flows (as per Format 2)

Plus: After tax non-operating income/cash flows*

Plus: Decrease (minus increase) in non-operating

Assets, say marketable securities

Free cash flows to Firm (FCFF)

* Non-operating income (1 – tax rate)

The free cash flow (FCFF) is the legitimate cash flow for the purpose of business valuation in that it reflects the cash flows generated by a company’s operations for all the providers (debt and equity) of its ‘capital’. The FCFF is a more comprehensive term as it includes cash flows due to after tax non-operating income as well as adjustments for non-operating assets. Format 3 exhibits the procedure of determining FCFF.