Valuation of financial instruments16/08/2021 1 By indiafreenotes
Financial Instruments Valuation includes determining the Fair Value of equity instruments, debt instruments, derivatives (option and future contracts) and embedded derivatives (convertible bonds / preference shares). Financial Instruments may require valuation for commercial, financial reporting or regulatory purposes.
- Non-convertible Bonds
- Equity Instruments
- Options, Warrants, Grants and Rights and other derivatives
- Hybrid Instruments
- Futures & Options and Forward Contracts
- Financial Liabilities
Selection of Valuation Method:
Valuation Standard 303 “Financial Instruments” prescribes followings are the indicative factors that need to be consider for determining appropriate method or combination of methods for the purpose of valuation of financial instruments:
The purpose of valuation:
The purpose for which valuation is being used is also a determining factor. Generally, in the case of business combination transaction the valuation methodology which consider more observable inputs is given priority over other approaches.
The valuation base and terms and conditions of the instrument being valued:
In selection appropriate valuation method, due consideration must be given to the nature of instrument and the terms conditions embodying with instrument. While determining the market comparable the terms and conditions of the instrument plays and important role.
The control framework of the entity and input data sets:
In selection of the appropriate valuation method, a valuer shall also give importance to the control environment under which the entity and the instrument operates. The control environment consists the entity’s internal governance and control objectives, procedures and their operating effectiveness with the objective of enhancing the reliance on the valuation process and outcome thereof. A valuer, if relying on valuation inputs provided by the entity, shall form independent opinion on the valuation control environment and factor outcome on the valuation method, approach, outcome and reporting thereof.
Methods of Valuation of Financial Instruments:
Market Approach Valuation:
- In market approach, the value of the financial instrument is determined by considering traded prices of such instrument in an active market; or prices and other relevant information generated by market transactions involving identical or comparable (similar) assets.
- This method uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities or a group of assets and liabilities.
- In absence of an active market benchmark price, comparable pricing or private transaction pricing may also be considered.
Cost Approach Valuation:
- From the perspective of a market participant seller, the price that would be received for the asset is based on the cost to a market participant buyer to acquire or construct a substitute asset of comparable utility.
- Cost approach is a valuation approach that reflects the amount that would be required currently to replace the service capacity of an asset.
- The usage of cost method is of more predominance in valuation of non-financial assets.
Income Approach Valuation:
- In this approach value of a financial instrument is determined based on the expected economic benefits by way of income, cash flows or cost savings generated by such financial instrument and level of risk associated with such financial instrument. It generally involves discounting future amounts to a single present value after adjusting inherent risks.
- Income approach is the valuation approach that converts maintainable or future amounts (e.g., cash flows or income and expenses) to a single current i.e., discounted amount.
- Black-Scholes-Merton formula or a binomial model and similar other pricing models are examples of income approach, that incorporate present value techniques and reflect both the time value and the intrinsic value of an option.