ED/Ind VS- 103/2018-2019/11

Exposure Draft

of

Indian Valuation Standard 103
Valuation Approaches and Methods

(Last date for Comments: May 12, 2018)

Issued by Valuation Standards Board

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA
(Set up under an Act of Parliament)

Exposure Draft

Indian Valuation Standard 103 Valuation Approaches and Methods

Following is the Exposure Draft of the Indian Valuation Standard 103 Valuation Approaches and Methods issued by the Valuation Standards Board of the Institute of Chartered Accountants of India, for comments.

The Board invites comments on any aspect of this Exposure Draft. Comments are most helpful if they indicate the specific paragraph or group of paragraphs to which they relate, contain a clear rationale and, where applicable, provide suggestions for alternative wording.

Comments can be submitted using one of the following methods, so as to be received not later than May 12, 2018.

1. Electronically: Click on http: https://goo.gl/forms/Z1qeffZPcnSJlrdp1 to submit comments online. (Preferred method)

2. Email: Comments can be sent to [email protected]

3. Postal: Secretary, Valuation Standards Board, The Institute of Chartered Accountants of India, ICAI Bhawan, A- 29, Sector- 62, Noida – 203209.

Further clarifications on any aspect of this Exposure Draft may be sought by e-mail to [email protected]

Exposure Draft

Indian Valuation Standard- 103

Valuation Approaches and Methods

Contents Paragraph
OBJECTIVE 1-3
SCOPE 4-7
VALUATION APPROACHES 8-108
Market Approach 15-49
Market Price Method 19-21
Comparable Companies Multiple (CCM) Method 22-29
Comparable Transaction Multiple (CTM) Method 30-36
Discounts and Control Premium 37-49
Discount for Lack of Marketability (DLOM) 39-42
Control Premium / Discount for Lack of Control (DLOC) 43-49
Income Approach 50- 94
Discounted Cash Flow (DCF) Method 55-73
Cash Flows 62-68
Discount Rate 69-73
Terminal Value 74-83
Gordon (Constant) Growth Model 77-78
Variable Growth Model 79
Exit Multiple 80-81
Salvage / Liquidation value 82
Terminal Growth 83
Relief from Royalty (RFR) Method 84-86
Multi-Period Excess Earnings Method (MEEM) 87-89
With and Without Method (WWM) 90-91
Option Pricing Models 92- 94
Cost Approach 95-108
Replacement Cost Method 100-102
Reproduction Cost Method 103-108
Obsolescence 105-107
EFFECTIVE DATE 108

 

Exposure Draft

Indian Valuation Standard 103, Valuation Approaches and

Methods

(The Exposure Draft of the Indian Valuation Standard includes paragraphs set in bold type and plain type, which have equal authority. Paragraphs in bold type indicate the main principles. (This Exposure Draft of the Indian Valuation Standard should be read in the context of Framework for the Preparation of Valuation Report in accordance with Indian Valuation Standards)

Objective

1. This Standard:

(a) defines the approaches and methods for valuing an asset; and

(b) provides guidance on use of various valuation approaches/methods.

2. The objective of this Standard is to provide guidance on various valuation approaches/methods that can be adopted while valuing an asset.

3. The principles enunciated in this Standard shall be applied in conjunction with the principles prescribed and contained in the Framework for the Preparation of Valuation Report in accordance with Indian Valuation Standards.

Scope

4. A valuer shall follow the requirements of this Standard in valuation of an asset or a liability.

5. This Standard provides guidance on use of multiple approaches/methods.

6. This Standard does not provide an exhaustive list of all the valuation methods. For example, valuation methods applicable for valuation of intangible assets and financial instruments have been covered briefly in this Standard and detailed guidance has been covered separately in the relevant Standards.

7. In order to comply with the requirements of Indian Valuation Standards, a valuer may be requiredto use a valuation method(s) not mentioned in this Standard, for example, in case of valuation of asset where a valuer is required to adopt valuation bases that are prescribed by the statute or regulations, the valuer shall apply the specific method/formulae as have been laid down under the said statute or regulation.

Valuation Approaches

8. This Standard provides guidance for following three main valuation approaches:

  • market approach;
  • income approach; and
  • cost approach.

9. Under each approach, there are various valuation methods. The appropriateness of the valuation approach/method for valuing an asset would depend on the base(s) and premise(s) for valuation.

10. In addition, following are some of the key factors that a valuer shall consider while determining the appropriateness of a particular valuation approach/method:

(a) nature of asset to be valued;

(b) availability of adequate inputs/information and its reliability;

(c) strengths and weakness of each valuation approach/method; and

(d) valuation approach/method considered by market participants.

11. A valuer shall be responsible to select the appropriate valuation approach(es)/method(s) as there is no single approach/method that is best suited for valuation in every situation.

12. A valuer may consider adopting a valuation approach/method or multiple valuation approaches/methods as may be appropriate to produce a reliable value. When weighing indications of value resulting from use of multiple valuation approaches/methods, a valuer shall consider the reasonableness of the range of values. If the values under different approaches and/or methods are significantly different then it would not be appropriate to simply weight such values. The valuershall consider the factors given in paragraph 10 to determine whether a particular approach/method is more appropriate or not.

13. The selected valuation approaches /methods shall maximise the use of relevant observable inputs and minimise the use of unobservable inputs. The price information from an active market is generally considered to be strong evidence of value.

14. A valuer shall use another valuation approach/method that shall maximise the use of relevant observable inputs, where a price of the asset to be valued is not observable.

Market Approach

15. Market approach is a valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (i.e., similar) assets, liabilities or a group of assets and liabilities, such as a business.

16. The following are some of the instances where a valuer applies the market approach:

(a) where the asset to be valued or its identical/comparable asset is traded in the active market;

(b) there is a recent transaction in the asset to be valued in an orderly transaction; or

(c) there are recent transactions in the identical/comparable asset(s) (comparable transaction) in an orderly transaction and information for the same is available and reliable.

17. In some instances, a valuer may consider using other valuation approaches instead of Market approach or in combination with Market approach, such as:

(a) where the asset has fewer identical/comparable assets (market comparable);

(b) the asset to be valued or its market comparable are not traded in the active market;

(c) sufficient information on the comparable transaction(s) is not available;

(d) there is no recent transaction that has happened in the asset to be valued or in the market comparables; or

(e) there are material differences between the asset to be valued and the market comparable, which require significant adjustments.

18. The following valuation methods are commonly used under the market approach:

(a) Market Price Method (see paragraphs 19 -21);

(b) Comparable Companies Multiple (CCM) Method (see paragraphs 22-29); and

(c) Comparable Transaction Multiple (CTM) Method (see paragraphs 30-49).

Market Price Method

19. A valuer shall consider traded price observed over a reasonable period while valuing assets which are traded in the active market.

20. A valuer shall consider the market where the trading volume of asset is the highest when such asset is traded in more than one active market.

21. A valuer shall use volume-weighted average price of the asset over a reasonable period. It helps to reduce the impact of volatility or any one time event in the asset.

Comparable Companies Multiple (CCM) Method

22. Comparable Companies Multiple Method, also known as Guideline Public Company Method, involves valuing an asset based on market multiples derived from prices of market comparables traded on active market.

23. The following are the major steps in the CCM method:

(a) identify the market comparables;

(b) select and calculate the market multiples of the identified market comparables;

(c) compare the asset to be valued with the market comparables to understand material differences; and make necessary adjustments to the market multiple to account for such differences, if any;

(d) apply the adjusted market multiple to the relevant parameter of the asset to be valued to arrive at the value of such asset; and

(e) if valuation of the asset is derived by using market multiples based on different metrics/parameters, the valuer shall consider the reasonableness of the range of values.

24. While identifying and selecting the market comparables, a valuer may consider the factors such as-

(a) industry to which the asset belongs;

(b) geographic area of operations;

(c) similar line of business, or similar economic forces that affect the asset being valued; or

(d) other parameters such as size (for example – revenue, assets, etc), stage of lifecycle of the asset, profitability, diversification, etc.

This list is not an exhaustive list, there may be certain other factors which a valuer shall consider while identifying and selecting the market comparables.

25. The market multiples are generally computed on the basis of following inputs:

(a) trading prices of market comparables on active market; and

(b) financial metrics such as Earnings Before Interest, Depreciation and Amortisation (EBITDA), Profit After Tax (PAT), Sales, Book Value, etc.

26. If market participants are using market multiple based on non-financial metrics for valuing an asset, such multiples may also be considered by the valuer in addition to market multiple based on the financial metrics. For example, Enterprise Value (EV) / Tower in case of tower telecom companies, EV/Tonne in case of cement industry, etc.

27. A valuer shall preferably use multiple market comparables as compared to relying on a single comparable.

28. A valuer shall exercise judgement while selecting the multiple in case where the market multiple computed for each comparable is significantly different from each other.

29. The following are some of the differences between the asset to be valued and market comparable that the valuer may consider while making adjustments to the market multiple:

(a) size of the asset;

(b) geographic location;

(c) profitability;

(d) stage of lifecycle of the asset

(e) diversification

(f) historical and expected growth; or

(g) management profile (for example – private ownership vs. public sector undertaking).

Comparable Transaction Multiple (CTM) Method

30. Comparable Transaction Multiple Method, also known as ‘Guideline Transaction Method’ involves valuing an asset based on transaction multiples derived from prices paid in transactions of asset to be valued /market comparables (comparable transactions).

31. Such transactions generally include control premium in the price paid, except where transaction involves acquisition of minority stake.

32. The following are the major steps in the CTM method:

(a) identify comparable transaction appropriate to the asset to be valued;

(b) select and calculate the transaction multiples from the identified comparable transaction;

(c) compare the asset to be valued with the market comparables to understand the differences, and make necessary adjustments to the transaction multiple to account for such differences, if any;

(d) apply the adjusted transaction multiple to the relevant parameter of the asset to be valued to arrive at the value of such asset; and

(e) if valuation of the asset is derived by using transaction multiples based on different metrics / parameters, the valuer shall consider the reasonableness of the range of values.

33. While identifying and selecting the comparable transaction, a valuer may consider the factors such as-

(a) transactions that have been consummated closer to the valuation date are generally more representative of the market conditions prevailing during that time;

(b) there shall be in an orderly transaction;

(c) availability of sufficient information on the transaction to enable the valuer to reasonably understand the market comparable and derive the transaction multiple; or

(f) availability of information on transaction from reliable sources such as regulatory filings, industry magazines, M&A databases, etc.

34. The transaction multiples are generally computed based on the following two inputs:

(a) price paid in the comparable transaction; and

(b) financial metrics such as EBITDA, PAT, Sales, Book Value, etc of the market comparable.

Even multiples based on non-financial metrics (for example – price per square foot, EV/Bed for hospitals) can be considered.

35. A valuer shall preferably use multiple comparable transactions of recent past as compared to relying on a single transaction.

36. The following are some of the differences between the asset to be valued and comparable transaction that the valuer may consider while making adjustments to the transaction multiple:

(a) size of the asset;

(b) geographic location;

(c) profitability

(d) stage of lifecycle of the asset;

(e) diversification;

(f) historical and expected growth;

(g) management profile (for example – private ownership vs. public sector undertaking); or

(h) terms and conditions in the comparable transaction (for example – deferred payment of consideration on achievement of certain milestones).

Discounts and Control Premium

.37. A valuer shall analyse and make adjustments for differences between the asset to be valued and market comparables/comparable transactions. The most common adjustment under CCM method and CTM method pertains to ‘Discounts’ and ‘Control Premium’.

38. ‘Discounts’ include Discount for Lack of Marketability (DLOM) and Discount for Lack of

Control (DLOC).

Discount for Lack of Marketability (DLOM)

39. DLOM is based on the premise that an asset which is readily marketable (such as frequently traded securities) commands a higher value than an asset which requires longer marketing period to be sold (such as securities of an unlisted entity) or an asset having restriction on its ability to sell (such as securities under lock-in-period or regulatory restrictions).

40. Generally, restrictions on marketability that are only inherent in the asset to be valued shall be considered while valuing the asset to be valued. Marketability restrictions that are specific to a particular owner of the asset to be valued shall not be considered for most valuation bases.

41. The consideration shall be given to the specific nature and characteristics of the asset to be valued and the facts and circumstances surrounding the valuation, as determining an appropriate level of DLOM can particularly be complex and subjective process.

42. A valuer shall use his professional judgement while applying DLOM and consider the factors such as-

(a) size and nature of the asset to be valued;

(b) time and costs associated with marketing of the asset to be valued /making a public offer;

(c) restrictions on transferability of the asset to be valued;

(d) history of past transactions in the asset to be valued;

(e) exit rights available to the asset to be valued; or

(f) lack/ limitation on access to information.

Control Premium / Discount for Lack of Control (DLOC)

43. Control Premium is an amount that a buyer is willing to pay over the current market price of a publicly-traded company to acquire a controlling interest in such company. It is opposite of a discount for lack of control to be applied in case of valuation of a non-controlling/minority interest.

44. Control Premium generally represents the amount paid by acquirer for the benefits it would derive by controlling the acquiree’s assets and cash flows.

45. Generally, on acquisition an acquirer can derive the benefits from the following:

(a) potential synergies as a result of merger/combination of its and acquiree’s assets; and

(b) its ability to influence the acquiree’s operating, financial, or corporate governance policies such as improve operating efficiency, appoint board members, declare dividends, sale of asset, etc.

46. Under the CCM method, the value of the asset is on a minority interest/non-controlling interest basis as the market multiples of market comparables are derived from traded price of such comparables in the active market. The traded price of such comparables does not include the benefit derived from controlling the market comparable’s assets and cash flows. Therefore, while applying the CCM method to value the asset having controlling interest, a control premium may be considered.

47. Under the CTM method, the transaction price generally include price paid for control premium.
Therefore, while valuing the asset for a non-controlling/minority interest, the DLOC may be considered.

48. The consideration shall be given to the specific nature and characteristics of the asset to be valued and the facts and circumstances surrounding the valuation as determining an appropriate level of Control Premium and DLOC can particularly be a complex and subjective process.

49. A valuer shall use his professional judgement while applying control premiums and DLOC, considering the factors such as amount/ extent of control in the asset to be valued, distribution of control of the remaining interest in the subject entity, statutory provision relating to protections of minority shareholders; the shareholder protection restrictions contained in the articles of incorporation, the bye-laws and/or the shareholders’ agreement, etc.

Income Approach

50. Income approach is the valuation technique that converts future amounts (eg cash flows or income and expenses) to a single current (i.e., discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts.

51. This approach involves discounting future amounts (cash flows/income/cost savings) to a single present value.

52. The following are some of the instances where a valuer applies the income approach:

(a) where the asset does not have any market comparable / comparable transaction;

(b) where the asset has fewer relevant market comparables; or

(c) where the asset is an income producing asset for which the future cash flows are available and can reasonably be projected.

53. In some instances, a valuer may consider using other valuation approaches instead of income approach or in combination with income approach, such as, where –

(a) the asset has depleting resources and has limited life;

(b) the asset has not yet started generating income/cash flows (for eg. projects under development);

(c) there is significant uncertainty on the amount and timing of income/future cash flows (for example start-up companies); or

(d) the client does not have access to the information relating to the asset being valued (for example minority shareholder may not have access to projections/budgets).

54. Some of the common valuation methods under income approach are as follows:

(a) Discounted Cash Flow (DCF) Method (see paragraphs 55- 83);

(b) Relief from Royalty (RFR) Method (see paragraphs 84-86);

(c) Multi-Period Excess Earnings Method (MEEM) (see paragraphs 87-89);

(d) With and Without Method (WWM) (see paragraphs 90-91); and

(e) Option pricing models such as Black-Scholes-Merton formula or binomial (lattice) model (see paragraphs 92-94).

Discounted Cash Flow (‘DCF’) Method

55. The DCF method values the asset by discounting the cash flows expected to be generated by the asset for the explicit forecast period and also the perpetuity value (or terminal value) in case of indefinite lived assets. Terminal value is the value of the asset at the end of the explicit forecast period.

56. The DCF method is one of the most common methods for valuing various assets such as shares, businesses, real estate projects, debt instruments, etc.

57. This method involves discounting of future cash flows expected to be generated by an asset over the life of the asset using an appropriate discount rate to arrive at the present value.

58. The following are the major steps in theDCF method:

(a) obtain the projections from the client or the target to determine the future cash flows expected to be generated by the asset;

(b) analyse the projections and its underlying assumptions to assess the reasonableness of the cash flows;

(c) choose the most appropriate type of cash flows for the asset, viz., pre-tax or post-tax cash flows, free cash flows to equity or free cash flows to firm;

(d) determine the discount rate and growth rate beyond explicit forecast period; and

(e) apply the discount rate to arrive at the present value of the explicit period cash flows and for arriving at the terminal value.

59. While using the DCF method, it may also be necessary to make adjustments to the valuation to reflect matters that are not captured in either the cash flow forecasts or the discount rate adopted. The examples may include adjustments for discount for the marketability of the interest being valued or whether the interest being valued is non-controlling interest/minority interest in the business. A valuer shall use his professional judgement while applying the DLOM / DLOC.

60. In case of the DCF method, projected cash flows reflect the benefits of control and accordingly the value of asset arrived under this method is not to be grossed up for control premium.

61. The following are two important inputs for the DCF method:

(a) Cash flows; and

(b) Discount rate

Cash Flows

62. In most cases, the projections shall generally comprise the statement of profit & loss, balance sheet, cash flow statement, along with the underlying key assumptions. However, in certain cases, if balance sheet and cash flow statement are not available, details of future capital expenditure and working capital requirements may also suffice.

63. The projections reflect the accounting income and expenses. For arriving at the cash flows, non-cash expenses, such as depreciation and amortisation, shall be added back. Further, cash outflows relating to capital expenditure needs and incremental working capital requirements, if any shall be deducted.

64. Generally, the historical financial statements are used as base for preparation of projections. If there are changes in the circumstances expected in future, the assumptions underlying the projections shall reflect such differences vis-à-vis the historical financial statements.

65. A valuer shall use tools for analysis of financial information such as ratio analysis, trend analysis to determine historical trends, which may provide the necessary information to assess the risks inherent in the achievability of the projections.

66. The fact that the valuer considers the projections while arriving at the valuation of the asset shall not be construed as the valuer being associated with or being a party to such projections.

67. The length of the period of projections (explicit forecast period) shall be determined based on the following factors:

(a) Nature of the asset- In case the asset is of cyclical nature, explicit forecast period should cover entire one cycle to the extent possible (for example cement business).

(b) Life of the asset- In case of asset with definite life, explicit period should be for the entire life of the asset (for example, debt instruments, Build Operate Transfer (BOT) road projects).

(c) Sufficient period- The period which is sufficient for the asset to achieve stable levels of growth.

(d) Reliable data- The availability of reliable data that are used for projecting the cash flows.

68. The following are the cash flows which are used for the projections:

(a) Free Cash Flows to Firm (FCFF): FCFF refers to cash flows that are available to all the providers of capital, i.e. equity shareholders, preference shareholders and lenders. Therefore, cash flows required to service lenders and preference shareholders such as interest, dividend, repayment of principal amount and even additional fund raising are not considered in the calculation of FCFF.

(b) Free Cash Flows to Equity (FCFE): FCFE refers to cash flows available to equity shareholders and therefore, cash flows after interest, dividend to preference shareholders, principal repayment and additional funds raised are considered.

FCFF is most commonly used to arrive at an asset value.

Discount Rate

69. Discount Rate is the return expected by a market participant from a particular investment and shall reflect not only the time value of money but also the risk inherent in the asset being valued as well as the risk inherent in achieving the future cash flows.

70. The following discount rates are most commonly used depending upon the type of the asset:

(a) cost of equity;

(b) weighted average cost of capital;

(c) Internal Rate of Return (‘IRR’);

(d) cost of debt; or

71. There are many methods which are used for determining the discount rate. The most commonly used methods are as follows:

(a) Capital Asset Pricing Model (CAPM) for determining the cost of equity.

(b) Weighted Average Cost of Capital (WACC) is the combination of cost of equity and cost of debt weighted for their relative funding in the asset.

(c) Build-up method (generally used only in absence of market inputs).

72. A valuer may consider the following factors while determining the discount rate:

(a) type of asset being valued (for example debt, preference shares, business, real estate, intangibles, etc.);

(b) life of the asset (for example the risk-free rate used for determining the cost of equity in the CAPM model differs for an asset with a one-year life vs an indefinite life);

(c) functional currency in which the projections have been prepared;

(d) discount the cash flows in the functional currency using a discount rate appropriate for that functional currency;

(e) geographic location of the asset;

(f) type of cash flows;

(g) pre-tax cash flows need to be discounted by pre-tax discount rate and post-tax cash flows to be discounted by post tax discount rate;

(h) cash flows used for the projections as FCFE needs to be discounted by Cost of Equity whereas FCFF to be discounted using WACC; and

(i) risk in achieving the projected cash flows.

73. Regardless of the method used, a valuer shall include appropriate risk adjustments, including risk premium that a market participant shall demand as compensation for uncertainty inherent in the cash flows.

Terminal Value

74. Terminal value represents the present value at the end of explicit forecast period of all subsequent cash flows to the end of the life of the asset or into perpetuity if the asset has an indefinite life.

75. In case of assets with indefinite life, it is not practical to project the cash flows. Even in case of assets with long life, it may not be practical to project the cash flows for the entire life of the asset. Therefore, the valuer needs to determine the terminal value to capture the value of the asset at the end of explicit forecast period.

76. There are many different methods for calculating the terminal value. The commonly used methods for calculating the terminal value are :

(a) Gordon (Constant) Growth Model;

(b) Variable Growth Model;

(c) Exit Multiple; and

(d) Salvage / Liquidation value

Gordon (Constant) Growth Model

77. The terminal value under this method is computed by dividing the perpetuity maintainable cash flows with the discount rate as reduced by the stable growth rate.

78. The estimation of stable growth rate is of great significance because even a minor change in stable growth rate can change the terminal value and the value of the asset too.

Variable Growth Model

79. The Constant Growth Model assumes that the asset grows (or declines) at a constant rate beyond the explicit forecast period whereas the Variable Growth Model assumes that the asset grows (or declines) at variable rate beyond the explicit forecast period.

Exit Multiple

80. The calculation of terminal value under this method involves application of a market-evidence based capitalisation factor or a market multiple (for example, Enterprise Value (EV) / Earnings before Interest, Tax, Depreciation and Amortisation (EBITDA), EV / Sales) to the perpetuity earnings / income.

81. The multiple needs to be estimated based on multiples of comparable assets and therefore, the valuers should comply with guidelines laid down in the market approach section of this standard.

Salvage / Liquidation value

82. In case of some assets, such as mine or oil fields, the terminal value of the asset has limited or no relationship with the cash flows projected for the explicit forecast period. For such assets, the terminal value is calculated as the salvage value/realisable value less costs to be incurred for disposing of such asset.

Terminal growth rate

83. The following are some of the factors that a valuer may consider while determining the terminal growth rate:

(a) whether the level of operations post explicit forecast period are expected to be significantly different from the level projected in the last year of the explicit forecast period or only a normal growth is expected;

(b) capacity utilisation at the end of explicit forecast period;

(c) market share;

(d) product life cycle;

(e) life of the asset after the explicit forecast period;

(f) necessary capital investment requirement to support the growth;

(g) whether there is future growth potential for the asset beyond the explicit forecast period, or whether the asset is deteriorating in nature; and

(h) for cyclical assets, the terminal value should consider the cyclical nature of the asset.

Relief from Royalty (RFR) Method

84. RFR Method is generally adopted for valuing intangible assets that are subject to licensing, such as trademarks, patents, brands, etc.

85. The fundamental assumption underlying this method is that if the intangible asset to be valued had to be licensed from a third-party owner there shall be a royalty charge for use of such asset. By owning the said intangible asset, royalty outgo is avoided. The value under this method is equal to the present value of the licence fees / royalty avoided by owning the asset over its remaining useful life.

86. The following are the major steps in the RFR method:

(a) obtain the projected income statement attributable to the intangible asset to be valued over the remaining useful life of the said asset from the client or the target;

(b) analyse the projected income statement and its underlying assumptions to assess the reasonableness;

(c) select the appropriate royalty rate based on market-based royalty rates for similar intangible assets;

(d) apply the selected royalty rate to the future income attributable to the said asset;

(e) use the appropriate marginal tax rate or such other appropriate tax rate to arrive at an after-tax royalty savings; and

(f) discount the after-tax royalty savings to arrive at the present value using an appropriate discount rate.

Multi-Period Excess Earnings Method (MEEM)

87. MEEM is generally used for valuing intangible asset that is leading or the most significant intangible asset out of group of intangible assets being valued.

88. The fundamental concept underlying this method is to isolate the earnings attributable to the intangible asset being valued. The value under this method is equal to the present value of the incremental after-tax cash flows (‘excess earnings’) attributable to the intangible asset to be valued over its remaining useful life.

89. The following are the major steps in the MEEM :

(a) obtain the projections for the entity or the combined asset group over the remaining useful life of the said intangible asset to be valued from the client or the target to determine the future after-tax cash flows expected to be generated ;

(b) analyse the projections and its underlying assumptions to assess the reasonableness of the cash flows;

(c) Contributory Asset Charges (CAC) or economic rents to be reduced from the total net after-tax cash flows projected for the entity/combined asset group to obtain the incremental after-tax cash flows attributable to the intangible asset to be valued;

(d) the CAC represent the charges for the use of an asset or group of assets (e.g. working capital, fixed assets, assembled workforce, other intangibles) based on their respective fair values and should be considered for all assets, excluding goodwill, that contribute to the realization of cash flows for the intangible asset to be valued; and

(e) discount the incremental after-tax cash flows attributable to the intangible asset to be valued to arrive at the present value using an appropriate discount rate.

With and Without Method (WWM)

90. Under WWM, the value of the intangible asset to be valued is equal to the present value of the difference between the projected cash flows over the remaining useful life of the asset under the following two scenarios:

(a) business with all assets in place including the intangible asset to be valued; and

(b) business with all assets in place except the intangible asset to be valued.

91. The following are the major steps in the WWM :

(a) obtain the projections for the business over the remaining useful life of the said asset from the client or the target under the following two scenarios:

(i) business with all assets in place including the intangible asset to be valued; and

(ii) business with all assets in place except the intangible asset to be valued.

(b) analyse the projections and its underlying assumptions to assess the reasonableness of the cash flows; and

(c) discount the difference between the projected cash flows under two scenarios to arrive at the present value using an appropriate discount rate.

Option Pricing Models

92. There are several methods to value options, of which the Black-Scholes-Merton Model and Binomial Model are widely used. The important inputs required in these models are as under:

(a) current price of asset to be valued;

(b) exercise price;

(c) life of the option;

(d) expected volatility in the price of the asset;

(e) expected dividend yield; and

(f) risk free interest rate.

93. These models value options by creating replicating portfolios composed of asset to be valued and riskless lending or borrowing.

94. MEEM, Relief from Royalty method,With and Without method are used only in case of valuation of intangible assets and Option Pricing Models are used in case of valuation of options. Indian Valuation Standards dealing with valuation of these assets provides specific guidance on the aforesaid valuation methods.

Cost Approach

95. Cost approach is a valuation technique that reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost).

96. In certain limited cases, historical cost of the asset may be considered by the valuer where it has been prescribed by the applicable regulations/law/guidelines or is appropriate considering the nature of the asset.

97. The following are some of the instances where a valuer applies the cost approach:

(a) an asset can be quickly recreated with substantially the same utility as the asset to be valued and without regulatory or legal restrictions;

(b) in case of liquidation; or

(c) income approach and/or market approach cannot be used

98. In some instances, the valuer may consider using other valuation approaches instead of cost approach or in combination with cost approach, such as:

(a) the asset has not yet started generating income / cash flows (directly or indirectly);

(b) an asset of substantially the same utility as the asset to be valued can be created but there are regulatory or legal restrictions and involves significant time for recreation; or

(c) the asset was recently created.

99. The following are the two most commonly used valuation methods under the Cost approach:

(a) Replacement Cost Method (see paragraph 100-102); and

(b) Reproduction Cost Method (see paragraph 103-108).

Replacement Cost Method

100. Replacement Cost Method, also known as ‘Depreciated Replacement Cost Method’ involves valuing an asset based on the cost, that a market participant shall have to incur to recreate an asset with substantially the same utility (comparable utility) as that of the asset to be valued, adjusted for obsolescence.

101. Obsolescence includes physical deterioration, functional (technological) and economic obsolescence. It is important to note that the physical properties of the new asset may or may not be similar, but the utility of the new asset shall be similar with that of the asset to be valued. It is different than the depreciation for financial reporting purposes or tax purposes.

102. The following are the major steps in the Replacement Cost method :

(a) estimate the costs that will be incurred by a market participant for creating an asset with comparable utility as that of the asset to be valued;

(b) assess whether there is any depreciation on account of physical, functional or economic obsolescence in the asset to be valued; and

(c) adjust the depreciation, if any as determined under (b) above from the total costs estimated under (a) above, to arrive at the value of the asset to be valued.

Reproduction Cost Method

103. Reproduction Cost Method involves valuing an asset based on the cost that a market participant shall have to incur to recreate a replica of the asset to be valued, adjusted for obsolescence.

104. The following are the major steps in the Reproduction Cost method:

(a) estimate the costs that will be incurred by a market participant for creating a replica of the asset to be valued;

(b) assess whether there is any depreciation on account of physical, functional or economic obsolescence in the asset to be valued; and

(c) adjust the depreciation, if any as determined under (b) above from the total costs estimated under (a) above, to arrive at the value of the asset to be valued.

Obsolescence

105. Under the Replacement Cost Method or the Reproduction Cost Method, the estimated cost of creating an asset is required to be adjusted for depreciation on account of obsolescence in the asset to be valued.

106. The following are common types of obsolescence

(a) Physical obsolescence represents the loss in value on account of decreased usefulness of the asset as the useful life expires.

(b) Functional (technological) obsolescence represents the loss in value on account of new technological developments; whereby the asset to be valued becomes inefficient due to availability of more efficient replacement assets.

(c) Economic (external) obsolescence represents the loss in value on account of decreased usefulness of the asset caused by external economic factors such as change in environmental or other regulations, oversupply, high interest rates, etc.

107. Cost approach is generally used in case of valuation of property, plant and equipment and certain intangible assets. Indian Valuation Standards dealing with valuation of these assets provides specific guidance on the aforesaid valuation methods under the Cost approach.

Effective Date

108. Indian Valuation Standard 103 Valuation Approaches and Methods, shall be applied for the valuation reports issued on or after….. , 20181.

1 Date to be specified by notification

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