AFS 4 Advanced Accounting Concepts

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

AFS 4 Advanced Accounting Concepts

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