SFM Notes Units 1 - 3

Syllabus
Strategic Financial Management Hours: 08

Unit 1:
Introduction, Constituents, Financial planning, Capital allocation and Corporate strategy

Corporate Valuation Hours: 10
Unit 2:
Introduction, Approaches - Adjusted Book Value Approach, Stock and Debt Approach, Comparable Companies Approach, Discounted Cash Flow
Approach - Concept of Free Cash Flow to the Firm, Two and Three Stage Valuation Models, Valuation of Physical Assets, Valuation of Intangible Assets
Value Metrics Hours: 10

Unit 3:
Shareholder value creation - Traditional and modern approaches, Value drivers, Approaches to Value Based Management - Marakon Approach, Alcar
Approach, Mc Kinsey Approach, Economic Value Added Approach, BCG HOLT Approach, Metrics for Measurement of Performance, Executive
Compensation and Value Creation, Employee Stock Option Plans
Corporate Restructuring Hours: 10

Unit 4:
Introduction, Forms of corporate restructuring - Spin off, Split off, Split up, Leveraged Buyout, Divestiture and other forms of corporate restructuring
Mergers and Acquisitions Hours: 15

Unit 5:
Mechanics of Merger - Legal, Accounting and Tax, Valuation of Mergers and Acquisitions, Financing of Merger and settlement, Takeovers
Challenges in Strategic Financial Management Hours: 15

Unit 6:
Financial Management in Knowledge Intensive Companies and Public Sector Companies, Financial Management in Sick Units, Financial Innovations and
Financial Engineering - Overview, Scope, Tools of Financial Engineering, Financial Engineering versus Financial Analysis
1 - Strategic Financial management
1.1 What is “strategic financial management” (SFM)?
A) Strategic financial management is :
 identification of possible strategies capable of maximising an entity’s competitive advantage (business
valuation) aligned with sustainability and net-zero carbon goals ;
 sourcing capital on competitive terms in order to finance acquisition and expansion of tangible and
intangible assets that have been identified to generate competitive-advantage (financing);
 the allocation of scarce capital resources, among the competing opportunities (investing); and the
 implementation and monitoring of the chosen strategy so as to achieve stated objectives (leadership
and performance-management).
1.2 What are key imperatives that SFM will have to incorporate as part of its scope ?
A) SFM has to incorporate the following imperatives as part of its scope :
 sustainability - incorporating environmental, social and governance considerations in decisions on
investing, financing and making returns to capital-providers. Environmental decision also includes
consideration of climate-change mitigation and adaptation
 digitisation - automating processes, use of dita visualisation and use of advanced AI-driven analytics to
drive SFM
1 - Strategic Financial management (contd)
1.3 What are the competences needed for SFM ?
A) According to CGMA Competence Framework, the following skills and competences are required for the
finance function to be a trusted and reliable business-partner :
1.3.1 Technical skills
 Financial accounting and reporting
 Cost accounting and management
 Business planning
 Management reporting and analysis
 Corporate finance and treasury management
 Risk management and internal control
 Accounting information systems
 Tax strategy, planning and compliance
1.3 What are the competences needed for SFM ? (contd)
1.3.2 Business skills
 Macroeconomic analysis
 Strategy
 Business models
 Market and regulatory environment
 Process management
 Business relations
 Business ecosystems management
 Project management
contd..
1.3.3 People skills
 Influence
 Negotiation and decision-making
 Communication
 Collaboration and partnering
1.3.4 Leadership skills

 Team building
 Coaching and mentoring
 Driving performance
 Motivating and inspiring
 Change management
1.3.5 Digital skills
 Information and digital literacy
 Digital content creation
 Problem-solving
 Data strategy and planning
 Data analytics
 Data visualisation
1.4 What are the key processes that are part of SFM ? (contd)
A) The key processes, not necessarily sequential, that are part of SFM are :
 valuing the business as-is-where-is and comparison with peers for providing inputs on securing
competitive advantage for business alongwith combating climate-change and sustainability;
 modelling various strategic options to illustrate pay-offs from implementing various strategic options-scenarios;
 preparing business-plans for chosen strategy identifying key strategic enablers to be implemented, resources
required - capex, technology, people, M&A, financing required, risk-management and performance management
dashboards to be implemented, sustainability and climate adaptation and mitigation metrices to be achieved;
 capital raising on competitive terms from both global and domestic sources;
 capital-budgeting / evaluating investments required under approved business-plan;
 managing risks arising / anticipated to arise from implementing business-strategy;
 reporting on key strategic enablers showing business-performance, gaps to be bridged;
 achieving compliance with financial reporting standards, tax laws, commercial, labour and environmental laws;
 managing interests of investors - dividends, share buy-backs, interest; and
 managing reputation with external rating agencies-credit analysts, sustainability-analysts.
1.5 What are the key external and internal influences that impact SFM function ?
A) The key external and internal influences are :
1.5.1 - External influences
 need to maintain robust relations with external investors - equity, debt
 major economic indicators - inflation rates, interest rates, foreign currency rates, GST rates, income tax rates
 major regulations - constitution, WTO trade and dumping laws, competition laws, tax laws, insolvency and asset-
recovery laws, intellectual property regimes, data-protection laws, labour laws
 key vendor and customer profiles and opportunities / risks arising
1.5.2 - Internal influences

 financial risk / leverage
 extent of compliance with financial covenants
 employee productivity and bargaining profile
 quality of capital assets and intangible assets
 strength of balance-sheet
 strength of organisational values
1.6 What are the key tools available for the SFM function ?
A) Key tools available for SFM function include (source - CGMA) :
Category Tool
Governance & risk-mgmt. CIMA Strategic Scorecard
Enterprise Risk Mgmt.
Risk Heat Maps
CGMA Ethical Reflection Checklist
Strategic planning & execution Porter’s 5 forces of industry competitiveness
Strategic planning - SWOT, PEST, strategic
objectives
Balanced Scorecard
Strategy Mapping
1.6 What are the key tools available for the SFM function ? (contd)
Category Tool
Performance management & Performance Prism
measurement
Benchmarking
KPIs - financial and non-financial
Planning & forecasting Scenario and contingency-planning
Rolling plans and forecasts
Cashflow modelling
Activity-based budgeting
Value recognition Value Chain Analysis
Customer Relationship Mgmt.
1.6 What are the key tools available for the SFM function ? (contd)
Category Tool
Product & service delivery Activity-based Costing (ABC)
Lean
Total Quality Mgmt - Six Sigma, Cost of Quality
ESG UNSDG ESG Tracker
1.7 How does the SFM vary by type of entity ?
A) SFM varies by type of entity,
1.7.1 - Type of Entity

 commercial enterprise - maximisation of shareholder wealth, RoCE, profitability, liquidity
 not-for-profit - VFM (economy, efficiency and effectiveness)
The focus of SFM also varies as the firm progresses through its life-cycle and based on industry
1.7.2 - based on life-sycle
 introduction - SFM to support increased spend on entry into market, setting up start-up systems with equity funding
 growth - SFM to focus on supporting higher capture of market, scale-up of systems and support with higher equity
funding with some level of debt
 maturity - SFM to support R&D for newer products, product-customer profitability analysis with high competitive
sources of funding
 decline - SFM to support with sale of tangible and intangible assets and deliver returns to investors
1.17.3 - based on type of industry (quick product turnover, idea-based, people-based etc.)
1.8 What is financial planning ?
A) Financial planning refers to the process of quantifying the outlays required for capital investment and working
capital including maintaining reserves for contingencies and raising financial capital in order to fund capital
investments and working capital.
The financial manager must possess a good knowledge of the sources of available funds and their respective costs, and
should ensure that the entity has a sound capital structure, that is, a proper balance between equity capital and
borrowings. Such managers also need to have a very clear understanding of the difference between profit and cash flow,
bearing in mind that profit is of little avail unless the entity is adequately supported by cash to pay for assets and
sustain the working capital cycle.
Financing decisions also call for a good knowledge of evaluation of risk: excessive borrowing carries high risk for an
entity’s equity because of the priority rights of the lenders.
PECKING THEORY :
This theory provided that the finance-manager will raise capital in the following order :
 Retained earnings
 Tax-effective debt
 Equity
Key considerations in financial planning are :
 how much of cash to be held (trade off between too much and too little of cash)
 Flexibility to change busines-plan
 Expectations of shareholders (whether they are willing to invest in projects or they want it back as buy-backs or
dividends)
1.9 What is financial capital-allocation ?
A) Financial managers have responsibility for the allocation of financial resources to achieve the organisation's
objectives. An important part of their job is to understand the short, medium and longterm capital requirements for
investment in fixed assets and working capital that fits with the overall strategy.
Whilst financial managers are unlikely to be solely responsible for the final choice of capital investment projects to be
undertaken, they will be actively involved in the evaluation of possible investment opportunities. When considering
whether a project is worthwhile, a company must consider its implications on the following :
 The liquidity of the company – All projects involve cash flows in and out. The size and timing of such flows should be
considered when appraising projects. If an aim of investment appraisal is to satisfy shareholders then it is important
to remember that, if a company has no cash, it cannot pay a dividend.
 The reported profit and earnings – All projects will change the revenues, expenses and asset values shown in the
financial accounts. If shareholders are concerned about such statistics as earnings per share, then the effect of
investments on reported figures must be part of the investment appraisal.
 The variability of cash flows and earnings – Investors are concerned about the variability of returns from their
investments. The greater the variability, the greater the risk, and therefore the greater the return they will require.
Thus, when appraising potential projects, managers should consider not only the likely size and direction of cash
flows and profits but also whether they are likely to add to or reduce the variability of such flows.
1.9 What is dividend decision ?
A) Dividends provide important returns to shareholders and can be seen as an indicator of success of the business.
Shareholder returns comprise both increase in share price and cash in the form of dividends and share buy-backs.
When deciding on the type of investment and level of finance needed, the financial manager must have regard for the
potential effects on the risk and level of dividends payable to shareholders. If the shareholders are not happy with their
return, they will be reluctant to invest further, which in turn will affect the funding available for future investment.
However, the cash needs of the business must also be considered.
The business may wish to retain cash resources to finance investments rather than increase gearing by raising new
funding. Cash resources may also be retained in order to provide rapid access to funds to respond to investment
opportunities that might arise in the future or to provide flexibility in the face of poor trading conditions.
The dividend decision thus has two elements:
 the amount to be paid out, and
 the amount to be retained to support the growth of the entity (note that this is also a financing decision).
2 important behavioural theories on dividends :

1) signalling - company’s announcement of an increase in dividend payout is an indication of future positive prospects
2) capital structure - dividend payout does not have implications on capital-structure
1.10 Are the key decisions in financial management inter-related ?
A) Investment decisions cannot be taken without consideration of where and how the funds are to be raised to finance
them. The type of finance available will, in turn, depend to some extent on the nature of the project – its size, duration,
risk, capital asset backing, etc.
Dividends represent the payment of returns on the investment back to the shareholders, the level and risk of which will
depend upon the project itself, and how it was financed.
Debt finance, for example, can be cheap (particularly where interest is tax deductible) but requires an interest payment
to be made out of project earnings, which can increase the risk of the shareholders' dividends.
It is important to consider the interrelationship between investment, financing and dividend decisions when
assessing the impact of the decisions on the entity's ratios.
1.11 Korex Ltd., which requires investment outlay of Rs 100 million is considering two capital structures.
Component of Capital Capital Structure A Capital Structure B

Equity 100 50
Debt 0 50
Average cost of debt is fixed at 10%; tax-rate is 50%. Calculate :

(i) Calculate Return on Equity (RoE) for Return on Investment (RoI) at 5%, 10%, 15%, 20$ and 25% for both Capital
Structures A and B
(ii) On a diagram, show the relationship between RoI and RoE for both capitalk-structures A and B and provide analysis.
Mathematical formula RoE = RoI + (RoI-r) * (D/E) * (1-t)

1.11 Korex Ltd (contd)
Capital Structure A Capital Structure B
RoI 5% 10% 15% 20% 25% 5% 10% 15% 20% 25%
PBIT 5 10 15 20 25 5 10 15 20 25
Interest - - - - - 5 5 5 5 5
PBT 5 10 15 20 25 - 5 10 15 20
Tax 2.5 5 7.5 10 12.5 - 2.5 5 7.5 10
PAT 2.5 5 7.5 10 12.5 - 2.5 5 7.5 10
RoE 2.5% 5% 7.5% 10% 12.5% 0% 5% 10% 15% 20%
 RoE is higher in Capital Structure A than B when RoI is less than post-tax cost of debt
 RoE is higher in capital structure B than A when RoI is more than post-tax cost of debt
 Indifference point is when RoI is equal to post-tax cost of debt
1.11 What is strategy and what are the two levels in strategy ?
A) Strategy is a broad formula for how a business is going to compete. It is concerned with inventing new competitive
spaces and new rules for competitive engagement. It also involves matching a firm’s capabilities with the opportunities
present in the external environment.
Strategy is formulated at two levels viz. corporate level and business-unit level.
1.11.1 What is corporate strategy ?

A) Corporate strategy is concerned with the following questions :
 what businesses should we be in and how resources should be allocated - business-strength and industry-
attractiveness ?
 how should the Corporate-Centre influence and relate to the businesses under its control ?
1.11.1.1 Whar are the types of overall strategy for a business ?

A) The broad business strategy is based on dimensions of product and market. The strategic typology is illustrated
below with customisations required from SFM.
Product-market Typology Strategy SFM capital-allocation strategy
Existing product-existing market Product-market penetration Capex for supporting increasing market
share, M&A activity and horizontal
integration, supported by relevant
financial metrices to measure and
manage
New product-existing market Product development Capex for R&D, product-launch, vertical
integration, supported by relevant
manage
New market - existing product Market expansion Capex for new market development,
M&A activity, supported by relevant
manage
New market-new product Diversification Capex for product-development and
market-development, M&A, de-risking
and managing investor expectations.
Supported by relevant financial metrices
to measure and manage
1.11.2 What is business-level strategy ?
A) Diversified firms do not compete at the corporate level. Rather, a business-unit of one firm competes with the
business unit of another.
Among the various models that can be used as frameworks for developing a business level strategy, the Porter’s generic
model is perhaps the most popular.
Sources of Competitive Advantage

Unique value as Lowest cost
perceived by
Strategic customer
Scope Broad Overall differentiation Overall cost leadership
(industry-
wide)
Narrow Focused differentiation Focused cost leadership
(segment only)
2 - Corporate Valuation
2.1 Introduction
2.1.1 Value of company / business / asset / liability is an estimate of the most probable of a range of possible outcomes
based on assumptions made in the valuation process.
2.1.2 Various parameters - quantitative and qqualitative can affect estimation of the value of the company / business /
asset. / liability. They are :
 perspective of value - whose viewpoint is most represented in a perspective of value eg. purchaser vs employees
 purpose of valuation - for fair-value reporting under IFRS / IndAS or strategic decision-making or for regulatory
requirements
 subject of valuation - whether valuation of enterprise or valuation of equity or valuation of tangible / intangible asset
or specific liability
 bases of valuation - fair value, participant specific value, orderly liquidation value, forced liquidation / distress value,
synergistic value
 premises of valuation - highest and best use basis, as-is-where-is basis, going concern basis, orderly liquidation basis,
distress-sale basis
 time of valuation - valuation is a time-specific exercise and estimates of value can vary significantly between 2 dates
depending on changes in key assumptions and values of key assumptions
2.1.3 - Valuation is a subjective exercise and prone to subjective bias / judgement of the valuer
2 - Corporate Valuation (contd)
2.1.4 Big-picture on valuation-approaches
A) Market Approach
 market-price method (also called “stock and debts” method” = market value of equity + market value of debt)
 comparable companies multiple
 comparable transaction multiple
B) Income Approach
 DCF method
 Gordon constant growth model and variable growth model
 Relief from Royalty method
 Multiple-period excess earnings method
 With and without method
 Option pricing method
C) Asset Approach
 Replacement cost / Reproduction cost methods
 Adjusted book-value / underlying assets method
2.1.5 Common Adjustments made for Valuation of Business
 Discount for acquiring minority-lots of equity shares

 A premium for shares that are readily tradeable in a recognised stock exchange
 A control premium to factor in the benefits of controlling the business operations, directly or indirectly
 Any other specific adjustments such as synergy gains, cost of post transaction integration, etc.
2.2 Adjusted Book Value Approach
2.2.1 What is Adjusted Book Value Approach and when is it relevant to be considered ?
A) The Adjusted Book Value Approach is a valuation procedure performed under the “Asset Approach” / Underlying Net
Assets Approach. This valuation procedure shall be relevant in the following situations :
i) In cases where there is paucity of information about profits that would serve as a basis of valuing shares, such
as:
 In case of new companies whose accounts do not serve as a guide to future profits.
 Where a company has been trading at a loss and there are no prospects of earning any profit in the foreseeable
future.
 In case of companies where there is no reliable evidence of future profits due to Profound fluctuations in business, or
disruption in business.
ii) Other circumstances, such as, when it is intended to liquidate the company and to realise the assets and
distribute the net proceeds among shareholders.
iii) The Cost Approach and its variant, Underlying Asset Approach can also be utilized in valuing holding companies,
real estate companies and investment holding companies etc.
2.2 Adjusted Book Value Approach (contd)
2.2.2 What are the important considerations to be adopted in using Adjusted Book Value Approach ?
A) The important considerations to be considered are as follows :
i) It should be recognised that book value reflects only the historical cost of assets, which in the case of old
concerns may be much lower than their economic value. Investments are generally recognised at their market
values even where other assets are considered at their book valueIn case of new companies whose accounts do
not serve as a guide to future profits.
ii) If a concern is being valued on a going concern basis, net replacement value of the assets gives a fair measure of
their current value. However, in this case too intangible assets may need to be valued and added to recognise the
fact that individual net replacement value of the assets does not represent the inherent strength of the concern.
iii) Where a concern is being wound up, its assets are best valued on the basis of their net realisable value.
iv) Intangible assets of a company have also to be included, no matter whether they are shown in the books or not.
Intangible assets generally consist of goodwill, patents, trade-marks, copyrights, etc. Goodwill is generally
inseparable from business, and it can fetch a price only if the business is sold on a going concern basis.
v) In practice while applying Underlying Asset Approach often a combination of book values, replacement values
and realisable values is adopted. For example, even where a concern is being valued on going concern basis,
excess assets may be valued at their net realisable values.
Item of Asset Valuation considerations (in the case of going concern)

Fixed assets Net book value (original cost less accumulated depreciation and impairment),
which should not EXCEED the replacement or reproduction cost of the asset
Intangible assets Cost approach in case of engineering drawings, market approach for
customer-loyalty and other approaches for other items
Investments  In case of quoted investments, based on average quoted-value only when
there is regular trading.
 In case of unquoted, fair-value as per IFRS / AS (amortised cost adjusted
for impairment or net realisable value)
Inventory At book-value as per relevant AS adjudted for provision for non-moving, slow-
moving, obsolescence
Receivables At book-value less bad-debts and provision for doubtful debts
Other current At book-value less bad-debts and provision for doubtful receivables
assets
Item of Valuation considerations (in the case of going concern)

Liability
Current At book-values plus any highly probable additional amount for interest eg.
liabilities interest on delayed payment to MSMEs, interest penalty awarded by
arbitrators
Provisions At book-values plus additional liability based on Court-Orders, Orders as per
Statutory Authorities, Quasi-Judicial Authorities, internal assessments
External loans At book-values plus any additional liability based on provisions of respective
loan / debenture agreements
Contingent At amounts highly probably to materialise supported with evidence
liabilities
Preference share At book-values plus accumulated dividends as per terms of issue
dues
2.3 Comparable Companies Approach
2.3.1 What are the important considerations to be adopted in using Comparable Companies Approach ?
A) This is a type of valuation under the overall market-approach. The important considerations to be
considered are as follows :
i) CCM Method involves valuing an asset based on market multiples derived from prices of market
comparables traded on active market and is also known as Guideline Public Company Method. A
comparable company/assets selection is based on various factors including operational processes, cash
flows, growth potential and risk similar to the company being valued.
For Example – valuing a company in healthcare business under the comparable company approach we will
look into the value of a similar publicly traded company in the same industry and make necessary
adjustments for evident difference like enterprise value/No of hospital beds and volume of business etc.
The inherent drawback of this method is that direct comparability is hard to achieve and can only be
achieved in a few industries. This model uses a contextual approach to derive the value of a business or
asset, as opposed to Income Approach that value a company internally based on cash flow and other
factors, without any comparisons.
2.3 Comparable Companies Approach (contd)
The steps to be considered for carrying out valuation are :
i) Identifying and selecting the market comparable
ii) Computing Market Multiples

The market multiples are generally computed on the basis of following inputs:
 trading prices of market comparables in an active market; and
 financial metrics such as Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA), Profit
After Tax (PAT), Sales, Book Value of assets, etc. Industry-specific multiples may also be considered by
the valuer, as required.
iii) Adjustments to the market multiple

As comparable companies are not exactly similar to the company being valued, the multiples derived from
such companies cannot be applied as it is, and thus subjective adjustments are required to account for
differences in risk profile, growth rate, contingent liability etc.
For example, a company with a better growth potential shall require a positive adjustment to its multiple
iv) Arriving at the value of asset to be valued
Apply the adjusted market multiple to the relevant parameter of the asset to be valued to arrive at the value
of such asset
Case study of WhatsApp acquisition by Facebook (from the Valuation Standard published by The
Institute of Chartered Accountants of India - all copyrights reserved)
WhatsApp was acquired by Facebook in 2014 at a whopping $ 19 Billion. $15 Billion in Facebook stocks
and $4 Billion in cash.
User base of WhatsApp at the time of acquisition ~ 450 Million with ~70% active daily on this platform.
It stated that its plan was to charge 99 cents per year for each subscriber, after the initial first year, though
this had not been put to use.
From a trader’s perspective, if WhatsApp
Company EV ($mn) Users (mn) EV / User acquisition even led to increase in Facebook
Netflix 25830 44 577 users by 1/3rd of the WhatsApp’s then user
base, then with the $130 EV/User of
Groupon 5880 43 137 Facebook, the deal was well worth the
Facebook 160090 1230 130 outlay for the acquisition.
Zynga 2930 27 109
For Facebook, this deal was not a very big
Open Table 1500 14 107 risk. Its own market cap was $ 180 Billion
Pandora 7150 73 98 at that time and as of Dec 2013, had $11 B
in liquid funds and its cash from operations
Twitter 18790 243 77 in one year of 2013 itself was $4 Billion,
Linked In 19980 277 72 which was the cash component of the deal
with the rest being paid by way of Facebook
Yelp 5790 120 48 stock only.
Whatsapp 19000 450 42
The user base has indeed grown manifold
and is presently in the region of 2000 Mn
WhatsApp users and 2450 Mn Facebook
users.
2.4 Discounted Cashflow Method
2.4.1 What is the discounted cashflow approach to value a business ?
A) The Discounted Cash Flow (DCF) method indicates the Fair Value of a business based on the value of cash
flows that the business is expected to generate in future. This method involves the estimation of post-tax
cash flows for the projected period, after taking into account the business’s requirement of
reinvestment in terms of capital expenditure and incremental working capital. These cash flows are
then discounted at a cost of capital that reflects the risks of the business and the capital structure of
the entity.
2.4.2 When is the DCF method best-suited for valuing a business ?

A) DCF is best-suited in the following scenarios :
 Cashflows are currently positive and can be estimated with some reliability for future periods, and where a
proxy for risk that can be used to obtain discount rates is available.
 It works best for investors who either have a long-time horizon, allowing the market time to correct its
valuation mistakes and for price to revert to “true” value or are capable of providing the catalyst needed to
move price to value, as would be the case if you were an activist investor or a potential acquirer of the whole
firm.
2.4 Discounted Cashflow Method (contd)
2.4.3 What is the concept of free cashflow to Firm (FCFF) in the DCF approach ?
A) FCFF = Earnings Before Interest and Tax * (1-tax rate) + Depreciation – Capital Expenditure – Increase
in Non-Cash Working Capital
2.4.4 How is FCFF used to estimate value of the business ?

A) FCFF is used to arrive at value of business using following steps :
Step 1 - calculate primary value by capitalising the FCFF for the forecast period by using weighted average
cost of capital (calculating cost of equity and cost of debt by using market-values as weights)
Step 2 - calculate terminal value of business by using Gordon terminal value method (Expected dividends
after the forecast period / cost of capital - growth rate). Terminal value can also be calculated using exit
multiple used in industry or liquidation salvage value for physical-asset intensive companies.
In India, it is also acceptable to use book-values of equity and debt in order to calculate WACC.
The XYZ Co Ltd. in the year 2019-20 earned INR 10 million before interest and taxes with total revenues of
INR 50 million. in the same year the company had gross fixed capital to the tune of Rs.10 million,
depreciation was 5 million and working capital investment = 3 million.
XYZ Co. Ltd expects EBIT, investment in fixed assets, working capital, depreciation and sales to grow at
10% per year for next 5 years.
After 5 years, the growth in sales, EBIT and working capital investment will decline to stable 5% per year
and investments in fixed capital and depreciation will offset each other.
Tax rate= 30%,
WACC= 11% during the high growth stage and 8% during stable stage
a) Calculate the Free Cash Flow to the Firm in Year 6
b) Calculate the Terminal Value at the end of Year 5
(source - ICAI, copyrights reserved by ICAI)

FCFF= EBIT(1-t) + Dep - FCInv – WCInv
Description Y1 Y2 Y3 Y4 Y5 Y6
Sales 50 55 60.5 66.55 73.21 76.8
EBIT 10 11 12.21 13.31 14.64 15.3
EBIT * (1-t) 7 7.7 8.47 9.32 10.25 10.7
Depreciation 5 5.5 6.05 6.66 7.32 -
FC Invt (5) (5.5) (6.05) (6.66) (7.32) -
WC Invt (3) (3.3) (3.63) (3.99) (4.39) (4.6)
FCFF 4 4.4 4.84 5.32 5.86 6.1
Discounted FCFF 3.6 3.57 3.54 3.5 3.47
Terminal Value Year 5 = FCFF in stable period/(discount rate- Growth during Stable period)
= Rs 5.86/(8%-5%) Mn
= Rs 195.53 Mn, Discounted value = 195.53 * (1+5% growth) * 0.593 = Rs 121.75 mn
Value of Firm = (3.6+3.57+3.54+3.5+3.47+ + 195.53 = Rs 17.7 mn + Rs 121.8 mn = Rs 139.5 mn
2.5 Two Stage FCFF Valuation Model
2.5.1 When is this Model suited for valuation of Firm ?
A) The Two-Stage FCFF Model is designed to value a Firm, which si expected to grow much faster than a
stable firm in the initial period and at a stable rate after that.
2.5.2 How is the value calculated using Two Stage FCFF approach ?
A) The value of the Firm is the present value of the free cash flows that accrue to the Firm during the
extraordinary growth period plus the present value of the terminal value at the end of the extraordinary
growth period.
2.5.3 When is this model preferred over a Two Stage Dividend Valuation Model ?
A) While this model make the same assumptions regarding growth as the Two Stage Dividend Growth
Model, this will provide better results than the Dividend-based Model when valuing Firms, which either
have dividends that are not sustainable (higher than free cashflows) or which pay less in dividends than
they can afford to.
2.6 Three Stage FCFF Valuation Model
2.6.1 When is this Model suited for valuation of Firm ?
A) The Three-Stage FCFF Model is designed to value a Firm, that are expected to go through three stages of
growth - an initial phase of high growth rates, a transitional period where the growth rate declines and a
steady state period where growth is stable.
2.6.2 How is the value calculated using Three Stage FCFF approach ?
A) The value of the Firm is the present value of the free cash flows that accrue to the Firm during the
different growth periods plus the present value of the terminal value at the end of the transitional growth
period.
2.6.3 When is this model preferred over a Three Stage Dividend Valuation Model ?
A) While this model make the same assumptions regarding growth as the Three Stage Dividend Growth
Model, this will provide better results than the Dividend-based Model when valuing Firms, which either
have dividends that are not sustainable (higher than free cashflows) or which pay less in dividends than
they can afford to.
2.7 Valuation of Physical Assets
2.7.1 What are the key valuation approaches for valuation of physical or tangible assets ?
A) The 3 key valuation approchases for valuation of physical or tangible assets are as follows :
 cost approach;
 market approach - sales comparison and
 income approach
2.7.2 What are the key principles and key steps part of cost approach ?
A) Key principle is that a prudent investor will not purchase an asset for more than it will cost him to
replace this asset with an asset of comparable utility.
Key steps in valuation are :
 identify credible sources for obtaining reliable valuation estimates;
 estimate technical useful life based on informaton provided by OEM; and
 depreciate replacement cost over new economic life; and
 adjust for functional (internal to asset) and economic (external factors) obsolescence
2.7 Valuation of Physical Assets (contd)
2.7.2 What are the key principles and key steps part of market approach ?
A) The principle behind the sales comparison method is that the value of the asset is equal to the
market price of an asset of comparable features such as location and size.

 identify credible sources for obtaining reliable valuation estimates on comparable assets eg. property
transactions in property registry office, published third-party reports;
 identify key differences between subject-asset and comparable assets eg. road-access, amenability to
development, restrictons on end-use etc ;
 adjust for the differences in the comparable valuation; and also
 adjust for any obsolescene.
2.7.3 What are the key principles and key steps part of income approach ?
A) The principle behind the Income Approach is that the value of the asset is equal to the earnings
potential of this asset (ie) net present value of the cashflows that will be earned from the asset during its
economic useful life.

 develop cashflow forecast for both revenues and expenses based on assumptions verified with reliable
sources;
 select the discount-factor that will be the rate of return required by investor to invest in the asset;
 discount the net cashflows with applicable discount factor and arrive at yearly discounted cashflows;
 calculate terminal value of the asset in perpetuity using applicable capitalisation-rate; and
 adjust for any obsolescene to arrive at value of subject property.
2.7.4 What are the different types of obsolescence ?
A) The following are common types of obsolescence
(a) Physical obsolescence represents the loss in value on account of decreased usefulness of the asset as
the useful life expires.
(b) Functional (technological) obsolescence represents the loss in value on account of new technological
developments; whereby the asset to be valued becomes inefficient due to availability of more efficient
replacement assets.
(c) Economic (external) obsolescence represents the loss in value on account of decreased usefulness of
the asset caused by external economic factors such as change in environmental or other regulations,
excess supply, high interest rates, etc.
2.8 Valuation of Intangible Assets
2.8.1 What are generally accepted attributes of intangible assets ?
A) Generally accepted attributes of intangible assets are as follows :
 Identifiability - An intangible asset is considered as identifiable, if the asset meets either of contractual-
legal or separability criteria;
 control - power to obtain the future economic benefits associated with an asset and the ability to
restrict the access of others to those benefits;
 future economic benefits - Such benefits from an intangible asset may include product or service related
revenues, cost savings
2.8.2 - What is a generally accepted functional classification of intangible assets ?

A) A generally accepted functional classification of IA is as follows :
 contractual-legal - examples include non-competition agreements, licenses, permits, royalty
agreements
2.8 Valuation of Intangible Assets (contd)
 contractual-customer-based
 market-based - examples include trademarks or trade names, service marks, copyrights, internet
domain names
 technology-related - examples include rights to use patented or unpatented technology, software,
databases (including title plants), trade secrets, technical know-hows, technical designs
 Artistic related - right to benefits from artistic works, such as royalties from pictures, photographs,
videos, plays, books, magazines, newspapers, films and music
2.8.3 - When can Income Approach be generally used for valuation of intangible assets ?
A) Income Approach can be reliably used to value a wide range of intangible assets including developed
technology, non-competition agreements, trade names/trademarks/domain names, and customer related
intangibles.
2.8.3.1 - What are the generally accepted methods used under Income Approach ?
A) Some of the common methods under the Income Approach used to value intangible assets include Relief
from royalty, With and without, Multi-period excess earning, and Distributor and Greenfield.
2.8.3.2 - Explain key principles used in valuation using “Relief-from-Royalty” Method ?

A) This method is based on a hypothetical royalty (typically calculated as a percentage of revenue) that the
owner will otherwise be willing to pay in order to use the asset—assuming it was not already owned. Under
relief-from-royalty-method, the value of an intangible asset is determined by estimating the value of total
costs saved that would have otherwise been paid by the user as royalty payments, if had been taken on lease
from another party. Alternatively, it could also indicate the value of an intangible asset that could have
fetched cash flows in the form of royalty payments, had it been leased to a third party. Any associated costs
expected to be incurred by the licensee needs to be adjusted from the forecasted revenues.
2.8.3.3 - Explain key principles used in valuation using “With and without” Method ?
A) The ‘with and without method’ is typically used in order to value intangibles such as covenant not to
compete agreements. The fundamental concept underlying this method is that the value of the subject
intangible asset is the difference between an established, ongoing business and one where the subject
intangible asset does not exist.
Under this method, the value of the subject intangible asset is calculated by taking the difference between
the business value estimated under two sets of cash flow projections:
(a) value of the business with all assets in place as of the valuation date
(b) value of the business with all assets in place except the subject intangible asset at the valuation date.
2.8.3.4 - Explain key principles used in valuation using “Multi-period excess earning” Method ?
A) The excess earnings method calculates the value of an asset based on the expected revenue and profits
related to that particular asset, reduced by the portion of those profits attributable to other supporting
assets (tangible and intangible) that contribute to the generation of cash flow (for example, working
capital, fixed assets, assembled workforce etc.)
2.8.4 - Explain Market Approach and how it can be used in valuation of Intangible Assets ?
A) The Market Approach is often inapplicable to the valuation of intangible assets. Intangible assets are
often purchased "bundled" with other assets, so the price paid for an individual intangible asset is not
observable with certainty. Without knowing the amount paid for an asset in a transaction, the Market
Approach would not serve as a useful valuation measure for an individual intangible asset.
This approach should be used ONLY if the following criteria are met :
(i) The transaction is based on arm's length assumption and information is available on identical or
similar intangible assets on or near the valuation date; and
(ii) Sufficient information on the transaction is available that helps the valuer to adjust for all
significant differences between the subject intangible asset and those involved in the transactions.
2.8.5 - Explain Cost Approach and how it can be used in valuation of Intangible Assets ?
A) Under this method, the value of an intangible asset is the total cost (based on current prices) to
produce an exact replica of the intangible asset to be valued. Costs to reproduce could include data-sets
like direct costs, indirect costs, developer’s profit for the intangible asset, etc. The cost obtained under this
method shall be adjusted for any physical, functional or economical obsolescence.
The Cost Approach, though effective for some replicable assets, such as software and assembled
workforce, is not always a useful indication of value for other intangibles. It tends to look backwards in
time, which is not the way most buyers and sellers view assets or transactions. Even a relatively simple
piece of software, if it provides a competitive advantage that generates incremental profits, may have a
value significantly different than its cost.
Further, not all costs are incurred wisely, efficiently, or successfully.

2.9 Key Formula and Practice Questions
2.9.1 - Key Formula
1) Value of Company = Earnings per Share * PE Ratio
2) Value of company = earnings × (1 + g) / (earnings yield – g). Earnings Yield = EPS / Market price and g
= growth rate
3) Weighted Average Cost of Capital (WACC) = (VE / VE + VD) KE + (VD / VE + VD) KD *(1-t)
VE = value of equity, VD =value of debt, KE - cost of equity, KD*(1-t) = post-tax cost of debt
4) Cost of equity under dividend model = (Dividend at end of Period post growth) / (Price per share)
2.9 Key Formula and Practice Questions (contd)
5) Cost of equity under CAPM = RF + Beta * (Market return on Equity - RF), where RF = Risk-free rate in
country of entity
6) Adjustment of equity-beta to asset-beta

Step 1 - ßa = ße × (Ve / Ve + Vd (1 – T)) where ßa = Asset-beta, ße = Equity-beta
Step 2 - ßa = ße × (Ve / Ve + Vd (1 – T)) based on target-gearing
Step 3 (CAPM method) - Ke = Rf + ß (Rm – Rf)
7) Intrinsic value = Fair value per share - Book value per share
2.9 Key Formula and Practice Questions (contd..)
2.9.2 - TXYZ Co Ltd. is dealing automobile sector. Below listed is the Balance Sheet as on 31st March, 2018.
Particulars Amount (Rs.)
I EQUITIES AND LIABILITIES
1. Shareholders’ funds
(a) Share Capital
Authorised, Issued subscribed and paid up capital 15,00,000 22,50,000
14% Preference shares of Rs. 100 each 7,50,000
Equity shares of Rs. 10 each, fully called up and paid up
(b) Reserve and surplus
General reserve 9,00,000
2. Non-current liabilities
15% Debentures 7,00,000
3. Current Liabilities
Current liabilities 5,00,000
TOTAL 43,50,000
2.9 Practice Questions (contd..)
II ASSETS
1. Non-current Assets
(a) Fixed Assets
Tangible Assets & intangible Assets 32,50,000
(b) Investment 6,00,000
2. Current Assets
Misc Current Assets 5,00,000
TOTAL 43,50,000
Calculate under Net Assets method

(a) Discharge 15% debentures at a premium of 10%
(b) Fixed assets 10% above the book value.
(c) Investments at par value.
(d) Current assets at a discount of 10%.
2.9.3 The expected EPS of a company for the current year is Rs. 8. In the industry the standard P/E ratio is
15 to 18.
The company is in high growth stage. What is the best estimate of company’s share price? Should the share
be purchased?
Solution:
Since the company is in growth stage, we can assume that the appropriate P/E ratio is 18.
Therefore, Share price = 18 x 8 = Rs. 144
If the actual price is lower than Rs. 144, then the share should be purchased.
2.9.4 You are given the following information about a company

Recent EPS = Rs. 1.89
Growth rate (constant)= 6%
Dividend payout ratio = 50%
Required rate of return = 10%
After five years, the expected P/E ratio is 12.5.
Calculate
(i) The intrinsic value of share at present
(ii) The expected selling price of share at the end of 5th year
(iii) The maximum price at which the investor should buy this share
Solution:
(i) E0 = 1.89; g = 6%; Ke = 10%; b = 0.50
Po = E 1 (1-b)/ (Ke – g)
E1 = E 0 (1 + g)
= 1.89(1 + 0.06)
= 2.0034
Po = 2.0034 (1 – 0.50)/ (0.10 - .06)
= Rs. 25.04
ii) The expected P/E ratio at the end of 5th year = 12.5
Expected selling price at the end of 5th year will be:
P5 = P/E X EPS6
= 12.5 x 1.89 (1 + 0.06) 6
= 33.45
(iii) The maximum price an investor will be willing to pay would be the intrinsic value of this share i.e. Rs.
25.04
2.9.5 An investor wants to invest in an equity share of ABC Ltd. The company’s last EPS was Rs. 50 per
share and dividend payout ratio is 40%. The required rate of return from equity investment is 20%.
Calculate the intrinsic value of equity if
(i) There is no growth in dividend
(ii) Dividend are expected to grow at a constant rate of 18% p.a.
Dividend = 40%, So, last dividend (D0) = 40% of Rs. 5 = Rs. 20
(i) When there is no growth in dividend
So, D0 = D1 = Rs 20
P0 = D 1 / Ke
= 20 / 0.20
= Rs. 100
Therefore, the intrinsic value is Rs. 100 when there is no growth in dividend.
(ii) When there is constant growth rate in dividend
g = 18%, therefore,
D1 = D0 (1+ g)
= 20 (1 + 0.18) = 23.6
P0 = D1/ (Ke – g)
= 23.6/ .20 - 0.18
= Rs. 1180
Therefore, the intrinsic value is Rs. 1180, when there is constant growth of 18%.
Equity shares are currently selling at Rs. 60. The company is expected to pay a dividend of Rs. 3 with a
growth rate of 8%. Find out the rate of return.
Solution:
P0 = Rs. 60; g= 8%; D1 = Rs.3
P0 = D1/ (Ke – g)
Ke = D1 / P0 + g
= 0.05 + .08
= 0.13 or 13%
2.9.6 Practice Questions
From the following information, calculate the value of the Firm using 2-stage growth model
Description Base Year

Revenues 400 crs.
EBIT (12.5% of revenues) 50 crs.
Capital expenditure 30 crs.
Depreciation 20 crs.
Net working capital as % of revenues 30%
Corporate tax rate 40%
Paid up equity capital (Rs 10 par) 30 crs.
Market value of debt 125 crs.
2.9.6 Practice Questions (contd..)
From the following information, calculate the value of the Firm using 2-stage growth model
Description High-Growth Stable-Growth Phase

Phase
Length of growth phase 5 yrs.
Growth rate in revenues, depreciation, 10% 6%
EBIT and capital expenditure
Net working capital as % of revenues 3% 3%
Cost of debt (pre-tax) 15% 15%
Debt-equity ratio 1:1 2:3
Risk-free rate 13% 12%
Market risk premium 6% 7%
Equity beta 1.333 1
Solution (in Rs. crs.)
S No. Description 1 2 3 4 5 Terminal

Value
1 Revenues 440 484 532.4 585.64 644.2 682.86
2 EBIT 55 60.5 66.56 73.21 80.51 85.34
3 EBIT (1-t) 33 36.3 39.93 43.92 48.32 51.21
4 Capex - Deprn. 11 12.1 13.31 14.64 16.11 -
5 Net working capital 12 13.2 14.52 15.97 17.57 11.6
6 FCFF (3-4-5+Deprn) 28.8 29.7 32.7 35.97
Description Cost of Equity using Weighted Average Cost of Capital
CAPM Model
High-Growth Period 13% + 1.333 * 6%
= 21% 0.5 * 21% + 0.5 * 15% * 60%
= 15%
Stable Growth Period 12% + 1* 7% 0.6 * 19% + 0.4 * 15% * 60%
= 19% = 15%
P.V of FCFF during explicit forecast period is :

10 / (1.15) + 11 / (1.15)^2 + 12.1 / (1.15) ^ 3 + 13.31 / (1.15)^ 4 + 14.64 / (1.15) ^ 5 = Rs 39.74 crs.
P.V of terminal value

39.6 / (0.15 - 0.06) * (1 / 1.15 ^ 5) = Rs 218.82 crs.
Total value of Firm = Rs 39.74 crs. + Rs 218.82 crs. = Rs 258.57 crs.

A 100-room apartment building that rents @ Rs 50,000 per unit per month, and currently has 80 units
that are rented. Other incomes generated from parking and laundries are expected to be Rs 2500 per unit
per month.
Operating expenses, including property taxes, insurance, maintenance, and advertising are typically @
35% of EGI. The property manager is paid @ 15% of EGI.
Capitalisation factor is taken at 10.5. Calculate the Net Operating Income (NOI) and the value of the
property using NOI.
Description Amount (Rs.)

Value of Property =
1 Rental income @ full occupancy 60,000,000 NOI * Capitalisation Factor
2 Other income 3,000,000 Rs 25.2 mn * 10.5 = Approx Rs 260 mn
3 Potential Gross Income (PGI) 63,000,000 Note - Cap Factor is inverse of Yield-
4 Vacancy & collection loss (12,600,000) Rate and not the same
5 Effective Gross Income (EGI) 50,400,000
6 Operating Expenses @ 15% (7,560,000)
7 Operating Expenses @ 35% (17,640,000)
8 Net Operating Income 25,200,000
XYZ Ltd.has acquired a AI-based process knowhow and seeks to value the same. Market based royalty rate
for comparable asset is 9%. Risk-Adjusted cost of capital is 12%, growth is 2% and applicable tax-rate on
earnings is 30%. Sales (in Rs. Mn.) is 400, 520, 624, 686 and 755 for fys 2018, 2019, 2020, 2021 and 2022
respectively.
Calculate value of intangible asset using relief-from-royalty method.
Description 2018 2019 2020 2021 2022 Terminal value
Sales 400 520 624 686 755 770
Royalty 36 47 56 62 68 69
Income tax (11) (14) (17) (19) (20) (21)
Royalty after 25 33 39 43 48 49
income tax
DF 0.89 0.80 0.71 0.64 0.57 0.51
PV of cashflows 23 26 28 27 27 279
Fair Value 410
For Company XYZ ltd, Net operating assets is Rs 10 Lakhs while net average earning after tax is Rs 2 lakhs.
The required rate of return on Net Assets is 10% and capitalization rate for excess earning is 20%.
Calculate value of intangible asset using Multi-Period Excess earnings method.
Solution ;
NAV = 10 Lakhs, Expected Return on Assets = 10 Lakhs * 10% = 1 Lakhs
Net Average Earnings = 2 lakhs: Excess Earnings attributable to intangibles = 2lakhs – 1 Lakhs = 1 Lakhs
Value of Excess Earnings = 1 lakhs/20% = 5 Lakhs = Value of Goodwill
Value of Company = 10 lakhs + 5 Lakhs = 15 Lakhs
3 - Shareholder Value Creation
3.1.1 What is shareholder value-creation ?
A) In simple terms, maximisation of value of shares owned by shareholders of a enterprise. This raises two key
questions – how can we measure whether shareholder value is being created or destroyed, and which
performance appraisal targets ensure that managers act in such a way as to generate shareholder value?
Traditional approaches to measuring managerial performance, such as profit and return on investment (ROI),
have the significant disadvantage that they correlate poorly with shareholder value.
Attempts to develop more useful metrics have focused on incorporating three key issues:
 Cash is preferable to profit
Cash flows have a higher correlation with shareholder wealth than profits.
 Exceeding the cost of capital
The return, however measured, must be sufficient to cover not just the cost of debt (for example by exceeding
interest payments), but also the cost of equity.
 Managing both long and short-term perspectives
Investors are increasingly looking at long-term value. When valuing a company’s shares, the stock market places
a value on the company’s future potential, not just its current profit levels.
3 - Shareholder Value Creation
3.1.1 What is stakeholder value and how is it different from shareholder value ?
A) The principal contender to the shareholder value theory is called “stakeholder theory”. The stakeholder
theory argues that the managers should make decisions, taking into consideration the interest of all
stakeholders in a firm. The major stakeholders of a Firm are customers, employees, investors, vendors, general
public and the Government. It does not have a clear-cut decision-criterion on how to choose among
multiple constituencies with competing and often conflicting demands. Stakeholder value has to be
measured and managed through a “balanced scorecard”.
Shareholder theory is based on maximisation of wealth of shareholders that can be demonstrated through
financial tools like NPV, IRR etc.
3 - Shareholder Value Creation (contd)
3.2 What are value-drivers ?
A) 3.2 What are value-drivers ?
A) Value-drivers have a significant impact on the valuation of a enteprise and include both financial and non-
financial factors. They also include both internal and external factors.
Internal value drivers : External value drivers :
 sales growth credit-rating
 product gross-margin tax-rate
 incremental capital investment brand and reputation
 incremental working-capital
 cost of capital
 competitive-advantage period
3.3 What is Value-based Management (VBM)?
A) VBM is the management approach that ensures corporations are run consistently based on generally
accepted framework of values that function cohesively, normally maximizing shareholders value. VBM aims to
provide consistency of the firm’s strategy, mission, governance, culture, communication, organization structure,
decision processes, reward processes and systems etc. Basically, value of shareholder can be measured in terms
of earning after tax (EAT) and return to equity shareholders.
3.3.1 What are the different approaches to VBM ?
A) The important approaches to VBM are discussed below :
a. Marakon Approach :
This method was proposed by Marakon Associates, an international management consultancy firm in the year
1978. The approach is based on market-to-book value ratio. The market value taken in computation of ratio is
the long-term equilibrium market value.
b. Alcar Consulting Group Approach :
This method quantifies the value created by a strategy as the difference between “value existing prior to
implementation of strategy and value expected to be created post implementation of strategy”.
c. Boston Consulting Group - Holt Approach :
This method uses “Cashflow Return on Investment” (CFROI), which works with inflation-adjusted cashflows,
gross assets adjusted for inflation and economic useful lives of assets.
After adjusting for the above, CFROI is calculated as the internal rate of return that equates the inflation-
adjusted cash flows as mentioned above with the estimate of the current value of gross investment.
d. Mckinsey Consulting Approach :
i. Ensure the supremacy of value maximization
ii. Identify the value drivers that form part of cohesive VFM Framework
iii. Establish appropriate managerial process
iv. Implement value based management based on portfolio of key financial and non-financial indicators
e. Economic Value Added (EVA)
This approach was proposed by Stern Stewart & Co. The economic value added (EVA) is calculated as profit
before interest but after tax annd deducting weighted average cost of capital on funds employed. A positive EVA
indicates that a business is not only earning, it is earning enough to satisfy the providers of fund. Therefore, EVA
as a performance measure is better than accounting profit. The EVA sends a clear message to the operating
managers that any further investment can be made only if the cost of capital on both equity and debt
incremental investment can be recovered. EVA encourages projects with shorter payback period
Earnings before interest and taxes, (EBIT )
Income tax
NOPAT (Net operating profit after tax) = EBIT − tax
Total assets
Current liabilities
Capital investment (C) = Total assets − Current liabilities
Total equity = (shareholders funds/equity)
Average equity proportion = Total equity/total assets
Equity cost
Average debt proportion = 1 - Average equity proportion
Debt cost (debt interest rate) = Interest expense/LT debt
Tax rate
Cost of capital (COC) = Average equity proportion × equity cost + Average debt proportion × debt cost × (1-tax
rate)
EVA = NOPAT − COC
f. 10 Principles followed by Berkshire Hathaway in Shareholder Value Creation
Principle 1 - Do not manage earnings or provide earnings guidance
Principle 2 - Make strategic decisions that maximize expected value of cashflows, even at the expense of
lowering near-term earnings.
Principle 3 - Make acquisitions that maximize expected value of cashflows, even at the expense of lowering
near-term earnings.
Principle 4 - Carry only assets that maximize value.
Principle 5 - Return cash to shareholders when there are no credible value-creating opportunities to invest in
the business.
Principle 6 - Reward CEOs and other senior executives for delivering superior long-term returns.
Principle 7 - Reward operating-unit executives for adding superior multiyear value.
Principle 8 - Reward middle managers and frontline employees for delivering superior performance on the key
value drivers that they influence directly.
Principle 9 - Require senior executives to bear the risks of ownership just as shareholders do.
Principle 10 - Provide investors with value-relevant information.
3.4 What are metrics for measurement of performance ?
A) Balanced scorecard is a useful performance-management tool that helps in evolving, designing and
impleneting key performance indicators that help in measuring and managing organisational, SBU and
individual strategies.
Balanced Scorecard helps in putting together key non-financial and financial indicators that are key for
implementing enterprise, SBU and individual strategies.
The key non-financial and financial indicators are prepared based on 4 key different perspectives :
 Financial
 Customer
 Process excellence / operations / technology
 People - growth & learning
Research findings from implementation of Balanced Scorecard in India (Vikalpa Volume 30 Vol.2).
3.4.1 Provide a example of value-metric framework ?
A) One of the frameworks used is as follows :
Stock Market Performance

• total shareholder return
• market value added
Intrinsic Value
• Value of DCF
• Option value
Financial Determinants
• Return on Invested Capital
• Growth
• Cost of Capital
• Invested Capital
Value Drivers
• Market share
• Cost per Unit
• R&D projects
• Employee Productivity
3.5 What is applicable financial reporting standard that deals with definition, measurement, recognition and
disclosure of employee-related compensation ?
A) Ind AS 102 deals with the above subject.
3.5.1 What are the categories of employees covered under employee share-based payment arrangements ?
A) Individuals who render personal services to the entity and either (a) the individuals are regarded as
employees for legal or tax purposes, (b) the individuals work for the entity under its direction in the same way
as individuals who are regarded as employees for legal or tax purposes, or (c) the services rendered are similar
to those rendered by employees.
Examples - those persons having authority and responsibility for planning, directing and controlling the
activities of the entity, including non-executive directors.
3.5.2 What are key forms of employee share-based payments ?

A) An agreement between the entity (or another group entity or any shareholder of any group entity) and
another party (including an employee) that entitles the other party to receive ;
3 - Shareholder Value Creation (contd)..
(a) cash or other assets of the entity for amounts that are based on the price (or value) of equity instruments
(including shares or share options) of the entity or another group entity, or
(b) equity settlement (including shares or share options) of the entity or another group entity, provided the
specified vesting conditions, if any, are met.
3.5.3 What are key types of employee share-based payment plans ?

A) The Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations,
2021 [“SBEB and SE Regulations, 2021”] provides following categories of employee share-based payment plans :
i. Employee Stock Option Schemes;
ii. Employee Stock Purchase Schemes;
iii. Stock Appreciation Rights Schemes;
iv. General Employee Benefits Schemes;
v. Retirement Benefit Schemes; and
vi. Sweat Equity Shares.
Retrictive Stock Units will be covered under the above and Phantom Stock Plans will not be covered as they are
cash-based
3.5.4 Why are employees given share-based payment plans ?
A) The shares, options or other equity instruments are granted to employees as part of their remuneration
package, in addition to a cash salary and other employment benefits. Usually, it is not possible to measure
directly the services received for particular components of the employee’s remuneration package. It might also
not be possible to measure the fair value of the total remuneration package independently, without measuring
directly the fair value of the equity instruments granted. Furthermore, shares or share options are sometimes
granted as part of a bonus or ex-gratia arrangement, rather than as a part of basic remuneration, e.g. as an
incentive to the employees to remain in the entity’s employment or to reward them for their efforts in improving
the entity’s performance.
By granting shares or share options, the entity is paying additional remuneration that also provides a sense of
ownership to the employees and also optimises cash outgo.
3.5.5 What is vesting period for encashment of share-options ?
A) The period during which all the specified vesting conditions of a share-based payment arrangement have to
be satisfied. A vesting condition is either a service condition or a performance condition. The performance-
condition can either be a market-based condition or a non market-based condition.
3.6 Practice Questions
3.6.1 A limited issued 100 shares each to its 120 employees subject to service condition of next two years. Grant
date fair value of the share is Rs. 85 each, however the fair value of the share at the end of 1st and 2nd year is Rs.
90 and Rs. 95 respectively. Calculate expenses for year 1 and 2.
Year Vest Expense
1 1/2 100X120X90X1/2=540,000
2 2/2 100X120X95X2/2-540000= 600,000
3.6.2 ABC Limited granted to its employees, share options with a fair value of INR 5,00,000 on 1 April 20X0, if
they remain in the organization upto 31st March 20X3. On 31st March 20X1, ABC limited expects only 91% of
the employees to remain in the employment. On 31st March 20X2, company expects only 89% of the employees
to remain in the employment. However, only 82% of the employees remained in the organisation at the end of
March, 20X3 and all of them exercised their options. Calculate expenses for year 1, 2 and 3.
Year Vest Fair Value % vested Cum.Expense Expense
1 1/3 500,000 91 151,667 151,667
2 2/3 500,000 89 296,667 145,000
3 3/3 500,000 82 410,000 113,333
3.6 Practice Questions (oontd)
3.6.3 X limited issues 11000 share appreciation rights (SARs) that vest immediately to its employees on 1 April
20X0. The SARs will be settled in cash. Using an option pricing model, at that date it is estimated that the fair
value of a SAR is INR 100. SAR can be exercised any time until 31 March 20X3. It is expected that out of the total
employees, 94% at the end of period on 31 March 20X1, 91% at the end of next year will exercise the option.
Finally when these were vested i.e. at the end of the 3rd year, only 85% of the total employees exercised the
option. Calculate expenses for years 1, 2 and 3.
Year Vest Fair Value % vested Cum.Expense Expense

100 100 11,00,000 11,00,000
1 1/3 132 94 13,64,880 264,880
2 2/3 139 91 13,91,390 26,510
3 3/3 141 85 13,18,350 (73,040)
3.6.4 Global Ltd. has an invested capital of 50 million. Its return on invested capital (RoIC) is 12% and its
weighted average cost of capital is 11%. The expected growth rate in Global’s invested capital will be 20% for
first 3 years, 12% for following 2 years and 8% thereafter. Calculate Economic Profit and valuation using
Economic Profit stream.
(all amounts in Rs. Million)
Year 1 2 3 4 5 6 7
Invested Capital 50.00 60.00 72.00 86.40 96.77 108.38 117.05
NOPLAT 6.00 7.20 8.64 10.37 11.61 13.00 14.05
Cost pf Capital (in %) 11 11 11 11 11 11 11
Capital Charge 5.50 6.60 7.92 9.50 10.64 11.92 12.88
Economic Profit 0.50 0.60 0.72 0.87 0.97 1.08 1.17
Discount factor 0.9009 0.8116 0.7312 0.6587 0.5934 0.5346 0.4816
P.V. of EP = Rs 24 million. Total valuation = Rs 50 million + Rs 24 million = Rs 74 million

3.6.5 M Ltd. earns a return on equity of 25%. Its dividend payout ratio is 0.40. Equity shareholders of M Ltd.
require a return of 18%. The book value per share is 50.
(a) What is the market price per share, according to Marakon model ?
(b) If the return on equity falls to 22%, what should be the payout ratio to ensure that the market price per
share remains unchanged ?
A) - (a) r = 25%; b = 0.4; k = 18%; g = 25% * (1-0.4) = 15%
Market price = (0.25-0.15) / (0.18-0.15) * book-value = Rs 166.67 per share
(b) r = 22%
166.67 / 50 = (0.22 - g) / (0.18 - g)
30 - 166.67 g = 11 - 50 g
19 = 116.67 g; g = 16.28%
(1-b) * r = 16.28%
(1-b) = 16.28% / 22 = 0.74
Therefore, b = 0.26 or 26%
3.6.6 A new plant entails an investment of Rs 300 million (Rs 250 million in fixed assets and Rs 50 million in net
working capital). The plat has an economic life of 14 years and is expected to produce a NOPAT of Rs 21.085
million every year. After 14 years, the net working capital will be realised at par whereas fixed assets will fetch
nothing. The cost of capital for projects is 10%. The straight line method of depreciation is used.
(a) what will the ROCE be for Year 5 ? assume that the capital employed is measured at the beginning of the year
(b) What will the ROGI (GI is gross invt.) be for year 5
(c) What will the economic depreciation be for Year 5
(d) What will the CVA be for Year 5
End of Year
1 2 3 4 5
Net value of fixed assets 232.14 214.28 196.42 178.56 160.70
Investment in current assets 50 50 50 50 50
Total capital employed (book value) 282.14 264.28 246.42 228.56 210.70
Annual depreciation = Rs 250 mn / 14 yrs = Rs 17.86 mn

3.6.6 (contd)
(a) ROCE for Yr 5 = NOPAT / Capital Employed = 21.085 / 228.56 = 9.22%
(b) RoGI for Yr 5 = NOPAT + Deprn / Capital Invested = (21.085+17.86) / 300 = 12.98%
(c) Economic Deprn

Rs 250 mn = X * FVIFA(10%, 14 years); X = Rs 8.937 mn
(d) CVA for Yr 5 = (NOPAT + Deprn ) - Economic Deprn - (Cash invested * cost of Capital)
(21.085 + 17.86) - 8.937 - (300 * 10%) = 0
3.6 Practice Questions (contd)
3.6.7 M Ltd is considering a capital project for which the following information is available :
(all amounts in Rs million)
Investment outlay 5,000
Project life (in yrs.) 4 Depreciation St.Line
Salvage value 0 Tax rate 40%
Annual revenues 6,000 Debt-equity 4:5
Annual costs (excluding deprn, 4,000 Cost of equity 18%
interest and taxes)
Cost of debt (post-tax) 9%
(a) Calculate EVA of project over its life

(b) Calculate NPV of the project
3.6.7 (contd)
Cost of capital = 4/9 * 9% + 5/9 * 18% = 14%
1 2 3 4
Revenues 6,000 6,000 6,000 6,000
Costs (4,000) (4,000) (4,000) (4,000)
PBDIT 2,000 2,000 2,000 2,000
Depreciation (1,250) (1,250) (1,250) (1,250)
PBIT 750 750 750 750
NOPAT (750 - 40%) 450 450 450 450
Cash profit 1,700 1,700 1,700 1,700
Capital balance 5,000 3,750 2,500 1,250
WACC * capital balance 700 525 350 175
EVA = NOPAT - Capital Charge (250) (75) 100 275
3.6.7 (contd)
NPV of Cashflows
1 2 3 4
Cash profit 1,700 1,700 1,700 1,700
Discount factor (1/1.14) (1/1.14)^2 (1/1.14)^3 (1.1.14)^4
Discounted cashflow 1,491 1,308 1,148 1,006
NPV (5,000) - 4,953 = (46)
3.6.8 Income Statement for Yr 0 (year which has just ended) and balance sheet at end of Yr 0 for F Ltd are as
follows : (Rs mn)
Income Statement Balance Sheet
Sales 10,000 Equity 6,000 Fixed assets 4,000
Gross margin (20%) 2,000 Current assets 2,000
Selling and general admn.(10%) (1,000) 6,000 6,000
Profit before tax 300
Tax 700
Sales will remain constant at 10,000. %s of gross margin and selling OH to sales are same.
Depreciation will be equal to new investment
Asset turnover ratio will remain constant
Discount rate will be 15%
Tax rate will be 30%
3.6.8 (contd)
If F Ltd adopts a new strategy, its sales will grow at at a rate of 20% per year for 3 years. The margins, turnover
ratios, capital structure, income tax rate and discount rate will remain unchanged. Depreciation charge will be
equal to 10% of the net fixed asset at the beginning of the year.
What value will the new strategy create ?
A) Value of Existing Strategy
Profit after tax / Cost of Capital
= Rs 700 mn / 0.15
= Rs 4,667 mn
B) Value of New Strategy
Description Yr 1 Yr 2 Yr 3 Residual
Sales 12,000 14,400 17,280 17,280
Gross margin (20%) 2,400 2,880 3,456 3,456
Selling, general expenses (10%) (1,200) (1,440) (1,728) (1,728)
Profit before tax 1,200 1,440 1,728 1,728
Tax (360) (432) (518) (518)
Profit after tax 840 1,008 1,210 1,210
Balance Sheet Projections
Fixed assets (0.4 of sales) 4,800 5,760 6,912 6,912
Current assets (0.2 of sales) 2,400 2,880 3,456 3,456
Total assets 7,200 8,640 10,368 10,368
Equity 7,200 8,640 10,368 10,368
Cashflow Projections
Profit after tax 840 1,008 1,210 1,210
Depreciation (10% of opening FA) 400 480 576 690
Capital expenditure (change in net block + deprn.) (1,200) (1,440) (1,728) (690)
Net working capital (400) (480) (576) -
Operating cashflows (360) (432) (518) 1,210

Discount factor 0.8696 0.7561 0.6575 0.5718
Present value of operating cashflows (313) (327) (340)
Residual value (1,210 / 0.15) 8,064
Present value of Residual Value 8,064 / (1.15)^3 5,300
Total shareholder value of new strategy (5,300 - 980) = 4,320
Shareholder value of new strategy = 4,320

Shareholder value of existing strategy = 4,667
Implementation of new strategy will cause decline in shareholder value

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Syllabus

Strategic Financial Management Hours: 08

Introduction, Constituents, Financial planning, Capital allocation and Corporate strategy

Value Metrics Hours: 10

Corporate Restructuring Hours: 10

Mergers and Acquisitions Hours: 15

Challenges in Strategic Financial Management Hours: 15

1.3.4 Leadership skills

1.5.2 - Internal influences

1.7.1 - Type of Entity

2 important behavioural theories on dividends :

Component of Capital Capital Structure A Capital Structure B

Average cost of debt is fixed at 10%; tax-rate is 50%. Calculate :

Mathematical formula RoE = RoI + (RoI-r) * (D/E) * (1-t)

1.11.1 What is corporate strategy ?

1.11.1.1 Whar are the types of overall strategy for a business ?

Sources of Competitive Advantage

 Discount for acquiring minority-lots of equity shares

Item of Asset Valuation considerations (in the case of going concern)

Item of Valuation considerations (in the case of going concern)

ii) Computing Market Multiples

iii) Adjustments to the market multiple

2.4.2 When is the DCF method best-suited for valuing a business ?

2.4.4 How is FCFF used to estimate value of the business ?

(source - ICAI, copyrights reserved by ICAI)

Key steps in valuation are :

Key steps in valuation are :

2.8.2 - What is a generally accepted functional classification of intangible assets ?

2.8.3.2 - Explain key principles used in valuation using “Relief-from-Royalty” Method ?

Further, not all costs are incurred wisely, efficiently, or successfully.

1) Value of Company = Earnings per Share * PE Ratio

6) Adjustment of equity-beta to asset-beta

Step 2 - ßa = ße × (Ve / Ve + Vd (1 – T)) based on target-gearing

Step 3 (CAPM method) - Ke = Rf + ß (Rm – Rf)

Calculate under Net Assets method

2.9.4 You are given the following information about a company

Description Base Year

Description High-Growth Stable-Growth Phase

S No. Description 1 2 3 4 5 Terminal

P.V of FCFF during explicit forecast period is :

P.V of terminal value

Total value of Firm = Rs 39.74 crs. + Rs 218.82 crs. = Rs 258.57 crs.

Description Amount (Rs.)

Calculate value of intangible asset using Multi-Period Excess earnings method.

Stock Market Performance

3.5.2 What are key forms of employee share-based payments ?

3.5.3 What are key types of employee share-based payment plans ?

Year Vest Fair Value % vested Cum.Expense Expense

P.V. of EP = Rs 24 million. Total valuation = Rs 50 million + Rs 24 million = Rs 74 million

Annual depreciation = Rs 250 mn / 14 yrs = Rs 17.86 mn

(c) Economic Deprn

(a) Calculate EVA of project over its life

Tax (360) (432) (518) (518)

Profit after tax 840 1,008 1,210 1,210

Balance Sheet Projections

Fixed assets (0.4 of sales) 4,800 5,760 6,912 6,912

Current assets (0.2 of sales) 2,400 2,880 3,456 3,456

Total assets 7,200 8,640 10,368 10,368

Equity 7,200 8,640 10,368 10,368