CORPORATE VALUATION AND VALUE BASED MANAGEMENT

Introduction:Value maximization is the central theme in

financial management. Owners of corporate securities will hold management responsible if they fail to enhance the value.

Managers in the present scenario must understand what determines value and how it should be appraised.

The goal of such appraisal is to estimate fair market value of the company.Fair Market Value:

“It is the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts”. - Internal Revenue Service of US

Approaches of Corporate Valuation:There are four approaches to appraise the

value of a company. They are:1. Adjusted book value approach2. Stock and Debt approach3. Direct comparison approach4. Discounted cash flow approachAdjusted book value approach:It is the simplest approach to value a firm relies on the information found on its balance sheet. There are two methods to use balance sheet information to appraise the value of firm. They are:1. Book value of investor claims summarized directly.2. Assets of firm may be totalled and from this total non investor claims ( accounts payable and provisions) may be deducted.

Following illustration gives us a clear idea about the two methods of adjusted book value approach

Assets

Share Capital 250 Fixed Assets (Net) 430

Equity Gross block 790

Preference Accrued depreciation

360

Reserves & Surplus

122 Investments 15

Secured Loans 193 Current assets, loans, and advances

334

Term Loans Cash and bank 20

Debentures Debtors 164

Unsecured Loans 89 Inventories 115

Bank Credit Prepaid expenses 35

Inter corporate loans

Miscellaneous expenditure and losses

__

Current liabilities and provisions

115

769 769

Balance sheet of XYZ ltd as on 31-03-2010

Balance Sheet Valuation based on investor claims method:

In this method the book values of investor claims will be added directly. In the above balance sheet the investor claims are :

Rs in millionsShare Capital 250Reserves & Surplus 122Secured Loans 193Unsecured Loans 89

654Balance Sheet valuation based on Asset – Liabilities Approach:

In this method the value of firm is calculated as the difference between asset and liabilities.

Rs in millionsTotal Assets 769Less: Current liabilitiesand Provisions 115

654

The accuracy of book value approach depends on how well the net book values of the assets reflect their fair market values.Reasons for divergence of book value from market price:1. Inflation2. Technological changes3. Organizational CapitalInflation:

The book value of asset is the difference of historical cost and depreciation. Hence it does not consider inflation which influences the market value.Technological Changes:

Assets will be replaced when ever they become obsolete and worthless even before they are fully depreciated in the books.Organizational Capital

It is the value created by bringing together employees, customers, suppliers, and managers in a mutually beneficial and productive relationship. It will not be shown in the balance sheet and it cannot be easily separated from the firm.

Adjusting Book value to Reflect Replacement Cost:Various assets are valued as follows:

1. Cash: There is no problem in valuing it and hence it remains same.2. Debtors: They are valued at their face value. 3. Inventories: It is further classified into 3 categories. Raw material, Work in process and Finished goods. Raw material is valued at their most recent cost of acquisition. Work in process is valued based on cost point view i.e., cost of raw materials plus cost of processing or based on selling price point view i.e., selling price of final product less expenses to be incurred in translating work in process into sales. Finished goods are valued by determining the sale price realizable in ordinary course of business less expenses to be incurred in packaging, handling, transporting, selling and collection of receivables.4. Other Current Assets: These include deposits, prepaid expenses, and accruals. These are valued at their book value.5. Fixed Tangible Assets: They are mainly land, buildings and civil works, and plant and machinery. Land is valued as if it is vacant and available for sale. Buildings and civil works may be valued at replacement cost less physical depreciation and deterioration. The value of plant and machinery is appraised by the market price of similar assets (used) plus cost of transportation and installation.6. Non Operating Expenses: Assets not required for meeting the operating requirements of business are referred to as non operating assets. They are excess land and infrequently used buildings. These are valued at their fair market value.

Adjusting book value to Reflect Liquidation Value:The most direct approach for approximating fair market

value of asset on the balance sheet of a firm is to find out what they would fetch if the firm were liquidated immediately. If there is a secondary market then liquidation values equal secondary market prices. If active secondary market is not available then we must try to estimate hypothetical price at which the asset may be sold.

This method ignore organizational capital. This approach makes sense for a firm that is worth more dead than alive.Bottom Line :

The unadjusted book value approach makes sense only in rare cases, such as appraisal of regulated industries. The adjusted book value approach or liquidation value approach makes sense for firms which derive their value mainly from owning natural resources. Even such cases are not common because most firms have valuable organizational capital. In real life book value approach has applicability.

Stock and Debt ApproachWhen the securities of a firm are publicly traded its value

can be obtained by merely adding the market value of all its outstanding securities. This is called stock and debt approach.

Let us consider an example of ABC corporation whose outstanding shares on March 31, 2010 is 20 million at a closing price of Rs. 30 on that date. The market value of ABC Corporation equity is Rs. 600 million. On March 31, 2010 the outstanding debt of ABC Corporation with market value is Rs.370 million. By adding Market value of Equity and market value of Debt the total value of firm is Rs.970 million.

Though it is a straight forward there is some debate about what prices to use when valuing the securities, particularly the equity shares. Since stock prices are volatile some appraisers suggest using an average of recent stock prices, rather than the price on the lien date. Lien date is the day on which the appraiser is attempting to value. Their argument is that the average of prices over a period of time is more reliable than current stock price to estimate the firms true value.

Is averaging is reasonable this depends on whether the stock market is efficient or not. If market is considered efficient implying that security prices reflect all publicly available information there is no justification for averaging.

The efficient market hypothesis has two important implications for appraisal practice:

1. Where stock and debt approach can be employed, it will produce the most reliable estimate of value.

2.The securities of the firm should be valued at the market price obtaining on the lien date. Averaging of prices over a period of time is not correct. It reduces the accuracy of appraisal.Direct Comparison Approach:

This approach is based on the principle that similar assets should sell at similar prices. One can value asset by looking at price at which a comparable asset has changed hands between a reasonably informed buyer and a reasonably informed seller. This can be calculated using the formula:VT=x T V c / x c

where VT is the appraised value of the target firmx T is the observed variable for the target firm that supposedly drives value V c is the observed value of the comparable firm x c is the observed variable for the comparable company.

Steps In Applying the Direct Comparison ApproachThis involves the following steps:1.Analyze the economy2.Analyze the industry3.Analyze the subject company4.Select comparable companies5.Analyze subject and comparable companies6.Analyze multiples7.Value the subject companyAnalyze the Economy:

The analysis of the economy provides the basis for assessing the prospects of various industries and evaluating individual companies within an industry. It examines the following factors and forecast their growth rates. They are :a) Gross national productb) Industrial productionc) Agricultural outputd) Inflatione) Interest ratesf) Balance of Paymentg) Exchange Ratesh) Government budget

Analyze the Industry:It focus on the following:

1. The relationship of the industry to the economy as a whole2. The stage in which the industry is in its life cycle3. The profit potential of the industry4. The nature of regulation applicable to the industry5. The relative competitive advantages of procurement of raw materials, production costs, marketing and distribution arrangements , and technological resources.Analyze the subject Company:

The key aspects covered in this are:1. Product portfolio and market segments covered by the firm.2. Availability and cost of inputs.3. Technological and production capability.4. Market image, distribution reach, and customer loyalty.5. Product differentiation and economic cost position.6. Managerial competence and drive.7. Quality of human resources.8. Competitive dynamics.9. Liquidity, leverage and access to funds10. Turnover, margins, and return on investment.

Select Comparable Companies:Companies which are similar to the subject company in terms

of the lines of business, nature of markets served, scale of operation and so on are to be selected. It is difficult to find similar companies because companies are engaged in a variety of businesses, serve different segments and have varying capacities. In practice analyst should make effort to look carefully at 10 to 15 companies in the same industry and select at least 3 to 4 which come as close as possible to the subject company.Analyze the financial aspects of the subject and comparable companies:

Once the comparable companies are selected the historical financial statements of the subject and comparable companies must be analyzed to identify similarities and differences and make adjustments so that they are put on a comparable basis. Adjustment s are required for intangible assets for off balance sheet items and so on. The purpose is to normalize the financial statements.Choose the observable financial variable:

In order to provide a reliable estimate of value, the ratio of value indicator to the observed financial variable i.e. V/x must not vary widely for the comparable firms and the target firm. Where V and x are the variables which have to be chosen carefully.

The value of firm is ultimately based on the cash generated for its investors, financial variables like earnings and cash flow are the obvious choices for x. In addition financial variables like sales and net worth which influence earning power are also to be considered.

The value indicator must be consistent with the financial variable chosen. If PBDIT( Profit Before Depreciation Interest and Tax) is chosen then is should be matched with total firm value. If equity earnings is chosen it should be matched with equity value not the total firm value. The ratios or multiples that are commonly used on direct comparison method are:1. Firm value to sales2. Firm value to book value of assets3. Firm value to PBIDT4. Firm value to PBIT5. Equity value to equity earnings (Price – Earnings multiple)6. Equity value to net worth (Market – Book value)Value the subject Company:

In this step we will decide where the subject company fits in relation to the comparable companies. Once this is done, appropriate multiples may be applied to the financial numbers of the subject company to estimate its value. If several bases are employed the several value estimates may be averaged.Bottom Line:

The direct comparison approach is very popular because it relies on multiples that are easy to relate to and can be obtained easily and quickly. They are particularly useful when several comparable companies are traded and the market prices them accurately. But there is a possibility of misuse and manipulation as no two firms are likely to be identical in terms of risk and growth. The multiples used reflect the valuation errors i.e. overvaluation or undervaluation of the market.

Discounted Cash Flow Approach:Traditionally adjusted book value approach and direct

comparison approach were used more commonly but from 1990s, DCF approach has received greater attention, emphasis, and acceptance mainly because of its conceptual superiority and its strong endorsement by leading consultancy organizations.

Valuing a firm using DCF approach is conceptually identical to valuing the capital project using PV method. There are two important differences:1. A capital project will have finite life and a firm has an indefinite life. i.e., a project is valued based on its economic life and impute salvage value to the assets of the project at the end of its economic life. For a firm we don’t define economic life and impute a salvage value to its assets at the end of such a period.2. A capital project is valued as one off investment. A firm is viewed as a growing entity and for valuing a firm we take into account all the investments in fixed assets and net working capital that are expected to be made over time to sustain the growth of the firm.

Value of firm= Present value of cash flow during an explicit forecast period + Present value of cash flow after the explicit forecast period.Explicit forecast period is normally for 5 to 15 years.The DCF method of valuing a firm involves the following steps:1. Analyzing historical performance2. Estimating the cost of capital3. Forecasting performance4. Determining the continuing value5. Calculating the firm value and interpreting the resultsAnalyzing Historical Performance:The historical performance focus on:a) extracting valuation related metrics from accounting

statementsb) Calculating the free cash flow and the cash flow available to

investorsc) Getting a perspective on the drivers of free cash flowd) Developing the ROIC tree

To understand the concept of historical performance analysis let us consider an example of ALWIL LTD whose balance sheet and profit and loss account for 3 years are as follows:

Rs in million

Profit and Loss Account

Particulars 1 2 3

Net Sales 180 200 229

Income from marketable securities --- --- ---

Non operating Income --- --- ---

Total Income 180 200 240

Cost of goods sold 100 120 125

Selling and general administration expenses

30 35 45

Depreciation 12 15 18

Interest expenses 12 15 16

Total costs and expenses 154 170 204

PBT 26 30 36

Tax provision 8 9 12

PAT 18 21 24

Dividend 11 12 12

Retained earnings 7 9 12

Balance Sheet

Years

1 2 3

Equity capital 60 90 90

Reserves & Surplus 40 49 61

Debt 100 119 134

Total 200 258 285

Fixed assets 150 175 190

Investments --- 20 25

Net Current Assets 50 63 70

Total 200 258 285

Extracting valuation related metrics from accounting statements:

The following are evaluated using accounting statements:1. Operating invested capital2. NOPLAT3. ROIC4. Net Investment1. Operating invested capital = total assets in the balance

sheet – Non operating fixed assets like surplus land – excess cash and marketable securities.

Let us assume that investment represent excess cash and marketable securities.Operating invested capital for year 1=200-0=200Operating invested capital for year 2=258-20=238Operating invested capital for year 3=285-25=2602.Net operating profit less adjusted taxes(NOPLAT) = EBIT – Taxes on EBITEBIT= PBT + Interest expense – Interest income – non operating incomeTaxes on EBIT = Tax provision from income statement + Tax shield on interest expense – tax on interest income – tax on non operating income.

Year 1 Year 2 Year 3

Profit before tax 26 30 36

Add: Interest expense 12 15 16

Less: Interest income --- --- 3

Less: Non operating income --- --- 8

EBIT 38 45 41

Tax provision from income statement

8 9 12

Add: Tax shield on interest expense 4.8 6 6.4

Less: Tax shield on interest income --- --- 1.2

Less: Tax shield on non operating income

--- --- 3.2

Taxes on EBIT 12.8 15 14

NOPLAT 25.2 30 27

Return on Invested Capital:ROIC = NOPLAT / Invested capital

Invested capital is usually measured at the beginning of the year or as the average at the beginning and end of the year.The ROIC of ALWIL LTD is calculated as follows:

Year 2 Year 3NOPLAT 30 27Invested capital at theBeginning of the year 200 238ROIC 30/200 =15% 27/238=11.3%ROIC focuses on the true operating performance of the firm.Net Investment:

Net investment is the difference between gross investment and depreciation.Net Investment = Gross investment – Depreciation

Gross investment is sum of incremental outlays on capital expenditures and net working capital.

Depreciation refers to all non cash charges.Net investment during the year can be calculated as follows:Net fixed assets at the end of the year + net current assets at the end of the year – ( Net fixed assets at the beginning of the year + net current assets at the beginning of the year)

Net investment of ALWIL LTD is as follows:Year 2 Year 3

Net fixed assets at the end of the year 17527

Add: Net current assets at the end of the year 6370

Less: Net fixed assets at the beginning of the year 150175

Less: Net current assets at the beginning of the year 5063

Net Investment 38 22Calculating The Free Cash Flow:

The free cash flow is the post tax cash flow generated from the operations of the firm after providing for investments in fixed investment and net working capital required for the operations of the firm.FCF = NOPLAT –Net InvestmentFCF = ( NOPLAT + Depreciation ) – ( Net Investment + Depreciation)FCF = Gross cash flow – Gross InvestmentFCF of ALWIL LTD is calculated as follows:

Year 1 Year 2 Year 3NOPLAT 25.5 30.0 27.0Depreciation 12 15 18Gross cash flow 37.2 45 45Increase / decrease in working capital 13 7Capital expenditure 40 33Gross Investment 53 40Free Cash Flow (8) 5

Cash flow available to investors = Free cash flow + Non operating cash flowNon operating cash flow arises from non operating items like sale of assets, restructuring and settlement of disputes.The cash flow available to investors can be viewed as the financing flow which is derived as follows: Financing flow = After tax interest expense

+ Cash dividend on equity and preference capital + Redemption of debt – New borrowings + Redemption of preference shares + Share buybacks – Share issues + change in excess marketable securities – after tax income on excess market securities

Calculation of cash flow available to the investors is as follows:

Year 2 Year 3

Free cash flow (8) 5

Add: Non operating cash flow --- 4.8

Cash flow available to investors (8) 9.8

After tax interest expense 9 9.6

Add: Cash dividend on equity and preference capital

12 12

Add: Redemption of debt --- ---

Less : New borrowings 19 15

Add: Share buybacks --- ---

Less: Share issues 30 ---

Add: Difference of excess marketable securities 20 5

Less: After tax income on excess securities --- 1.8

Financing flow (8) 9.8

Estimating The Cost of Capital:Cost of capital is the discount rate used for converting the

expected free cash flow into its present value. Features of cost of capital:• It represents a weighted average of the costs of all sources of capital as the free cash flow reflects the cash available to all providers of capital.• It is calculated in post tax terms because the free cash flow is expressed in post tax terms.• It is defined in nominal terms since the free cash flow is stated in nominal terms.• It is based on market value weights for each component of financing, as market values, not book values, represent the economic claims of various providers of capital.• It reflects the risks borne by various providers of capital.The formula for calculating weighted average cost of capital is:WACC = r E (S / V) + R P (P / V) + r D ( 1 - T) (B / V)Where WACC = Weighted Average Cost of Capital.r E = Cost of Equity Capital .S = Market Value of Equity. V = Market Value of Firm.R P = Cost of Preference Capital.P = Market Value of Preference Capital. r D = Pre Tax Cost of Debt.T = Marginal Rate of Tax Applicable .B = Market Value of Interest Bearing Debt.

ALWIL LTD has a target capital structure in which debt and equity have weights of 2 and 3. The component costs of debt and equity are 12.67% and 18.27%. Marginal rate of tax is 40%. The weighted average of capital is :WACC = 3/5 *18.27 + 2/5 * 12.67 (1 – 0.4) =14%FORECASTING PERFORMANCE:This involves the following steps:1. Selecting the explicit forecast period2. Developing a strategic perspective on the future performance

of the company3. Converting the strategic perspective into financial forecasts4. Checking for consistency and alignmentSelecting the explicit forecast period:

It is such that the business reaches a steady state at the end of this period. It is based on the following assumptions:5. The firm earns a fixed profit margin achieves a constant asset

turnover and hence earns a constant rate of return on the invested capital.

6. The reinvestment rate and growth rate remain constant.Developing a Strategic perspective:

It reflects a credible story about the company’s future performance. A story is to be developed on the basis of thoughtful strategic analysis of the company and the industry to which it belongs. The prominent among them are classical industry structure analysis, customer segmentation analysis, and competitive business system analysis.

Converting the strategic perspective into financial forecasts:Once story is crafted you have to develop a forecast of free cash

flow. Sometimes free cash flow is developed directly without going through the profit and loss account and balance sheet. It is advisable to base free cash flow on the basis of profit and loss account and balance sheet.

For non financial companies the most common method for forecasting the profit and loss account and balance sheet is as follows:1. Develop the revenue forecast on the basis of volume growth and price

changes2. Use the revenue forecast to estimate operating costs, working capital,

and fixed assets.3. Forecast non operating items such as investments, non operating

income, interest expense and interest income.4. Project net worth. Net worth at the end of the ear n is equal to net

worth at the end of year n – 1, plus the amount ploughed back from the earnings of year n, plus new share issues during year n, minus share repurchases during year n.

5. Use the cash and debt account as the balancing account.Checking for consistency and alignment:

The forecast for consistency and alignment is done by asking the following questions:

1. Is the projected revenue growth consistent with industry growth?2. Is the ROIC justified by the industry’s competitive structure?3. What will be the impact of technological changes on risk and

returns?4. Is the company capable of managing the proposed investments?5. Will the company be in a position to raise capital for its expansion

needs?Empirical evidence suggests that:• Industry average ROICs and growth rates are related to economic fundamentals.• It is difficult for a company to out perform its peers for an extended period of time because competition often catches up sooner or later.DETERMINING THE CONTUNING VALUE:

A company value is sum of two terms:Present value of cash flow during the explicit forecast period + Present value of cash flow after the explicit forecast period.The second one represents the terminal value of continuing value. There are two steps in estimating the continuing value:• Choosing an appropriate method• Calculating the continuing valueChoosing an appropriate method:A variety of methods are available for estimating the continuing value. They are as follows:

Cash flow Methods:• Growing free cash flow perpetuity method• Value driver methodNon Cash flow Methods:• Replacement cost method• Price PBIT ratio method• Market to book ratio methodGrowing free cash flow perpetuity method:This method assumes that free cash flow would grow at a constant rate for ever after the explicit forecast period T. The continuing value of such a stream can be established by applying the constant growth valuation model:CVT = FCF T+1 / WACC – gWhereCVT = Continuing value at the end of year TFCF T+1 = Expected free cash flow for the first year after the explicit forecast periodWACC = Weighted average cost of capital g = Expected growth rate of free cash flow forever.

Value Driver Method:It uses the growing free cash flow perpetuity formula but

expresses it in terms of value drivers as follows:CVT = NOPLAT T+1 ( 1 – g / r ) / WACC – gWhere CVT = Continuing value at the end of year TNOPLAT T+1 = Net operating profit less adjusted tax for the first year after the explicit forecast periodWACC = Weighted average cost of capital g = Constant growth rate of NOPLAT after the explicit forecast periodr = Expected rate of return on net new investment.Replacement Cost Method:The continuing value is equated with expected replacement cost of fixed assets of the company.Limitations:• Only tangible assets can be replaced.• It may simply be uneconomical for a firm to replace some of its assets. Price to PBIT ratio method:

In this method PBIT in the first year after the explicit forecast period is multiplied by a suitable price to PBIT ratio.Limitations:• It assumes that PBIT drives prices which is not a reliable bottom line for purposes of economic evaluation.

• There is an inherent inconsistency in combining cash flows during the explicit forecast period with PBIT for the post forecast period.•There is a practical problem as no reliable method is available for forecasting the price to PBIT ratio.Market to book ratio method:

The continuing value of the company at the end of the explicit forecast period is assumed to be some multiple of its book value. It suffers from same problems as that of previous method. The distortion from inflation and arbitrary accounting policies may be high.Calculating the continuing value:Continuing value = FCF9 / WACC – g

= FCF8 (1+g) / WACC – gCalculating the firm value and interpreting the results:Calculating the firm value:

The value of firm is equal to sum of the following three components:• Present value of the free cash flow during the explicit forecast period• Present value of the continuing value at the end of the explicit forecast period•Value of non operating assets which were ignored in free cash flow analysis

Interpreting the results:Valuation is done to guide some management decision like

acquiring a company, divesting a division or adopting a strategic initiative. While decision based on any one scenario is fairly obvious given its expected impact on shareholder value, interpreting multiple scenarios is far more complex. We should evaluate the following questions:• If the decision is positive, what can possibly go wrong to invalidate it? How likely is that to happen?• If the decision is negative, what upside potential is being given up? What is the probability of the same?The process of examining initial results may well uncover unanticipated questions tat are best resolved through evaluating additional scenarios. DCF Approach : 2 STAGE and 3 STAGE Growth Model:

This method is useful when detailed forecasts are not available.Two Stage growth model:

This model allows for two stages of growth an initial period of higher growth followed by a stable growth forever. In Value of firm = present value of the FCF (free cash flow) during the high growth phase + Present value of terminal value.FCF = cash flow available to investors.

Let us consider an example to understand this model. ABC Ltd is expected to grow at a higher rate for five years thereafter the growth rate will fall and stabilize at a lower level.The following information is available:Base Year Information:Revenues Rs. 4000 millionEBIT (8% of Revenues) Rs. 500 millionCapital expenditure Rs. 300 millionDepreciation Rs. 200 millionWorking capital as a percentage of revenues 30 percentCorporate tax rate (for all time) 40 percentPaid up equity capital (Rs. 10 par) Rs. 300 millionMarket value of debt Rs. 1250 millionInputs for the High Growth Rate:Length of the high growth phase 5 yearsGrowth rate in revenues, depreciation, EBIT and capital expenditure 10 percentWorking capital as a percentage of revenues 30 percentCost of debt 15 percent (pre tax)Debt Equity ratio 1:1Risk free rate 13 percentMarket risk premium 6 percentEquity beta 1.333

Inputs for the Stable Growth Period:Expected growth rate in revenues and EBIT 6 percentCapital expenditures are offset by depreciationWorking capital as a percentage of revenues 30 percentCost of debt 15 percentDebt Equity ratio 2:3Risk free rate 12 percentMarket risk premium 7 percentEquity beta 1.0Forecasted FCF during high growth rate are calculated as below:Particulars

Years

1 2 3 4 5 Terminal year

Revenues 4400

4840

5324 5856.4

6442.0

6828.6

EBIT 550 605 665.6 732.1 805.1 ------------

EBIT (1- t) (tax=40%)

330 363 399.3 493.2 483.2 512.1

Capital expenditure – depreciation

110 121 131.1 146.4 161.1 ----------

Change in working capital

120 132 145.2 159.7 175.7 116.0

FCF (3-4-5) 100 110 123 133.1 146.4 396.1

Cost of equity and weighted average cost of capital during the high growth period and stable growth period is calculated as follows:Cost of equity = risk free rate + equity beta (market risk premium)High growth period = 13% +1.333 (6%) = 21%Stable growth period = 12% + 1(7%)= 19%Weighted average cost of capital = proportion of equity * cost of equity + proportion of debt * cost of debt (1- t)High growth firm = 0.5 (21%) + 0.5 (15)(0.6) = 15%Stable growth firm = 0.6(19%)+ 0.4(15%)(0.6) = 15%Present value of FCF during explicit forecast is 100/1.15 +110/(1.15)2 +121/(1.15)3 + 131.1/(1.15)4 +146.4/(1.15)5 = 397.44 millionPresent value of terminal value is 396.1/(0.15 – 0.06)*(1.15)5 = Rs. 2188.23 millionValue of firm = 397.44 + 2188.23 = 2585 millionThree Stage Growth Model:

It has the following assumptions:• The firm will enjoy a high growth rate for a certain period ( usually 3 to 7 years)• The high growth period will be followed by a transition period during which the growth rate will decline in linear increments.• The transition period will be followed by a stable growth rate forever.

Value of firm = PV of FCF during high growth period + PV of FCF during the transition period + PV of terminal valueThe above will be explained with an example:Let XYZ Ltd is being appraised by an banker the following is the information of XYZ Ltd:Base Year Information:Revenues Rs. 1000 millionEBIT Rs. 250 millionCapital Expenditure Rs. 295 millionDepreciation and Amortization Rs. 240 millionWorking capital as a percentage of revenues 20 %Tax rates 40 % (for all time to come)Inputs for the High Growth Period:Length of the high growth period 5 yearsGrowth rate in revenues, depreciation,EBIT, and capital expenditures 25 %Working capital as a percentage of revenues 20 %Cost of Debt 15 % (pre tax)Debt Equity Ratio 1.5Risk free rate 12 %Market risk premium 6 %Equity Beta 1.583WACC = 0.4(12+1.583(6))+0.6(15(1 – 0.4))=14 %

Inputs for the Transition Period:Length of transition period 5 yearsGrowth rate in EBIT will decline from 25 % in year 5 to 10 % in year 10 in linear movements of 3 % each yearWorking capital as a percentage of revenues 20%The debt equity ratio during his period will drop to 1:1 and the pre tax cost of debt will be 14 %Risk free rate 11 %Market risk premium 6%Equity beta 1.10WACC 0.5[11+1.1(6)]+0.5[14(1-0.4)]=13%Growth rate in revenues, EBIT, capitalExpenditure and depreciation 10%Working capital as a percentage of revenues 20 %Debt equity ratio 0:1Pre tax cost of debt 12 %Risk free rate 10 %Market risk premium 6%Equity beta 1 WACC 1[10+1(6)] = 16 %From the above inputs we will estimate free cash flows to firm, cost of capital and present values during high growth and transition period.

Period Growth rate

EBIT (1–t)

Cap Exp

Dep WC ∆ WC

FCF D /E Beta WACC Present Value

1 25 187.5 368.8 300 250 50 68.7 1.5 1.583 14 60.26

2 25 234.4 460.9 375 312.5 62.5 85.9 1.5 1.583 14 66.10

3 25 293.0 576.2 468.8 390.6 78.1 107.3 1.5 1.583 14 72.43

4 25 366.2 720.2 585.9 488.3 97.7 134.2 1.5 1.583 14 79.45

5 25 457.8 900.3 732.4 610.4 122.1 167.8 1.5 1.583 14 87.09

6 22 558.5 1098.3 893.6 744.6 134.2 219.6 1.0 1.100 13 100.80

7 19 664.6 1307.0 1063.3 886.1 141.5 279.4 1.0 1.100 13 113.44

8 16 770.9 1516.1 1233.5 1027.9 141.8 346.5 1.0 1.100 13 124.74

9 13 871.1 1713.2 1393.8 1161.5 133.6 418.1 1.0 1.100 13 139.96

10 10 958.2 1884.6 1533.2 1277.7 116.2 490.6 1.0 1.100 13 138.35

The terminal value at the end of the year 10 can be calculated based on FCF in 11 year, the stable growth rate of 10 %, and the WACC of the stable growth period, 16%FCF 11 = FCF 10 (1.06) = 490.6 (1.10) = 539.7Terminal value 10 = FCF 11 / WACC – g = 539.7 / 0.16 – 0.10 =Rs. 8995 millionPresent value of terminal value = 8995 / (1.14)5(1.13)5 = Rs.2535.62 millionThe value of firm is as follows:Present value of FCF during the high growth period is Rs. 365.33 millionPresent value of FCF during the transition period is Rs. 617.29 millionPresent value of the terminal value is Rs. 2535.62 millionValue of firm is Rs. 3518.24 million