In this article, Tirumala Chakraborty pursuing M.A, in Business Law from NUJS, Kolkata discusses Valuation of a manufacturing unit.

Introduction to the Term Manufacture

In India, Manufacturing Sector has emerged and developed as one of the high growth sectors and has become one of the most attractive sectors for investment by foreign concerns. In India, various initiatives have already been taken by the Government to promote the advancement of manufacturing sectors.

In general terms, the process of manufacture involves conversion of raw materials or components into a finished good or product as per the expectation of the customers. In this process, man labor and various equipment or machineries are employed. The term Manufacture has been defined under various Acts. According to Section 2(k) of the Factories Act, 1948, manufacturing process means making, altering, finishing and packaging of any article or substance with a view to its use, sale, transportation and delivery. This process of manufacturing also includes washing, cleaning, oiling, repairing, preserving and demolishing of any substance or article. Power generation or transmission also comes under the process of manufacturing. Any composition types such as printing, lithography, book binding or other similar process are also considered as manufacturing process under this.

The Apex Court has repeatedly recommended the revenue department to consider and examine the process used for making the product as the dictionary meaning of manufacture is not enough for deciding the issue in regard to benefits under the provision of the Income Tax Act, Excise Act and the Customs Act. The Apex Court has dismissed various appeals and clarified that one has to examine the process adopted by the assessee to decide whether the process would constitute “manufacture” or not. The Court further added that the structure, features and the use of the good has to be taken into consideration for deciding the process.

As per Section 2(29BA) of the Income Tax Act, manufacture process means a physical change in a non-living object or thing or article. It transforms the object and brings into existence a new and discrete object with a different name, characteristics such as structure and use.

Valuation of a Manufacturing Unit

The valuation of a business is an idiosyncratic process mainly based on extensive financial analysis and prediction of future performance in regard to that business. Manufacturing businesses are the most challenging to value among other types of business considering its nature of operations and the high level of definite assets. The worth or the valuation of a particular business is not only required to be projected at the time of closing or selling off such business or when the owner quits or leaves the business. Apart from these, valuations are also useful such as for planning out the succession, merger and acquisition and for complying with the regulations made by the Government. It is very important to understand the value or the worth of the business as it plays a vital role in decision making.

Valuation helps in making smart business choices and it is expected that the owner must understand the maximum value of the business or the amount to be paid by an investor at the time of sale. Unlike the private companies, the value of a public traded company can be calculated by the stock value of that company.  Valuation determines the amount of cash a company generates or expects to generate in future. It also evaluates how much an investor would have need as a return on the investment made by him. The process of calculation is not any scientific mechanism but it depends on data and investigations and assumptions to be made by the valuator.  In order to estimate the goodwill, the valuator must make an assumption of the intangibles of the concerned business which includes the reputation of the business, its client base, employee loyalty, patents and its strategies. Goodwill is determined as the excess price a buyer is willing to pay for a company over the book value of the company. Book value is the cost of assets listed on the balance sheet and it is shown in the equity of the company’s owner or stockholder. Intangible assets of a company add value and make a company worth more than the value shown in the financial statements.

In most of the cases, the valuation is done by an independent valuation expert hired by the company and has a comprehensive idea of the company and its operations. The scope of valuation and methods to be applied for the purpose of valuation must be spelled out in an engagement letter at the initial stage and it should also contain the responsibilities of the parties involved. The engagement letter must detail out the reason behind such valuation and the concerned authority for preparing the final report of the valuation. The methods that are usually adopted at the time of valuing a manufacturing unit are market- based valuation, income-based valuation and assets-based valuation. Market-based method of valuation is the most well known method and also referred as the comparative transaction method. Under this method, the value is ascertained by comparing the business with that of its similar kind been sold in the recent past and helps in determining the fair market value of the business in a compelling way. Income- based business valuation is done by forecasting the cash flow of the business and the discount rate and risks involved and this method is commonly known as the Discount cash flow method. Under the assets-based valuation category, Capitalized excess earnings method is the frequent and the classic method applied to evaluate a manufacturing business. This assesses the goodwill of the business.   

A site visit must be conducted by the valuator and he must readily review the financial statements, the tax returns and all the contracts and agreements. Once the investigations are done and the necessary information collected, the valuator after analyzing produces an estimated value. The estimated value is then recorded in the final report of the valuation and is considered as the best price.

Key aspects of Valuing a Manufacturing Business

It is a real challenging task to assess the value of a manufacturing unit considering the nature of its operation and its high level of tangible assets. There is always a scope of committing unintentional errors by the appraiser while valuing the manufacturing unit and such result can be extremely devastating for the owner of that unit. To get an authentic valuation result, there are certain specific areas to be given special consideration to, which are discussed below briefly:

All Income Producing Assets and Excess Assets

Usually, a large number of assets are used and involved in a manufacturing unit and a large portion of investment is represented by its assets such as property, machinery and equipments. A manufacturing unit may have some assets recorded on books but they do not always give away to income generation. But off- balance sheet assets such as intellectual property, product and technologies used for process can be accredited to generate additional income which further contributes to increase the business worth or value.

In case of a distressed unit, valuation is likely to be done using the earning-based methods and in such a case projected earning is either divided by a capitalization rate or it is multiplied by an earnings multiple. It helps in recognising the risk factors involved in the said unit. This approach provides goodwill and value to the staple or core operational assets of the unit. Manufacturing units in general are more likely to have excess assets because of improper and weak management control along with their purposive intent to avoid stock-outs. These excess assets are not part of the core asset structure and are often left unnoticed within the balance sheet. But it is important to recognise these excess assets of the unit as failure to such may result in a heavy undervaluation of the concerned unit.

Cash Flow Forecast and Assessment of Risk Factors

Globally heavy amount is invested in developing new products and their development processes by the manufacturing units. Due to lack of innovation, technology obsolescence takes place quickly and it reduces the income to be derived from the sale of the products manufactured by the unit. This affects the income prospects. To avoid these problems in terms to evaluating a manufacturing unit, accurate projection of sale and proper forecasting of cash flow are to be done along with risk assessment.

Real Estate

Unlike many other service businesses, manufacturing businesses usually operate from the real estate owned by them. Real estate holdings by the unit can create complication at the time of assessment of valuation. All these real estate are usually considered as discrete assets. This kind of discrete assets can be separated from the businesses and can be utilized for different purposes. But its application or use may not be contributing to the unit’s earnings at maximum possible. Real estate does not capture the same risk that of the business which is an essential factor in ascertaining the worth or value of the unit. Depreciation accounting can have a significant imprint on the reported earnings of the unit and especially in small businesses where real estate forms a major portion of the total value of the entity. Thus the involvement of real estate is almost always prone to complicate the valuation result. The correct approach is to evaluate the real estate separately by a commercial real estate appraiser with specialized skills. The business appraiser should consider and gather the leases and adjust the normalized earnings accordingly.

Expense in relation to Depreciation

The value or worth of a unit can be easily deteriorated by the depreciation accounting. This has become an issue of concern for many manufacturing units considering the heavy amount of depreciation relating to equipments and machineries that hits the income stream. But this distortion in regard to valuation can be avoided by adjusting the depreciation expenses appropriately.

Minimum Turnkey Value

The earning based method of valuation gives relevant result only when a business generates earnings at such level that substantiates the capital investment of the same. But this method is not useful when a business operates at or below a stage where the books reflect neither profit nor loss. This method returns the value that is less than the net asset value which is absolutely not reasonable. A business that satiates the essentials of a going concern has a minimum turnkey value as it has already formed a structure capable of operating or conducting a business. Minimum turnkey value means the fair market of the net assets plus the goodwill of the going concern. Minimum value is based on reality and thus eliminates the start up period of the business at the time of valuation. This period can be eliminated by acquiring a business already operating even without earnings. A start up period is required at the time of launching a business for various purposes such as compiling resources, hiring and training their employees and establishing a customer base.

Minimum turkey value has to be recognised by the appraiser at the time of valuing a manufacturing unit, failing which may result to undervaluation. It is applicable even for the small businesses and businesses that are operating with marginal profitability.

Research and Development

Research and development is a key aspect for valuing a manufacturing unit and may have a major impact on the estimated value of a unit. It is usual to ignore the incidental research and development in process of valuation of a manufacturing unit. But it is much essential to adjust the significant expenses in regard to research and development from the normalized earnings of the unit as it will diminish the fair value of the unit. Normalized earnings do not include discretionary expenses such as research and development. Only the reasonable expenses that are necessary for the operation of the manufacturing unit are listed as normalized earnings. If new product gets introduced in the market as an outcome of research and development, the increment earned for such outcome will be reflected in the projected earning structure and such shall be considered for valuation.

Legal Issues on Valuation in India

The process and methods used for the assessment of valuation by the valuators are scrutinised and governed by the various courts and judicial forums in their respective jurisdiction but no Court has been given the power of issuing orders or directions in contravention to any statutory provisions. The Supreme Court and High Courts and other judicial forums in India have discussed and considered the issues arising out of a valuation process adopted by the valuator. From time to time the Courts have faced various issues in regard to valuation such as correct valuation, circumstances under which a valuation can be challenged etc. Usually, any problem in regard to valuation is solved as an issue of fact. In Duncans Industries Ltd. vs. State of UP, it was held by the Apex Court, that the question of valuation is a question of fact and the Court is unwilling to interfere with the finding if the methodologies adopted for such valuation is based on relevant material on record. This was later followed by the Supreme Court in many other cases such as Balco’s Employees Union vs. Union of India, Ram Kishun vs. State of U.P.  The process of valuation is subjective and sometimes technical issues are raised in relation to valuation which may have its roots in the question of law. It was further held by the Supreme Court in CGT vs. Executors and Trustees of the Estate of Late Shri Ambalal Sarabhai, that the correct principle of valuation is recognised by law and it is considered as a question of law, while the actual valuation would be a question of fact. In case the parties are available with two or more principles, the parties are permissible to make a choice of any of the alternative modes of valuation.

In G. L. Sultania and Another vs. SEBI & Another., it was held by the SC, that any valuation which involves technical and tangled issues must be left to the prudence of the experts. The method of valuation can be only challenged and criticised if it is proved that such valuation was assessed on a fallacious manner or that the method adopted by the valuator was wrong, or some grave mistake was committed.

Conclusion

The economic condition and the forecast of a manufacturing unit, its future financial potential, its background and the intangible assets are the key issues to be considered by a valuator for gaining the acumen necessary to make an assessment of value of that unit.  The valuation also reflects the strengths and the weaknesses of the concern and provides guidance for increasing the value or the worth of that concern. The valuator should be given an extensive knowledge about the in and outs of the concern given for valuation to ensure a worthy valuation.

To determine the valuation or worth of a manufacturing unit, it is important to lay down a precise picture of the unit’s assets and income and this can be done through the process of recasting of the financial statements and the balance sheet of that unit. It is important to reconstruct the balance sheet accurately by removing the excess cash levels of operating essentials in case of assets.  The value of the real estate owned by the concern has to be considered separately at the time of valuing the unit. All kind long term assets have to be adjusted and the current value of any prepaid expenses has to be determined. While recasting the balance sheet, all the currently owned amounts are to be recorded in the accounts payable and all the accrued expenses such as tax dues are to be confirmed. Any loan including loans from the owners and real estate has to be removed. At the time of determining the value, it is also needed to prepare a future cash flow forecast and provide a concrete image of the business earning potential.

In the year 2014, a program known as ‘Make in India’ was launched by Narendra D. Modi, the present Prime Minister of India. This program was launched to ensure a position on the world map as a manufacturing hub. Its main motive is to give global recognition to the Indian economy. By 2025, our country is expected to increase its contribution in the manufacturing sector by 25 to 30 percent of GDP and reserve its position as the 5th largest manufacturing country in the world. To encourage this initiative and to promote the growth of manufacturing sectors, India was showcased or casted as one of the business friendly manufacturing destination at the World International Fair held in Germany in the year 2015. The Government has also has introduced several policy measures for this purpose such as reduction of income tax for MSME’s, the Modified Special Incentive Package Scheme etc, removal of excise duty and special additional duty on machines in regard to manufacturing of point-of-sale, etc. One of the major investments made in this sector in recent past is the investment made by Apple in a plant in Bengaluru, owned by one of its partner for the purpose of assembling Apple iPhones.

References

Legislations referred

• The Factories Act, 1948
• Income Tax Act, 1961

Websites referred

• www.indiankanoon.com
• https://www.valuadder.com/blog/
• www.magellanadvisors-il.com
• www.hmwccpa.com
• www.ctconline.org

Dictionaries referred

• Oxford Dictionary
• Black’s law Dictionary