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Category: M & A

Tax Due Diligence — Direct Taxation

M&A

Introduction:


Devising an M&A strategy is the first critical step for any
business contemplating a transaction. Armed with a plan and knowledge of the
competitive marketplace, companies are ready to practise the art of the deal.
But the need for a speedy transaction and post-merger integration should not
entice companies to take short cuts along the way. Companies should follow
necessary steps to execute an M&A transaction in a way that drives shareholder
value. All transactions — whether mergers, acquisitions, joint ventures, private
equity investments, etc., are full of complex business and tax issues that
require an expert to get on top of the transaction process and to reach the best
solution that is tax-efficient and meets commercial and business expectations.

The Indian tax regime is as complicated as any other matured
regime. Over the years, the Indian regulations have provided sufficient leverage
to foreign investments and at the same time, have ensured a closely controlled
mechanism on these investments.

In the M&A world, some of the typical tax challenges faced
today include non-availability of interest deduction for funds borrowed for
investment in shares of Indian companies, restricted group relief on asset
transfers, restricted debt push down mechanism and existence of high tax
compliance.

Every deal is unique in itself. It brings with it a basket of
complexities and issues, be it accounting, regulatory or taxation. Given the
complexities, it has become incumbent upon a good service provider to have a
dedicated and experienced team to provide tax due diligence services.

This write-up seeks to provide an overview of the key
features of a tax due diligence; it touches upon the procedure to be followed;
and it provides some ground rules for reporting findings so as to meet the
expectations of all stakeholders to the transaction.

Scoping of work:

One of the initial steps to be undertaken is to formulate the
scope of the assignment. One’s drafting skills are tested to the core whilst
formulating the scope for the tax piece of the due diligence. An essential
aspect of this is to explicitly provide for areas which would not be covered as
part of the due diligence process (generally referred to as ‘scope
limitations’).

Given the complexity and the time required to resolve
disputes with the tax authorities, it is of utmost importance to clearly bring
out the period of coverage as part of the scope of work to be covered in a due
diligence assignment. As a general practice, the tax returns filed by the target
company in the last 2 to 3 years are reviewed. Further, the status of all
pending assessments, disputes is obtained and reviewed for the earlier years.
One of the reasons for reviewing the last 2 to 3 years tax returns is that the
audit by the tax authorities for these years is typically not complete on the
date of carrying out the due diligence exercise.

Apart from the coverage, the scope of the tax piece of the
due diligence process needs to be very case-specific i.e., it would
depend upon the Industry to which the target company pertains, the age of the
target company, the shareholding pattern, etc.

For example, in a transaction in the power sector, it would
be critical to examine the continuity of availability of tax holiday and
incentives claimed by the target entity. Further, in case the target is a
private limited company, it would be essential to review the movement in its
shareholding pattern with a view to assess the continuity of availability of
business losses.

Characteristics and key features:

The tax specialists who are part of the due diligence team need to work very closely with the financial and accounting
specialists.

Before discussing the methodology to be adopted to conduct a
tax due diligence, it is imperative to understand the characteristics and
features of conducting the tax due diligence. The main objectives can be
classified as under:



Understanding the target:





  • its legal structure, cash flow mechanism and its operational strategy.






Assessment of tax impact arising from ‘change in control’




  •   carry forward of past tax losses, relevant exchange control regulations
    (especially recent developments)



  •   availability and continuity of tax holidays/concessions




Assessment of
historical tax exposures





  •   pending tax litigations, aggressive tax positions adopted in the past (possible


consequences)



  •   risk of disallowance of expenditure for tax purposes



  •   interest and penal consequences




Assessment of current
tax position





  •   possible disallowances



  •   ramification of past tax audits.




Tax benefits





  •   There are various direct and indirect tax benefits in India for
    companies/businesses. The conditions attached to such benefits are
    important.




Contingent liabilities — disputed tax demands





    These are largely potential liabilities (i.e., tax demand + interest + penalty which could extend to 300% of the tax sought to be evaded) arising on account of disputes with tax authorities. Since it is difficult to predict the outcome of such disputed demands, it is likely that in some businesses, even genuine tax demands may not be provided on the ground that such liabilities are ‘contingent’ and are being disputed (depending upon the likelihood of the company succeeding in defending these disputes).

Tax litigation procedure:

    The tax litigation procedure in India is cumber-some and time consuming (the average time frame for an appeal to attain finality is in the range of 10-15 years). Further, positions adopted by the tax authorities in the initial years are generally followed by them in the subsequent years as well, unless there is a strong reason or a judicial/appellate pro-nouncement to change the position earlier adopted. Accordingly, disallowances made in a particular year are likely to be a routine occurrence in future years as well and the only option in such a scenario is to litigate. Hence, it may be advisable to be cautious while evaluating targets which are engulfed in too many tax litigations involving sizeable tax demands.

Current assets:

    These may include balances that may not be realisable in the short term — such as (i) tax refunds due (ii) deposits with various tax authorities, etc. — such deposits generally are not realised for a very long time. These would consequentially have an impact on the working capital financing needs of the target.

Various tax compliances (including withholding tax):

    The Indian tax laws prescribe several tax compliances for Indian companies. Failure to comply with these could inter alia give rise to penal consequences. Especially, in case there is a default in withholding taxes on payments made, it could have several con-sequences for the payer, such as recovery of the tax not so with held/deposited, interest thereon, penalty (which could be equivalent to the tax amount) and disallowance of the expenditure in relation to which tax has not been withheld/deposited. Hence, one should ensure that the target is tax compliant (more importantly, the withholding tax compliant).

Typical areas prone to income-tax litigation: While there is surfeit of issues that is prevalent in the tax litigation environment in India, there are some issues that typically arise during a tax due diligence, viz.:

  •     ramification of past tax audits.


  •     Depreciation for income-tax purposes and its impact on the deferred tax calculations.


  •     allowability of expenses which are quasi-capital in nature (e.g., non-compete fee payments).


  •     computation of various tax deductions/exemptions available.


  •     disallowances on account of failure to withhold tax on payments (especially in cases where payments are made to non-residents).


  •     levy and computation of interest on tax demands and refunds.


  •     income characterisation (say, business income v. income from house property).


  •     carry forward and set-off of tax losses.


  •     levy of penalty.


  •     taxability under presumptive taxation provisions.


  •     computation of tax liability as per ‘Minimum Alternate Tax’ provisions, etc.


Transfer pricing adjustments:

Given that the tax authorities have commenced reacting to the transfer pricing report, policy and documentation filed by the taxpayers, it is very important to consider the rationale and reasoning behind determining the arm’s-length price, level of compliances and filings as required by the regulations. These are particularly important in the context of the potential future impact of similar transactions.

Fringe Benefit Tax:

In the short span when Fringe Benefit Tax was applicable, there were emerging controversial issues, some of which were resolved by the circulars/clarifications issued by the tax authorities. Although this legislation does not exist today, there is litigation which is gradually surfacing on this count.

The mechanics:

Tax is a complicated subject and to carry out a tax review which involves an understanding of the tax disputes, challenges faced from the tax authorities by the target entity, tax positions taken by the target entity, and to formulate a view on the basis of the documents reviewed and analysis performed normally within a short span of time is an uphill task. This is the precise reason that the tax due diligence team members need to be experienced, and should be well equipped to dissect and digest the flow of information and documents provided to them in the data room within the stipulated time.

Success, in the backdrop of the above challenges can be achieved by following an appropriate methodology while conducting the tax review.

Activities to be performed while conducting a tax due diligence would mainly include?:

  •     Examination of status of tax assessments — cur-rent tax position, open years and evaluation of past liabilities.
  •     Review the income-tax/fringe benefit/wealth tax returns filed for the open years.
  •     Study the disputes between the entity and the tax department.
  •     Identify potential liabilities on account of pending assessments and disputes.
  •     Discuss the various direct tax benefits availed and attached conditions for continuation of the same with the target management and tax advisors.
  •     Analyse the withholding tax compliance.


  •     Examine the applicability of the double taxation avoidance agreements entered into by India while reviewing the tax treatment given to various transactions entered into by the target and analyse the implications arising thereof.


  •     Read opinions obtained by the target management from external counsel and stands taken by the target/target’s advisors during assessment.


  •     Peruse transfer pricing policy adopted.


  •     Examine the various tax balances (particularly the deferred tax asset/liability) reflected in the financial statements.


The procedure to be followed while conducting tax due diligence has to be very discreet and well planned. There is an expectation of providing comments on the tax position adopted by the target entity. Given the areas to be covered in the tax due diligence, one is saddled with a large number of tax documents, records in relation to tax matters of the target. The tasks to be performed in the above context would include carrying out a review and check of the following:

  •     Correspondence with the tax authorities.


  •     Current and deferred tax calculations — reconciliations with the amounts disclosed in accounts.


  •     All tax payments made within due dates — if not, check interest/penalties arising on account of the same.


  •     Calculations supporting advance tax payments made.


  •     Carry forward losses schedule — both as returned and also as assessed — also confirm the expiry dates/restrictions on utilisation of the same.


  •     Details of transactions with related parties (interacting with the team carrying out the financial due diligence on this aspect should be useful as at times identification of all ‘related parties’ itself raises challenges).


  •     Transactions with related parties from the transfer pricing perspective and confirm the pricing method/documentation maintained.

    

  • Details of permanent establishments in other countries.


  •     Whether withholding tax provisions are being adhered to — also examine as to whether the withholding tax returns are filed in time.


  •     Tax findings of non-India jurisdictions, if any, in which the target company operates — this may require liaising with local tax experts.


  •     Potential implications of the existing tax position for future years considering the proposed Direct Taxes Code Bill, 2010, which has been recently introduced.

   

 

 

 

Years
subject to statute of

 

 

 

Limitation

 

 

 

Outside
scope (entities,

 

 

 

years, taxes)

Controlling

 

 

 

tax due

 

 

Materiality

 

 

diligence
risk

 

 

 

 

 

 

 

 

 

 

External
advice

 

 

 

 

 

 

Low
risk areas

 

 

 
  • Applicability of Wealth-tax.


Like any other due diligence process, the tax due diligence is also prone to risk. Con-trolling the tax due diligence risk therefore becomes a key aspect of the process. The elements of a tax due diligence risk can be addressed by considering the aspects shown in the diagram?:

Submission of findings and reporting:

It is always easy to document a detailed analysis arising out of the due diligence process. However, this may not serve the purpose of the report and the investor’s expectations. It is therefore advisable to articulate and document the findings in a reader- friendly manner. In addition to the complexities and the volume involved whilst carrying out the tax due diligence process, some ground rules which need to be followed include?:

Anticipate problems and opportunities

    Early identification of and discussion of preliminary issues with client.

Measure exposures and seek solutions

    Quantify estimated amounts and likelihood of exposures resulting in future cash outflows (range/sensitivity analysis).

Interpret findings in ways clients can use

  •     Focus on material issues.


  •     Use plain English — many of the decision-makers may not understand or appreciate a detailed technical tax answer to a question.


Timely communication of findings:

In order to generate a report which meets the expectations of all stake-holders, certain ground rules need to be followed as under:

One needs to

  •     be clear and concise.
  •     focus on key issues.
  •     classify tax exposures into high/medium/low risk category and estimate the quantum.
  •     consider additional verbal feedback.
  •     issue a draft for comment and discussion prior to finalising the report.
  •     add additional information as appendix.
  •     be mindful of other readers e.g., financiers.
An integral part of the tax due diligence process is to identify issues and more importantly discuss the same with the target management, their advisor, as the case may be. This ensures that the tax findings given in the due diligence report do not give rise to surprises when these are discussed with the target management.

Tax Issues could primarily be classified as:

    Deal breakers — Those issues which would impediment the consummation of the proposed transaction. For example, sizeable risk on account of various tax disputes, some of which may be quite material, could act as a ‘Deal Breaker’.

    Negotiation points — Those issues which would be necessary to consider in the valuation of business/negotiation of bid price.

    Issues for agreements — Those issues which would warrant indemnities and identify conditions precedent for happening of the transaction

    Commercial override — Those risks and issues which are knowingly taken over as a calculated commercial decision.

In summary:

The due diligence exercise maps the way forward for transaction closure. Tax-related findings would form the bases of valuation of the target and aid in negotiating for a better price. These are also relevant for consideration in some of the key areas of the transaction documents. Tax indemnities and conditions precedents incorporated in the agreements are based on the due diligence exercise. Some of the observations and areas falling out in a tax due diligence report could also be relevant whilst structuring the transaction.

Studies suggest that tax factors are of significant magnitude in less than 10% of merger transactions. Be that as it may, there have been some large transactions which have fallen apart primarily due to adverse tax findings as a result of the due diligence exercise.

Therefore, the onus is on the tax specialist to identify the potential tax risks and exposures and to document them appropriately in order to provide adequate visibility to the investor.

Financial and Accounting Due Diligence — Some Aspects

M&A

Part-IV

Conducting a financial due diligence — A well-planned
approach

This is the fourth part of the article on ‘Financial and
accounting due diligence — Some aspects’. The first three parts highlighted the
various forms of due diligence, the process of carrying out an FDD exercise and
some of the key focus areas in an FDD exercise. This part continues and
concludes the discussion on the key focus areas.

Loans & Net Debt :

Analysis of the debt position is important and significantly
depends upon the transaction structure and valuation mechanism. As mentioned
earlier, the transactions are generally valued based on a debt-free, cash-free
mechanism. In view of the same, it is critical to define the components of debt
and quantify the same. The elements of trapped cash (i.e., cash that is not
freely usable, such as deposits with government authorities, margin monies,
etc.) need to be highlighted to allow for computation of equity value.

In most situations, particularly in the case of distressed
assets, the analysis of debt and related covenants assumes the most important
aspect of the transaction. Typically, the loan documents, including the
documents approving the restructuring, provide for conditions attached to the
loan including repayment terms, interest rates, stipulation of minimum financial
ratios, security mechanism and prepayment terms and each such provision would
need to be carefully assessed to identify its impact on the transaction.

Key elements to be analysed while reviewing loans are :

   • Negative covenants in loan agreements/sanction letters (change of control) : a very common covenant is the need for prior approval of lenders for the transaction including release of charge on the assets;

    • Compliance with terms of debt restructuring schemes : with a need to assess the level of promoter contribution required as per the scheme approved.

    • Debt-like items (pension underfunding, severance and other non-operating liabilities) to be considered in valuation : identification of non-operating liabilities (capital creditors, etc.) reported as part of current liabilities under working capital that should be identified as debt-like items.


Potential liabilities and commitments :

This area is particularly important in the case of a complete
acquisition of a target with no future involvement of the existing promoters.
The extent of availability of representations and warranties and indemnities in
this area, although considered as a must in any transaction, should at best
provide only limited comfort. This is primarily considering the ability of the
acquirer to enforce such claims in the courts of law in India and the time value
of such claims. The identification/estimation of such liabilities therefore has
a direct valuation impact.

It is equally difficult to analyse this area since the
procedures are expected to identify liabilities that are not accounted for in
the books of account and may or may not have come to the notice of the existing
management and they may not have a basis to provide reasonable estimates.

The areas to be covered in the analysis and identification of
liabilities are summarised below :

 • Provisioning policy : assessing the general approach towards cut-off and provisioning policies adopted by the management; (for example in the financial sector when the target management tries to postpone provisioning for non-performing assets or in the manufacturing sector when provisions for warranties tend to get accounted for only on cash basis or in the mining sector when future costs for rehabilitation under environmental regulations are currently ignored and provided for only when incurred);

    • Contingent liabilities and off balance sheet items : (where aggressive tax opinions enable a target not to provide against matters in litigation); assessing guarantees/off balance sheet obligations in respect of related parties;

    • Change of control matters : potential payments arising out of change of control/additional costs; severance/retention pay upon the occurrence of transaction;

    • Pension and related obligations : assessing the provisioning and funding of liabilities; this is particularly important in cross-border transactions — there is a need to take the help from specialised local resources to assess the liabilities;

    • Earn-outs/contingent consideration from prior business combinations : for e.g., an acquisition in the past that may have contingent payments to be taken into consideration or where receivables are securitised with a bank with recourse i.e., the target has an obligation to buy back delinquent receivables.

Separation, structuring and integration issues :

Typically, these issues are relevant for a strategic investor
engaged in a similar line of activity. The FDD exercise would focus on
identifying areas that may result in changes in the cost structure post
transaction, requirement of additional infrastructure to be created by the
client or potential utilisation of the existing infrastructure of the client or
additional cost of integration.

The areas that may be covered from a financial viewpoint
would typically cover :

• Identification of broad synergies : due diligence process should identify different kinds of synergies, and then an estimate of their potential value, likelihood, time and cost to achieve the synergies.

• Accounting policy conformity : extent of differences between the accounting policies of the buyer and the seller and its impact post the transaction. This assumes significant importance particularly in the case of a transaction where the buyer and the seller are from different countries — foreign buyer following a local GAAP — IFRS, USGAAP, etc. and the Indian seller following Indian GAAP. The differences in accounting may have a significant impact on the reported profitability/value of assets post the transaction. This may also create significant challenges in upgrading the existing systems and procedures of the target to be able to support the reporting requirements of the buyer.

• Transition services agreement : the target may have dependencies on the parent entity (the seller) and would thus require an agreement for continuity in the availability of goods or services in future (utilisation of common utilities, distribution network, etc.).

•    Stand-alone considerations (impact of economies of scale, support functions) : it is essential to understand the dependencies on the parent entity and enter into the transition services agreement as mentioned above. However, it is also important to understand the impact on costs on a go-forward basis considering potential stand-alone operations.


Other matters :
During an FDD exercise, apart from the aforesaid broad areas that are directly linked to accounting matters, there are other aspects relating to the business that may have an impact on the financial position of the business and are thus important to consider during an FDD exercise. These are discussed below.

Related-party transactions :
Related-party transactions could have a significant impact on the reported historical earnings/margins of the business. Further, these transactions may also create significant dependencies and have a material impact on the continuity of the operations on the business. In such situations, it is important to identify the nature of transactions, the level of existing charges recovered from the target business, the availability of such services/facilities in future and the charges thereof. The arrangements that would need to be agreed during the transition period should be identified and provided for in the transaction documents. Further, any impact on the valuation model would also need to be considered for any revisions in the current costs.

Generally, ‘related parties’ are defined by law and the transactions are required to be reported in the financial statements. However, it is important to identify the related parties that are not covered by the definition as per law, but that are de facto related parties in common business parlance. This identification is generally achieved based on discussions with the management of the target and analysis of the key transactions in respect of purchase and sales relating to the terms and conditions.

Key aspects while reviewing related party transactions would involve an assessment of :

•    Financial appropriateness of transactions within family-run businesses (arm’s-length pricing);

•    Level of dependency of the target operating within a ‘group’ (assets used by the target entity but that are actually owned by a related party; e.g., office premises, the IT infrastructure or even the title to the corporate/product brand);

•    Extent of sharing of resources and the allocation of common costs;

•    Details of financing arrangements with related parties;

•    Arrangements that are based on oral under-standings and/or are on a ‘no-cost’ basis.

Human resources :
Analysis of human resources is a multifaceted task and is generally covered by the legal due diligence, HR due diligence with defined inputs from the FDD exercise. The key focus areas of the FDD exercise in relation to human resource matters are to establish the total cost to the company (CTC) of all human resources, to assess the extent of accumulated unprovided/unfunded for liabilities in relation to employee benefits and to also understand the level of current charge of such costs and any underprovisioning thereof.

Identification of the total employee strength and total CTC of the target company may become an issue where there is a high level of contracted employees (like in the media advertising sector) or when there is high level of casual labour that is ‘permanently temporary’ !

In certain instances such as relocation of facilities post acquisition, the analysis may need to be extended to understand the implication of severance of employees not willing to transfer to the proposed new location and also additional facilities/ benefits that may need to be incurred to ensure transfer of necessary employees to the new location besides addressing the issues relating to availability of skilled resources in the new location.

It is important to analyse the movements in the level of staff in the recent period with specific emphasis on understanding if there have been attrition in respect of key staff. Particularly, in a distress situation, the current staff may not be adequate and may not represent the true requirement for the business and would need to be replenished. The costs relating to such optimum level of requirements of the staff would need to be assessed and considered in the valuation model.

In case of a strategic acquisition, matters relating to integrating the two businesses assume importance. The compensation levels and structure may be significantly different across the buyer and the seller and may have material implications for the buyer post acquisition. Thus a careful analysis is required in relation to the current staff cost of the target and potential changes post the transaction.

Conclusion :
In today’s environment, as a key input during the decision-making process and also as a part of general corporate governance, financial due diligence is considered as a must. It is not just checking of facts and summarising them, but it is about evaluation, interpretation and communication that require a proficient understanding of the business and of the transaction besides exercising strong financial and accounting skills.

Companies making acquisitions typically look for answers to four basic questions :

•    What is being acquired ? (customers, competition, costs, capabilities)

•    What is the target’s stand-alone value ?

•    Where are the synergies and skeletons ?

•    What is the walk-away price ?

It is vital that the FDD team remembers the above and exercises a degree of prudence and professional skepticism when carrying out the assignment — deal making is glamorous, due diligence is not. The FDD team may focus on negative information and on identifying the risks and problems surrounding the transaction, but as a professional service provider, the FDD team must devise solutions to problems or mechanisms to reduce or manage the risks involved in the transaction. For every man-made problem there is a man-made solution — the skill is to find it !

Valuation of intangible assets

M & A

Unlike in accounting, where
the accounting for tangible assets and intangible assets is different, the same
is not the case in valuation. Whether an asset is a tangible asset or an
intangible asset, the concept of valuation does not change. However, globally
with the exchange of only intangible assets being infrequent and the market for
intangible assets not fully developed, the subjectivity involved in the
valuation of intangible assets is more than, say, for valuation of equity shares
or valuation of a business. In this article we will discuss the various methods
of valuation of intangible assets. We will not discuss the identification or
recognition of intangible assets here, but the valuation of an identified
intangible asset.

At the end of the discussion
we will also touch upon the recent acquisition of Cadbury by Kraft Foods.

Examples of intangible
assets :

Different industries have
different value drivers and thus different intangible assets. There is no
exhaustive list of intangible assets, but accounting guidance from US GAAP and
IFRS give us the following examples as given in the chart.

Approaches to valuation of
intangible assets :

Similar to valuation of any other asset,
there are three basic approaches to valuation of intangible assets viz. the cost
approach, the market approach and the income approach. Again as applicable to
valuation of any other asset, the use of any of the above approaches differs
from asset to asset and industry to industry. Also an intangible asset in one
industry may not be an intangible asset in another industry and the economic
benefit of the same intangible may differ from industry to industry and in the
same industry from company to company. The following are the generally accepted
methods that are used in valuation of intangible assets :


Cost approach :





l Valuation is based on the cost to reproduce or replace the asset and the
principle of substitution



l The valuation of an asset using the cost
approach is based upon the concept of replacement as an indicator of value



l The premise is that a prudent investor would pay no more for an asset than
the amount required to replace the asset afresh. Value is not the actual
historical cost of creating the subject intangible asset. It is also not the
sum of the costs for which the willing seller would like to be compensated



l The approach establishes value based on the cost of reproducing or
replacing the asset, less depreciation from physical deterioration and
functional obsolescence, if present and measurable



l Applications :

Reproduction cost

Replacement cost



Market approach :





l Valuation is based on transactions involving the sale or licence of
similar intangible assets in the market place and the principles of
competition and equilibrium



l Value is derived by analysing similar intangible assets that have recently
been sold or licensed and then comparing these transactions to the subject
intangible asset



l Applications :

Transaction multiples derived from (the sale or
licensing) of the comparative intangible asset.



Income approach :





l Valuation is based on the present value of expected future cash flows to
be derived from ownership of the asset and the principle of future benefits



l Value of the subject intangible asset is the present value of the expected
economic income to be earned from the ownership of a particular intangible
asset



l Primary applications :

Relief from royalty

Excess earnings


l Other applications :

Discounted cash flow

Incremental cash flows/profits

Profit split



Valuation methodologies for intangible assets :

Replacement cost method under

the cost approach :

This method represents the hypothetical cost that would be
incurred to replace the subject asset by a new asset of similar utility.

Reproduction cost method under

the cost approach :

This method represents the hypothetical cost that would be
incurred to recreate or reproduce (either by constructing or by acquiring) the
subject asset by a new asset of similar utility.

After establishing the replacement/reproduction costs,
adjustments are made to represent any losses in value resulting from physical
deterioration and from functional and economic obsolescence. The above methods
are generally used when a substitute can be developed in-house and are normally
used in valuing intangible assets like assembled workforce, internally developed
software, etc.

Comparable transactions method under the market approach :

l    The value of an asset under this method is measured through an analysis of sales and offering prices for the comparable asset. Such prices are then adjusted for differences, if any, between the comparable asset and the subject asset. This method is similar to the comparable transaction multiples approach used in business valuations.

->    The two requisites in this approach are an active public market and an exchange of comparable assets.

->    The key is to select the most appropriate/ relevant transaction multiples involving intangible assets. The difficulty however is in finding comparable assets and the adjustments required to make it comparable to the subject asset.

->   On account of the infrequent activity happening in intangible assets, generally this method can be made applicable to brands only.

Relief from royalty method under the income approach:

->   This method is based on the principle of opportunity cost.

->    The value of an asset under this method is the present value of the future savings that is available to the owner on account of his owning the subject asset.

l    Had the owner not owned the asset, he/she would have had to license in the asset for which it would have had to pay a royalty. By owning the asset, the owner is thus saving these costs. This savings is generally quantified in terms of royalty savings on revenues.

l    The general steps to implement this method are:

  •     research licensing transactions with comparable assets to establish a range of market levels for royalty rates
  •     select a royalty rate or range of royalty rates
  •     apply the selected royalty rate to the future revenue stream attributable to the asset
  •     use the appropriate marginal tax rate to arrive at an after-tax royalty rate
  •     discount the resulting cash flow stream to the present using an appropriate risk-adjusted discount rate.

Excess earnings method under the income approach:
  •     This method is based on the principle of elimination and residual value and is similar to the discounted cash flow method except that it does not take into account the cash flows but the earnings.
  •     This method considers assets in isolation from all other assets. Assets do not generate cash flows in a vacuum — they also utilise contributory assets to generate earnings and hence to isolate the earnings attributable only to the subject asset, contributory charge on such assets are deducted. 



The main steps under this method are:

  •     estimate and forecast the earnings from the subject asset
  •     deduct applicable tax charge on these earnings
  •     deduct an appropriate required rate of return on all other assets (tangible and intangible) used in obtaining such earnings — the residual earnings thus obtained are ‘excess earnings’ arising from the use in the business of the subject asset being valued
  •     assess an appropriate discount rate for the forecast after-tax excess earnings
  •     discount the excess earnings to obtain the value of the subject asset.

In addition to the above, there are also various adaptations of the income approach like the
  •     Discounted cash flows method

  •     Incremental cash flows/profits method

  •     Profits split method
There are also various valuation concepts applicable generally and some specifically to intangible asset valuations like
  •     Tax amortisation benefit factor,

  •     Residual life of the intangible asset

  •     Return ‘on’ and return ‘off’
  •     Market value of invested capital
  •     Invested capital analysis
  •     Weighted average return on assets.
All of the above we shall discuss in the next article where we shall start with the purchase price allocation process and by a case study cover all the above points including the valuation of intangible assets under each of the approaches.

Cadbury acquisition:

On February 2, 2010 Kraft Foods’ Cadbury acquisition was valued at $ 18,546 million ($ 17,485 million net of cash and cash equivalents). As part of that acquisition, Kraft Foods acquired the following assets and assumed the following liabilities:


The above goodwill of $ 9.1 billion was attributable to Cadbury’s workforce and the significant synergies that were expected from the acquisition. Also $ 10.1 billion of the intangible assets acquired were expected to be having an indefinite life.

If we analyse the above details, the following observations can be made:

  •        74% of the asset value paid was attributable to intangibles and goodwill (which is nothing but unidentified intangible).
  •         Though there is no official information available, Cadbury primarily being in the food and confectionery business, the intangible assets could primarily have been brands, trademarks, trade names, logos, marketing & distribution network, non-compete agreements and vendor relationships.

Brand Finance (R) Global 500 February 2010 summary report on the world’s most valuable brands ranks Cadbury brand at No. 274 with an enterprise value of USD 21,196 million and a brand value of USD 3,261 million which is about 15% of the enterprise value. The same report values Kraft at an enterprise value of USD 6,277 million and a brand value equivalent to USD 2,168 million which is 35% of the enterprise value. The Kraft brand has been ranked at No. 437.

LEGAL DUE DILIGENCE IN M&A TRANSACTION

M

Any responsible management will
require a comprehensive assessment of the possible legal risks related to the
corporate status, assets, contracts, securities, intellectual property, etc. of
the target company concerned before concluding any merger and acquisition
(‘M&A’) deal. Therefore, the process of legal due diligence assumes great
importance in a M&A transaction.

Meaning :

The expression ‘due diligence’
in a M&A transaction is used to refer to sort of an audit of a company’s legal,
financial, environmental and business affairs, and includes investigations into
the acquisition of the assets, risk analysis and general inquiries about the
company prior to entering into a contract. This process is undertaken by the
buyer before investing in a company, to ensure that the seller and the target
company have good title to assets proposed to be bought and also to know the
extent of the liabilities it will assume. Therefore, this data gathering process
forms an integral and critical part of the M&A process as it provides
information about the target’s business that enables the buyer to decide whether
the proposed acquisition represents a sound commercial investment.

Purpose :

Typically in an acquisition, the
purpose of legal due diligence is for the acquirer to check :


(i) the value of the assets
the seller is proposing to sell,

(ii) that the seller has
good title to the assets/shares free from all encumbrances,

(iii) that there are no
liabilities or risks that will reduce the value or use of the assets,
i.e., no third party has any right to use the assets,

(iv) applicable labour laws
and service contracts, etc.; and

(v) that there are no
existing or potential undisclosed liabilities that may adversely affect the
business of the target company and also evaluate disclosed liabilities.


The due diligence process helps
the buyer to properly evaluate the target company by investigating items that
either validate the offered price or items that diminish the company’s value and
its purchase price. The buyer may seek contractual protection from the seller in
the form of representations and warranties, but in practice, the protection
offered may be limited by disclosure and other contractual provisions. The
seller is required to disclose all relevant information relating to the target
to the buyer and often finds himself in a conflicting situation. On the one
hand, the seller wants to provide all relevant information to the buyer so as to
make the buyer comfortable with the seller’s offered price and on the other
hand, the seller does not want to reveal unnecessary information to the buyer,
for fear that should the deal not consummate, the prospective buyer may obtain
valuable commercial information and use to compete unfairly with the seller. In
the event of buyer’s breach, seller’s right to sue for damages and injunctive
relief may not be adequate protection or remedy, as such damages for breach may
be difficult to quantify and to enforce. Some prudent sellers require the buyer
and its advisers to enter into a confidentiality agreement.

Scope :

The scope of due diligence
review will depend on the purpose and nature of M&A transactions. For example,
acquisition of a company will demand extensive areas of inquiry than the
investigation made by a potential joint venture partner on the other joint
venture partners or inquiry made by a purchaser of shares in a company. The
extent of due diligence review is also likely to be governed by factors such as
available time, cost, the need to get the transaction done and the seller’s
sensitivity about the exercise.

In a due diligence process,
risks are identified and are borne by one or both parties and the parties will
negotiate the risks and the bargaining between the seller and the buyer will
relate to apportionment of the risks between them. The seller may give
warranties and indemnities with respect to risks that are identified, but more
often the seller is not aware of its problems until the buyer discovers it
during the due diligence process. However, representations, warranties and
indemnities from a seller covering a particular risk is not an adequate
substitute for carrying out the due diligence, because :


(i) warranties and
indemnities survive only for a few years by operation of law and contract,

(ii) warranties are often
qualified as to the materiality or the warrantor’s best knowledge,

(iii) indemnity claim have a
de minimis limit,

(iv) there is a time limit
in which the claim must be made usually within two to three years after
closing,

(v) sellers are more
cooperative prior to the closing as they need to close the transaction, but
are reluctant to address even the most valid warranty claims post closing,
and

(vi) by the time the
warranty claim is made, the warrantor may not be in existence or may not be
in a position to meet the claims.


The information obtained in the
due diligence review will place the buyer in a better position to assess the
risks and advantages of his investment and enable him to appropriately
renegotiate the terms of the acquisition. Therefore, a buyer not undertaking due
diligence would lose the opportunity to obtain more favourable terms of
purchase.

It must be noted that every due
diligence investigation depends on the quantity of data supplied by the seller.
The data may be sent to the buyer and its due diligence team to analyse at it
own offices or the buyer’s due diligence team is sent to the target’s office
where it is given access to the data room. It is necessary for the buyer to
support the data collection by securing representation, warranties an indemnity
from the seller, wherever possible, on those issues that are impossible for the
buyer to check and verify.The buyer usually requires that the seller warrants that the information supplied by the seller to the buyer’s due diligence team is complete and accurate. The seller more often would not war-rant those matters that would be known to the buyer during the course of due diligence process. In a situation where the due diligence exercise is limited, the buyer usually investigates key issues and may take the following precautionary steps to protect itself, such as:

    i) secure appropriate representations, warranties and indemnities;

    ii) consider negotiating a retention of the purchase price to cover potential claims;

    iii) propose a price adjustment, if required;

    iv) require compliance of certain conditions as a condition precedent to close of transaction, for example, obtaining of consents to the change of control from lender, etc.

Team conducting due diligence:

The legal due diligence team of a law firm usually consists of a partner, a senior associate, associates and paralegals (number of associates and para-legals will depend on the volume of documents to be reviewed). The senior associate is generally responsible for preparing the due diligence report for the client. The partner will be responsible for supervising the due diligence report and negotiating the acquisition agreements. The legal team prepares the legal due diligence questionnaire/ checklist and same is forwarded to the buyer’s personnel who after reviewing it will forward it to the seller. The legal team is constantly in touch with the buyer’s personnel to discuss issues arising out the due diligence review as the buyer’s personnel is the only person who will be able to make effective judgments as to the commercial importance and potential risk brought to light by the information revealed in the due diligence process.

Areas of legal due diligence:

The legal due diligence exercise will generally cover all of the areas listed below. This list is usually indicative and not conclusive and is tailored according to such factors as to whether the transaction is an asset purchase or share purchase and will also depend on the target’s industrial sector and size of the transaction:

    i) Secretarial

    ii) Real Estate

    iii) Intellectual Property

    iv) Litigation

    v) Insurance

    vi) Licences

    vii) Employees

    viii) Loans/Debts

    ix) Material Contracts

    x) Investments

    xi) Environmental

    xii) Competition

    xiii) Other Laws

Gist of what the due diligence team investigates under the following heads are given below?:

Secretarial:

The investigation of corporate secretarial focus on the incorporation particulars, memorandum of association containing details about its objects, paid up capital, authorised capital, the number of shares issued, and the articles of association of the target containing provisions as to the directors, restrictions on shares, if any, shareholding pattern, etc. Under corporate secretarial, the register of members and directors and the minutes of meetings of the target are examined as well. Every company under the provisions of the Companies Act, 1956 is liable to maintain a register of members, register of charges and a register of directors to record and maintain minutes of all meetings of shareholders and of the board of directors held in the course of transacting business of the company. The target company is required to file records pertaining to their balance sheet and profit & loss account, annual return, consent of persons to act as directors, in case of increase of share capital/members, registration of resolution, creation/modification of charges, return of allotment, share transfer form, etc. with the registrar of companies. The due diligence team reviews all filings made with the registrar of companies. In case a company commits default in maintaining the said registers, or do not file their records with the registrar of companies in time, penal action may be initiated against the target company. The due diligence team besides examining compliance under the general provisions of the Companies Act, 1956, also gives particular attention to review compliances with provisions requiring government sanction.

Real Estate:

Investigation of real estate should delineate the immovable property held by the target, to whether it is leased, licensed or owned. If it is an owned property, the title of the target to such property must be ascertained. The due diligence team examines covenants attached to the transfer deed which may prohibit certain activities or may reserve easement rights and also assesses if there is a situation where the target may not have fully paid up the consideration or certain installments may be pending. In some cases, the target may not have obtained final deed of conveyance/sale deed in respect of the owned immovable property and there could also be outstanding dues pertaining to such property, namely, property tax, electricity and water charges, all of which needs to be checked. In case of leased and licensed property, one must check its capability to transfer the said property.

Intellectual property:

As regards the intellectual property, such as patents, designs, softwares, trade marks, careful assessment is required to ascertain whether they are owned and/or licensed by the target company and/ or licensed to the target company and whether they are registered or unregistered and whether they are in compliance with the relevant laws. The due diligence team examines whether there are any challenges, disputes or infringements of any registered and unregistered intellectual property rights licensed or owned by the target company. The due diligence team will also review pending applications related to intellectual property.

Litigation:

The due diligence team examines significant details of any disputes by or against the target company. Buyers may set a threshold in monetary terms to determine those litigation matters to be reviewed (for example, the buyer may not be interested in any claims for outstanding amounts from debtors below a certain figure). The diligence team may assess the contingent liability that the target may incur and examine the likely impact on the business of the target and details of any judgments given against the target and its assets as a result of litigation.

Insurance:

The investigation of documents relating to insurance would involve assessing the significant details of the insurance arrangements for the target company, such as whether there are any circumstances likely to give rise to a claim under insurance policies for the target company, whether insurance obtained by the target is valid, or whether the renewal of the policy is refused or premiums increased, whether there are any unusual terms in the insurance policies, and whether the target’s assets have been fully insured.

Licences:

The due diligence team must assess whether the licences or consents necessary to the operation of the target’s business, have been obtained, are valid and whether they are capable of being transferred/assigned to the buyer.

Employees:

With respect to employees and consultants of the target company, due diligence review would involve examination of service/employment contracts, letters of appointments, the executive and non-executive directors, consultants, key employees and managers have signed with the target company and the significant terms of those letters of appointments and contracts such as remuneration provisions, notice period for termination, any special payments on termination, term of contracts, absence of provisions on confidentiality, any restrictions during employment, restrictive covenants post-employment and confidentiality clause, etc.

The due diligence team inquires if there are any employees who have terminated or intend to terminate their employment in the period leading up to the transaction and examines the employee benefits such as share option schemes, bonus schemes, employee provident fund, gratuity, retirement benefits, etc. Investigation would also identify whether there are any trade unions / associations representing the personnel of the target company. The due diligence team makes inquiries about payment obligations to employees, whether relevant labour legislation has been complied with, whether there has been any strikes or litigation with respect to trade unions and employees or if there are any anticipated, industrial disputes or employment related litigation, involving the target company.


Loans:

Investigation with respect to loans would involve assessment of loans given by the target company to third parties and other members of the target group, whether there are any pending instalments or restrictive covenant in the loan documents that requires intimation to the lender in case of change in constitution of the target or whether the liability under the loan documents can be transferred to the buyer. The due diligence team also inquires if the seller has given any guarantees or indemnities in respect of the target and whether the target has provided any guarantees or indemnities for any other third party.

Material Contracts:

Evaluation of material contracts would include review of commercial agreements to which the target is party for example, any agency agreements, distribution agreements, share purchase agreements, licensing agreements and supply or purchase of goods agreements, hire-purchase agreements, etc. The due diligence team draws attention of the buyer to the relevant provisions in such agreements, such as obligations of the parties, termination provisions and effect of termination, change of control provisions, non-assignment provisions, representations and warranties, indemnities and guarantees, any other restrictive covenants.

Investments:

The due diligence team makes inquiries regarding any investments made by the target, including shares held in other companies, or fixed deposits or purchase of any other kind of instruments.

Environmental:

Environmental due diligence may be required in case of acquisition of a company which is a manufacturing company, or whose assets include land used for industrial processes. Environmental due diligence is conducted by lawyers or technical personnel who are experts in the field of environment. The environment due diligence team investigates potential responsibility for any clean-up and liability in relation to environmental damage. The investigation may range from a brief site visit to a more detailed survey involving detailed sampling of soil and ground water.

Competition:

The competition law is at a nascent stage in India, but the lawyer engaging in the diligence exercise is required to bear in mind the general competition law principles while reviewing the data of the target company. The due diligence team would need to seek information from the sellers to assess anti-competitive behavioural risks. Competition issues may have an effect on the acquisition value of the business or target, or may have an impact on the timelines for an M&A transaction. The analysis on competition issues is undertaken in consultation with lawyers specialising in competition law.

Other laws:

In case the target company is listed in any of the stock exchanges, the due diligence team would review all compliances the listed company is required to make under the Securities and Exchange Board of India Act, 1992, the Foreign Exchange Management Act, 1999 and other applicable laws.

Legal due diligence report:

The legal due diligence report is prepared by the buyer’s lawyers and addressed to the client-buyer, pursuant to the due diligence process of reviewing documents provided by the seller. The client may request for detailed form of report or just an executive summary summarising all the key findings of the legal due diligence review. The key findings in the executive summary will enable the buyer to consider issues for negotiations with the seller and help in deciding whether or not to proceed with the transaction. The description of key issues would include the change of control provisions in material contracts, prohibitions on assignment in material contracts, expiration of critical agreements, licences and registrations necessary for the operation of the target’s business, high-value on-going litigation matters, etc. Detailed reporting would include summary of all the documents reviewed in all areas of law.

Discounted Cash Flow

1 Introduction

Discounted Cash Flow (DCF) is a widely used method in the value analysis of any business. The value of an asset is the present value of expected cash flows from an asset. In this context, all the valuation methods including Net Asset Value (NAV),Profit Earning Capacity Value (PECV) and market price endeavour to determine the economic value of an asset but by using different approaches.

The relevance of Net Asset Value (NAV) derived from accounting books continues to diminish as self-generated intangible assets, which are key value drivers of modern corporations, are not recorded under accounting conventions. In PECV, profitability, sales and other relevant multiples derived from the market price of a comparable business is used as the metrics to arrive at the value of the subject business. It is assumed that market participants have paid for the expected future cash flows (FCF) from the asset when price under free market conditions is considered as indicative of value.

Though DCF is the application of the Net Present Value (NPV) rule, which in essence could be reduced to two variables – discount rate and cash flows, the application of DCF could be challenging as cash flows are impacted by several variables and the appropriate discounting rate is always a matter of debate. Several adjustments are also required to derive a finely calibrated value estimate. This article aims to provide an overview of the application of the DCF method in a practical context and the underlying theoretical concepts.

Description

The DCF method values a business based on the projected cash flows the subject business is expected to generate over a given period of time. The expected cash flows are discounted at an appropriate discount rate to determine its present value and thus the time value of money is provided for. A business is assumed to have a perpetual existence and DCF value is the summation of the present values of the cash flows expected in the projected horizon and estimated for perpetuity beyond the horizon.

Future cash flow (FCF) projections are the basic requirement for application of DCF. FCF usually forms part of the projected financial statements or may be derived from the projected income statements and the balance sheets. The FCF could be at the firm level available to the financiers of the business (both debt [D] and equity [E]) or to the equity holders. Generally the FCF to the Firm (FCFF), which represent business related cash flows available for distribution to both the owners (equity holders) of and the lenders to the business, is used in DCF . FCFF is equal to Profit before Interest, Tax, Depreciation and Amortisation (PBITDA) less Capital Expenditure (Capex), Taxes and adjustment for working capital changes. From the foregoing, it is evident that the FCFF is not impacted by the financing pattern of the enterprise. Conceptually, therefore, the value outcomes should not change whether the FCFF is used or Free Cash flow to equity (FCFE) is used.

Projections

  1. The valuation estimate which is the output of a DCF model is only as good as the projections, which are built on subjective assumptions both at the macro level concerning the overall economy and business environment and at the micro level specific to the enterprise. In other words, integrity of the valuation output is largely determined by the thoroughness of the projections and its underlying assumptions. Projections review, therefore, entails a through understanding of the overall economy and the market in which the subject enterprise operates.

Common size statements, ratio analysis, peer group comparisons are analytical techniques employed in projections review. Inflationary expectations, currency movements, tariff levels are among the key macro assumptions. Business specific assumptions include pricing policy, salary levels and capital expenditure, which need to be consistent with the overall macro trends that are being projected. For example, it may not be realistic to assume a commodity would fetch prices higher than ruling market prices or to assume that raw material can be procured at lower than ruling market prices. In fact, it is likely that the prices may be influenced by the entry of other competitors prompting the incumbents to counter competition by reducing prices and influence the overall market.

At the micro level specific to the enterprise, working capital assumptions such as number of days of receivables and payables, inventories, trade advances and deposits will need to be estimated. Reasonableness of capex estimate may be ascertained through quotations/ orders placed for machinery and equipment. In this connection, it must be noted that maintenance capex should also be provided for in the projections. However, interest cost, if any, capitalized for accounting purposes is not be considered as capex for determining the FCFF.

Actual tax outflow must also to be projected with reference to the tax laws. Tax deduction on account of interest is to be ignored for computing the FCFF as the tax benefit on interest cost is captured in the discounting rate formula. Though the future FCF is derived from the accounting statements, it is the timing of the cash flows that is important and not the accounting distinction between revenue and balance sheet items. To illustrate- accounting of deferred tax does not impact cash flows but the actual outflow on payment of tax will affect the same.

2 A business entity under ordinary circumstances is expected to have a perpetual existence. But, projections are usually for a finite period. In a DCF model, the estimate of cash flows beyond the horizon is based on the cash flows generated in the last year of the horizon after appropriate adjustments. In order to fit the cash flow projections in a DCF model, the projections need to be at least up to the year in which the business is expected to achieve stable cash flows as the cash flows for perpetuity are based on the cash flows of the last year of the horizon after suitable adjustments. Conceptually the length of the forecast period should not impact value outcome.

It is important to note that it is not possible to forecast the behaviour variables with certainty and projected numbers may be considered as the outcome derived from various possibilities and the probability of their occurrence. In this context, a sensitivity analysis to assess the impact on cash flows by changes in the behaviour of variables is a necessary part of a value analysis exercise.

Theoretical Concepts

There are various theoretical concepts underlying the application of the DCF method. These are explained below:

Discount rate is the return expected by investors after taking into consideration the risk associated with the business. The investor raises return expectations when there appears to be an increase in risk.

Measurement of risk is at the heart of finance and we rely on theoretical insights and certain statistical concepts to arrive at the discount rate. In 1952, Harry Markowitz formulated the Portfolio Theory in a paper entitled “Portfolio Selection” wherein the principle of creation of the frontier of invest-ment portfolios is such that each of them had the highest expected return, given the level of risk that was set out and thus gave formal expression to the intuitive idea that diversification reduces risk. In Markwitz’s formula, Standard deviation (s) of the return on the security is considered as the risk. An investor is concerned with the risk of the portfolio which is the variance (s2) of the portfolio. A well diversified portfolio would encompass all securities in the market and would react to the general market movement and market risk.

Capital Asset Pricing Model (CAPM) is a theory about pricing assets in relation to the risks, which was independently formulated by John Lintner , Jan Mossin and William Sharpe in the 1960s. CAPM continues to be widely used although alternates such as Arbitrage Pricing Theory (APT) and Fama-French Three-Factor Model have been developed subsequently. Among other assumptions, CAPM assumes that all the investors employing Harry Markowitz theory are holding portfolios that are efficient and will maximize return at a given level of risk. An individual is concerned with the risk attached to the final portfolio and thus the risk of the individual asset will be assessed on the basis of the contribution to the variance of the portfolio.

Beta (b), which is the measure of sensitivity of a security in relation to the market as a whole, is the measure of risk. The statistical formula for Beta of a particular security is b = sim / s m2 where sim is the co-variance between the return of the particular security and the market return and s m2 is the variance of the market return.

Treasury bills/ government securities returns are assured and considered risk free thus assumed have a beta of 0. The aforementioned assumption is widely used although it is strictly not correct since only the nominal returns are assured while the real returns (inflation adjusted ) are not unless the security is inflation protected. An investor in a portfolio of well diversified stocks would require a premium for the market risk and this premium is the market risk premium.

Market risk premium = Market returns ( rm ) – Return from treasury/ government securities (rf).

A firm is exposed to business risk and financial risk. The value of a firm and business risk is dependent on its investment decisions and not by how the investments are funded. The theory that capital structure is irrelevant to the value of a firm is a proposition of Franco Modigliani and MH Miller. From a balance sheet perspective of an accountant, the value of the enterprise on the asset side is in-dependent of the ratios of debt and equity on the liability side. Leverage determines the financial risk. Cost of debt is lower than that of equity since debt holders claim ranks before that of equity holders. Increase in debt, however, increases the financial risk and thus the returns expectation of the equity holders (who are the residual claimants) would increase and the overall return expectations may not change. Equity holders have a limited liability and increase in debt may prompt the debt holder to demand a return closer to that of equity to cover the possibility of failure of debt repayment. In the real world, companies operating in sectors such as technology that have high degree of business risk and probability of failure do not have debt or have very low leverage so that the overall risk does not become unsustainable. In contrast utilities which have stable cash flows and thus lower business risks can afford to assume financial risk.

Usually the estimate of beta of the business that is valued is derived from the beta of a comparable company listed on the exchange. The leverage of the comparable company may be different from the leverage the target company has or intends to have. Under the circumstances the observed beta is to be unlevered to derive the asset beta and re-levered based on the firm’s targeted debt equity ratio. While the business risk exposure is reflected in the asset beta the financial risk element is captured on re-levering the beta. Levered beta increases as the proportion of debt increases to reflect the risk of volatility in earnings available to equity holders after providing for interest. It is assumed in practice that debt has a beta of 0. The equation bL = ba (1+(1-t)(D/E)) can be used for levering and re-levering the beta (wherein bL is the levered beta observed in the market, ba is the asset beta (unlevered beta), t is the tax rate and the tax shield on interest payments, D is the market value of debt and E is the market equity value).

Discount rate

It is important to link the discount rate to the as-sumptions underlying the FCF projections and also the expectations of the investor class who are the claimants of the cash flow. Real cash flows without inflation are to be discounted by the rate without inflation, while nominal cash flows, which have inflationary impact, are discounted using nominal rates. FCFE is to be discounted by the return expec-tations of equity holders while FCFF is discounted by the Weighted Average Cost of Capital (WACC). The WACC represents the returns required by the investors of both debt and equity weighted for their relative funding in the entity. WACC is de-rived based on the principles set out in the earlier paragraph.

WACC = Cost of equity (rE)* [E/ (D+E)] + Post tax cost of debt (rD)* [D / (E + D)]

rE = (rf )+ b * (market risk premium)

rD   = Interest rate on debt* ( 1- tax rate)

The equity and debt ratios are based on the mar-ket values and not book values. In practice, book value of debt may be considered its market value if it can be retired with minimum cost or has been contracted recently or can be called on by the lender. Exceptions such as sales tax deferral loan (which does not carry interest) may need to be valued suitably. Equity value may need to be obtained by an iterative process because of the interdependence between cost of equity (due to leverage) and the resultant value.

Thus, the WACC formula clearly illustrates the relationship between return expectations and assumption of risk. Risk that can be diversified away is not rewarded while non-diversifiable risk is compensated in the formula. The minimum re-turn, which is the risk free rate, and market risk are common to all companies. A Beta of 1 means the firm is as risky as the market or a well diver-sified portfolio. Beta of 1.5 means the firms return expectation is 50% more volatile than the market and thus the risk premium increases by 50% over the market risk premium. A firm’s beta of 0.5 would reduce the return expectation to 50% of the market risk premium as the firm is less volatile than the market and its addition to the portfolio reduces the volatility of the portfolio. The building blocks of discounting rate are very clearly visible in the WACC formula.

The WACC formula also implies that unlisted shares, which do not have an exit mechanism that a listed security affords, may have a higher return expecta-tion from investors because of their lack of market-ability. similarly, in certain cases the project may not be complete and the asset beta of a completed project would not capture the project completion risk. The WACC may have to be appropriately adjusted up to compensate for the aforementioned factors.

The formula for discounting factor to be applied for each period is 1/( 1+WACC)n where n is the year in which the cash flow occurs. In a business, cash flows are distributed through the year and do not occur as a lump sum at the year end. Therefore n is corrected for midyear (on an average).

Perpetuity value

A business is expected to have perpetual life though it is usual to have a financial projection for a limited time horizon. The value of business beyond the horizon is captured in the perpetuity value. Perpetuity value usually accounts for a large part of the business value and needs to be estimated with care.

Usually the starting point for estimating the FCF

for perpetuity is PBITDA in the terminal year of the horizon period. Capex/ incremental working capital requirement for perpetuity are to be linked to assumed growth and depreciation. In case full plant utilization has already been achieved in the horizon, growth is not possible without capex invest-ment. Tax is a major outflow and is to be modeled carefully. Tax depreciation benefit is not available unless there is capex. The depreciation benefit may be equated to the capex though the tax benefit is spread over a longer period and its present value is usually lower.

Additional working capital requirement may be estimated by applying the growth percentage to the net working capital available at the end of the horizon. Year on year growth in cash flows for per-petuity is assumed after considering factors such as the competitive environment of the business, stage of growth of the overall economy, actual growth achieved and expected in the horizon etc. Typically companies in a mature economy grow at a lower rate as compared to entities in a developing economy. The cash flow is capitalized at the rate (WACC – g ) where g is the % growth assumed. The value is discounted for the present using the appropriate discount factor.


Other adjustments

The entity being valued may have non -operating assets on the valuation date, the income streams of which do not form part of the cash flows. The market value of such assets (net of taxes and expenses on realization ) is to be added to the business value. Treasury investments, land holdings (surplus) are examples of non- operating assets. Contingent li-abilities on the valuation date needs to be adjusted after considering the probability of materialisation and notional tax relief on the same. Arrears of divi-dend on cumulative preference shares not recoded in books are to be adjusted, if necessary.

Merits and Limitations of DCF

DCF explicitly uses forecast of cash flow genera-tion while other methods use proxies to get to the present value of cash flows. DCF unbundles key value drivers and the sources of risk with a great deal of clarity, thus facilitating value analysis and informed decision making much more effectively as compared to other methods. In an acquisition scenario, the synergy benefits and costs can be mapped in the model and its valuation implica-tions clearly understood through a DCF analysis. PECV, for example, captures the risk related return and growth in a single number. Given the forego-ing, DCF is indispensable as a tool to understand value drivers and facilitate value discovery from a corporate finance perspective. To value a finite life project, DCF may be the better alternate as multiples of comparable companies usually factor in perpetual existence.

The various data parameters used in building the WACC appears objective. On a closer examination, however, each of the parameters is open to chal-lenge and interpretation. Beta estimate of a traded company varies with the time period which is used to obtain the estimate. Risk free rate is strictly not risk free and impacted by several factors. There are theoretical issues with market risk premium. The parameters based on historical data are used to discount future cash flows and there is no assurance that the future will be a repetition of the past (extensive theoretical literature giving the dimensions of the issues involved is outside the scope of this overview).

In sum, DCF value is as good as the projections it is based on. Any bias in the projections would impact the value. The reasonableness of value and the projections necessarily needs to be tested with market prices of comparable companies. In case the value outcome under DCF is at significant variance with the value derived from market comparables, it would be necessary to inter alia reassess the reasonableness of the projections / market benchmarks applied to attempt to reconcile the values under both the approaches.

Considering the high level of subjectivity, DCF is seldom used in isolation and market benchmarks are important sanity checks to assess the reasonableness of the value outcome as the fair value is defined as the “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. Under various accounting standards, the projections being unobservable inputs are lower in the hierarchy as compared to market based inputs such as multiples. Thus DCF may have a limited application for pure value measurement required for financial reporting, statutory purposes.

Practical application (in the Indian context)

As already discussed application of CAPM in its pure form may not be very challenging particularly in the Indian context. Apart from subscription based data services, stock exchange websites (NSE, BSE) are rich sources of data an d qualitative information and are freely available. The return on 10 year Government of India security may be considered as the rf. A well diversified index (in India– BSE 100, NIFTY, Sensex) is considered as a proxy for the market. The return from the index may be used to derive an estimate of market risk premium. The beta estimate of a particular security (used as a comparable) can be derived from the historical data of the prices and the indices by applying the statistical formula. Betas of the shares that are part of the index are readily available on the websites of the exchanges. An illustrative DCF computation is set out in the annexure.

Balance Sheet
Position as at 1Jan 2010 INR
Share capital 100.00
Reserves and surplus 200.00
Loans 400.00
Total funds employed 700.00
Fixed assets 400.00
Investments ( treasury) 100.00
Net current assets 200.00
Total application of funds 700.00

Notes:

Fixed assets include land not used for business which has book value of INR 100 and market value of INR 300.

The market value of Investments is INR 90 Excise duty claim of INR 25 is matter of legal dispute. Legal counsel has opined the probability of materialisation of the claim is ~ 25%.

Income Statements INR
Actual Projected
Particulars for the year 2009 2010 2011 2012 2013 2014 2015
ended 31 December
Sales 500.00 550.00 600.00 650.00 700.00 750.00 800.00
Investment Income 10.00 12.00 12.00 12.00 12.00 12.00 12.00
Less:
Rawmaterials 200.00 220.00 240.00 260.00 280.00 300.00 320.00
Employee costs 100.00 104.00 108.16 112.49 116.99 121.67 126.53
Sales and administration 100.00 103.00 106.09 109.27 112.55 115.93 119.41
Profit before Interest, 110.00 135.00 157.75 180.24 202.46 224.41 246.06
Tax Depreciation and
Amortisation( PBITDA)
Depreciation 25.00 23.00 23.00 22.00 20.00 19.00 19.00
Profit before Interest) 85.00 112.00 134.75 158.24 182.46 205.41 227.06
and Tax (PBIT
Interest 45.00 40.00 40.00 30.00 20.00 10.00 8.00
Profit before Tax (PBT) 40.00 72.00 94.75 128.24 162.46 195.41 219.06
Tax 14.00 25.20 33.16 44.88 56.86 68.39 76.67
Profit after Tax (PAT) 26.00 46.80 61.59 83.36 105.60 127.01 142.39
IDCF Computation
Valuation Date : 1 Jan 2010 INR
PBITDA 135.00 157.75 180.24 202.46 224.41 246.06
Less
Investment income 12.00 12.00 12.00 12.00 12.00 12.00
Operational EBITDA 123.00 145.75 168.24 190.46 212.41 234.06
Taxes ( Refer Note 1) 35.00 42.96 51.18 59.66 67.69 75.27
Capex 10.00 15.00 15.00 15.00 15.00 15.00
Working capital requirements 12.00 12.00 12.00 12.00 12.00 12.00
FCFF 66.00 75.79 90.06 103.80 117.71 131.79
Discounting Factor ( Note 2) 0.9395 0.8292 0.7318 0.6459 0.5701 0.5031
Present Value of FCFF 62.00 62.84 65.91 67.05 67.11 66.31
Perpetuity value INR Remarks
PBITDA of terminal year 234.06
Less Depreciation 20.00 equalised to  perpetuity capex
PBIT 214.06
Less : Taxes 74.92
Add: Depreciation 20.00
Less:
Capex 20.00 based  on  requirements  conidering  growth,
depreciation etc.
Additional Working capital 5.44 2% ( growth rate)  of NWC at the end of horizon
Net cash flow 133.70
Add Growth in cash flow 2.67
Cash flow for 2016 136.37
Capitalised at ( WACC- g) 11.30%
Capitalised value 1,206.64
Discount rate 0.5031
Perpetuity Value 607.12
Valuation  Summary
Particulars INR Remarks
Present Value of free cashflows
– Horizon period (upto 2015 ) 391.21
– Perpetuity( 2016 and beyond) 607.12
998.33
Less:
Contingent Liabililities 4.06 after adjusting for probability of materialisation
and  net of taxes
Business Value of Enterprise 994.27
Add:
Investments 90.00 at realisable value
Land 230.00 net of tax on appreciation @35%
Enterprise Value 1,314.27
Borrowings 400.00
Equity value 914.27

.

Business WACC Remarks
Debt weightage 40.0% assuming book value equal to market value and
debt is for funding business
Equity weightage 60.0% based on equity value ( surplus assets and invest
ments funded by equity )
Cost of Debt 7.8% Post tax cost of debt after tax shield
Cost of debt 12.00% Interest rate contracted with lenders
Average Tax Rate 35.00%
Cost of Equity 17.0%
Risk Free Rate 7.87% Yield  on 10  year Government  of India
Security
Market Premium 7.00% Estimate based on surveys and market returns
Beta 1.30 Unlevered and  relevered  beta;  asset  beta
obtained from market price of comparable
and index movement
WACC 13.30%
Discount rate to be used 13.30%
Growth in  perpetuity assumed 2%
Capex requirements 10 15 15 15 15 15
Additional working captal 12 12 12 12 12 12
requirements
NWC position 200 212 224 236 248 260 272
Taxes
PBT 72.00 94.75 128.24 162.46 195.41 219.06
Add: Interest 40.00 40.00 30.00 20.00 10.00 8.00
Less : Investment Income 12.00 12.00 12.00 12.00 12.00 12.00
PBT 100.00 122.75 146.24 170.46 193.41 215.06
Taxes 35% 35.00 42.96 51.18 59.66 67.69 75.27


Suggested Reading / References:

Damodaran on Valuation ( 2nd Edition) by Aswath Damodaran; Published by John Wiley and Sons, Inc.

Principles of Corporate Finance (6th Edition) by Richard Brearley and Stewart C Myers; Published by Tata McGraw- Hill Publishing Company Limited.

Valuation – Measuring and Managing the Value of Companies ( 4th Edition) by Tim Koeller, Mark Goedhart and David Wessels; Published by John Wiley and Sons, Inc.

Net Assets Method of Valuation

Background :

    There are many methods of valuation of shares or businesses. One of the commonly used approaches of valuation is Net Assets Approach. Before we look into the finer aspects of this method, it may be important to note that each method of valuation proceeds on different fundamental assumptions. The data which is used for valuation has to be carefully chosen. In current times, when you have lots of data available at a click of the mouse, one needs to obtain and analyse only the relevant data. It is observed that lots of time is wasted in reviewing irrelevant information and at the end, time at disposal to review the relevant data is limited. One more factor which has materially changed in last couple of years is the time available to complete the valuation. There are times when the urgency is self-created or artificial. Only in few cases the urgency is justified.

    Let us now look at some finer aspects of Net Assets Method.

    1. The Net Assets Method represents the value of a share with reference to the historical cost of the assets owned by the company and the attached liabilities on the valuation date. Such value represents the support value of a share of a going concern. It is usual to ignore the market value of the operating assets under this method.

    2. While the historical cost is adopted in respect of the assets that are to continue as a part of the going concern, it is necessary to adjust the market value of non-operating assets such as investments and any assets which are capable of being easily disposed of, without affecting the operations of the company.

    3. The value as per Net Assets Method can also be arrived at by considering the replacement cost or the realisable value of the assets owned by the entity. This value generally represents the amount, which the company can fetch, if the assets are sold.

    4. Under what situations Net Assets Method is adopted ?

    The method to be adopted for a particular valuation must be judiciously chosen. Net Assets Method may be adopted in the following cases :

  •      In case of start-up companies, where the commercial production has not yet started.

  •      In case of manufacturing companies, where fixed assets have greater relevance for earning revenues. It would also be appropriate to use Net Assets Method for valuation in case of companies operating in the industry, which is capital intensive and is relevant to revenues in an industry, where norms are related to the capital cost per unit.

  •      In case of companies where there is no reliable evidence of future profits due to significant fluctuations in the business or disruption of business.

  •      In case of companies, where there is an intention to liquidate it and to realise the assets and distribute the net proceeds.

    5. Methodology :

    The value as per Net Assets Method is arrived at as follows :

  •      Net Assets value represents equity value which is arrived at after reducing all external liabilities and preference shareholders’ claims, if any, from the aggregate value of all assets, as valued and stated in the balance sheet as on valuation date. It is very important that the valuer critically goes through the financial statements (Directors Report, Management Analysis and Discussions, Auditors Report, Accounts including notes). It is experienced that on review of all the above documents, chances of missing any important adjustments are very less.

  •      The value so arrived at is further adjusted for contingent liabilities, if any, as on valuation date and increase in realisable value of surplus assets and investments on a net of tax basis to arrive at the value as per Net Assets Method.

    6. Some issues and its treatment in valuation :

    The following are some issues which one has to deal with in arriving at the Net Assets Valuation :

        6.1 Contingent liabilities :

        The amount of contingent liabilities as disclosed in the financial statements of the entity or otherwise needs to be given due consideration. The management’s perception of such liability materialising may also be considered. It is observed that certain items of contingent liabilities may involve a very peculiar technical or legal issue. It is not uncommon in such situations to seek some expert’s view in the matter. The valuer should mention in his report the adjustments made based on opinion of the expert. When an impact of contingent liabilities is captured in the valuation, if the item is tax deductible, the amount should be considered after taking into account the tax impact. For example if contingent liability on account of excise duty liability is, say, Rs.100. If the valuer has taken probability of 50% for such liability, the amount to be reduced from Net Assets of the company should be Rs.33 [Rs.100 X 50% X (100% — 33.99%)]. If the claim is in arbitration and the award is likely to take a long time, it is usual to take present value of such liability.

        6.2 Investments :

        If the entity which is being valued is holding shares in other companies, the same needs to be valued and captured in the overall valuation. Investment in shares and securities, which are regularly traded in a stock exchange, may be valued on the basis of the prices quoted on the stock exchange. It is usual to take either 3 months or 6 months average if the holding is large. For small lots a single day market price may be used. It must, however, be seen that there is regular trading in those securities. An isolated transaction may lead to erroneous results.

        In case of quoted shares with isolated transactions and also in case of unquoted shares, if the amount is material, a secondary valuation of such shares may be necessary using accepted methodology of valuation.

        In case of investment in subsidiary company, net asset value of the subsidiary may be considered instead of the cost.

        The appreciation or diminution in the value of any investment needs to be taken after taking into account notional tax implications, as applicable.

6.3 Surplus assets :

There are many entities which are holding certain assets which are surplus in nature. They are not used for any operations of the entity. It could be a vacant flat, vacant land or a closed factory. It is generally observed that if such assets are disposed off, it will not affect the operations of the entity. The identification of surplus assets is an important task. Generally the valuer accepts management’s representation on the same. However it is always better to review the facts based on which a particular asset has been identified as surplus. In many cases it is observed that the assets identified as surplus were not surplus in nature. For example area vacant between two factory buildings was identified as surplus in one case. However it was not actually possible to dispose of that piece of land as it would have materially affected the operation of the plant. In such case it is not surplus asset.

It is usual to take the market value of the surplus assets based on a report of the technical valuer. The appreciation or depreciation in the value of surplus assets adjusted for the tax liability on such appreciation or depreciation would be added/deducted from the Net Assets Value.

6.4 Fixed assets :

While valuing the Shares/Business of a Company, the valuer takes into consideration the last audited financial statements and works out the net asset value. Following factors needs consideration in respect of fixed assets :

  •  It has to be seen that book value is arrived at after charging adequate depreciation consistently. Any capital improvements in the past, which have been charged-off to revenue, should also be taken into account.

  •  In taking the value of plant and machinery, the factor of obsolescence due to technological improvements, changes in designs, etc., should be given due consideration. If due to technical improvements, the present machinery is found to be so outdated that it has to be discarded, then the value which the plant and machinery would fetch, if sold piece-meal, should alone be taken account of.

  •  At times, when a transaction is in the nature of transfer of asset from one entity to another, or when the intrinsic value of the assets is easily available, or when the projections of future profits cannot be made with reasonable accuracy or where there are losses or where the value of the entity is derived substantially from the value of its assets, the valuer can consider the intrinsic value of the underlying assets. For determining the intrinsic value of fixed assets, the valuers can place reliance on report from the approved Chartered Engineers or other approved valuers.

6.5 Inventory and debtors :

Due allowance should be made for any obsolete, unusable or unmarketable stocks held by the company. In case of debtors, bad debts and debts, which are doubtful of recovery need to be adjusted. If the valuation is carried after the Due Diligence Review, all adjustments arising on account of such review need to be captured in the valuation.

6.7 Contingent assets :

If the company has made escalation claims, insurance claims or other similar claims, then the possibility of their recovery should be carefully made, particularly having regard to the time frame in which they are likely to be recovered. The present value of such claims can be added to the valuation.

6.8 Qualifications & Notes to Accounts :

Qualifications in the Auditors Report and Notes to Accounts should also be given due consideration. If it calls for any adjustment, the same should be carried out while arriving at the Net Assets Value. Such items could be diminution in the value of long term investments not provided for, provision for gratuity and leave encashment not made, provision for doubtful debts not made, etc.
 
6.9 Liquidation :

Where the business of the company is being liquidated, its assets have to be valued as if they were individually sold and not on a going concern basis. In such cases, the total net realisable value will often be less than that on the basis of a going concern.

Regard should also be had to the tax consequences of liquidation. If fixed assets are to be sold at a price in excess of cost, the capital gains tax should be taken into account.

6.10 Brought forward losses :

Brought forward tax losses of a business should be considered if the buyer of the business would be entitled to take benefit of set off of such losses. Generally there is a practice to share the benefit of tax losses between both the parties.

6.11 Warrants :

If the Company has issued warrants which are yet to be exercised, the valuer has to take a call considering the current fair value and the amount to be paid on warrant conversion. If the fair value is higher, the warrant holder is likely to exercise his right. In such cases, amount receivable on warrant is added to the Net Assets Value. To arrive at the per share value, the current number of shares as well as the additional shares on exercise of warrants is considered.

Conclusion :

In many cases, Net Assets Method may not be relevant particularly where human capital or intangible are main assets used for generating revenues. In such cases, the Maintainable Profit Basis or the Discounted Cash Flow Method may be adopted.

For companies using tangible assets such as plant and machinery, building, etc, this method is relevant. Net Assets Method may sometimes be used as a backup to support the value arrived at as per other methods. In many cases, particularly valuation for mergers, Net Assets Method is used alongwith other methods but is given a lower weightage in arriving at final fair value. In many court cases where valuations were challenged, usage of Net Assets value as one of the methods of valuation was well accepted.

Following is an illustration of Valuation of Company PQR Ltd. as per the Net Assets Method :

Purchase Price Allocation (PPA)

M & A

Introduction :

As referred in my previous article on ‘Valuation of
Intangible Assets’, a purchase price allocation process is one exercise where
valuation of intangible assets plays an important part. Purchase Price
Allocation (PPA) is relatively new in India. However with the amount of mergers
and acquisitions (M&A) activity happening and with the roadmap for IFRS
convergence chalked out (beginning 2011), it cannot and should no longer remain
new.

PPA, very crudely put, can be defined as a process of
assigning values to acquired assets and liabilities. Unlike a normal valuation
exercise where ones efforts are driven towards finding and arriving at a value
of the target, in a PPA the value of the target is already known and where the
valuation of target ends, the process of PPA starts. The focus in a PPA exercise
is to allocate the total value paid for the target to individual assets and
liabilities acquired.

Rationale :

Just as a PPA is the reverse of a normal valuation, in order
to understand the full meaning of a PPA, the words have also to be read in
reverse. Purchase Price Allocation is ‘the process of ALLOCATION of the PRICE
paid for the PURCHASE of shares or of assets.’ The process is carried out to
ascertain the rationale behind paying a purchase price. The process identifies
the tangible and intangible assets/liabilities that have been purchased/taken
over, for which the purchase price has been paid. Most of us would be surprised
to know how much more a price has been paid if we compare the price paid for a
target to the book value of the target and that surprise element is the precise
reason why carrying out such a process is required by standards under US GAAP
and IFRS and with India’s planned convergence to IFRS, the knowledge of this
process along with its application is imperative. With this process, not only
would the shareholders of the acquirer understand why or why not a particular
purchase price was paid for a target but it would also bring to light the
inherent value of intangibles which may not get captured in the book value or in
the share price of a company. The following are the primary reasons why a PPA
would be carried out :



  •  For transparency to shareholders



  •  For the management to ascertain the reason for overpayment/underpayment



  •  For
    getting benefits of amortisation under revenue laws



Guiding Accounting Standards :

Currently the requirement of a PPA is mandatory only for
companies preparing financial statements under IFRS and US GAAP; however with
the much awaited convergence of Indian Accounting Standards with IFRS, the same
will be mandatory for companies preparing financial statements under Indian GAAP
as well.

Broad steps under the PPA process :




  • Business Enterprise Valuation to estimate the Internal Rate of Return (“IRR”)



  •  Identification of Intangible Assets



  •  Valuation Analysis of Intangible Assets



  • Reconciliation of Results


This is the first of the series of articles on PPA. Each
article in this series will explain the various steps in carrying out a PPA
process and how to value intangible assets forming part of a PPA. The series
will cover in detail the following aspects and the practical issues under each :


    1. General Overview

    2. Glossary of Business Terms and Definitions under a PPA

    3. Computation of Purchase Price to be allocated

    4. Calculation of IRR

    5. Computation of Weighted Average Cost of Capital (‘WACC’)

    6. Possible reasons for differences between the IRR and the WACC

    7. Identification of Intangible Assets

    8. Remaining Useful Life

    9. Tax Amortisation Benefit Factor

    10. Valuation Approaches and Methods

    11. Tangible assets — Identification and

    Valuation

    12. Weighted Average Return on Assets

    13. Reconciliation of Results

    14. Non reconciliation of Results

    15. Interpretation of Results

    16. Negative Goodwill

    17. Value additions

    18. Case Study

    19. Discussion of questions and answers received over the period of the series

    20. Chartered Accountants as Valuers

    21. Useful links and resources

levitra

Tax Due Diligence — Indirect Taxes

M & A

After reading the series of
articles of ‘Financial and accounting due diligence’ and Tax due diligence —
direct tax, readers would be clear about the circumstances under which due
diligence exercise is performed and its objectives. In the context of mergers
and acquisitions, due diligence is mandated either by a vendor who intends to
divest stake in a particular business/unit or by the potential acquirer who
intends to acquire the subject business/unit. The objective, in both the cases,
is common i.e., to avoid any post-transaction unpleasant surprises.

In terms of process of
performing indirect tax due diligence, it is no different from the manner in
which it has been discussed in the earlier articles on financial, accounting and
direct tax due diligence. In fact, the process should be so integrally linked
that it should appear seamless to the target and the client management.

Need for indirect tax due
diligence :

As the words ‘indirect tax’
suggest, these taxes are not a direct hit to the person who has the statutory
obligation to pay these taxes since these are recoverable in nature. However,
the indirect tax-related exposure, whether emerging from pending litigation or
from a potential exposure identified during the course of due diligence, remains
and/or travels with the subject-business.

This is one of the prominent
distinctions between direct tax and indirect tax i.e., the indirect
tax-related risks in terms of statutory liabilities and obligations are largely
associated with the business, irrespective of the manner in which the business
changes the ownership; say, by slump-sale or by transfer of equity or by sale of
merely the manufacturing unit or service centre or a particular branch, etc.
Thus, unlike income-tax where generally the statutory obligations remain with
the transferor entity, in the case of a business transfer, the indirect tax
obligations travel with the business. Hence, identifying and analysing indirect
tax obligations pertaining to the subject-business remain key focus areas as
discussed below.

Incidentally, it would be
important to also define in the scope of work with the client as to which
indirect taxes are being covered by the indirect tax diligence and which other
taxes/duties are excluded, say, that are expected to be covered by the legal due
diligence. Generally, custom duties, excise duties, sales tax, VAT and service
tax are covered in an indirect tax due diligence and taxes such as stamp duties
are picked up by the legal due diligence team.

Key focus areas :

One may broadly examine the
indirect tax diligence through eight key focus areas viz. :

1. Pending litigations and contingent liabilities :

    This is one of the most common and traditional method of commencing the tax due diligence work. Here, the issues involved initially need to be studied from source documents, say, notices, demand orders and appeal papers made available along with interaction with the management and/or their tax advisors. The next step is to undertake research based on legal provisions, notifications, clarifications and judicial precedents found relevant. This leads to the third and important step involving merit analysis of the issue involved after considering the contentions of both the parties to the dispute and the result of indigenous research work along with tax positions adopted by industry members. Copies of legal opinion obtained should be reviewed with developments subsequent to the date of the opinion.

    It is generally accepted that unlike tax advisors/advocates who are attending to the tax disputes, the diligence team does not have the luxury to take significant amount of time to analyse the issue. Needless to say, the expectations are always there for the diligence team to arrive at an independent and conclusive view on each of the issues involved. Hence, greater focus should be applied on providing ‘substance’ rather than ‘form’ in terms of detailed articulation of arguments of both sides before arriving at the view. For example, in media industry, specifically in production and distribution segment, one of the issues that is under litigation is VAT liability and the state in which such liability to pay VAT arises on transfer of distribution and various broadcasting rights in the content (say, film, television serial, event, etc.). Companies are known to take different positions, ranging from a conservative stand to execute the agreement in the state where the business of the media company resides and pay VAT as applicable in that state, to a more aggressive stand where the agreements are executed outside India or in any of the Indian states where VAT is not applicable or exempted.

    Mere merit analysis of the disputed issues does not complete the exercise. What helps in achieving completion is understanding the accounting treatment in the books/financial statements i.e., the extent to which the amount is paid, provided as liability or disclosed as contingent liability. Even in case of payment, it would be relevant to ascertain the extent to which the amount paid under protest is accounted as a ‘receivable’ or charged to revenue. In case of industry engaged in export of services, say, IT and ITES industries, typically companies account for service tax and excise duty paid on input services, input and capital goods as a receivable, though the time the Tax Department generally takes in accepting the company’s contention, processing the refund claim and granting a refund is such that the possibility of receiving refund in the near future appears remote.

    It is also important to note that the analysis should not be restricted to the disputed period. If the issue involved is ‘recurring’ in nature, the aggregate exposure needs to be quantified including the potential exposure for periods subsequent to the dispute if there is no change in the provision of law and adopted tax position. The two long-ranging disputes that come to mind are applicability of service tax and/or VAT on (i) construction and sale of residential/commercial premises, and (ii) licensing of software/copyrights. These issues are perennially being faced by the construction & real-estate and IT & media industries, respectively.


2.    Observations in completed assessments and audits:

Completed assessment orders and audit memos provide opportunity to observe the acceptance or otherwise of the critical tax positions taken by the company. Tax positions include exemptions, abatements, incentives, reliefs, set-off claims, etc. claimed the company.

It may be noted that even though the assessments and/or audit memos finally do not result in any litigation, it is important to observe any disallowance or rejection of tax relief claimed which resulted into demand, which in turn have been accepted and paid by the company. These observations form the basis for analysing the tax positions in open assessments. At times, companies have been known to claim the benefit of inter-state sales at concessional tax rate against declarations in Form C, etc. in the return, but the collection and furnishing of these forms are not pursued aggressively until assessment (which generally takes after a period of three years or more) and results in some differential tax liability along with interest and penalty, when assessments are concluded. Hence, based on past trend of the company in completed assessments, the potential liability, if observed on this account, needs to be indicated.

3.    Potential issues in open/unassessed periods:

The best way to tap the open assessment periods is to peruse the tax returns and filings including VAT Audit reports. However, it is not practical to peruse all the tax returns, payments and filings done say on monthly basis for excise, VAT and service tax for each of the locations where the indirect tax registration has been obtained. This needs to be done judiciously on sample basis.

The focus here should be applied on the tax claims and tax positions not yet tested in the assessments/audits. On a case-to-case basis, if the stake involved in adopted tax positions is significant, focussed interaction with management is desired to know the rationale and compliance to conditions for taking such positions. When found relevant, key customer contracts and/or vendor contracts may be perused on sample basis. This helps in gathering some comfort about tax positions adopted in the open assessment period which carries higher element of uncertain risk as compared to the risk in the matters already under litigation.

4.    Positions vis-à-vis industry issues:

At times, it would be difficult to argue that merely because many/most players in the industry have adopted the same practice, the tax position would be acceptable. However, one cannot afford to ignore this altogether. It is because, there have been instances in the past where mere clarifications to the provisions of law (which otherwise is deemed to have been effective with retrospective effect) have been articulated in the Departmental circular or clarification so as to implement prospectively by providing relief for the past in indirect manner. The one example I recollect here is about clarifications on service tax liability in the case of international roaming under various scenarios of inbound and outbound roaming which provided some relief to telecom operators for the positions taken in historical period. This has happened generally when the issue involved is an ‘industry issue’ and contended on bonafideness. Thus, providing information on industry positions provides different level of business comfort.

5.    Tax incentives — eligibility, admissibility, fulfilment of terms, conditions & obligations and continuity:

Tax incentives, specifically area-based tax incentives (say, available to manufacturing units in Uttaranchal, Himachal, Kutch, North Eastern States, etc. and/or to units in Special Economic Zone, Electronic Software/Hardware Technology Park and/ or to units in specified backward areas in States for VAT incentives, etc.) are subject to complying with specified terms and conditions. In this regard, it is important to gauge the continuity of tax incentives post transaction. This is because the quantum of unused tax incentives and its entitlement play a vital role in valuation of the transaction and hence its fate.

When the transaction structure is known at the time of due diligence, it is appreciated if the things found critical for continuation of tax benefits post transaction are briefly but appropriately communicated along with major concerns and listing of broader compliance steps for continuation.

6.    Tax balances — perusal of reconciliation statement:

Understanding the quantum of tax balances accounted as ‘income’ (e.g., tax incentives/refunds), ‘expense’ (e.g., tax paid during audit observations), ‘assets’ (e.g., tax paid under protest and tax credit balance) and ‘liabilities’ (e.g., provision for periodical tax amount and for tax disputes) is important. It is because at the end of the due diligence exercise, one needs to identify the appropriateness of their accounting and the impact on profitability, net-worth and working capital.

After seeking reconciliation of tax balances, attention here needs to be paid on the rationale/ justification for each of the items forming part of the reconciliation statement. Post analysis, the resultant adjustments in terms of computation of profitability, net-worth, working capital, etc. should be identified and reported. The illustrative list of such adjustments includes (i) service tax refund for export of services, VAT refund for export, export incentives like duty drawbacks, etc. though entitled, not actually claimed before the appropriate authorities and accounted as ‘income’ and ‘receivable’, should be highlighted (ii) VAT/CST, etc. for March payable in April not accounted as ‘expense’ and ‘liability’ in the accounts for financial year, should be highlighted.

7.    Related-party transactions:

Transactions with related party(ies) desire twofold attention i.e., (i) when the provision of law (say governing excise duty and VAT in some states), require transactions between related parties to be at fair market value, and (ii) when the provision of law is silent (say, service tax law or VAT in some states).

In the first scenario, the potential exposure should be identified. While in the second case, it needs to be understood that if the proposed transaction is structured in such a way that the benefit of ‘related party’ may not continue post transaction (say, where only one of the related entities is proposed to be acquired and hence the concessional transaction value regime shall come to an end in commercial terms). In such situations, the consequential tax implications need to be identified, analysed and discussed.

8.    Important compliance procedures:

Verifying and reporting compliance matters is generally outside the work scope of due diligence as they generally do not give birth to any deal-breaker or significant valuation/risk issue. Besides, this requires greater amount of time and cost which always are constraints. However, understanding and providing broad flavour of tax compliance management (in terms of tax filings, tax payments, withholding tax on payment to works contract, etc.), tax team (in terms of qualification, level of competencies, etc.) and related systems (say, to undertake tax computations, to monitor collection of declaration forms, etc.) helps the client specifically in transactions envisaging change of management whether partially or completely.

In this regard, the indirect tax team would be well advised to clearly state the ‘exclusions’ from the scope of work of the indirect tax diligence so that there are no gaps in client expectations. Normally exclusions from an indirect tax diligence are review of tax compliance/procedural matters, providing tax advisory/planning services, etc.

Reporting:

Reporting is very critical to the entire exercise. Without adequate and smart reporting, the due diligence exercise may prove futile. While discussing the key issues, it needs to be ensured that though the approach and substance should suggest advisory role, the form in which the report is articulated should in no way appear as advisory deliverable like tax memo or opinion. The reason is obvious; the primary intention is not to repair the potential issue but to understand the worth and implications of the issues correctly.

For the foregoing reasons, the report is generally divided into three parts i.e.:

(i)    Key issues (i.e., ‘must to know’ issues involving significant implications on the financial state-ments based on historical issue or from future perspective (say, continuity of tax incentives in special industrial areas, view on high-value litigation matters, etc.)

(ii)    Other issues (involving non-key but ‘need to know’ issues) and

(iii)    Informative issues (i.e., help in understanding overview of business from indirect tax perspective).

It is important to note that when the key issues could be in the nature of potential deal-breakers, there is no formal or structured way to communicate them for the first time during the diligence exercise. It means, such deal-breakers must be communicated ‘as and when’ they are observed without waiting for due date.

For each of the issues explained in the report, it must cover, inter alia, the exposure period, the quantum of exposure along with interest and mandatory penalty. When the penalty is not mandatory, a broad range should be indicated. Each issue needs to be analysed on merit by classifying risk as ‘probable’, ‘possible’ or ‘remote’ with agreed weightage for valuation adjustments, say for arriving normalised earnings, net-worth and/or working capital.

Lastly, reporting the issues without mitigation a strategy may leave the client clueless. Hence, it is equally important to provide a risk mitigation strat-egy in terms of obtaining warranty/indemnity, or in making a valuation adjustment, or deferring a part of the consideration in escrow account, etc. till a more definitive resolution of the issues concerned.

Conclusion:

It may be said that though there may not be a standard error-proof approach for carrying out a relatively subjective exercise of due diligence under different circumstances, the foregoing should help practitioners in carrying out an indirect tax due diligence exercise in a more structured manner to bring out the value to the client along with building efficiency and superior risk management to the whole diligence process.

A misperception at times amongst clients and their advisors is that indirect tax does not have the same flamboyance as a direct tax or a legal issue which then dangerously leads to a lack of adequate focus by the client on the unresolved indirect tax issues. We, indirect tax practitioners are well aware of the unending complexities of the indirect tax acts, rules, notifications and clarifications in our country and the multitude of judicial interpretations. And I humbly submit that a majority of my fellow direct and indirect tax practitioners would also acknowledge that more often than not, the potential tax liability arising from an indirect tax issue can be far more crippling than any other demand!

It remains the responsibility of the indirect tax team to correct any such misperceptions of the client or his advisors about ‘indirect tax’ and to ensure that the client has a true and fair appreciation of the indirect tax issues in the proposed M&A transaction.

Valuation — Market Approach

New Page 6

Oscar Wilde once described a cynic as “A man who knows the
price of everything and the value of nothing”. He was probably describing those
who believe in ‘survivor investing’ i.e., the theory of the value of an asset
being irrelevant as long as there is a ‘bigger fool’ willing to buy the asset at
a higher price.

A postulate of sound investing is that an investor does not
pay more for an asset than its worth. While this statement seems logical and
obvious, it is forgotten and rediscovered at some time in every generation and
in every market.

Every asset, financial as well as real, has a value. The key
to successfully investing in and managing these assets lies in understanding not
only what the value is but also the sources of the value.

Valuation is a process of determining a value. It’s a myth
that the value is nothing but a price. Price paid and the value determined can
sometimes be two ends of a pole. Valuation is subjective and may not provide any
precise or accurate estimate of value. Minimal skills sets required to carry out
a valuation include accounts and finance background, research and analytical
abilities, technology, communication and common sense.

Typically, there are three primary approaches to value the
business in practice. These approaches make very different assumptions but they
do share some common characteristics and can be classified as hereunder :

1. Market approach :


The market approach assumes that companies operating in the
same industry will share similar characteristics and the company values will
correlate to those characteristics. Therefore, a comparison of the subject
company to similar companies whose financial information is publicly available
may provide a reasonable basis to estimate the subject company’s value. There
are three forms of the Market Approach — the Comparable Companies approach (‘CoCos’),
the Comparable Transactions approach (‘CoTrans’) and the Market Price Method.
Market Approach is typically used to provide a market cross-check to the
conclusions reached under a theoretical Discounted Cash Flow approach.

2. Income approach :


The income approach recognises that the value of an
investment is premised on the receipt of future economic benefits. These
benefits can include earnings, cost savings, tax deductions and the proceeds
from disposition. There are several different income approaches, including
earnings capitalisation method (ECM), discounted cash flow (‘DCF’), and the
excess earnings method (which is a hybrid of asset and income approaches). ECM
considers company’s adjusted historical financial data for a single period,
whereas DCF and excess earnings require data for multiple future periods.

3. Cost approach :


The cost approach considers reproduction or replacement cost
as an indicator of value. The cost approach is based on the assumption that a
prudent investor would pay no more for an asset than the amount for which he
could replace or re-create it or an asset with similar utility. Historical costs
are often used to estimate the current cost of replacing the entity valued. When
using the cost approach to value a business enterprise, the equity value is
calculated as the appraised fair market value of the individual assets that
consists of the business less the fair market value of the liabilities that
encumber those assets.

Under a going-concern premise, the cost approach is normally
best suited for use in valuing asset-intensive companies, such as investment or
real estate holding companies, or companies with unstable or unpredictable
earnings.

Valuers generally use a combination of different approaches
to arrive at the fair value of an asset. In this issue we will discuss some
important aspects of the market approach.

Important definitions :





à Fair market value — fair market value means the amount at
which an asset or property would change hands between, a willing seller and
a willing buyer when neither is acting under compulsion and when both have
knowledge of reasonable facts.



à Enterprise value — market value of invested capital in the
business which includes all types of stocks and interest-bearing debts or a
measure of a business value calculated as market cap plus interest-bearing
debt, minority interest and preferred shares, minus total cash and cash
equivalents, non-operating assets and surplus assets.



à Equity value — Equity value is the value of a company
available to owners or equity shareholders.



à Book value — Book value is the value at which an asset is
carried on a balance sheet. In simple words, the book value is nothing but
an net worth of a company.



à Valuation multiple — Valuation multiple is computed by
dividing the price of the company’s stock as of the valuation date by some
relevant economic variable observed or calculated from the company’s
financial statements.



à EBITDA — Earnings before interest tax depreciation and
amortisation



à EBIT — Earnings before interest and tax



à PAT — Profit after tax




Market approach :

In the real estate sector, recent sale of comparable homes in
an area are used to establish the reasonable price range within which any home
is likely to sell. Similarly, market comparables are used as guidelines to value
a business, security or an intangible asset based on recent transactions in
comparable businesses, securities or intangible assets.

We will discuss in detail the following methods of valuation
under the market approach :

    a. Comparable companies
    b. Comparable transactions
    c. Market price

Comparable Company Method (CoCo) or Guideline Company Method :
Under the comparable company method, valuation multiples are computed based on prices at which stocks of similar companies are traded in a public market. The valuation multiples thus computed will be applied to the subject company’s fundamental data to arrive at an estimate of value for the company.

The value derived from CoCo method often represents a publicly traded equivalent value or freely traded value. In other words, it is a price at which the stock would be expected to trade if it were traded publicly. Thus, the value indication is appropriate for a marketable, minority ownership inter-est, using the premise of value in continued use, as a going-concern business. The method leads to fair market value, as it is a value at which an asset can be exchanged between willing buyer and willing seller with a full market knowledge and on an arm’s-length transaction.

We will use an example of AB Television Limited (‘ABTV’) to demonstrate practical application of market approach. ABTV is a general and business news channel with :

    Revenues of INR 5,000 million;
    EBITDA of Loss. INR 2,000 million; and
    EBIT of Loss. INR 2,500 million.

ABTV has around 6 news channels in its bouquet which includes 1 general English news channel, 1 general Hindi news channel, 1 English business news channel and 1 Hindi business news channel. It also has 2 regional language general news channels. It also has its general news Internet portal named www.abtv.com.

    Identification of comparable companies :

Comparability of companies often becomes a central issue in litigated valuations. Companies can never be absolutely comparable to each other. The economics that drive the comparable companies should match those that drive the target company.

In order to determine the comparability factors such as product-mix, geographies, size, stages of business, market positioning, operating or EBITDA margins, dividend history, trading volumes, management, etc. should be considered.

Table 1 below shows list of broader comparables of ABTV.

The current portfolio of ABTV constitutes only news channels — business and general. It also includes its Internet business. Based on the business of ABTV and the above selection criteria, we selected com-panies like Zee News Limited, IBN 18 Broadcast Limited, TV Today Network, Television 18 Limited. NDTV has recently announced that it has sold off its 3 entertainment channels NDTV Imagine, NDTV Lumiere, NDTV Showbiz to Turner International. The TTM revenues of NDTV include revenues from the general entertainment business and hence, due to major restructuring of the businesses we have excluded NDTV Limited from the list of comparables. Though we have ignored the multiple of NDTV, we have tried to corroborate news channels’ multiples with the multiple of NDTV Limited.

    Normalise the financial statements :

Normalising the financial statements is essential to remove the impacts of non-recurring and non-operating income or expenses, accounting differences, etc. from the financials, to arrive at maintainable or sustainable earnings and margins, operating revenues, etc.

    Calculate multiples based on various financial parameters :

Multiples may take many forms. The numerator may be based on equity or enterprise value and the denominator may be based on a variety of normalised financial performance matrices on pretax or after tax basis.

If the numerator of a multiple is an equity value, then the denominator of the multiple should be an equity measure, such as PAT or net income or book value. Similarly, if it is enterprise value, then it should be operating parameter like operating revenue, EBIT-DA, EBIT, etc.

 

Company

Business

Country of

MCap

Net
worth

TTM sales

EBITDA

Trading

 

 

INR Millions

 

operation

 

 

margin

%

 

 

 

 

 

 

 

 

 

 

 

 

 

Zee News Ltd.

General and business

 

 

 

 

 

 

 

 

 

news channels

India

12,420

2,406

5,801

20%

52%

 

 

 

 

 

 

 

 

 

 

 

 

IBN 18 Broadcast Ltd.

News and general

 

 

 

 

 

 

 

 

 

entertainment
channels

India

18,978

2,787

4,826

-13%

8%

 

 

 

 

 

 

 

 

 

 

 

 

NDTV Ltd.

General and business

 

 

 

 

 

 

 

 

 

news channel and

 

 

 

 

 

 

 

 

 

Internet

India

10,076

2,614

5,237

-66%

79%

 

 

 

 

 

 

 

 

 

 

 

 

Sun TV Network Ltd.

Regional entertainment

 

 

 

 

 

 

 

 

 

and news channels

India

124,165

17,016

12,790

82%

4%

 

 

 

 

 

 

 

 

 

 

 

 

TV Today Network

 

 

 

 

 

 

 

 

 

Ltd.

General news channels

India

6,533

3,212

2,545

33%

23%

 

 

 

 

 

 

 

 

 

 

 

 

Zee Entertainment

Regional and

 

 

 

 

 

 

 

 

Enterprises Ltd.

entertainment
channels

India

96,749

33,995

20,611

34%

18%

 

 

 

 

 

 

 

 

 

 

 

 

Television Eighteen

News channels and

 

 

 

 

 

 

 

 

India Ltd.

business news and

 

 

 

 

 

 

 

 

 

Internet

India

11,570

4,442

4,853

-17%

81%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The time period used to calculate multiples is generally trailing twelve months (‘TTM’) or latest fiscal year. Sometimes the estimates of next year’s expected results also are considered.

Generally, TTM multiples display the latest information and the current state of operations, however they may not be readily available and need to be computed by using interim financial statements. Latest fiscal year multiples are directly available, but would not reflect the current state of operations. Forward multiples give a forward looking valuation, however they may not be accurate as they are estimates.

Valuation multiples computed from comparable company data for some time period (say, TTM), applied to the target company data for a different time period (say, last fiscal year) can result into consider-able distortions, especially if the industry conditions differ significantly between the time periods.

Either avoid comparable companies with recent corporate actions like mergers, acquisitions, etc., or make the adjustments to time period to arrive at real value. This is to make like to like comparisons and avoid speculative effect due to corporate announcements.

To calculate market capitalisation of the comparable companies, calculate 3 months’ or 6 months’ or 12 months’ volume-weighted average market price (‘VWAP’) to avoid daily fluctuations and speculative effect on the market prices.

In case of ABTV we have selected TTM revenue and TTM EBITDA to arrive at the enterprise value of the company. Further, we have considered 6 months’ VWAP for arriving at market capitalisation for the comparable companies.
 

Table 2 shows the range of multiples for ABTV Limited.

Notes : Market Cap. is Market Capitalisation; MI = Minority Interest; EV means Enterprise Value; TTM EBITDA numbers are adjusted for non-operat-ing and non-recurring items; NA is Not Applicable.

    Select the type of multiple to be applied :

Selecting the type of multiple requires significant judgment. Industry practices are good indicators of the type of multiple that can be selected. In case of companies that are mature and generate stable cash flows, one must consider using earnings multiples.

In Table 2, we have not considered EBIT multiple or PAT multiple as most of the companies including ABTV Limited are making losses at EBITDA level. Ideally, EBITDA and EBIT multiple are best parameters to judge the business value. Hence, the key parameters for valuing ABTV Limited would be EV/Revenue. EV/EBITDA should also be ignored as EBITDA multiple is derived based on 2 companies’ parameters which may distort the valuation. To get the robust multiple, larger set of comparable should be adopted. But if the similarity of the businesses of the two companies is very similar, then one can consider even two companies as benchmark. In other words, more the disparity in the businesses of the comparable companies, the larger should be the group.

Further, while valuing ABTV Limited, EBITDA multiple will have to be multiplied with EBITDA number of ABTV which is a negative number. Therefore, for the purpose of this example, we have only considered revenue multiple which is also in range of multiple of NDTV Limited.

    Selected comparable company multiple :

The median multiple is generally selected because the median provides a better measure of central tendency than the mean. Outliers would have a higher distorting effect on the mean than the median. The selected multiple needs to reflect the relative strengths and weaknesses of the subject company relative to comparable companies. If the outlook of the subject company is lower in terms of risk and/or more in terms of growth, then a multiple which is higher than the median may be selected.

In our illustration, the comparable companies are comparable in terms of risk and growth opportunities, as more or less all the companies are in business or general news channel except for IBN 18 broadcast which has various entertainment channels under its bouquet like MTV, Colours, Nick, and Vh1. It is also engaged in other businesses like film production, distribution of branded merchandise which though are in a start-up phase and are immaterial to its channel businesses. Therefore, if we remove it as an outlier, then median EV/Revenue is around 2.4x and average EV/Revenue is around 2.7x.

    Apply adjustments for non-operating as sets and liabilities :

Excess cash and other non-operating assets need to be added and non-operating liabilities and inter-est-bearing debts should be subtracted from the enterprise value arrived at by applying the selected multiple to the financial performance matrices of the target company.

For example, ABTV has cash and cash equivalent of INR 1,200 million and Debt + Minority interest of INR 9,125 million which needs to be adjusted to its enterprise value. Enterprise Value of ABTV = EV/Rev-enue x TTM Revenue.

Types of multiples :

    Price to earnings multiple :

Price to earnings (‘P/E’) multiple is calculated as follows :

Current Market Price

PE Multiple  = ————————————————

Earnings per Share

Earning power of a company is one of the key drivers of its valuation. P/E ratio is one of the most widely accepted valuation parameters. Net profit after taxes, post adjustments for extraordinary and non-recurring income should be used to calculate the P/E ratio. The ratio cannot be used for companies with negative earnings. The P/E ratio is significantly influenced by the accounting decisions of the company. The guideline companies should have similar financing structures to compare their P/E ratio.

    PEG ratio :

PEG ratio is calculated as follows :

                                                      PE Ratio
PEG ratio    =             _____________________________

                                           Expected Growth Rate

Analysts compare PE ratios of a company with its growth rate to identify undervalued and overvalued stocks. PEG ratio of a firm must be compared with other firms operating within the same industry. A lower PEG ratio indicates undervaluation and a higher PEG ratio indicates overvaluation. The firm’s equity is considered fairly valued if PEG ratio reaches value of one. PEG ratio is useful to predict future growth of companies.

    Price to book value multiple :

Price to book value multiple is calculated as follows :

                                                  Market price per share
Price to book value =_______________________________________

                                               Book value of equity per share

The price to book (‘P/B’) multiple can be used for companies with negative earnings. The multiple is stable as the book value of a company does not change much from year to year. Book value of an asset is driven by the original price paid for the asset and accounting decisions of the company. As common sense would suggest that there is significant degree of correlation between return on equity and price to book value. Hence, while considering multiples of comparable companies also correlate the return on equities of the comparable companies and subject company.

Book value multiple is used in traditional manufacturing companies that derive their value from assets in place and high capital expenditure. The multiple is useful to value finance, investment, insurance and banking firms that hold significant liquid assets. P/B ratio can also be used for firms that are going out of business. The multiple is generally not used for valuation of companies in service industries primarily, because the multiple does not capture the potential of identifiable and unidentifiable intangible assets.

    Revenue multiple :

Revenue multiple is calculated as follows :
Revenue Multiple = Enterprise Value/Revenue

Revenue multiple is another widely accepted valuation ratio because of several factors. Firstly, growth rate is a fundamental driver of valuation, which begins with sales. Secondly, sales information is subject to less manipulation than any other financial parameter. Besides, sales information is easily available for all types of firms including troubled and very young firms. Thirdly, revenue multiple is less volatile than the earnings multiple, therefore it can be used in cases where there are large fluctuations in earnings. A drawback of this ratio is that it does not capture the difference in cost structures and capital struc-tures between different companies. Further, it can be one of the best parameters for the companies in growth phase, or when company has launched new products and has not broke even.

    Enterprise value to EBITDA/EBIT :

EBITDA multiple is calculated as follows :

                                                        Enterprise Value
EV/EBITDA or EBIT    =            _______________________

                                                         EBITDA or EBIT

EBITDA or EBIT multiple is one of the best param-eters to analyse the business value of the company. Since EBITDA or EBIT are operating margins of the business they are best to use for any industry. EBIT-DA or EBIT multiple can be used for comparing firms with different degrees of leverage. For these rea-sons, this multiple is particularly useful for valuation of companies in almost all industry. It may not be useful when the companies are in the growth phas-es or haven’t broke even. Best time to use these multiple is when the industry or subject company are in stable phase or mature phase.

    Other multiples :

Analysts use other valuation multiples such as sec-tor specific ratios, for example price per hit ratio is used to value startup website companies, price per subscriber is used for valuation of cable and telecom companies, price per megawatt is used to value power generation companies, EV per tone can be used for cement or steel industry, etc.

Comparable Transaction Approach (‘Cotrans’) : One can derive indication of value from the price at which a company or an operating unit of a company has been sold or the price at which a significant in-terest in a company has changed hands. Such data is harder to find as compared to daily stock trading data. The steps followed by a valuer/analyst using the comparable transaction approach are similar to those of the comparable companies approach.

The primary difference between CoCos method and CoTrans method is that in CoTrans method the transaction price is the basis of calculating the multiple, whereas in CoCos method basis is the current market price of similar companies. Transactions in the target company’s industry or similar industry are analysed over a period of 3 to 5 years depending upon availability of set of transactions and changes in the industry.

This is because there are fewer transactions, and acquisition price multiples generally do not fluctuate a lot over time as compared to market price multiples. Characteristics of each transaction need to be analysed to decide which adjustments may be necessary in order to use the transaction price multiples. In case of ABTV we have considered the following as comparable transactions :

Valuer/Analysts should take into account the follow-ing aspects while using the CoTrans method :

    Source of data :

Generally, the availability of data for comparable transactions is comparatively scarce v. stock price data for comparable companies. Data on the acqui-sitions of private companies are not subject to any regulations and vary tremendously in scope and format. If the subject company itself has changed control in the last few years, the transaction may be an excellent source of valuation multiples.

 

Date

Target

 

Bidder

Deal

Stake

EV/

EV/

EV/

 

P/E

 

 

 

 

 

 

 

 

 

 

value

acquired

Revenue

EBITDA

EGIT

 

 

 

 

USD million

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

31st Dec. 2009

NDTV imagine

 

Turner

81

92%

n.a.

n.a.

n.a.

 

n.a.

 

 

 

 

 

International

 

 

 

 

 

 

 

 

 

 

 

29th Oct. 2009

Zee News Limited

 

Zee Entertainment

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Enterprises Limited

252

N.A.

3.8

16.1

N.A.

 

N.A.

 

 

22nd Dec. 2008

Broadcast

 

HDIL Infra

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Initiatives Limited

 

Projects Pvt. Ltd.

7

N.A.

2.6

1.0

1.0

 

N.A.

 

 

27th Oct. 2008

UTV Software

 

The Walt Disney

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Communications

 

Ltd.

302

N.A.

18.1

103.5

113.6

 

37.4

 

 

 

Ltd.

 

 

 

 

 

 

 

 

 

 

 

 

 

7th July 2008

New Delhi

 

Prannoy Roy,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Television Limited

 

Radhika Roy, RRPR

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Holdings Pvt. Ltd.

140

N.A.

10.9

96.6

241.9

 

N.A.

 

 

28th Feb. 2007

Udaya TV Private

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Limited

 

Sun TV Network

401

N.A.

19.7

36.5

N.A.

 

71.6

 

 

28th Feb. 2007

Gemini TV Pvt. Ltd.

 

Sun TV Network

603

N.A.

15.8

23.0

N.A.

 

59.8

 

 

 

 

 

 

 

 

 

Average-All

 

 

11.8

46.1

118.8

 

56.3

 

 

 

 

 

 

 

 

 

 

 

 

 

Median-All

 

 

13.3

29.8

113.6

 

59.8

 

 

 

 

Average-post
outliers

 

 

11.8

19.1

1.0

 

65.7

 

 

 

 

 

 

 

 

 

 

 

Median-post outliers

 

 

13.3

19.5

1.0

 

65.7

 

 

 

Average-recent
(2009)

 

 

3.2

8.5

1.0

 

N.A.

 

 

 

 

 

 

 

 

 

 

Median-recent (2009)

 

 

3.2

8.5

1.0

 

N.A.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Several databases are also available such as Bloomberg, Merger Market, Capital IQ, etc., which provide information on transactions across different sectors and different geographic locations. We have selected comparable transactions for ABTV from Merger Market.

    Non-availability of data :

In case of most transactions, financial data is not available. In case of acquisitions of privately held companies, the data with respect to purchase price, revenue or earnings measures of the target company, percentage stake acquired, etc. are usually not available in the public domain. Therefore, analysts need to use appropriate judgment in case of trans-actions where data is not available.

    Understanding the deal structure :

One must understand the rationale of each comparable transaction. For example, one must understand if the transaction was a strategic investment or financial investment, percentage of stake sold in the transaction, whether the sale was a distress sale, etc. Typically, due to different purposes of investments, transaction rationale and synergy benefits, different control premiums and minority discounts are embedded in the transaction values. Differences between the comparable transactions and the contemplated subject transaction should be noted and adjusted appropriately in developing valuation multiples. Due to lack of information on such parameters it would be difficult to really analyse these aspects of transactions and hence, comes the judgment of the Valuer.

    Announcement versus closing date

The announcement and the closing date of a trans-action can be months apart. There may be a difference between the indicated deal values on the two dates. Generally, the date used does not make a material difference to the valuation. Most multiples are developed based on announcement date. This gives an indication of what the buyer and seller originally intended to pay or receive for the company based on the information available at the time when the deal was originally analysed and negotiated.

    Rule of thumb :

Some industries have rules of thumb about how com-panies are valued for transfer of controlling ownership interests. If such rules of thumb are widely disseminated and referenced in the industry then, they should be used. Generally, there is no credible evidence on how these rules of thumb are developed. They fail to differentiate operating characteristics of one company to another and do not consider differences in the terms of the transactions.

    Control premium :

The value of a majority stake in a company is always more than the value of a minority stake, because the majority shareholder gets control of the financial and operating decisions of the company. Therefore, if a transaction considers the acquisition a majority stake, then the price includes a control premium. The market price considered in calculation of multiples in CoCos method does not take into account any control premium. Therefore analysts should adjust the transaction multiples to remove the effect of the control premium while valuing a minority stake in a company.

Market Price Method :
Under the market price method, an asset is valued based on the price at which it is traded in the open market. This method gives a reliable indication of the value of an asset as the market price reflects the value that a buyer is willing pay to a seller for an asset in the free market. In case of shares of a company that is listed on a stock exchange, one can consider the market price of the company based on the last six-month VWAP on the stock exchange where the company’s shares are most frequently traded. It may happen that the equity market may not reflect the fair value of a stock, as the equity prices on a stock exchange get influenced by the market sentiments. It is important for a valuer/analyst to consider these market sentiments while using the market price method. At times the valuation practitioner may choose to ignore this method of valuation if market price is not a fair reflection of the company’s underlying assets or profitability.