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FEMA Valuation Aspects By: Chander Sawhney (FCA, CS, Certified Valuer (ICAI) Asst. Vice President SEBI REGISTERED (CAT -I) MERCHANT BANKER Ggdd “CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013

Fema Valuation : Business Valuation Article

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FEMA VALUATION (Foreign Exchange Valuation) ASPECTS: Mr. Chander Sawhney at CKF Masterclass on "Recent Developments in Foreign Exchange Management Law". Highlight: Case Study- Valuation of a Hotel Industry Company- DCF Approach,

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Page 1: Fema Valuation : Business Valuation Article

FEMA Valuation Aspects

By: Chander Sawhney(FCA, CS, Certified Valuer (ICAI)

Asst. Vice President

SEBI REGISTERED (CAT -I) MERCHANT BANKER

Ggdd

“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013

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Contents

TABLE OF CONTENT

Particulars Pg. No.

Valuation Overview 3

FDI Valuation - Background of FEMA Valuation - Approaches to FDI Valuation - Major Characteristics of DFCF - DFCF Valuation Process - Free Cash Flow Calculation - Cost of Capital Calculation - Terminal Value Calculation - Tricky Issues in DFCF - Case Study

111415161718202123

Approaches to ODI Valuation 29

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VALUATION OVERVIEW

3

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Valuation

Valuation is the process of determining the “Economic Worth” of an Asset or Company

under certain assumptions and limiting conditions and subject to the data available on the

valuation date. * Source -International Valuation Standard Council

Depends upon :

“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013 4

• Mergers

• IPO

• RBI

• Income Tax

• ESOP

• Companies Act

• SEBI

• Stock Exchange

Purpose Regulatory Accounting

• Purchase Price Allocation

Dispute Resolution

• Company Law Board/ Courts

• Impairment / Diminution

• Arbitration

• Mediation• Acquisitions / Investment

• Voluntary Assessment

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Key Facts of Valuation

The Value of a business, by whatever valuation method it is obtained, is not the selling price of the business. Value is an economic concept based on certain data & assumptions, however Price is what a Buyer is willing to pay keeping in consideration the Economic and Non Economic factors like Emotions, Perception, Greed Etc which cannot be valued as such.

The Value is a subjective term and can have different connotations meaning different things to different people and the result may not be the same, as the context or time changes.

Valuation is more of an art and not an exact science. The Art is Professional Judgment and Science is Statistics. Mathematical certainty is neither determined nor indeed is it possible as use of professional judgment is an essential component of estimating value

Though the value of a business can be objectively determined employing valuation approaches, this value is still subjective, dependent on buyer and seller expectations and subsequent negotiations and the Transaction happens at negotiated price only.

PRICE IS NOT THE SAME AS VALUE

TRANSACTION CONCLUDES AT NEGOTIATED PRICES

VALUATION IS HYBRID OF ART & SCIENCE

VALUE VARIES WITH PERSON, PURPOSE AND TIME

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Growing Cos.

Turnover/Profits: Increasing still Low Proven Track Record: Limited Valuation Methodology: Substantially on Business Model Cost of Capital: Quite High

High Growth Cos.

Turnover/Profits : Good Proven Track Record: Available Valuation Methodology: Business Model with Asset

Base Cost of Capital: Reasonable

Mature Cos.

Turnover/Profits: Saturated Proven Track Record: Widely Available Method of Valuation: More from Existing Assets Cost of Capital: May be High

Declining Cos.

`

Turnover/Profits: Drops Proven Track Record:

Substantial Operating History Method of Valuation: Entirely

from Existing Assets Cost of Capital: N.A.

Turnover/Profits: Negligible Proven Track Record: None Valuation Methodology: Entirely on Business Model Cost of Capital: Very High

Start Up Cos.

Tu

rno

ver

/ P

rofi

ts

Time

Valuation across business cycle follow the law of economics

Valuation: The law of Economics

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CASH FLOW Investor assign value based on the cash flow they expect to receive in the future - Dividends / distributions - Sale of liquidation proceeds Value of a cash flow stream is a function of - Timing of cash Receipt - Risk associated with the cashflow

ASSETS

Operating Assets - Assets used in the operation of the business including working capital, Property, Plant & Equipment & Intangible assets - Valuing of operating assets is generally reflected in the cash flow generated by the businessNon - Operating Assets - Assets not used in the operations including excess cash balances, and assets held for investment purposes, such as vacant land & Securities - Non operating assets are generally valued separately and added to the value of the operations

Key drivers of valuation

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Broad Approaches to Valuation

8

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Broad Approaches to FDI / ODI Valuation

FDIFDI

ODIMinority Stake

Valuation

ODIMinority Stake

Valuation

ODIControl Stake

Valuation

ODIControl Stake

Valuation

Proxy Minimum

Value

Proxy Minimum

Value

9

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FDI VALUATION

• Notification No. FEMA 20/2000-RB dated May 3, 2000, as amended from time to time deals with

Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India)

Regulations, 2000.

•In terms of Schedule 1 of the Notification, an Indian company may issue equity shares/compulsorily

convertible preference shares and compulsorily convertible debentures (equity instruments) to a person

resident outside India under the FDI policy, subject to inter alia, compliance with the pricing guidelines.

•The price/ conversion formula of convertible capital instruments should be determined upfront at the

time of issue of the instruments.

10

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Particulars Valuation before April 21, 2010 Valuation after April 21, 2010

Guidelines in Force CCI Guidelines In case of FDI Transactions:Listed Company: Market Value as per SEBI Preferential Allotment Guidelines

Unlisted Company: DFCF

In case of ODI Transactions:No method has been prescribed

Methods Prescribed Net Assets Value (NAV)Profit Earning Capacity Value(PECV)Market Value (in case of Listed Company)

Discount 15% Discount has been prescribed on account of Lack of Marketability

No such Discount has been prescribed

Historical / Futuristic It is based on Historical Values It is based on Future Projections

Possibility of variation in Value Conclusion

As valuation is more Formulae based, final values came standardized

As valuation is more dependent on Assumptions and choice of factors like Growth Rate, Cost of Capital etc, value conclusion may vary significantly.

Background of FEMA Valuation

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Recent Development in FDI Valuation

“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013

The RBI is considering inclusion of any internationally accepted valuation method in place of the

existing discounted cash flow method (DFCF) prescribed in the FDI policy to remove the practical

difficulties faced by strictly following this method in all closely held companies though it may not be

relevant in case of minority stake/start up valuation etc. The strict approach thus restricts the

commercial flexibility of the parties.

Globally, investors have the freedom to pick valuation method of their choice due to absence of

capital controls in most countries.

The above is a welcome step as it gives liberty to the Valuer to choose the most relevant valuation

method based on the facts of each case and may boost foreign capital inflows to India.

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Discounted Free Cash Flow Method (DFCF)

Approaches to FDI Valuation

As on date, RBI has prescribed DFCF as the only valuation method in case of FDI for closely

held companies as it is one of the most acceptable Valuation methods used by Business

valuer’s worldwide; but has not provided any guidance on its technical aspects.

DFCF expresses the present value of the business as a function of its future cash earnings capacity. In this method, the appraiser estimates the cash flows of any business after all operating expenses, taxes, and necessary investments in working capital and capital expenditure is being met to arrive at Enterprise Value (EV).

Valuing equity using the free cash flow to stockholders requires estimating only free cash flow to equity holders, after debt holders have been paid off. 

DFCF expresses the present value of the business as a function of its future cash earnings capacity. In this method, the appraiser estimates the cash flows of any business after all operating expenses, taxes, and necessary investments in working capital and capital expenditure is being met to arrive at Enterprise Value (EV).

Valuing equity using the free cash flow to stockholders requires estimating only free cash flow to equity holders, after debt holders have been paid off. 

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Forward Looking and focuses on cash generation

Recognizes Time value of Money

Allows operating strategy to be built into a model

Incorporates value of Tangible and Intangible assets

Only as accurate as assumptions and projections used

Works best in producing a range of likely values

It Represents the Control Value

Major Characteristics of DFCF Valuation

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DFCF Valuation Process

Understand Business Model

Identify Business Cycle

Analyze Historical Financial Performance

Review Industry and Regulatory Trends

Understand Future Growth Plans (including Capex needs)

Segregate Business and Other Cash Generating Assets

Identify Surplus Assets (assets not utilized for Business say

Land/Investments)

Create Business Projections (Profitability statement and Balance Sheets)

Discount Business Projections to Present (Explicit Period and Perpetuity)

Add Value of Surplus Assets and Subtract Value of Contingent Liabilities

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Free cash flows to firm (FCFF) is calculated as

EBITDAEBITDA

Taxes

Change in Non Cash Working capital

Capital Expenditure

Free Cash Flow to Firm

Note that an alternate to above is following (FCFE) method in which the value of Equity is directly valued in lieu of the value of Firm. Under this approach, the Interest and Finance charges is also deducted to arrive at the Free Cash Flows. Adjustment is also made for Debt (Inflows and Outflows) over the definite period of Cash Flows and also in Perpetuity workings.

Theoretically, the value conclusion should remain same irrespective of the method followed (FCFF or FCFE), (Provided, assumptions are consistent).

FREE CASH FLOWS

Free Cash Flow calculation

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DISCOUNT RATE – WEIGHTED AVERAGE COST OF CAPITAL

Where:D = Debt part of capital structureE = Equity part of capital structureKd = Cost of Debt (Post tax)Ke = Cost of Equity

(Kd x D) + (Ke x E)

(D + E)

In case of following FCFE, Discount Rate is Ke and Not WACC

WACC

Cost of Capital calculation

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DISCOUNT RATE - COST OF EQUITY

Where:Rf = Risk free rate of return (Generally taken as 10-year Government Bond Yield)B = Beta Value (Sensitivity of the stock returns to market returns)Ke = Cost of EquityRm= Market Rate of Return (Generally taken as Long Term average return of Stock Market)SCRP = Small Company Risk PremiumCSRP= Company specific Risk premium

Mod. CAPM Modelke = Rf + B ( Rm-Rf) + SCRP + CSRP

The Cost of Equity (Ke) is computed by using Modified Capital Asset Pricing Model

(Mod. CAPM)

Cost of Equity calculation

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PERPETUITY FORMULA

– Usually comprises a Large part of Total Value and is sensitive to small changes

– Capitalizes FCF after definite forecast period as a growing perpetuity;

– Estimate Terminal Value using Terminal Value Multiplier applied on last year cash flows;

– Gordon Formula is often used to derive the Terminal CashFlows by normalizing the last year cash flows as a multiple of the growth rate and discounting factor;

– Estimated Terminal Value is then discounted to present day at company’s cost of capital based on the discounting factor of last year projected cash flows

(1 + g)

(WACC – g)

IMPORTANT TIP- It is advised to do Sanity check by applying Relative Valuation Multiples to the Terminal Year Financials and also doing Scenario Analysis.

Terminal value calculation

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Tricky issues in DFCF

Pre Money or Post Money: If the effect of the money coming in Company is taken in

Projections, the Expanded capital base should be considered or else the Equity Value

should be reduced by the inflow amount to reconcile with the existing capital base.

Terminal growth rate: Since it is tough to estimate the perpetual growth rate of a

company as it is based on the cyclical Industry trends, however the maximum perpetuity

growth rate factors in long term average GDP and Inflation of a Country.

Projection Validation via-a-vis Industry: Need to have Sanity check of the

projections with the trend of the industry, particularly in Terminal Value.

Beta of Unlisted Company: It is calculated on relative basis by adjusting the average

beta of its comparable companies for differences in Capital Structure of the unlisted

company with the listed peers.

Risk Free Rate: Yield of a Zero Coupon Bond or Long Term government Bond yield

should be taken as the risk free rate since it does not have any reinvestment risk .

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Adjustment of Company Specific Risk Premium or Small Company Risk Premium:

Small Companies are generally more risky than big companies. CAPM model does not

take into consideration the size risk and specific company risk as Beta measures only

systematic risk and Market Risk Premium (generally pertaining to Sensex Companies).

These risks should also be taken into account while computing the cost of equity.

Length of Projections: The Projected Cash Flows should factor in the entire Business

Cycle of a Company.

Notional/Actual Tax: Actual Tax Liability may be worked out and replaced for the

Notional Tax Liability

Investments: Investments should be valued separately based on their Independent Cash

Flows

Surplus Assets: The Value of Surplus Assets (not being utilized for Business purposes)

should be added separately and their cash flows should be ignored while computing the

Free Cash Flows.

Tricky issues in DFCF (Cont.)

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CASE STUDY

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Valuation of a Hotel Industry Company – DCF Approach

All Amount in Rs. Million

Particulars Year –I Year-II Year-III Year-IV Year-V

Sales 811.48 1,020.65 1,221.10 1,305.91 1,379.81

PAT 196.61 204.79 213.72 218.05 214.43

CAPEX 2,109.40 252.64 71.95 -  - 

Interest

- 8.48 44.82 82.90 118.51

Business ModelEngaged in the business of development, operation & management

of Hotels in India

Projected Financials for 5 Years

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Risk-free Rate – 8.36%

EMRP – 9.04%

Beta – 0.75

Cost of Equity – 15.14%

Pre-tax cost of debt – 0%

Tax Rate – 32.45%

Post-tax cost of debt – 0%

WACC15.14%

Debt – Equity – 100% EquityPerpetuity Growth

Rate – 4%

Discount and Perpetuity growth rates

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Particulars Year I Year II Year III Year IV Year V Terminal

Profit After Tax 197.00 205.00 214.00 218.00 214.00  

Add : Depreciation 61.00 116.00 134.00 136.00 133.00  

Add : Interest(Post Tax) - 6.00 30.00 56.00 80.00  

Less :Capital Expenditure 2,109.00 253.00 72.00   -  

Free Cash Flows (1,852.00) 74.00 306.00 410.00 427.00 4,004.00

Discounting Factor 0.87 0.76 0.66 0.57 0.50 0.50

Present value of Cash flows (1,611.00) 56.00 202.00 234.00 214.00 2,002.00

Cumulative present value of Cash Flows 1,097.00          

Enterprise Value 1,097.00          

Add: cash as on Valuation date 121.00          

Less: Debt as on Valuation date -          

Equity Value 1,218.00          

Discounted Free Cash Flow

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Valuation Assumptions

• For the sake of simplicity-

– Working capital changes not considered above;

– Full Year discount rates have been considered;

– During Terminal Value, Capex has not been deducted. A better view is to keep

Depreciation and Capex as same while normalizing the last year cash flows;

– Depending upon changes in Capital structure in projections, WACC may be

adjusted based on the Debt Equity ratio of each year;

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• Selection of Comparable companies based on the industry, size, product profile, nature of business etc.

• Evaluation of Enterprise Value to Net Sales or EBITDA multiples

• Evaluation of Equity Value to Profit multiples

• Evaluation of a range of observed multiples

• Evaluation of Maintainable financials of the company

• Based on observed multiples

– Industry EV / Net Sales Range = 1.30 – 1.50

– Industry PE Range = 8.0-9.0

• Enterprise Value Range – Rs. 1027 Million – Rs. 1185 Million

• Equity Value Range- Rs. 1240 Million – Rs. 1395 Million

Current Financials of Company A

Net Sales – Rs 790 Million

Net Profit - Rs 155 Million

Comparable Companies EV/Net Sales PE

Company I 1.50 8.00

Company II 1.40 8.00

Company III 1.30 9.00

Sanity Check of Our DFCF Analysis

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APPROACHES TO ODI

VALUATION

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Market Multiples of Comparable Listed Companies are computed and applied to the Company being valued to arrive at a multiple based valuation. The difficulty here is in the selection of a comparable company, since it is rare to find two or more companies with the same product portfolio, size, capital structure, business strategy, profitability and accounting practices. Most Valuations in stock markets are market based. Also Valuations for Tax purposes are done using this method.

It Involves determining long term industry multiples using relevant parameters like:

Sales – EV / Sales looks at the enterprise value (market value of equity and debt) of firm vis-à-vis sales

Earnings before interest, taxes and depreciation (EBDITA) – EV / EBIDTA, values the firm on the basis of operating efficiency. Net Debt is deducted to arrive at the value of Equity

Net Profit – P / E, values the Equity on the basis of net earnings of company

Book Value – P / BV values the Equity on basis of book value of company

It Involves determining long term industry multiples using relevant parameters like:

Sales – EV / Sales looks at the enterprise value (market value of equity and debt) of firm vis-à-vis sales

Earnings before interest, taxes and depreciation (EBDITA) – EV / EBIDTA, values the firm on the basis of operating efficiency. Net Debt is deducted to arrive at the value of Equity

Net Profit – P / E, values the Equity on the basis of net earnings of company

Book Value – P / BV values the Equity on basis of book value of company

Comparable Companies Market Multiples Method (CCM)

Approaches to ODI Valuations

For valuing Minority Stake

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Approaches to ODI Valuations (Contd)

For valuing Majority StakeRecommended Methods are as follows:

DFCF (Already discussed in earlier slides)

Comparable Transaction Multiple Method

This technique is mostly used for valuing a company for M&A, the transaction that have taken place in the

Industry which are similar to the transaction under consideration are taken into account. With the transaction

multiple method, similar acquisition or divestitures are identified, and the multiples implied by their purchase

prices are used to assess the subject company’s value. The greatest impediment in finding truly comparable

transactions is the absence of available information on private transactions based on which such transactions

took place. The more recent the transaction, the better this technique, with all other things being equal.

“CKF Master class on Recent Developments in Foreign Exchange Management Law” – 10 th April,2013 32

Price of Recent Investment (PORI)

Under this valuation approach, the recent investment in the business by an Independent party may be taken as

the base value for the current appraisal, if no substantial changes have taken place since the date of such last

investment. Generally the last Investment is seen over a period of last 1 year and suitable adjustments are made

to arrive at current value.

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Inbound Investment Inbound Investment DFCFDFCF

Gift of Unquoted Equity Shares (Min)

Gift of Unquoted Equity Shares (Min)

NAVNAV

Outbound Investment Outbound Investment Valuer DiscretionValuer Discretion

Gift of Unquoted Shares other than Equity Shares Gift of Unquoted Shares

other than Equity Shares Price it would fetch if sold in

open marketPrice it would fetch if sold in

open market

Takeover Code/ Delisting - Infrequently Traded

Takeover Code/ Delisting - Infrequently Traded

Only Parameters Prescribed – Return on Net Worth, EPS, NAV

vis-a vis Industry Average

Only Parameters Prescribed – Return on Net Worth, EPS, NAV

vis-a vis Industry Average

Takeover Code/ Delisting - Frequently Traded

Takeover Code/ Delisting - Frequently Traded

Based on Market PriceBased on Market Price

Reserve Bank of India

ESOP Tax ESOP Tax Valuer DiscretionValuer Discretion

ESOP AccountingESOP Accounting Option – Pricing ModelOption – Pricing Model

Income Tax

SEBI

CA / MBCA / MB

>5Mn$ - MB, otherwise CA/MB>5Mn$ - MB, otherwise CA/MB

--

MBMB

MBMB

--

CA/MBCA/MB

--

Stock Exchanges Relisting Base Price Determination

Relisting Base Price Determination

Valuer DiscretionValuer Discretion

Companies Act Sweat EquitySweat Equity Valuer DiscretionValuer Discretion

MBMB

--

Transactions

Prescribed Methodologies

Mandate to be done by

REGULATORY VALUATIONS

35

Gift of Unquoted Equity Shares from Resident (Max)

Gift of Unquoted Equity Shares from Resident (Max)

DCF (Valuation Based on Assets, Business & Intangibles

is also acceptable)

DCF (Valuation Based on Assets, Business & Intangibles

is also acceptable)

FCA / MBFCA / MB

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Any Specific Valuation Query may be mailed @ [email protected] / [email protected]

M: +91 9810557353; Ph: 011-40622252W: www.corporatevaluations.in; corporateprofessionals.com

Mr. Chander Sawhney(FCA, CS, Certified Valuer (ICAI)

Disclaimer:This presentation contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither corporatevaluations.in nor any other member of the Corporate Professionals organization accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this presentation. On any specific matter, reference should be made to the appropriate advisor.

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