ABC, a large business house is planning to sell its wholly owned subsidiary KLM. Another large business entity XYZ has expressed its interest in…

CA Final · Advanced Financial Management · RTP · May 2025
ABC, a large business house is planning to sell its wholly owned subsidiary KLM. Another large business entity XYZ has expressed its interest in making a bid for KLM. XYZ expects that after acquisition the annual earning of KLM will increase by 10%. Following information, ignoring any potential synergistic benefits arising out of possible acquisitions, are available: (i) Profit after tax for KLM for the financial year which has just ended is estimated to be 10 crore. (ii) KLM's after-tax profit has an increasing trend of 7% each year and the same is expected to continue. (iii) Estimated post tax market return is 10% and risk-free rate is 4%. These rates are expected to continue. (iv) Corporate tax rate is 30%. XYZ ABC Proxy entity for KLM in the same line of business No. of shares 100 lakhs 80 lakhs Current share price 287 375 Dividend pay out 40% 50% 50% Debt: Equity at market values 1 : 2 1 : 3 1 : 4 P/E ratio 10 13 12 Equity beta 1 1.1 1.1 Assume that gearing level of KLM to be the same as for ABC and a debt beta is zero. You are required : (a) To calculate appropriate cost of equity for KLM based on the data available for the proxy entity. (b) A range of values for KLM both before and after any potential synergistic benefits to XYZ of the acquisition. (c) Compute the market value of KLM as a part of ABC. Note: Round off calculation up to 2 decimal and compute figure in ₹ crores.

Suggested Answer and Working Notes:

(a) To calculate cost of equity for KLM first we shall calculate β of KLM as follows: β (equity ungeared for the proxy company) = 1.1 X 4 / [4 + (1-0.3)] = 0.94 0.94 = β equity geared X 3/ [ 3 + (1 - 0.3)] β equity geared = 1.16 Cost of equity = 0.04 + 1.16 X (0.10 – 0.04) = 10.96% (b) Based on the data available range of valuation can be computed using P/E and dividend-based valuation approach. (i) P/E valuation (Based on earning of 10Crore) Using proxy entity's P/E Using XYZ's P/E Pre synergistic value = 12 X 10 Crore = 120 Crore = 10 X 10 Crore = 100 Crore Post synergistic value = 12 X 10 Crore X 1.1 = 132 Crore = 10 X 10 Crore X 1.1 = 110 Crore (ii) Divided valuation model Based on 50% pay-out Based on 40% pay-out Pre synergistic value = 0.5 ×10×1.07 / (0.1096-0.07) = 135.10 Crore = 0.4×10×1.07 / (0.1096-0.07) = 108.08 Crore Post synergistic value = 0.5×10×1.1×1.07 / (0.1096-0.07) = 148.61 Crore = 0.4×10×1.1×1.07 / (0.1096-0.07) = 118.89 Crore Range of valuation P/E Based Dividend Based Pre synergistic 100 Crore 135.10 Post synergistic 110 Crore 148.61 (c) Market Price Although no information is available about the value of KLM, it may be possible to calculate a market value based on proportion of earnings of ABC that is generated by KLM. Market value of ABC = 80 Lakh Shares X 375 = 300 Crore Post-tax earnings of = 300 crore/13 = 23.08 Crore ABC If market value of ABC is allocated to KLM in the proportion of relative earning of KLM to that of ABC, KLM would have a market value of 300crore X [ 10/23.08] = 129.98 Crore. KLM's Post Tax earning = 10 Crore. If ABC's P/E ratio is applied to it, the market value of KLM becomes 10Crore X 13 = 130 Crore.

Topics: Business Valuation

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