Question and Answers regarding EBIT

TMA 02 TMA 02 contributes 25 per cent to the total marks available for continuous assessment on BB831. The overall word limit is 2500 words. No specific word limits will be applied to the individual questions in this TMA. However, when you are allocating your word count, you should take account of the marks available for each question. Answer all questions. Question 1 (20 marks) Discuss in detail the following aspects of investment appraisal: a. Investment appraisal projects use cash flows rather than profit. Explain the above highlighting the difference between cash flows and profit. (5 marks) b. While performing investment appraisal, managers need to consider only relevant cash flows. Explain this statement highlighting which cash flows are ‘relevant’ and which are ‘irrelevant’. (5 marks) c. Investment appraisal forecasts need to keep in mind ‘inflation’ in the economy.

Ans 1
(a) Most, if not all finance managers and decision makers use cash flows, instead of profit of a
project for the investment appraisal. Cash flows means the amount of cash that the project
has been able to generate for the entity, whereas, profit refers to the amount that the entity
has earned from the project, whether or not the same has been realised in cash.
Since capital investment required in making a project is huge, management is interested in
the cash that it would be able to generate from the project, before investing in the project.
Cash flows from the project are then used to compute payback period of the project, net
present value of the project.
The major reason for not using profit number for such analysis, could be, profit can be
misleading in scenarios, where the entity has not been able to convert the same in cash and
also, profit is generally impacted by various non-cash expenses such as depreciation, which
should not be considered in investment appraisal (Kengatharan L, 2017).
(b) Investment appraisal is an exercise, whose outcome is, whether or not an investment should
be made in the project being evaluated. In arriving at this answer, investment appraisers use
relevant cash flows from the project, relevant cash flows are the cash flows which would
affect the decision to invest or not to invest in the project. These are cash flows that will
occur to the entity in the future and are incremental in nature, i.e. these cash flows will not
occur if the project is not undertaken by the entity (Relevant cash flows of capital
budgeting).
Irrelevant cash flows, as the name suggests, are cash flows that are not impacted by the
project being undertaken by the management. These are cash flows (both inflows and
outflows), that occur irrespective of the project being undertaken.
(c) Investment appraisal process involves forecasting the revenue and cost relevant to the
project over the useful life of the project, the useful life could be 5 years or 10 or in certain
cases, it could also be 15 years or beyond.
Since the appraisers are required to forecast the cash flows that project would be able to
generate in the future, they are very well required to consider inflation in their analysis.
Inflation will affect both the cost and revenue of the products planned to be manufactured
by the entity, but the degree of impact on both cost and revenue could differ significantly.
(d) ‘Make or buy decision’ involves choosing between manufacturing a product or outsourcing
the production to a third party and procuring the material from the third party.
This decision is driven by the relevant cost for manufacturing the component inhouse or the
landed cost of procuring it from outside. Relevant cost in this case, is the direct cost of
manufacturing the component inhouse, i.e. the cost which is directly attributable to

manufacturing and will not be incurred in case the entity decides to outsource the
production to a third party.
This implies that fixed cost, such as rent, salaries of permanent staff, etc, should not be
loaded in the cost for decision making purpose, as these are irrelevant costs (Steven Bragg,
2018).
Ans 2:
(i) Computation of Beta:
Beta of a stock is a function of variance of the stock and covariance of stock and the
market index.
Variance as well as covariance can be computed with the help of % change in daily price
of stock as well as index. Based on the given data, the variance for stock and covariance
for stock and nifty is as under:
Variance of Tata
steel
Covariance of Tata steel and
Nifty
0.000401447 8.04917E-05
Beta for the stock is Variance /Covariance, i.e. 0.20.
(ii) Computation of weighted average cost of capital:
WACC
= ke*Equity/(Debt+equity) +
Kd*Debt/(Debt+equity)
Ke = Rf + beta (Rm-Rf)
Rf 6%
Rm 8%
Beta 0.2
Ke 6%
kd 27.42%
Equity 49,659
Debt 27,934
WACC 13.97%

(iii) Terminal value of the project:
In INR Crores
2017
Act
2018
Act
2019
Act
2020
FC
2021
FC
2022
FC
2023
FC
2024
FC
2025
FC
Revenue from sales and
services 105,627 139,986 158,976
174,87
4 192,361 211,598
232,75
7 256,033
% growth year on year 10% 10% 10% 10% 10% 10%
COGS
99,830 110,309 128,382 148,09
9
162,909 179,200 197,12
0
216,832
% COGS 94.51% 78.80% 80.76% 84.69% 85% 85% 85% 85%
EBITDA 5,797.2
29,677.
4 30,594.4 26,775.0 29,452.5 32,397.8 35,637.6 39,201.3 43,121
D&A 5,673 5,962 7,342 7,342 7,342 7,342 7,342 7,342
EBIT 124.3
23,715.
7 23,252.5 19,433.2 22,110.7 25,056.0 28,295.7 31,859.5
Financial income/expenses 5,072 5,502 7,660 8,850 9,955 11,320 12,841 14,533
EBT (4,947.9)
18,214.
0 15,592.4 10,583.2 12,155.7 13,736.4 15,455.0 17,326.8
Taxes 2,778 3,405 6,718 4,560 5,238 5,919 6,659 7,466
Net Income (7,725.9)
14,808.
6 8,874.0 6,023.0 6,918.0 7,817.6 8,795.6 9,860.9
D&A 5,673 5,962 7,342 7,342 7,342 7,342 7,342 7,342
Change in (O)working
capital 2,551 2,551 2,551 2,551 2,551 2,551
Free Cash flows
18,766.8 15,915.8 16,810.8 17,710.4 18,688.5 19,753.7 20,938.93
6%
Terminal value
Terminal value @ 5.00
FCF (Next) 20,939
WACC 13.97%
g 4%
Terminal value of
projection period 210,075
PV of terminal value 109,263

(iv) Enterprise value of the firm
(v) Implied share price as per calculations:
Particulars Rs.
Value of cash flows 60,224
PV of terminal value 109,263
Total enterprise value 169,487
Total debt 53,588
Implied equity value 115,899
Number of shares 1,126,490,211
Implied Value of share 1028.9
Ans 3:
Economic value refers to the value that the company can generate from the funds that are invested
in the business. This is the difference between cost of capital and actual rate of return of the
company. This also implies that the return generated over and above the cost of capital of the
company is the economic value of the company.
Economic value, also known as economic value-added is one of the methods of arriving at the
valuation of the company. This method is more practical and focusses on the real value that a
company has been able to generate for its shareholders.
Another common approach of valuation of shares is the adjusted book value approach of valuation
of assets and liabilities. Under this approach a line by line analysis of the financial statements of a
company is performed in order to arrive at the true fair value of the assets held in the financial
statements of the company, it is pertinent to note that this method focuses on asset and liabilities
held in the financial statements of the company, implying that there could be certain other assets
and liabilities which are held or owed by the company but are not appearing or recorded in the
Particulars Rs.
Value of cash flows 60,224
PV of terminal value 109,263
Total enterprise value 169,487

financial statements of the company, such as self-developed intangible assets, like Goodwill,
contingent liabilities.
Thus, the value driven by the adjusted book value approach may be under or over-stated as it might
not capture all the assets held by the company, i.e. skipping the assets which are not recorded.
In order to compute the valuation of Reliance using the adjusted book value approach, various
assets held by the company, majorly in the following categories, are required to be valued at fair
value:
i. Property plant and equipment –
It is presently recorded at INR 1,94,895 Crores, whereas the fair value of the assets in
this category could be significantly different than their book value, as the book value is
the value at which these were purchased, as reduced by depreciation and amortisation
over the period, fair value on the other hand, will be driven by the market forces and
market prices of the assets in discussion.
ii. Intangible assets:
The book value of 8,293 Crores of intangible assets, is reflecting the cost less
accumulated depreciation on such assets, and is not reflective of the real market value
of the assets on the date of valuation.
These two items, along with Capital work in progress, will be the major reason for the difference
between adjusted book value and book value. Similarly there could be certain other assets and
liabilities, which are recorded in the books of accounts, at values different to their current market
value, those assets will also be required to be revalued to reflect the fair market value as on the date
of valuation.
In order to compute the Economic value for Reliance there are various adjustments that are
required to be made in the numbers published in the financial statements of the company, those
adjustments include:
1. In the general expenses of 1,453 crores incurred by the company in the year 2019,
Identifying the expenses that have been incurred on training and R&D, as these expenses are
required to be considered as an investment in the business and same should not be
deducted to compute the actual return that has been generated by the business.
This school of though doesn’t consider the amount incurred on training and R&D as expense
and rather it is considered as an investment in the business and net investment is increased
by such amount.
Thus, the net investment in business by Reliance, will be further increased by the amount
spent by it on training and R&D related areas.

2. For the leased assets in the balance sheet of the Company, amounting to INR 317 Crores as
on 31st March, 2019, the company needs to derive the fair value of such assets, as those
assets have contributed to the return generated by the company and hence, the fair value of
these assets should be considered in computing the actual return on assets of the company.
These assets are in the nature of plant and machinery and ships, which have been used in
generating the return from business and thus, based on the economic value school of
thought, to arrive at actual return generated on assets, the fair value of such assets are
required to be computed and considered in the computation of economic value.
3. The company needs to eliminate the impact of any unusual income that is considered in the
EBIT of the company, so as to be able to compute the actual return generated on total
assets. Actual return is the normal return that the company would earn in the normal course
of business.
4. The company should adjust the net investment made in the business, to reflect the net asset
values of the assets employed in the business, assuming that straight line method of
depreciation is deployed by the company, i.e. the depreciation charged on diminishing
balance method, needs to be adjusted to straight line method, so as to be able to compute
the book value accordingly.
b.
i. EV/EBITDA:
Enterprise value of a company is the value that the equity of the company would fetch in the
market, which is also known as market capitalisation of the company, added with debt,
minority interest and preferred share, the amount so derived is reduced by total cash and
cash equivalent and marketable securities.
Market capitalisation of reliance as on 31st March, 2019 is INR 863,996 Cr. (Annual report, 2019)
Gross Debt held by the company as on 31st March, 2019 is INR 287,505 Cr. (Annual report, 2019)
Less: Cash and cash equivalents as on 31st March, 2019 is INR 133,027 Cr. (Annual report, 2019)
Thus, the enterprise value of Reliance as on 31st March, 2019 is INR 1,018,474 Cr.
EBITDA of the company is 76,780 Crores (66,222 Cr + 10,558 Crores) (Annual report, 2019)
EV/EBITDA = 1,018,474/76,780 = 13.27
ii. Price to earnings ratio:
P/E ratio = Current share price/Earning per share
Current share price of reliance as on 31st March, 2019 is 1370. (Yahoo Finance)
EPS is INR 66.8 (Annual report, 2019)

P/E Ratio = 1370/66.8 = 20.51
iii. Price to cash-flow ratio:
Price to cash flow ratio = Current share price/Cash flow share
Average Share price of reliance as on 31st March, 2019 is 1230 (Yahoo Finance)
The price used to compute this ratio is the three months average price, for period
beginning on 01st January, 2019 and ending on 31st March, 2019, to avoid one off
movement in prices at a particular date.
Operating cash flow per share is INR 67.30 (Annual report, 2019)
Price to cash flow Ratio = 1230/67.3 = 18.27
iv. Price to book ratio:
Book value of each share of Reliance as on 31st March, 2019 is 474.68 (Annual report,
2019)
Current share price of reliance as on 31st March, 2019 is 1370. (Yahoo Finance)
Price to book ratio = 1370/474.68 = 2.88.
This implies that the price of the share of the company is 2.88 times the book value of
the share of the company.
v. Each market multiple ratio computed above, has different significance in the valuation of
a company, for the purpose of investment.
Results of different multiple ratios computed above, vary significantly, based on the
parameter used for computation of such ratios. These ratios perse, doesn’t
communicate any significant message about the performance of the entity, rather,
these, when compared with similar ratios for other companies, provides a good
comparison base for different companies.
Economic value/EBITDA:
This ratio provides the number of times the economic value of an entity is, of the EBITDA
generated by the entity. This ratio is comparable across the industry with any other
company irrespective of the capital structure of the company, as computation of
economic value removes the effect of different capital structure and makes the ratio
comparable across companies.

Price earnings ratio:
It is the most widely used ratio amongst the equity market analysts, to determine
whether the a share is undervalued, overvalued or at par valued, based on the industry
average P/E for the company.
Price earning ratio computes the multiple of EPS that price carries, so in case of Reliance,
P/E ratio is 20.51, implying that the price of Reliance’s share is 20.51 times the earnings
per share of the company.
To derive any meaningful message from this number, it needs to be compared with the
comparable companies’ P/E ratio as well as industry P/E ratio, this standalone number
perse has no or little relevance.
Price to cash flow ratio:
Another important multiple, being used by the analysts these days, is the price to cash
flow ratio, which computes the price as multiple of operating cash flow per share,
generated by the company.
This ratio is more relevant as it compares the prices to the cash generated by business
and not only to the earnings per share, which is driven by the profit generated by the
business, irrespective of whether the same is converted into cash or not.
Price to book ratio:
Price to book ratio is a traditional ratio, widely used by analysts to conclude whether a
share is trading overvalued, undervalued or at fair valued.
This ratio provides the comparison between the book value of the share and the market
value of the share (Tim Smith, 2019) .
Multiples are broadly of two types, i.e. Equity multiple and enterprise value multiple,
equity multiples are driven by the market price of the equity shared of the entity and
since, the market price doesn’t always fluctuate based on the performance of the
company, there could be a scenario, wherein the equity based multiple might change
without a significant change in the business performance of the company.
On the other hand, enterprise value related multiple enables the managers to compare
the companies irrespective of their capital structure, since, enterprise value of a
company eradicates the impact of capital composition of the company.

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