MCom I Semester Corporate Accounting Valuation Shares study Material Notes

MCom I Semester Corporate Accounting Valuation Shares study Material Notes: The necessity of Valuation of Shares Factors Affecting valuation of Shares Methods of Valuation of shares assets valuations method Metits of Net Assets method Demerits of Net Assets Method Valuation of Shares Estate Duty Purpose Yield or Income Valuation method Suitability of Earnings Basis Fair Value Method Long Answer Questions Short Answer Questions :

CTET Paper Level 2 Previous Year Questions Answer Language I English ( 2011 )

Valuation of Shares

Valuation of shares implies finding out the value of shares on which they are purchased, sold transferred, and assessed. This is an important but complex problem. The basic principles are by no means difficult but their application calls for a considerable knowledge of technical points Necessity of Valuation of Shares

From a valuation point of view, shares may be classified into two categories — listed shares and unlisted shares. Listed shares are those which are registered for purchase and sale in any recognized stock exchange whereas shares that are not registered for purchase and sale in any stock exchange, are called as unlisted shares. Listed shares are purchased and sold in the stock exchange and their prices are published by the stock exchange. Normally, these published prices are taken as the fair values of shares specifically for transactions involving small block of shares. But stock exchange prices form an unreliable basis because prices on a particular day are affected by so many external factors which are outside the control of the company. Hence, not only shares of private companies and the unquoted shares of public companies need valuation but even the quoted shares of public companies are also required to be valued.

Valuation Shares study Material

Generally the necessity for valuation of shares arises in the following circumstances :

(1) When unquoted shares are being purchased and sold.

(2) When shares of a private company are being sold or fair value of its shares is to be found out.

(3) When two or more companies are to be amalgamated.

(4) When a company absorbs the other company.

(5) When a company is reconstructed under section 494 of the Act and there are dissentient shareholders whose shares have to be acquired.

(6) When a shareholder dies and his shares have to be valued for estate duty purposes.

(7) When shares are pledged as a security against a loan.

(8) When shares of one class are to be converted into shares of another class.

(9) When block of shares are purchased for acquiring controlling interest in another company.

(10) When assets of a finance company or an investment trust company are to be valued.

(11) Where a company is not nationalized and the amount of compensation to the shareholders is to be ascertained.

(12) For wealth tax purposes where the assets of an assessed included shares of a company.

(13) Purchase of shares by the employees of the company where retention of such shares is limited to the period of their employment.

(14) Sometimes shares are valued on the order of the Court.

Factors Affecting Valuation of Shares

The main factors affecting the value of shares of a company are:

(1) Nature of business of the company.

(2) Profitability of the company.

(3) Net tangible assets of the company.

Besides these three factors, the following factors also affect the value of shares of a company

(1) The demand for and supply of shares in market.

(2) The extent of competition among different companies.

(3) Dividend declared by the company in the past.

(4) Capitalization of the company.

(5) Reserves of the company.

(6) Number of shareholders of the company.

(7) Restrictions on transfer of shares of the company.

(8) Possibility of bonus and rights issues.

(9) Goodwill of company products.

(10) Possibility of future progress of the company.

(11) Ability, capacity and experience of directors of the company.

(12) Death of owner of major holdings or sale of shares by such a shareholder.

(13) Change in company management.

(14) Political conditions in the country.

(15) Peace and safety conditions in the country.

(16) The extent of government control on the company.

(17) The extent of investment restrictions in the country.

Valuation Shares study Material

(18) General economic conditions, e.g. difficulty in the supply of labour and materials, transport bottlenecks, trade boom and depression etc.

Methods of Valuation of Shares

The method of valuation depends on the purpose for which the valuation is required. Following are three methods of valuation of shares:

1 Assets Valuation Method t o

2. Yield Valuation Method Sue s

3. Fair Value Method

Assets Valuation Method

The other names of this method are as follows:

(i) Net Assets Method

(ii) Internal Value Method or Intrinsic Value Method

(iii) Assets Cover Method or Assets Backing Method

(iv) Equity Valuation Method

(v) Break-up Value Method

(vi) Capital Valuation Method

This method aims at finding out the possible value of share in the event the company goes into liquidation. Under this method, net assets of the company are determined and then this figure is divided by the number of shares. The procedure is as follows:

(1) Calculation of Net Assets : This can be done by any of the following two ways:

(a) By deducting all external or outside liabilities of the company from the realisable value (or market value) of its real assets including non-trading and intangible assets* but excluding fictitious assets, i.e.

Net Assets = Realisable Value of Real Assets – External Liabilities

For wealth tax purpose, assets are taken at their book values for valuation of unquoted equity shares.

External or outside liabilities imply claims against the company of parties other than shareholders of the company whether recorded in the books of account or not but are likely to rank for payment. This includes debentures, trade creditors, bills payable, outstanding expenses, provision for taxation, liabilities on account of gratuities, arrears of preference dividends, employees provident fund, employees account etc ;

Proposed Dividend : The treatment of this item would depend upon the fact whether the value of the is to be calculated ex-dividend or cum-dividend. If the valuation is done after the declaration of dividend resulting in ex-dividend price, it is deducted from the realisable value of the assets treating it as a liability However, if the valuation is done before the declaration of dividend, it is not deducted from the realisable value of the assets resulting in cum-dividend price. Unless stated otherwise, it is presumed that the company has not declared the current year’s dividend and hence the share price is cum-dividend.

(b) By aggregating the share capital, reserves and surplus and profit on revaluation and deducting there from all fictitious assets (such as preliminary expenses, underwriting commission, discount on issue of shares or debentures, deferred revenue expenditures etc.) and loss on revaluation of assets. The formula is : Net Assets = (Share Capital + Reserves and Surplus + Profit on Revaluation) – (Fictitious Assets + Trading Losses +Loss on Realization)

(2) Finding out the value per share : This is found out as follows:

Valuation Shares study Material

(A) If the company has issued only equity shares and all equity shares are on the same type and equally paid-up : In such a case, the value per share is calculated by dividing the net assets by the number of equity shares, i.e., Value Per Share =

Net Assets

Number of Equity Shares (See illustrations from 1 to 6.)

(B) If the company has issued only equity shares but the paid up value of the same type er different types of equity shares is different : In such a case there are the following three alternative methods of determining the value of each type of share : (i) On the basis of unit value of capital : In this case, at first the unit value of capital is calculated by dividing the amount of net assets of the company by the total of paid up values of all types of equity shares and then the value per share of each type of share is found out separately by multiplying the unit value of capital with the paid up value of each type of equity share. In brief, the calculation procedure is as follows:

Net Assets

Step 1. Unit Value of Capital =

Paid – up Value of Total Equity Capital

Step 2. Value Per Share = Paid-up Value Per Share Unit Value of Capital

(See illustrations 7 and 8.)

(ii) On the basis of proportion of paid-up capital : Under it, at first the net assets of the company are divided in different types of equity shares in proportion of their paid-up values and then value per share of each type of equity share is calculated separately by dividing the share in net assets of each type of equity share with its respective number of equity shares.

Here it is important to state that if there is any calls in arrear on any type of share then the paid-up value of that type of share will be found out by assuming the amount of calls in arrear having been received on such shares but the value of such share will be determined by deducting the amount of calls in arrear from the value per share of that type of share calculated on the basis of (i) or (ii) above.

(See illustrations 7 and 8.)

(iii) On the basis of notional call of uncalled part of share capital : If there is possibility of call of uncalled part of partly paid share capital in near future, net assets may be calculated on the assumption of notional realization of such call. In such a case, the uncalled amount of different types of equity shares should be added to the aggregate of revalued value of all other assets of the company and outside liabilities be deducted there from. The amount of net assets so calculated will be divided by the total number of all

Types of shares, the resultant figure will be the value per fully paid share. For finding the value of each type of partly paid share, the uncalled amount of that share will be deducted from the value per fully paid share calculated as above. (See illustrations 12 and 27.)

Note : In the case of liquidation of the company, a different approach is followed. In this case, pald-up value of all types of equity shares is deducted from the net assets of the company and the amount of supus is found out and then this surplus amount is divided among the different types of equity shares in proportion of their numbers. Thereafter the proportionate surplus of each type of share so calculated is added to the paid up value of the concerned share and to find out the value per share the total of paid up value of Share and its proportionate surplus is divided by the number of shares of that type. (See illustration 12)

(C) If the company has issued equity and preference shares both : If both types of shares are issued by a company then for the valuation of shares it is essential to take into consideration the provisions of Articles of the company in respect of the rights of preference shareholders. In the absence of any specific information in the question, the preference shares will be presumed as non-participating having priority in respect of refund of capital only. In this respect there may be the following situations in the Articles :

(1) Preference shares have priority as to capital and dividend both : In this situation, the amount of preference share capital and the amount of arrear of dividend will be deducted from the value of net assets and the balance represents net assets available for equity shareholders. This balance is divided by the number of equity shares to find out the value per equity share. The preference shares are usually valued at their paid-up value and this value is increased by the amount of arrears of dividend, if any. But if the dividend rate on preference shares is different from the normal rate of dividend, the dividend payable on them should be capitalized at a normal rate and the capitalized value be divided by the number of preference shares to calculate their value per share. The procedure is as follows:

Step 1. Capitalized Value of Preference Dividend = Amount of Preference Dividend x 100

Normal Rate of Preference Dividend ”

Step 2. Value Per Preference Share = Capitalized Value of Preference Dividend Number of Preference Shares

(2) Preference shares have priority as to capital only : In this situation, only the amount of preference share capital is deducted from the value of net assets and the balance is divided by the number of equity shares to find out the value per equity share. The preference shares are valued at their paid-up value, if dividend rate attached to them is equal to the normal rate.

(3) Preference shares have priority as to dividend only : In this situation, the arrear of preference dividend is deducted from the value of net assets and the share of preference and equity shareholders in net assets is calculated separately by dividing the balance in proportion of their paid-up capitals. The share of equity shareholders in net assets is divided by the number of equity shares to get the value per equity share. Similarly, the share of preference shareholders in net assets is divided by the number of preference shares to get value per preference share which is further increased by the arrear of dividend per share.

(4) Preference shares have no any priority : If the face value and paid up value of preference and equity shares are equal then value per preference and equity shares is calculated by dividing the net assets of the company by the total of the number of equity and preference shares. If, however, the face value and/or paid-up value of the two classes of shares are not equal then in that case at first the net assets of the company will be divided among the two classes of shares in proportion of paid-up values of their shares and thereafter value per share of each class of shares will be calculated separately by dividing their respective share in net assets of the company by their number of shares.

Valuation Shares study Material

(5) If preference shares are participating : In this situation, the net assets of the company are divided among the two classes of shares as per the provisions of Articles of the company. Thereafter the share of each in net assets is divided by the number of corresponding share to find out the value per shier class of shares separately.

Suitability of Assets Valuation Method : This method is most appropriate in the following situations

1 Where shares are being valued for wealth tax purposes.

2. Where the shares of a new company are to be valued and it is not possible to forecast its future maintainable profits.

3. Where the company has been consistently trading at a loss and there is no apparent prospect of recovery.

4. Where there is no reliable evidence of future profits due to violent fluctuations in the business or disruption of business.

5. Where the assets of the company are mostly of liquid nature and can be easily realized, e.g. shares of investment companies.

6. Where it is intended to liquidate the company and realise the assets for distribution among the various claimants including shareholders.

7. Where a large block of shares is to be transferred.

8. Where the shares are valued for amalgamation, absorption or external reconstruction purposes.

9. Where shares of private companies are valued.

10. Where shares of a controlled company are valued.

A controlled company is a company which, at any time before the death of a shareholder, was under the control of not more than five persons and which is not a subsidiary company or a company in which the public are substantially interested.

Merits of Net Assets Method

1 Assets basis of valuation of shares is very useful when the company is being liquidated since the very foundation of this method is net realizable value of assets.

2. This method takes into consideration both types of assets, i.e., tangible and intangible.

3. This method creates no problem where the company has issued different types of equity shares.

Demerits of Net Assets Method

1 It is difficult to estimate the realizable value of all the assets. There is considerable scope for personal bias,

2. Where there is no possibility of liquidation of the company in the near future, this method of share valuation is the most hypothetical

3. It is difficult to estimate the true value of goodwill of a company.

4. This method of share valuation is not desirable for a growing company since it does not take into consideration the future profit-earning capacity of the company under consideration.

Illustration 1. From the following information, find out the value of each equity share :

Valuation Shares study Material