Purchase of the division Plant

With the step-up corporate restructuring activity, purchase and sale of divisions or plants are becoming commonplace. Here are some prominent examples of recent years:

1. Oswal Agro Limited bought the petrochemical plant of Union Carbide Limited
2. India Cement limited bought the Cement division of Coromandal Fertilizers Limited.
3. Heinz Indian Limited bought the foods divisions of Glaxo India Limited
4. SRF bought he nylon tire cord division of CEAT Limited
5. Lafarge bought the cement plant of TISCO

The counterpart for purchase is divestiture: If firm A purchases a plant or factory or business division of firm B, from the point of firm B it represents a divestiture. Purchases (and divestitures) are expected to grow in importance in the years to come as firms restructure themselves with grater freedom in the more liberalized industrial environments.

Typically when a division is purchased the acquiring company takes over the assets of that division along with its accompanying liabilities. For example, when India Cements Limited bought the cement division of Coromandal Fertilizers Limited it took over the liabilities associated with that division as well.

Valuing a division:

There approaches that are commonly used for valuing a business or a division there of –after all a division is a mini business:

1. Adjusted book value approach
2. Direct comparison approach
3. Discounted cash flow approach

Adjusted Book Value Approach:

A straight forward approach to valuing a business is to rely on the information found in the balance sheet. the value of the business is simply the book value of its assets less the book value of its non-investors claims (like sundry debtors and provisions).

A major shortcoming of this approach is that accounting values often diverge from market values. To overcome this limitation replacement values are used instead of accounting values. For example, if it costs Rs 100 million to replace a building its replacements cost of Rs 100 million is used instead of its book value which is likely to be much less as it reflects its historical cost. Hence it is called the adjusted book value approach. Even though the adjusted book value approach is an improvement over accounting value approach, it ignores valuable assets such as organizational capital which are not reported on the balance sheet.

Direct Comparison Approach:

Common sense and economic logic tell us that similar assets should sell at similar prices Based on this principle one can value a business by looking at the valuation of similar businesses.

Suppose you want it value the cement division of a conglomerate company which is currently producing a PBIT of Rs 500 million. Looking at the valuation of cement companies you find that companies which have comparable cement plants are trading in the market at 6 times their PBIT. So, as a first approximation you may put a value of Rs 3000 million on the cement division under review.

In the above example you looked at the price-to-PBIT multiple. Financial analysts consider multiples as well the price to sales multiple price to PBDIT (profit before depreciation interest and taxes) multiples and price to book value multiple.

The direct comparison method is intuitively appealing and hence very popular in practice. However finding comparable companies may be difficult. Often, it may be hard to find truly comparable companies because companies operate in a variety of businesses serve different Market segments have varying capacities and own assets of different vintages.

Discounted cash flow Approach:

The discounted cash flow approach to business valuation involves three basic steps:
Step1: Define the preset value of the free cash from the purchase
Step2: Establish the horizon value and discount it to the present time.
Step3: Add the present value of free cash flow and horizon value of purchase.

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