As per section 10 of the SEBI (Research Analyst) Regulations, 2014 the registration is valid for five years from the date of issue. I am not aware of why some people got perpetual registration. Could be that they got it before 2014.
How do we evaluate return when there is either no cash-flow expectations or cash-flows are expected after a few more events (such as the development of a new product which needs to be commercialised to generate cash-flows)?
To deal with such questions, we can evaluate a project based on value created rather than expected cash-flows. We can use various methods used to value intangible assets to assess the value of the project outcome and then compare the value with the investments required. So, let us dive in.
1. Relief from Royalty method
This method is often used for evaluating intellectual properties, regulatory licences, brands etc. This method evaluates the value of the intangible asset based on hypothetical royalty payments saved by owning the intangible asset. We will need to adjust these payments for income tax as actual royalty payments would be considered as expenses and will lower the taxable income.
Then we will need to calculate the present value of all these tax adjusted royalty payments with the appropriate cost of capital (WACC for the project to develop the intangible asset) and compare with the investment required.
2. Replacement Cost Approach
This method calculates a rather conservative value of the intangible asset based on the assumption that a potential buyer will not be willing to pay for the asset more than what would cost to develop a comparable asset by them.
We can evaluate the return by calculating the IRR assuming a hypothetical sale of the intangible asset at the end of the project. The process of the hypothetical sale should be adjusted for costs associated the sale such as cost for searching such a buyer, legal and regulatory costs etc.
The IRR can be compared with project WACC to decide on the project.
3. Real Options Method
How do you value an asset when its value is contingent on future events. Consider the development of new technology. Just development of the technology will not create cash-flow – it needs to be either commercialised which will involve further costs or licensed to other players. How do we evaluate the product development project?
We can face the same issues with costs involving getting regulatory approval or licenses. Getting the approval or license will not create cash-flows but these are precursors to the venture which can generate cash-flows.
Aswath Damodaran, professor at NYU Stern School of Business suggests using an option valuation method for such scenarios.
Note: Link for Dr Damodaran’s document is provided below.
The point is that we cannot asses such projects without considering the contingent options for future cash-flows associated with them. Let us consider the above-mentioned example of product development. To properly assess the product development project we need to consider a call option of product commercialisation. We can value the call option and then use the value as the outcome of the project in hand i.e. the product development project. Dr Damodaran’s document has some examples that I strongly recommend the readers to refer to.
4. Market Comparables
This method uses readily available market data for comparable assets which the project intends to develop. Using this method requires us to adjust the value of the asset based on the project specifics. Also, we need to remember that intangible assets may not be completely replicable for various reasons. Sometimes there can be regulatory or legal restrictions or simply strategic factors. For example, it will nearly impossible to replicate the brand values of Coka Cola or Starbucks even after considerable investment.
It is always recommended to use various different methods to evaluate such complex project and making a judgement. More than readily available number pointing out clear decisions, use of these methods is about getting different insights about the project. None of the methods, traditional or non-traditional, will take the decision for us – they will just empower us to look at the project from different perspectives. The ultimate decision should be based on our judgement.
The Value of Intangibles, Aswath Damodaran
Now, that we know how to calculate the cost of capital, let us dive into the investment assessment methods.
In the second post in this series, I have mentioned that value has many different facets. An innovative product, intellectual property, market power, access to regulatory approval which are difficult to get – all can be valuable if someone is willing to pay for that. Also, we talked about how value can be created in stages.
Traditional capital investment assessment is based on the assumption that all capital investments will result in cash-flows which are fairly predictable. Entrepreneurs often face complex projects where either the outcome is not cashflows or cash flow (or income) can after a few stages after the implementation of the current project. Consider the example of a CSR project which has obviously reputational benefit and may increase long term value of the company but does not result in any cash flow. Consider another example of a research and development project to develop a new intellectual property (IP). The IP will not readily generate cashflow unless it is commercialised.
Traditional investment assessment methods are not capable of handling such complexities. We will divide this discussion into two sections. The first section (this post) will introduce the traditional methods and the second section (next post) will introduce non-traditional methods which can deal with the problems mentioned above.
We can further classify the traditional methods into non-discounting and discounting based methods.
1. Non – Discounting Methods
a. Accounting Rate of Return (ARR)
= (Average Annual Income) / (Investment)
There are various versions of this method. We can consider the average total return for the total investment or calculate returns from the book value of the investment at the beginning of the years and calculate the average of them or calculate the average income and divide it by the average book value of the investment.
The basic idea is to calculate on an average, how much income the investment generates.
b. Payback Period
= (Capital Invested) / (Average Annual after-tax cash-flow)
Payback period tells us how long it takes to get the invested money back.
2. Discounting Methods
The problem with non-discounting methods is that they do not consider the time value of money. Also, there is no way to incorporate the return expectations in the decision-making process.
Discounting methods try to solve these issues.
a. Net Present Value (NPV)
NPV discounts the future cash-flows with the weighted average cost of capital (WACC) and nets it with the initial investment. A positive NPV indicates that a project is economically feasible. We have discussed the calculation of the WACC in the last post in this series.
Many projects are often an extension of other projects. For example, a manufacturing company is setting up a machining facility and trying to choose between machines of different capacities – one light and another of heavy capacity. The heavy capacity (and expensive) machine will increase the capacity but the company is not sure how much of the extra capacity can be used. For this kind of cases, we can calculate the NPV of the excess earnings generated by the heavy capacity machine over the light capacity machine. This is called the Excess Earnings method.
Also, the company may want to evaluate whether the machine is at all required. In this case, the company can calculate NPV without the machine and with the machine and compare them. This is called 'with or without' analysis.
b. Internal Rate of Return (IRR)
IRR is the discount rate at which the discounted future cash-flows equate to the initial investment. An investment proposal is accepted if the IRR is higher than the WACC and rejected if it is lower than that.
Also, projects can be compared based on IRR.
The IRR method assumes that the future cash flows will be reinvested back at the same rate as the IRR – this is a stretch.
Also, IRR is very sensitive to the pattern of cash-flows. This makes IRR of limited ability to compare different projects with different cash-flow patterns.
c. Modified Internal Rate of Return (MIRR)
MIRR tries to solve the above-mentioned issues with IRR. In this method, the future cash-flows are brought to the terminal value using an appropriate discount rate (generally WACC). So, we are only dealing with two values – initial investment and the terminal value which is the aggregate of all the future cash-flows. Then we can simply calculate the rate of return based on these two figures and the time period to the terminal date.
d. Profitability Index (PI)
= (Sum of the present value of all cash inflows) / ((Sum of the present value of all cash outflows)
A project is accepted when the PI is higher than one and rejected if it is lower than one. Also, we can compare projects by comparing PI values.
e. Discounted Payback Period
As mentioned before, the Payback Period method fails to consider the time value of money. The discounted payback period method adjusts the future cash-flows by the appropriate discounting rate and then calculates the payback period.
To be continued......
In this series, we have already discussed the high-level considerations and the concept of stage-wise value assessment. In this post, we will discuss the assessment of the cost of capital before moving to different methods of capital investment assessment. Whatever method we use for capital investment assessment, whether an investment is feasible or not significantly depends on the cost of capital for funding the project. Please notice that I mentioned the cost of capital to fund the project not the capital structure of the firm.
The cost of capital reflects the aggregate expectations of the sources of capital depending on the market condition, the financial standing of the firm and other investment opportunities available to the funders. To arrive at the cost of capital, we need to first decide how we are going to fund a project based on the available sources of capital.
SOURCES OF CAPITAL
A project can be funded using internal capital source i.e. retained earnings or external sources i.e. issuing debt or issuing new equity or preference shares.
1. Internal - Retained Earnings
Retained earnings is the part of the income which the firm chooses to reinvest in the business after distributing dividends to preferred shareholders and common shareholders.
On the outset, it may seem like the retained earnings do not involve any cost for the firm. This notion is erroneous. By reinvesting the earnings (after paying contractual obligations to debt and preferred shareholders) the firm is effectively raising capital from the common shareholders who could otherwise claim the earnings as dividends. From a common shareholder’s point of view, the opportunity cost for the retained earnings depends in the expected market return (or return from any other comparable investment), dividend distribution tax and income tax on received dividends.
A representative opportunity cost would be = Market Return X (1 - % Distribution Tax) X (1 - %income tax on dividend)
The expected return on equity for the firm should be higher than the opportunity cost.
Debt means the sources of funds which the firm is contractually obligated to repay. A firm can raise capital using debt in various ways – bank loans, debentures & bonds, commercial papers etc. The basic idea is that the repayment amount and schedule is predefined and the firm is contractually obligated to repay.
As we are considering the cost of debt for a project, we should consider the cost lenders likely to charge for new debt issuance not the historical cost of the firm. The cost will depend on prevailing market rates, assets which can be pledged, seniority of the instrument and expected credit rating for the instrument etc.
Apart from these, we should also consider that issuance of debt costs money and the cost of debt should consider that cost of issuance as well.
As interest payments reduce the taxable income for the firm thus reducing the tax liabilities. So, the after-tax cost of debt
= Pre-tax cost of debt X ( 1 - % Income tax rate for the company)
Equity does not represent any contractual obligation to repay but involve ownership in the firm. As there is no predefined rate of return, it may seem that the equity comes for free. In reality, equity involves opportunity cost for investors.
Determination of cost of equity is based on the opportunity cost. For publicly listed companies, the capital asset pricing model is used to estimate the cost of equity. For privately held companies, CAPM should not be used. To implement CAPM we need to find the sensitivity of the market equity return of the company with the market return i.e. beta. Privately held companies have rare valuation events i.e. when the shares of the company are valued. We simply cannot estimate beta with such limited data.
Note: Valuation expert and profession at NYU Stern school of business, Dr Aswath Damodaran suggests some ways to estimate the beta for a private company link provided below the post. We are going to explore some other let theoretical options.
Many private equity investors, including venture capital firms and angel investors, are pretty upfront about their return expectations mostly expressed in terms of multiples. We can calculate the expected Internal Rate of Return (IRR) from the expected multiple based on a reasonable payback period assumption. This IRR can be used as the cost of equity.
If we do not have such expressed return expectations, we can estimate the cost of equity-based on the opportunity cost. We can calculate the average cost of equity of the publicly traded companies in the same industry and then add a liquidity premium to reflect the fact that the shares of the private company cannot be liquidated readily.
Another option is to estimate the beta based on comparable companies, calculate the cost of capital using CAPM and then add liquidity premium.
4. Preference Share Capital
Preference shares are shares which has a preference over the common shareholders over the dividends. The predefined dividend rate is generally considered as the cost of preference share capital.
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
WACC represents the overall cost of capital for the project from all the sources. WACC is calculated as the weighted average of the costs for the sources of funds mentioned above.
The weights are calculated by dividing funds from an individual source by the sum of all funds. For equity we can consider either the book value or the market value for the calculation of the weights – market values are more reasonable because it represents the expectations for the investors in the market for any new fundraising.
For the debt, the after-tax cost of capital should be used to reflect the tax-saving effect of interest payments.
WACC = (Opportunity Cost of Retained Earnings) X (Retained earnings used / Total Investment)
+ (Cost of Equity ) X (Equity capital used / Total Invesment)
+ (Cost of Preference share capital) X (Preference share capital used / Total Investment)
+ (Pre-tax cost of debt) X (Debt used / Total Investment) X ( 1 - % Income tax rate)
Entrepreneurs often deal with projects without any historical comparable i.e. novel projects. To deal with the inherent ambiguity, these projects are implemented in phases and different milestones are set to be achieved. Capital is raised in stages to achieve some milestones.
It will not be proper to assume that the cost of capital will be the same for all the stages. It is better to consider each stage as a separate project and estimate the cost of capital for each stage.
Estimating Beta for private companies :
The Finance Miniter in her budget speech mentioned that the reduction of GST rated has led to relief of around Rs. 92,000 crores per annum.
Free accounting software for preparation of tax returns is being made available to smalle businesses and a fully automated GST refund module is expected to be implemented.
Taxpayers with annual turnovers less than Rs. 5 crores need to file quarterly returns. Electronic invoice details are to be captured in a central system to enable pre-filled taxpayer returns and a simultaneous e-way bill to be generated. These are expected by January 2020.
She also mentioned of "Sabka Vishwas Dispute Resolution Scheme, 2019" that will allow quick closure of litigation. More than Rs. 3.75 Crores is blocked in litigations in service tax and excise duties from the pre-GST regime.
To promote economic growth and Make in India, the Indian Government is to launch a scheme inviting global companies bidding to set-up mega-manufacturing plants in sunrise and advanced technology areas such as Semi-Conductor Fabrication (FAB), Solar Photo Voltaic cells, Lithium storage batteries, Solar electric charging infrastructure, Computer Servers, Laptops etc. Investment-linked income tax exemptions will be given under section 35 AD of the Income Tax Act, and other indirect tax benefits.
In the last post, we talked about the high-level considerations before even considering the project economics. So, should we just assume some numbers and calculate the returns?
We cannot just “invent” numbers arbitrarily. We need a suitable framework to get to some reasonable estimates. Matured businesses generally have a wide experience of project implementations and understanding of expected economic output. For an entrepreneur often the case is different. Either the project is novel and has no comparable or it is a completely new field for the entrepreneur or both.
To deal with the inherent uncertainty and novelty of projects entrepreneurs deal with, I am proposing the following framework which involves stagewise assessment of value creation and return opportunities. Without further adieu, let us get to it.
STAGE WISE VALUE ASSESSMENT AND RETURN OPPORTUNITIES
The framework depends on identifying the real options embedded in the project. Real options are choices at some stages of a project to expand, wait or abandoned etc. Anyways, the point of identifying the real options is to safeguard against rash exits when things get tough.
1. Stage wise value identification
In the last post in this series, we discussed the broad phases on project implementation –
A. Set-up which involves product/facility development, legal and regulatory registrations.
B. Validation which involves measuring project outcome with the stated objectives, and
C. Operations involve user acquisition or integration with the existing processes etc.
One can further divide these stages into substage depending on the project.
Now, it is time to identify the value which is expected to be created in these phases or substages. For example, after the set-up stage, we will have some product and or facilities, some regulatory registrations and approvals etc. After the validation stage, we will have some market traction along with the assets created in the set-up stage.
Note: Many entrepreneurs face this issue while raising capital from investors who claim that unless a business is generating profit it has no value. It is a fallacious notion at the least. Value has many different facets. An innovative product, intellectual property, market power, access to regulatory approval which are difficult to get – all can be valuable if someone is willing to pay for that. Keeping an open mind about what constitutes value is the key to this exercise.
Now, that we have identified the value which is likely to be created in the different stages of sub-stages, it is time to identify the return opportunities at different stages.
2. Return Opportunities
A return opportunity means that at any stage if you decide to abandon how can you maximize exploitation of the value already created.
For example, if you abandon the project after the set-up stage, a possible opportunity for return can be arranged with strategic investors (existing players in the market), licensing of intellectual property, licensing of regulatory approvals if allowed by law etc.
Depending on the project, there can be various return opportunities and entrepreneur is suggested to be open-minded (and less emotional) about identifying those return opportunities.
Also, only identifying those return opportunities is not enough, we need to judge the feasibility of those return opportunities as well. What kind of resources, connections and expertise required to manifest return at those opportunities? Do you have those resources, connections and expertise?
3. Scenario-based return
After we have a pretty good idea about the return opportunities based on stages and/ or substages, we can now get into the numbers.
Based on different return opportunities, we can estimate the return amount. We can estimate the numbers based on the recent transactions in the market, interviewing the industry experts etc.
It is also required that we understand the possible cost (both in terms of money and time) required to actually exploit the return opportunities. Depending on the project the costs cane be legal costs, commission charged by intermediaries, a requirement of regulatory approval etc.
We need to arrive at the net return for all possible return opportunities.
Next, we will move to actually appraise the project but first, we need to understand the cost of capital.
...to be continued
- Services sector (excluding construction) has a share of 54.3 per cent in India’s GVA and contributed more than half of GVA growth in 2018-19.
- The IT-BPM industry grew by 8.4 per cent in 2017-18 to US$ 167 billion and is estimated to reach US$ 181 billion in 2018-19.
- The services sector growth declined marginally to 7.5 per cent in 2018-19 from 8.1 per cent in 2017-18.
o Accelerated sub-sectors: Financial services, real estate and professional services.
o Decelerated sub-sectors: Hotels, transport, communication and broadcasting services.
- Services share in employment is 34 per cent in 2017.
o 10.6 million foreign tourists received in 2018-19 compared to 10.4 million in 2017-18.
o Forex earnings from tourism stood at US$ 27.7 billion in 2018-19 compared to US$ 28.7 billion in 2017-18.
Finance Minister Nirmala Sitharaman said in her maiden budget speech that the Government is planning to make PAN and Aadhar interchangeable.
Aadhar numbers can be quoted where PAN is required. So, those without a PAN card can quote Aadhar number to file income tax.
Also, pre-filled tax returns will be provided to taxpayers with details of salary income, capital gains, bank interest, and dividends and tax deductions. Information regarding these will be collected from the concerned sources such as Banks, Stock Exchanges, mutual funds, EFPO etc.
A Scheme of Faceless Assessment in electronic mode involving no human interface is being launched this year in phased manner.
Finance Minister said in her budget speech that to resolve the Angel Tax issue the startups and investors who file requisite declarations will not be subjected to any kind of scrutiny in respect of valuation of share premium. A mechanism of e-verification will be put in place and with this, the funds raised by startups will not require any tax scrutiny.
The issue of establishing the identity of the investor and the source of funds will be resolved by putting in place a mechanism of e-verification. The funds raised by startups will not require any scrutiny by the Income Tax department.
Startups will not be required to justify the fair market value of their shares issued to Category-II Alternative Investment Funds. Valuation of shares will be beyond the scope of the Income Tax Department.
She also proposed to relax some of the conditions for carry-forward and set-off of losses in the case of start-ups.