Valuation under FEMA Presentation by: CA. Sudha G. Bhushan

Sudha@taxpertpro.com

`

ContentsTABLE OF CONTENT

Introduction to FEMA• Current and capital Account transactions• Rules and Regulations• Few Important Sections

Valuation • Introduction• Value• Methodologies • Best FitValuation under FEMA - FDI Valuation • Approaches to FDI Valuation• Governing Regulations• ChangesValuation under FEMA - ODI Valuation

2

`

Introduction to FEMA

Preamble to the Act Relevant Sections Entities

Rules, Regulations, Notifications,

Circular Master circular,

Current account Transactions and Capital Account

Transactions

Governing Authorities

Valuation Overview

“Like beauty, value is in the eye of the beholder. What is value to one may be inconsequential to another. In this regard, value is mere subjective perception.

`

Valuation Valuation is the process of determining the “Economic Worth” of an Asset or Company

under certain assumptions and limiting conditions and subject to the data available on the

valuation date. * Source -International Valuation Standard Council

Depends upon :

5

• Mergers

• IPO

• RBI

• Income Tax• ESOP

• Companies Act

• SEBI

• Stock Exchange

Purpose Regulatory Accounting

• Purchase Price Allocation

Dispute Resolution

• Company Law Board/ Courts

• Impairment / Diminution

• Arbitration

• Mediation• Acquisitions / Investment

• Voluntary Assessment

`

Valuation Under FEMA

6

• Before 21 April 2010 valuation based on CCI Guidelines

• After 21 April 2010 DCF valuation to be followed

• Changed to internationally accepted method w.e.f 15 July 2014

• From Chartered Accountant

• SEBI Registered Merchant Banker

• Notification No. FEMA 20/2000-RB dated May 3, 2000, as amended from time to time deals with Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000.

•At the time of issue of shares to non resident•At the time of transfer of shares from resident to non resident•At the time of transfer of shares from non resident to resident •Downstream Investment

When Required

Governing Regulations

At What Value Certificate

`

Particulars Valuation before April 21, 2010 Valuation after April

21, 2010

Valuation after 15th

July 2014

Guidelines in Force

CCI Guidelines Listed Company: Market Value as per SEBI Preferential Allotment Guidelines

Unlisted Company: DFCF

Listed Company : Same

Unlisted Company : Any internationally accepted method

Methods Prescribed

Net Assets Value (NAV)Profit Earning Capacity Value(PECV)Market Value (in case of Listed Company)

Discount 15% Discount has been prescribed on account of Lack of Marketability

No such Discount has been prescribed

No such Discount has been prescribed

Historical / Futuristic

It is based on Historical Values

It is based on Future Projections

Left to the prudence of industry

Possibility of variation in Value Conclusion

As valuation is more Formulae based, final values came standardized

value conclusion may vary significantly.

Value may to the extent of method used.

Background of FEMA Valuation

7

`

Pricing Guidelines

FDI I

nves

tmen

t

Issue of Shares to non-residents

In case of listed companies : At price worked out in accordance with the SEBI

guidelines

Unlisted: internationally accepted pricing methodology for valuation of

shares on arm’s length basis

Transfer by Resident to Non-resident

In case of unlisted companies : internationally accepted method

In case of listed companies : in accordance with the SEBI guidelines

Transfer by Non-resident

In case of unlisted company: Internationally accepted pricing

methodology for valuation of shares on arm’s length basis

In case pf listed company: As per SEBI Guidelines

Exit

Listed as per SEBI Guidelines

Unlisted Company at the internationally accepted method

Prices not less than

Prices not less than

Prices not more than

Broad Approaches to ValuationValuation Approaches

Asset Based Method

Book Value Method

Liquidation Value Method

Replacement Value Method

Income Based Method

Capitalization of Earning Method

Discounted Free Cash Flow

Method

Market Based Method

Comparable Companies Market Multiples Method

Comparable Transaction

Multiples Method

Market Value Method (For

Quoted Securities)

9

`

Key Facts of Valuation

The Value of a business, by whatever valuation method it is obtained, is not the selling price of thebusiness. Value is an economic concept based on certain data & assumptions, however Price iswhat a Buyer is willing to pay keeping in consideration the Economic and Non Economic factorslike Emotions, Perception, Greed Etc which cannot be valued as such.

The Value is a subjective term and can have different connotations meaning different things todifferent people and the result may not be the same, as the context or time changes.

Valuation is more of an art and not an exact science. The Art is Professional Judgment andScience is Statistics. Mathematical certainty is neither determined nor indeed is it possible as useof professional judgment is an essential component of estimating value

Though the value of a business can be objectively determined employing valuation approaches,this value is still subjective, dependent on buyer and seller expectations and subsequentnegotiations and the Transaction happens at negotiated price only.

PRICE IS NOT THE SAME AS VALUE

TRANSACTION CONCLUDES AT NEGOTIATED PRICES

VALUATION IS HYBRID OF ART & SCIENCE

VALUE VARIES WITH PERSON, PURPOSE AND TIME

10

Asset Based Valuation-CCI guidelines, 1990 (para 6.1) state that “The net asset value, as atthe latest audited balance-sheet date, will be calculated starting fromthe total assets of the Company or of the branch and deducting therefrom all debts, dues, borrowings and liabilities, including current andlikely contingent liabilities and preference capital, if any.

Book Value Replacement Value

Fair Value Liquidation value

Involves methods of determining acompany’s value by analyzing the value of acompany’s assets.

This approach is generally preferred to valueintangible asset (like brands, patents,goodwill etc) of the business

Business whose value derives mainly fromthe underlying value of its assets rather thanits earnings, such as property holding andinvestment business.

Business that is not making an adequatereturn on assets and for which a greatervalue can be realized by liquidating thebusiness and selling its assets.

Of great relevance in industries such asutilities, manufacturing and transport thatare dependent on physical infrastructure andassets,

May not have particular significance inindustries such as information technology,pharmaceutical that are driven byintangibles not recorded in the books.

Income Based Approach CCI guidelines, 1990 (para 7.3) state that "The crux of estimating theProfit Earning Capacity Value lies in the assessment of the futuremaintainable earnings of the business. While the past trends in profitsand profitability would serve as a guide, it should not be overlookedthat valuation is for the future and that it is the future maintainablestream of earnings that is of great significance in the process ofvaluation. All relevant factors that have a bearing on the futuremaintainable earnings of the business must, therefore, be given dueconsideration"

The concept is to value a business or asset based on its earning capacity.

Derives an estimation of value based on thesum of the present value of expectedeconomic benefits associated with the asset orbusiness (Economic benefits have twocomponents: cash flow (or dividends) andcapital appreciation).

The capitalization method is usually employedwhen a company is expected to experiencesteady financial performance for theforeseeable future and when growth isexpected to remain fairly constant.

DCF is the most robust method and is mostcommonly used when the company isexpected to experience a period of abnormalgrowth and when the growth rate for the nearterm is anticipated to be significantly differentfrom the long-term rate of growth.

Income Based Approach

Capitalization method

Value = Normalized earnings *

Appropriate multiple

Multi-period discounted future income method.

`DCF

Market Based Approach Relative Valuation“If you think I’m crazy, you should see the guy who lives across the hall”

The basis of market value is theassumption that if comparable Asset(or property) has fetched a certainprice, then the subject asset (orproperty) will realize a pricesomething near to it.

The value of an asset is compared tothe values assessed by the market forsimilar or comparable assets.

Benefits of Relative Valuation fewer assumptions Can be completed fast Simpler to understand Easier to present to clients More likely to reflect the current

mood of the market, since it is an attempt to

measure relative and not intrinsic value.

Comparable Companies

Multiple Method

Comparable Transactions

Multiple Method

`

Approaches to FDI Valuation

DFCF expresses the present value of the business as a function of itsfuture cash earnings capacity. In this method, the appraiser estimatesthe cash flows of any business after all operating expenses, taxes, andnecessary investments in working capital and capital expenditure isbeing met to arrive at Enterprise Value (EV).

Valuing equity using the free cash flow to stockholders requiresestimating only free cash flow to equity holders, after debt holders havebeen paid off.

14

Discounted Free Cash Flow Method

` Forward Looking and focuses on cash generation

Recognizes Time value of Money

Allows operating strategy to be built into a model

Incorporates value of Tangible and Intangible assets

Only as accurate as assumptions and projections used

Works best in producing a range of likely values

It Represents the Control Value

Major Characteristics of DFCF Valuation

15

`

DFCF Valuation Process

Understand Business Model

Identify Business Cycle

Analyze Historical Financial Performance

Review Industry and Regulatory Trends

Understand Future Growth Plans (including Capex needs)

Segregate Business and Other Cash Generating Assets

Identify Surplus Assets (assets not utilized for Business say

Land/Investments)

Create Business Projections (Profitability statement and Balance Sheets)

Discount Business Projections to Present (Explicit Period and Perpetuity)

Add Value of Surplus Assets and Subtract Value of Contingent Liabilities

16

`

Free cash flows to firm (FCFF) is calculated as

EBITDA

Taxes

Change in Non Cash Working capital

Capital Expenditure

Free Cash Flow to Firm

Note that an alternate to above is following (FCFE) method in which the valueof Equity is directly valued in lieu of the value of Firm. Under this approach,the Interest and Finance charges is also deducted to arrive at the Free CashFlows. Adjustment is also made for Debt (Inflows and Outflows) over the definiteperiod of Cash Flows and also in Perpetuity workings.

Theoretically, the value conclusion should remain same irrespective of the methodfollowed (FCFF or FCFE), (Provided, assumptions are consistent).

Free Cash Flow calculation

17

`

DISCOUNT RATE – WEIGHTED AVERAGE COST OF CAPITAL

Where:D = Debt part of capital structureE = Equity part of capital structureKd = Cost of Debt (Post tax)Ke = Cost of Equity

(Kd x D) + (Ke x E)

(D + E)

In case of following FCFE, Discount Rate is Ke and Not WACC

WACC

Cost of Capital calculation

18

`

DISCOUNT RATE - COST OF EQUITY

Where:Rf = Risk free rate of return (Generally taken as 10-year Government Bond Yield)B = Beta Value (Sensitivity of the stock returns to market returns)Ke = Cost of EquityRm= Market Rate of Return (Generally taken as Long Term average return of

Stock Market)SCRP = Small Company Risk PremiumCSRP= Company specific Risk premium

Mod. CAPM Modelke = Rf + B ( Rm-Rf) + SCRP + CSRP

The Cost of Equity (Ke) is computed by using Modified Capital Asset Pricing Model

(Mod. CAPM)

Cost of Equity calculation

19

`

PERPETUITY FORMULA– Usually comprises a Large part of Total Value and is sensitive to small

changes

– Capitalizes FCF after definite forecast period as a growing perpetuity;

– Estimate Terminal Value using Terminal Value Multiplier applied on last year cash flows;

– Gordon Formula is often used to derive the Terminal CashFlows by normalizing the last year cash flows as a multiple of the growth rate and discounting factor;

– Estimated Terminal Value is then discounted to present day at company’s cost of capital based on the discounting factor of last year projected cash flows

(1 + g)

(WACC – g)

IMPORTANT TIP- It is advised to do Sanity check by applying Relative Valuation Multiples to the Terminal Year Financials and also doing Scenario Analysis.

Terminal value calculation

20

`

Tricky issues in DFCF

Pre Money or Post Money: If the effect of the money coming in Company is taken in

Projections, the Expanded capital base should be considered or else the Equity Value

should be reduced by the inflow amount to reconcile with the existing capital base.

Terminal growth rate: Since it is tough to estimate the perpetual growth rate of a

company as it is based on the cyclical Industry trends, however the maximum perpetuity

growth rate factors in long term average GDP and Inflation of a Country.

Projection Validation via-a-vis Industry: Need to have Sanity check of the

projections with the trend of the industry, particularly in Terminal Value.

Beta of Unlisted Company: It is calculated on relative basis by adjusting the average

beta of its comparable companies for differences in Capital Structure of the unlisted

company with the listed peers.

Risk Free Rate: Yield of a Zero Coupon Bond or Long Term government Bond yield

should be taken as the risk free rate since it does not have any reinvestment risk .

21

`

Adjustment of Company Specific Risk Premium or Small Company Risk

Premium: Small Companies are generally more risky than big companies. CAPM model

does not take into consideration the size risk and specific company risk as Beta

measures only systematic risk and Market Risk Premium (generally pertaining to Sensex

Companies). These risks should also be taken into account while computing the cost of

equity.

Length of Projections: The Projected Cash Flows should factor in the entire Business

Cycle of a Company.

Notional/Actual Tax: Actual Tax Liability may be worked out and replaced for the

Notional Tax Liability

Investments: Investments should be valued separately based on their Independent

Cash Flows

Surplus Assets: The Value of Surplus Assets (not being utilized for Business purposes)

should be added separately and their cash flows should be ignored while computing the

Free Cash Flows.

Tricky issues in DFCF

22

`

Growing Cos.

Turnover/Profits: Increasing still Low Proven Track Record: Limited Valuation Methodology: Substantially on Business Model Cost of Capital: Quite High

High Growth Cos.

Turnover/Profits : Good Proven Track Record: Available Valuation Methodology: Business Model with Asset

Base Cost of Capital: Reasonable

Mature Cos.

Turnover/Profits: Saturated Proven Track Record: Widely Available Method of Valuation: More from Existing Assets Cost of Capital: May be High

Declining Cos.

`

Turnover/Profits: Drops Proven Track Record:

Substantial Operating History Method of Valuation: Entirely

from Existing Assets Cost of Capital: N.A.

Turnover/Profits: Negligible Proven Track Record: None Valuation Methodology: Entirely on Business Model Cost of Capital: Very High

Start Up Cos.

Turn

over

/ Pr

ofits

Time

Valuation across business cycle follow the law of economics

Valuation: The law of Economics

23

`

Valuation under FEMA : ODI

Overseas Investment

Remittance of funds exceeds USD 5

million

Mandatory valuation by SEBI registered Merchant Banker

Swap of SharesMandatory valuation

by SEBI registered Merchant Banker

Any other caseMerchant Banker /

Chartered Accountant

No Specific Method prescribed by RBI

`

Inbound Investment DFCF

Gift of Unquoted Equity Shares (Min)

NAV

Outbound Investment Valuer Discretion

Gift of Unquoted Shares other than Equity Shares

Price it would fetch if sold in open market

Takeover Code/ Delisting -Infrequently Traded

Only Parameters Prescribed –Return on Net Worth, EPS, NAV vis-

a vis Industry Average

Takeover Code/ Delisting -Frequently Traded

Based on Market Price

Reserve Bank of India

ESOP Tax Valuer Discretion

ESOP Accounting Option – Pricing Model

Income Tax

SEBI

CA / MB

>5Mn$ - MB, otherwise CA/MB

-

MB

MB

-

CA/MB

-

Stock Exchanges

Relisting Base Price Determination

Valuer Discretion

Companies Act Sweat Equity Valuer Discretion

MB

-

Transactions Prescribed Methodologies Mandate to be done by

Regulatory Valuations

35

Gift of Unquoted Equity Shares from Resident (Max)

DCF (Valuation Based on Assets, Business & Intangibles is also

acceptable)FCA / MB

`

Taxpert Professionals Private LimitedTel: +91 22 25138323E-mail us: info@taxpertpro.comVisit us at: www.taxpertpro.com