Paper18 Solution

Answer to PTP_Final_Syllabus 2008_Jun 2015_Set 2
Paper-18: BUSINESS VALUATION MANAGEMENT
Time Allowed: 3 Hours Full Marks: 100
The figures in the margin on the right side indicate full marks.
Answer Question No. 1 which is compulsory carrying 25 marks and any five from the rest.
Working Notes should form part of the answer.
“Whenever necessary, suitable assumptions should be made and indicated in answer by the
candidates.”
1. (a) Fill in the blanks by using the words/phrases given in the brackets: [1x10=10]
(i) Key to income-based approach of valuation is ------------- (capitalization rate/
internal rate of return)
(ii) β factor does not measure ---------------- risk (systematic/unsystematic).
(iii) Super profit is the excess of future maintainable profits over -----------------
expected profits (normally/abnormally).
(iv) The value of the patent does not show up if it is …………… generated.
(internally/externally).
(v) The risk that the cash flows will not be delivered is called --------------- (liquidity
risk/default risk).
(vi) Organizational capital is a ------------- component of intellectual capital
(primary/secondary).
(vii) A real estate investment trust is -------------- investment company that invests only
in real estate (closed-end/opened-end).
(viii) ----------- takes place when a healthy company merges into a financially weak
company (merger/reserve merger).
(ix) The price paid by the option buyer to the option seller to acquire the right to buy or
sale is ------------------ (Strike Price/ Option Premium).
(x) ----------- implies risk arising from debtors default on financial claim (default
risk/credit risk).
(b) In each of the questions given below one out of the four options is correct. Indicate the
correct answer: [2×5=10]
(i) RIL (FV `10) quotes `520 on NSE, and 3 months future price quoting at NSE is `542,and
one month borrowing rate is given as 15%.The price of 3-month RIL futures is
a) 539.50
b) 598
c) 578.50
d) 545
Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 1
(ii) S & Co. earns `12 per share, capitalization rate of 10% and has a return on investment
at the rate of 20%. According to Walter’s model price per share at 30% dividend
payout ratio will be
a) `212
b) `204
c) `220
d) `224
(iii) A bank borrowed call money for 3 days in the overnight call money market and paid
`152345 for these 3 days on a borrowing of `40 crores. The implied call money rate
will be
a) 4.61%
b) 4.63%
c) 4.65%
d) 4.67%
(iv) A convertible bond with a face value of `1,000 issued at `1,300 with a coupon rate of
12%.The conversion rate is 20 shares per bond. The current market price of the bond
is `1,500 and that of stock is `60.The conversion value premium is
a) 15%
b) 18%
c) 20%
d) 25%
(v) A wishes to sell his business and his business has been good. Revenues are growing
each year. He desires to pick a best offer and have patience till he gets best price. In
this situation on which basis he should value his business
a) Book Value
b) NPV of future earnings
c) Auction value
d) Fair Market Value
(c) State whether the following statements are true or false: [1x5=5]
(i) Horizontal mergers are also known as conglomerate mergers.
(ii) A market is efficient when trading oriented strategies can beat the market.
(iii) Industrial groups are inherently less conservative than investors in allocating
resources.
(iv) A levered portfolio provides increasing returns with increased risk.
(v) In constant growth model, the value of equity share is sensitive to growth rates.
Answer:
1. (a)
(i) Capitalization rate
(ii) Unsystematic
(iii) Normally
(iv) Internally
(v) Default risk
(vi) Primary
(vii) Closed-end
(viii) Reverse Merger
(ix) Option Premium
(x) Credit Risk
(b)
(i) `539.50
Hints: Future’s Price = Spot + Cost of Carry – Dividend
F = 520 + 520 x 0.15 x 0.25 – 0 = 539.50
(ii) `204
Hints: As per Walter Model P =

D + (E - D)
r
k
=
 0.20 
 3.60+ 0.10(12-3.60 
 
= 204
k 0.10
(iii) 4.63%
3 r
Hints: Interest for 3 days = 40 Crores x x = `1,52,345
365 100
r = 4.63%
(iv) 25%
Hints: Conversion rate is 20 shares per bond. Market price of share ` 60.
Conversion Value 20 x ` 60 = ` 1,200.
Market price of bond = ` 1,500
300
Premium over Conversion Value (`1,500 – `1,200) = x100 = 25%
1,200
(v) Fair Market Value
(c)
(i) False
(ii) False
(iii) False
(iv) True
(v) True
2. (a) XYZ Ltd. has a capital of ` 10,00,000 in equity shares of ` 100 each. The shares are
currently quoted at par. The company proposes to declare a dividend of `10 per share at
the end of the current financial year. The capitalization rate for the risk class of which the
company belongs is 12%. What will be the market price of the share at the end of the
year, if
(i) a dividend is not declared?
(ii) a dividend is declared?
(iii) assuming that the company pays the dividend and has net profits of `5,00,000 and
makes new investments of `10,00,000 during the period, how many new shares must
be issued? Use the MM model.
(b) Khan Ltd. furnishes the following information relating to the previous three years, and
requests you to compute the value of the brand of the company.
[ ` in lakhs]
Particulars 2012 2013 2014
Profits Before Interest and Tax 75.00 100.00 150.00
Loss on Sale of Assets 3.00 10.00 18.00
Non Operating Income 12.00 12.00 8.00
Inflation was 10% for 2013 and 12% for 2014. If the capitalisation factor considering
internal and external value drivers to the brand is 15, determine the brand value. Assume
an all inclusive future tax rate of 40%. [(2+2+4)+7]
Answer:
1
(a) As per MM model, the current market price of equity share is: P = x(D1 +P1)
0 1+ k
e
(i) If the dividend is not declared:
1
100 = (0 +P1)
1+ 0.12
P
100 = 1
1.12
P1 = ` 112
The Market price of the equity share at the end of the year would be `112.
(ii) If the dividend is declared:

1
100 = (10 +P1)
1+ 0.12
10 + P1
100 =
1.12
112 = 10 + P1
P1 = 112 – 10 = ` 102
The market price of the equity share at the end of the year would be ` 102.
(iii) In case the firm pays dividend of ` 10 per share out of total profits of ` 5,00,000 and
plans to make new investment of ` 10,00,000, the number of shares to be issued may
be found as follows: `
Total Earnings 5,00,000
Less: Dividends paid 1,00,000
Retained earnings 4,00,000
Total funds required 10,00,000
Fresh funds to be raised 6,00,000
Market price of the share 102
Number of shares to be issued (` 6,00,000/102) 5,882.35
Or, the firm would issue 5,883 shares at the rate of ` 102
(b)
Particulars 2012 2013 2014
Profits Before Interest and Tax 75.00 100.00 150.00
Add: Loss on Sale of Assets 3.00 10.00 18.00
Less: Non Operating Income (12.00) (12.00) (8.00)
Branded Earning 66.00 98.00 160.00
Inflation Adjustment Factor 1.10 x 1.12 = 1.23 1.12 1.00
Inflation Adjusted Earnings as at 31.03.2012 81.18 109.76 160.00
Weights 1 2 3
Product 81.18 219.52 480.00
Weighted Average Earnings Before [(81.18 + 219.52 + 480)/(1+2+3)] 130.12
Less: Taxes at 40% (52.05)
Weighted Average Brand Earnings After 78.07
Capitalisation Factor 15
Brand Value `1,171.05
lakhs
3. (a) From the following particulars of three companies, ascertain the value of goodwill. Terms
and conditions are as follows:
(i) Assets are to be revalued.
(ii) Goodwill is to be valued at four years’ purchase of average super profits for three
years. Such average is to be calculated after adjustment of depreciation at 10% on
the amount of increase/decrease on revaluation of fixed assets. Income tax is to be
ignored.
(iii) Normal profit on capital employed is to be taken at 10%, capital employed being
considered on the basis of net revalued amounts of tangible assets.
The summarized Balance Sheets and relevant information are given below: (` in lakhs)
Liabilities P Ltd. Q Ltd. R Ltd. Assets P Ltd. Q Ltd. R Ltd.
Equity shares of `10 each 12.00 14.00 6.00 Goodwill - 1.00 -
Reserves 2.00 1.00 2.00 Net tangible block 16.00 12.00 10.00
10% Debentures 4.00 - 2.00 Current assets 6.00 5.00 2.00
Trade & expense creditors 4.00 3.00 2.00
Total 22.00 18.00 12.00 Total 22.00 18.00 12.00
P Ltd. Q Ltd. R Ltd.

(`) (`) (`)
Revaluation of tangible block 20,00,000 10,00,000 12,00,000
Revaluation of current assets 7,00,000 2,80,000 1,60,000
Average annual profit for three years before 3,60,000 2,88,000 1,56,000
charging debenture interest
[7]
(b) Consider a bond portfolio comprising of a zero coupon bond, 8% coupon bond and a
10% coupon bond (all with 10years to maturity). All have a face value of `1000. The
current prices of these bonds are `463.19, `1000 and `1134.20 respectively. If the yield
over the next 1 year period is likely to stay at 8%, what is the current value of the portfolio
and what will be the portfolio value at the end of next year? Calculate the individual
return earned on each bond? [8]
Answer:
3. (a)
Valuation of Goodwill
(`) (`) (`)
Average annual profit after charging debenture interest 3,20,000 2,88,000 1,36,000
Less/Add: Depreciation on amount increased/
decreased on revaluation (40,000) 20,000 (20,000)
2,80,000 3,08,000 1,16,000
Less: Normal profit at 10% on capital employed as
calculated in working note (1,90,000) (98,000) (96,000)
Super Profit 90,000 2,10,000 20,000
Goodwill valued at four years’ purchase of super profits 3,60,000 8,40,000 80,000
Working Note:
Calculation of Capital Employed
(`) (`) (`)
Tangible fixed assets 20,00,000 10,00,000 12,00,000
Current assets 7,00,000 2,80,000 1,60,000
27,00,000 12,80,000 13,60,000
Less: Debentures and Creditors (8,00,000) (3,00,000) (4,00,000)
19,00,000 9,80,000 9,60,000
(b) The zero coupon bond if discounted with 8% for the next 9 years would give us value at
the end of 1 year to be = ` 500.25. Secondly the 8% bond is currently quoting at ` 1,000. It
would continue to quote at ` 1000 because the yield is slated to remain at 8% = coupon
rate. In contrast, the 10% bond is currently quoting at ` 1134.20. It would quote cheaper
at ` 1124.94. This can be calculated as follows:
Price at the end of 1 year = ` 100 x PVIFA (8%,n) + ` 1000 x PVIF (8%,n) = `1124.94
Zero coupon 8% coupon 10% coupon Portfolio Value
Current prices ` 463.19 ` 1000 ` 1134.20 ` 2597.39
Price one year from now ` 500.25 ` 1000 ` 1124.94 ` 2625.19
Price increase ` 37.06 ` 0.00 -`9.26 ` 27.80
Coupon income ` 0.00 ` 80.00 ` 100.00 ` 180.00
Income ` 37.06 ` 80.00 ` 90.74 ` 207.80
Rate of Return 8.00% 8.00% 8.00% 8.00%
We therefore get a portfolio Value of ` 2597.39 now and ` 2625.19 a year later. With a
overall capital gain of ` 27.80 and overall coupon income of ` 180.00 we have overall
return of 8% on the portfolio. Note that this is equal to the yield we expect over the next
one year.
4. (a) D.K. International Ltd. is developing a new production process. During the financial year
ending 31st March, 2014, the total expenditure incurred was `50 lakhs. This process met
the criteria for recognition as an intangible asset on 1st December, 2013. Expenditure
incurred till this date was `22 lakhs. Further expenditure incurred on the process for the
financial year ending 31st March, 2015 was `80 lakhs. As at 31st March, 2015, the
recoverable amount of know-how embodied in the process is estimated to be `72 lakhs.
This includes estimates of future cash outflows as well as inflows.
You are required to calculate:

(i) Amount to be charged to Profit and Loss A/c for the year ending 31 st March, 2014 and
carrying value of intangible as on that date.
(ii) Amount to be charged to Profit and Loss A/c and carrying value of intangible as on
31st March, 2015.
Ignore Depreciation. [3+3]
(b) Sun Pharma with its need to grow and maintain its leadership position in the pharma
industry is planning to acquire ABTCPL. The recent financial details of the two companies
are as follows:
Particulars Sun Pharma ABTCPL
PAT `2200 lakhs `40 lakhs
MPS(FV`10) `200 `24
P/E Ratio 18.18 12
Projected Growth Rates(p.a.) 9% 5%
There are two views expressed by two leading consultants on the benefits due to
Synergy, one arguing that there can be no benefit from synergy while the other projects
a 3% increase in earnings after the acquisition.
(i) If ABTCPL’s shareholders want an exchange ratio of 0.4 ( i.e. 4 shares for every 1 share
of ABTCPL), would that be acceptable to the shareholders of Sun Pharma, if
1. There is no synergy due to merger.
2. There is an increase in earnings of the merged entity by 3% due to synergy.
(ii) If Sun Pharma accepts an exchange ratio of 0.4 and synergy benefits are not realized,
will there be any dilution in EPS of Sun Pharma? If so, when will the dilution be wiped
off? [5+4]
Answer:
4. (a) As per AS 26 ‘Intangible Assets’
(i) For the year ending 31.03.2014

(1) Carrying value of intangible as on 31.03.2014:
At the end of financial year 31st March 2014, the production process will be
recognised (i.e., carrying amount) as an intangible asset at a cost of ` 28 lakhs
(expenditure incurred since the date the recognition criteria were met, i.e., from
1st December 2013).
(2) Expenditure to be charged to Profit and Loss Account:
The ` 22 lakhs is recognised as an expense because the recognition criteria were
not met until 1st December 2013. This expenditure will not form part of the cost of
the production process recognised in the balance sheet.
(ii) For the year ending 31.03.2015.

(1) Expenditure to be charged to Profit and Loss account.
(` in lakhs)
Carrying amount as on 31.03.2014 28
Expenditure during 2013-2015 80
Total book cost 108
Recoverable Amount (72)
Impairment loss 36
` 36 lakhs to be charged to Profit and Loss Account for the year ending
31.03.2015.
(2) Carrying value of intangible as on 31.03.2015

(` in lakhs)
Total Book Cost 108
Less: Impairment loss (36)
Carrying amount as on 31.03.2014 72
(b) (i) The shareholders of Sun Pharma would not like their existing EPS to go down. So, they
would at least prefer current EPS of 200/18.18= ` 11.
1. Without synergy
Using the given data and equating it to ` 11.
EPSsNs +EPS N 200
A A = EPS = = ` 11
Ns +ER(N ) SA 18.18
A
Where, EPSA = 24/12 = ` 2, Ns= 2200/11 = 200 lakhs, NA = 40/2 = 20 lakh
Therefore
11x 200 lakh + 2 x 20 lakh
` 11 = Therefore, ER = 0.182
200 lakh + ER (20 lakh)
2. With Synergy
EPSsNs +EPSANA  x1.03 200
= EPS = = ` 11
Ns +ER(N ) SA 18.18
A
Therefore
11x 200 lakh + 2 x 20 lakh x 1.03
` 11 = Therefore, ER = 0.487
200 lakh + ER (20 lakh)
So, Sun Pharma shareholders would accept at least the average of these ER.
= 0.5 x 0.182 + 0.5 x 0.487 = 0.335
So, ABTCPL’s demand for ER of 0.4 will not be acceptable to Sun Pharma.
(ii) Projected EPS of the merged entity

EPSsNs +EPSANA  x 1+g
= EPS = Projected EPS of the merged entity
Ns + 0.4(N ) SA
A
200 x 1.09 + 24 x 1.05
‘g’ of the merged entity = - 1 = ` 8.57%
200 + 24
11x 200 lakh + 2 x 20 lakh x 1.0857
Projected EPS = = ` 11.7
200 lakh + 0.4 (20 lakh)
Without merger EPSs = ` 11 x 1.09 = ` 11.99
Dilution =
11.99 -11.70 = 2.42%
11.99
The shareholders of Sun Pharma will never be able to wipe off the dilution since the
‘g’ of the merged entity is lower than the pre-merger growth rate. So only if the
prediction of synergy works and ‘g’ earnings growth rate increases beyond 9% then
only the shareholders can hope for wiping off the dilution of share value.
5. (a) Yahoo is considering the acquisition of Bookpad in a stock-for-stock transaction in which

Bookpad would receive ` 85 for each share of its common stock. Yahoo does not expect
any change in its price/earnings ratio multiple after the merger and chooses to value the
Bookpad conservatively by assuming no earning growth due to synergy.
Calculate
(i) The purchase price premium
(ii) The exchange ratio
(iii) The number of new shares issued by Yahoo
(iv) Post- merger EPS of the combined firms
(v) Pre-merger EPS of the Yahoo
(vi) Pre-merger P/E ratio
(vii) Post merger share price
(viii) Post merger equity ownership distribution
The following additional information is available

Yahoo Bookpad
Earnings `2,50,000 `72,500
Number of Shares 1,10,000 20,000
Market price per share `52 `64
Also comment on the results. [1+1+1+1+1+1+1+1+2]
(b) From the following details, compute according to Lev and Schwartz (1971) model, the
value of the skilled employees.
Skilled
Annual average earning of an employee till the retirement age `50,000
Age of retirement 65 years
Discount rate 15%
No. of employees in the group 20
Average age 62 years
[5]
Answer:
5. (a) (i) Purchase price premium = Offer price for Bookpad stock / Bookpad Market price per
share = 85 / 64 = 1.328 or 33% app.
(ii) Exchange ratio = Price per share offered for Bookpad / market price per share for
Yahoo = 85 / 52 = 1.6
Yahoo issues 1.6 shares of stock for each of Bookpad’s stock.
(iii) New shares issued by Yahoo = Shares of Bookpad x Exchange ratio

= 20,000 x 1.6 = 32,000
(iv) Post-merger EPS of the combined companies = Combined earning / Total number of
share.
Combined earnings = ` (2,50,000 + 72,500)
= ` 3,22,500
Total shares outstanding of the new entity

= 1,10,000 + 32,000 = 1,42,000
= ` 2.271
(v) Pre-merger EPS of Yahoo

= Earnings / Number of shares
= `2,50,000 / 1,10,000 = ` 2.273
(vi) Pre-merger P/E = Pre-merger market price per share / Pre-merger earnings per share
= 52/2.273 = 22.87
(vii) Post-merger share price = Post-merger EPS x Pre-merger P/E

= 2.271x22.87=` 51.94 (as compared to ` 52 Per-merger)
(viii) Post-merger Equity Ownership Distribution

Bookpad = Number of new shares / Total number of shares
= 32,000 / 1,42,000 = 0.2253 or 22.53%
Yahoo = 100 – 22.53 = 77.47%
Comment – The acquisition results in a ` 0.06 reduction in the market price of the Yahoo
due to a 0.002 decline in the EPS of the combined companies. Whether the acquisition is
a poor decision depends upon what happens to the earnings would have in the
absence of the acquisition, the acquisition may contribute to the market value of the
acquiring company.
(b) According to Lev and Schwartz, the value of human capital embodied in a person of
age is the present value of his remaining future remaining future earnings from
employment. Their valuation model for a discrete income stream is given by the following
formula:
t I(t)
V= 
t r (1+r)t r
Where,
V = the human capital value of a person years old.
I(t) = the person’s annual earnings up to retirement.
r = a discount rate specific to the person.
t = retirement age.
Value of skilled employees:

50,000 50,000 50,000
= + +
(65-62) (65-63) (65-64)
(1+ 0.15) (1+ 0.15) (1+ 0.15)
` 32,875.81 + ` 37,807.18 + ` 43,478.26 = ` 1,14,161.25
Total value of skilled employees is ` 1,14,161.25 x 20 = ` 22,83,225.
6. (a) How do you value acquired brand? [5]
(b) The following information is given for 2 companies that are identical except for their
capital structure:
RED BLUE
Total Invested Capital 1,00,000 1,00,000
Debt/Asset Ratio 0.8 0.5
Shares Outstanding 6,100 8,300
Pre Tax Cost of Debt 16% 13%
Cost of Equity 26% 22%
Operating Income(EBIT) 25,000 25,000
Net Income 8,970 12,350
The tax rate is uniform 35% in all cases.

(i) Compute the weighted average cost of capital for each company.
(ii) Compute the Economic Value Added (EVA) for each company.
(iii) Based on the EVA, which company would be considered for best investments?
(iv) If the industry PE ratio is 11, estimate the price for the share of each company.
(v) Calculate the estimated market capitalization for each of the companies.
[2+2+1+3+2]
Answer:
6. (a) A purchased brand is one, which is acquired from other existing concerns. The acquiring
company may acquire only the brand names. The value of acquired brands is given
below:
Brand value=Price paid for acquisition.
On the other hand, a company may acquire an existing business concern along with its
brands. It happens in case of mergers & acquisitions. The sum involved in these
transactions provides an indication of the financial value of brands. In this case;
Brand value=Purchase consideration(x)-Net assets acquired(y).
Does excess price always represent brand value? (X-Y) represents the amount of
purchased goodwill but acquiring company might have paid excess price for varied
factors also. Those are;
Location of the factory;

Long term contracts with suppliers;
Better manufacturing technology etc.
Competitive force may make the acquirer to increase the bid price thereby increasing
the amount of purchased goodwill. This inseparability of brand from other intangible
assets makes it difficult to value brands.
(b) (i) Computation of WACC of each company:

RED BLUE
Wd 0.8 0.5
Kd 10.4 8.45
We 0.2 0.5
Ke 26 22
WACC [Wd × Kd + We × Ke] 13.52 15.225
(ii) Computation of Economic Value Added (EVA) for each company:

RED BLUE
WACC 13.52 15.225
Invested Capital 100000 100000
EBIT 25000 25000
NOPAT 16250 16250
EVA 2730 1025
(NOPAT – WACC x Invested Capital)
(iii) Based on the EVA, RED considered for best investments.
(iv) If the industry PE ratio is 11, calculation of price for the share of each company:
RED BLUE
Shares 6100 8300
Net Income 8970 12350
EPS 1.47 1.49
Price [P/E × EPS] 16.17 16.37
[where (P/E = 11)]
(v) Calculation of the estimated market capitalization for each of the companies:
RED BLUE
Shares 6100 8300
Price [P/E × EPS] 16.17 16.37
Market Cap 98637 135871
7. (a) List the reasons why companies are going for restructuring? [6]
(b) Describe the progress made by India so far in the field of human resource accounting.
[5]
(c) List the applications of DCF Valuation? [4]
Answer:
7. (a) There are basically six reasons why companies are going for restructuring:
(1) The globalization of business has compelled Indian companies to open new export
houses to meet global competition. Global market concept has necessitated many
companies to restructure because lowest cost producers only can survive in the
competitive global market.
(2) Changed fiscal and government policies like deregulation/decontrol has led many
companies to go for newer market and customer segments.
(3) Revolution information technology has made it necessary for companies to adapt
new changes in the communication/information technology for improving corporate
performance.
(4) Many companies have divisionalised into smaller businesses. Wrong divisionalisation
strategy has led to revamp themselves. Product divisions which do not fit into the
company's main line of business are being divested. Fierce competition is forcing
Indian companies to relaunch themselves.
(5) Improved productivity and cost reduction has necessitated downsizing of the work
force-both at works and managerial level.
(6) Convertibility of rupee has attracted medium-sized companies to operate in the
global market.
(b) Human resource accounting can be defined as the process of indentifying, measuring
and communicating information about human resources in financial statements in order
to facilitate effective management. Human resource accounting is a recent
phenomenon in India. Leading public sector units like OIL, BHEL, NTPC, MMTC and SAIL
etc. have started reporting Human Resources in their annual reports as additional
information. The Indian companies basically adopted the model of human resource
valuation as advocated by Lev and Schwartz (1971). Indian Companies focused their
attention on the present value of employee earning as a measure of their human
capital. However the Indian Companies have suitably modified the Lev and Schwartz
model to suit their individual circumstances.
(c) Application of DCF Valuation:

(1) DCF valuation approach is the easiest to use for assets or firms with the following
characteristics:
cash flows are currently positive the cash flows 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.
(2) DCF approach is also attractive for investors who have a long time horizon, allowing
the market time to correct its valuation mistakes and for price to revert to "true" value,
or those who are capable of providing the needed thrust as in the case of an
acquirer of a business.
8. (a) Write a short note on Accounting for investment by a holding company in subsidiaries. [7]
(b) The following table contains expected returns estimated from historical data, required
returns from the CAPM, the covariance of the security with the true market portfolio, and
the security’s beta.
Stock Expected Required return Covariance Beta Overvalued or

Return % from CAPM % with Market Undervalued
Stock X 19.0 17.000 0.40 1.000 ?
Stock Y 16.0 12.875 0.25 ? ?
Stock Z 25.5 ? ? 2.000 ?
Risk-Free T-Bill 6.0 6.000 0 0
Using the CAPM formulas, assuming the CAPM is true and assuming the market variance
is 0.40, fills in all the blanks. Assuming the CAPM is true, which investment(s) would you
choose to invest in? Why? [8]
Answer:
8. (a) Investments by a holding company in the shares of its subsidiary company are normally
considered as long term investments. Indian holding companies show investment in
subsidiary just like any other investment and generally classify it as trade investment. As
per AS 13 'Accounting for Investments', investments are classified as long term and
current investments. A current investment is an investment that by its nature is readily
realizable and is intended to be held for more than one year from the date of
acquisition. A long term investment is one that is not a current one.
Costs of investment include besides acquisition charges, expenses such as brokerage,

fees and duties. If an investment is acquired wholly or partly by an issue of shares or other
securities, the acquisition cost is determined by taking the fair value of the shares/
securities issued. If an investment were to be acquired in exchange - part or whole - for
another asset, the acquisition cost of the investment is determined with reference to the
value of the other asset exchanged. Dividends received out of income earned by a
subsidiary before the acquisition of the shares by the holding company and not treated
as income but treated as recovery of cost of the assets (investment made in the
subsidiary). The carrying cost for current investment is the lower of cost or fair/market
value whereas investment in the shares of the subsidiary (treated as long term) is carried
normally at cost.
(b) Stock X is undervalued as it provides more returns than CAPM returns. (19% > 17%).
σsm 0.25
For stock Y, we have β = = = 0.625 .CAPM returns of stock Y is less than
2 0.40
σm
expected returns, indicating stock is under-valued.
For stock Z, we need to find CAPM returns for which we use same Rm as that of Stock X.
i.e., 17%. This is because stock X has same beta as that of market. = 1. Thus, we get,
E(Rc) = 0.06 + 2(0.17 – 0.06) = 28%. We can find the covariance using the same formula
σcm σcm
used above i.e., β = = = 2.0 , i.e. σcm = 2 x 0.40 = 0.80. Now, Stock Z is
2 0.40
σm
overvalued as it provides less return than CAPM return. (25.5% < 28%).
Thus, stocks X and Y are undervalued according to the CAPM, thus, these investments
should be chosen as their prices will increase for equilibrium to be restored.

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Answer to PTP_Final_Syllabus 2008_Jun 2015_Set 2

Paper-18: BUSINESS VALUATION MANAGEMENT

Time Allowed: 3 Hours Full Marks: 100

Hints: As per Walter Model P =

(v) Fair Market Value

(ii) If the dividend is declared:

P Ltd. Q Ltd. R Ltd.

You are required to calculate:

4. (a) As per AS 26 ‘Intangible Assets’

(i) For the year ending 31.03.2014

(ii) For the year ending 31.03.2015.

(2) Carrying value of intangible as on 31.03.2015

(ii) Projected EPS of the merged entity

5. (a) Yahoo is considering the acquisition of Bookpad in a stock-for-stock transaction in which

The following additional information is available

Also comment on the results. [1+1+1+1+1+1+1+1+2]

(iii) New shares issued by Yahoo = Shares of Bookpad x Exchange ratio

Total shares outstanding of the new entity

(v) Pre-merger EPS of Yahoo

(vii) Post-merger share price = Post-merger EPS x Pre-merger P/E

(viii) Post-merger Equity Ownership Distribution

Value of skilled employees:

6. (a) How do you value acquired brand? [5]

The tax rate is uniform 35% in all cases.

Location of the factory;

(b) (i) Computation of WACC of each company:

(ii) Computation of Economic Value Added (EVA) for each company:

(iii) Based on the EVA, RED considered for best investments.

(c) Application of DCF Valuation:

Stock Expected Required return Covariance Beta Overvalued or

Costs of investment include besides acquisition charges, expenses such as brokerage,

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