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.

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.

Earning based Valuation Model

Earnings-based business valuation methods value your company by its ability to be profitable
in the future. It is best to use earnings-based valuation methods for a company that is stable
and profitable. There are two main approaches:

Capitalization of Earnings

The Capitalization of Earnings method assumes the calculations for a single time period will
continue and calculates future profitability based on cash flow, annual ROI, and expected
value.

Capitalization of earnings is determined by calculating the NPV (Net present value) of the
expected future cash flows or profits. The estimate here is found by taking the future earnings
of the company and dividing them by a cap rate.

In short, this is an income-valuation approach that lets us know the value of a company by
analyzing the annual rate of return, the current cash flow and the expected value of the
business.

Disadvantages of Capitalization of Earnings Method

There isn’t one perfect method to determine a company’s value, which is why assessing a
company’s future earnings has some drawbacks. At first, the method used to predict the future
earnings might give an inaccurate figure, which would eventually result in less than expected
generated profits.

In addition to this, exceptional circumstances can occur that eventually compromises the
earnings, and affect the valuation of the investment. Further, a business that has just entered
the market might lack adequate information for finding out an accurate valuation of the
company.

The buyer has to know all about the desired ROI and the acceptable risks, as the capitalization
rate has to be reflected in the risk tolerance, market characteristics of the buyer, and the
expected growth factor of the business. For instance, if a buyer is not aware of the targeted rate,
he might pass on a more suitable investment or overpay for an investment.

Multiple of Earnings

The Multiple of Earnings method, like Capitalization of Earnings, values a business by its
future profitability. However, this method calculates a company’s worth by assigning a
multiplier to its current revenue. The appropriate multiplier varies widely depending on the
specific industry, current market trends, and economic climate.

Valuation of a sole proprietorship in terms of past earnings can be tricky, as customer loyalty
is directly tied to the identity of the business owner.

Any valuation of a service-oriented sole proprietorship needs to involve an estimate of the

percentage of business that might be lost under a change of ownership.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a general equilibrium market model developed to
analyse the relationship between risk and required rates of return on assets when they are held
in well-diversified portfolios. The Capital Asset Pricing Model (CAPM) provides a linear
relationship between the required rate of return (Ri) of a security and its Systematic or
undiversifiable risk as measured by the security’s beta. The systematic risk of a security, which
is measured by the beta coefficient of the security, is the market risk that cannot be eliminated
through diversification.

Concept of Risk and Return

After investing money in a project a firm wants to get some outcomes from the project. The
outcomes or the benefits that the investment generates are called returns. Wealth maximization
approach is based on the concept of future value of expected cash flows from a prospective
project.

So cash flows are nothing but the earnings generated by the project that we refer to as returns.
Since fixture is uncertain, so returns are associated with some degree of uncertainty. In other
words there will be some variability in generating cash flows, which we call as risk. In this
article we discuss the concepts of risk and returns as well as the relationship between them.

CONCEPT OF RISK
 A person making an investment expects to get some returns from the investment in the future.
However, as future is uncertain, the future expected returns too are uncertain. It is the
uncertainty associated with the returns from an investment that introduces a risk into a project.
The expected return is the uncertain future return that a firm expects to get from its project.
The realized return, on the contrary, is the certain return that a firm has actually earned.

Elements of Risk

Various components cause the variability in expected returns, which are known as elements of
risk. There are broadly two groups of elements classified as systematic risk and unsystematic
risk.

(i) Systematic Risk

Business organizations are part of society that is dynamic. Various changes occur in a society
like economic, political and social systems that have influence on the performance of
companies and thereby on their expected returns. These changes affect all organizations to
varying degrees. Hence the impact of these changes is system-wide and the portion of total
variability in returns caused by such across the board factors is referred to as systematic risk.
These risks are further subdivided into interest rate risk, market risk, and purchasing power
risk.

(ii) Unsystematic Risk

The returns of a company may vary due to certain factors that affect only that company.
Examples of such factors are raw material scarcity, labour strike, management inefficiency,
etc. When the variability in returns occurs due to such firm-specific factors it is known as
unsystematic risk. This risk is unique or peculiar to a specific organization and affects it in
addition to the systematic risk. These risks are subdivided into business risk and financial risk

The CAPM requires an extensive set of assumptions:

 All investors are single-period expected utility of terminal wealth maximizers, who choose
among alternative portfolios on the basis of each portfolio’s expected return and standard
deviation.
 All investors can borrow or lend an unlimited amount at a given risk-free rate of interest.
 Investors have homogeneous expectations (that is, investors have identical estimates of the
expected values, variances, and covariances of returns among all assets).
 All assets are perfectly divisible and perfectly marketable at the going price, and there are no
transaction costs.
 There are no taxes.
 All investors are price takers (that is, all investors assume that their own buying and selling
activity will not affect stock prices).
 The quantities of all assets are given and fixed.

According to the Capital Asset Pricing Model approach, the required return on a security is
given by the equation:
 Ri = Rf + βi ( Rm — Rf )

Where,

 Ri = Required rate of return on security i or cost of equity.

 Rf = Risk-free rate of return.
 βi = Beta of security i.
 Rm = Rate of return on the market portfolio.

Limitations of CAPM:

 Rates that are risk-free tend to fluctuate frequently

The risk-free premium, or rate used for CAPM calculations, is generated by
short-term government securities. This model has a major flaw: the risk-free
rate can change in a matter of days.

 A risk-free rate is not realistic

Individual investors are not able to borrow or lend at the same rate as the
government. It is impossible to assume a zero-risk rate of return for
calculations. This means that the real return on investment could be lower
than what the CAPM model shows.

 It can be difficult to determine a beta

This model of return calculation requires investors to calculate a beta value
that reflects the security being invested in. It can be difficult and time-
consuming to calculate an accurate beta value. In most cases, a proxy value
for beta is used. This not only speeds up return calculations, but it also
reduces their accuracy. Compared to other scientific models, a capital asset
pricing model has similar problems. However, it still gives an accurate
picture of what kind of dividends investors can expect if they place their
money at risk.

Discounted cash-flow Techniques

Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an
investment opportunity. DCF analyses use future free cash flow projections and discounts
them, using a required annual rate, to arrive at present value estimates. A present value estimate
is then used to evaluate the potential for investment. If the value arrived at through DCF
analysis is higher than the current cost of the investment, the opportunity may be a good one.

Types of DCF Techniques:

There are mainly two types of DCF techniques viz… Net Present Value [NPV] and Internal
Rate of Return [IRR].

(A) Net Present Value Techniques [NPV]:

Net Present Value may be defined as the excess of present value of project cash inflows [stream
of benefits] over that of outflows [cash outlays]. The cash flows of a project are discounted at
some desired rate of return, which is mostly equivalent to the cost of capital.

(B) Internal Rate of Return [IRR]:

The Internal Rate of Return may be defined as that rate of interest when used to discount the
cash flows of an investment, reduce its NPV to zero. Or it is the rate of discount, which equates
the aggregate discounted benefits with aggregate discounted costs.
IRR is also called as ‘Discounted Cash Flow Method’ or ‘Yield Method’ or ‘Time Adjusted
Rate of Return Method’. This method is used when the cost of investment and the annual cash
inflows are known but the discount rate [rate of return] is not known and is to be calculated.

Arbitrage Pricing Theory (APT)

Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that
an asset's returns can be predicted using the linear relationship between the asset’s expected
return and a number of macroeconomic variables that capture systematic risk. It is a useful
tool for analyzing portfolios from a value investing perspective, in order to identify
securities that may be temporarily mispriced.

How the Arbitrage Pricing Theory Works

The arbitrage pricing theory was developed by the economist Stephen Ross in 1976, as an
alternative to the capital asset pricing model (CAPM). Unlike the CAPM, which assume
markets are perfectly efficient, APT assumes markets sometimes misprice securities, before
the market eventually corrects and securities move back to fair value. Using APT,
arbitrageurs hope to take advantage of any deviations from fair market value.

However, this is not a risk-free operation in the classic sense of arbitrage, because investors
are assuming that the model is correct and making directional trades—rather than locking in
risk-free profits.

Mathematical Model for the APT

While APT is more flexible than the CAPM, it is more complex. The CAPM only takes into
account one factor—market risk—while the APT formula has multiple factors. And it takes
a considerable amount of research to determine how sensitive a security is to various
macroeconomic risks.

The factors as well as how many of them are used are subjective choices, which means
investors will have varying results depending on their choice. However, four or five factors
will usually explain most of a security's return. (For more on the differences between the
CAPM and APT, read more about how CAPM and arbitrage pricing theory differ.)

APT factors are the systematic risk that cannot be reduced by the diversification of an
investment portfolio. The macroeconomic factors that have proven most reliable as price
predictors include unexpected changes in inflation, gross national product (GNP), corporate
bond spreads and shifts in the yield curve. Other commonly used factors are gross domestic
product (GDP), commodities prices, market indices, and exchange rates.

Economic Value Added

Economic value added (EVA) is a financial measurement of the return earned by a firm that
is in excess of the amount that the company needs to earn to appease shareholders. In other
words, it is a measure of an organization’s economic profit that takes into account the
opportunity cost of invested capital and ultimately measures whether organizational value was
created or lost.

EVA compares the rate of return on invested capital with the opportunity cost of investing
elsewhere. This is important for businesses to keep track of, particularly those businesses that
are capital intensive. When calculating economic value added, a positive outcome means that
the company is creating value with its capital investments.

Conversely, a negative outcome would mean that the company is destroying value with its
capital investments and the capital would be better spent elsewhere. Businesses can use
economic value added to assess managerial performance as it serves as a measure of value
creation for shareholders.

The EVA formula is calculated using the following equation:

EVA = NOPAT – (Capital x Cost of Capital)

EVA = NOPAT – (WACC * capital invested)
Where NOPAT = Net Operating Profits After Tax

WACC = Weighted Average Cost of Capital

Capital invested = Equity + long-term debt at the beginning of the period

and (WACC* capital invested) is also known as finance charge

Components of EVA:

These three components of EVA are described below:

(i) NOPAT:

NOPAT is defined as follows:

(Profits before interest and taxes) (1- tax rate)

(ii) Cost of capital:

Providers of capital (shareholders and lenders) want to be suitably compensated for investing
capital in the firm. The cost of capital reflects what they expect.
The formula employed for estimating cost of capital is:

Cost of capital = (Cost of equity) (Proportion of equity in the capital employed)

+ (Cost of preference) (Proportion of preference in the capital employed) +
(Pre-tax cost of debt) (1- tax rate) (Proportion of debt in the capital employed)
(iii) Capital employed:

To obtain capital employed, we have to make adjustments to the ‘accounting’ balance sheet to
derive the ‘economic book value’ balance sheet. These adjustments are meant to reflect the
economic value of assets in place of value determined by historical cost.

Example

Paul is the CFO of an organization in Boston. In order to assess the organization’s value
creation or destruction, Paul would like to calculate economic value added for 2015. The
organization’s NOPAT is $3,500,000, cost of capital is 5%, and the organization employed
1,000,000 in capital in 2015.

By plugging the values into the EVA calculation above, we can compute the value that Paul
needs:

$3,500,000 – ( 1,000,000 x 5% ) = $3,450,000

Paul’s organization had a total added value amount of $3,450,000 in 2015.

Advantages of EVA:

(i) EVA is a tool which helps to focus managers’ attention on the impact of their decisions in
increasing shareholders’ wealth.

(ii) EVA is a good guide for investors; as on the bias of EVA, they can decide whether a
particular company is worth investing money in or not.

(iii) EVA can be used as a basis for valuation of goodwill and shares.
(iv) EVA is a good controlling device in a decentralised enterprise. Management can apply
EVA to find out EVA contribution of each decentralised unit or segment of the company.

(v) EVA linked compensation schemes (for both operatives and managers) can be developed
towards protecting (or rather improving) shareholders’ wealth.

Time Value of Money

The time value of money (TVM) is the concept that money available at the present time is
worth more than the identical sum in the future due to its potential earning capacity. This core
principle of finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received. TVM is also sometimes referred to as present discounted
value.

The time value of money draws from the idea that rational investors prefer to receive money
today rather than the same amount of money in the future because of money’s potential to grow
in value over a given period of time. For example, money deposited into a savings account
earns a certain interest rate, and is therefore said to be compounding in value.

Basic Time Value of Money Formula

Depending on the exact situation in question, the TVM formula may change slightly. For
example, in the case of annuity or perpetuity payments, the generalized formula has additional
or less factors. But in general, the most fundamental TVM formula takes into account the
following variables:

 FV = Future value of money

 PV = Present value of money
 i = interest rate
 n = number of compounding periods per year
 t = number of years

Based on these variables, the formula for TVM is:

FV = PV x [1 + (i / n)] (n x t)

There are five (5) variables that you need to know

1. Present value (PV)– This is your current starting amount. It is the money you have in
your hand at the present time, your initial investment for your future.
2.
3. Future value (FV)– This is your ending amount at a point in time in the future. It
should be worth more than the present value, provided it is earning interest and growing
over time.
4. The number of periods (N)– This is the timeline for your investment (or debts). It is
usually measured in years, but it could be any scale of time such as quarterly, monthly,
or even daily.
5. Interest rate (I)– This is the growth rate of your money over the lifetime of the
investment. It is stated in a percentage value, such as 8% or .08.
6. Payment amount (PMT)– These are a series of equal, evenly-spaced cash flows.

Finance and its Scope Financial Decisions

Finance is a term describing the study and system of money, investments, and other financial
instruments. Some people prefer to divide finance into three distinct categories: public finance,
corporate finance, and personal finance. There is also the recently emerging area of social
finance. Behavioral finance seeks to identify the cognitive (e.g. emotional, social, and
psychological) reasons behind financial decisions.

Finance is a field that is concerned with the allocation (investment) of assets and liabilities over
space and time, often under conditions of risk or uncertainty. Finance can also be defined as
the art of money management. Participants in the market aim to price assets based on their risk
level, fundamental value, and their expected rate of return. Finance can be split into three sub-
categories: public finance, corporate finance and personal finance.

Some of the major scope of financial management are as follows:-

1. Investment Decision
The investment decision involves the evaluation of risk, measurement of cost of capital and
estimation of expected benefits from a project. Capital budgeting and liquidity are the two
major components of investment decision. Capital budgeting is concerned with the allocation
of capital and commitment of funds in permanent assets which would yield earnings in future.

Capital budgeting also involves decisions with respect to replacement and renovation of old
assets. The finance manager must maintain an appropriate balance between fixed and current
assets in order to maximize profitability and to maintain desired liquidity in the firm.

Capital budgeting is a very important decision as it affects the long-term success and growth
of a firm. At the same time it is a very difficult decision because it involves the estimation of
costs and benefits which are uncertain and unknown.

2. Financing Decision

While the investment decision involves decision with respect to composition or mix of assets,
financing decision is concerned with the financing mix or financial structure of the firm. The
raising of funds requires decisions regarding the methods and sources of finance, relative
proportion and choice between alternative sources, time of floatation of securities, etc. In order
to meet its investment needs, a firm can raise funds from various sources.

The finance manager must develop the best finance mix or optimum capital structure for the
enterprise so as to maximize the long- term market price of the company’s shares. A proper
balance between debt and equity is required so that the return to equity shareholders is high
and their risk is low.

Use of debt or financial leverage effects both the return and risk to the equity shareholders. The
market value per share is maximized when risk and return are properly matched. The finance
department has also to decide the appropriate time to raise the funds and the method of issuing
securities.

3. Dividend Decision

In order to achieve the wealth maximization objective, an appropriate dividend policy must be
developed. One aspect of dividend policy is to decide whether to distribute all the profits in the
form of dividends or to distribute a part of the profits and retain the balance. While deciding
the optimum dividend payout ratio (proportion of net profits to be paid out to shareholders).

The finance manager should consider the investment opportunities available to the firm, plans
for expansion and growth, etc. Decisions must also be made with respect to dividend stability,
form of dividends, i.e., cash dividends or stock dividends, etc.

4. Working Capital Decision

Working capital decision is related to the investment in current assets and current liabilities.
Current assets include cash, receivables, inventory, short-term securities, etc. Current liabilities
consist of creditors, bills payable, outstanding expenses, bank overdraft, etc. Current assets are
those assets which are convertible into a cash within a year. Similarly, current liabilities are
those liabilities, which are likely to mature for payment within an accounting year.