APC308 Financial Management: Investment Appraisal Techniques and Merger & Takeovers

This article covers investment appraisal techniques such as payback period, accounting rate of return, net present value, and internal rate of return. It also evaluates the effects of new proposals on the company's capital structure and critically evaluates the benefits and limitations of various investment appraisal techniques. Additionally, it covers the valuation of Dragon PLC using price/earnings ratio, discounted cash flow method, and dividend valuation method in the context of mergers and takeovers.

APC308 FINANCIAL
MANAGEMENT

TABLE OF CONTENTS
QUESTION 2 - INVESTMENT APPRAISAL TECHNIQUES.....................................................1
a) Calculating investment appraisal techniques...........................................................................1
b) Critically evaluating the effects of new proposal on company...............................................4
c) Critical evaluation of benefits and limitation of various investment appraisal technique.......5
QUESTION 3- MERGER AND TAKEOVERS.............................................................................6
a) Price/ earnings ratio.................................................................................................................6
b) Discounted cash flow method.................................................................................................7
c) Dividend valuation method.....................................................................................................8
d) Evaluation of various techniques of valuation and recommending one method to the board.8
REFERENCES..............................................................................................................................11

QUESTION 2 - INVESTMENT APPRAISAL TECHNIQUES
a) Calculating investment appraisal techniques
year cash inflows Cash outflow depreciation EBIT
net cash
inflow
1 223,600 32700 83342.5 107,558 190,900
2 223,600 32700 83342.5 107,558 190,900
3 223,600 32700 83342.5 107,558 190,900
4 223,600 32700 83342.5 107,558 190,900
5 223,600 32700 83342.5 107,558 190,900
6 223,600 32700 83342.5 107,558 190,900
i) Payback period
Year
Cash flows of System
A Cumulative cash flows
1 190900 190900
2 190900 381800
3 190900 572700
4 190900 763600
5 190900 954500
6 190900 1145400
Payback period 3
0.1
Payback period 3 year and 1 months
From the evaluation of the given payback period which helps in evaluating that how
effectively Super Tasty Soup (STS) Limited can cover its initial investment capital so that
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accomplishing objective of having higher profitability. New machinery will become able to
cover initial investment in 3 years 1 month.
ii) Accounting rate of return
Year Cash inflows
1 190900
2 190900
3 190900
4 190900
5 190900
6 190900
Average profit or cash inflow 190900
Average initial investment 294,150
average initial investment [(initial
investment + scrap value) / 2]
ARR 65%
The accounting rate of return allows to estimate the potential profitability of long term
investment over a period of time. From the analysis of the calculated figure it can be analysed
that machinery has potential to offer the profitability of 65%which is indicating positive sign of
particular investment. On the basis of this, it can be specified that particular project in terms of
profitability will be beneficial for the organization.
iii) Net present value
year
cash
inflows PV factor @ 10%
Discounted cash
flows
1 190900 0.91 173545
2 190900 0.83 157769
3 190900 0.75 143426
4 190900 0.68 130387
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5 190900 0.62 118534
6 190900 0.56 107758.1
Total discounted cash inflow 831419
Initial investment 588,300
NPV (Total discounted cash
inflows - initial investment) 243119
Net present value method is helpful in specifying the discounted cash flow so that
relevant insights according to the time value of money can be derived. The present highlighted
investment is offering positive net cash flow which is 243119 that is favourable indicator of the
project so that higher profitability can be obtained.
iv) Internal rate of return
year cash inflows
0 -588,300
1 190900
2 190900
3 190900
4 190900
5 190900
6 190900
IRR 23%
Internal rate of return is having ability to assess that how effective the particular
investment will offer return. On the basis of given information by computation it can be assessed
that internal rate of return is 23%.
Recommendation
From the economic feasibility of the particular project is highly effective as the
profitability, efficiency, etc. of the project is good. In addition to this, there are several aspects
such as time value of money, return on investment, higher profitability, etc. which is reflecting
that organization can achieve organizational objective higher profitability can be derived. There
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are several objectives of the organization which is required to be accomplished for having
significant growth and development of company. On the basis of payback period it can be
recognized that particular investment will recover investment in 3.1 years that indicates higher
efficiency. This is helpful in meeting the organizational objective of gaining greater amount
profitability via continuing operational practice. Discounted cash flow is helpful in meeting the
organizational goal of having net present value higher which is reflecting good sign of project
and indicating to accept the specific project. The IRR and ARR are higher that helps in
understanding that accepting project is beneficial for the company. On the basis of this, it can be
recognized that accepting project is beneficial for the organization in turn accepting the
particular machinery is recommended.
b) Critically evaluating the effects of new proposal on company
Capital structure is one of the crucial activity of business that is formulated by
appropriate proposition of debt and equity. It is essential for the organization to pay attention on
having relevant application of capital structure to influence business functioning positively.
There is requirement to pay attention on identifying the proper strategy of capital structure that
can boost the overall performance of the company. In the current proposal, it has been
emphasized that higher emphasis is provided on having 40% of capital equity which indicates to
pay remaining fund for cash dividend. Net income approach is one of the significant theory of
capital structure which indicates that firm value incline by decreasing the cost of capital (Capital
Structure and its Theories, 2020.). When organization need to pay less cost of capital it become
able to optimize the resources. The possibility of mentioned benefit is possible when cost of
debt is less than expense of equity, no tax, etc. on the basis of this approach it can be mentioned
that there is optimal structure of capital when there is less cost of debt.
On the other side, pecking order theory of the capital structure it can be recognized that
prioritizing their path of financing by least of resistance which is helpful in ensuring that internal
financing as preferred method. In addition to this, equity financing is considered to last resort of
having monetary resource. On the basis of this, paying attention on debt based capital is highly
preferred to get greater amount of benefits. Traditional theory states that minimum weighted
average cost of capital is minimized and then inclining market value of assets in maximized. On
the basis of the given theory of the capture structure it can be mentioned that there is
requirement to pay attention on having such optimal structure of capital so that achieving
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organizational objective can become possible. There should be significant proposition of debt &
equity so that significant level of benefit by ensuring lower cost of capital so that higher
effectiveness in managing operational activities can become possible.
c) Critical evaluation of benefits and limitation of various investment appraisal technique
According to Baum, Crosby and Devaney (2021) net present value is one of the
significant method of investment appraisal which allows to get the accurate information about
discounted cash flow according to the time value of money. There are several benefits of the
NPV technique of investment appraisal which includes that incorporate the time value of money
that aids in having accurate information. The decision making regarding acceptance of project
can be effectively done by the particular method. On the other side, Ogunbayo and et.al., (2019)
depicted that there are few lacking areas such no ability to compare projects. The other
limitations include ignoring sunk cost, optimistic projections, difficulty in estimating required
rate of return, etc.
In the views of Alkaraan (2020) payback period is one of the technique that is helpful in
determining the duration in which firm will become able to cover the initial invested capital.
There are various positive side of this particular technique of capital expenditure which
comprises simple use & understand, quick solution, preference to liquidity ad having useful case
of uncertainties. These provides assistance in having effective ability to make decision so that
achieving objective can become possible. In against to this, Bakri Bakri (2019) depicted that
there are few disadvantages which are needed to be eliminated for having effective performance.
This includes ignoring time value of money, not all cash flows covered, non-realistic, ignoring
profitability and neglecting the projects return on investment. These lacking part of the
technique that does not allow to make right choice of option which tend to impact the business
performance in negative manner. On the basis of this, it can be specified that these are the major
drawback which are required to be taken into consideration so that higher profitable decision can
be made.
According to this, Warren and Seal (2018) there are four types of technique of
investment appraisal which allows the investor to get ability to make strategic decision. The one
of the significant approach for evaluating the specific option internal rate of return is considering
to be accurate & effective. This provides assistance in calculating rate of return of the
investment. There are few benefiting part of this specific method which comprises time value of
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money incorporation, simple measurement and judgement of calculation, effective ranking of
project, non-requirement of required rate of return, On the other side, Lawal and et.al., (2021)
there are certain demerits which are require to focused for making effective evaluation which
involves economies of scale, impractical implicit assumption, neglecting of contingency
project, , non-classification of positive & negative cash flows, etc.
Idehen (2021) articulated that accounting rate of return is highly used approach which
assist in measuring the potential of generating profitability for long duration. In addition to this,
there are several kinds of pros which can be received by investor through application of this
specific practice of analysing the investment which involves easy to compute showing
profitability of investment, etc. in against to this Verma and et.al., (2021) limiting aspect that
impact the validity of the business includes ignoring life the project, fails to consider time value
of money and size of investment. From this, it can be specific that these are demerits of
particular method.
QUESTION 3- MERGER AND TAKEOVERS
Calculating the value of Dragon PLC
Before investing in other business it is very important for the company to critically
evaluate the other business option. Hence, for this valuation of the company need to be
undertaken and for this the following methods can be undertaken-
a) Price/ earnings ratio
The price to earnings ratio or the P/E ratio is the method of valuing the cost of company
by measuring the current share price and the earning per share of the company. Before taking or
merging with any of the company it is necessary that its price or the market value is being
calculated and in that case the use of price to earnings ratio is very important (Miciuła, Kadłubek
and Stępień, 2020). This is particularly because of the reason that this method assists in
analysing the relationship between the earning of the company and its stock price.
Particular Formula
Amount
(in £)
Distributable earning 40.4
Market price per share 4.15
Earnings per share 0.29
Number of shares 145
Prices earnings ratio of King plc (MPS/ EPS) 14.3
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EPS of Dragon plc 0.29
Value of share of Dragon PER of Kings plc * EPS of Dragon 4.15
Determining the marker value of
Dragon plc
Value of share of Dragon * number of shares
outstanding 601.75
With the above analysis it is clear that the market value of company Dragon plc is
£601.75. this simply implies that in case King plc will take over the company then they will
have to pay this much of amount to the company.
b) Discounted cash flow method
It is also a type of method which is being used in order to calculate the valuation of
company. The discounted cash flow is being calculated as sum of cash flow for every period is
being divided by the one plus the discounted rate. This is being used in order to calculated in
order to analyse the market value and then decide that whether the company is worth for merger
or not (Brotons and Sansalvador, 2018). The necessary element required for the calculation of
this is cash flow, discount rate and period and this is being used in order to value the company
and its current market position.
Particular Formula
Amount (in
£)
Net income 40.4
Less: increase in working capital 0
Less: capital expenditure 0
Add: Non- cash expenses 0
Free cash flow 40.4
Discounting rate 12%
MPS Free cash flow/ discounting rate 337
Number of shares 145
Market value of Dragon plc MPS * Number of share 48817
On evaluating the calculation based on the discounted cash flow method the value of
Dragon plc is 48817 which is the discounted cash flow. This simply means that the present value
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of the future cash flow is this much. With this it is evident that the King plc have to pay this
amount in future and this is discounted for the present value.
c) Dividend valuation method
It is also a type of method which is used in order to value the price of the company or the
stock on basis of information relating to the company’s dividend. In the present case of valuing
the company for merger this method is also assistive as it can be used in order to calculate the
current market value of the company (Fazzini, 2018). This model aims at looking at the future
cash flow being generated by the dividend for determining the price which the investor must pay
acquiring the stock of company. this method is based on the assumption that current price of the
stock is equivalent to sum of future dividend of company.
Particular Formula
Amount (in
£)
Latest dividend paid 0.14
Growth rate 2.50%
Risk free rate (Rf) 5.50%
Beta 1.05
Number of shares 145
Return on market (Rm) 6%
CAPM Rf + (Rm- Rf) * ß 6.02500%
Market value per share 4.070922
market value of Dragon plc Market price per share * number of shares 590.28
As per the dividend valuation method, the market value of Dragon plc is £590.28. this
simply means that in case King plc want to take over the company then they will be paying off
this much amount to Dragon plc for acquiring the position.
d) Evaluation of various techniques of valuation and recommending one method to the board
With the above analysis there is requirement of valuing the company in order to decide
that whether the company is worth investment or not (Pupentsova and Gromova, 2021). In case
the market value of the other company will not be good then this will be affecting the working
efficiency of the company. hence the various problem associated with the different valuation
methods are as follows-
Price to earnings ratio
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 The major limitation of using price to earnings ratio for company valuation is that it is
difficult to value the company. This is because of the reason that each and every
company has different growth rate and it is not necessary that at time of valuing it is
considered in same manner.
 Further another limitation is that this method of valuation does not provides the anything
relating to the EPS growth of the company and this does not outline accurate
information.
Discounted cash flow method
 The drawback of using this method for valuing the company is that this method is prone
to the errors and as a result of this precise and accurate information will not be analysed
properly.
 Moreover, another limitation of using this method of valuation is that this method
undertakes the use of too many assumption and because of this, proper working will not
be ensured.
 Along with this another limitation of using this method for valuing other company is that
this method does not include valuation of the competitors. Hence, this does not provide
the accurate and correct information.
 In addition to this another limitation of using this method for valuing company is that
there is requirement of high degree of confidence relating to the cash flow in future.
 Furthermore, another drawback of using this method of valuation is that the terminal
value of this includes too much of total value (DCF Analysis Pros & Cons, 2022).
Hence, a little variation of difference between the assumption creates an improve over
the terminal year as well which in turn affects the final valuation of the company.
 Moreover, this method is also not good because of the reason that it is not suitable for the
short term investment and it only focuses on the long term value creation of the firm.
Dividend valuation method
 With the analysis of the method it is clear that the limitation of using this method is that
this method is not applicable in case of stocks which does not pay dividend. Also, this
method only operates in case the dividend of the stock is expected to rise in future as
well.
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 Moreover, another limitation of using this method for valuing the company and its
market position is that there are too many assumption being involved at time of the
calculating. There are different assumption relating to the dividend, growth rate, interest
rate and other market rates as well. Thus, in case the assumption will not be correct then
this will be affecting the whole valuation in negative manner.
 Along with this another limitation of using dividend valuation method is that there is
very less control over the elements being considered while calculating the value. This is
because of the reason that all the rates like growth, market rate, risk free rate and others
are not in hand of company (Dranko, 2020). So changes in all these elements can affect
the working and calculation of the company and its value and these changes are based on
changes in market condition.
 In addition to this, another limitation of using the dividend valuation method is that the
dividend is not related to the earning of the company. This is because of the reason that it
is the income of the business and as a result of this it must not be correlated with the
earning of company.
With the above analysis it is clear that there are many drawbacks of all the different
methods which are being used by the company for valuation. Hence, it is recommended to King
plc that they must use the price earnings ratio for the valuation of the other company at time of
merger. The reason for selecting the price to earnings ratio is that this provides much better view
of the project and its viability. The reason behind this fact is that in case this method is good and
will provide for the better view that whether the project of takeover will be beneficial to the
company or not. Along with this, above calculation also highlights the fact that price to earnings
ratio is beneficial for the company as it is providing limited market value of the company which
need to be taken over.
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REFERENCES
Books and Journals
Alkaraan, F., 2020. Strategic investment decision-making practices in large manufacturing
companies: a role for emergent analysis techniques?. Meditari Accountancy Research.
Bakri Bakri, A., 2019. Capital investment appraisal: the case of Lebanon (Doctoral dissertation,
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Baum, A.E., Crosby, N. and Devaney, S., 2021. Property investment appraisal. John Wiley &
Sons.
Brotons, J. M. and Sansalvador, M. E., 2018. Fuzzy systems in business valuation. International
Journal of Uncertainty, Fuzziness and Knowledge-Based Systems. 26(Suppl. 1). pp.1-19.
Dranko, O., 2020, September. The Aggregate Model of Business Valuation by Three Methods.
In 2020 13th International Conference" Management of large-scale system
development"(MLSD) (pp. 1-4). IEEE.
Fazzini, M., 2018. Business valuation: Theory and practice. Springer.
Idehen, A.V., 2021. Capital investment decisions of small and medium enterprises in Benin-
City, Nigeria. International Journal of Research in Business and Social Science (2147-
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Lawal, Y.S and et.al., 2021. A simulation-based binomial model for building development
appraisal. Journal of Engineering, Design and Technology.
Miciuła, I., Kadłubek, M. and Stępień, P., 2020. Modern methods of Business Valuation—case
study and new concepts. Sustainability. 12(7). p.2699.
Ogunbayo, O.T and et.al., 2019. The significance of real estate development process analysis to
residential property investment appraisal in Abuja, Nigeria. International Journal of
Construction Management. 19(3). pp.270-279.
Pupentsova, S. V. and Gromova, E. A., 2021. Risk Management in Business Valuation in the
Context of Digital Transformation. Real Estate Management and Valuation. 29(2). pp.97-
106.
Verma, S and et.al., 2021. Investment appraisal and financial benefits of corporate green
buildings: a developing economy case study. Built Environment Project and Asset
Management.
Warren, L. and Seal, W., 2018. Using investment appraisal models in strategic negotiation: The
cultural political economy of electricity generation. Accounting, organizations and
society. 70. pp.16-32.
Online
Capital Structure and its Theories. 2020. [Online]. Available through:
<https://efinancemanagement.com/financial-leverage/capital-structure-and-its-theories >.
DCF Analysis Pros & Cons. 2022. [Online]. Available through: <
https://corporatefinanceinstitute.com/resources/knowledge/valuation/dcf-pros-and-cons/>
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