Project Report On
“BUSINESS VALUATION”
Submitted by
DINESH.N.DIKONDA PGDM Academic Year 2013-14
Under the Guidance of
Prof. Kirandeep Kaur Anand
In fulfillment of Post-Graduation Diploma in Management
Guru Nanak Institute Of Management Studies
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Supervisor’s Certificate
I, certify that the dissertation entitled “Business valuation” an original work by Dinesh.N.Dikonda of Guru Nanak Institute of Management Studies of Semester # 04 completed the Final project. Under me in the academic year 2013-14.The information submitted is authentic to the best of my knowledge.
Name of the Guide:
Signature of Project Guide
Signature of Director
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Declaration
I, the Dinesh.N.Dikonda of PGDM Finance Guru Nanak Institute of Management Studies Semester # 04 hereby declare that I have completed this project on,
“BUSINESS VALUATION”
In the academic year 2013-14 Under My Project Guide: Prof. Kirandeep Kaur Anand Faculty of GNIMS Guru Nanak Institute of Management Studies The Information Submitted is true and original to Best of Our Knowledge
Date: 01/03/2013 Place: Mumbai Roll No.: 09
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“BUSINESS VALUATION”
A PROJECT SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS MANAGEMENT FOR POST GRADUATION DIPLOMA IN
2011 - 2013
Name of the Student: Dinesh.N.Dikonda
Roll No #09
Name of the Institute: Guru Nanak Institute of Management Studies
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PROJECT GUIDE CERTIFICATE FORM I, Dinesh.N.Dikondaundersigned Roll No # 09 studying in the Second Year of PGDM is doing my project work under the guidance of Kirandeep Ma’am wish to state that I have met my internal guide on the following dates mentioned below for Project Guidance:-
Sr. No. 1. 2. 3. 4. 5. 6. 7. 8.
Date Jan 8 Jan 14 Feb 9 Feb 19 Feb 21 Feb 23 Feb24 Feb 25
Signature of the Internal Guide
____________________________
__________________________
Signature of the Candidate
Signature of Internal Guide
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N.B.: The candidate should retain the Project Guide Certificate Form and submit the same while submitting the Project to the Institute i.e. on or before 1st March 2013.
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TABLE OF CONTENT
Sr.no
Particulars
Page no
01. 02. 03.
INTRODUCTION LITERATURE REVIEW INDUSTRY PROFILE, COMPANY PROFILE & SWOT ANALYSIS
08 30 37
04. 05. 06. 07.
OBJECTIVES AND SCOPE DATA ANALYSIS CONCLUSION SUGGESTION
46 47 62 63
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INTRODUCTION
WHAT IS VALUE? Value is the „worth? of a thing. It can also be defined as „a bundle of benefits? expected from it. It can be tangible or intangible. Value is defined as: a. The worth, desirability, or utility of a thing, or the qualities on which these depend b. Worth as estimated c. The amount for which a thing can be exchanged in the market d. Purchasing power e. Estimate the value of, appraise (professionally)
Valuation is defined as: • Estimation (esp. by professional valuer) of a thing?s worth • Worth so estimated • Price set on a thing HOW IS VALUE DIFFERENT FROM COST AND PRICE? Cost is defined as „resources sacrificed to produce or obtain a thing, (a product or service). Price is what is charged by a seller or provider of product or service. Many a time, it is a function of market forces. Oscar Wilde said, “A cynic is one who knows the price of everything and the value of nothing”. DIFFERENT CONNOTATIONS OF VALUE: Value, like „utility?, has different connotations in different contexts, and may vary from person, place and time. It can range from a precise figure to something bordering on sentimental or emotional, or even the absurd.
Valuation Basics
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Value is also different from „Values?, which refers to one?s principles or standards WHAT HAS VALUE? Everything under the sun has value. There is nothing in God?s creation that does not have value. This applies to all physical things. If something has not been assigned any value, it can only be said that its value or utility has not yet been explored or discovered yet. A case in point is the element called Gadolinium. It was considered a useless rare earth element by the chemists, till hundred years later when magnetic resonance imaging (MRI) was invented and the use of Gadolinium was found in MRI as the perfect contrast material. This only goes to show that no material can be perceived to be useless, i.e., without any value. In a philosophical context, „Values? have „Value?, as they guide a person through life and provide the moorings or anchorage in the sea of life. Refer Swami Dayanand Saraswathi?s “The Value of Values”. WHY VALUE? Value is sought to be known in a commercial context on the eve of a transaction of „buy or sell? or to know the „worth? of a possession. WHO WANTS TO VALUE? The following entities may require valuation to be carried out: 1. A buyer or a seller 2. A lender 3. An intermediary like an agent, a broker 4. Regulatory authorities such as tax authorities, revenue authorities 5. General public Global/corporate investors have become highly demanding and are extremely focused on maximizing corporate value. The list of investors includes high net worth individuals, pension and hedge funds, and investment companies. They no longer remain passive investors but are keen followers of a company?s strategies and actions aimed at maximizing and protecting the value of their investments.
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WHEN TO VALUE? Valuation is done for “numerous purposes, including transactions, financings, taxation planning and compliance, intergenerational wealth transfer, ownership transition, financial accounting, bankruptcy, management information, and planning and litigation support”, as listed by AICPA. We see that the corporate world has increasingly become more dynamic, and sometimes volatile. Globalization, enhanced IT capabilities, the all pervasive role of the media, and growing awareness of investors have rendered the situation quite complex. Mergers, acquisitions, disinvestment and corporate takeovers have become the order of the day across the globe, and are a regular feature today.
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BUSINESS VALUATION MANAGEMENT Understanding the factors that determine the value of any business will pay tangible dividends by focusing the management on ways to increase the firm?s short and long - run profitability. Investors in shares and companies seeking to make acquisitions need to know how much a company is worth and how much to pay for their investment. We need to determine „Value? mainly on the following occasions: 1. PORTFOLIO MANAGEMENT/TRANSACTIONS: A transaction of sale or purchase, i.e., whenever an investment or disinvestment is made. Transaction appraisals include acquisitions, mergers, leveraged buy-outs, initial public offerings, ESOPs, buy-sell agreements, sales of interest, going public, going private, and many other engagements. 2. MERGERS AND ACQUISITION: Valuation becomes important for both the parties – for the acquirer to decide on a fair market value of the target organization and for the target organization to arrive at a reasonable for itself to enable acceptance or rejection of the offer being made. 3. CORPORATE FINANCE: The desire to know intrinsic worth and enhance value is important, as financial management itself is defined as “maximization of corporate value”. A proper valuation will help in linking the value of a firm to its financial decisions such as capital structure, financing mix, dividend policy, recapitalization and so on. 4. RESOLVE DISPUTES AMONG STAKEHOLDERS/LITIGATION: Divorce, bankruptcy, breach of contract, dissenting shareholder and minority oppression cases, economic damages computations, ownership disputes, and other cases.
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5. OTHERS : Taxes (or estate planning), including gift and estate taxes, estate planning, family limited partnerships, ad valorem taxation, and other tax-related reasons. WHO DETERMINES VALUE? The concept of Value is like beauty. Just as it is said that „beauty lies in the eyes of the beholder?, value is determined by a person who seeks or perceives value in a thing. Value can also be estimated, assessed, or determined by a professional called „Valuer?. The process of determining value is called „Valuation?. Business Valuation is the process of determining the economic value of a business. Valuation is an estimation, by a professional valuer, of a thing?s worth. WHAT TO VALUE? Value all assets and liabilities to know the value of „what we own? and „what we owe?. Assets will include both the tangibles and intangibles. Liabilities will include both the apparent and contingent. HOW TO VALUE? There are several tools and techniques, covered in the field of valuation, depending on what is valued. These range from simple thumb rules to complex models.
TYPES OF VALUES: There are a number of types of Values: 1. Original Value 2. Book Value 3. Depreciated Value 4. Sale Value 5. Purchase Value
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6. Replacement Value 7. Market Value 8. Economic Value 9. Residual Value 10. Disposal Value/Scrap Value
Business Valuation: The objective of any management today is to maximize corporate value and shareholder wealth. This is considered their most important task. A company is considered valuable not for its past performance, but for what it is and its ability to create value to its various stakeholders in future. Therefore, in analyzing a company, it is not suffi cient just to study its past performance. We must understand the environment – economic, industrial, social and so on – and its internal resources and intellectual capital in order to gauge its future earning capabilities. It is therefore essential to understand that business valuation is important in determining the present status as well as the future prospects of a company, which in turn is important to understand how to maximize the value of a company. The creation and development of corporate value is the single most important long – term measure of the performance of a company?s management. Further, this is the only common goal all shareholders agree on.
Business Valuation is a fascinating topic, as it requires an understanding of fi nancial analysis techniques in order to estimate value, and for acquisitions, it also requires good negotiating and tactical skills needed to fix the price to be paid. The aim of the study materials on Business Valuation Management is to equip the student in the following areas: 1. Become familiar with various methods and techniques of business valuation. 2. Appreciate the advantages and disadvantages of each technique. 3. Be able to decide on the most appropriate method or methods of valuation according to the circumstance, i.e., the purpose for which it is being done.
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FACTORS DETERMINING VALUE: There a host of factors that go into determining value. Some of them are listed below: 1. Level of technology 2. Design and engineering 3. Material of construction. 4. Aesthetics 5. Features in a product, asset or business 6. Performance of an asset or business 7. Reliability 8. Maintenance and upkeep 9. Service features 10. Level of obsolescence of asset, or stage of product in its life cycle
The various factors relevant in a business valuation are: • The nature of the business and its history from its inception. • The economic outlook in general and the condition and outlook of the specific industry in particular. • The book value and the financial condition of the business. • The earning capacity of the company. • The company?s earnings and dividend paying capacity. • Whether the enterprise has goodwill or other intangible value. • Sales of the stock and the size of the blocks of stock to be valued. • The market price of the stock of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market. • The marketability, or lack thereof, of the securities.
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MISCONCEPTIONS ABOUT VALUATION: There are a number of misconceptions about valuation and some of them are given below: Myth 1: A valuation is an objective search for “true” value. Truth 1.1: All valuations are biased. The only questions are how much and in which direction. Truth 1.2: The direction and magnitude of the bias in your valuation is directly proportional to who pays you and how much you are paid.
Myth 2: A good valuation provides a precise estimate of value. Truth 2.1: There are no precise valuations. Truth 2.2: The payoff to valuation is greatest when valuation is least precise.
Myth 3: The more quantitative a model, the better the valuation. Truth 3.1: One?s understanding of a valuation model is inversely proportional to the number of inputs required for the model. Truth 3.2: Simpler valuation models do much better than complex ones.
Myth 4: Valuing a private business should only be done when the business is ready to be sold or a lender requires a valuation as part of its due diligence process. Truth 4.1: Although the above situations require valuations to be carried out, effective planning for ownership transition requires a regular valuation of the business.
Myth 5: Businesses in an industry always sell for x times the annual revenue (the revenue multiple). So why should valuation of the business be done by an external valuer? Truth 5.1: While median multiple values are commonly used as a rule of thumb, they do not represent the revenue multiple for any actual transaction.
Myth 6: The business should be at least worth equivalent to what a competitor sold his business for recently. Truth 6.1: What happened a few months ago is not really relevant to what something is worth today.
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Truth 6.2: What a business is worth today depends on three factors: 1) how much cash it generates today; 2) expected growth in cash in the foreseeable future; and 3) the return buyers require on their investment in the business. Therefore, unless a firm?s cash flows and growth prospects are very similar to the competitor firm, that firm?s revenue multiple is irrelevant to valuing the firm. Also, the current value of the business is likely to be different than a few months ago because economic conditions may have changed.
Myth 7: How much a business is worth depends on what the valuation is used for! Truth 7.1: The value of a business is its fair market value, i.e., what a willing buyer will pay a willing seller when each is fully informed and under no pressure to transact.
Myth 8: The business loses money, so it is not worth much. Truth 8.1: While most private businesses may appear to lose money, the cash a business generates determines the value of the business. Quantifying the size of discretionary expenses is often a critical determinant of the fi rm?s value.
1.15 Written Valuation Reports: 1.15.1 A written valuation report must summarize the appraisal procedures and the valuation conclusions. It should consist of the following: * Company description. * Relevant valuation theory, methodology, procedures. 8 Business Valuation Management * A valuation synthesis and conclusion. * A summary of the quantitative and qualitative appraisal. * A listing of the data and documents the valuer relied on. * A statement of the contingent and limiting conditions of the appraisal. * An appraisal certification. * The professional qualifications of the principle analysts.
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PRINCIPLES & TECHNIQUES OF VALUATION
ELEMENTS OF BUSINESS VALUATION: Business valuation refers to the process and set of procedures used to determine the economic value of an owner?s interest in a business. The three elements of Business Valuation are: 1. ECONOMIC CONDITIONS: As we see in Portfolio Management Theory, wherein we adopt the Economy-IndustryCompany (E-I-C) approach, in Business Valuation too, a study and understanding of the national, regional and local economic conditions existing at the time of valuation, as well as the conditions of the industry in which the subject business operates, is important. For instance, while valuing a company involved in sugar manufacture in India in January 2008, the present conditions and forecasts of Indian economy, industries and agriculture need to be understood, before the prospects of Indian sugar industry and that of a particular company are evaluated. 2. NORMALIZATION OF FINANCIAL STATEMENTS: This is the second element that needs to be understood for the following purposes: a. Comparability adjustments: to facilitate comparison with other organizations operating within the same industry. b. Non-operating adjustments: Non-operating assets need to be excluded. c. Non-recurring adjustments: Items of expenditure or income which are of the nonrecurring type need to be excluded to provide meaning comparison between various periods. d. Discretionary adjustments: Wherever discretionary expenditure had been booked by a company, they will need to be adjusted to arrive at a fair market value.
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3. VALUATION APPROACH: There are three common approaches to business valuation - Discounted Cash Flow Valuation, Relative Valuation, and Contingent Claim Valuation - and within each of these approaches, there are various techniques for determining the fair market value of a business.
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DISCOUNTED CASH FLOW VALUATION
WHAT IS DCF? In Discounted Cash Flow (DCF) valuation, the value of an asset is the present value of the expected cash flows on the asset. The basic premise in DCF is that every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. Though the DCF Valuation is one of the three approaches to Valuation, it is essential to understand the fundamentals of this approach, as the DCF method finds application in the use of the other two approaches also. The DCF model is the most widely used standalone valuation model. DISCOUNTED CASH FLOW (DCF) ANALYSIS: To use DCF valuation, we need to estimate the following: the life of the asset the cash flows during the life of the asset the discount rate to apply to these cash flows to get present value The Present Value of an asset is arrived at by determining the present values of all expected future cash flows from the use of the asset. ASSUMPTIONS OF THE DCF MODEL: The DCF model relies upon cash flow assumptions such as revenue growth rates, operating margins, working capital needs and new investments in fixed assets for purposes of estimating future cash flows. After establishing the current value, the DCF model can be used to measure the value creation impact of various assumption changes, and the sensitivity tested.
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IMPORTANCE OF DCF: Business valuation is normally done to evaluate the future earning potential of a business, and involves the study of many aspects of a business, including anticipated revenues and expenses. A the cash flows extend over time in future, the DCF model can be a helpful tool, as the DCF analysis for a business valuation requires the analyst to consider two important components of: a. projection of revenues and expenses of the foreseeable future, and, b. determination of the discount rate to be used. Projecting the expected revenues and expenses of a business requires domain expertise in the business being valued. For example, a DCF analysis for a telecom company requires knowledge of the technologies involved, their life cycle, cost advantages and so on. Similarly, a DCF analysis of a proposed mine requires the expertise of geologists to ascertain the quality and quantity of deposits. ADVANTAGES OF DCF VALUATION: a. As DCF valuation is based upon an asset?s fundamentals, it should be less exposed to market moods and perceptions. b. DCF valuation is the right way to think about what an investor would get when buying an asset. c. DCF valuation forces an investor to think about the underlying characteristics of the firm, and understand its business. LIMITATIONS OF DCF VALUATION: a. Since DCF valuation is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches. b. The inputs and information are difficult to estimate, and can also be manipulated by a smart analyst to provide the desired conclusion. c. It is possible in a DCF valuation model to find every stock in a market to be over valued. d. The DCF valuation has certain limitations when applied to firms in distress; firms in cyclical business; firms with unutilized assets, patents; firms in the process of reorganizing or involved
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in acquisition, and private firms. APPLICATION OF DCF VALUATION: 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. 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. VALUE DRIVERS: In business valuation, it is important to understand the value creation process in a company, and this warrants an understanding of the hundreds of value-drivers and their effect on the company?s future cash flow. Value drivers include Financial value drivers such as operating margins and return on invested capital, and operational, non-financial value drivers. While financial drivers are generic, operational value drivers differ from company to company and from industry to industry. According to David Frykman and Jakob Tolleryd, the key value drivers can be divided into three distinct areas: 1. The company?s internal resources and its intellectual capital (such as brand strength, innovation power, management and board motivation and past performance, and person-independent knowledge) 2. The company?s external environment and its industry structure (sector growth, relative market share and barriers to entry) 3. The company?s strategy, the way the company chooses to exploit its key value drivers.
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STEPS IN DCF VALUATION: The steps in valuing a company using DCF are given below: 1. Determine the time horizon for specific forecasts: Consider economic and business cycles, positive and negative growth. 2. Forecast operating cash flows: Determine value drivers, estimate historic, current and future ratios, decide on cash/investment policy. 3. Determine residual value: Decide on residual value methodology, estimate growth rate in perpetuity. 4. Estimate WACC: Estimate cost of equity and debt, the debt-equity ratio. 5. Discount cash flows: Determine enterprise value and equity value, conduct sensitivity analysis
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CONTINGENT CLAIM VALUATION
WHAT IS A REAL OPTION? Traditional DCF approaches cannot properly capture the company?s flexibility to adapt and revise decisions in response to unexpected market developments. They assume an expected scenario of cash flows and presume an organization?s passive commitment to a certain static operating strategy. However, the real world is characterized by change, uncertainty and competitive interactions. A company may exhibit flexibility in its operating strategy and agility to respond to changing circumstances and market conditions, to seize and capitalize on favorable future opportunities or to react so as to mitigate losses. This flexibility is like financial options, and is known as Real Options. ENTERPRISE VALUE IN REAL OPTIONS VALUATION: The enterprise value using this approach is given as follows: Enterprise Value = Value of existing operations + Value of future potential operations = Value of all discounted future cash flows + Value of the company?s portfolio of real options EXAMPLES OF REAL OPTIONS: • Option to invest in a new technology-based service/product, as the result of a successful R&D effort. • Equity in a firm with negative earnings and high leverage. • The patent and other intellectual property owned by a firm.
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DISADVANTAGES OF REAL OPTION VALUATION MODELS: 5.4.1 When real options are valued, many of the inputs for the option pricing model are difficult to obtain. For instance, R&D projects do not trade and thus getting a current value for a project or its variance may be a daunting task. CONCLUSIONS: The following conclusions can be made about Real Options: a. The option pricing models derive their value from an underlying asset. Thus, to do option pricing, Mwe first need to value the assets. It is therefore an approach that is an addendum to another valuation approach. b. Traditional valuation procedures cannot properly capture the company?s flexibility to adapt and revise later decisions in response to unexpected competitive/technological/market developments. c. The real option technique can value the company?s flexibility to alter its initial operating strategy in order to capitalize on favorable future growth opportunities or to react so as to mitigate losses. d. Valuations computed using the real option technique are often closer to market valuations for highgrowth stocks in high-risk industries.
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ASSET VALUATION
DETERMINING BOOK VALUE: In asset based valuation, the value of a company is equal to the net assets attributable to the equity shareholders. Asset values can be of many types: Book Value, Net present value based on future cash flows to be derived from the assets, and Replacement Value based on worth to be derived from the future use of the asset. Assets are capital items and the key resources of a firm that have the potential to confer benefits over a long period of time. They represent the infrastructure and productive assets a firm can use in producing and delivering its products and services. All countries have internal accounting standards and guidelines in regard to accounting for assets. The classification and codification of assets are done as per these standards, while, however, valuing these assets and determining the reliability of these values are areas still weak. Determining Book value is centred around the balance sheet value of a company as presented in the latest Annual Report. In terms of book-value based valuation, the principle is that a company is worth to its ordinary shareholders the value of its assets less the value of any liabilities to third parties. This is also referred to as net asset value, shareholders? funds or the book value of the equity. ADJUSTING BOOK VALUE: In the books of accounts the assets are classified according to various groups, the primary groups being fixed assets which have long-term value, current assets with short-term value, and investments outside the business. Then come the intangible assets. Assets are valued at historical cost, i.e., the cost of acquisition. Costs incurred towards upgradation are added and depreciation is applied for usage of the assets. Thus, we have the gross block (original cost) and the net block (gross block - depreciation) available as book value in the accounting books. The asset values in the books of accounts need to be adjusted to offer a closer estimate of economic value than does the conventional book value.
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TANGIBLE ASSETS: Tangible assets are valued at historical cost, and depreciation is applied for diminution in value. Determining the depreciation to be charged is governed more by accounting standards, company law and income tax rules, and nor by any technical estimation of the life of the asset. There are two methods by which depreciation can be charged: the straight line method and the written down value method. Therefore, the choice of depreciation method employed and the rate of depreciation adopted can greatly influence the book value of an asset. Land is not depreciated as it is not expected to wear out as in the case of buildings and plant and machinery. Current assets include inventories, cash and marketable securities. INVENTORIES are generally valued on the three commonly bases: FIFO (First-In-First-Out), LIFO (Last-In-First-Out), and Weighted Average. The method adopted will have a bearing on the cost of goods sold as well as the closing stock. Under FIFO, the cost of goods sold will bear more of the cost of materials bought during earlier periods, while the closing stock will reflect the more recent or current replacement cost. In LIFO, the converse will hold good. Under Weighted average method, both the cost of goods sold and closing inventory will bear the average cost of materials purchased during the period. CASH: While valuing cash should not pose any problem in the normal course, problem will arise when it is deployed in short-term interest-bearing deposits or treasury deposits. These are generally risk-free and there is no default risk. ACCOUNTS RECEIVABLES are the sums owned by the customers to whom products have been sold or services rendered on credit. Depending on the accounting jurisdiction, property assets such as land, buildings and plant and machinery, may be carried on the balance sheet either at historic cost or at recent market valuation, and this choice can radically affect book value. While in India the assets are shown at historic cost, in the U.K. property owned by companies is often revalued on a regular basis and
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included in the accounts at close to current values. The practice in the USA, France and Germany are similar to that in India, and in all these cases of historical cost accounting, the book value will be lower than the current value. Where properties are valued by expert valuers or surveyors using, for instance estimates of rental income, they can be considered to be included at economic value (the present value of future income generated) rather than historic cost. However, the practice in U.K., where tangible assets are shown at lesser of depreciated book value or market value, gives a better indicator of current values, though not very accurate. The book value of assets do not take into account factors such as inflation or obsolescence. If the valuer has more detailed information on the type and age of assets than is available from the accounts, it is possible to adjust book values of fixed and, indeed current, assets to a closer estimate of current value. Another fixed asset which may be included at other than historic cost is property under construction. In some countries, including India, companies are allowed to capitalize the interest they pay on debt related to the construction rather than write it off as an expense. INTANGIBLE ASSETS: Intangible assets include expenditure on research and development (R&D), brand values, intellectual capital and goodwill. R&D expenditure represents cash spent on a knowledge base which may generate future revenues. Treatment of R&D expenses varies from country to country. Similarly, there is some argument for capitalizing expenditure on other forms of knowledge, as in database systems within consultancy firms or expertise provided by professional employees in investment banks. This is known as intellectual capital and firms such as Scandia, a Swedish insurance company, have pioneered approaches to the valuation of intellectual capital for inclusion in the balance sheet. Another type of intangible asset over which there has been controversy is capitalization of brand values in the balance sheet, as done by Coca-Cola or Amazon.com. The methods for valuing brands are linked to forecast cash flows related to the brands and hence to economic value.
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Therefore, capitalization of brands will give a closer approximation to market value than would the exclusion of the brands. The difference between the price paid for a company and its book value is known as goodwill. This is because goodwill is an intangible asset, which arises as a result of the fact that book values of companies typically do not reflect their economic values, and hence the prices paid for companies, especially for high value-added firms such as advertising agencies and consulting firms. OFF-BALANCE SHEET ITEMS: Besides fixed assets and intangible assets, another possible area where the value of the shareholders? funds can mislead is its exclusion, by definition, of what are known as off-balance sheet items. These can be leases, pension assets or liabilities, employee-related liabilities and other contingent liabilities which may be mentioned in the notes to the accounts. FACTORS IN ASSET VALUATION: The factors to be considered for valuation of Assets are given below: a. Type of Building/Plant/Equipment b. Specifications/Ratings c. Make and Model d. Year of construction/installation e. Service conditions f. Extent of upkeep/maintenance g. Upgradation, Retrofits, Modifications and Modernisation of assets, if any Capacity costs are non-linear and follow an exponential equation. „Factor Estimating? is an established method of estimating the cost of a project, and is widely used in Project Cost Estimation. If the cost of a given unit (C1) is known at one capacity (Q1) and it is desired to estimate the cost at another capacity (Q2), the cost at the second capacity (C2) can be determined using the following equations: Basis of Asset Valuation: a. Replacement Cost/Value
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b. Market Value = Replacement Cost – Depreciation c. Agreed Value Replacement Cost/Value is the Current Cost of a new asset of same kind – Value of similar new property, and is based on current prices/quotes. However, it is costly to determine, time consuming, and is not always feasible.
Replacement cost factors: a. Current F.O.B/F.O.R Cost of a new asset b. Price escalation c. Foreign Currency rate d. Duties & Taxes : Customs/Excise/S.Tax e. Set off as Cenvat credit f. Freight, Insurance, Handling, Inland transit g. Erection costs Market Value: It is the amount at which a property of the same age and description can be bought or sold. Estimating of replacement costs can be done by indexing the original acquisition costs, or through an ab initio estimating from technical specifications. Determination of market value requires estimating depreciation or the life of an asset and the residual life of an asset. Agreed Values are arrived at for properties whose Market Value cannot be ascertained, such as Curios, Works of art, Manuscripts, and Obsolete machinery. However, such valuations require Valuation certificate from expert valuers.
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LITERATURE REVIEW
Valuing Contingent Consideration under SFAS 141R, Business Combinations: Issues and Implications for CFOs and the Transaction Team
Lynne J. Weber, PhD, and Rick G. Schwartz, PhD
Statement of Financial Accounting Standards No. 141, Business Combinations (revised 2007) (SFAS 141R) overhauls the fi nancial reporting requirements for business combinations. The implications are broad and numerous: The transaction price will change. The amount of goodwill will change. More items in the fi nancial statements will be recorded at fair value. The time it takes for a transaction to become accretive will be different. New contributors to earnings volatility will emerge. The Dr. Lynne J. Weber is a managing director and the leader of the Strategic Value Advisory Practice at Duff & Phelps. Dr. Weber has more than 25 years of experience consulting on valuation of business strategies, transactions, and operational improvement strategies. She holds a Ph.D. in operations research and a master.s degree in statistics, both from Stanford University, and a B.A. in mathematics from Cornell University. Dr. Rick G. Schwartz is a managing director in Duff & Phelps.s Corporate Finance Consulting Practice. Dr. Schwartz provides valuation and strategic advisory services to support merger and acquisition transactions; licensing and partnering decisions; and strategic investments in the life sciences, high technology, and other industries. He has a Ph.D. in engineering.economic systems from Stanford University. 1We anticipate that over time, additional guidance will be provided and both Practice
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optimal structuring and terms of merger and acquisition transactions will change. SFAS 141R takes effect for the fi rst fi scal year starting on or after 15 December 2008. For calendar year-end companies the impact is already being felt: the new rules are affecting their business combinations for which the acquisition date is on or after 1 January 2009. One of the changes in the new standard is the requirement to recognize contingent consideration at fair value on the acquisition date. Consequently, a contingent consideration asset or liability will be remeasured to fair value at each reporting date until the contingency is resolved; any corresponding change in recorded value will often impact earnings. This is a big change. Under the old rules, contingent consideration was usually not recognized until the contingency was resolved. The requirement to measure the acquisition-date fair value of contingent consideration raises a number of important valuation and merger and acquisition transaction issues. In this paper, we address the following topics: How to value contingent consideration • Implications for chief fi nancial offi cers (CFOs), the fi nancial reporting function, and the transaction team Before discussing these issues, we begin with a defi nition of contingent consideration and a description of the guidance regarding contingent consideration in SFAS 141R, as issued.1 DeÞ nition of Contingent Consideration As defi ned in SFAS 141R, contingent consideration is: • An obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specifi ed future events occur or conditions are met or • The right of the acquirer to the return of previously
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transferred consideration if specifi ed conditions are met. Thus, contingent consideration can be a liability, as in the fi rst bullet point above, or an asset, as in the second bullet point above. Contingent consideration is a part of many transactions in which substantial uncertainties exist about how the acquired business will perform post-transaction. Contingent consideration can help achieve the objectives of both sides of a transaction negotiation by: • Closing the gap in expectations for the business between the buyer and seller • Allowing the buyer to share the risk associated with the future of the business with the seller by making some of the consideration contingent on future performance • Allowing the seller to participate in the upside post-transaction • Providing incentives for the seller to remain involved with, and help drive the future success of, the business. A common example of a contingent consideration liability is an earn-out clause, with payments conditional on reaching milestones or on the magnitude of sales or profi tability. The Requirements of SFAS 141R Regarding Contingent Consideration Under SFAS 141R, as issued, contingent consideration is to be recognized at acquisition-date fair value as part of the consideration transferred. SFAS 141R uses the fair value defi nition in Statement of Financial Accounting Standards No. 157, Fair Value Measurements, which defi nes fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The subsequent accounting for contingent consideration will depend on whether it is classifi ed as equity or as an asset or a liability. An obligation to pay contingent consideration will be classifi ed either as equity or as a
32
liability based on applicable generally accepted accounting principles (GAAP).2 A contingent right to the return of previously transferred consideration will be classifi ed as an asset. Classifi cation of contingent consideration will not always be obvious. For example, some technology companies routinely structure contingent consideration with the option for the acquirer to pay the additional consideration in cash or in equity. The classifi cation of such arrangements will depend on the specifi c facts and circumstances incorporated in the transaction terms. However, the expectation is that such arrangements will more often be classifi ed as a liability than as equity. The guidance on subsequent accounting for contingent consideration under SFAS 141R is as follows: • Contingent consideration classifi ed as equity is not remeasured. Its subsequent settlement is accounted for within equity. • Contingent consideration classifi ed as an asset or a liability will be remeasured to fair value at each reporting date until the contingency is resolved. The changes in fair value will be recognized in earnings unless the arrangement is a hedging instrument for which SFAS 133, as amended by SFAS 141R, requires that the changes be recognized in other comprehensive income. The Impact on Earnings The impact of the requirement of SFAS 141R to remeasure contingent consideration assets and liabilities to fair value appears to be obvious; one might assume the volatility of earnings would increase. However, if we look below the surface, we see that remeasurement of contingent consideration to fair value actually may, in some 2In particular, an obligation to pay contingent consideration is classifi ed as a liability or as equity in accordance with Financial Accounting Standards Board Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company?s Own Stock,” or other Applicable
33
situations, buffer earnings from the ups and downs of the acquired business. Consider the case in which a cash payment of additional consideration is to be made after twelve months, contingent on the performance of the business in each of the fi rst four quarters post-acquisition. Suppose the acquired business succeeds in generating cash fl ows above some baseline expectations in the fi rst quarter post-acquisition. Then the business will have a positive impact on quarterly earnings compared to expectations. At the same time, it will become more likely that the acquirer will be required to pay the contingent con sideration and/or that the amount of contingent consideration paid will be larger. Thus, the fair value of the contingent consideration liability will rise. Remeasurement of the contingent consideration liability will have a negative impact on earnings, counterbalancing some of the positive impact from the good results. The net impact on earnings may be positive or negative. However, the remeasurement of the contingent consideration value has the opposite effect on earnings from the direct effect on earnings of the change in business performance. A similar buffering phenomenon can be observed for certain contingent consideration assets, e.g., clawbacks of consideration in case of poorer-than-expected performance. Payment of consideration can also be contingent on changes in expectations for the future performance of the business. For example, consider the case in which a cash payment of additional consideration is contingent on the achievement of a certain research and development (R&D) milestone. Missing that milestone may reduce the likelihood that the acquirer will pay, lengthen the time frame for payment of, and/or decrease the expected payment amount of any contingent consideration related to achievement of the milestone. Negative changes in the expected amounts or delays in timing for payment of the contingent consideration would have a positive effect on earnings. However, under SFAS 141R, in-process R&D (IPR&D) projects acquired in a business combination are to be capitalized at their acquisition-date fair values and subsequently tested for impairment at fair value until
34
completion or abandonment. Missing an important R&D milestone may lead to an impairment of the IPR&D pro ject. Thus, any impairment charge related to IPR&D acquired in a business combination could be counterbalanced to some degree by a gain on any related contingent consideration liability. While missing an important milestone for R&D acquired in a business combination may lead to both an impairment charge and a gain on a related contingent consideration liability, achieving that milestone may dampen current earnings without any contemporaneous mitigating effect. Achieving an important R&D milestone brightens future prospects for the business, but it may simultaneously dampen current earnings via the increase in fair value of any corresponding contingent consideration liability. Of course, this effect could also have occurred under the old rules. Regardless of whether the consideration is contingent on actual performance of the business or expectations for its future performance, if positive business results having a less positive (or even negative) net impact on earnings due to the new accounting required for contingent consideration, that can delay the time until a transaction is accretive. Identifying Contingent Consideration Before contingent consideration can be valued, it must be identifi ed. While this sounds simple, it may not always be easy to determine. The most obvious question is whether the business combination includes additional consideration (cash, equity, warrants, options, etc.) to be provided only if certain conditions are met. Examples include: • Additional consideration if the acquired business meets certain revenue, profi t, margin or stock targets and • Milestone payments for product development or liquidity events. Valuation Techniques There are three traditional approaches to value:
35
income, market, and cost. Be aware, however, that not all such incremental consideration will be classifi ed as contingent consideration; an accounting determination must be made as to whether any such consideration is part of the business combination or part of a separate transaction that should be accounted for outside of the business combination. One must also fi nd out if any circumstances are present under which the transaction agreement requires consideration to be returned. Examples include failures to meet targets, pass regulatory reviews, and meet covenants. While this question may also seem somewhat obvious, it is perhaps less natural for many fi nancial reporting teams to ask about return of consideration, as prior to SFAS 141R, contingent assets were rarely recorded. Turning to the less obvious questions, one must ask (a) whether selling shareholders or management may gain any future performance-based compensation and (b) whether any other agreements are in place between the acquirer and any of the selling shareholders that are not at market rate.
36
INDUSTRY PROFILE , COMPANY PROFILE & SWOT ANALYSIS Introduction India is the ninth largest aviation market in the world, according to RNCOS research report, titled "Indian Aerospace Industry Analysis". It is anticipated that the civil aviation market will register more than 16 per cent compound annual growth rate (CAGR) during 2010-2013 on back of strong market fundamentals. The rapidly expanding aviation sector in India handles about 2.5 billion passengers across the world in a year; moves 45 million tonnes (MT) of cargo through 920 airlines, using 4,200 airports and deploying 27,000 aircraft. Currently, 87 foreign airlines fly to and from India and five Indian carriers fly to and fro from 40 countries. India is expected to be amongst the top five nations in the world in the next 10 years. An efficient civil aviation sector is important for India as it is inter-linked with other sectors in the economy and generates income and employment through global commerce and tourism, as per a National Council of Applied Economic Research (NCAER) study titled 'Emirates in India Assessment of Economic Impact and Regional Benefits'. Airport infrastructure in India is witnessing improvisation and expansion on a massive scale, with the Government avidly supporting private participants. The need for airport infrastructure in India has increased considerably. In order to ramp up airport infrastructure, the Government has unveiled reforms to facilitate investment in this segment. The investment in Indian airport infrastructure market, especially in the greenfield projects is expected to increase. Market Size The domestic airlines carried 438.4 million passengers during January -September 2012 (first three quarters of calendar year), according to data released by the Directorate General Civil Aviation (DGCA). The air transport (including air freight) in India has attracted foreign direct investment (FDI) worth US$ 446 million from April 2000 to September 2012, as per data released by Department of Industrial Policy and Promotion (DIPP). Market Players
?
SpiceJet Ltd has announced the launch of two new international flights from Kochi, Kerala to Male and Dubai. The airline has deployed the Bombardier Q400 aircraft, with a capacity of 78 passengers, in the Kochi-Male route
37
?
IBS Software has entered into a contract with Lufthansa Cargo AG for the implementation of its air cargo solution - iCargo. The deal worth Rs 700 crore (US$ 127.50 million) has three segments and IBS Software has major share of the contract
Aerospace on a High
?
?
?
India and New Zealand have signed the "Arrangement for Cooperation on Civil Aviation". Under the arrangement, the two countries will promote and support the development of training and technical cooperation in the field of civil aviation GVK Power and Infrastructure Ltd has signed an operations and management contract with the Airports Authority of Indonesia (Angkasa Pura Airports). The scope of the contract includes managing non-aeronautical commercial operations at both the existing terminals and the new international terminal of Indonesia's second busiest Bali (Denpasar) international airport Maldivian Airlines has expanded its flight network by connecting Chennai, Mumbai and Dhaka with Male, the capital city of Maldives. "India is our focus market, as it has a great potential," said Mr Bandhu Ibrahim Saleem, Chairman, Maldivian Airlines
India will be the fourth biggest market in terms of value for all new aircraft deliveries after China, the US and the UAE during the next 20 years, according to aircraft maker Airbus
38
Factors that are not in favor of investments… Aviation economics are not favorable in India Higher taxes on ATF and airport charges continue to be key headwinds for the sector; besides higher cost base, airlines in India are also mandatorily required to fly on certain unviable routes Inadequate Infrastructure Development of airport infrastructure has not kept pace with demand, thereby resulting in delays and higher costs for airlines Poor financial health of most airlines Intense competition, sharp fluctuation in ATF prices and high debt burden continue to weigh on the financial performance of Indian airlines; foreign exchange fluctuation and lack of adequate hedging mechanism (for fuel) have added to the woes Highly competitive & Price Sensitive traveler base .
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01. COMPANY PROFILE
Jet Airways is the second largest Indian airline based in Mumbai, Maharashtra, both, in terms of market share[4] and passengers carried.[5] It is owned by Naresh Goyal. It operates over 400 flights daily to 76 destinations worldwide. Its main hub is Mumbai, with secondary hubs at Delhi,Kolkata, Chennai, Bengaluru and Pune.[6] It has an international hub at Brussels Airport, Belgium. The recession forced Jet Airways to discontinue the following routes: Ahmedabad–London, Amritsar–London, Bangalore–Brussels, Mumbai–Shanghai–San Francisco and Brussels-New York.[7] It also had to put an indefinite delay on its expansion plans. Jet Airways was forced to lease out seven of its ten Boeing 777-300ERs to survive the financial crunch. Due to the recession all flights to North America were operated on an Airbus A330200 replacing the Boeing 777-300ERs. It also had to sell a brand-new, yet-to-be-delivered Boeing 777-300ER in 2009 and had to defer all new aircraft deliveries by at least two years. The airline planned to restore the Mumbai-Shanghai route by the end of 2011 but never went through with it.[8] As the economic crisis in the eurozone countries worsened, Jet also closed the DelhiMilan route.[9] Jet Airways was incorporated as an air taxi operator on 1 April 1992. It started commercial operations on 5 May 1993 with a fleet of four leased Boeing 737-300 aircraft. In January 1994 a change in the law enabled Jet Airways to apply for scheduled airline status, which was granted on 4 January 1995. Naresh Goyal – who already owned Jetair (Private) Limited, which provided sales and marketing for foreign airlines in India – set up Jet Airways as a full-service scheduled
40
airline to compete against state-owned Indian Airlines. Indian Airlines had enjoyed a monopoly in the domestic market between 1953, when all major Indian air transport providers were nationalised under the Air Corporations Act (1953), and January 1994, when the Air Corporations Act was repealed, following which Jet Airways received scheduled airline status. Jet began international operations from Chennai to Colombo in March 2004. The company is listed on theBombay Stock Exchange, but 80% of its stock is controlled by Naresh Goyal (through his ownership of Jet?s parent company, Tailwinds). It has 13,177 employees (as at 31 March 2011).[10] In January 2006 Jet Airways announced that it would buy Air Sahara for US$500 million in an all-cash deal, making it the biggest takeover in Indian aviation history. It would have resulted in the country's largest airline but the deal fell through in June 2006. On 12 April 2007 Jet Airways agreed to buy out Air Sahara for INR14.5 billion (US$340 million). Air Sahara was renamed JetLite, and was marketed between a low-cost carrier and a full service airline. In August 2008 Jet Airways announced its plans to completely integrate JetLite into Jet Airways.[11] In October 2008, Jet Airways laid off 1,900 of its employees, resulting in the largest lay-off in the history of Indian aviation.[12] However the employees were later asked to return to work; Civil Aviation Minister Praful Patel said that the management reviewed its decision after he analysed the decision with them.[13][14] Jet Airways and their rival Kingfisher Airlines announced an alliance which primarily includes an agreement on code-sharing on both domestic and international flights, joint fuel management to reduce expenses, common ground handling, joint utilisation of crew and sharing of similar frequent flier programmes.[15] On 8 May 2009 Jet Airways launched its lowcost brand, Jet Konnect. The decision to launch a new brand instead of expanding the JetLite network was taken after considering the regulatory delays involved in transferring aircraft from Jet Airways to JetLite, as the two have different operator codes. The brand was launched on sectors that had 50% or less load factor with the aim of increasing it to 70% and above. Jet officials said that the brand would cease to exist once the demand for the regular Jet Airways increases.
2010-PRESENT: RISE TO INDIA'S LARGEST AIRLINE
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According to a PTI report, for the third quarter of 2010, Jet Airways (Jet+JetLite) had a market share of 26.9%[16] in terms of passengers carried, thus making it a market leader in India, followed by Kingfisher Airlines with 19.9%. In July 2012, Jet Airways officially sought government approval to join Star Alliance.[17] In June 2011, Jet Airways banned carrying fish, crab, meat, poultry products and liquid items as check-in baggage.[18] Jet is the first domestic airline to impose such a ban. Jet claimed that passengers complained of their baggage getting soiled by seepage from bags containing meat products. Early in 2013, Etihad Airways, on of the flag carriers of the United Arab Emirates based out of Abu Dhabi planned to buy a stake in Jet Airways. Jet announced that they were ready to sell a 24% stake to Etihad at US$330 million. Earlier, in September 2012, the government of India announced that foreign airlines can take up a stake of upto 49% in Indian airlines, thereby making this deal possible. Etihad, which had already purchased stakes in 4 other loss making airlines, said, they were "concentrating on future potential rather than past performance", and were ready to take up the stake in Jet.[19] Initially, Jet announced that they were likely to sign the stake sale deal with Etihad between January 22 and February 3,[20]which they later confirmed to as January 25.[21] However, the date passed by and the deal was further postponed.[22] Meanwhile, Jet Airways concentrated well on revenues, costs and network side, which resulted in the airline making profits for the first time since therupee depreciation. Nikos Kardassis, the Chief Executive Officer of Jet Airways said "The combined impact of higher yields and lower costs (ex-fuel) have resulted in significantly lowering the breakeven seat factor levels in the business."[23] The airline announced a sale on its website, which offered 2 million seats for travel within India, till December 31 2013. This sale was announced a little over one month after rival low-cost carrier SpiceJet announced a sale, which was expected to have triggered a farewar.[24] High airfares throughout 2012 due to grounding of Kingfisher Airlines caused passengers to opt out of air travel, leading to negative growth in traffic for the first time since 2009. Jet Airways planned to attract more passengers by subsequently lowering the fares, which was followed by SpiceJet again. With two airlines offering cheaper travel, India's flag carrier started losing passengers and it too offered cheaper tickets. This was followed by IndiGo and GoAir, resulting in a full-fledged fare war.[25] Jet had introduced four different slabs of discounts depending upon the distance to destination. Under the offer, the fare up to 750 kilometres was priced at 2,250 (US$40.95), while for 75042
1000 kilometres it was 2,850 (US$51.87). For air travel over a distance ranging from 1000 to 1400 kilometres, tickets were sold for 3,300 (US$60.06) and for travel beyond 1400 kilometres, tickets were sold for a maximum of 3,800 (US$69.16).[26] Based on a calculation by The Economic Times, on average, Jet Airways was selling 6400 tickets per day, or 14 tickets per flight at these discounted rates. According to the news agency, several Indian travel sites started experiencing sever issues following a sudden increase in bookings. MakeMyTrip chief operating officer Keyur Joshi said that this move would help airlines increase aircraft occupancy from 75% to 85%.[27]
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SWOT ANALYSIS OF JET AIRWAYS
Jet Airways Parent Company Tailwinds Limited
Category
Indian domestic sector
Sector
Airlines
Tagline/ Slogan
The Joy of Flying
USP
Premium Airline, High Class
STP
STP
Segment
Passengers preferring comfort
Target Group
Corporate, Upper Middle Class
Positioning
Premium
SWOT Analysis
SWOT Analysis
1. Has created a good image among the Indian fliers 2. Trusted Airline by the Corporates 3. One of the biggest Indian airline companies with over 13,000 employees 4. Operations in over 75 Indian cities and over 400 daily flights 5. Top of the mind brand due to excellent operations and marketing Strength 6. It also has international destinations in nearly 20 countries
1. Competition from the LCCs and other competitors means market share growth is tough Weakness 2. Presence of other airlines on international routes making it difficult
44
to have significant market share
1. Strongly positioned in the International routes 2. Has presence in every segment Opportunity 3. Increasing number of people opting to travel by airlines
1. LCCs eatiing up the marketshare 2. Rising Fuel Costs and Labour Costs Threats 3. Unfavorable Govt policies and aviation regulations
Competition
1.Kingfisher Competitors 2.Air India
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OBJECTIVES AND SCOPE
OBJECTIVES :01) Become familiar with various methods and techniques of business valuation 02) Be able to decide on the most appropriate method or methods of valuation according to the circumstance, i.e., the purpose for which it is being done. SCOPE :01. TO GET FAMILIAR WITH THE VALUATION CONCEPTS AND ITS TYPES
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DATA ANALYSIS
VALUATION OF JET AIRWAYS THROUGH DISCOUNTED CASH FLOW VALUATION
01.
SECTOR PERFORMANCE
The Indian Aviation Industry has been going through a turbulent phase over the past several years facing multiple headwinds – high oil prices and limited pricing power contributed by industry wide over capacity and periods of subdued demand growth. Over the near term the challenges facing the airline operators are related to high debt burden and liquidity constraints most operators need significant equity infusion to effect a meaningful improvement in balance sheet. Improved financial profile would also allow these players to focus on steps to improve long term viability and brand building through differentiated customer service. Over the long term the operators need to focus on improving cost structure, through rationalization at all levels including mix of fleet and routes, aimed at cost efficiency. At the industry level, long term viability also requires return of pricing power through better alignment of capacity to the underlying demand growth. While in the beginning of 2008-09, the sector was impacted by sharp rise in crude oil prices, it was the decline in passenger traffic growth which led to severe underperformance during H2, 2008-09 to H1 2009-10. The operating environment improved for a brief period in 2010-11 on back of recovery in passenger traffic, industry-wide capacity discipline and relatively stable fuel prices. However, elevated fuel prices over the last three quarters coupled with intense competition and unfavorable foreign exchange environment has again deteriorated the financial performance of airlines. During this period, while the passenger traffic growth has been steady (averaging 14% in 9m 2011-12), intense competition has impacted yields and forced airlines back into losses in an inflated cost base scenario. To address the concerns surrounding the
47
operating viability of Indian carriers, the Government on its part has recently initiated a series of measures including (a) proposal to allow foreign carriers to make strategic investments (up to 49% stake) in Indian Carriers (b) proposal to allow airlines to directly import ATF (c) lifting the freeze on international expansions of private airlines and (d) financial assistance to the national carrier. However, these steps alone may not be adequate to address the fundamental problems affecting the industry. While the domestic airlines have not been able to attract foreign investors (up to 49% FDI is allowed, though foreign airlines are currently not allowed any stake), foreign airlines may be interested in taking strategic stakes due to their deeper business understanding, longer investment horizons and overall longer term commitment towards the global aviation industry. Healthy passenger traffic growth on account of favorable demographics, rising disposable incomes and low air travel penetration could attract long-term strategic investments in the sector. However, in our opinion, there are two key challenges: i) aviation economics is currently not favorable in India resulting in weak financial performance of airlines and ii) Internationally, too airlines are going through period of stress which could possibly dissuade their investment plans in newer markets. Besides, foreign carriers already enjoy significant market share of profitable international routes and have wide access to Indian market through code-sharing arrangements with domestic players. Given these considerations, we believe, foreign airlines are likely to be more cautious in their investment decisions and strategies are likely to be long drawn rather than focused on short-term valuations. On the proposal to allow import of ATF, we feel that the duty differential between sales tax (averaging around 22-26% for domestic fuel uplifts) being currently paid by airlines on domestic routes and import duty (8.5%-10.0%) is an attractive proposition for airlines. However the challenges in importing, storing and transporting jet fuel will be a considerable roadblock for airlines due to OMCs monopoly on infrastructure at most Indian airports. From the working capital standpoint too, airlines will need to deploy significant amount of resources in sourcing fuel which may not be easy given the stretched balance sheets and tight liquidity profile of most airlines. Historically, the Indian aviation sector has been a laggard relative to its growth potential due to excessive regulations and taxations, government ownership of airlines and resulting high cost of air travel. However, this has changed rapidly over the last decade with the sector showing explosive growth supported by structural reforms, airport modernizations, entry of private
48
airlines, adoption of low fare - no frills models and improvement in service standards. Like elsewhere in the world, air travel is been transformed into a mode of mass transportation and is gradually shedding its elitist image. Strong passenger traffic growth aided by buoyant economy, favorable demographics, rising disposable incomes and low penetration levels India aviation industry promises huge growth potential due to large and growing middle class population, favorable demographics, rapid economic growth, higher disposable incomes, rising aspirations of the middle class, and overall low penetration levels (less than 3%). The industry has grown at a 16% CAGR in passenger traffic terms over the past decade. With advent of LCCs and resultant decline in yields, passenger traffic growth which averaged 13% in the first half has increased substantially to 19% CAGR during 2006-2011. Despite strong growth, air travel penetration in India remains among the lowest in the world. In fact, air travel penetration in India is less than half of that in China where people take 0.2 trips per person per year; indicating strong long term growth potential. A comparative statistic in United States, the world?s largest domestic aviation market stands at 2 trips per person per year. We expect passenger demand to remain stable and grow between 12-15% in the medium term, assuming a no major weakness in GDP growth going forward. However domestic airlines operate under high cost environment; intense competition has constrained yields; aggressive fleet expansions have impacted profitability and capital structures Despite reforms, the domestic aviation sector continues to operate under high cost environment due to high taxes on Aviation Turbine Fuel (ATF), high airport charges, significant congestion at major airports, dearth of experienced commercial pilots, inflexible labor laws and overall higher cost of capital. While most of these factors are not under direct control of airline operators, the problems have compounded due to industry-wide capacity additions, much in excess of actual demand. Intense competitive pressure from Low cost carriers (focusing on maximizing load factors) and national carrier (looking to regain lost market share) have constrained yields from rising in-sync with the elevated cost base. Besides, aggressive fleet expansions (LCCs have added aircrafts mainly on long-term operating leases; FSC?s have purchased aircrafts – debt financed, most often backed by guarantees from the US EXIM Bank or Europe?s ECA) to leverage upon the anticipated robust growth and to support international operations have
49
significantly impacted the capital structure and weakened the credit profile of most domestic airlines.
The domestic airlines industry is facing significant operating (slowing growth, rising fuel costs) and non-operating (interest costs, rupee depreciation) challenges as evident in the quarterly performance trends of listed airline companies. Sales Growth: After a strong rebound in 2010, the pax growth has been moderating over the last few quarters due to moderating economic growth and weak industrial activity. Besides, severe competitive pressure from domestic LCC players (rapidly gaining market share) and Air India (trying to maintain market share) have resulted in price wars (at times below cost pricing), lowered yields and moderated sales growth for the airlines. Even on international routes, the yields have remained weak due to weaker economic conditions and severe competition from global airlines. Rising ATF Prices & Steep Rupee Depreciation: The airlines industry had been severely impacted by the significant increase in ATF prices (up 57% in last 18 months) as Indian Carriers do not hedge fuel prices and have exhibited limited ability to charge fuel surcharges due to irrational and undisciplined pricing dictated by competition rather than costs / demand. Besides, the steep rupee depreciation (~18.7% depreciation in CY11, although partly reversed through 7.3% YTD appreciation in CY12) acts double whammy as apart from fuel costs, substantial portion of other operating costs like lease rentals, maintenance, expat salaries and a portion of sales commissions are USD-linked or USD-denominated. Profit Margins: With combined impact of 1) moderating pax growth 2) lower yields due to excessive competitive 3) rising ATF prices 4) steep rupee depreciation and 5) rising debt levels and interest costs, the profitability margins of the airlines industry have been severely impacted. As per Centre for Asia Pacific Aviation (CAPA), Indian carriers could be posting staggering losses of $2.5 billion (~Rs 12,500 crore) in 2011-12, worse than the losses of 2008-09 when traffic was declining and crude oil prices spiked to $150 per barrel. Overall, the industry has been marred by cost inefficiencies and is bearing the brunt of aggressive price cuts, rising costs, expensive jet fuel, a weaker rupee, high interest payments and hence mounting losses. The government support required to bailout the loss making Air India has increased substantially; while the leading private players like Kingfisher Airlines, Jet
50
Airways and SpiceJet are making significant losses. With Banks unwilling to enhance their exposure to the industry, recast their loans or pick up equity stakes without viable business plans, industry needs to come out with strong equity infusion plans. Hence, the government is mulling allowing foreign carriers to pick strategic stakes in domestic airlines to help them stay afloat in these difficult times, besides bringing global expertise and best industry practices over the medium term.
FDI in Aviation: Feasibility and Impact Analysis for various stakeholders
FDI Proposal: The Civil Aviation Ministry is expected to soon circulate a proposal before the union cabinet to consider allowing up to 49% equity investment by foreign carriers in domestic airlines. In case of listed airlines, if the proposal does not get a waiver from SEBI?s Takeover Code, foreign carriers may have to first make an open offer of 26% stake to public shareholders and later acquire up to 23% stake (from promoters or fresh equity), such that their stake remains within the 49 % cap. Indian Carriers: The FDI proposal, if approved, would certainly be an important milestone in the aviation sector and may provide much-needed relief to the domestic aviation industry reeling under the pressure of mounting losses and rising debt burden. Besides, the move will help bring global expertise and best industry practices over the medium term. Foreign Carriers: It will not just provide entry into one of the fastest growing aviation market globally but also an opportunity to establish India as their hub for connections between US/Europe and South-East Asian countries. While full-service airlines could help them further consolidate their market position on international routes (and improve connectivity within India), acquisition of low-cost airlines could help them compete in a market where travelers are highly price sensitive. Consumers: New players could enter the market as they could now have a strategic foreign player with deep pockets to support the airline in difficult times. Besides, it would provide more flexibility in international travels when one travels through the same airline domestically as well as internationally. Overall, this could increase competition, offer more alternatives, reduce tariffs and improve customer service standards over the medium term.
51
However, the Global Airline industry is itself currently going through a tough phase (Bloomberg World Airline index down 22%, Asia-Pacific Airline index down 25% in last one year), due to below trend economic growth across advanced economies and high crude oil prices ($100125/Barrel). Besides, aviation economics currently remain unfavorable in India due to intense competition, mandatory route dispersal guidelines, higher taxes on ATF, airport related charges and inadequate airport infrastructure. For example, airlines like Air Asia (citing high infrastructure costs) & American Airlines (parent facing financial stress) have recently withdrawn from India. Lastly, foreign carriers already enjoy significant market share of profitable international routes and have wide domestic access through code sharing agreements. Given these considerations, we believe, attracting investments from foreign airlines may not be easy
. Foreign carriers already enjoy significant share of international traffic; domestic access through code sharing agreements As per DGCA data, foreign carriers already enjoy ~65% market share in international traffic and hence ~27% of total passenger traffic (Domestic + International). For Jet Airways, due to longer haulage (~4.6 hrs avg block hours in international routes as compared to ~1.6 hrs avg block hours in domestic routes), revenue per passenger carried on international route has been 2.5x to 3.0x revenue per passenger carried on do mestic route. We expect this ratio to be higher on an industry wide basis as foreign carriers dominate longer haulage routes, full service offerings and business traffic as compared to shorter haulage, low fare offerings & VFR (visiting friends and relatives) traffic prominence of Indian carriers. As a result, we estimate that the foreign carriers have already garnered 42-48% of total airline revenues (inbound, outbound & within India). Besides, the stark difference between Jet Airways? domestic and International EBITDAR margins indicates that the foreign airlines could be already enjoying majority of the industry profits, with the domestic carriers left with price conscious no-frills pax traffic, less viable routes and hence saddled with high operating losses. Besides, due to number of code sharing agreements, foreign carriers can offer enhanced connectivity into Indian cities without acquiring stakes in Indian carriers. Dilutions at Current market capitalizations unlikely to solve issues of staggering debt levels and mounting losses
52
Besides, since the airlines stocks have corrected significantly over the last two years, fresh equity infusions are current market capitalizations (although 50-100% higher YTD) could lead to considerable stake dilution for the existing promoters who have built these businesses over the years. Besides, the amount of fresh equity that could be raised at current market prices would not be a game-changer considering the staggering debt levels and quarterly losses posted by the airline industry (auditors have already raised concerns over the rapid depletion of networth for all listed airline companies).
Factors that support investments in Indian Aviation Sector… Strong growth prospects Passenger traffic growth has grown at a CAGR of 16% in India over the past 10 years Relative underpenetrated market Penetration of air travel at <3% is significantly below benchmarks in other markets An opportunity to create India as an hub An opportunity for foreign airlines to create India as their hub for international traffic between Europe and South East Asia; Additionally offer better connectivity within India with international destinations An opportunity to create India as an MRO centre Foreign airlines could also look at leveraging on India?s lowcost arbitrage by setting up MRO facilities in India Low Valuations Market valuation of listed airlines in India has suffered due to poor performance
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Factors that are not in favor of investments… Aviation economics are not favorable in India Higher taxes on ATF and airport charges continue to be key headwinds for the sector; besides higher cost base, airlines in India are also mandatorily required to fly on certain unviable routes Inadequate Infrastructure Development of airport infrastructure has not kept pace with demand, thereby resulting in delays and higher costs for airlines Poor financial health of most airlines Intense competition, sharp fluctuation in ATF prices and high debt burden continue to weigh on the financial performance of Indian airlines; foreign exchange fluctuation and lack of adequate hedging mechanism (for fuel) have added to the woes Highly competitive & Price Sensitive traveler base .
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02. COMPANY PROFILE
Jet Airways is the second largest Indian airline based in Mumbai, Maharashtra, both, in terms of market share[4] and passengers carried.[5] It is owned by Naresh Goyal. It operates over 400 flights daily to 76 destinations worldwide. Its main hub is Mumbai, with secondary hubs at Delhi,Kolkata, Chennai, Bengaluru and Pune.[6] It has an international hub at Brussels Airport, Belgium. The recession forced Jet Airways to discontinue the following routes: Ahmedabad–London, Amritsar–London, Bangalore–Brussels, Mumbai–Shanghai–San Francisco and Brussels-New York.[7] It also had to put an indefinite delay on its expansion plans. Jet Airways was forced to lease out seven of its ten Boeing 777-300ERs to survive the financial crunch. Due to the recession all flights to North America were operated on an Airbus A330200 replacing the Boeing 777-300ERs. It also had to sell a brand-new, yet-to-be-delivered Boeing 777-300ER in 2009 and had to defer all new aircraft deliveries by at least two years. The airline planned to restore the Mumbai-Shanghai route by the end of 2011 but never went through with it.[8] As the economic crisis in the eurozone countries worsened, Jet also closed the DelhiMilan route.[9] Jet Airways was incorporated as an air taxi operator on 1 April 1992. It started commercial operations on 5 May 1993 with a fleet of four leased Boeing 737-300 aircraft. In January 1994 a change in the law enabled Jet Airways to apply for scheduled airline status, which was granted on 4 January 1995. Naresh Goyal – who already owned Jetair (Private) Limited, which provided sales and marketing for foreign airlines in India – set up Jet Airways as a full-service scheduled airline to compete against state-owned Indian Airlines. Indian Airlines had enjoyed a monopoly in the domestic market between 1953, when all major Indian air transport providers were nationalised under the Air Corporations Act (1953), and January 1994, when the Air Corporations Act was repealed, following which Jet Airways received scheduled airline status. Jet began international operations from Chennai to Colombo in March 2004. The company is listed on theBombay Stock Exchange, but 80% of its stock is controlled by Naresh Goyal (through his ownership of Jet?s parent company, Tailwinds). It has 13,177 employees (as at 31
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March 2011).[10] In January 2006 Jet Airways announced that it would buy Air Sahara for US$500 million in an all-cash deal, making it the biggest takeover in Indian aviation history. It would have resulted in the country's largest airline but the deal fell through in June 2006. On 12 April 2007 Jet Airways agreed to buy out Air Sahara for INR14.5 billion (US$340 million). Air Sahara was renamed JetLite, and was marketed between a low-cost carrier and a full service airline. In August 2008 Jet Airways announced its plans to completely integrate JetLite into Jet Airways.[11] In October 2008, Jet Airways laid off 1,900 of its employees, resulting in the largest lay-off in the history of Indian aviation.[12] However the employees were later asked to return to work; Civil Aviation Minister Praful Patel said that the management reviewed its decision after he analysed the decision with them.[13][14] Jet Airways and their rival Kingfisher Airlines announced an alliance which primarily includes an agreement on code-sharing on both domestic and international flights, joint fuel management to reduce expenses, common ground handling, joint utilisation of crew and sharing of similar frequent flier programmes.[15] On 8 May 2009 Jet Airways launched its lowcost brand, Jet Konnect. The decision to launch a new brand instead of expanding the JetLite network was taken after considering the regulatory delays involved in transferring aircraft from Jet Airways to JetLite, as the two have different operator codes. The brand was launched on sectors that had 50% or less load factor with the aim of increasing it to 70% and above. Jet officials said that the brand would cease to exist once the demand for the regular Jet Airways increases.
2010-PRESENT: RISE TO INDIA'S LARGEST AIRLINE
According to a PTI report, for the third quarter of 2010, Jet Airways (Jet+JetLite) had a market share of 26.9%[16] in terms of passengers carried, thus making it a market leader in India, followed by Kingfisher Airlines with 19.9%. In July 2012, Jet Airways officially sought government approval to join Star Alliance.[17] In June 2011, Jet Airways banned carrying fish, crab, meat, poultry products and liquid items as check-in baggage.[18] Jet is the first domestic airline to impose such a ban. Jet claimed that passengers complained of their baggage getting soiled by seepage from bags containing meat products. Early in 2013, Etihad Airways, on of the flag carriers of the United Arab Emirates based out of Abu Dhabi planned to buy a stake in
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Jet Airways. Jet announced that they were ready to sell a 24% stake to Etihad at US$330 million. Earlier, in September 2012, the government of India announced that foreign airlines can take up a stake of upto 49% in Indian airlines, thereby making this deal possible. Etihad, which had already purchased stakes in 4 other loss making airlines, said, they were "concentrating on future potential rather than past performance", and were ready to take up the stake in Jet.[19] Initially, Jet announced that they were likely to sign the stake sale deal with Etihad between January 22 and February 3,[20]which they later confirmed to as January 25.[21] However, the date passed by and the deal was further postponed.[22] Meanwhile, Jet Airways concentrated well on revenues, costs and network side, which resulted in the airline making profits for the first time since therupee depreciation. Nikos Kardassis, the Chief Executive Officer of Jet Airways said "The combined impact of higher yields and lower costs (ex-fuel) have resulted in significantly lowering the breakeven seat factor levels in the business."[23] The airline announced a sale on its website, which offered 2 million seats for travel within India, till December 31 2013. This sale was announced a little over one month after rival low-cost carrier SpiceJet announced a sale, which was expected to have triggered a farewar.[24] High airfares throughout 2012 due to grounding of Kingfisher Airlines caused passengers to opt out of air travel, leading to negative growth in traffic for the first time since 2009. Jet Airways planned to attract more passengers by subsequently lowering the fares, which was followed by SpiceJet again. With two airlines offering cheaper travel, India's flag carrier started losing passengers and it too offered cheaper tickets. This was followed by IndiGo and GoAir, resulting in a full-fledged fare war.[25] Jet had introduced four different slabs of discounts depending upon the distance to destination. Under the offer, the fare up to 750 kilometres was priced at 2,250 (US$40.95), while for 7501000 kilometres it was 2,850 (US$51.87). For air travel over a distance ranging from 1000 to 1400 kilometres, tickets were sold for 3,300 (US$60.06) and for travel beyond 1400 kilometres, tickets were sold for a maximum of 3,800 (US$69.16).[26] Based on a calculation by The Economic Times, on average, Jet Airways was selling 6400 tickets per day, or 14 tickets per flight at these discounted rates. According to the news agency, several Indian travel sites started experiencing sever issues following a sudden increase in bookings. MakeMyTrip chief operating officer Keyur Joshi said that this move would help airlines increase aircraft occupancy from 75% to 85%.[27]
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03. VALUE DRIVER OF JET AIRWAYS
MOST NIMBLE FULL SERVICE CARRIER IN INDIA
Jet Airways caters to all classes of flyers, offering services in all three segments, namely, Full Service Carriers, Full Service & Low Fare Carriers and Low Cost Carriers. This not only helps the airline to meet the diverse needs but also gives it the flexibility to move seats between the segments according to the market conditions and cyclicality, helping it to maximize revenues. With the economy picking up and air travel growing strongly, Jet has reintroduced business class seats in Jet Konnect while also adding new capacities under its FSC brand, „Jet Airways?.
OPERATIONAL EXCELLENCE
Jet Airways enjoys one of the best operating margins in the industry and the best amongst the listed companies. While international operations provide support to the overall margins of the company, the airline has effectively cut costs and has improved its personnel utilization substantially over the last couple of years. We expect Jet Airways to be able to further expand its margins cover the coming quarters.
IMPROVED DOMESTIC AND INTERNATIONAL MACROECONOMIC
Jet stands to benefit hugely from the sharp upturn in domestic business sentiments because of being the largest player in the segment. Improved global macroeconomic environment helped the company score even better load factors and margins in its international business segment. Given the huge international network and alliances, Jet is the best placed Indian airlines to benefit from the growing global attention towards India
INCREASING BUSINESS TRAVEL
Bulk of the demand for air travel comes from the corporate and business travelers.
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Further, shifts in demand for business travel mirrors the economic trends. India with its high GDP growth rate and stable economy is expected to witness strong demand for air travel from the corporate. Already, with almost all blue-chip companies having detailed travel policies, travel costs have emerged as the third largest expenses for them, after salaries and raw materials.
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04.
RATIOS OF JET AIRWAYS
ESTIMATION OF HISTORIC AND CURRENT RATIOS
MAR?12 Investment Valuation Ratios Face Value Dividend Per Share Operating Profit Per Share (Rs) Net Operating Profit Per Share (Rs) Free Reserves Per Share (Rs) Bonus in Equity Capital Profitability Ratios Operating Profit Margin(%) Profit Before Interest And Tax Margin(%) Gross Profit Margin(%) Cash Profit Margin(%) Adjusted Cash Margin(%) Net Profit Margin(%) Adjusted Net Profit Margin(%) Return On Capital Employed(%) Return On Net Worth(%) Adjusted Return on Net Worth(%) Return on Assets Excluding Revaluations Return on Assets Including Revaluations Return on Long Term Funds(%) 10.00 -214.50 1,763.46 -79.02 10.89 12.16 5.85 5.99 -1.53 -1.53 -7.93 -7.93 12.28 229.14 -93.98 -62.48 136.78 15.41
MAR?11 10.00 -289.91 1,480.59 80.48 10.89 19.58 12.29 12.45 4.42 4.42 0.07 0.07 12.33 1.15 -40.33 96.91 301.66 14.31
MAR?10 10.00 -244.11 1,209.09 79.35 10.89 20.18 10.81 10.97 3.35 3.35 -4.41 -4.41 8.81 -56.54 -73.29 95.79 306.02 12.08
Liquidity And Solvency Ratios Current Ratio Quick Ratio Debt Equity Ratio Long Term Debt Equity Ratio Debt Coverage Ratios Interest Cover
0.39 0.50 --1.31
0.64 0.77 16.11 14.22 1.72
0.34 0.86 16.80 11.98 1.31
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Total Debt to Owners Fund Financial Charges Coverage Ratio Financial Charges Coverage Ratio Post Tax Management Efficiency Ratios Inventory Turnover Ratio Debtors Turnover Ratio Investments Turnover Ratio Fixed Assets Turnover Ratio Total Assets Turnover Ratio Asset Turnover Ratio Average Raw Material Holding Average Finished Goods Held Number of Days In Working Capital .
8.22 1.10 0.85 3,051.04 13.64 3,051.04 0.81 1.50 1.08 ---85.64
16.11 1.43 1.49 2,778.81 14.39 2,778.81 0.72 0.91 0.78 --11.12
16.80 1.24 1.27 4,349.40 13.53 4,349.40 0.59 0.72 0.58 --2.22
05. WEIGHTED AVERAGE COAST OF CAPITAL.
Risk Free Rate 8% Beta 1.02 Equity Risk Premium 8% Cost of Equity 16% Cost of Debt (pre tax) 10.0% Tax rate 33.99% Total Long Term Debt / Equity Ratio 1 WACC 11.4% Growth Phase I - 5 yrs 12% Growth Phase II - 10 yrs 8% Growth Phase III - Terminal 3
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CONCLUSIONS
Business Valuation Management is a fascinating subject, as it, foremost, provides (and also warrants) the most comprehensive analysis of a business model. It perforce enjoins upon the business valuer to delve into the depths of the business that is being valued and come to grips with the macro and micro, technical and fi nancial, the short and longer term aspects of the business.
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SUGGESTIONS WWW.WIKIPEDIA.COM WWW.ICRA.COM WWW.MONEYCONTROL.COM.
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doc_730147016.docx
“BUSINESS VALUATION”
Submitted by
DINESH.N.DIKONDA PGDM Academic Year 2013-14
Under the Guidance of
Prof. Kirandeep Kaur Anand
In fulfillment of Post-Graduation Diploma in Management
Guru Nanak Institute Of Management Studies
1
Supervisor’s Certificate
I, certify that the dissertation entitled “Business valuation” an original work by Dinesh.N.Dikonda of Guru Nanak Institute of Management Studies of Semester # 04 completed the Final project. Under me in the academic year 2013-14.The information submitted is authentic to the best of my knowledge.
Name of the Guide:
Signature of Project Guide
Signature of Director
2
Declaration
I, the Dinesh.N.Dikonda of PGDM Finance Guru Nanak Institute of Management Studies Semester # 04 hereby declare that I have completed this project on,
“BUSINESS VALUATION”
In the academic year 2013-14 Under My Project Guide: Prof. Kirandeep Kaur Anand Faculty of GNIMS Guru Nanak Institute of Management Studies The Information Submitted is true and original to Best of Our Knowledge
Date: 01/03/2013 Place: Mumbai Roll No.: 09
3
“BUSINESS VALUATION”
A PROJECT SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS MANAGEMENT FOR POST GRADUATION DIPLOMA IN
2011 - 2013
Name of the Student: Dinesh.N.Dikonda
Roll No #09
Name of the Institute: Guru Nanak Institute of Management Studies
4
PROJECT GUIDE CERTIFICATE FORM I, Dinesh.N.Dikondaundersigned Roll No # 09 studying in the Second Year of PGDM is doing my project work under the guidance of Kirandeep Ma’am wish to state that I have met my internal guide on the following dates mentioned below for Project Guidance:-
Sr. No. 1. 2. 3. 4. 5. 6. 7. 8.
Date Jan 8 Jan 14 Feb 9 Feb 19 Feb 21 Feb 23 Feb24 Feb 25
Signature of the Internal Guide
____________________________
__________________________
Signature of the Candidate
Signature of Internal Guide
5
N.B.: The candidate should retain the Project Guide Certificate Form and submit the same while submitting the Project to the Institute i.e. on or before 1st March 2013.
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TABLE OF CONTENT
Sr.no
Particulars
Page no
01. 02. 03.
INTRODUCTION LITERATURE REVIEW INDUSTRY PROFILE, COMPANY PROFILE & SWOT ANALYSIS
08 30 37
04. 05. 06. 07.
OBJECTIVES AND SCOPE DATA ANALYSIS CONCLUSION SUGGESTION
46 47 62 63
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INTRODUCTION
WHAT IS VALUE? Value is the „worth? of a thing. It can also be defined as „a bundle of benefits? expected from it. It can be tangible or intangible. Value is defined as: a. The worth, desirability, or utility of a thing, or the qualities on which these depend b. Worth as estimated c. The amount for which a thing can be exchanged in the market d. Purchasing power e. Estimate the value of, appraise (professionally)
Valuation is defined as: • Estimation (esp. by professional valuer) of a thing?s worth • Worth so estimated • Price set on a thing HOW IS VALUE DIFFERENT FROM COST AND PRICE? Cost is defined as „resources sacrificed to produce or obtain a thing, (a product or service). Price is what is charged by a seller or provider of product or service. Many a time, it is a function of market forces. Oscar Wilde said, “A cynic is one who knows the price of everything and the value of nothing”. DIFFERENT CONNOTATIONS OF VALUE: Value, like „utility?, has different connotations in different contexts, and may vary from person, place and time. It can range from a precise figure to something bordering on sentimental or emotional, or even the absurd.
Valuation Basics
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Value is also different from „Values?, which refers to one?s principles or standards WHAT HAS VALUE? Everything under the sun has value. There is nothing in God?s creation that does not have value. This applies to all physical things. If something has not been assigned any value, it can only be said that its value or utility has not yet been explored or discovered yet. A case in point is the element called Gadolinium. It was considered a useless rare earth element by the chemists, till hundred years later when magnetic resonance imaging (MRI) was invented and the use of Gadolinium was found in MRI as the perfect contrast material. This only goes to show that no material can be perceived to be useless, i.e., without any value. In a philosophical context, „Values? have „Value?, as they guide a person through life and provide the moorings or anchorage in the sea of life. Refer Swami Dayanand Saraswathi?s “The Value of Values”. WHY VALUE? Value is sought to be known in a commercial context on the eve of a transaction of „buy or sell? or to know the „worth? of a possession. WHO WANTS TO VALUE? The following entities may require valuation to be carried out: 1. A buyer or a seller 2. A lender 3. An intermediary like an agent, a broker 4. Regulatory authorities such as tax authorities, revenue authorities 5. General public Global/corporate investors have become highly demanding and are extremely focused on maximizing corporate value. The list of investors includes high net worth individuals, pension and hedge funds, and investment companies. They no longer remain passive investors but are keen followers of a company?s strategies and actions aimed at maximizing and protecting the value of their investments.
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WHEN TO VALUE? Valuation is done for “numerous purposes, including transactions, financings, taxation planning and compliance, intergenerational wealth transfer, ownership transition, financial accounting, bankruptcy, management information, and planning and litigation support”, as listed by AICPA. We see that the corporate world has increasingly become more dynamic, and sometimes volatile. Globalization, enhanced IT capabilities, the all pervasive role of the media, and growing awareness of investors have rendered the situation quite complex. Mergers, acquisitions, disinvestment and corporate takeovers have become the order of the day across the globe, and are a regular feature today.
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BUSINESS VALUATION MANAGEMENT Understanding the factors that determine the value of any business will pay tangible dividends by focusing the management on ways to increase the firm?s short and long - run profitability. Investors in shares and companies seeking to make acquisitions need to know how much a company is worth and how much to pay for their investment. We need to determine „Value? mainly on the following occasions: 1. PORTFOLIO MANAGEMENT/TRANSACTIONS: A transaction of sale or purchase, i.e., whenever an investment or disinvestment is made. Transaction appraisals include acquisitions, mergers, leveraged buy-outs, initial public offerings, ESOPs, buy-sell agreements, sales of interest, going public, going private, and many other engagements. 2. MERGERS AND ACQUISITION: Valuation becomes important for both the parties – for the acquirer to decide on a fair market value of the target organization and for the target organization to arrive at a reasonable for itself to enable acceptance or rejection of the offer being made. 3. CORPORATE FINANCE: The desire to know intrinsic worth and enhance value is important, as financial management itself is defined as “maximization of corporate value”. A proper valuation will help in linking the value of a firm to its financial decisions such as capital structure, financing mix, dividend policy, recapitalization and so on. 4. RESOLVE DISPUTES AMONG STAKEHOLDERS/LITIGATION: Divorce, bankruptcy, breach of contract, dissenting shareholder and minority oppression cases, economic damages computations, ownership disputes, and other cases.
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5. OTHERS : Taxes (or estate planning), including gift and estate taxes, estate planning, family limited partnerships, ad valorem taxation, and other tax-related reasons. WHO DETERMINES VALUE? The concept of Value is like beauty. Just as it is said that „beauty lies in the eyes of the beholder?, value is determined by a person who seeks or perceives value in a thing. Value can also be estimated, assessed, or determined by a professional called „Valuer?. The process of determining value is called „Valuation?. Business Valuation is the process of determining the economic value of a business. Valuation is an estimation, by a professional valuer, of a thing?s worth. WHAT TO VALUE? Value all assets and liabilities to know the value of „what we own? and „what we owe?. Assets will include both the tangibles and intangibles. Liabilities will include both the apparent and contingent. HOW TO VALUE? There are several tools and techniques, covered in the field of valuation, depending on what is valued. These range from simple thumb rules to complex models.
TYPES OF VALUES: There are a number of types of Values: 1. Original Value 2. Book Value 3. Depreciated Value 4. Sale Value 5. Purchase Value
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6. Replacement Value 7. Market Value 8. Economic Value 9. Residual Value 10. Disposal Value/Scrap Value
Business Valuation: The objective of any management today is to maximize corporate value and shareholder wealth. This is considered their most important task. A company is considered valuable not for its past performance, but for what it is and its ability to create value to its various stakeholders in future. Therefore, in analyzing a company, it is not suffi cient just to study its past performance. We must understand the environment – economic, industrial, social and so on – and its internal resources and intellectual capital in order to gauge its future earning capabilities. It is therefore essential to understand that business valuation is important in determining the present status as well as the future prospects of a company, which in turn is important to understand how to maximize the value of a company. The creation and development of corporate value is the single most important long – term measure of the performance of a company?s management. Further, this is the only common goal all shareholders agree on.
Business Valuation is a fascinating topic, as it requires an understanding of fi nancial analysis techniques in order to estimate value, and for acquisitions, it also requires good negotiating and tactical skills needed to fix the price to be paid. The aim of the study materials on Business Valuation Management is to equip the student in the following areas: 1. Become familiar with various methods and techniques of business valuation. 2. Appreciate the advantages and disadvantages of each technique. 3. Be able to decide on the most appropriate method or methods of valuation according to the circumstance, i.e., the purpose for which it is being done.
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FACTORS DETERMINING VALUE: There a host of factors that go into determining value. Some of them are listed below: 1. Level of technology 2. Design and engineering 3. Material of construction. 4. Aesthetics 5. Features in a product, asset or business 6. Performance of an asset or business 7. Reliability 8. Maintenance and upkeep 9. Service features 10. Level of obsolescence of asset, or stage of product in its life cycle
The various factors relevant in a business valuation are: • The nature of the business and its history from its inception. • The economic outlook in general and the condition and outlook of the specific industry in particular. • The book value and the financial condition of the business. • The earning capacity of the company. • The company?s earnings and dividend paying capacity. • Whether the enterprise has goodwill or other intangible value. • Sales of the stock and the size of the blocks of stock to be valued. • The market price of the stock of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market. • The marketability, or lack thereof, of the securities.
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MISCONCEPTIONS ABOUT VALUATION: There are a number of misconceptions about valuation and some of them are given below: Myth 1: A valuation is an objective search for “true” value. Truth 1.1: All valuations are biased. The only questions are how much and in which direction. Truth 1.2: The direction and magnitude of the bias in your valuation is directly proportional to who pays you and how much you are paid.
Myth 2: A good valuation provides a precise estimate of value. Truth 2.1: There are no precise valuations. Truth 2.2: The payoff to valuation is greatest when valuation is least precise.
Myth 3: The more quantitative a model, the better the valuation. Truth 3.1: One?s understanding of a valuation model is inversely proportional to the number of inputs required for the model. Truth 3.2: Simpler valuation models do much better than complex ones.
Myth 4: Valuing a private business should only be done when the business is ready to be sold or a lender requires a valuation as part of its due diligence process. Truth 4.1: Although the above situations require valuations to be carried out, effective planning for ownership transition requires a regular valuation of the business.
Myth 5: Businesses in an industry always sell for x times the annual revenue (the revenue multiple). So why should valuation of the business be done by an external valuer? Truth 5.1: While median multiple values are commonly used as a rule of thumb, they do not represent the revenue multiple for any actual transaction.
Myth 6: The business should be at least worth equivalent to what a competitor sold his business for recently. Truth 6.1: What happened a few months ago is not really relevant to what something is worth today.
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Truth 6.2: What a business is worth today depends on three factors: 1) how much cash it generates today; 2) expected growth in cash in the foreseeable future; and 3) the return buyers require on their investment in the business. Therefore, unless a firm?s cash flows and growth prospects are very similar to the competitor firm, that firm?s revenue multiple is irrelevant to valuing the firm. Also, the current value of the business is likely to be different than a few months ago because economic conditions may have changed.
Myth 7: How much a business is worth depends on what the valuation is used for! Truth 7.1: The value of a business is its fair market value, i.e., what a willing buyer will pay a willing seller when each is fully informed and under no pressure to transact.
Myth 8: The business loses money, so it is not worth much. Truth 8.1: While most private businesses may appear to lose money, the cash a business generates determines the value of the business. Quantifying the size of discretionary expenses is often a critical determinant of the fi rm?s value.
1.15 Written Valuation Reports: 1.15.1 A written valuation report must summarize the appraisal procedures and the valuation conclusions. It should consist of the following: * Company description. * Relevant valuation theory, methodology, procedures. 8 Business Valuation Management * A valuation synthesis and conclusion. * A summary of the quantitative and qualitative appraisal. * A listing of the data and documents the valuer relied on. * A statement of the contingent and limiting conditions of the appraisal. * An appraisal certification. * The professional qualifications of the principle analysts.
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PRINCIPLES & TECHNIQUES OF VALUATION
ELEMENTS OF BUSINESS VALUATION: Business valuation refers to the process and set of procedures used to determine the economic value of an owner?s interest in a business. The three elements of Business Valuation are: 1. ECONOMIC CONDITIONS: As we see in Portfolio Management Theory, wherein we adopt the Economy-IndustryCompany (E-I-C) approach, in Business Valuation too, a study and understanding of the national, regional and local economic conditions existing at the time of valuation, as well as the conditions of the industry in which the subject business operates, is important. For instance, while valuing a company involved in sugar manufacture in India in January 2008, the present conditions and forecasts of Indian economy, industries and agriculture need to be understood, before the prospects of Indian sugar industry and that of a particular company are evaluated. 2. NORMALIZATION OF FINANCIAL STATEMENTS: This is the second element that needs to be understood for the following purposes: a. Comparability adjustments: to facilitate comparison with other organizations operating within the same industry. b. Non-operating adjustments: Non-operating assets need to be excluded. c. Non-recurring adjustments: Items of expenditure or income which are of the nonrecurring type need to be excluded to provide meaning comparison between various periods. d. Discretionary adjustments: Wherever discretionary expenditure had been booked by a company, they will need to be adjusted to arrive at a fair market value.
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3. VALUATION APPROACH: There are three common approaches to business valuation - Discounted Cash Flow Valuation, Relative Valuation, and Contingent Claim Valuation - and within each of these approaches, there are various techniques for determining the fair market value of a business.
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DISCOUNTED CASH FLOW VALUATION
WHAT IS DCF? In Discounted Cash Flow (DCF) valuation, the value of an asset is the present value of the expected cash flows on the asset. The basic premise in DCF is that every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. Though the DCF Valuation is one of the three approaches to Valuation, it is essential to understand the fundamentals of this approach, as the DCF method finds application in the use of the other two approaches also. The DCF model is the most widely used standalone valuation model. DISCOUNTED CASH FLOW (DCF) ANALYSIS: To use DCF valuation, we need to estimate the following: the life of the asset the cash flows during the life of the asset the discount rate to apply to these cash flows to get present value The Present Value of an asset is arrived at by determining the present values of all expected future cash flows from the use of the asset. ASSUMPTIONS OF THE DCF MODEL: The DCF model relies upon cash flow assumptions such as revenue growth rates, operating margins, working capital needs and new investments in fixed assets for purposes of estimating future cash flows. After establishing the current value, the DCF model can be used to measure the value creation impact of various assumption changes, and the sensitivity tested.
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IMPORTANCE OF DCF: Business valuation is normally done to evaluate the future earning potential of a business, and involves the study of many aspects of a business, including anticipated revenues and expenses. A the cash flows extend over time in future, the DCF model can be a helpful tool, as the DCF analysis for a business valuation requires the analyst to consider two important components of: a. projection of revenues and expenses of the foreseeable future, and, b. determination of the discount rate to be used. Projecting the expected revenues and expenses of a business requires domain expertise in the business being valued. For example, a DCF analysis for a telecom company requires knowledge of the technologies involved, their life cycle, cost advantages and so on. Similarly, a DCF analysis of a proposed mine requires the expertise of geologists to ascertain the quality and quantity of deposits. ADVANTAGES OF DCF VALUATION: a. As DCF valuation is based upon an asset?s fundamentals, it should be less exposed to market moods and perceptions. b. DCF valuation is the right way to think about what an investor would get when buying an asset. c. DCF valuation forces an investor to think about the underlying characteristics of the firm, and understand its business. LIMITATIONS OF DCF VALUATION: a. Since DCF valuation is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches. b. The inputs and information are difficult to estimate, and can also be manipulated by a smart analyst to provide the desired conclusion. c. It is possible in a DCF valuation model to find every stock in a market to be over valued. d. The DCF valuation has certain limitations when applied to firms in distress; firms in cyclical business; firms with unutilized assets, patents; firms in the process of reorganizing or involved
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in acquisition, and private firms. APPLICATION OF DCF VALUATION: 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. 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. VALUE DRIVERS: In business valuation, it is important to understand the value creation process in a company, and this warrants an understanding of the hundreds of value-drivers and their effect on the company?s future cash flow. Value drivers include Financial value drivers such as operating margins and return on invested capital, and operational, non-financial value drivers. While financial drivers are generic, operational value drivers differ from company to company and from industry to industry. According to David Frykman and Jakob Tolleryd, the key value drivers can be divided into three distinct areas: 1. The company?s internal resources and its intellectual capital (such as brand strength, innovation power, management and board motivation and past performance, and person-independent knowledge) 2. The company?s external environment and its industry structure (sector growth, relative market share and barriers to entry) 3. The company?s strategy, the way the company chooses to exploit its key value drivers.
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STEPS IN DCF VALUATION: The steps in valuing a company using DCF are given below: 1. Determine the time horizon for specific forecasts: Consider economic and business cycles, positive and negative growth. 2. Forecast operating cash flows: Determine value drivers, estimate historic, current and future ratios, decide on cash/investment policy. 3. Determine residual value: Decide on residual value methodology, estimate growth rate in perpetuity. 4. Estimate WACC: Estimate cost of equity and debt, the debt-equity ratio. 5. Discount cash flows: Determine enterprise value and equity value, conduct sensitivity analysis
22
CONTINGENT CLAIM VALUATION
WHAT IS A REAL OPTION? Traditional DCF approaches cannot properly capture the company?s flexibility to adapt and revise decisions in response to unexpected market developments. They assume an expected scenario of cash flows and presume an organization?s passive commitment to a certain static operating strategy. However, the real world is characterized by change, uncertainty and competitive interactions. A company may exhibit flexibility in its operating strategy and agility to respond to changing circumstances and market conditions, to seize and capitalize on favorable future opportunities or to react so as to mitigate losses. This flexibility is like financial options, and is known as Real Options. ENTERPRISE VALUE IN REAL OPTIONS VALUATION: The enterprise value using this approach is given as follows: Enterprise Value = Value of existing operations + Value of future potential operations = Value of all discounted future cash flows + Value of the company?s portfolio of real options EXAMPLES OF REAL OPTIONS: • Option to invest in a new technology-based service/product, as the result of a successful R&D effort. • Equity in a firm with negative earnings and high leverage. • The patent and other intellectual property owned by a firm.
23
DISADVANTAGES OF REAL OPTION VALUATION MODELS: 5.4.1 When real options are valued, many of the inputs for the option pricing model are difficult to obtain. For instance, R&D projects do not trade and thus getting a current value for a project or its variance may be a daunting task. CONCLUSIONS: The following conclusions can be made about Real Options: a. The option pricing models derive their value from an underlying asset. Thus, to do option pricing, Mwe first need to value the assets. It is therefore an approach that is an addendum to another valuation approach. b. Traditional valuation procedures cannot properly capture the company?s flexibility to adapt and revise later decisions in response to unexpected competitive/technological/market developments. c. The real option technique can value the company?s flexibility to alter its initial operating strategy in order to capitalize on favorable future growth opportunities or to react so as to mitigate losses. d. Valuations computed using the real option technique are often closer to market valuations for highgrowth stocks in high-risk industries.
24
ASSET VALUATION
DETERMINING BOOK VALUE: In asset based valuation, the value of a company is equal to the net assets attributable to the equity shareholders. Asset values can be of many types: Book Value, Net present value based on future cash flows to be derived from the assets, and Replacement Value based on worth to be derived from the future use of the asset. Assets are capital items and the key resources of a firm that have the potential to confer benefits over a long period of time. They represent the infrastructure and productive assets a firm can use in producing and delivering its products and services. All countries have internal accounting standards and guidelines in regard to accounting for assets. The classification and codification of assets are done as per these standards, while, however, valuing these assets and determining the reliability of these values are areas still weak. Determining Book value is centred around the balance sheet value of a company as presented in the latest Annual Report. In terms of book-value based valuation, the principle is that a company is worth to its ordinary shareholders the value of its assets less the value of any liabilities to third parties. This is also referred to as net asset value, shareholders? funds or the book value of the equity. ADJUSTING BOOK VALUE: In the books of accounts the assets are classified according to various groups, the primary groups being fixed assets which have long-term value, current assets with short-term value, and investments outside the business. Then come the intangible assets. Assets are valued at historical cost, i.e., the cost of acquisition. Costs incurred towards upgradation are added and depreciation is applied for usage of the assets. Thus, we have the gross block (original cost) and the net block (gross block - depreciation) available as book value in the accounting books. The asset values in the books of accounts need to be adjusted to offer a closer estimate of economic value than does the conventional book value.
25
TANGIBLE ASSETS: Tangible assets are valued at historical cost, and depreciation is applied for diminution in value. Determining the depreciation to be charged is governed more by accounting standards, company law and income tax rules, and nor by any technical estimation of the life of the asset. There are two methods by which depreciation can be charged: the straight line method and the written down value method. Therefore, the choice of depreciation method employed and the rate of depreciation adopted can greatly influence the book value of an asset. Land is not depreciated as it is not expected to wear out as in the case of buildings and plant and machinery. Current assets include inventories, cash and marketable securities. INVENTORIES are generally valued on the three commonly bases: FIFO (First-In-First-Out), LIFO (Last-In-First-Out), and Weighted Average. The method adopted will have a bearing on the cost of goods sold as well as the closing stock. Under FIFO, the cost of goods sold will bear more of the cost of materials bought during earlier periods, while the closing stock will reflect the more recent or current replacement cost. In LIFO, the converse will hold good. Under Weighted average method, both the cost of goods sold and closing inventory will bear the average cost of materials purchased during the period. CASH: While valuing cash should not pose any problem in the normal course, problem will arise when it is deployed in short-term interest-bearing deposits or treasury deposits. These are generally risk-free and there is no default risk. ACCOUNTS RECEIVABLES are the sums owned by the customers to whom products have been sold or services rendered on credit. Depending on the accounting jurisdiction, property assets such as land, buildings and plant and machinery, may be carried on the balance sheet either at historic cost or at recent market valuation, and this choice can radically affect book value. While in India the assets are shown at historic cost, in the U.K. property owned by companies is often revalued on a regular basis and
26
included in the accounts at close to current values. The practice in the USA, France and Germany are similar to that in India, and in all these cases of historical cost accounting, the book value will be lower than the current value. Where properties are valued by expert valuers or surveyors using, for instance estimates of rental income, they can be considered to be included at economic value (the present value of future income generated) rather than historic cost. However, the practice in U.K., where tangible assets are shown at lesser of depreciated book value or market value, gives a better indicator of current values, though not very accurate. The book value of assets do not take into account factors such as inflation or obsolescence. If the valuer has more detailed information on the type and age of assets than is available from the accounts, it is possible to adjust book values of fixed and, indeed current, assets to a closer estimate of current value. Another fixed asset which may be included at other than historic cost is property under construction. In some countries, including India, companies are allowed to capitalize the interest they pay on debt related to the construction rather than write it off as an expense. INTANGIBLE ASSETS: Intangible assets include expenditure on research and development (R&D), brand values, intellectual capital and goodwill. R&D expenditure represents cash spent on a knowledge base which may generate future revenues. Treatment of R&D expenses varies from country to country. Similarly, there is some argument for capitalizing expenditure on other forms of knowledge, as in database systems within consultancy firms or expertise provided by professional employees in investment banks. This is known as intellectual capital and firms such as Scandia, a Swedish insurance company, have pioneered approaches to the valuation of intellectual capital for inclusion in the balance sheet. Another type of intangible asset over which there has been controversy is capitalization of brand values in the balance sheet, as done by Coca-Cola or Amazon.com. The methods for valuing brands are linked to forecast cash flows related to the brands and hence to economic value.
27
Therefore, capitalization of brands will give a closer approximation to market value than would the exclusion of the brands. The difference between the price paid for a company and its book value is known as goodwill. This is because goodwill is an intangible asset, which arises as a result of the fact that book values of companies typically do not reflect their economic values, and hence the prices paid for companies, especially for high value-added firms such as advertising agencies and consulting firms. OFF-BALANCE SHEET ITEMS: Besides fixed assets and intangible assets, another possible area where the value of the shareholders? funds can mislead is its exclusion, by definition, of what are known as off-balance sheet items. These can be leases, pension assets or liabilities, employee-related liabilities and other contingent liabilities which may be mentioned in the notes to the accounts. FACTORS IN ASSET VALUATION: The factors to be considered for valuation of Assets are given below: a. Type of Building/Plant/Equipment b. Specifications/Ratings c. Make and Model d. Year of construction/installation e. Service conditions f. Extent of upkeep/maintenance g. Upgradation, Retrofits, Modifications and Modernisation of assets, if any Capacity costs are non-linear and follow an exponential equation. „Factor Estimating? is an established method of estimating the cost of a project, and is widely used in Project Cost Estimation. If the cost of a given unit (C1) is known at one capacity (Q1) and it is desired to estimate the cost at another capacity (Q2), the cost at the second capacity (C2) can be determined using the following equations: Basis of Asset Valuation: a. Replacement Cost/Value
28
b. Market Value = Replacement Cost – Depreciation c. Agreed Value Replacement Cost/Value is the Current Cost of a new asset of same kind – Value of similar new property, and is based on current prices/quotes. However, it is costly to determine, time consuming, and is not always feasible.
Replacement cost factors: a. Current F.O.B/F.O.R Cost of a new asset b. Price escalation c. Foreign Currency rate d. Duties & Taxes : Customs/Excise/S.Tax e. Set off as Cenvat credit f. Freight, Insurance, Handling, Inland transit g. Erection costs Market Value: It is the amount at which a property of the same age and description can be bought or sold. Estimating of replacement costs can be done by indexing the original acquisition costs, or through an ab initio estimating from technical specifications. Determination of market value requires estimating depreciation or the life of an asset and the residual life of an asset. Agreed Values are arrived at for properties whose Market Value cannot be ascertained, such as Curios, Works of art, Manuscripts, and Obsolete machinery. However, such valuations require Valuation certificate from expert valuers.
29
LITERATURE REVIEW
Valuing Contingent Consideration under SFAS 141R, Business Combinations: Issues and Implications for CFOs and the Transaction Team
Lynne J. Weber, PhD, and Rick G. Schwartz, PhD
Statement of Financial Accounting Standards No. 141, Business Combinations (revised 2007) (SFAS 141R) overhauls the fi nancial reporting requirements for business combinations. The implications are broad and numerous: The transaction price will change. The amount of goodwill will change. More items in the fi nancial statements will be recorded at fair value. The time it takes for a transaction to become accretive will be different. New contributors to earnings volatility will emerge. The Dr. Lynne J. Weber is a managing director and the leader of the Strategic Value Advisory Practice at Duff & Phelps. Dr. Weber has more than 25 years of experience consulting on valuation of business strategies, transactions, and operational improvement strategies. She holds a Ph.D. in operations research and a master.s degree in statistics, both from Stanford University, and a B.A. in mathematics from Cornell University. Dr. Rick G. Schwartz is a managing director in Duff & Phelps.s Corporate Finance Consulting Practice. Dr. Schwartz provides valuation and strategic advisory services to support merger and acquisition transactions; licensing and partnering decisions; and strategic investments in the life sciences, high technology, and other industries. He has a Ph.D. in engineering.economic systems from Stanford University. 1We anticipate that over time, additional guidance will be provided and both Practice
30
optimal structuring and terms of merger and acquisition transactions will change. SFAS 141R takes effect for the fi rst fi scal year starting on or after 15 December 2008. For calendar year-end companies the impact is already being felt: the new rules are affecting their business combinations for which the acquisition date is on or after 1 January 2009. One of the changes in the new standard is the requirement to recognize contingent consideration at fair value on the acquisition date. Consequently, a contingent consideration asset or liability will be remeasured to fair value at each reporting date until the contingency is resolved; any corresponding change in recorded value will often impact earnings. This is a big change. Under the old rules, contingent consideration was usually not recognized until the contingency was resolved. The requirement to measure the acquisition-date fair value of contingent consideration raises a number of important valuation and merger and acquisition transaction issues. In this paper, we address the following topics: How to value contingent consideration • Implications for chief fi nancial offi cers (CFOs), the fi nancial reporting function, and the transaction team Before discussing these issues, we begin with a defi nition of contingent consideration and a description of the guidance regarding contingent consideration in SFAS 141R, as issued.1 DeÞ nition of Contingent Consideration As defi ned in SFAS 141R, contingent consideration is: • An obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specifi ed future events occur or conditions are met or • The right of the acquirer to the return of previously
31
transferred consideration if specifi ed conditions are met. Thus, contingent consideration can be a liability, as in the fi rst bullet point above, or an asset, as in the second bullet point above. Contingent consideration is a part of many transactions in which substantial uncertainties exist about how the acquired business will perform post-transaction. Contingent consideration can help achieve the objectives of both sides of a transaction negotiation by: • Closing the gap in expectations for the business between the buyer and seller • Allowing the buyer to share the risk associated with the future of the business with the seller by making some of the consideration contingent on future performance • Allowing the seller to participate in the upside post-transaction • Providing incentives for the seller to remain involved with, and help drive the future success of, the business. A common example of a contingent consideration liability is an earn-out clause, with payments conditional on reaching milestones or on the magnitude of sales or profi tability. The Requirements of SFAS 141R Regarding Contingent Consideration Under SFAS 141R, as issued, contingent consideration is to be recognized at acquisition-date fair value as part of the consideration transferred. SFAS 141R uses the fair value defi nition in Statement of Financial Accounting Standards No. 157, Fair Value Measurements, which defi nes fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The subsequent accounting for contingent consideration will depend on whether it is classifi ed as equity or as an asset or a liability. An obligation to pay contingent consideration will be classifi ed either as equity or as a
32
liability based on applicable generally accepted accounting principles (GAAP).2 A contingent right to the return of previously transferred consideration will be classifi ed as an asset. Classifi cation of contingent consideration will not always be obvious. For example, some technology companies routinely structure contingent consideration with the option for the acquirer to pay the additional consideration in cash or in equity. The classifi cation of such arrangements will depend on the specifi c facts and circumstances incorporated in the transaction terms. However, the expectation is that such arrangements will more often be classifi ed as a liability than as equity. The guidance on subsequent accounting for contingent consideration under SFAS 141R is as follows: • Contingent consideration classifi ed as equity is not remeasured. Its subsequent settlement is accounted for within equity. • Contingent consideration classifi ed as an asset or a liability will be remeasured to fair value at each reporting date until the contingency is resolved. The changes in fair value will be recognized in earnings unless the arrangement is a hedging instrument for which SFAS 133, as amended by SFAS 141R, requires that the changes be recognized in other comprehensive income. The Impact on Earnings The impact of the requirement of SFAS 141R to remeasure contingent consideration assets and liabilities to fair value appears to be obvious; one might assume the volatility of earnings would increase. However, if we look below the surface, we see that remeasurement of contingent consideration to fair value actually may, in some 2In particular, an obligation to pay contingent consideration is classifi ed as a liability or as equity in accordance with Financial Accounting Standards Board Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company?s Own Stock,” or other Applicable
33
situations, buffer earnings from the ups and downs of the acquired business. Consider the case in which a cash payment of additional consideration is to be made after twelve months, contingent on the performance of the business in each of the fi rst four quarters post-acquisition. Suppose the acquired business succeeds in generating cash fl ows above some baseline expectations in the fi rst quarter post-acquisition. Then the business will have a positive impact on quarterly earnings compared to expectations. At the same time, it will become more likely that the acquirer will be required to pay the contingent con sideration and/or that the amount of contingent consideration paid will be larger. Thus, the fair value of the contingent consideration liability will rise. Remeasurement of the contingent consideration liability will have a negative impact on earnings, counterbalancing some of the positive impact from the good results. The net impact on earnings may be positive or negative. However, the remeasurement of the contingent consideration value has the opposite effect on earnings from the direct effect on earnings of the change in business performance. A similar buffering phenomenon can be observed for certain contingent consideration assets, e.g., clawbacks of consideration in case of poorer-than-expected performance. Payment of consideration can also be contingent on changes in expectations for the future performance of the business. For example, consider the case in which a cash payment of additional consideration is contingent on the achievement of a certain research and development (R&D) milestone. Missing that milestone may reduce the likelihood that the acquirer will pay, lengthen the time frame for payment of, and/or decrease the expected payment amount of any contingent consideration related to achievement of the milestone. Negative changes in the expected amounts or delays in timing for payment of the contingent consideration would have a positive effect on earnings. However, under SFAS 141R, in-process R&D (IPR&D) projects acquired in a business combination are to be capitalized at their acquisition-date fair values and subsequently tested for impairment at fair value until
34
completion or abandonment. Missing an important R&D milestone may lead to an impairment of the IPR&D pro ject. Thus, any impairment charge related to IPR&D acquired in a business combination could be counterbalanced to some degree by a gain on any related contingent consideration liability. While missing an important milestone for R&D acquired in a business combination may lead to both an impairment charge and a gain on a related contingent consideration liability, achieving that milestone may dampen current earnings without any contemporaneous mitigating effect. Achieving an important R&D milestone brightens future prospects for the business, but it may simultaneously dampen current earnings via the increase in fair value of any corresponding contingent consideration liability. Of course, this effect could also have occurred under the old rules. Regardless of whether the consideration is contingent on actual performance of the business or expectations for its future performance, if positive business results having a less positive (or even negative) net impact on earnings due to the new accounting required for contingent consideration, that can delay the time until a transaction is accretive. Identifying Contingent Consideration Before contingent consideration can be valued, it must be identifi ed. While this sounds simple, it may not always be easy to determine. The most obvious question is whether the business combination includes additional consideration (cash, equity, warrants, options, etc.) to be provided only if certain conditions are met. Examples include: • Additional consideration if the acquired business meets certain revenue, profi t, margin or stock targets and • Milestone payments for product development or liquidity events. Valuation Techniques There are three traditional approaches to value:
35
income, market, and cost. Be aware, however, that not all such incremental consideration will be classifi ed as contingent consideration; an accounting determination must be made as to whether any such consideration is part of the business combination or part of a separate transaction that should be accounted for outside of the business combination. One must also fi nd out if any circumstances are present under which the transaction agreement requires consideration to be returned. Examples include failures to meet targets, pass regulatory reviews, and meet covenants. While this question may also seem somewhat obvious, it is perhaps less natural for many fi nancial reporting teams to ask about return of consideration, as prior to SFAS 141R, contingent assets were rarely recorded. Turning to the less obvious questions, one must ask (a) whether selling shareholders or management may gain any future performance-based compensation and (b) whether any other agreements are in place between the acquirer and any of the selling shareholders that are not at market rate.
36
INDUSTRY PROFILE , COMPANY PROFILE & SWOT ANALYSIS Introduction India is the ninth largest aviation market in the world, according to RNCOS research report, titled "Indian Aerospace Industry Analysis". It is anticipated that the civil aviation market will register more than 16 per cent compound annual growth rate (CAGR) during 2010-2013 on back of strong market fundamentals. The rapidly expanding aviation sector in India handles about 2.5 billion passengers across the world in a year; moves 45 million tonnes (MT) of cargo through 920 airlines, using 4,200 airports and deploying 27,000 aircraft. Currently, 87 foreign airlines fly to and from India and five Indian carriers fly to and fro from 40 countries. India is expected to be amongst the top five nations in the world in the next 10 years. An efficient civil aviation sector is important for India as it is inter-linked with other sectors in the economy and generates income and employment through global commerce and tourism, as per a National Council of Applied Economic Research (NCAER) study titled 'Emirates in India Assessment of Economic Impact and Regional Benefits'. Airport infrastructure in India is witnessing improvisation and expansion on a massive scale, with the Government avidly supporting private participants. The need for airport infrastructure in India has increased considerably. In order to ramp up airport infrastructure, the Government has unveiled reforms to facilitate investment in this segment. The investment in Indian airport infrastructure market, especially in the greenfield projects is expected to increase. Market Size The domestic airlines carried 438.4 million passengers during January -September 2012 (first three quarters of calendar year), according to data released by the Directorate General Civil Aviation (DGCA). The air transport (including air freight) in India has attracted foreign direct investment (FDI) worth US$ 446 million from April 2000 to September 2012, as per data released by Department of Industrial Policy and Promotion (DIPP). Market Players
?
SpiceJet Ltd has announced the launch of two new international flights from Kochi, Kerala to Male and Dubai. The airline has deployed the Bombardier Q400 aircraft, with a capacity of 78 passengers, in the Kochi-Male route
37
?
IBS Software has entered into a contract with Lufthansa Cargo AG for the implementation of its air cargo solution - iCargo. The deal worth Rs 700 crore (US$ 127.50 million) has three segments and IBS Software has major share of the contract
Aerospace on a High
?
?
?
India and New Zealand have signed the "Arrangement for Cooperation on Civil Aviation". Under the arrangement, the two countries will promote and support the development of training and technical cooperation in the field of civil aviation GVK Power and Infrastructure Ltd has signed an operations and management contract with the Airports Authority of Indonesia (Angkasa Pura Airports). The scope of the contract includes managing non-aeronautical commercial operations at both the existing terminals and the new international terminal of Indonesia's second busiest Bali (Denpasar) international airport Maldivian Airlines has expanded its flight network by connecting Chennai, Mumbai and Dhaka with Male, the capital city of Maldives. "India is our focus market, as it has a great potential," said Mr Bandhu Ibrahim Saleem, Chairman, Maldivian Airlines
India will be the fourth biggest market in terms of value for all new aircraft deliveries after China, the US and the UAE during the next 20 years, according to aircraft maker Airbus
38
Factors that are not in favor of investments… Aviation economics are not favorable in India Higher taxes on ATF and airport charges continue to be key headwinds for the sector; besides higher cost base, airlines in India are also mandatorily required to fly on certain unviable routes Inadequate Infrastructure Development of airport infrastructure has not kept pace with demand, thereby resulting in delays and higher costs for airlines Poor financial health of most airlines Intense competition, sharp fluctuation in ATF prices and high debt burden continue to weigh on the financial performance of Indian airlines; foreign exchange fluctuation and lack of adequate hedging mechanism (for fuel) have added to the woes Highly competitive & Price Sensitive traveler base .
39
01. COMPANY PROFILE
Jet Airways is the second largest Indian airline based in Mumbai, Maharashtra, both, in terms of market share[4] and passengers carried.[5] It is owned by Naresh Goyal. It operates over 400 flights daily to 76 destinations worldwide. Its main hub is Mumbai, with secondary hubs at Delhi,Kolkata, Chennai, Bengaluru and Pune.[6] It has an international hub at Brussels Airport, Belgium. The recession forced Jet Airways to discontinue the following routes: Ahmedabad–London, Amritsar–London, Bangalore–Brussels, Mumbai–Shanghai–San Francisco and Brussels-New York.[7] It also had to put an indefinite delay on its expansion plans. Jet Airways was forced to lease out seven of its ten Boeing 777-300ERs to survive the financial crunch. Due to the recession all flights to North America were operated on an Airbus A330200 replacing the Boeing 777-300ERs. It also had to sell a brand-new, yet-to-be-delivered Boeing 777-300ER in 2009 and had to defer all new aircraft deliveries by at least two years. The airline planned to restore the Mumbai-Shanghai route by the end of 2011 but never went through with it.[8] As the economic crisis in the eurozone countries worsened, Jet also closed the DelhiMilan route.[9] Jet Airways was incorporated as an air taxi operator on 1 April 1992. It started commercial operations on 5 May 1993 with a fleet of four leased Boeing 737-300 aircraft. In January 1994 a change in the law enabled Jet Airways to apply for scheduled airline status, which was granted on 4 January 1995. Naresh Goyal – who already owned Jetair (Private) Limited, which provided sales and marketing for foreign airlines in India – set up Jet Airways as a full-service scheduled
40
airline to compete against state-owned Indian Airlines. Indian Airlines had enjoyed a monopoly in the domestic market between 1953, when all major Indian air transport providers were nationalised under the Air Corporations Act (1953), and January 1994, when the Air Corporations Act was repealed, following which Jet Airways received scheduled airline status. Jet began international operations from Chennai to Colombo in March 2004. The company is listed on theBombay Stock Exchange, but 80% of its stock is controlled by Naresh Goyal (through his ownership of Jet?s parent company, Tailwinds). It has 13,177 employees (as at 31 March 2011).[10] In January 2006 Jet Airways announced that it would buy Air Sahara for US$500 million in an all-cash deal, making it the biggest takeover in Indian aviation history. It would have resulted in the country's largest airline but the deal fell through in June 2006. On 12 April 2007 Jet Airways agreed to buy out Air Sahara for INR14.5 billion (US$340 million). Air Sahara was renamed JetLite, and was marketed between a low-cost carrier and a full service airline. In August 2008 Jet Airways announced its plans to completely integrate JetLite into Jet Airways.[11] In October 2008, Jet Airways laid off 1,900 of its employees, resulting in the largest lay-off in the history of Indian aviation.[12] However the employees were later asked to return to work; Civil Aviation Minister Praful Patel said that the management reviewed its decision after he analysed the decision with them.[13][14] Jet Airways and their rival Kingfisher Airlines announced an alliance which primarily includes an agreement on code-sharing on both domestic and international flights, joint fuel management to reduce expenses, common ground handling, joint utilisation of crew and sharing of similar frequent flier programmes.[15] On 8 May 2009 Jet Airways launched its lowcost brand, Jet Konnect. The decision to launch a new brand instead of expanding the JetLite network was taken after considering the regulatory delays involved in transferring aircraft from Jet Airways to JetLite, as the two have different operator codes. The brand was launched on sectors that had 50% or less load factor with the aim of increasing it to 70% and above. Jet officials said that the brand would cease to exist once the demand for the regular Jet Airways increases.
2010-PRESENT: RISE TO INDIA'S LARGEST AIRLINE
41
According to a PTI report, for the third quarter of 2010, Jet Airways (Jet+JetLite) had a market share of 26.9%[16] in terms of passengers carried, thus making it a market leader in India, followed by Kingfisher Airlines with 19.9%. In July 2012, Jet Airways officially sought government approval to join Star Alliance.[17] In June 2011, Jet Airways banned carrying fish, crab, meat, poultry products and liquid items as check-in baggage.[18] Jet is the first domestic airline to impose such a ban. Jet claimed that passengers complained of their baggage getting soiled by seepage from bags containing meat products. Early in 2013, Etihad Airways, on of the flag carriers of the United Arab Emirates based out of Abu Dhabi planned to buy a stake in Jet Airways. Jet announced that they were ready to sell a 24% stake to Etihad at US$330 million. Earlier, in September 2012, the government of India announced that foreign airlines can take up a stake of upto 49% in Indian airlines, thereby making this deal possible. Etihad, which had already purchased stakes in 4 other loss making airlines, said, they were "concentrating on future potential rather than past performance", and were ready to take up the stake in Jet.[19] Initially, Jet announced that they were likely to sign the stake sale deal with Etihad between January 22 and February 3,[20]which they later confirmed to as January 25.[21] However, the date passed by and the deal was further postponed.[22] Meanwhile, Jet Airways concentrated well on revenues, costs and network side, which resulted in the airline making profits for the first time since therupee depreciation. Nikos Kardassis, the Chief Executive Officer of Jet Airways said "The combined impact of higher yields and lower costs (ex-fuel) have resulted in significantly lowering the breakeven seat factor levels in the business."[23] The airline announced a sale on its website, which offered 2 million seats for travel within India, till December 31 2013. This sale was announced a little over one month after rival low-cost carrier SpiceJet announced a sale, which was expected to have triggered a farewar.[24] High airfares throughout 2012 due to grounding of Kingfisher Airlines caused passengers to opt out of air travel, leading to negative growth in traffic for the first time since 2009. Jet Airways planned to attract more passengers by subsequently lowering the fares, which was followed by SpiceJet again. With two airlines offering cheaper travel, India's flag carrier started losing passengers and it too offered cheaper tickets. This was followed by IndiGo and GoAir, resulting in a full-fledged fare war.[25] Jet had introduced four different slabs of discounts depending upon the distance to destination. Under the offer, the fare up to 750 kilometres was priced at 2,250 (US$40.95), while for 75042
1000 kilometres it was 2,850 (US$51.87). For air travel over a distance ranging from 1000 to 1400 kilometres, tickets were sold for 3,300 (US$60.06) and for travel beyond 1400 kilometres, tickets were sold for a maximum of 3,800 (US$69.16).[26] Based on a calculation by The Economic Times, on average, Jet Airways was selling 6400 tickets per day, or 14 tickets per flight at these discounted rates. According to the news agency, several Indian travel sites started experiencing sever issues following a sudden increase in bookings. MakeMyTrip chief operating officer Keyur Joshi said that this move would help airlines increase aircraft occupancy from 75% to 85%.[27]
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SWOT ANALYSIS OF JET AIRWAYS
Jet Airways Parent Company Tailwinds Limited
Category
Indian domestic sector
Sector
Airlines
Tagline/ Slogan
The Joy of Flying
USP
Premium Airline, High Class
STP
STP
Segment
Passengers preferring comfort
Target Group
Corporate, Upper Middle Class
Positioning
Premium
SWOT Analysis
SWOT Analysis
1. Has created a good image among the Indian fliers 2. Trusted Airline by the Corporates 3. One of the biggest Indian airline companies with over 13,000 employees 4. Operations in over 75 Indian cities and over 400 daily flights 5. Top of the mind brand due to excellent operations and marketing Strength 6. It also has international destinations in nearly 20 countries
1. Competition from the LCCs and other competitors means market share growth is tough Weakness 2. Presence of other airlines on international routes making it difficult
44
to have significant market share
1. Strongly positioned in the International routes 2. Has presence in every segment Opportunity 3. Increasing number of people opting to travel by airlines
1. LCCs eatiing up the marketshare 2. Rising Fuel Costs and Labour Costs Threats 3. Unfavorable Govt policies and aviation regulations
Competition
1.Kingfisher Competitors 2.Air India
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OBJECTIVES AND SCOPE
OBJECTIVES :01) Become familiar with various methods and techniques of business valuation 02) Be able to decide on the most appropriate method or methods of valuation according to the circumstance, i.e., the purpose for which it is being done. SCOPE :01. TO GET FAMILIAR WITH THE VALUATION CONCEPTS AND ITS TYPES
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DATA ANALYSIS
VALUATION OF JET AIRWAYS THROUGH DISCOUNTED CASH FLOW VALUATION
01.
SECTOR PERFORMANCE
The Indian Aviation Industry has been going through a turbulent phase over the past several years facing multiple headwinds – high oil prices and limited pricing power contributed by industry wide over capacity and periods of subdued demand growth. Over the near term the challenges facing the airline operators are related to high debt burden and liquidity constraints most operators need significant equity infusion to effect a meaningful improvement in balance sheet. Improved financial profile would also allow these players to focus on steps to improve long term viability and brand building through differentiated customer service. Over the long term the operators need to focus on improving cost structure, through rationalization at all levels including mix of fleet and routes, aimed at cost efficiency. At the industry level, long term viability also requires return of pricing power through better alignment of capacity to the underlying demand growth. While in the beginning of 2008-09, the sector was impacted by sharp rise in crude oil prices, it was the decline in passenger traffic growth which led to severe underperformance during H2, 2008-09 to H1 2009-10. The operating environment improved for a brief period in 2010-11 on back of recovery in passenger traffic, industry-wide capacity discipline and relatively stable fuel prices. However, elevated fuel prices over the last three quarters coupled with intense competition and unfavorable foreign exchange environment has again deteriorated the financial performance of airlines. During this period, while the passenger traffic growth has been steady (averaging 14% in 9m 2011-12), intense competition has impacted yields and forced airlines back into losses in an inflated cost base scenario. To address the concerns surrounding the
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operating viability of Indian carriers, the Government on its part has recently initiated a series of measures including (a) proposal to allow foreign carriers to make strategic investments (up to 49% stake) in Indian Carriers (b) proposal to allow airlines to directly import ATF (c) lifting the freeze on international expansions of private airlines and (d) financial assistance to the national carrier. However, these steps alone may not be adequate to address the fundamental problems affecting the industry. While the domestic airlines have not been able to attract foreign investors (up to 49% FDI is allowed, though foreign airlines are currently not allowed any stake), foreign airlines may be interested in taking strategic stakes due to their deeper business understanding, longer investment horizons and overall longer term commitment towards the global aviation industry. Healthy passenger traffic growth on account of favorable demographics, rising disposable incomes and low air travel penetration could attract long-term strategic investments in the sector. However, in our opinion, there are two key challenges: i) aviation economics is currently not favorable in India resulting in weak financial performance of airlines and ii) Internationally, too airlines are going through period of stress which could possibly dissuade their investment plans in newer markets. Besides, foreign carriers already enjoy significant market share of profitable international routes and have wide access to Indian market through code-sharing arrangements with domestic players. Given these considerations, we believe, foreign airlines are likely to be more cautious in their investment decisions and strategies are likely to be long drawn rather than focused on short-term valuations. On the proposal to allow import of ATF, we feel that the duty differential between sales tax (averaging around 22-26% for domestic fuel uplifts) being currently paid by airlines on domestic routes and import duty (8.5%-10.0%) is an attractive proposition for airlines. However the challenges in importing, storing and transporting jet fuel will be a considerable roadblock for airlines due to OMCs monopoly on infrastructure at most Indian airports. From the working capital standpoint too, airlines will need to deploy significant amount of resources in sourcing fuel which may not be easy given the stretched balance sheets and tight liquidity profile of most airlines. Historically, the Indian aviation sector has been a laggard relative to its growth potential due to excessive regulations and taxations, government ownership of airlines and resulting high cost of air travel. However, this has changed rapidly over the last decade with the sector showing explosive growth supported by structural reforms, airport modernizations, entry of private
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airlines, adoption of low fare - no frills models and improvement in service standards. Like elsewhere in the world, air travel is been transformed into a mode of mass transportation and is gradually shedding its elitist image. Strong passenger traffic growth aided by buoyant economy, favorable demographics, rising disposable incomes and low penetration levels India aviation industry promises huge growth potential due to large and growing middle class population, favorable demographics, rapid economic growth, higher disposable incomes, rising aspirations of the middle class, and overall low penetration levels (less than 3%). The industry has grown at a 16% CAGR in passenger traffic terms over the past decade. With advent of LCCs and resultant decline in yields, passenger traffic growth which averaged 13% in the first half has increased substantially to 19% CAGR during 2006-2011. Despite strong growth, air travel penetration in India remains among the lowest in the world. In fact, air travel penetration in India is less than half of that in China where people take 0.2 trips per person per year; indicating strong long term growth potential. A comparative statistic in United States, the world?s largest domestic aviation market stands at 2 trips per person per year. We expect passenger demand to remain stable and grow between 12-15% in the medium term, assuming a no major weakness in GDP growth going forward. However domestic airlines operate under high cost environment; intense competition has constrained yields; aggressive fleet expansions have impacted profitability and capital structures Despite reforms, the domestic aviation sector continues to operate under high cost environment due to high taxes on Aviation Turbine Fuel (ATF), high airport charges, significant congestion at major airports, dearth of experienced commercial pilots, inflexible labor laws and overall higher cost of capital. While most of these factors are not under direct control of airline operators, the problems have compounded due to industry-wide capacity additions, much in excess of actual demand. Intense competitive pressure from Low cost carriers (focusing on maximizing load factors) and national carrier (looking to regain lost market share) have constrained yields from rising in-sync with the elevated cost base. Besides, aggressive fleet expansions (LCCs have added aircrafts mainly on long-term operating leases; FSC?s have purchased aircrafts – debt financed, most often backed by guarantees from the US EXIM Bank or Europe?s ECA) to leverage upon the anticipated robust growth and to support international operations have
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significantly impacted the capital structure and weakened the credit profile of most domestic airlines.
The domestic airlines industry is facing significant operating (slowing growth, rising fuel costs) and non-operating (interest costs, rupee depreciation) challenges as evident in the quarterly performance trends of listed airline companies. Sales Growth: After a strong rebound in 2010, the pax growth has been moderating over the last few quarters due to moderating economic growth and weak industrial activity. Besides, severe competitive pressure from domestic LCC players (rapidly gaining market share) and Air India (trying to maintain market share) have resulted in price wars (at times below cost pricing), lowered yields and moderated sales growth for the airlines. Even on international routes, the yields have remained weak due to weaker economic conditions and severe competition from global airlines. Rising ATF Prices & Steep Rupee Depreciation: The airlines industry had been severely impacted by the significant increase in ATF prices (up 57% in last 18 months) as Indian Carriers do not hedge fuel prices and have exhibited limited ability to charge fuel surcharges due to irrational and undisciplined pricing dictated by competition rather than costs / demand. Besides, the steep rupee depreciation (~18.7% depreciation in CY11, although partly reversed through 7.3% YTD appreciation in CY12) acts double whammy as apart from fuel costs, substantial portion of other operating costs like lease rentals, maintenance, expat salaries and a portion of sales commissions are USD-linked or USD-denominated. Profit Margins: With combined impact of 1) moderating pax growth 2) lower yields due to excessive competitive 3) rising ATF prices 4) steep rupee depreciation and 5) rising debt levels and interest costs, the profitability margins of the airlines industry have been severely impacted. As per Centre for Asia Pacific Aviation (CAPA), Indian carriers could be posting staggering losses of $2.5 billion (~Rs 12,500 crore) in 2011-12, worse than the losses of 2008-09 when traffic was declining and crude oil prices spiked to $150 per barrel. Overall, the industry has been marred by cost inefficiencies and is bearing the brunt of aggressive price cuts, rising costs, expensive jet fuel, a weaker rupee, high interest payments and hence mounting losses. The government support required to bailout the loss making Air India has increased substantially; while the leading private players like Kingfisher Airlines, Jet
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Airways and SpiceJet are making significant losses. With Banks unwilling to enhance their exposure to the industry, recast their loans or pick up equity stakes without viable business plans, industry needs to come out with strong equity infusion plans. Hence, the government is mulling allowing foreign carriers to pick strategic stakes in domestic airlines to help them stay afloat in these difficult times, besides bringing global expertise and best industry practices over the medium term.
FDI in Aviation: Feasibility and Impact Analysis for various stakeholders
FDI Proposal: The Civil Aviation Ministry is expected to soon circulate a proposal before the union cabinet to consider allowing up to 49% equity investment by foreign carriers in domestic airlines. In case of listed airlines, if the proposal does not get a waiver from SEBI?s Takeover Code, foreign carriers may have to first make an open offer of 26% stake to public shareholders and later acquire up to 23% stake (from promoters or fresh equity), such that their stake remains within the 49 % cap. Indian Carriers: The FDI proposal, if approved, would certainly be an important milestone in the aviation sector and may provide much-needed relief to the domestic aviation industry reeling under the pressure of mounting losses and rising debt burden. Besides, the move will help bring global expertise and best industry practices over the medium term. Foreign Carriers: It will not just provide entry into one of the fastest growing aviation market globally but also an opportunity to establish India as their hub for connections between US/Europe and South-East Asian countries. While full-service airlines could help them further consolidate their market position on international routes (and improve connectivity within India), acquisition of low-cost airlines could help them compete in a market where travelers are highly price sensitive. Consumers: New players could enter the market as they could now have a strategic foreign player with deep pockets to support the airline in difficult times. Besides, it would provide more flexibility in international travels when one travels through the same airline domestically as well as internationally. Overall, this could increase competition, offer more alternatives, reduce tariffs and improve customer service standards over the medium term.
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However, the Global Airline industry is itself currently going through a tough phase (Bloomberg World Airline index down 22%, Asia-Pacific Airline index down 25% in last one year), due to below trend economic growth across advanced economies and high crude oil prices ($100125/Barrel). Besides, aviation economics currently remain unfavorable in India due to intense competition, mandatory route dispersal guidelines, higher taxes on ATF, airport related charges and inadequate airport infrastructure. For example, airlines like Air Asia (citing high infrastructure costs) & American Airlines (parent facing financial stress) have recently withdrawn from India. Lastly, foreign carriers already enjoy significant market share of profitable international routes and have wide domestic access through code sharing agreements. Given these considerations, we believe, attracting investments from foreign airlines may not be easy
. Foreign carriers already enjoy significant share of international traffic; domestic access through code sharing agreements As per DGCA data, foreign carriers already enjoy ~65% market share in international traffic and hence ~27% of total passenger traffic (Domestic + International). For Jet Airways, due to longer haulage (~4.6 hrs avg block hours in international routes as compared to ~1.6 hrs avg block hours in domestic routes), revenue per passenger carried on international route has been 2.5x to 3.0x revenue per passenger carried on do mestic route. We expect this ratio to be higher on an industry wide basis as foreign carriers dominate longer haulage routes, full service offerings and business traffic as compared to shorter haulage, low fare offerings & VFR (visiting friends and relatives) traffic prominence of Indian carriers. As a result, we estimate that the foreign carriers have already garnered 42-48% of total airline revenues (inbound, outbound & within India). Besides, the stark difference between Jet Airways? domestic and International EBITDAR margins indicates that the foreign airlines could be already enjoying majority of the industry profits, with the domestic carriers left with price conscious no-frills pax traffic, less viable routes and hence saddled with high operating losses. Besides, due to number of code sharing agreements, foreign carriers can offer enhanced connectivity into Indian cities without acquiring stakes in Indian carriers. Dilutions at Current market capitalizations unlikely to solve issues of staggering debt levels and mounting losses
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Besides, since the airlines stocks have corrected significantly over the last two years, fresh equity infusions are current market capitalizations (although 50-100% higher YTD) could lead to considerable stake dilution for the existing promoters who have built these businesses over the years. Besides, the amount of fresh equity that could be raised at current market prices would not be a game-changer considering the staggering debt levels and quarterly losses posted by the airline industry (auditors have already raised concerns over the rapid depletion of networth for all listed airline companies).
Factors that support investments in Indian Aviation Sector… Strong growth prospects Passenger traffic growth has grown at a CAGR of 16% in India over the past 10 years Relative underpenetrated market Penetration of air travel at <3% is significantly below benchmarks in other markets An opportunity to create India as an hub An opportunity for foreign airlines to create India as their hub for international traffic between Europe and South East Asia; Additionally offer better connectivity within India with international destinations An opportunity to create India as an MRO centre Foreign airlines could also look at leveraging on India?s lowcost arbitrage by setting up MRO facilities in India Low Valuations Market valuation of listed airlines in India has suffered due to poor performance
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Factors that are not in favor of investments… Aviation economics are not favorable in India Higher taxes on ATF and airport charges continue to be key headwinds for the sector; besides higher cost base, airlines in India are also mandatorily required to fly on certain unviable routes Inadequate Infrastructure Development of airport infrastructure has not kept pace with demand, thereby resulting in delays and higher costs for airlines Poor financial health of most airlines Intense competition, sharp fluctuation in ATF prices and high debt burden continue to weigh on the financial performance of Indian airlines; foreign exchange fluctuation and lack of adequate hedging mechanism (for fuel) have added to the woes Highly competitive & Price Sensitive traveler base .
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02. COMPANY PROFILE
Jet Airways is the second largest Indian airline based in Mumbai, Maharashtra, both, in terms of market share[4] and passengers carried.[5] It is owned by Naresh Goyal. It operates over 400 flights daily to 76 destinations worldwide. Its main hub is Mumbai, with secondary hubs at Delhi,Kolkata, Chennai, Bengaluru and Pune.[6] It has an international hub at Brussels Airport, Belgium. The recession forced Jet Airways to discontinue the following routes: Ahmedabad–London, Amritsar–London, Bangalore–Brussels, Mumbai–Shanghai–San Francisco and Brussels-New York.[7] It also had to put an indefinite delay on its expansion plans. Jet Airways was forced to lease out seven of its ten Boeing 777-300ERs to survive the financial crunch. Due to the recession all flights to North America were operated on an Airbus A330200 replacing the Boeing 777-300ERs. It also had to sell a brand-new, yet-to-be-delivered Boeing 777-300ER in 2009 and had to defer all new aircraft deliveries by at least two years. The airline planned to restore the Mumbai-Shanghai route by the end of 2011 but never went through with it.[8] As the economic crisis in the eurozone countries worsened, Jet also closed the DelhiMilan route.[9] Jet Airways was incorporated as an air taxi operator on 1 April 1992. It started commercial operations on 5 May 1993 with a fleet of four leased Boeing 737-300 aircraft. In January 1994 a change in the law enabled Jet Airways to apply for scheduled airline status, which was granted on 4 January 1995. Naresh Goyal – who already owned Jetair (Private) Limited, which provided sales and marketing for foreign airlines in India – set up Jet Airways as a full-service scheduled airline to compete against state-owned Indian Airlines. Indian Airlines had enjoyed a monopoly in the domestic market between 1953, when all major Indian air transport providers were nationalised under the Air Corporations Act (1953), and January 1994, when the Air Corporations Act was repealed, following which Jet Airways received scheduled airline status. Jet began international operations from Chennai to Colombo in March 2004. The company is listed on theBombay Stock Exchange, but 80% of its stock is controlled by Naresh Goyal (through his ownership of Jet?s parent company, Tailwinds). It has 13,177 employees (as at 31
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March 2011).[10] In January 2006 Jet Airways announced that it would buy Air Sahara for US$500 million in an all-cash deal, making it the biggest takeover in Indian aviation history. It would have resulted in the country's largest airline but the deal fell through in June 2006. On 12 April 2007 Jet Airways agreed to buy out Air Sahara for INR14.5 billion (US$340 million). Air Sahara was renamed JetLite, and was marketed between a low-cost carrier and a full service airline. In August 2008 Jet Airways announced its plans to completely integrate JetLite into Jet Airways.[11] In October 2008, Jet Airways laid off 1,900 of its employees, resulting in the largest lay-off in the history of Indian aviation.[12] However the employees were later asked to return to work; Civil Aviation Minister Praful Patel said that the management reviewed its decision after he analysed the decision with them.[13][14] Jet Airways and their rival Kingfisher Airlines announced an alliance which primarily includes an agreement on code-sharing on both domestic and international flights, joint fuel management to reduce expenses, common ground handling, joint utilisation of crew and sharing of similar frequent flier programmes.[15] On 8 May 2009 Jet Airways launched its lowcost brand, Jet Konnect. The decision to launch a new brand instead of expanding the JetLite network was taken after considering the regulatory delays involved in transferring aircraft from Jet Airways to JetLite, as the two have different operator codes. The brand was launched on sectors that had 50% or less load factor with the aim of increasing it to 70% and above. Jet officials said that the brand would cease to exist once the demand for the regular Jet Airways increases.
2010-PRESENT: RISE TO INDIA'S LARGEST AIRLINE
According to a PTI report, for the third quarter of 2010, Jet Airways (Jet+JetLite) had a market share of 26.9%[16] in terms of passengers carried, thus making it a market leader in India, followed by Kingfisher Airlines with 19.9%. In July 2012, Jet Airways officially sought government approval to join Star Alliance.[17] In June 2011, Jet Airways banned carrying fish, crab, meat, poultry products and liquid items as check-in baggage.[18] Jet is the first domestic airline to impose such a ban. Jet claimed that passengers complained of their baggage getting soiled by seepage from bags containing meat products. Early in 2013, Etihad Airways, on of the flag carriers of the United Arab Emirates based out of Abu Dhabi planned to buy a stake in
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Jet Airways. Jet announced that they were ready to sell a 24% stake to Etihad at US$330 million. Earlier, in September 2012, the government of India announced that foreign airlines can take up a stake of upto 49% in Indian airlines, thereby making this deal possible. Etihad, which had already purchased stakes in 4 other loss making airlines, said, they were "concentrating on future potential rather than past performance", and were ready to take up the stake in Jet.[19] Initially, Jet announced that they were likely to sign the stake sale deal with Etihad between January 22 and February 3,[20]which they later confirmed to as January 25.[21] However, the date passed by and the deal was further postponed.[22] Meanwhile, Jet Airways concentrated well on revenues, costs and network side, which resulted in the airline making profits for the first time since therupee depreciation. Nikos Kardassis, the Chief Executive Officer of Jet Airways said "The combined impact of higher yields and lower costs (ex-fuel) have resulted in significantly lowering the breakeven seat factor levels in the business."[23] The airline announced a sale on its website, which offered 2 million seats for travel within India, till December 31 2013. This sale was announced a little over one month after rival low-cost carrier SpiceJet announced a sale, which was expected to have triggered a farewar.[24] High airfares throughout 2012 due to grounding of Kingfisher Airlines caused passengers to opt out of air travel, leading to negative growth in traffic for the first time since 2009. Jet Airways planned to attract more passengers by subsequently lowering the fares, which was followed by SpiceJet again. With two airlines offering cheaper travel, India's flag carrier started losing passengers and it too offered cheaper tickets. This was followed by IndiGo and GoAir, resulting in a full-fledged fare war.[25] Jet had introduced four different slabs of discounts depending upon the distance to destination. Under the offer, the fare up to 750 kilometres was priced at 2,250 (US$40.95), while for 7501000 kilometres it was 2,850 (US$51.87). For air travel over a distance ranging from 1000 to 1400 kilometres, tickets were sold for 3,300 (US$60.06) and for travel beyond 1400 kilometres, tickets were sold for a maximum of 3,800 (US$69.16).[26] Based on a calculation by The Economic Times, on average, Jet Airways was selling 6400 tickets per day, or 14 tickets per flight at these discounted rates. According to the news agency, several Indian travel sites started experiencing sever issues following a sudden increase in bookings. MakeMyTrip chief operating officer Keyur Joshi said that this move would help airlines increase aircraft occupancy from 75% to 85%.[27]
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03. VALUE DRIVER OF JET AIRWAYS
MOST NIMBLE FULL SERVICE CARRIER IN INDIA
Jet Airways caters to all classes of flyers, offering services in all three segments, namely, Full Service Carriers, Full Service & Low Fare Carriers and Low Cost Carriers. This not only helps the airline to meet the diverse needs but also gives it the flexibility to move seats between the segments according to the market conditions and cyclicality, helping it to maximize revenues. With the economy picking up and air travel growing strongly, Jet has reintroduced business class seats in Jet Konnect while also adding new capacities under its FSC brand, „Jet Airways?.
OPERATIONAL EXCELLENCE
Jet Airways enjoys one of the best operating margins in the industry and the best amongst the listed companies. While international operations provide support to the overall margins of the company, the airline has effectively cut costs and has improved its personnel utilization substantially over the last couple of years. We expect Jet Airways to be able to further expand its margins cover the coming quarters.
IMPROVED DOMESTIC AND INTERNATIONAL MACROECONOMIC
Jet stands to benefit hugely from the sharp upturn in domestic business sentiments because of being the largest player in the segment. Improved global macroeconomic environment helped the company score even better load factors and margins in its international business segment. Given the huge international network and alliances, Jet is the best placed Indian airlines to benefit from the growing global attention towards India
INCREASING BUSINESS TRAVEL
Bulk of the demand for air travel comes from the corporate and business travelers.
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Further, shifts in demand for business travel mirrors the economic trends. India with its high GDP growth rate and stable economy is expected to witness strong demand for air travel from the corporate. Already, with almost all blue-chip companies having detailed travel policies, travel costs have emerged as the third largest expenses for them, after salaries and raw materials.
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04.
RATIOS OF JET AIRWAYS
ESTIMATION OF HISTORIC AND CURRENT RATIOS
MAR?12 Investment Valuation Ratios Face Value Dividend Per Share Operating Profit Per Share (Rs) Net Operating Profit Per Share (Rs) Free Reserves Per Share (Rs) Bonus in Equity Capital Profitability Ratios Operating Profit Margin(%) Profit Before Interest And Tax Margin(%) Gross Profit Margin(%) Cash Profit Margin(%) Adjusted Cash Margin(%) Net Profit Margin(%) Adjusted Net Profit Margin(%) Return On Capital Employed(%) Return On Net Worth(%) Adjusted Return on Net Worth(%) Return on Assets Excluding Revaluations Return on Assets Including Revaluations Return on Long Term Funds(%) 10.00 -214.50 1,763.46 -79.02 10.89 12.16 5.85 5.99 -1.53 -1.53 -7.93 -7.93 12.28 229.14 -93.98 -62.48 136.78 15.41
MAR?11 10.00 -289.91 1,480.59 80.48 10.89 19.58 12.29 12.45 4.42 4.42 0.07 0.07 12.33 1.15 -40.33 96.91 301.66 14.31
MAR?10 10.00 -244.11 1,209.09 79.35 10.89 20.18 10.81 10.97 3.35 3.35 -4.41 -4.41 8.81 -56.54 -73.29 95.79 306.02 12.08
Liquidity And Solvency Ratios Current Ratio Quick Ratio Debt Equity Ratio Long Term Debt Equity Ratio Debt Coverage Ratios Interest Cover
0.39 0.50 --1.31
0.64 0.77 16.11 14.22 1.72
0.34 0.86 16.80 11.98 1.31
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Total Debt to Owners Fund Financial Charges Coverage Ratio Financial Charges Coverage Ratio Post Tax Management Efficiency Ratios Inventory Turnover Ratio Debtors Turnover Ratio Investments Turnover Ratio Fixed Assets Turnover Ratio Total Assets Turnover Ratio Asset Turnover Ratio Average Raw Material Holding Average Finished Goods Held Number of Days In Working Capital .
8.22 1.10 0.85 3,051.04 13.64 3,051.04 0.81 1.50 1.08 ---85.64
16.11 1.43 1.49 2,778.81 14.39 2,778.81 0.72 0.91 0.78 --11.12
16.80 1.24 1.27 4,349.40 13.53 4,349.40 0.59 0.72 0.58 --2.22
05. WEIGHTED AVERAGE COAST OF CAPITAL.
Risk Free Rate 8% Beta 1.02 Equity Risk Premium 8% Cost of Equity 16% Cost of Debt (pre tax) 10.0% Tax rate 33.99% Total Long Term Debt / Equity Ratio 1 WACC 11.4% Growth Phase I - 5 yrs 12% Growth Phase II - 10 yrs 8% Growth Phase III - Terminal 3
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CONCLUSIONS
Business Valuation Management is a fascinating subject, as it, foremost, provides (and also warrants) the most comprehensive analysis of a business model. It perforce enjoins upon the business valuer to delve into the depths of the business that is being valued and come to grips with the macro and micro, technical and fi nancial, the short and longer term aspects of the business.
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SUGGESTIONS WWW.WIKIPEDIA.COM WWW.ICRA.COM WWW.MONEYCONTROL.COM.
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