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8/3/2019 AFS 4 Advanced Accounting Concepts
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Advanced Accounting concepts
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Value Based Management
Creating value for shareholders is accepted as acorporate objective in todays times
Many VBM approaches have been developed tomeasure and create value. These are synergiesof various disciplines
Finance DCF and shareholder value maximisationBusiness strategy Value creation through exploitation of
business oppurtunitiesAccounting Structure of financial statements with modificationsOrganisational Behaviour - Incentive plans for creating value
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Principal methods of VBM
1.Free cash flow Mckinsey and Alcar2.EVA / MVA Stern Stewart
3.Cash flow return on investment / Cash value added
( CFROI /CVA ) BCG
Common threads
1. Value of any company = PV of future cash flows
2. Firms should use value metrics and employ themacross all management functions
3. A well designed incentive structure will motivateemployees to create shareholder value.
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Economic Value AddedEVA
EVA as a concept was developed byStern Stewart & Co. EVA is the surplusover and above the cost of capital.
A company which gives a return morethan the cost of capital creates wealthor adds shareholder value whereas a
company earning a return less than thecost of capital destroys value.
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EVA = PAT cost of equity
= PAT (cost of equity rate * equity capital)
EVA = NOPAT Weighted Average cost of capital
(PAT + INT(1-t)) (Capital * WACC)
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1.Net sales 300
COGS 258
PBIT 42Interest 12
PBT 30
Tax @30% 9
PAT 21
Cost of equity = 18%
Cost of debt = 12%Debt Equity ratio = 1:1
Equity = 100 , Debt = 100
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2. Determine EVA in the following cases
a)PAT = 300 L ,Ke = 18% , Debt = 500, Equity = 1200
b) ROE = 20% , Ke = 19% , Debt = 500 , Equity =1200
c) Ke = 15%, kd = 12% , PAT = 250 L, Int = 25 L, Debt = 500, Equity =1200
d) NOPAT = 400 , ke= 18%, kd= 12%, Debt = 500, Equity = 1200
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Components of EVA
NOPAT
Cost of capitalCapital employed
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Value creating strategies using EVA
Capital = 10000, NOPAT =2000, c = 15%, r=20%
EVA = 10000* ( 20-15) = 500
I. Improvement of operating performance to 2250
II . Profitable investment of 10000 at a return of 18%
III. Withdrawal of unproductive capital of 1000 therebyreducing return by 50.
IV. Reduction in cost of capital by altering capitalstructure.
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From the following information available for ICLLtd. Compute EVA.
Equity 50Debt 50
Revenues 90COGS 50Operating expenses ( excl. interest ) 16Tax rate 30%Risk free rate 6%Equity beta 0.9Market risk premium 6%
Cost of debt ( pre tax ) 8%
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EVA and firm valuation
Firm value = economic book value ofassets +PV of EVA associated with it.
Ideally firm value using EVA will be moreor less similar to firm value using DCF
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1. Global Ltd. is interested in acquiring the fooddivision of Regional Ltd. They have forecasted
the free cash flow on the basis of followingassumptions :
Opening value of assets is Rs.50 lacs
1. Growth rates in assets, revenues and profitsafter tax will be 20% for the first 3 years,
12% for the next 2 years and 8% thereafter.
2. The ratio of PAT to net assets would be 0.12
3. The opportunity cost of capital is 11%
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1 2 3 4 5 6
Asset value 50.00 60.00 72.00 86.40 96.77 108.38
NOPAT 6.00 7.20 8.64 10.37 11.61 13.00Net Invt. 10.00 12.00 14.40 10.37 11.61 8.67
FCF (4.00) (4.80) (5.76) nil nil 4.33
Terminal value 4.33 ( 1+0.8) =156
0.11 -0.08
PV ( FCF+TV) = (9.39 ) + 83.46 = 74.07
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EVA projection
1 2 3 4 5 6
Op. capital 50.00 60.00 72.00 86.40 96.77 108.38
NOPAT 6.00 7.20 8.64 10.37 11.61 13.00
Cost of capital 11% 11% 11% 11% 11% 11%
Capital charge 5.50 6.60 7.92 9.50 10.64 11.92EVA 0.50 0.60 0.72 0.87 0.97 1.08
TV 1.08 * 1.08 = 1.17 = 39
0.11-0.08 0.03Firm value = 50 + PV ( EVA + TV )
= 50 + 24.05 = 74.05
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2.Revenues 1800
Operating expenses 1000
Net assets at the beginning of the year 2500Equity 1500 Debt 1000
Expected forecast period 5 years
Expected growth rate in net assets 10%Expected growth rate in revenues 20%
Operating expenses to maintain the same ratio torevenues
Cost of debt ( pre tax ) 12%Cost of equity 16%
Long term growth rate 5%
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3. From the following information available for ICLLtd. Compute EVA.
Equity 50Debt 50Revenues 90COGS 50Operating expenses ( excl. interest ) 16Tax rate 30%
Risk free rate 6%Equity beta 0.9Market risk premium 6%Cost of debt ( pre tax ) 8%
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Mergers and Acquisitions
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Economic rationale of a merger is that the value ofthe combined entity will be more than that ofindividual entities.
Realistic reasons in favour of mergers
1. Strategic benefit entry / expansion in an industry
2. Economies of scale Horizontal, vertical ,conglomerate
3. Economies of scope
4. Economies of vertical integration Ongc -Hpcl
5. Complementary resources Brown Bovery & Asea
6. Tax shields
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Mechanics of a mergerI. Legal Procedure Sec 391-394 of the
Companies Act 1956
Examination of object clause Intimation to stock exchanges
Approval of draft amalgamation proposal by theBoards
Application to High courts Notice to shareholders and creditors
Meetings of shareholders and creditors Passing of High court orders Filing the High court order with Registrar Transfer of assets and liabilities Issue of shares and debentures
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II . Tax aspects
Tax concessions are available to amalgamated company only if
the amalgamating company is a Indian company.
Following deductions remaining unabsorbed by theamalgamating company will be allowed to the amalgamated
company.
Capital expenditure on scientific research
Expenditure on acquisition of patents / know how etc.
Expenditure for obtaining license to operate telecom services
Amortisation of preliminary expenses
Carry forward of losses and unabsorbed depreciation
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Accounting for amalgamations AS -14
Pooling method - merger
Purchase method - acquisition
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Illustration
Beta Ltd. has agreed to merge with Alpha Ltd.
The swap ratio of 3:5 has been fixed. The facevalue per share of both companies is Rs.10/-.The assets & liabilities of Beta Ltd. arerevalued as :
Net fixed assets 3200
Investments 400
Current assets 2900
Current liabilities 1600
Loan funds 2400
Before merger After merger
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Before merger After merger
Pooling Purchase
Liabilities A Ltd. B Ltd. Alpha Ltd. AlphaLtd.
Share capital 4000 1000 4600 4600Capital reserve - - 400 1900
Share premium 2000 500 2500 2000
G. Reserve 6000 1500 7500 6000
Loan funds 4000 2500 6500 6400
C.Liab & Prov. 2000 1500 3500 3600
18000 7000 25000 24500
Assets
Net fixed assets 7000 3000 10000 10200
Investments 3000 500 3500 3400
Current assets 7000 3000 10000 9900
Misc. expenses 1000 500 1500 1000
18000 7000 25000 24500
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Cox Ltd. is planning to acquire Box Ltd. to form C&BLtd. The pre amalgamation Balance Sheets are as
under :Amt. Rs. lacs
Cox Ltd Box Ltd.
Fixed Assets 250 100
Current assets 200 75
Total 450 175
Share capital (FV Rs.10)200 50Reserves & Surplus 100 100
Debt 150 25
Total 450 175
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For every share of Box Ltd. 2 shares of CoxLtd. were given. The fair market value offixed assets and current assets of Box Ltd.were Rs.200 lacs and Rs.100 lacsrespectively. Prepare a post amalgamation
Balance Sheet of Cox & Box Ltd. using
1. Purchase method
2. Pooling method
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Exchange ratio in a merger
Basis
Book value per shareEarnings per share
Dividend discounted value per share
Discounted cash flow value per share
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Book value per share
If BV per share of acquiring company is Rs.25and that of target company is Rs.15, theexchange ratio will be 15/25 = 3/5
for every 5 shares in target company 3 shares inacquiring company.
Drawback of this method Book values do not reflect economic
values
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Market price per share
The exchange ratio is based on the relative marketprice of the shares of the company.
If the shares of the company are actively traded thenthe market prices indicate current earnings, growthprospects and risks. If the shares are not actively
traded market price may not be a realistic indicator
Share prices may be manipulated by vested interests.
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Dividend discounted value per share
The dividend discounted value is the presentvalue of expected dividends
This method is useful only if the dividendstreams can be predicted with reasonablesurety
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Discounted cash flow value per share
DCF value per share
= Firm value by DCF method debt value
Number of equity shares
This method is useful if the companiesbusiness plans and cash flow projections areavailable for 5 10 years.
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Cost and benefits in a merger
Benefit of a merger = PV a+b (PVa + PVb)
a) Cost of a merger ( cash compensation) =
Cash PVb
b) Cost of a merger ( shares ) = shareholding
in combined entity PVb
Net PV of the merger = Benefit - Cost
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1. Firm A acquires Firm B. The details are as under
A B
Market Value 20000000 5000000
1. The expected cost savings due to merger isRs.5000000.
2. Firm A offers Rs.6000000 cash compensation toB
Determine the benefit, cost and NPV of the merger.
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2. A B
1. Market price per share Rs.50 Rs.20
2. Number of shares 1000000 500000
3. Mkt value Rs 500 lacs Rs.100 lacs
a) The merger is expected to have a synergy gain ofRs.100 lacs
b) A offers 250000 shares in exchange of 500000
shares of B
Calculate the benefit, cost and NPV of the merger
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3. Ajeet Co plans to acquire Jeet Co . The relevantfinancial details of the merger is as under:
Ajeet Co Jeet Co
Market price per share Rs.60 Rs.25
Number of shares 3,00,000 2,00,000
The merger will bring gains which has a PV of 40lacs. Ajeet Co offers 1 share in exchange of every2 shares of Jeet .Co
Calculate Benefit , cost and NPV of the merger