9373 &2
TRANSCRIPT
Valuation Articles: CA Pitam Goel (Partner VPTP & Co)
VPTP & CO
CHARTERED ACCOUNTANTS
Content
A. Chapter 1 – Company Specific Risk
A.1 Cost of Equity …………………………………………………………………………….1
A.2 What is Company Specific Risk? ..........................................................................2
A.3 Estimation of Company Specific risk ………………………………………………...2
A.4 Impact on Valuation ……………………………………………………………………2
A.5 Benchmarking of Company risk ……………………………………………………...3
A.6 Factor Analysis ……………………………………………………………………………3
A.7 Case Study…………………………………………………………………………………4
B. Chapter 2 – Startup Valuation
B.1 Introduction …………………………………………….....…………………..….………9
B.2 Initial Rounds of Funding …………………………..………….……….….…….........10
B.3 Lifecycle of Startups …….…….…………………….…………….……….….……....10
B.4 Valuation Methods ..…….…….…………………….………….……….….………....11
B.5 Berkus Method …………...…….………………….…………….……….….………....11
B.6 Scorecard Method ……………….………………….…….…………….….…………12
B.7 Risk Factor Summation Method ……….…………….……………….…….............12
B.8 Venture Capital Method ……………………..…………….…………….…….…....13
B.9 First Chicago Method …………………………..…………….……….….………......14
B.10 Benefits of getting Business Valuation …..……………….……..…………............14
B.11 Things to look out while valuing ……………..……………….…….………............15
C. Chapter 3 – Valuation Under Ind AS 36
C.1 Introduction ………………………….…………………………………….…………......16
C.2 Scope ……………………………………….……………………………….…………….16
C.3 Level of testing …………………………….…………………………….……………....16
C.4 Timings of Testing ………………………….………………………….……………........17
C.5 Abbreviations and Definitions ..………….……………………….……...…..............17
C.6 Indicators of Impairment Testing …….…….……………………….………..............18
C.7 Calculation of Impairment Loss …….………….…………………….………............19
C.8 Value in Use (VIU) …………………….……………….………………….………..........21
C.9 Fair value less cost to sell …………..………………………………………….............24
C.10 Recognising the Impairment loss in books……………………….……….…...........24
C.11 Goodwill…………………………………………………………………….………….…..24
C.12 Impairment assessment on Goodwill…………………………….…….……............25
C.13 Corporate Assets………………………………………………………….….……….....26
C.14 Reversal of Impairment Loss…………………………………………..………….........26
D. Chapter 4 - Valuation of International Transactions
D.1 International Transaction or Cross Border Transaction ……..………..................27
D.2 Method of Valuation ………………………………………………………………...…27
D.3 Approaches under DCF method …………………………………………….....……27
D.4 Steps in valuation .…………………………………………………………………....…28
D.5 Cost of capital.………………………………………………………………………......28
D.6 International Fisher Effect.……………………………………………………........…..29
D.7 Uncovered Interest Rate Parity.………………………………………………...........30
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A.1 Cost of Equity
As per Capital Asset Pricing Model (CAPM) method, cost of equity is termed as
= Rf + β (ERP) + Size premium + Company Specific Risk premium
Where;
Rf is Risk free rate
β is Beta
ERP is Equity Risk premium
Small Company Size premium – It shows the long term average return of small cap portfolio reduced
from long term average return on large cap portfolios.
Company Specific Risk premium – This can be attributed to the unsystematic risk associated with the
Company. We will be covering the same in this article
Classification of risk
As we know that the risk associated with the investment in a company consists of two components viz-
systematic risk and unsystematic risk.
Total Risk = Systematic Risk + Unsystematic Risk
Systematic Risk Unsystematic Risk
Systematic risk, is associated with the market as
a whole and economic environment in the
country as well.
Unsystematic risk, is associated with the internal
risk factors associated with investment in the
Company.
Beta is the measure of this risk. This is generally
unavoidable in nature.
This is also known as the diversifiable risk.
It is generally unavoidable as, diversification of
the portfolio of the investor can protect him from
unsystematic risk.
(A) Chapter - 1 (Company Specific Risk)
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A.2 What is Company Specific Risk?
As we read in the table above, Unsystematic risk (Company specific risk) is avoidable and
diversification of the portfolio of the investor can protect him.
However, this looks good from a theoretic perspective. Since, we are doing valuation of private
Companies in general, and the investor of a private company may not enjoy the same level of liberty
when it comes to diversification that is enjoyed by a portfolio of publically traded companies.
Hence, it can be concluded that the elimination of unsystematic risk associated with the private
company is not that easy.
Therefore, when doing valuation, allocation of Company Specific risk (which represents the
unsystematic or unavoidable risk) should be incorporated to arrive at the correct cost of equity.
A.3 Estimation of Company Specific risk
Beta and Small size risk premium can be determined from the historic data available. However, there
is no predefined method or data when it comes to calculation of "Company Risk premium"
There is no model or method to exactly quantify the Company Specific Risk. Therefore, the onus is on
the Valuer to justify the approach used. Experience is not necessarily enough for an appraiser to rely
upon in estimating the Company Specific Risk, provided the valuer has not done a lot of valuation in
the same industry.
Further various articles and reports published also points out that the Company Specific Risk premium
is just a "best guess” of the valuer.
A.4 Impact on Valuation
Lack of guidelines and methods to estimate the Company Specific Risk presents a challenge before
the Valuers.
As we all know that any components of cost of capital have inverse relationship with the “Value”. Any
error in estimation of Company Specific risk will result in over or under valuation of Company.
Components of cost of capital have inverse relationship with the value of the company, so higher the
Company specific risk lower the value of the Company and vice versa.
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A.5 Benchmarking of Company Specific Risk
Benchmarking is important to protect the valuation reports from potential litigation and regulatory
issues. Valuer has to come up with some sort of benchmarking to justify the Company specific risk
allocated in the cost of capital.
We have gone through a lot of articles and books and found that “Factor Analysis” is one of the
approach that Valuers can use to benchmark the Company Specific Risk. It has to be noted that, this
approach is not defined in any of regulatory authorities, but rather cumulative knowledge pool
gathered over the years by the valuation experts.
A.6 Factors Analysis
There are no data bases in public of paid domain that helps in estimation of Company specific risk.
Secondly, lack of historical data of private companies make it difficult to create an estimation of
Company specific risk. Hence, we are left only with “Factor analysis”.
Under factor analysis, certain factors (based on the experience and convenience of the Valuer) are
taken into consideration. These “can be” based upon
i) Revenue
ii) Profitability
iii) Industry Risk
iv) Financial Risk
v) Operational Risk
vi) Funding risk for Startups etc……
As per experts, only the most influential factors that should be quantified shall be considered in the
factor analysis.
Weights: Factors selected shall be allocated weights based on the professional judgement of the
valuer.
Rating: Factors shall be rated from 0 to 10, with “0” having as no risk associated and “10” being the
highest risk associated with the factor.
Although this method is not prescribed in any of the guidelines or standards, but this will help the valuer
to quantify the Company specific risk especially to young firms, startups etc.
i) Revenue
Revenue shares an inverse relationship with the risk, higher the revenue growth and lower the risk
associated with the Company.
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ii) Profitability
Company’s risk can be readily reflected in PAT of the Company. Higher the profits, lower the
“company specific risk” associated with the Company.
Loss making Company shall be given the highest rating of 10.
iii) Industry Risk
Valuer must be aware of the developments in the industry as a whole. Hence comparing the
performance of the Company (or performing ratio analysis) to its peers, can help in analyzing the
industry risk associated with the firm.
iv) Financial Risk
Debt burden of the Company can be a good factor to measure the Financial risk associated with the
Company. Higher the debt equity ratio, higher the risk associated with the Company.
v) Operational Risk
This risk is represented with Fixed cost to sales ratio. This represents, whether the Company will be able
to meet its fixed cost or not. Higher the fixed cost to sales, higher the risk of Company might not be
able to meet it.
vi) Funding risk for startups
This is generally applicable to Startups, with high cash burn rates and running out of funds is new to
the startup companies. Hence, risk is associated that if the Company runs out of money and doesn’t
receive funding at the right time, it might have to file for bankruptcy.
A.7 Case Study
Company A was incorporated in the year 20XX. It is a startup with high turnover but incurring losses
over the years. Financials details of the Company are as follows:
i) Company's revenue has grown at a CAGR of 50% during the last 3 years and projected to grow at
a CAGR of 25% for the next 5 years.
ii) Net Profits of the Company are negative i.e. loss making will have the same for the next five years.
iii) ROA of the Company for the recent financial years is -10%, whereas the peers in the industry has
an average 8 %.
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iv) Average debt equity ratio for the last three years is 0.60.
v) Fixed cost to sales ratio is 9%.
vi) Company cash and bank balance will last for 6 months is the Company doesn’t raise funds either
internally (equity) or externally (debt)
i) Revenue growth Rate: The Company’s sales are growing at a CAGR of 50% over the last three
years and projected numbers are growing at a CAGR of 25%. Hence, rating of “0” shall be assigned
as it is above the specified criteria of 8% (refer the table below)
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ii) Profitability: The Company has incurred continuous losses in the past and will have the same in
the future. Hence, maximum risk of “10” shall be allocated to the Company.
iii) Industry Risk: Company has reported ROA of -10% for the recent financial years, whereas the
peers in the industry has an average 8 %. Hence, rating of “10” shall be assigned (refer the table
below)
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iv) Financial Risk: Company has debt equity ratio of 0.60 or 60% of Equity. Hence rating of “6” shall
be assigned. Refer the table below)
v) Operational Risk: Company has fixed assets to sales ratio of 9%. Hence, rating of “1” shall be
assigned to the Company (refer the table below)
v) Funding Risk: As given in the details, Company cash and bank balance will last only for six
months, provided the Company raises funds either internally or externally. Hence, highest rating of
‘10” shall be allocated for the same.
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Now, we have allocated the ratings, appropriate weights shall be allocated based o the importance
of the risk factors. We have given equal weightage to all the factors in this case study. Therefore, the
final results of the Company specific risk is 6.2%. This can be used in the determination of Cost of
Equity.
We hope that this article will give a direction to the readers and help them in quantifying the
Company specific risk.
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B.1 Introduction
Various VC’s in their interviews has termed early stage valuation as-
“Early Stage company valuation are more of art than Science. VC’s are constantly in the market
evaluating hundreds of startups each month. So we get a good sense of what is reasonable for a
particular sector and stage of business.
Later stage startups are easier to value. We use both trailing and forward multiples based on public
comparable companies and recent acquisitions. The most conventional multiples are those based
on revenue or EBITDA, although we often use less common benchmarks like gross bookings or
enterprise value per active user in some of the cases.
As per Jason Calacanis, (one of UBER’s earliest investor and Serial Entrepreneur, Valuation of startups
is par science and part art. It depends on many things, ranging from current market conditions to
founder's past record, team, Intellectual Property, traction, risks, geographical location, competition,
human psychology, and more. Hence it’s not that easy to value a startup just merely based on an
excel sheet.
Startups investors are generally high risk appetite individuals, who wants to outperform the normal
modes of returns, available in the market for general public. They don’t look for regular income unless
the payoff at the end or after a brief period is on a very large scale.
Most of the VC’s use various benchmarks to value startups, some of them are as follows:
- What’s the idea?
- What’s the problem, that the startup is trying to solve
- What could be the potential market size that the startup is looking to address
- What’s the background of the founders?
- Are there any competitors in the market?
- What is the moat or advantage that the startup is having (in the form of patented tech or
intellectual property over it competitors)?
- What is the demand of the startup among the investors (higher the number of investors
interested in the startup, higher the valuation)?
- Likelihood of lucrative exit for the investor
(B) Chapter - 2 (Startup Valuation)
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Also, it has to be noted that present day startups are tech oriented and have highly valued
intellectual property. There has been instances in the past that the Large Company’s acquired
startups not because of their business but rather because of their intellectual property or patents. So
that’s also in consideration of the VC’s or investors.
B.2 Initial rounds of Funding:
Initial round of funding is generally termed as friends, family and fools (FFF). These rounds generally
go for a maximum of $ 1 million of investments.
Then comes the angel investors, they generally go for valuation of $ 1 - 3 million. These are the people
who generally either worked in the domain or ex founders of various startups.
Finally, the VC’s come in to the play. They invest huge chunks of money into the Startups.
B.3 Lifecycle of startups:
- Idea
- Initial Funding – funding is used to establish the product in the market.
- Growth (Entry of VC’s) – Startup has established itself in the market, and need funding to take
it to next level
- Expansion through acquisition of other startups
- Maturity (exit through IPO’s)
It has to be noted, that most of the startups get acquired by competitors or existing players in the
market at premium valuation by third or fourth round of funding.
Also, present day startups are tech oriented and have highly valued intellectual property. There has
been instances in the past that the Large Company’s acquired startups not because of their business
but rather because of their intellectual property or patents.
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B.4 Valuation methods:
1) Berkus Method
2) Scorecard Method
3) Risk Factor Summation Method
4) VC Method
5) First Chicago Method
B.5 Berkus Method:
This method assigns a range of values to various factors as the startup begins to make progress.
If the following exists in the startup Add to Company Value
Sound Idea (primary value) + $ 0.5 million
Prototype (reducing technology risk) + $ 0.5 million
Quality of management team (reducing execution risk) + $ 0.5 million
Strategic relationship (reducing market risk) + $ 0.5 million
Product rollout or sales (reducing production risk) = $ 2.5 million
Total Value = $ 2.5 million
As per experts, this number of $ 0.5 million is subjective and shall be adjusted for risk involved,
geography of the startups and any other relevant factors shall also be taken into consideration. Also,
once the Company starts generating revenues, this method is not used by the investors. Hence this
method is generally used for pre revenue companies.
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B.6 Scorecard Method:
This method uses the valuation assigned to already angel funded company in the same geography
and same domain with similar stage of business.
Parameters Weight Targets’ Score Factor
Size of the opportunity 25% 140% 0.350
Product/ Technology 30% 130% 0.390
Strength of management 15% 135% 0.203
Competitive Environment 10% 75% 0.075
Marketing 10% 80% 0.080
Funding requirement 5% 100% 0.050
Others 5% 100% 0.050
Total 1.198
Now this multiple of 1.198 shall be multiplied with the valuation of the competitor’s valuation and you
will get the valuation of startup under consideration. This method is again used only for pre revenue
companies.
B.7 Risk factor summation Method:
This method is combination of Berkus and scorecard method with higher emphasize on risk factors.
Grades are assigned to various risk associated with investment in the startup.
Risk Assessment Grade:
Risk Assessment Grade Rating
Very Positive +2
Positive +1
Neutral 0
Negative -1
Very Negative -2
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Risk Category Grade Assigned Rating
Management Very Positive +2
Stage of business Neutral 0
Sales and Marketing risk Neutral 0
Funding requirement risk Very Negative 0
Competition Risk Very Negative -2
Technology Risk Positive +1
Litigation Risk Neutral 0
International Risk Neutral 0
Reputation Risk Very Positive +2
Potential Lucrative Exit Neutral 0
Total + 3
After determining the risk factors, a value is assigned for each point (let’s take $ 1 million) for every
rating point. Hence, addition value that has to be allocated to the Company against its peers be $
1 million * 3 = $ 3 million. So, if the competitor is valued at $ 40 million, the Startup under
consideration to be valued at $ 43 million. This method is also used for pre revenue startups valuation.
B.8 Venture capital method:
This method emphasizes on the exit or the terminal value.
Particulars Symbols Value
Expected terminal/exit value A $ 50 million
Expected return on Investment or
WACC
B 30%
Expected period for attaining the
terminal value
T 5 Years
Post Money Value (based on the
above factors)
c = a/(1+b)^ t $ 13.47 million
Investment amount D $ 2 million
Pre Money Valuation e = c – d $ 11.47 million
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This method is useful for valuations of pre revenue companies where it is easier to estimate a potential
exit value once certain target milestones are achieved.
B.9 First Chicago method:
The first Chicago method is a business valuation approach used by venture capital and private equity
investors that combines elements of both a multiple based valuation and a discounted cash flow
method. This method was first developed by, and consequently named for, the venture capital arm
of the First Chicago Bank. This method uses three scenarios viz Base case, Best Case and Worst case.
Particulars Base case ($
million)
Best case ($
million)
Worst case ($
million)
Revenue at Year 0 50 50 50
Annual revenue growth rate 20% 30% 10%
Explicit period present value @ 20%
WACC
221.55 281.65 173.16
Exit Value (Multiple based) 3x 3x 3x
Discount Rate 25% 25% 25%
Present Value of Terminal Value 146.77 237.25 87.07
Sum of Explicit and Terminal Value 368.32 518.90 260.24
Weights (Scenario) 50% 25% 25%
Weighted Values 184.16 129.72 65.06
Total of weighted values 378.94
B.10 Benefits of getting business valuation:
- Better knowledge of Company’s assets
- Understanding of Company resale value
- Understanding the true value of the Company
- Helpful in merger and acquisitions
- Helpful in raising funds
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B.11 Things to look out for while valuing a business
- Financial performance
- Assets and Liabilities
- Intellectual property or any other intangibles
- People Staff
- Factors outside the business (target market size, competitors, industry environment etc.
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C.1 Introduction
Ind As 36 requires that “assets” should not be carried above their “recoverable value”. Hence,
need of the valuation (recoverable amount) arises before the Companies.
C.2 Scope
It is quite crucial to identify the assets that are covered under Ind AS 36 and attracts the provision
of impairment testing. Ind AS 36 applies to impairment of all assets until specifically excluded from
its purview:
As of now following assets have been excluded from the purview of Ind AS 36:
- Inventories (Ind AS 2)
- assets arising from construction contracts (Ind AS 11)
- deferred Tax assets (Ind AS 12)
- assets arising from employee benefits (Ind AS 19)
- financial Assets that are within the scope of Ind As 39 financial instruments: recognition and
measurement
- Investment property measured using the fair value model (Ind AS 40)
- biological assets related to agricultural activity that are measured at fair value less costs to
sell (Ind AS 41)
- deferred acquisition costs, and intangible assets, arising from an insurer’s contractual rights
under insurance contracts (Ind AS 104)
- non-current assets (or disposal groups) classified as held for sale (Ind AS 105)
However, Financials assets covered under Ind AS 27 subsidiaries, Ind AS 28 Associates, and Ind
AS 31 Joint ventures are well within the purview of Ind As 36.
C.3 Level of testing
Impairment testing shall be performed at the lowest level i.e. at the individual asset level.
However, if the same is not possible (due to non-generation of cash flows that are largely
independent of those from other assets or group of assets), then it should be calculated at the
CGU level to which the asset pertains to.
(C) Chapter -3 (Valuation under Ind As 36)
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C.4 Timing of testing
Ind As 36 requires an entity to perform impairment testing (calculate the recoverable amount),
At the end of each reporting period, there exists indicators for impairment of the asset
or cash generating unit
At least annually for the following assets (irrespective of whether there is an indication
of impairment or not
goodwill acquired under business combination under Ind AS 103
intangible assets with an indefinite useful life
intangible assets not yet available for use
C.5 Abbreviations and definitions:
Before we start with the technical part of the report, it’s better to understand the terms that are
going to be used in this report,
Terms Abbreviation Meaning Carrying amount CA Amount at which the assets is recognised after
deducting any accumulated depreciation or
amortisation and accumulated impairment
losses thereon (if any).
Recoverable amount RA Higher of asset’s or Cash generating unit’s (CGU)
calculated “fair value less cost to sell (FCLCS)”
and “value in use (VIU)”
Impairment loss IL Carrying amount (CA) less recoverable amount
(RA)
Value in use VIU Present value of the discounted future cash flows
generated from the asset or CGU under
consideration.
Fair Value less cost to
sell
FVLCS Amount generated or obtainable from a
transactions at arm’s length between two
knowledgeable willing parties, reduced by cost
to sell.
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C.6 Indicators for impairment testing
Ind AS 36 provides for a non-exhaustive list of internal, external and other indicators that an
entity shall consider, are given below:
Internal indicators:
i. Evidence exists obsolescence or physical damage of an asset
ii. Significant changes with adverse impact have occurred or expected to occur:
asset becoming idle, plans to discontinue or restructure the operation to which an
asset belongs,
plans to dispose of an asset before the previously expected date
and reassessing the useful life of an asset as finite rather than indefinite.
iii. decline in the economic performance of the asset
iv. For an investment in a subsidiary, jointly controlled entity or associate, the investor
recognizes a dividend from the investment and evidence is available that
the carrying amount of the investment in the separate financial statements
exceeds the carrying amounts in the consolidated financial statements of the
investee’s net assets, including associated goodwill; or
the dividend exceeds the total comprehensive income of the subsidiary, jointly
controlled entity or associate in the period the dividend is declared.
External Indicators:
I. Significant and unexpected decline in the market value of assets
II. Significant changes with adverse impact have occurred or expected to occur market,
economic or legal environment
III. Change in the market interest rates that will have an impact on the discount rates
used in calculating an asset’s VIU and decrease the asset’s recoverable amount
materially.
IV. The carrying amount of the net assets of the entity is more than its market
capitalization.
Other indicators:
I. Fact that an active market no longer exists for a revalued intangible asset.
II. Indicators from internal reporting that indicates that an asset may be impaired
includes:
cash flows for acquiring the asset, or subsequent cash needs for operating or
maintaining it, that are significantly higher than those originally budgeted;
actual net cash flows or operating profit or loss flowing from the asset that are
significantly worse than those budgeted;
a significant decline in budgeted net cash flows or operating profit, or a significant
increase in budgeted loss, flowing from the asset; or
operating losses or net cash outflows for the asset, when current period amounts
are aggregated with budgeted amounts for the future.
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C.7 Calculation of impairment loss (IL)
Impairment loss (IL) = carrying amount (CA) - recoverable amount (RA)
We have already discussed the basic meaning of these terms in point no. 5, so now, here we
will cover the calculation part of these terms
Carrying amount can be obtained from the financials statements of the Company. In case of
CGU, not reduced by liabilities unless the recoverable amount of the CGU cannot be
determined without taking them into account. This will only be the case for liabilities that would
have to be assumed by any buyer.
Recoverable amount = fair value less cost to sell (FVLCS)
Higher of
value in use (VIU)
Now, the biggest question arises, “Are we supposed to calculate both FVLCS and VIU”
always?
The answer to this question is “No” it is not always necessary to determine both an asset’s fair
value less costs to sell and its value in use. If either of these amounts exceeds the asset’s
carrying amount, the asset is not impaired and it is not necessary to estimate the other
amount.
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What if the asset under consideration doesn’t generate independent cash flows?
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C.8 Value in use (VIU)
The present value of the future cash flows expected to be derived from an asset or CGU. This is
based on the assumption that assets value shall be recovered through continuing use and
ultimate disposal. rather than through a sale transaction. It also points out how the company is
going to use the asset in future.
Calculation of Value in use (VIU):
It is generally consisting of two main steps i.e.
i) Estimation of future cash inflows and cash outflows
ii) applying the appropriate discount rate to these cash flows
Factors ignored under value in use (VIU):
Future cash flows projections:
i) assumptions that represent management’s best estimate over the remaining useful life
of the asset. Greater weight shall be given to external evidence
ii) but shall exclude any estimated future cash inflows or outflows expected to arise from
future restructurings or from improving or enhancing the asset’s performance.
iii) period of projections: cover a maximum period of five years, unless a longer period
can be justified.
iv) Growth Rate: using a steady or declining growth rate for subsequent years, unless an
increasing rate can be justified. This growth rate shall not exceed the long-term
average growth rate for the products, industries, or country or countries in which the
entity operates, or for the market in which the asset is used, unless a higher rate can
be justified.
v) Excluding:
• future restructuring to which an entity is not yet committed; or
• improving or enhancing the asset’s performance.
vi) However, if then entity has already created provision for such restructuring in the books
of accounts (Ind AS 37 Provisions, contingent liabilities. Then, it is allowed to be
considered. &
vii) Entities may also take account of efficiency improvements. These are a normal part
of any business and the effects of such ongoing improvements should be included.
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What if my cash flows are in foreign currency? How do I project and discount the cash flows?
Future cash flows are estimated in the currency in which they will be generated and then
discounted using a discount rate appropriate for that currency. An entity translates the present
value using the spot exchange rate at the date of the value in use calculation.
Approaches to calculate cash flows:
Traditional approach Expected cash flow approach Uses a single set of estimated cash flows and
a single discount rate
Uses all expectations about possible cash
flows instead of the single most likely cash
flow
Assumes, single discount rate convention
can incorporate all the expectations for cash
flows and appropriate risk premium.
Uses probability for all the possible cash flow
outcomes.
Emphasis on selection of the discount rate. Emphasis on direct analysis of the cash
flows
Easier to apply In some situations (complex measurement
problems), a more effective measurement
tool than the traditional approach.
Estimating the Discount Rate:
Although cash flows are company specific, discount rate has to be Market specific
When an asset-specific rate is not directly available from the market, an entity uses
surrogates to estimate the discount rate
However, WACC / incremental borrowing cost/other market rates of the Company can
be used if the market discount rates for the asset or the CGU is not available.
Ind AS 36 requires the discount rate used to be a pre-tax rate. Therefore, when the basis
used to estimate the discount rate is post-tax, that basis is adjusted to reflect a pre-tax
rate.
The discount rate shall be a pre-tax rate that reflect current market assessments of:
i) the time value of money; and
ii) the risks specific to the asset for which the future cash flow estimates have
not been adjusted.
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The issue over here, is that the discount rate is not observable in the market. Hence,
requirement of formula based calculation arises. One of most used method in practice is
weighted average cost of capital (WACC).
WACC is a post tax rate, hence, it needs to be adjusted to a pre tax rate.
The effective pre tax rate Is calculated by removing the tax cash flows and use of iterative
methods to calculate the rate, at which the present value of the adjusted cash flows
equal to the Value in Use (VIU) determined using post tax cash flows.
Conversion of post tax discount rate into pre tax discount rate:
(Ind AS 36 doesn’t provide specific guidelines with regards to make such adjustment of post tax
to pre tax discount rate. However, corresponding IFRS standard i.e. IAS 36: Impairment of
assets contains an appendix “basis of conclusion”. Paragraph BCZ85 of the appendix states that
it would be erroneous to convert a post tax rate into pre tax rate by simply grossing up the post
tax rate by marginal tax rate.
The same paragraph, provides an example and gives the correct way to calculate pre tax
discount rate from post tax rate is by an “iterative” calculation. This rate if used will give the exact
pre tax value in use (VIU) calculated using post tax cash flows and post tax discount rate.
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C.9 Fair Value less cost to sell
Fair Value:
Binding agreement for sale between two knowledgeable parties at the arm’s length price
Asset is traded in active market, then the trading price
Most recent transaction price for similar assets within the same industry.
Cost to disposal/sell:
Legal cost
Stamp duty
Any other transaction cost etc.
costs of removing the asset
direct incremental costs to bring an asset into condition for its sale
Fair value less costs to sell does not reflect a forced sale, unless management is compelled to
sell immediately.
C.10 Recognising the impairment loss in books
Impairment is recognized immediately in the statement of profit and loss
If the impaired asset was revalued earlier (under Ind AS 16), IL is recognised in other
comprehensive income to the extent that the impairment loss does not exceed the
amount in the revaluation surplus for that same asset. Such an impairment loss on a
revalued asset reduces the revaluation surplus for that impair asset.
C.11 Goodwill
Goodwill at its own doesn’t generate cash flows, of its own; rather it contributes to the
cash flows of cash generating units.
Under Ind AS Goodwill is no longer amortised but tested for impairment.
For impairment testing, goodwill acquired in business combination (Ind AS 103) shall, from
the acquisition date, be allocated to each of the acquirer’s CGU’s, or groups of CGU’s
that is expected to benefit from the synergies of the combination. This is irrespective of
whether other assets or liabilities of the acquiree company are allocated to this unit.
Each unit or group of units to which the goodwill is so allocated shall:
i) represent the lowest level within the entity at which the goodwill is monitored for
internal management purposes; and
ii) not be larger than an operating segment as defined by paragraph 5 of Ind AS 108
Operating Segments before aggregation.
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C.12 Impairment assessment of Goodwill
There are two scenarios in which goodwill is tested for impairment
1. CGU or group of CGU to which goodwill has been allocated is being tested for
impairment on account of existence of indicators for impairment
2. Annual mandatory goodwill testing (without any indications of impairment in the
respective CGU or CGU’s
1st Step: Impairment test
at the Indiv idual CGU or
asset level without
goodwill
e.g Asset 1, Asset 2, Asset
3 tested seprately
Scenario I I
Annual impairment
testing
Entire CGU (including the
goodwill) is tested for
impairment
2nd Step: Impairment test
at the group of CGU's
level to which the
goodwill relates
e.g whole CGU or group
of CGU
Indiv idual CGU Group of CGU
Goodwill
Additional imapirment
loss arising out of step 2
shall only be adjusted
"only against the
Goodwill amount" and
assets shall no be
reduced to less than their
indiv idual recoverable
amounts.
Impairment first to the
Goodwill and balance to
the CGU in the ratio of
carrying amount
Impairment first to the
Goodwill and balance to
the CGU in the ratio of
carrying amount
Scenario I
CGU or group of CGU to
which goodwill has been
allocated is being tested
for impairment (indicators
based)
Allocated to
Entire CGU/CGU's
(including the goodwill) is
tested for impairment
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C.13 Corporate Assets
These are assets other than goodwill that contribute to the future cash flows of both the cash-
generating unit under review and other cash-generating units. They do not generate cash
inflows independently and their carrying amount cannot be fully attributed to the CGU’s
under review. It generally includes;
Headquarters building
IT equipment
Research Centre
C.14 Reversal of impairment loss
Impairment shall be reversed if the economic circumstances for the asset or CGU has
improved. However, reversal for impairment of goodwill is not allowed.
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D.1 International Transaction or Cross Border Transaction
An International Transaction or Cross Border Transaction can be defined as a transaction in an
international trade between two or more entities beyond the territorial limits of a country.
Example: Company A (located in India) wants to make an investment in Company B (located in
USA).
Try to remember this example, as we would be considering the same in all the scenarios of this
paper.
D.2 Method of Valuation: We will be covering the “Discounted cash flow” in this article.
D.3 Approaches under DCF method
Issue that is generally faced by the valuers under DCF is regarding the use of data. Which country’s
data (India or USA) shall be considered in determination of value? Investor’s country or the
investee’s country?
To tackle this challenge, there are two suggested approaches in this regard, which as follows:
Foreign Currency approach ($) Home Currency approach (₹)
Perform the valuation in the investee
currency ($) and convert the value derived
at the spot rate (exchange rate) to the Investors currency (₹)
Convert the cash flows in the home (investors) currency (₹) and discount the
converted cash flows in the WACC of investors currency (₹)
This method is generally used in India for cross
border valuations.
In this case, the forecasted exchange rate
already includes the risk associated with
exchange rate fluctuations.
There’s not much difference between the approaches, it’s just that both the approaches convert
the amount from investee currency to investors currency at different stages, which brings out the
difference between them.
(D) Chapter - 4 (WACC for International Transactions)
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D.4 Steps in Valuation
Following are the steps involved in valuation under both the approaches:
Step Foreign Currency Approach ($) Home Currency Approach (₹)
I Calculate the cash flows in the investee
currency ($)
Calculate the cash flows in the Investee
currency ($)
II Calculate the discount rate ($) or cost of
capital (as per our example USA’s)
International Fisher Effect Equation would
be used where, reliable data w.r.t risk free
rate, beta, Equity risk premium etc. is not
available for the investee country.
Calculate the Exchange rate using the
“Uncovered Interest Rate Parity method”
(we would be covering this method in later
part of this report)
III Discount the cash flows in investee
currency ($) at the discount rate
calculated in Step II.
Convert the cash flows ($) into the home currency (₹) using the exchange rate derived
in step II
IV Convert the valued per share ($) derived in Step III into home currency (₹) at the
Spot rate.
Discount the converted cash flows (₹) at the
home currency (Investors) WACC.
We hope, that you have understood the difference between both the approaches and have arrived
at the required values.
D.5 Cost of Capital
Now, the questions arise before an Indian valuer is regarding WACC under the Foreign currency
approach (which is generally used in India). Which country’s WACC should he consider, Investor’s
country (₹) or investee country’s ($)?
The answer to this is that, since we are calculating the value in investee currency ($), it is suggested
to use the WACC of investee countries ($). However, what if the data (risk free rate, equity risk
premium of the investee country is not available?
Generally, this would be the case with some of the emerging or developing countries, where you
would not able to find the relevant data for calculation of WACC. In this case, you’ll have to use the
“International Fisher Effect” to determine the WACC for the investee country.
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D.6 International Fisher Effect
What is International Fisher Effect?
The International Fisher Effect suggests that countries with high inflation rates should expect to see
higher interest rates relative to countries with lower inflation rates. This relationship can be extended
from interest rates into discount rates
Equation 1: The International Fisher Effect Equation
Interest Rate (Investee Country Currency) =
1 + Interest Rate (Investor Country)
International Fisher effect is based on certain assumptions i.e.
i) there is no government intervention in capital markets; and
ii) capital can flow freely in international financial markets from one currency to another,
such that any potential arbitrage opportunity across countries will be quickly eliminated.
In reality, market frictions (e.g. transaction costs, regulations, etc.) and government
interventions do exist in practice, which means that using the International Fisher Effect to
translate the home currency discount rate into a local currency will result in only an
approximation
Despite these limitations, the International Fisher Effect can be useful in ensuring that inflation
assumptions embedded in the projected cash flows are consistent with those implied by discount
rates.
Following are the equations that can be used for the purpose for WACC (cost of equity and
debt) calculation:
Equation 2: International Fisher Effect Applied to Cost of Equity Capital
Cost of Equity Capital (Investee Country Currency) =
1 + Cost of the Equity Capital (Investor Country)
Equation 3: International Fisher Effect Applied to Cost of Debt Capital
Cost of Debt Capital (Investee Country Currency) =
1 + Cost of the Debt Capital (Investor Country)
X
1 + Inflation Rate (Investee Country currency)
1 + Inflation Rate (Investor Country currency) - 1
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D.7 Uncovered Interest Rate parity
Uncovered interest rate parity (UIP) theory states that the difference in interest rates between two
countries will equal the relative change in currency foreign exchange rates over the same period.
It is one form of interest rate parity (IRP) used alongside covered interest rate parity.
Uncovered interest rate parity assumes foreign exchange equilibrium, thus implying that the
expected return of a domestic asset (i.e., a risk-free rate like a U.S. Treasury Bill or T-Bill) will equal
the expected return of a foreign asset after adjusting for the change in foreign currency exchange
spot rates.
How to calculate forward rates under uncovered interest rate parity:
Expected Rate =Spot rate * (1+ (Risk free rate foreign currency – Risk free rate home currency)) ^
T
Example:
Spot Rate (₹/$) = ₹ 75
Risk free foreign currency (US) = 1%
Risk free home currency (India) = 6%
Using the above formula, we will get the forward rates as follows:
Year 1 2 3 4 5
Exchange Rate (₹/$)
71.25 64.30 55.13 44.91 34.75
Thank You
Compiled by:
CA Pitam Goel
CA Sumesh Guleria
For any queries, please contact:
+ 91 9650 777 079