Business Analysis and Valuation- 18BAB6ED0

Unit- I
Principles and techniques of valuation - Asset valuation-Earnings valuation - Cash flow
valuation - Other valuation basis - Efficient market hypothesis - Impact of changing capital
structure on the market value of the company - Priorities of different stakeholders in terms of
business valuation.

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
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”.
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.
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 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.
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.
2. 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.
3. Resolve disputes among stakeholders/litigation: Divorce, bankruptcy, breach
of contract, dissenting shareholder and minority oppression cases, economic damages
computations, ownership disputes, and other cases.
4. 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.
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
6. Replacement Value
7. Market Value
8. Economic Value
9. Residual Value
10. Disposal Value/Scrap Value
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.

Business Valuation:
Business Valuation is a fascinating topic, as it requires an understanding ofnfiancial
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.
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-
Industry- Company (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 non- recurring 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.
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.
PRINCIPLES OF BUSINESS VALUATION:
1. Purpose of Valuation: Clearly define the purpose of the valuation. A valuation can be
conducted for different reasons, such as determining a selling price, attracting investors,
settling disputes, or financial reporting. The purpose of the valuation will influence the
methods, assumptions, and standards used in the process.
2. Market-Based Approach: The market-based approach, also known as the comparative
approach, is a common valuation method. It involves comparing the subject business to
similar companies (or market transactions) in the same industry that have recently been sold
or are publicly traded. This approach considers factors like revenue, earnings, market
multiples, and other financial metrics to derive an estimate of the business's value.
3. Income-Based Approach: The income-based approach determines the value of a business by
estimating its future income-generating capacity. This approach often involves methods such
as the discounted cash flow (DCF) analysis, which calculates the present value of projected
future cash flows. It takes into account factors like revenue growth rates, profit margins, and
the cost of capital to assess the business's potential worth.
4. Asset-Based Approach: The asset-based approach values a business based on its net asset
value. It involves assessing the fair market value of the company's tangible and intangible
assets, such as real estate, equipment, inventory, intellectual property, and goodwill. This
approach is particularly useful for businesses with significant asset holdings, such as real
estate or manufacturing companies.
5. Consideration of Risk: Valuation should incorporate an assessment of the business's risk
profile. Factors like industry stability, competition, market conditions, management quality,
and financial stability impact the risk associated with the business. A higher risk generally
leads to a lower valuation, as investors require a higher return on investment to compensate
for the increased risk.
6. Professional Judgment: Business valuation often requires professional judgment and
expertise. Valuation professionals, such as certified appraisers, financial analysts, or
investment bankers, employ their knowledge and experience to assess various aspects of the
business, interpret financial data, and select appropriate valuation methods. Their expertise
ensures a comprehensive and reliable valuation.
7. Use of Multiple Methods: It is common practice to use multiple valuation methods to cross-
validate the results and ensure a more accurate estimate of the business's value. Different
methods may yield different valuations, so considering multiple perspectives helps in
mitigating biases and uncertainties.
8. Consideration of Market Conditions: Market conditions and economic factors can
significantly impact the value of a business. Valuations should consider the broader economic
climate, industry trends, and market conditions at the time of the assessment. Understanding
the market dynamics provides context and helps in making informed judgments about the
business's value.
It's important to note that business valuation is a complex field, and these principles provide a
general overview. In practice, the specific circumstances of each business and the purpose of
the valuation will dictate the exact methodologies and considerations employed in the
process.
other Principles of valuation are:
• Principle of Substitution
• Principle of Alternative
• Principle of Time Value of Money
• Principle of Expectation
• Principle of Risk and Return &
• Principle o Reasonableness and Reconciliation of value

What Is Business Valuation?

At the most basic level, business valuation is the process by which the economic worth of a
company is determined.
As we mentioned, there are different approaches to evaluating the value of a small business,
but generally, each method will involve a full and objective assessment of every piece of your
company. This being said, business valuation calculations typically include the worth of your
equipment, inventory, property, liquid assets, and anything else of economic value that your
company owns. Other factors that might come into play are your management structure,
projected earnings, share price, revenue, and more.

Why Would You Need a Business Valuation?

Due to the complexity of the business valuation process, these calculations are probably not
something you’ll be doing every day—so, when would you need a business valuation?
Overall, there are a handful of common reasons why business owners need to evaluate the
worth of their company:
 When looking to sell your business
 When looking to merge or acquire another company
 When looking for business financing or investors
 When establishing partner ownership percentages
 When adding shareholders
 For divorce proceedings
 For certain tax purposes
Ultimately, different small business valuation methods will be preferable in different
scenarios. Generally, the best approach will depend on why the valuation is needed, the size
of your business, your industry, and other factors.
As an example, in a sale scenario, the majority of private small businesses are sold as asset
sales, whereas the majority of middle-market transactions involve the sale of equity—each of
these sales would require a different business valuation method.
Business Valuation Methods
1. Market Value Valuation Method
First, the market value business valuation formula is perhaps the most subjective approach to
measuring a business’s worth. This method determines the value of your business by
comparing it to similar businesses that have sold.
Of course, this method only works for businesses that can access sufficient market data on
their competitors. In this way, the market value method is a particularly challenging approach
for sole proprietors, for instance, because it’s difficult to find comparative data on the sale of
similar businesses (as sole proprietorships are individually owned).
This being said, because this small business valuation method is relatively imprecise, your
business’s worth will ultimately be based on negotiation, especially if you’re selling your
business or seeking an investor. Although you may be able to convince a buyer of your
business’s worth based on immeasurable factors, it’s unlikely that this approach will be
particularly useful for gaining investors.
Nevertheless, this valuation method is a good preliminary approach to gain an understanding
of what your business might be worth, but you’ll likely want to bring another, more
calculated approach to the negotiation table.
2. Asset-Based Valuation Method
Next, you might use an asset-based business valuation method to determine what your
company is worth. As the name suggests, this type of approach considers your business’s
total net asset value, minus the value of its total liabilities, according to your balance sheet.
There are two main ways to approach asset-based business valuation methods:
Going Concern
Businesses that plan to continue operating (i.e., not be liquidated) and not immediately sell
any of their assets should use the going-concern approach to asset-based business valuation.
This formula takes into account the business’s current total equity—in other words,
your assets minus liabilities.
Liquidation Value
On the other hand, the liquidation value asset-based approach to valuation is based on the
assumption that the business is finished and its assets will be liquidated. In this case, the
value is based on the net cash that would exist if the business was terminated and the assets
were sold. With this approach, the value of a business’s assets will likely be lower than usual
—as liquidation value often amounts to much less than fair market value.
Ultimately, the liquidation value asset-based method operates with a sort of urgency that
other formulas don’t necessarily take into account.
3. ROI-Based Valuation Method
An ROI-based business valuation method evaluates the value of your company based on your
company’s profit and what kind of return on investment (ROI) an investor could potentially
receive for buying into your business.
Here’s an example: If you’re pitching your business to a group of investors to get equity
financing, they’ll start with a valuation percentage of 100%. If you’re asking for $250,000 in
exchange for 25% of your business, then you’re using the ROI-based method to determine
the value of your business as you present this offer to the investors. To explain, if you divide
the amount by the percentage offered, so $250,000 divided by 0.25, you receive your quick
business valuation—in this case, $1 million.
From a practical standpoint, the ROI-method makes sense—an investor wants to know what
their return on investment will look like before they invest. This being said, however, a
“good” ROI ultimately depends on the market, which is why business valuation is so
subjective.
Plus, with this approach, you’ll often need more information to convince an investor or buyer
of the result. An investor or buyer will want to know:
 How long will it take to recover my original investment?
 After that, when I look at my share of the expected net income, compared with my
investment, what does my return look like?
 Is that number realistic? Ambitious? Conservative?
 Does it make me want to invest in this company?
All of these questions will inform an ROI-based business valuation.
To learn more about this method, watch the short video below.
4. Discounted Cash Flow (DCF) Valuation Method
Although the three business valuation methods above are sometimes considered the most
common, they’re not the only options out there. In fact, whereas the ROI-based and market
value-based methods are extremely subjective, some alternate approaches (as we’ll discuss)
use more of your business’s financial data to get a better evaluation of its worth.The
discounted cash flow valuation method, also known as the income approach, for
example, values a business based on its projected cash flow, adjusted (or discounted) to its
present value.The DCF method can be particularly useful if your profits are not expected to
remain consistent in the future. As you’ll see in the CFI business valuation example below,
however, the DCF method requires significant detail and careful calculations:

5. Capitalization of Earnings Valuation Method

Next, the capitalization of earnings valuation method calculates a business’s future
profitability based on its cash flow, annual ROI, and expected value.
This approach, unlike the DCF method, works best for stable businesses, as the formula
assumes that calculations for a single time period will continue. In this way, this method
bases a business’s current value on its ability to be profitable in the future.
6. Multiples of Earnings Valuation Method
Similar to the capitalization of earnings valuation method, the multiple of earnings valuation
method also determines a business’s value by its potential to earn in the future.
This being said, however, this small business valuation method, also known as the time
revenue method, calculates a business’s maximum worth by assigning a multiplier to its
current revenue. Multipliers vary according to industry, economic climate, and other factors.
7. Book Value Valuation Method
Finally, the book value method calculates the value of your business at a given moment in
time by looking at your balance sheet.
With this approach, your balance sheet is used to calculate the value of your equity—or total
assets minus total liabilities—and this value represents your business’s worth.
The book value approach may be particularly useful if your business has low profits, but
valuable assets.
What is Asset Valuation?
Asset valuation simply pertains to the process to determine the value of a specific property,
including stocks, options, bonds, buildings, machinery, or land, that is conducted usually
when a company or asset is to be sold, insured, or taken over. The assets may be categorized
into tangible and intangible assets. Valuations can be done on either an asset or a liability,
such as bonds issued by a company.

Asset Valuation – Valuing Tangible Assets

Tangible assets refer to a company’s assets that have a physical form, which have been
purchased by an organization to produce its products or goods or to provide the services that
it offers. Tangible assets can be categorized as either fixed asset, such as structures, land, and
machinery, or as a current asset, such as cash.Other examples of assets are company vehicles,
IT equipment, investments, payments, and on-hand stocks.
To compute the net tangible assets of a company:
 The company needs to look at its balance sheet and identify tangible and intangible
assets.
 From the total assets, deduct the total value of the intangible assets.
 From what is left, deduct the total value of the liabilities. What is left are the net
tangible assets or net asset value.
 Consider the following simple example:
 Balance sheet total assets: $5 million
 Total intangible assets: $1.5 million
 Total liabilities: $1 million
 Total tangible assets: $2.5 million
In the example above, the total assets of Company ABC equal $5 million. When the total
intangible assets of $1.5 million are deducted, that leaves $3.5 million. After the total
liabilities are deducted, which is another $1 million, only $2.5 million is left, which is the
value of the net tangible assets.
Asset Valuation – Valuing Intangible Assets
Intangible assets are assets that take no physical form, but still provide a future benefit to the
company. They may include patents, logos, franchises, and trademarks.Say, for example, a
multinational company with assets of $15 billion goes bankrupt one day, and none of its
tangible assets are left. It can still have value because of its intangible assets, such as its logo
and patents, that many investors and other companies may be interested in acquiring.

Methods of Asset Valuation

Valuing fixed assets can be done using various methods, which include the following:

1. Cost Method
The cost method is the easiest way of asset valuation. It is done by basing the value on the
historical price for which the asset was bought.

2. Market Value Method

The market value method bases the value of the asset on its market price or its projected price
when sold in the open market. In the absence of similar assets in the open market, the
replacement value method or the net realizable value method is used.

3. Base Stock Method

The base stock method requires a company to keep a certain level of stocks whose value is
assessed based on the value of a base stock.

4. Standard Cost Method

The standard cost method uses expected costs instead of actual costs, often based on the
company’s past experience. The costs are obtained by recording differences between
expected and actual costs.

Importance of Asset Valuation

Asset valuation is one of the most important things that need to be done by companies and
organizations. There are many reasons for valuing assets, including the following:

1. Right Price
Asset valuation helps identify the right price for an asset, especially when it is offered to be
bought or sold. It is beneficial to both the buyer and the seller because the former won’t
mistakenly overpay for the asset, nor will the latter erroneously accept a discounted price to
sell the asset.

2. Company Merger
In the event that two companies are merging, or if a company is to be taken over, asset
valuation is important because it helps both parties determine the true value of the business.
3. Loan Application
When a company applies for a loan, the bank or financial institution may require collateral as
protection against possible debt default. Asset valuation is needed for the lender to determine
whether the loan amount is covered by the assets as collateral.

4. Audit
All public companies are regulated, which means they need to present audited financial
statements for transparency. Part of the audit process involves verifying the value of assets.
Importance of asset valuation in various contexts
Investment Decisions: Asset valuation is essential for investors when evaluating potential
investments. Investors can assess the expected returns, risks, and growth prospects by
accurately valuing assets. It helps them allocate their resources effectively and make
informed decisions about buying or selling assets.
Financial Decision-making: Asset valuation provides crucial information for various
financial decisions. Lenders and financial institutions rely on asset valuations to assess
collateral value when extending loans. Businesses use asset valuations to make informed
decisions about capital expenditures, asset purchases, and divestitures, ensuring optimal use
of resources and maximizing returns.
Financial Reporting: Accurate asset valuation is crucial for presenting reliable financial
statements. It ensures that the value of assets recorded in balance sheets reflects their fair
value, providing stakeholders with an accurate picture of a company’s financial position.
Reliable financial reporting is vital for investors, creditors, and regulators to assess a
company’s performance, stability, and solvency.
Mergers and Acquisitions: Asset valuation is critical in mergers, acquisitions, and
partnerships. Valuing assets helps determine fair exchange ratios, negotiate deal terms, and
assess the overall value of the transaction.
Risk Assessment and Management: Asset valuation is vital in assessing and managing risk.
Understanding the value of assets allows individuals and organizations to evaluate potential
risks associated with their investments or operations. It helps identify overvalued or
undervalued assets, diversify portfolios, and make informed decisions to mitigate risk
exposure.
Legal Proceedings: Asset valuation is often required in legal proceedings such as divorce
settlements, tax assessments, bankruptcy cases, and estate planning. Accurate valuation helps
determine the equitable distribution of assets, assess tax liabilities, evaluate insolvency, and
facilitate the settlements of litigations.

Key factors influencing asset valuation

Several key factors influence asset valuation. These factors can vary depending on the type of
asset being valued, but some common considerations include:
Market Conditions: The overall market conditions, including supply and demand dynamics,
interest rates, economic indicators, and industry trends, can significantly impact asset
valuation. Market fluctuations can affect the perceived value of assets, leading to changes in
their valuation.
Cash Flows: The cash flows generated by an asset, such as rental income from real estate or
dividends from stocks, are essential factors in determining its value. The amount, stability,
and predictability of cash flows directly impact the valuation of an asset.
Growth Potential: The growth potential of an asset, including its ability to generate
increasing cash flows or appreciation in value over time, influences its valuation. Assets with
higher growth prospects are generally assigned higher values.
Risk Assessment: Evaluating the risks associated with an asset is crucial in determining its
value. Factors such as market volatility, economic uncertainty, regulatory changes, and asset-
specific risks affect the perceived risk and, consequently, the valuation.
Comparable Transactions: Comparative analysis with similar assets that have been recently
bought or sold in the market provides valuable insights into an asset’s value. Comparable
transactions serve as benchmarks for determining a fair value based on market activity.
Intangible Factors: Intangible factors, such as brand reputation, intellectual property,
patents, customer relationships, and proprietary technologies, can significantly impact the
value of certain assets. These factors are often considered in the valuation of businesses and
intellectual property.
Cost of Capital: The cost of capital, or the rate of return required by investors to invest in a
particular asset, plays a role in its valuation. Higher required rates of return typically lead to
lower valuations, while lower required rates of return may result in higher valuations.
Marketability: The ease with which an asset can be bought or sold in the market, known as
marketability or liquidity, affects its valuation. Assets that can be quickly and easily
converted into cash tend to have higher valuations.
It’s important to note that asset valuation is a complex process, and different assets may have
additional unique factors that influence their value. Valuation professionals and experts
utilize a combination of quantitative and qualitative analysis to assess these factors and arrive
at a comprehensive valuation estimate.

Methods of Asset Valuation

Cost-based valuation is a method used to determine the value of an asset by considering the
cost incurred to create, develop, or reproduce it. This approach focuses on the historical or
current cost associated with the asset rather than its market value or income-generating
potential.
1. Explanation and application
Explanation:
The cost-based valuation approach assumes that the value of an asset is equal to the cost
incurred to acquire or produce it. It takes into account the direct costs, such as the purchase
price or production expenses, as well as indirect costs, like research and development
expenses, legal fees, and other costs associated with the creation or acquisition of the asset.
Application:
The cost-based valuation method is commonly used for tangible assets, such as buildings,
equipment, or infrastructure, where the cost to reproduce or replace the asset is significant. It
also applies to intangible assets, including patents, copyrights, or software, where the
development or acquisition cost is considered.
In practice, cost-based valuation involves:
1. Determining the original cost of acquiring or producing the asset.
2. Adjusting the original cost for any depreciation, obsolescence, or wear and tear.
3. Considering additional costs incurred to maintain or upgrade the asset.
4. Assessing any potential costs to reproduce or replace the asset at the current market
rates.
The cost-based valuation approach is particularly relevant when the market data for similar
assets is limited or unreliable. It provides a conservative estimate of the asset’s value based
on the actual expenses incurred. However, it may not capture the asset’s market value or
income-generating potential.
It’s important to note that the cost-based valuation should be used in conjunction with other
valuation methods to obtain a comprehensive understanding of the asset’s value.
2. Advantages and limitations
Advantages of Cost-Based Valuation:
1. Objective Approach: The cost-based valuation method relies on tangible and
measurable factors such as actual costs incurred, making it a relatively objective
approach compared to other valuation methods.
2. Useful for Unique or Specialized Assets: Cost-based valuation is beneficial for unique
or specialized assets, where limited market data may be available for comparison. It
allows for a more accurate assessment of the value based on the actual costs incurred
to create or acquire the asset.
3. Useful for Financial Reporting: Cost-based valuation aligns with historical cost
accounting principles and is commonly used for financial reporting purposes. It
provides transparency and consistency in valuing assets on the balance sheet.
4. Simple and Easy to Understand: The cost-based valuation method is relatively
straightforward and easy to understand. It requires fewer assumptions and complex
calculations compared to other valuation methods, making it accessible to a wider
range of users.
Limitations of Cost-Based Valuation:
1. Ignores Market Factors: The cost-based valuation approach does not consider market
factors such as supply and demand, buyer preferences, or competitive dynamics. It
may result in a valuation that does not reflect the asset’s true market value.
2. Does Not Capture Intangible Value: Cost-based valuation focuses primarily on the
tangible costs incurred and may not account for the intangible value or potential
income-generating capacity of the asset. This limitation is particularly relevant for
intangible assets like intellectual property, where their value is derived from factors
beyond the initial cost.
3. Susceptible to Depreciation and Obsolescence: Cost-based valuation relies on
historical costs and may not reflect changes in the asset’s value due to depreciation,
technological advancements, or obsolescence. The valuation may not accurately
capture the current worth of the asset.
4. Limited Applicability for Marketable Assets: Cost-based valuation is less applicable
for assets that are actively traded in the market, where market-based valuation
methods like the market approach or income approach are more suitable. Assets with
readily available market data may require additional valuation methods to determine
their fair value accurately.
5. Does Not Consider External Factors: The cost-based valuation approach does not
account for external factors such as economic conditions, industry trends, or specific
market conditions. It may overlook the impact of these factors on the asset’s value.
Market-based valuation
Market-based valuation is a method used to determine the value of an asset by comparing it
to similar assets that have been recently bought or sold in the market. This approach relies on
the principle of supply and demand and uses market data to estimate the asset’s value.
Explanation and application
Explanation:
The market-based valuation approach assumes that the value of an asset is influenced by
market forces and transactions involving similar assets. It involves analyzing comparable
sales or transactions to identify the prices at which similar assets have been bought or sold.
These prices or valuation multiples are then used to estimate the value of the asset in
question.
Application:
The market-based valuation method is commonly used for assets where there is a sufficient
number of comparable transactions in the market. It is particularly applicable to actively
traded assets, such as real estate properties, publicly traded stocks, and certain types of
tangible or intangible assets.
In practice, market-based valuation involves:
1. Identifying comparable assets or transactions that are similar to the asset being
valued. These comparables should have similar characteristics, market conditions, and
transaction dates.
2. Analyzing the prices or valuation multiples associated with these comparables.
3. Adjusting the prices or multiples for any differences between the comparables and the
asset being valued, such as size, location, condition, or other relevant factors.
4. Applying the adjusted prices or multiples to estimate the asset’s value.
The market-based valuation approach provides a direct indication of the market value of the
asset based on actual transactions. It takes into account the supply and demand dynamics,
buyer preferences, and prevailing market conditions. This approach is particularly useful
when market data is readily available and reliable.
It’s important to note that the market-based valuation should consider a sufficient number of
comparable transactions to ensure accuracy and reliability. Additionally, adjustments must be
made for any differences between the comparable and the asset being valued to reflect its
specific attributes.
Market-based valuation is commonly used for pricing real estate properties, valuing publicly
traded securities, determining the fair value of business assets during acquisitions, and
assessing the value of collectibles or unique items sold in specialized markets.
Overall, the market-based valuation approach provides a practical and market-driven method
for estimating the value of an asset based on comparable transactions, enabling a more
accurate assessment of its worth.
Advantages and limitations
Advantages of Market-Based Valuation:
1. Market-Driven and Reflective of Supply and Demand: Market-based valuation
considers actual transactions and market data, making it a more accurate reflection of
the asset’s value based on supply and demand dynamics. It takes into account buyer
preferences, prevailing market conditions, and competitive factors that influence the
asset’s worth.
2. Relies on Actual Market Data: Market-based valuation relies on real market data,
such as recent sales prices or valuation multiples, which provide tangible evidence to
support the valuation estimate. This enhances the credibility and transparency of the
valuation process.
3. Applicable to Actively Traded Assets: Market-based valuation is particularly suitable
for assets that are actively traded in the market, such as publicly traded securities or
real estate properties. It leverages the availability of comparable transactions and
market data to arrive at a more accurate estimate of the asset’s value.
4. Reflects Current Market Conditions: By using recent market data, market-based
valuation captures the current market conditions and trends. This is especially
beneficial when valuing assets in rapidly changing or volatile markets.
5. Widely Accepted and Understood: Market-based valuation is a commonly used
method in the financial industry. It is widely accepted, understood, and relied upon by
investors, analysts, and other stakeholders, enhancing the comparability and
consistency of valuations.
Limitations of Market-Based Valuation:
1. Limited Comparable Transactions: The availability of comparable transactions may
be limited, especially for unique or specialized assets. This can pose challenges in
 finding sufficient and truly comparable data points, leading to potential inaccuracies
in the valuation estimate.
2. Subjectivity in Adjustments: Adjustments need to be made to the market data to
account for differences between the comparable and the asset being valued. The
subjectivity involved in making these adjustments introduces a level of judgment that
can impact the accuracy and reliability of the valuation.
3. Potential Bias in Market Data: The market data used for valuation may be subject to
biases or distortions, particularly in illiquid or opaque markets. In such cases, relying
solely on market-based valuation may not accurately reflect the asset’s value.
4. Inability to Capture Unique or Intangible Value: Market-based valuation may not
fully capture an asset’s unique or intangible aspects that contribute to its value. It may
overlook factors such as brand reputation, customer relationships, or proprietary
technology, which could significantly impact the asset’s worth.
5. Time Sensitivity: Market-based valuations are time-sensitive and may not capture
long-term value trends or changes that occur after the valuation date. Changes in
market conditions or economic factors can impact the asset’s value, making the
valuation estimate less relevant over time.
Income-based valuation
Income-based valuation is a method used to determine the value of an asset based on its
income-generating potential. This approach assesses the present value of the expected future
income or cash flows that the asset is anticipated to generate.
Explanation and application
Explanation:
The income-based valuation approach assumes that the value of an asset is derived from its
ability to generate income or cash flows over time. It focuses on estimating the future income
stream associated with the asset and discounts it back to its present value to arrive at a
valuation estimate. The underlying principle is that the value of an asset is directly linked to
the income it can produce.
Application:
The income-based valuation method is commonly used for income-producing assets like
rental properties, businesses, or investment portfolios. It is applicable when the primary value
driver of the asset is its income-generating capacity.
In practice, the income-based valuation involves:
1. Estimating the expected future income or cash flows the asset will generate. This may
involve projecting revenue, deducting expenses, and accounting for factors such as
growth rates, market conditions, and anticipated changes.
2. Determining an appropriate discount rate or capitalization rate to apply to the future
income stream. This rate reflects the required rate of return or the risk associated with
the asset and accounts for factors such as interest rates, market risk, and the asset’s
specific characteristics.
3. Discounting the projected future income or cash flows to their present value using the
selected discount rate. This involves converting future cash flows into their equivalent
value in today’s dollars.
4. Summing the present values of the projected income or cash flows to arrive at the
total valuation estimate for the asset.
It’s important to note that the accuracy of income-based valuation relies heavily on the
quality of the projected income or cash flow estimates, the appropriateness of the discount
rate, and the availability of reliable data for analysis. Sensitivity analysis and consideration of
different scenarios can enhance the robustness of the valuation.
Advantages and limitations
 1. Focuses on Income-Generating Potential: The income-based valuation method
directly considers the income or cash flows an asset can generate, making it relevant
for income-producing assets. It comprehensively assesses the asset’s financial
performance and potential returns.
2. Considers Future Cash Flows: Income-based valuation considers the expected
future cash flows rather than relying solely on historical or current data. This forward-
looking approach captures the potential growth and income opportunities of the asset.
3. Applicable to a Range of Assets: Income-based valuation can be applied to various
assets, including businesses, rental properties, investment portfolios, and other
income-generating assets. It is a versatile method that can accommodate different
asset types and industries.
4. Considers Risk and Return Trade-Off: The income-based valuation approach
incorporates the risk associated with the asset by applying an appropriate discount rate
or capitalization rate. This ensures that the valuation reflects the risk and return trade-
off and aligns with the required rate of return for investors.
5. Useful for Investment and Decision-Making: Income-based valuation helps in
making investment decisions by providing insights into the income potential and
return on investment. It assists in evaluating the feasibility and profitability of an
investment opportunity.
Limitations of Income-Based Valuation
1. Reliance on Future Projections: Income-based valuation heavily relies on accurate
and reliable future projections of income or cash flows. The valuation estimate may
be flawed if the projections are inaccurate or based on uncertain assumptions.
2. Sensitivity to Discount Rate: The selection of an appropriate discount rate is crucial
for income-based valuation. The discount rate reflects the required rate of return and
risk associated with the asset. A small change in the discount rate can significantly
impact the valuation estimate.
3. Vulnerability to Changes in Market Conditions: Income-based valuation is
sensitive to changes in market conditions, interest rates, and economic factors.
Variations in these factors can affect the projected cash flows and discount rates,
potentially leading to valuation inaccuracies.
4. Limited Applicability for Non-Income-Generating Assets: Income-based valuation
is not suitable for assets that do not generate income or cash flows, such as certain
tangible assets or early-stage startups. Valuing such assets based on their income
potential may not accurately represent their value.
5. Requires Detailed Financial Analysis: Conducting income-based valuation requires
thorough financial analysis, including projecting future cash flows, estimating growth
rates, and assessing the asset’s risk profile. It may involve complex calculations and
assumptions, which can introduce subjectivity and uncertainty into the valuation
process.
Factors Influencing Asset Valuation
A. Economic Conditions
Economic conditions, such as overall GDP growth, inflation rates, interest rates, and
unemployment levels, can significantly impact asset valuation. Asset valuations in a
thriving economy with high growth rates and low unemployment tend to be higher
due to increased demand and investor confidence. Conversely, asset valuations may
decline during economic downturns or recessions as demand weakens and investors
become more cautious.
B. Industry Trends and Market Demand

Industry trends and market demand directly affect asset valuation. Assets in industries
experiencing growth and high demand will likely have higher valuations. Factors such as
technological advancements, changing consumer preferences, and market competition can
influence the perceived value of assets within specific sectors.
C. Asset-Specific Characteristics
The unique characteristics of an asset, including its age, condition, location, size, and
functionality, play a crucial role in determining its valuation. Assets with desirable attributes,
such as prime locations, well-maintained conditions, or specialized features, may command
higher valuations. Conversely, assets with limitations or obsolescence may face lower
valuations.
D. Regulatory and Legal Factors
Regulatory and legal factors can impact asset valuation, including government regulations,
tax policies, zoning laws, environmental regulations, and contractual agreements.
Compliance with regulations and adherence to legal requirements can influence the value of
an asset. Changes in regulations or legal obligations can also affect the valuation of certain
assets, particularly in regulated industries.It’s important to note that these factors interact with
each other, and their impact on asset valuation can vary depending on the specific asset,
market conditions, and the purpose of the valuation. Professional expertise and careful
consideration of these factors are crucial for conducting accurate and comprehensive asset
valuations.
Challenges in Asset Valuation
A. Subjectivity and Uncertainty: Asset valuation often involves subjective judgments and
assumptions, which can introduce inherent uncertainty into the process. Valuation methods
require estimating variables such as future cash flows, discount rates, growth rates, and
market multiples, all of which involve some degree of subjectivity. Different values may
arrive at different valuation estimates based on their judgment and interpretation of available
information. Additionally, uncertainties in market conditions, economic factors, and industry
trends can further contribute to the subjective nature of asset valuation.
B. Lack of Reliable Data: Data availability and quality can pose challenges in asset
valuation. Accurate and relevant data is crucial for making informed valuation decisions.
However, there may be a lack of reliable data in some cases, particularly for unique or
specialized assets or in emerging markets. Insufficient data can make finding comparable
transactions challenging or establishing reliable market indicators tough. The reliance on
historical data may also limit the ability to accurately capture current market conditions and
future trends.

Valuation Approaches:
Discounted Cash Flow Valuation:
This approach is also known as the Income approach , where the value is determined
by calculating the net present value of the stream of benefits generated by the business
or the asset. Thus, the DCF approach equals the enterprise value to all future cash flows
discounted to the present using the appropriate cost of capital.
Relative Valuation:
This is also known as the market approach . In this approach, value is determined by
comparing the subject company or asset with other companies or assets in the same
industry, of the same size, and/or within the same region, based on common variables
such as earnings, sales, cash flows, etc.
The Profit multiples often used are:
 (a) Earnings before interest tax depreciation and amortisation (EBITDA),
(b) Earnings before interest and tax (EBIT),
(c) Profits before tax, and
(d) Profits after tax.
Historic, current and forecast profits/earnings are used as multiples from the quoted
sector and actual transactions in the sector.
Contingent Claim Valuation: This approach uses the option pricing models to
estimate the value of assets.
Asset-based approach: A fourth approach called asset-based approach is also touted
as another approach to valuation.
The valuation here is simply the difference between the assets and liabilities taken from
the balance sheet, adjusted for certain accounting principles.
Two methods are used here:
a. The Liquidation Value, which is the sum of estimated sale values of the assets owned by a
company.
b. Replacement Cost: The current cost of replacing all the assets of a company.
However, the asset-based approach is not an alternative to the first three approaches, as this
approach itself uses one of the three approaches to determine the values.
This approach is commonly used by property and investment companies, to cross check for
asset based trading companies such as hotels and property developers, underperforming
trading companies with strong asset base (market value vs. existing use), and to work out
break – up valuations.
Other Approaches:
The two other approaches are the EVA and Performance-based compensation plans. Refer
CPA article titled “Building Long-Term Value” included in the Reader.Extracts are given
below:
Economic Value added (EVA):
This analysis is based on the premise that shareholder value is created by earning a return in
excess of the company’s cost of capital. EVA is calculated bysubtracting a capital charge
(invested capital x WACC) from the company’s net operating profit after taxes (NOPAT). If
the EVA is positive, shareholder value has increased. Therefore, increasing the company’s
future EVA is key to creating shareholder value.An EVA model normally includes an analysis
of the company’s historical EVA performance and projected future EVA under various
assumptions. By changing the assumptions, such as for revenue growth and operating
margins, management can see the effects of certain value improvement initiatives.
A simple
illustration is
given below;

NOPAT=

Rs.15,000
Invested
Capital
=
Rs.50,0
00
WACC
EVA = NOPAT – (Invested capital x WACC)
= $15,000 – ($50,000 x 12%)
 = $9,000

Performance-based compensation.
This effective tool for motivating employees aligns their interests with the shareholders.
For example, establish a base level of compensation plus a bonus pool tied to certain
EVA targets. A minimum level of EVA is required for any bonus to apply, and the pool
increases based on how much actual EVA exceeds the minimum threshold. By tying
compensation to certain performance metrics, such as EVA or EVA improvement,
employees have a sense of ownership and strong incentives to help achieve the
company’s value- creation goals. Numerous criteria and performance metrics can be
used in setting up a performance- based compensation plan. However, to be effective,
the performance criteria must be achievable, measurable and clearly communicated to
the employees intended to be impacted by it. Regular feedback and information
reporting procedures should be established that will help employees monitor their
progress for meeting the performance goals throughout the year.

Earnings Valuation
Earnings approach. This is another common method of valuation and is based on the idea that
the actual value of a business lies in the ability to produce revenue in the future. There are a
lot of methods of valuation under the earning value approach, but the most common one
is capitalizing past earnings.

What is the earnings valuation model?

The valuation model looks at the expected profit that can be generated by the management. If
the earnings are higher than expected, an investor would be willing to pay more than the book
value, and if it's not expected to achieve the same, the investor would not be willing to pay
anything more than the book value.

How do you calculate earnings valuation?

You take the company's last 12 months' earnings and multiply it by (1 + WACC)^5. The
capitalized earnings valuation formula is a good way to value a company if you want to
compare it to other companies in the same industry.

What is income valuation method?

What is income-based valuation? Income-based valuation is a method used to estimate the
value of a company based on its expected future income streams. This approach involves
analyzing a company's historical financial data and making projections about its future
earnings potential to determine its present value.

What is the earnings method?

This approach, often referred to as the earnings approach, focuses on how an entity adds
value during the completion of a business transaction. While IFRS focuses on the balance
sheet (contract assets and liabilities

DISCOUNTED CASH FLOW VALUATION

“The value of a business is the future expected cash fl ows discounted at a rate that reflects
the risk of the cash flows”.
 - Copeland, Koller and Murrin McKinsey & Co., Valuation Measuring and
Managing the Value of Companies. 2nd Edition, 1994.

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. Mathematically,
i=n
Value of an asset =
 [(CFi / (1+r)i]
i=1
That is:
CF1 CF2 CFn (1+ r)1 (1+ r)2(1+ r)n
Value = + + …+
CFi = Expected Future Net Cash Flow during period i n = Life of the asset
r = rate of discount
The expected future net cash flow is defined as after-tax cash flow from operations on an
invested capital basis (excluding the impact of debt service) less the sum of net changes in
working capital and new investments in capital assets.
The discount rate should reflect the riskiness of the estimated cash flows. The rate will be
higher for high risk projects as compared to lower rates for safe or less risky investments. The
Weighted Average Cost of Capital (WACC) is used as the discount rate. The cost of capital
with which the cash flows are discounted should reflect the risk inherent in the future cash
flows.
The WACC is calculated using the following formula:
WACC = [(E/(D+E) x CE] + [(D/(D+E) x CD x (1-T)]
where E is the market value of equity, D is the market value of debt, C E is the cost of equity,
CD is the cost of debt and T is the tax rate.
The first step in determining WACC is the assessment of capital structure, i.e., how a
company has financed its operations.
It can thus be seen that the company’s net cash flows are projected for a number of years and
then discounted to present value using the WACC. The expected cash flows earned beyond
the projec- tion period are capitalized into a terminal value and added to the value of the
projected cash flows for a total value indication.

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 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.

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/invest-
ment 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.s
6. Prepare related financial statements.

Efficient Market Hypothesis

Efficient market hypothesis or EMH is an investment theory which suggests that the prices of
financial instruments reflect all available market information. Hence, investors cannot have
an edge over each other by analysing the stocks and adopting different market timing
strategies. According to this theory developed by Eugene Fama, investors can only earn high
returns by taking more significant risks in the market.

Assumptions of the Efficient Market Hypothesis

Also referred to as an efficient market theory, EMH is based on the following assumptions –
 Stocks are traded on exchanges at their fair market values.
 This theory assumes that the market value of stocks represents all the relevant information.
 It also assumes that investors are not capable of outperforming the market since they have to
make decisions based on the same available information.

Types of Efficient Market Hypothesis

EMH has three variations which constitute different market efficiency levels. They are
discussed below –
 Weak form efficient market hypothesis
This is based on the assumption that the market prices of all financial instruments represent
all public information related to the market. It does not reflect any information that is not yet
disclosed publicly. Moreover, the efficient market hypothesis assumes that historical data like
price and returns have no relation with the future price of a financial instrument.
This variation EMH also suggests that different strategies implemented by traders cannot
fetch consistent returns. This is owing to the assumption that historical price points cannot
predict future market value. Although this form of EMH dismisses the concept of technical
analysis, it provides the opportunity for fundamental analysis. This helps all market
participants to find out more information and earn an above-average return on investment.
 Semi strong form efficient market hypothesis
This version of EMH elaborates on the assumptions of the weak form and accepts that the
market prices make quick adjustments in response to any new public information that is
disclosed. Hence, there is no scope for both technical and fundamental analysis.
 Strong form efficient market hypothesis
This form of EMH states that the market prices of securities represent both historical and
current information. This includes insider information as well as publicly disclosed
information. It also suggests that the price reflects information available only to board
members or the CEO of a company.

Impact of Efficient Market Hypothesis

EMH is gradually gathering popularity among traders. Market participants who advocate this
theory usually tend to invest in index funds and exchange-traded funds (ETFs) which are
more passive in nature. This is one of the main advantages of the efficient market hypothesis.
These traders are reluctant to pay the high charges imposed by the experienced fund
managers as they don’t even rely on the experts to outperform the market. However, recent
data suggests that there are a few fund managers who have been consistent in beating the
market.

Limitations of the Efficient Market Hypothesis

Since its first implementation in the 1960s, many limitations of EMH have gradually
emerged. They are discussed in detail below –
 Market crashes and speculative bubbles
Speculative bubbles tend to arise when the price of a financial instrument rises above its fair
market value and reaches a point where market corrections take place. During this situation,
prices begin to fall rapidly, which leads to a market crash.
But EMA suggests that both financial crashes and market bubbles should not arise. As a
matter of fact, this theory completely dismisses their existence.
 Market anomalies
Market anomalies refer to a situation where there is a difference between the trajectory of a
market price as established by the efficient market hypothesis and its behaviour in reality.
Market anomalies may arise anytime for no particular reason. This proves that financial
markets do not remain efficient at all times.
 Investors have outperformed the market
 There are many investors who have consistently outperformed the market. They do not
subscribe to the suggestions of EMH and have been vocal in criticising the same for its
passive approach.
 Behavioural economics
Behavioural economics dismisses the idea that all market participants are rational individuals.
It also suggests that difficult circumstances may put stress on individuals, forcing them to
make irrational decisions. Thus, due to social pressure, traders may also commit major errors
and undertake unwarranted risks. Also, the herding phenomenon plays a vital role in
elucidating behavioural aspects of traders which are not considered by EMH.
Moreover, traders’ decisions may also be influenced by their individual personality traits and
emotions.
Generally, traders who feel that the stock market is volatile with rapid fluctuations in the
market price, subscribe to the efficient market hypothesis. But traders engaging in short-term
trade do not tend to support this hypothesis. Most investors prefer to choose a long-term
strategy due to rapid price fluctuations in the stock market.

Capital Structure
Defining the Capital Structure
When people refer to “the value of the company” (as opposed to just the value of the equity),
they usually mean the value of the company’s capital structure. However, this still may leave
ambiguity concerning exactly what is included in the “capital structure.” Treatment of
Interest-Bearing Debt. The most commonly used conceptual definition of capital structure is
all equity and all long-term debt (including current maturities of long-term debt). However, to
value the capital structure defined in this way using the discounted economic income method,
it is necessary to include the interest on the long-term debt in the income being discounted
and to treat other interest (such as on a bank operating line of credit) as an expense. If getting
the necessary information to separate the two elements of interest is not practical, a
commonly used solution to the problem is to define the capital structure to include all
interest-bearing debt. Interest-bearing debt may be defined to include the permanent portion
of interest-bearing current liabilities. This would be the case if, for example, 90-day notes
payable (otherwise classified as a current liability) are used as a permanent source of capital
for the subject company. Using all interest-bearing debt eliminates a judgment call by the
analyst as to the appropriate levels of long-term versus short-term debt.

Treatment of Non-Interest-Bearing Items. Another issue in some cases is whether or not to

include certain non-interest-bearing long-term liabilities in the capital structure. This may
include, for example, such items as deferred taxes and pension liabilities. If any such items
are included, some portion of the capital structure will have zero cost of capital.
Conceptually, the most commonly accepted answer is that these items should be included if it
is expected that they will be paid and excluded if payment is not expected. This, then,
requires a judgment call. The analyst should also keep in mind that weightings of the
components of the capital structure for the purpose of estimating a WACC are at market
value. Therefore, if non-interest-bearing liabilities are to be included, an estimate of when
they will be paid is required so that their face value can be discounted to a present market
value to determine their weight. As a practical matter, non-interest-bearing liabilities usually
are not included in calculations of a WACC, but there are times when they are important
enough to consider. In any case, when discounting the economic income available to the
company, it is important to specify what is assumed to be included in the capital structure.
Weighted-Average Cost of Capital Formula The basic formula for computing the after-tax
WACC is as follows:
 Formula 9–11 WACC = (ke ×We )+[kd (1– t) × Wd ]
where: WACC = Weighted average cost of capital
ke = Company’s cost of common equity capital
kd = Company’s cost of debt capital
We = Percentage of equity capital in the capital structure
Wd = Percentage of debt capital in the capital structure
t = Company’s effective income tax rate Assume the following:
Cost of equity capital: 0.25
Cost of debt capital: 0.10
Proportion of equity in capital structure: 0.70
Proportion of debt in capital structure: 0.30
Income tax rate: 0.40
These data would be substituted into this formula as follows:
(0.25 × 0.70) + [0.10(1– 0.40) × 0.30] = 0.175 + (0.06 × 0.30) = 0.175 + 0.018 = 0.193
So, the overall cost of capital in this example is 19.3 percent.
In many cases, there is a more complex capital structure, perhaps with preferred stock and
more than one class of debt. This formula would simply be expanded to include a term for
each class of capital.

STAKEHOLDERS IN BUSINESS
Stakeholders are individuals or organizations with a vested interest in a company's success.
It's important to avoid confusing them with shareholders, who own stock in a company.
Stakeholders represent a much broader audience.
There are two categories of stakeholders: Internal and external.
Internal stakeholders operate within an organization or have a direct relationship with a
company.
They're directly impacted by a business's activities while their own actions affect its
operations.
Key internal stakeholders include:
 Employees: The collection of individuals employed by a company in exchange for
compensation.
 Business owners: The individuals responsible for a business’s financial and operational
components.
 Investors: The individuals or groups who invest capital in a company in exchange for long-
term financial gain.

External stakeholders operate outside the company but are still impacted by the
organization’s actions.
Key external stakeholders include:
 Customers: The consumers of a business's goods or services.
 Suppliers: The companies selling raw materials needed to produce a business’s goods or
services.
Both internal and external stakeholders are necessary for success, so companies shouldn't
focus on one while neglecting the other. Instead, focus on maximizing value for each to
ensure long-term profitability.

CREATING VALUE FOR STAKEHOLDERS

Creating value in business is exceeding stakeholders' minimum expectations. The amount
expectations are exceeded—financial or perceived—is the amount of value created.
 In the online course Leading with Finance, Harvard Business School Professor Mihir Desai
explains that there are three sources of financial value creation:
1. Beating the cost of capital: Businesses must overcome the discount rate, which is the interest
rate used to discount future cash flow back to its present value. It's often the minimum
acceptable rate of return, also known as the hurdle rate, investors expect, so the greater it's
exceeded, the more value is created.
2. Continuing to beat the cost of capital: Exceeding expectations for only one year won’t
produce long-term value. To be financially successful, business initiatives must continue to
overcome the discount rate.
3. Growing: The more financial success your company achieves, the more value you create.
Growth allows you to reinvest profits back into your business, multiplying your value
creation.
Creating perceived value is more difficult, but possible. For example, effective branding can
motivate consumers to choose one company over another. To increase a customer's perceived
value of goods or services, business leaders must ensure they deliver on their promises and
create a sustainable business strategy. Equally important to defining value is determining
whether it's been created. The market-to-book ratio and value stick are visualizations of value
creation for a business’s key stakeholders.
Impact of changing capital structure on the market value of the company
Capital structure is the most critical factor in any business determining its value. The
composition of a company’s liabilities and equity can have a significant impact on its
valuation, as well as its ability to obtain financing and grow its operations. This blog post will
explore how capital structure affects business valuation and provide examples of how
different ratios can impact a company’s value. We hope you find this information helpful!
1. What is capital structure, and how does it affect business valuation
Capital structure refers to a company’s mix of debt and equity to finance its operations. The
proportion of debt to equity can significantly impact business valuation, as it affects the
amount of risk that investors are willing to take on. Companies with higher debt levels are
typically riskier, and their stock is often valued at a lower price-to-earnings ratio. Generally,
companies with solid credit ratings and stable earnings histories can access capital at lower
costs, giving them a competitive advantage. For this reason, investors need to consider a
company’s capital structure when making investment decisions.
2. The different types of debt and equity that make up a company’s capital structure
A company’s capital structure refers to its mix of debt and equity to finance its operations.
Debt is money borrowed from creditors and must be repaid with interest. Equity is an
ownership in a company that shareholders hold. Each type of capital has its advantages and
disadvantages. Debt is typically cheaper than equity and does not require giving up any
ownership stake in the company. In addition, equity investors may have certain rights and
preferences that can dilute existing shareholders’ ownership stake. A company must consider
the tradeoffs between debt and equity when deciding how to finance its operations.
3. How interest rates, dividends, and bankruptcy risk impact business value
Business value is determined by several factors, including interest rates, dividends, and
bankruptcy risk. Interest rates impact business value because they affect the cost of capital.
Finally, bankruptcy risk is also a factor in business value. A company at risk of bankruptcy is
generally worth less than a company that is not at risk. These three factors – interest rates,
dividends, and bankruptcy risk – all play a role in determining business value.
4. Ways to improve a company’s capital structure to increase its value
One of the most important ways a company can increase its value is by improving its capital
structure. The capital structure is a company’s mix of debt and equity to finance its
operations. Several factors can affect a company’s capital structure, including the level of
debt, the type of debt, and the maturity schedule of the debt. By carefully assessing these
factors, a company can make changes to its capital structure that will improve its value and
help it to reach its financial goals. One way to improve a company’s capital structure is by
reducing debt. This can be done by paying down existing debts or avoiding new borrowing.
By reducing the level of debt, a company can improve its financial flexibility and reduce its
interest costs.
By increasing the level of equity, a company can reduce its risk and make itself more
attractive to potential investors. Finally, another way to improve a company’s capital
structure is by lengthening or shortening the maturity schedule of its debts. This can be done
by refinancing existing debts or issuing new obligations with different terms.