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Chapter 17 Business Valuations

Answer 1

(a)(i)

Price/earnings ratio method valuation

Earnings per share of Danoca Co = 40c

Average sector price/earnings ratio = 10

mplied value of ordinar! share of Danoca Co = 40 " 10 = #4$00

%um&er of ordinar! shares = ' million

alue of Danoca Co = 4$00 " 'm = #0 million [2 marks]

(a)(ii)

Dividend gro*th model

Earnings per share of Danoca Co = 40c

Proposed pa!out ratio = +0,

Proposed dividend of Danoca Co is therefore = 40 " 0$+ = 4c per share [1 mark]

f the future dividend gro*th rate is e"pected to continue the historical trend in

dividends per share- the historic dividend gro*th rate can &e used as a su&stitute for

the e"pected future dividend gro*th rate in the dividend gro*th model. Average

geometric dividend gro*th rate over the last t*o !ears = (4/ )1/= 1$04' or 4$',

(Alternativel!- dividend gro*th rates over the last t*o !ears *ere , (4/$) and

+, ($/)- *ith an arithmetic average of (+ )/ = 4$',) [1 mark]

Cost of euit! of Danoca Co using the capital asset pricing model (CAP2)

= 4$+ 1$4 " (10$+ 3 4$+) = 4$+ (1$4 " +) = 1, [1 mark]

alue of ordinar! share from dividend gro*th model = (4 " 1$04')/(0$1 3 0$04') =

#$'alue of Danoca Co = $' " 'm = #14$5' million [2 marks]

Discussion:

1. 6he current mar7et capitalisation of Danoca Co is #1+$'m (#$0 " 'm).6he

price/earnings ratio value o Danoca Co is higher than this at !2"m- using

the average price/earnings ratio used for the sector.

. Danoca8s o*n price/earnings ratio is 9$'. 6he #ierence $etween the two

price/earnings ratios ma% in#icate that there is scope or improving the

inancial perormance o Danoca Co ollowing the ac&uisition . f Pho&is Co

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has the managerial s7ills to effect this improvement- the compan! and its

shareholders ma! &e a&le to &enefit as a result of the acuisition.

. 6he #ivi#en# growth mo#el value is lower than the current market

capitalisation at #14$5'm. 6his represents a minimum value that Danoca

shareholders *ill accept if Pho&is Co ma7es an offer to &u! their shares. 'n

realit% the% woul# want more than thisas an inducement to sell.

4. 6he current market capitalisation of Danoca Co of #1+m ma% relect the

$elie o the stock market that a takeover $i# or the compan% is imminent

and- depending on its efficienc!- ma! indicate a fair price for Danoca8s shares-

at least on a marginal trading &asis.

'. Alternativel!- either the cost of euit! or the e(pecte# #ivi#en# growth rate

use# in the #ivi#en# growth mo#el calculation coul# $e inaccurate - or the

difference &et*een the t*o values ma% $e #ue to a #egree o ineicienc% in

the stoc7 mar7et.

[) marks]

(&)

Calculation of mar7et value of each converti&le &ond

E"pected share price in five !ears8 time = 4$4' " 1$0+'' = #+$10

Conversion value = +$10 " 0 = #1 [1 mark]

Compared *ith redemption at par value of #100- conversion *ill &e preferred

6he current mar7et value *ill &e the present value of future interest pa!ments- plus

the present value of the conversion value- discounted at the cost of de&t of 5, per

!ear.

2ar7et value of each converti&le &ond = ( " 4$100) (1 " 0$51) = #1$9

[2 marks]

Calculation of floor value of each converti&le &ond

6he current floor value *ill &e the present value of future interest pa!ments- plus the

present value of the redemption value- discounted at the cost of de&t of 5, per !ear.:loor value of each converti&le &ond = ( " 4$100) (100 " 0$51) = #109$0

[2 marks]

Calculation of conversion premium of each converti&le &ond

Current conversion value = 4$4' " 0 = #9$00

Conversion premium = #1$9 3 9$00 = #4$9

6his is often e"pressed on a per share &asis- i.e. 4$9/0 = #1$5' per share

[1 mark]

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(c)

*eak orm eicienc%:

1. ;toc7 mar7et efficienc! usuall! refers to the *a! in *hich the prices of traded

financial securities reflect relevant information. random *al78 &!

responding to ne* information as it &ecomes availa&le.

[1 + 2 marks]

,emi-strong rom:

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fair prices.

. anagers should thereore simpl% concentrate on making inancial

#ecisions*hich increase the wealth o sharehol#ers.

[2 + 0 marks]

ACCA arking ,cheme

Answer 2

(a)

Calculation of share price

6?P Co dividend per share = +4 " 0$' = c per share [1 mark]

;hare price of 6?P Co = ( " 1$0')/(0$1 3 0$0') = #4$90 [2 marks]

2ar7et capitalisation of 6?P Co = 4$90 " m = #14$4m [1 mark]

(&)

@ights issue price

6his is at a 0, discount to the current share price = 4$90 " 0$9 = #$94 per share

[1 mark]

%e* shares issued = m/ = 1mCash raised = 1m " $94 = #-940-000 [1 mark]

6heoretical e" rights price = ( " 4$90) $94B/4 = #4$'+ per share [1 mark]

2ar7et capitalisation after rights issue = 14$4m $94m = #19$4 3 0$m = #15$m

6his is euivalent to a share price of 15$/4 = #4$49 per share [2 marks]

6he issue costs result in a decrease in the mar7et value of the compan! and therefore a

decrease in the *ealth of shareholders euivalent to 9c per share.

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(c)

Price/earnings ratio valuation

Price/earnings ratio of 6?P Co = 490/+4 = 5$' [1 mark]

Earnings per share of C@ Co = 44$9c per share

sing the price earnings ratio method- share price of C@ Co = (44$9 " 5$')/100 =

#$+

2ar7et capitalisation of C@ Co = $+ " 1m = #-+0-000 [2 marks]

(Alternativel!- earnings of C@ Co = 1m " 0$449 = #449-000 " 5$' = #-+0-000)

(d)(i)

1. n a semistrong form efficient capital mar7et- share prices reflect past and

pu&lic information. ' the e(pecte# annual ater-ta( savings are not

announce#- this information *ill not thereore $e relecte# in the share price

o 3 Co4

. n this case- the post ac&uisition market capitalisationof 6?P Co will $e the

market capitalisation ater the rights issue. plus the market capitalisation

o the ac&uire# compan% 5C6 Co8. less the price pai# or the shares o

C6 Co- since this cash has left the compan! in e"change for purchased shares.

t is assumed that the mar7et capitalisations calculated in earlier parts of this

uestion are fair values- including the value of C@ Co calculated &! the

price/earnings ratio method.

Price paid for C@ Co = $94m 3 0$m = #$'m

2ar7et capitalisation = 15$m $+m 3 $'m = #15$5+m

6his is euivalent to a share price of 15$5+/4 = #4$44 per share

. 6he market capitalisationhas #ecrease# rom the value ollowing the rights

issue &ecause 6?P Co has paid #$'m for a compan! apparentl! *orth

#$+m. 6his is a further decrease in the *ealth of shareholders- follo*ing onfrom the issue costs of the rights issue.

(d)(ii)

1. f the annual afterta" savings are announced- this information *ill &e relecte#

&uickl% an# accuratel% in the share price of 6?P Co since the capital

market is semi-strong orm eicient.

. 6he savings can $e value# using the price/earnings ratio metho#as having a

present value of #50-000 (5$' " +-000). 6he revise# market capitalisation o

3 Co is thereore !19)9m(15$5+m 0$5m)- euivalent to a share price of

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#4$+ per share (19$49/4).

. 6his makes the ac&uisition o C6 Co attractive to the shareholders of 6?P

Co- since it oers a higher market capitalisationthan the one follo*ing the

rights issue. Each shareholder of 6?P Co *ould e"perience a capital gain of 14c

per share (4$+ 3 4$49).

n practice- the capital mar7et is li7el! to anticipate the annual afterta" savings &efore

the! are announced &! 6?P Co.

(e)

6here are a num&er of factors that should &e considered &! 6?P Co- including the

follo*ing.

;earing an# inancial risk

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Answer 0

(a)

@ights issue price = $' " 0$9 = #$00 per share [1 mark]

6heoretical e" rights price = (($'0 " 4) (1 " $00)/'=#$40 per share [2 marks]

(Alternativel!- num&er of rights shares issued = #'m/#$00 = $'m shares

E"isting num&er of shares = 4 " $'m = 10m shares

6heoretical e" rights price per share = ((10m " $'0) ($'m " $00))/1$'m = #$40)

(&)

Current price/earnings ratio = '0/$4 = 5$5 times [1 mark]

Average gro*th rate of earnings per share = 100 " (($4/5$5) 0$'3 1) = 4$0,

Earnings per share follo*ing e"pansion = $4 " 1$04 = $5 cents per share

[1 mark]

;hare price predicted &! price/earnings ratio method = $5 " 5$5 = #$+0 [1 mark]

;ince the price/earnings ratio of Dartig Co has remained constant in recent !ears and

the e"pansion is of e"isting &usiness- it seems reasona&le to appl! the e"isting

price/earnings ratio to the revised earnings per share value.

(c)

Discussion o share price comparisons:

1. 6he propose# $usiness e(pansion *ill &e an accepta$le use o the rights

issue un#s i it increases the wealth o the sharehol#ers.

. 6he share price pre#icte# $% the price/earnings ratio metho# is !2?" . 6his

is greater than the current share price o !2="- &ut this is not a vali#

comparison- since it ignores the eect o the rights issue on the share price.

6he rights issue has a neutral eect on sharehol#er wealth - &ut the cum

rights price is changed &! the increase in the num&er of shares and &! the

transormation o cash wealth into securit% wealth from a shareholder pointof vie*.

. 6he correct comparison is with the theoretical e( rights price- *hich *as

found earlier to &e #$40. Dartig Co shareholders *ill e(perience a capital gain

due to the &usiness e"pansion of !2?" + 2)" @ 2" cents per share. ?o*ever-

these share prices are one %ear apartand hence not #irectl% compara$le.

[0 + ) marks]

Calculation o eect on sharehol#er wealth an# comment:

1. f the dividend !ield remains at +, per !ear (100 " 1'$0/'0)- the dividend per

share for 009 *ill &e 1'$+p (other estimates of the 009 dividend per share are

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possi&le). Adding this to the capital gain of 0p gives a total shareholder return

of '$+p or 14$4, (100 " '$+/40).

. 6his is greater than the cost o e&uit% o 1">and so sharehol#er wealth has

increase#.

[1 + 2 marks]

(d)

n order to use the dividend gro*th model- the e"pected future dividend gro*th rate is

needed. ?ere- it ma! &e assumed that the historical trend of dividend per share

pa!ments *ill continue into the future. 6he geometric average historical dividend

gro*th rate = 100 " ((1'$0/1$9)0$'3 1) = 4, per !ear. [2 marks]

(Alternativel!- the arithmetical average of annual dividend gro*th rates could &e

used. 6his *ill &e ('$' 0$0 5$4 $')/4 = 4$1,. Another possi&ilit! is to use the

ordon gro*th model. 6he average pa!out ratio over the last 4 !ears has &een 45,-

so the average retention ratio has &een ',. Assuming that the cost of euit!

represents an accepta&le return on shareholders8 funds- the dividend gro*th rate is

appro"imatel! ', " 10, = '$, per !ear.)

sing the formula for the dividend gro*th model from the formula sheet- the e"

dividend share price = (1'$0 " 1$04)/(0$10$04) = #$+0 [2 marks]

Discussion:

1. 6his is 10 cents per share more than the current share price of Dartig Co. 6here

are several reasons *h! there ma! &e a difference &et*een the t*o share prices.

6he uture #ivi#en# growth ratefor e"ample- ma! #ier rom the average

historical #ivi#en# growth rate- and the current share price ma! factor in a

more reasona&le estimate of the future dividend gro*th rate than the 4, used

here.

. 6he cost o e&uit% of Dartig Co ma! not $e e(actl% e&ual to 1">. 2oregenerall!- there ma! &e a degree of inefficienc! in the capital mar7et on *hich

the shares of Dartig Co are traded.

[2 marks]

(e)

Discussion o agenc% pro$lem:

1. 6he primar! financial management o&Fective of a compan! is usuall! ta7en to

&e the ma"imisation of shareholder *ealth. n practice- the managers of a

compan! acting as agents for the principals (the shareholders) ma! act in *a!s

*hich do not lead to shareholder *ealth ma"imisation. 6he ailure o

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managers to ma(imise sharehol#er wealth is reerre# to as the agenc%

pro$lem.

. ,harehol#er wealth increases through pa%ment o #ivi#en#s an# through

appreciation o share prices. ;ince share prices reflect the value placed &!

&u!ers on the right to receive future dividends- anal!sis of changes in

shareholder *ealth focuses on changes in share prices. 6he o&Fective of

ma"imising share prices is commonl! used as a su&stitute o&Fective for that of

ma"imising shareholder *ealth.

. 6he agenc% pro$lem arises$ecause the o$ectives o managers #ier rom

those o sharehol#ersI &ecause there is a divorce or separation of o*nership

from control in modern companiesJ and &ecause there is an as!mmetr! of

information &et*een shareholders and managers *hich prevents shareholders

&eing a*are of most managerial decisions.

[) + = marks]

Discussion o share option schemes:

1. Gne *a! to encourage managers to act in *a!s that increase shareholder *ealth

is to offer them share options. 6hese are rights to &u! shares on a future date at a

price *hich is fi"ed *hen the share options are issued. ,hare options will

encourage managers to make #ecisions that are likel% to lea# to share price

increases(such as investing in proFects *ith positive net present values)- since

this will increase the rewar#s the% receive rom share options. 6he higher

the share price in the mar7et *hen the share options are e"ercised- the greater

*ill &e the capital gain that could &e made &! managers o*ning the options.

. ,hare options therefore go some *a! to*ards re#ucing the #ierences

$etween the o$ectives o sharehol#ers an# managers. ?o*ever- it is

possi$le that managers ma% $e rewar#e# or poor perormance if sharepricesin general are increasing. t is also possi$lethat managers ma% not $e

rewar#e# or goo# perormance if share prices in general are alling. t is

#iicult to #eci#e on a share option e(ercise price an# a share option

e(ercise #atethat *ill encourage managers to focus on increasing shareholder

*ealth *hile still remaining challenging- rather than &eing easil! achieva&le.

[) + = marks]

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ACCA arking ,cheme

Answer )

(a)

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(&)(i)

Price/earnings ratio method

Earnings per share of %% = 90c per share

Price/earnings ratio of K:P Co = 9

;hare price of %% = 90 " 9 = +40c or #+$40

%um&er of ordinar! shares of %% = '/0$' = 10 million shares

alue of %% = +$40 " 10m = #+4 million [2 marks]

?o*ever- it can &e argued that a reduction in the applied price/earnings ratio is

needed as %% is unlisted and therefore its shares are more difficult to &u! and sell

than those of a listed compan! such as K:P Co. f *e reduce the applied

price/earnings ratio &! 10, (other similar percentage reductions *ould &e

accepta&le)- it &ecomes 5$ times and the value of %% *ould &e (90/100) " 5$ "

10m = #'5$+ million

(&)(ii)

Dividend gro*th model

Dividend per share of %% = 90c " 0$4' = +c per share [1 mark]

;ince the pa!out ratio has &een maintained for several !ears- recent earnings gro*th is

the same as recent dividend gro*th- i.e. 4$',. Assuming that this dividend gro*th

continues in the future- the future dividend gro*th rate *ill &e 4$',.

;hare price from dividend gro*th model = (+ " 1$04')/ (0$1 3 0$04') = '0c or

#'$0

alue of %% = '$0 " 10m = #'0$ million [0 marks]

(c)

A discussion of capital structure could start from recognising that euit! is more

e"pensive than de&t &ecause of the relative ris7 of the t*o sources of finance. Euit!is ris7ier than de&t and so euit! is more e"pensive than de&t. 6his does not depend

on the ta" efficienc! of de&t- since *e can assume that no ta"es e"ist.

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initiall% ver% little increase in the cost o e&uit% an# the *ACC #ecreases

&ecause the cost of de&t is less than the cost of euit!.

. A point is reached- ho*ever- *here the cost o e&uit% rises at a rate that

e(cee#s the re#uction eect o cheaper #e$t and the *ACC starts to

increase. n the traditional vie*- therefore- a minimum *ACC e(istsand- as a

result- a ma(imum value o the compan% arises.

[1 -2 marks]

an# capital structure:

. 2odigliani and 2iller assume# a perect capital market an# a linear

relationship $etween the cost o e&uit% an# inancial risk. 6he! argued that-

as a compan! geared up- the cost o e&uit% increase# at a rate that e(actl%

cancelle# out the re#uction eect o cheaper #e$t . *ACC *as therefore

constant at all levels o gearing an# no optimal capital structure - *here the

value of the compan! *as at a ma"imum- could &e found.

4. t *as argued that the no-ta( assumptionmade &! 2odigliani and 2iller *as

unrealistic- since in the real worl# interest pa%ments were an allowa$le

e(pense in calculating ta"a&le profit and so the eective cost o #e$t was

re#uce# $% its ta( eicienc%.

'. 6he! revise# their mo#elto include this ta" effect and sho*ed that- as a result-

the *ACC #ecrease# in a linear ashion as a compan% geare# up . 6he value

o the compan% increase# &! the value of the >ta" shield8 and an optimal

capital structure woul# result $% gearing up as much as possi$le.

[2 + 0 marks]

arket imperections:

+. t *as pointed out that market imperections associate# with high levels o

gearing- such as &an7ruptc! ris7 and agenc! costs- *ould limit the e(tent to

which a compan% coul# gear up.

5. n practice- therefore- it appears that companies can re#uce their *ACC $%increasing gearing- while avoi#ing the inancial #istressthat can arise at high

levels of gearing.

[1 + 2 marks]

ther relevant #iscussion:

9. t has further &een suggested that companies choose the source o inance

*hich- for one reason or another- is easiest or them to access(pecking or#er

theor%). 6his results in an initial preerence or retaine# earnings- ollowe#

$% a preerence or #e$t $eore turning to e&uit%.

. 6he vie* suggests that companies ma% not in practice seek to minimise

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Answer =

(a)

Divi#en# %iel# is calculate# as the #ivi#en# #ivi#e# $% the share price at the start

o the %ear4

009I dividend !ield = 100 " 9$'/540 = '$, [1 mark]

00I dividend !ield = 100 " 40$0/9' = 4$9, [1 mark]

6he capital gain is the difference &et*een the opening and closing share prices- and

ma! &e e"pressed as a monetar! amount or as a percentage of the opening share price.

009I capital gain = 9' 3 540 = 'c or 1$9, (100 " '/540) [1 mark]

00I capital gain = +49 3 9' = (195c) or ($4,) (100 " 3195/9') [1 mark]

6he total shareholder return is the sum of the percentage capital gain and the dividend

!ield- or the sum of the dividend paid and the monetar! capital gain- e"pressed as a

percentage of the opening share price.

009I total shareholder return = 100 " (' 9$')/540 = 19$0, ('$, 1$9,)

[1 mark]

00I total shareholder return = 100 " (3195 40)/9' = 315$+, (4$9, 3 $4,)

[1 mark]

(a)(i)

he return on e&uit% pre#icte# $% the CA3

1. 6he actual return for a shareholder of L; Co- calculate# as total

sharehol#er return- is ver% #ierent rom the return on e&uit% pre#icte# $%

the CA3.

. n 2""9the compan! provi#e# a $etter return than pre#icte# an# in 2""Fthe

compan! gave a negative return *hile the CA3 pre#icte# a positive

return.

;eneral #iscussion o returns:

. Mecause the risk-ree rate o return is positiveand the e&uit% risk premium

is either Gero or positive- and &ecause negative e&uit% $etas are ver% rare-

the return on e&uit% pre#icte# $% the CA3 is invaria$l% positive.

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(&)

?istorical dividend gro*th rate = (40/5)0$'3 1 = 0$04 or 4, per !ear [1 mark]

;hare price using dividend gro*th model = (40 " 1$04)/(0$1 3 0$04) = +c or #+$

[2 marks]

n three !ears8 time- the present value of the dividends received from the fourth !ear

on*ards can &e calculated &! treating the fourth!ear dividend as D 1in the dividend

gro*th model and assuming that the cost of euit! remains unchanged at 10, per

!ear. Appl!ing the dividend gro*th model in this *a! gives the share price in three

!ears8 timeI

;hare price = 50/(0$1 3 0$0) = 1-000c or #10$00.

:or comparison purposes this share price must &e discounted &ac7 for three !earsI

;hare price = 0$5'1 " 10$00 = #5$'1. [0 marks]

Comment on share prices:

1. 6he current share price o !?)9 is less than the share price o !?F0calculate# $% the #ivi#en# growth mo#el- in#icatingperhaps that the capital

market $elieves that uture #ivi#en# growth will $e less than historic

#ivi#en# growth.

. 6he share price resulting rom the propose# three-%ear suspension o

#ivi#en#s is higher than the current share price an# the share price

pre#icte# $% the #ivi#en# growth mo#el . ?o*ever- this share price is $ase#

on inormation that is not pu$licand it also relies on uture #ivi#en#s an#

#ivi#en# growth $eing as pre#icte#. t is ver% unlikel% that a pre#iction as

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tentative as this will prove to $e accurate.

[1 + 2 marks]

(c)

3ractical links $etween the #ecision areas:

1. nvestment decisions- dividend decisions and financing decisions have often

&een called the #ecision triangle o inancial management. 6he stud! of

financial management is often divided up in accordance *ith these three

decision areas. ?o*ever- the% are not in#epen#ent #ecisions. $ut closel%

connecte#.

[1 + 2 marks]

6elevant illustrations:

. :or e"ample- a decision to increase #ivi#en#s might lea# to a re#uction in

retaine# earningsand hence a greater nee# or e(ternal inancein order to

meet the reuirements of proposed capital investment proFects. ;imilarl!- a

decision to increase capital investment spending *ill increase the need for

financing- *hich could &e met in part &! reducing dividends. [1 + 2 marks]

an# investment an# inancing #ecisions:

. 6he uestion of the relationship &et*een the three decision areas *as

investigated &! 2iller and 2odigliani. 6he! sho*ed that- if a perect capital

market *as assumed- the market value o a compan% an# its weighte#

average cost o capital 5*ACC8 were in#epen#ent o its capital structure .

4. 6he market value therefore #epen#e# on the $usiness riskof the compan!

and not on its inancial risk. 6he investment #ecision- *hich determined the

operating income of a compan!- *as therefore shown to $e important in

#etermining its market value- *hile the inancing #ecision- given their

assumptions- *as sho*n to &e not relevant in this conte(t.

'. 'n practice- it is recognised that capital structure can aect *ACC an#

hence the market value o the compan%.[2 + 0 marks]

an# #ivi#en# #ecision:

+. 2iller and 2odigliani also investigated the relationship &et*een dividend

polic! and the share price of a compan!- i.e. the mar7et value of a compan!.

6he! sho*ed that- if a perect capital market was assume#- the share priceof

a compan! did not #epen# on its #ivi#en# polic%- i.e. the dividend decision

*as irrelevant to value of the share.

5. 6he market value o the compan% an# thereore the wealth o sharehol#ers

were shown to $e ma(imise# when the compan% implemente# its optimum

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investment polic%- *hich *as to invest in all proFects *ith a positive %P. 6he

investment decision *as therefore sho*n to &e theoreticall! important *ith

respect to the mar7et value of the compan!- *hile the dividend decision *as not

relevant.

[2 + 0 marks]

ther relevant #iscussion:

9. 'n practice- capital markets are not perectand a num$er o other actors

$ecome important in discussing the relationship $etween the three #ecision

areas.

. 3ecking or#er theor%- for e"ample- suggests that managers #o not in

practice make inancing #ecisions with the o$ective o o$taining an

optimal capital structure- &ut on the $asis o the convenience an# relative

cost o #ierent sources o inance. @etained earnings are the preferred source

of finance from this perspective- *ith a resulting pressure for annual dividends

to &e lo*er rather than higher.

[1 + 0 marks]

ACCA arking ,cheme

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Answer ?

6he approaches to use for valuation areI

(1) %et asset valuation.

() D2.

() PE ratio valuation.

518 Iet asset valuation

6arget is &eing purchased as a going concern- so realisa&le values are irrelevant.

#000

%et assets per accounts #(1-9 3 5+9) 1-14

AdFustment to freehold propert! #(900 3 4+0) 40

AdFustment to inventor! ('0)

aluation 1-414

528 DV

6he average rate of gro*th in 6arget8s dividends over the last 4 !ears is 5.4, on a

compound &asis.

9' (1g)4= 11.1 hence g = 5.4,

6he estimated value of 6arget using the D2 is thereforeI

aluation =054.01'.0

054.1100-11/

= #1-'9-9

508 3< ratio valuation

A suita&le PE ratio for 6arget *ill &e &ased on the PE ratio of Predator as &oth

companies are in the same industr!.

PE of Predator = 0.1'+/.9

4/0

04.0#

/0.4#50=

or

m

6he adFustmentsI Do*n*ards &! 0, or 0.0- i.e. multipl! &! 0.90.

(1) 6arget is a private compan! and its shares ma! &e less liuid.

() 6arget is a private compan! and it ma! have a less detailed compliance

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environment and therefore ma! &e more ris7!.

A suita&le PE ratio is therefore 1'.0 N 0.90 = 1.0

(multipl!ing &! 0.90 results in the 0, reduction).

6arget8s PA6 AdFustment for the savings in the director8s remuneration after ta"I#19-000 (#40-000 N +5,) = #0-900

6he estimated value is therefore #0-900 N 1.0 = #-'1-5+

A#vice to the $oar#

Gn the &asis of its tangi&le assets the value of 6arget is #1.4 million- *hich e"cludes

an! value for intangi&les.

6he dividend valuation gives a value of around #1.+ million.

6he earnings &ased valuation indicates a value of around #.' million- *hich is &ased

on the assumption- that not onl! *ill the current earnings &e maintained- &ut that the!

*ill increase &! the savings in the director8s remuneration.

Gn the &asis of these valuations an offer of around # million *ould appear to &e

most suita&le- ho*ever a revie* of all potential financial gains from the merger is

recommended. 6he directors should- ho*ever- &e prepared to increase the offer to

ma"imum price.

Answer 7

(a)(i)

Malance sheet value = #4'4-100.

(a)(ii)

@eplacement cost value = #4'4-100 #(5'-000 3 +'1-+00) #(''0-000 3 '1'-00) =#'+1-+00

(a)(iii)

@ealisa&le value = #4'4-100 #(4'0-000 3 +'1-+00) #('50-000 3 '1'-00) 3

#14-00 = #1-500

Mad de&ts are , " #54'-000 = #14-00. Mad de&ts are assumed not to &e relevant to

the statement of financial position and replacement cost values.

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(a)(iv)

6he dividend gro*th model value depends on an estimate of gro*th- *hich is far

from clear given the *ide variations in earnings over the five !ears.

1. 6he lo*est possi&le value- assuming Hero gro*th- is as follo*s.

alue cum div = ///-//#000-'#1.0

000-'#=+

t is not li7el! that this *ill &e the &asis ta7en.

. Ooo7ing at dividend gro*th over the past five !ears *e haveI

004 dividend = #'-000

000 dividend = #0-'00

f the annual gro*th rate in dividends is g

(1 g)4= '-000/0-'00 = 1.1'

1 g = 1.0'09

g = 0.0'09- sa! ',

6hen- 2 cum div =gK

D

e

1 current dividend

= 000-'#0'.01.0

,)'1(000-'+

+

= #400-000

. sing the ordon8s ro*th model- *e haveI

Average proportion retained =

4'.000-'400-/9/00-4/900-++/00-//

000-5400-1//00-1900-44900-1=

++++

++++

(sa! & = 0.')

@eturn on investment this !ear = '-00 / average investment

=

)B00-5100-4'4(100-4'4A

00-'/

+

= 0.109 (sa! r = 1,)

6hen g = 0.' " 1, = +,

;o 2 cum div = ++5-4++#000-'#0+.01.0

0+.1000-'#=+

(a)(v)

P/E ratio model

Compara&le uoted companies to 2anon have P/E ratios of a&out 10. 2anon is much

smaller an &eing unuoted its P/E ratio *ould &e less than 10- &ut ho* much less

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f *e ta7e a P/E ratio of '- *e have 2 = #'-00 " ' = #++-000.

f *e ta7e a P/E ratio of 10 " /- *e have 2 = #'-00 " 10 " / = #'4-++5.

f *e ta7e a P/E ratio of 10- *e have 2 = #'-000

(&)(i)

6he statement of financial position value

6he statement of financial position value should not pla! a part in the negotiation

process. ?istorical costs are not relevant to a decision on the future value of the

compan!.

(&)(ii)

6he replacement cost

6his gives the cost of setting up a similar &usiness. ;ince this gives a higher figure

than an! other valuation in this case- it could sho* the ma"imum price for Carmen to

offer. 6here is clearl! no good*ill to value.

(&)(iii)

6he realiHa&le value

6his sho*s the cash *hich the shareholders in 2anon could get &! liuidating the

&usiness. t is therefore the minimum price *hich the! *ould accept.

All the methods (i) to (iii) suffer from the limitation that the! do not loo7 at the going

concern value of the &usiness as a *hole. 2ethods (iv) and (v) do consider this value.

?o*ever- the realiHa&le value is of use in assessing the ris7 attached to the &usiness as

a going concern- as it gives the &ase value if things go *rong and the &usiness has to

&e a&andoned.

(&)(iv)

6he dividend model6he figures have &een calculated using 2anon8s Ke (1,). f () or () *ere

follo*ed- the value *ould &e the minimum that 2anon8s shareholders *ould accept-

as the value in use e"ceeds scrap value in (iii). 6he relevance of a dividend valuation

to Carmen *ill depend on *hether the current retention and reinvestment policies

*ould &e continued. Certainl! the value to Carmen should &e &ased on , rather than

1,. Moth companies are ungeared and in the same ris7 class so the different reuired

returns must &e due to their relative siHes and the fact that Carmen8s shares are more

mar7eta&le.

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Gne of the main limitations on the dividend gro*th model is the pro&lem of

estimating the future value of g.

(&)(v)

6he P/E ratio model

6he P/E ratio model is an attempt to get at the value *hich the mar7et *ould put on a

compan! li7e 2anon. t does provide an e"ternal !ardstic7- &ut is a ver! crude

measure. As alread! stated- P/E ratio *hich applies to larger uoted companies must

&e lo*ered to allo* for the siHe of 2anon and the nonmar7eta&ilit! of its shares.

Another limitation of P/E ratios is that the ratio is ver! dependent on the e"pected

future gro*th of the firm. t is therefore not eas! to find a P/E ratio of a similar firm.

?o*ever- in practice the P/E model ma! *ell feature in the negotiations over price

simpl! &ecause it is an easil! understood !ardstic7.

(c)

6he range *ithin *hich the purchase price is li7el! to &e agreed *ill &e the minimum

price *hich the shareholders of 2anon *ill accept and the ma"imum price *hich the

directors of Carmen *ill pa!.

E"amining the figures in part (a)- the range is #1-500 (realiHa&le value) to #'+1-+00

(replacement cost).

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