Valuation of Preference Shares :
These are valued on yield basis in a going concern. Compared to equity shares, the rate of return in preference shares would be, generally, lower because of greater safety. With fluctuations in the normal rate of return in respect of preference shares, the value of preference share will fluctuate but in the opposite direction, i.e., if the normal rate of return increases, the value tends to diminish. For instance, 12% preference shares of ` 100 each would be valued at Rs.85.72 when the expected rate of return is 14% (i.e., 12/14 x 100). The same share would be valued at Rs.120 if the expected rate of return is 10% (i.e., 12/10 x 100).
In case the dividend on cumulative preference shares is in arrears, the present value of such arrears of dividend (if there is a possibility of their payment) should be added to the value of preference share calculated.
As stated earlier, a valuer must exercise his own judgement in valuing preference shares, because of the diminishing real value of the fixed preference dividend. This is considered to be a handicap for sellers in an inflationary economy. The yield based valuation of preference shares would hold good only if:
(i) the dividend on the share has been paid regularly and it is reasonably expected that it would continue to be paid; and
(ii) that investment is adjudged by the criteria that the total assets of the concern are equal to 4 or 5 times the preference capital.
Preference shares may have certain additional rights, for example, the right to get an additional share of profits or the right to get the share converted into equity shares at a certain rate. The right to get an additional share of profit will probably increase the market value of the share depending upon the size of the total profit and the conditions under which the additional dividend will come to preference share holders. Total yield per share will have to be worked out and on that basis the market value will be ascertained by the formula :
| Total yield per share | x100 |
| Normal rate of yield |
The right to get the preference share converted into equity share will be valuable only if the equity share of the company commands good value in the market. As against this, there will also be the possibility that wholesale conversion into equity shares may depress the dividend on these shares and thus bring down their price. The price of such a right will be roughly equal to the difference in the market value of an equity share and the conversion price. Suppose holders of preference shares of Rs.100 have a right to convert their holding into equity shares at the end of 3 years at Rs.130 per equity share and the market value of the equity share at the time is likely to beRs.160 which is not likely to be affected by the conversion. The right of conversion in the circumstances would be ultimately worth Rs.30 (Rs.160 minusRs. 130). Taking 12% as the proper rate of interest, the present value of such a right (discounting it @ 12% for 3 years) would be Rs.21.36. The preference share therefore will command a value based upon its yield plus Rs. 21.36.
Illustration :
From the following figures calculate the value of a share of ` 10 on (i) dividend basis, and (ii) return on capital employed basis, the market expectation being 12%.
|
Year ended 31st March |
Capital Employed | Profit | Dividend (%) |
| Rs. | Rs. | Rs. | Rs. |
| 2010 | 5,00,000 | 80,000 | 12 |
| 2011 | 8,00,000 | 1,60,000 | 15 |
| 2012 | 10,00,000 | 2,20,000 | 18 |
| 2013 | 15,00,000 | 3,75,000 | 20 |
Solution:
(i) Valuation of share on dividend basis:
The dividend rate on the simple average is 65/4 or 16 4 1 %. But since the dividend has been rising it would be better to take the weighted average which come to 17.6% ¾ thus:
| Year ended | Capital Employed | Profit | Dividend (%) |
| 31st March | |||
| 2010 | 12 | 1 | 12 |
| 2011 | 15 | 2 | 30 |
| 2012 | 18 | 3 | 54 |
| 2013 | 20 | __4__ | __80__ |
| __10__ | __176__ |
Dividing 176 by ` 10, we get 17.6%.
The value of the share on the basis of dividend (weighted average) should be
17.6
12 x Rs. 10 = Rs.14.67.
(ii) Valuation of share on return on capital employed basis:
The return on capital employed for each year and its weighted average is as follows:
| Year ended
31st March |
Return on capital employed % | Weight | Product |
| 2010 | 16 | 1 | 16 |
| 2011 | 20 | 2 | 40 |
| 2012 | 22 | 3 | 66 |
| 2013 | 25 | 4 | 100 |
| 10 | 222 |
Weighted average is 22.2%.
The value of the share should be:
| 22.2 | x ` 10 = Rs.18.50. |
| 12 |
Illustration :
Diamond Limited
Balance Sheet as at 31st March, 2014
| Particulars | Note No. | Amount as at 31st March,2014 | Amount as at 31st March,2013 |
| 1 | 2 | 3 | 4 |
| I. EQUITY AND LIABILITIES | |||
| (1) Shareholders’ funds | |||
| (a) Share Capital | 2,00,000 | ||
| (b) Resrve and Surplus | 1 | 72,000 | |
| (2) Current liabilities | |||
| (a) Trade payable | 1,28,000 | ||
| (b) Provision for Income Tax | 60,000 | ||
| TOTAL | 4,60,000 | ||
| II. ASSETS | |||
| (1) Non current-assets | |||
| (a) Fixed Assets | 2,60,000 | ||
| (b) Preliminary expenses | 2 | 12,000 | |
| (2) Current Assets | |||
| (a) Inventories | 48,000 | ||
| (b) Trade receivable | 88,000 | ||
| (c) Cash at bank | 52,000 | ||
| TOTAL | 4,60,000 | ||
| Note No. 1 | |||
| Reserve and Surplus | |||
| General reserve | 40,000 | ||
| Profit and loss account | 32,000 | ||
| 72000 | |||
| Note No. 2 | |||
| Fixed Assets | |||
| Land and buildings | 1,10,000 | ||
| Plant and machinery | 1,30,000 | ||
| Patents | 20,000 | ||
| 2,60,000 |
The expert valuer valued the land and buildings at ` 2,40,000; goodwill at ` 1,60,000; and plant and machinery at ` 1,20,000. Out of the total debtors, it is found that debtors of ` 8,000 are bad. The profits of the company have been as follows:
Rs.
31.3.2012 92,000
31.3.2013 88,000
31.3.2014 96,000
The company follows the practice of transferring 25% of profits to general reserve. Similar type of companies earn at 10% of the value of their shares. Ascertain the value of shares of the company under:
(i) intrinsic value method;
(ii) yield value method; and
(iii) fair value method.
Solution:
Diamond Ltd.
Valuation of shares
(i) Intrisic value method
Assets: Rs.
Land and buildings 2,40,000
Goodwill 1,60,000
Plant and machinery 1,20,000
Patents and trade marks 20,000
Stock 48,000
Debtors less bad debts 80,000
Bank balance 52,000
7,20,000
Less: Liabilities:
Sundry creditors 1,28,000
Net assets 5,92,000
Intrinsic value of shares (each share) = Net Assets
No.of shares
=Rs. 5,92,000 =Rs.29.60
20,000
(ii) Yield value method `
Total profit of last three years 2,76,000
Less: Bad debts 8,000
2,68,000
Average profit = `Rs..2,68,000
3 89,333
Add: Decrease in depreciation on plant and machinery say @ 15% on Rs.10,000 1,500
Less: Increase in depreciation on land and building say @ 10% on Rs.1,30,000 13,000
Average profit 77,833
Less: Transfer to reserve
@ 25% of 77,833 19,458
Profit available for dividend 58,375
| Rate of dividend = | 58 375 | x 100 = Rs. 29.187% |
| 2 00 000
|
| Yield value of each share = | Rate of Divicend | x Paid-up value of each share |
| Normal rate of return |
| Yield value of each share = | 29.187 | x10 =Rs.29.19 |
| 10 |
(iii) Fair value method
| Fair value of each share = | Intrinsic value+YieldValue | x10 =Rs.29.19 |
| 2 |
= Rs. 29.60+ Rs.29.19 = Rs.A229.40
2
Illustration :
From the following particulars calculate the value of share of Z Ltd. on yield basis:
Z Limited
Balance Sheet as at 31st March, 2014
| Particulars | Note No. | Amount as at 31st March,2014 | Amount as at 31st March,2013 |
| Rs. | Rs. | ||
| I. EQUITY AND LIABILITIES | |||
| (1) Shareholders’ funds | |||
| (a) Share Capital | 12,00,000 | ||
| (b) Resrve and Surplus | 1 | 400,000 | |
| (2) Non-current liabilities | |||
| 10% Debentures | 2,00,000 | ||
| (3) Current liabilities | |||
| (a) Trade payable | 4,00,000 | ||
| TOTAL | 22,00,000 | ||
| II. ASSETS | |||
| (1) Non current-assets | |||
| (a) Fixed Assets | 2 | 13,00,000 | |
| (2) Current Assets | |||
| (a) Work in-progress and Inventories | 5,00,000 | ||
| (b) Trade receivable | 3,00,000 | ||
| (c) Cash at bank | 1,00,000 | ||
| TOTAL | 22,00,000 | ||
| Note Nos 1 | |||
| Share capital | |||
| 80,000 Equity shares of Rs.10 each | 8,00,000 | ||
| 4,000, 9% equity shares of Rs. 100 each | 4,00,000 | ||
| 12,00,000 | |||
| Note No 2 | |||
| Fixed Assets | |||
| Land and buildings | 5,00,000 | ||
| Plant and machinery | 6,00,000 | ||
| Patents | 2 ,00,000 | ||
| 13,00,000 |
Land and buildings to be valued at ` 9,00,000. The company’s earnings were as follows:
| Year ended 31st March | Profits before tax | Tax paid |
| 2009 | 3,00,000 | 80,000 |
| 2010 | 4,00,000 | 1,60,000 |
| 2011 | 1,00,000 | 40,000 . |
| 2012 | 5,00,000 | 2,30,000 |
| 2013 | 5,50,000 | 3,00,000 |
The company paid managerial remuneration of `60,000 per annum but it will become `1,00,000 in future. There has been no change in capital employed. The company paid dividend of 90 paise per share and it will maintain the same in future. The company proposes to build up a plant rehabilitation reserve. Dividend rate in this type of company is fluctuating and the asset backing of an equity share is about 1-1/2 times. The equity shares with an average dividend of 8% sell at par. (Tax rate is assumed to be 40%).
Solution:
Average maintainable profits in future. Profit of 2010-11 is not considered because of low profits for abnormal reasons.
| Year ended 31st March | Profits Rs. | Weight | Product |
| 2009 | 3,00,000 | 1 | 3,00,000 |
| 2010 | 4,00,000 | 2 | 8,00,000 |
| 2012 | 5,00,000 | 3 | 15,00,000 |
| 2013 | 5,50,000 | 4 | 22,00,000 |
| 10 | 48,00,000 |
| Rs. | ||
| Weighted average: | 4,80,000 | |
| Adjustment: | ||
| Less: Increase in managerial remuneration | 40,000 | |
| 4,40,000 | ||
| Less: Tax @ 40% | 1,76,000 | |
| Profit available for distribution | 2,64,000 | |
| Less: Rehabilitation Reserve (12.5% estimated) | 33,000 | |
| 2,31,000 | ||
| Less: Dividend on Preference Shares | 36,000 | |
| Profit available for distribution to _______ | ||
| equity shareholders | 1,95,000 | |
| `1,95,000 capitalised at 8% = Rs.1,95,000 x100/8 =Rs.24,37,500 | ||
| The value of equity share will be =Rs. 24,37,500/80,000 = Rs.30.47 | ||
| Alternatively: | ||
| Assets backing per equity share: ` | ||
| Total Asset as per balance sheet | 22,00,000 | |
| Add: Increase in value of land and buildings | 4,00,000 | |
| 26,00,000 | ||
| Less: Sundry creditors | 4,00,000 | |
| 10% Debentures | 2,00,000 | |
| 9% Preference shares | 4,00,000 | 10,00,000 |
| Net assets available for equity shareholders | 16,00,000 | |
| Equity share capital | 8,00,000 | |
| Asset backing | 2 times | |
| Normal dividend rate | 8.00% | |
| Less: For higher dividend rate (9%) and stability (say) | 0.5% | |
| Less: For higher asset backing 2 times as | ||
| compared to 1.5 times) (say) | 0.5% | |
| Adjusted normal rate of return | 7.00 | |
| Capital employed: | ||
| Equity share capital | 8,00,000 | |
| 9% Preference share capital | 4,00,000 | |
| 10% Debentures | 2,00,000 | |
| Reserves | 4,00,000 | |
| Increase in value of land and buildings | 4,00,000 | |
| 22,00,000 | ||
| Profit after tax | 2,64,000 | |
| Add: Debenture interest (after effect of income tax) | 12,000 | |
| Profit earned | 2,88,000 | |
| Rate of earning: Rs. 2,88,000 x 100 = 13.09%
22,00,000 |
||
(Since the capital employed includes the amount of debentures, debenture interest after the effect of income tax has been adjusted.)
Value of share:
On actual dividend basis = 9/7 x 10 = Rs. 12.90 (appx.)
On earning basis = 10.45/7 x 10 = Rs.18.7
Illustration :
| Year ended 31st March | Average net worth (excluding investment) | Adjusted taxed profit |
| 2011 | 18,50,000 | 1,80,000 |
| 2012 | 21,20,000 | 2,00,000 |
| 2013 | 21,30,000 | 2,30,000 |
The aforesaid figures relate to a company which has Rs.10,00,000 on equity shares of Rs.100 each and Rs.3,00,000 in 9% preference shares of Rs.100 each. The company has investments worth Rs.2,50,000 (at market value) on the valuation date the yield in respect of which has been excluded in arriving at the adjusted tax profit figures. It is usual for similar type of companies to set aside 25% of the taxed profit for rehabilitation and replacement purposes.
On the valuation day the net worth (excluding investment) amounts to 22,00,000. The normal rate of return expected is 9%. The company paid dividends consistently within a range of 8 to 10% on equity shares over the previous seven years and the company expects to maintain the same. Compute the value of each equity share on the basis of productivity.
Solution:
Since both profits and net worth of the company are showing a steady growth, it would be reasonable to attach due weightage to them for valuation purposes.
| Year ended 31st March | Average Net worth Rs. | Adj. taxed profit Rs. | Weight factors Rs. | Weighted Net worth Rs. | Profit Rs. |
| 2011 | 18,50,000 | 1,80,000 | 1 | 18,50,000 | 1,80,000 |
| 2012 | 21,20,000 | 2,00,000 | 2 | 42,40,000 | 4,00,000 |
| 2013 | 21,30,000 | 2,30,000 | 3 | 63,90,000 | 6,90,000 |
| 6 | 1,24,80,000 | 12,70,000 | |||
| Weighted average | 20,80,000 | 2,11,667 |
| Productivity Factor = | Rs. 2,11,6 67 20,80,000 | x100 = 10.18% |
Net worth on valuation date = Rs.22,00,000 `
Projected future maintainable profit = 10.18% of Rs.22,00,000 2,23,960
Less: Rehabilitation and replacement @ 25% 55,990
1,67,970
Less: Preference Dividend 27,000
1,40,970
Rs.1,40,970 capitalised @ 9% rate of return would be 15,66,333
Add: Value of investments 2,50,000
Value of 10,000 equity shares 18,16,333
| Therefore, the value of each equity share would be = | 18,16,334 10000 | = Rs.181.63. |
Illustration:
From the following balance sheet of M.P. Products Ltd., find out the values of equity shares and preference shares:
M.P. Products Ltd.
Balance Sheet of as at 31st March, 2014
| Particulars | Note No. | Amount as at 31st March,2014 |
Amount as at 31st March,2013 |
| Rs. | Rs. | ||
| 1 | 2 | 3 | 4 |
| I. EQUITY AND LIABILITIES | |||
| (1) Shareholders’ funds | |||
| (a) Share Capital | 1 | 3,00,000 | |
| (b) Resrve and Surplus | 2 | 40,000 | |
| (2) Current liabilities | |||
| (a) Short-term borrowings | 3 5,000 | ||
| (b) Trade Payables | 3 60,000 | ||
| (b) Other current liabilities | 4 20,000 | ||
| TOTAL | 4,25,000 | ||
| II. ASSETS | |||
| (1) Non-current-assets | |||
| (a) Fixed Assets | 5 | 1,90,000 | |
| (b) Other non current assets | 6 | 3,000 | |
| (2) Current Assets | |||
| (a) Inventories | 80,000 | ||
| (b) Trade Receivables | 1,50,000 | ||
| (c) Cash | 2,000 | ||
| TOTAL | 4,25,000 |
| Note No. 1: | |||
| Share capital | |||
| 20,000 equity shares of ` 10 each | 2,00,000 | ||
| 8% 1,000 preference shares of `100 each | 1,00,000 | ||
| 3,00,000 | |||
| Note No. 2 | |||
| Reserve and Surplus | |||
| Reserve | 30,000 | ||
| Profit and loss account | 10,000 | ||
| 40000 | |||
| Note No. 3 | |||
| Short-term borrowing | |||
| Overdrafts | 5,000 | ||
| 5000 | |||
| Note No. 5 ` | |||
| Fixed Assets | |||
| Machinery | 1,60,000 | ||
| Furniture | 5,000 | ||
| Goodwill | 25,000 | ||
| 1,90,000 | |||
| Note No. 6 | |||
| Other non-current assets | |||
| Preliminary expenses | 3,000 |
Further information
Goodwill is valued at Rs.15,000. Stock is overvalued by Rs.10,000. Machinery is undervalued by Rs. 15,000.
| Net Assets: |
| Goodwill 15000 |
| Machinery 1,75,000 |
| Furniture 5,000 |
| Stock 70,000 |
| Debtors 1,50,000 |
| Cash 2,000 |
| 4,17,000 |
| Less: Liabilities |
| Creditors 60,000 |
| Proposed preference dividend 8,000 |
| Overdraft 5,000 |
| Other liabilities 12,000 85,000 |
| 3,32,000 |
| Less: Preference share capital 1,00,000 |
| Net Assets for equity shareholders 2,32,000 |
Intrinsic value of equity shares: Rs.2,32,000 / 20,000 =Rs.11.60 per share.
Intrinsic value of preference shares:
Rs.100 + Proposed dividend i.e., Rs.(8,000 / 1,000) =Rs. 8 =Rs.108 per share.
If they are participating preference shares, the excess of net assets less preference share capital over the paid-up value of equity shares will be distributed over equity shares and preference shares converting them to equivalent number of same paid-up values. The share of surplus appropriate to each equity and preference share is to be added to the paid up amount of the respective shares. The total excess may also be distributed in the ratio of equity capital and preference capital. Participating shares in this connection are taken to mean that they participate in surplus in liquidation pari-passu with equity shares. In reality, the articles of association will govern the situation.
Assuming the preference shares in Illustration above are participating shares, determine the values of equity shares and preference shares, assuming they rank pari-passu.
Net Assets less preference share capital (as above) 2,32,000
Less: Equity share capital 2,00,000
Surplus 32,000
Equivalent number of equity and preference shares :
20,000 equity shares equivalent to 20,000 shares of Rs.10 each
1,000 preference shares equivalent to 10,000 shares of Rs10 each
30,000 shares of Rs.10 each
| Surplus per share of Rs.10 = | Rs.32,000 30,000 | = Rs. 1.07 |
Hence the value of equity shares:Rs.10 + Rs.1.07 =Rs.11.07 per share.
Value of preference shares:Rs.100 + Rs.8 + (`1.07 x 10) =Rs.118.70
Or, the surplus of Rs.32,000 may be divided between equity capital and preference capital in the ratio of 2 : 1, i.e., Rs.21,333 and Rs.10,667 respectively.
Values of shares:
| Equity: |
Rs. 2 00 000+ Rs. 21 333 20,000 |
= Rs. 2 21 333
20 000 |
= Rs. 11. 07 |
| Preference: | Rs.1 00 000+ Rs.10 667+ Rs.8 000
1 000 |
=Rs.1 8 667
1 000 |
= Rs.118 67 |
Illustration
Mark Ltd.
Balance Sheet as at 31st March, 2014
| Particulars | Note No. | Amount as at 31st March,2014 | Amount as at 31st March,2013 |
| Rs. | Rs. | ||
| 1 | 2 | 3 | 4 |
| I. EQUITY AND LIABILITIES | |||
| (1) Shareholders’ funds | |||
| (a) Share Capital | 1 | 4,00,000 | |
| (b) Resrve and Surplus | 2 | (5,000) | |
| (2) Non-current liabilities | |||
| 10% Debentures | 50,000 | ||
| (3) Current liabilities | |||
| Trade Payables | 95,000 | ||
| TOTAL | 5,40,000 | ||
| II. ASSETS | |||
| (1) Non current-assets | |||
| (a) Fixed Assets | 3 | 5,33,000 | |
| (b) Other non current assets | 4 | 7,000 | |
| TOTAL | 5,40,000 |
Note No. 1 Rs.
Share Capital `
10,000 12% Preference Shares of Rs.10 each fully paid 1,00,000
30,000 Equity Shares of `10 each fully paid 3,00,000
4,00,000
Note No 2 Rs.
Reserve & Surplus `
General Reserve 10,000
Debenture redemption fund 20,000
30,000
Less: Profit & Loss (Dr Balance) 35,000
(5,000)
Note No. 3 Rs.
Fixed Assets `
Sundry Assets 5,48,000
Discount on debentures 15,000
5,33,000
Note No. 4 Rs.
Other non-current assets `
Preliminary Expenses 5,000
Discount on debentures 2,000
Additional information
The debenture interest is owing for six months and dividends on preference shares are in arrears for one year. Assuming the assets are worth their book values, show the approximate value of preference and equity shares if :
(i) Preference shares are preferential as to capital and arrears are payable in a winding up; and:
(ii) Preference shares are preferential as to capital but arrears of preference dividends are not payable.
Solution:
| Calculation of net assets | Rs. | Rs. |
| Sundry Assets | 5,48,000 | |
| Less: Depreciation Fund | 15,000 | |
| 10% Debentures | 50,000 | |
| Sundry Creditors | 95,000 | |
| Debentures interest for six months | 2,500 | 1,62,500 |
| 3,85,500 |
(i) If preference shares are preferential as to capital and arrears are payable in a winding up, then the share valuation will be as under :
| Net Assets | 3,85,500 | |
| First payments to the preference shareholders : | ||
| Preference Share Capital | 1,00,000 | |
| Arrears of preference dividends | ||
| for one year @ 12% | 12,000 | 1,12,000 |
| Balance to equity shareholders | 2,73,500 | |
| Hence, Worth of Preference Shares : 10,000 /1,12,000 = Rs 11.20each
Equity Shares : 2,73,500 / 30,000 = Rs. 9.12 each |
(ii) If preferential shares are preferential as to capital but arrears are not payable, then the valuation will be as follows :
Net Assets 3,85,500
Less: Preference Share Capital 1,00,000
Hence Valuation of :
Per Preference Share : Rs. 1 00 000/ 10 000 =Rs.10 each
Per Equity Share : Rs. 2 85 000/ 30 000 = Rs. 9.52 each