Financial Management: Valuation of Companies and Investment Appraisal Techniques

This document provides an overview of financial management, focusing on the valuation of companies for acquisition and different investment appraisal techniques. It covers topics such as price earnings ratio, dividend valuation model, discounted cash flow method, payback period, accounting rate of return, net present value, and internal rate of return. The content includes detailed calculations and recommendations for Aztec plc and Love-well plc.

FINANCIAL
MANAGEMENT

Contents
INTRODUCTION.....................................................................................................................................3
MAIN BODY.............................................................................................................................................3
Question 2 – Mergers and Takeovers......................................................................................................3
Question 3: Investment appraisal techniques...........................................................................................8
CONCLUSION........................................................................................................................................15
REFERENCES........................................................................................................................................16

INTRODUCTION
In general, the financial management can be understood as a form of function which is
connected to effectively management of financial aspect of a company (Chandra, 2020). Under
financial management various kinds of activities are managed such as profitability, return, cost
and many more. This is the duty of financial managers to make effective use of all available
financial resources by making appropriate allocation. The objective of this project report is to
understand about different kinds of financial terms as valuation of companies for acquisition,
analysis of projects under investment appraisal methods. The report contains two questions
which are based on theoretical and practical application of merger & acquisition as well as on
different investment appraisal techniques.
MAIN BODY
In the project brief, there are three questions and out of these two questions have been selected
which are question two and three. Underneath, detailed solution of these questions has been done
in such manner:
Question 2 – Mergers and Takeovers
Overview: This question is based on valuation of company with an aim of acquiring. As per the
given information, it can be find out that Aztec plc is going to take over Trojan plc in upcoming
time period. For this purpose, detailed valuation of Trojan plc has been done so that managing
director of Aztec plc can determine that whether they should acquire or not this company.
(a) Price earnings ratio- Share price / Earnings per share
In order find out value of price earnings ratio, there should be availability of information
about share price and earnings per share. In accordance of brief, following information
are available such as:
Price of each share £2.05
Number of share outstanding 147 Million
Net income £40.4 Million

Computation of value of earnings per share:
EPS= Net income / Number of share outstanding
= £40.4 Million / 147 Million
= £0.27
From above part, value of both EPS and share price have been found, therefore price
earnings ratio will be as:
Price earnings ratio= £2.05 / £0.27
= 7.59
Interpretation: As per the above calculated value of price earnings ratio this can be find
out that Trojan plc is generating effective earnings from each share. Their earnings on
each share is around 0.27 pounds while value of each share is 2.05 pounds. Therefore,
price earnings ratio at 7.59 seems good to acquire Trojan plc by Aztec plc.
(b) Dividend valuation model:
Under this method, valuation is done in accordance of paid dividend during financial
year. There is a formula to apply this model that is as follows:
D1 / (1 + k) + D2 / (1 + k) 2 + D3 / (1 + k) 3 + D4 / (1 + k) 4………….
In this formula:
D1 refers to amount of dividend paid in 1st year.
D2 refers to amount of dividend paid in 2nd year.
D3 refers to amount of dividend paid in 3rd year.
D4 refers to amount of dividend paid in 4th year.
K refers to predicted rate of return

Given data:
Amount of dividend paid in 1st year (D1) 10p
Amount of dividend paid in 2nd year (D2) 10.5p
Amount of dividend paid in 3rd year (D3) 11p
Amount of dividend paid in 4th year (D4) 12p
Predicted rate of return (K) 11%
Putting values in formula:
= 10p (1 + 11%) + 10.5p (1 + 11%)2 + 11p (1 + 11%)3 + 12p (1 + 11%)4
= 10 p (0.11) + 10.5p (0.11)2 + 11p (0.11)3 + 12p (0.11)4
= 11.1 + 10.5 (0.0121) + 11 (0.001331) + 12 (0.000146)
= 11.1 + 0.127 + 0.014 + 0.00175
= £11.24
Interpretation- As per the dividend valuation model, this can be find out that Trojan plc’s
share value is around 11.24 pounds. It is indicating that company is able to pay an
effective sum of dividend to their stakeholders at the end of each financial year. In the
context of above Trojan plc, last four years’ dividend have been used to find out value of
share.
(c) Discounted cash flow method
In this method, valuation is done in accordance of cash flows by applying below
mentioned formula:
CF1 / (1+r)1 + CF2 / (1+r)2 + CF n / (1+r) n
Given information:
r= 5%
Cash flow= 40.4 Million Pounds
Putting values in formula:
= £40.4/ (1+5%)

= £808
Interpretation: In accordance of above calculated value of share price under DCF method
this can be stated that Trojan plc is generating effective earnings. This value of share is
computed in accordance of cash flow for year one and cost of capital at 5%.
(d) Analysis of problems associated with above mentioned valuation methods.
Price earnings ratio: It can be defined as a type of ratio which is associated with stating
relation between price of share and earnings on share of a company (Itemgenova and
Sikveland, 2020). This type of ratio is crucial for companies in order to do effective valuation
of a company in term of stock price. Basically, under it study of stock is done with an aim of
identifying measuring stock price of company. In the context of stakeholders and investors,
this ratio is useful as they can do comparison of current market value of company with
earnings. Using this ratio may lead to so issues or drawbacks which are explained below in
such manner-
Drawbacks:
 The main issue of using this ratio is that under it structure of debt/ finance is
completely neglected which lead to ineffective valuation.
 By using this ratio, users cannot get information about earnings per share growth
of company. As a consequence, investors do not find it useful to take decision for
making investment.
 In addition to this, it cannot be implemented in those companies which are
fronting the financial loss (Freihat and Razaq, 2019). The reason behind this issue
is that price earnings ratio fail to determine amount of loss during starting time
period of growth.
 Lastly, the anticipation of investors may become cause of inflated prices of stock
for entire sector. The reason behind this is that at the time of recession, share
value can be under evaluated in relation to PE ratio. While at the time of inflation,
earnings of businesses can be assessed as per the value of currency of any specific
country. As a consequence, value of price earnings ratio can be higher.

Dividend valuation model- This model of valuation is based on a theoretical framework
which states that stock is valuable of whole further dividend payments. It is linked with
measuring fair value of stock regardless of existing business condition that takes into
consideration the various dividend distribution factors (Akben-Selçuk, 2020). In the case
when interest gained through DVM is higher than price of currency stock exchange then
stock is considered undervalued vice versa. In order to measure value of stock under this
model, past years’ paid dividend are considered. As in regards to above company’s
valuation previous four years’ dividend has been used in order to do proper valuation.
This model has some limitations which are explained below:
Drawbacks:
 The main issue under this model is that it can be implemented on those
companies’ stock on which dividend is paid by them regularly. Like small
companies cannot apply this model because they do not make payment of
dividend. As a result, it becomes difficult for big companies to do proper
valuation of small companies.
 Another drawback of this method is that it considers only one factor for valuation
which is dividend. Apart from this factor, it neglects all other main factors such as
customer retaining, loyalty and many more (Hendrawan and Rahayu, 2020). Due
to this, it is not considered by most of the companies for complete valuation.
 In some regions, companies do not like to pay dividend due to perspective of tax
benefit. As a result, investors focus to make investment in rebuying of stock. In
this case, above method fails completely.
 In order to successful implementation of this model, there must be a range of
correct information. In the case if provided information is wrong then outcome
will also inaccurate which may lead to wrong valuation of company.

Discounted cash flow method: This is defined as a form of method under that valuation
of a company is done on the basis of future time period’s cash flow. Basically, main aim
of this method is to find out upcoming time period’s cash flow by using current financial
years’ information (Laitinen, 2019). One of the main feature of this method is that it is
used by both including owner of a company and investors. It is so because this method is
helpful to provide accurate information related to valuation. Though, it has some
limitations such as:
Drawbacks:
 The major drawback of this method is that under it a rage of assumptions is made
such as about cost of capital, upcoming period’s cash flow. Due to these
assumptions, it becomes difficult for companies to relay on this method.
 In addition to this, it is not suitable for those investment projects which are termed
for less than one year (Li, 2020). This can be applied only in those projects which
are termed for more than one year. It is so because this can be expensive and time
consuming for short term investment proposals.
 The efficiency of this method depends on availability of cash flow for more than
one year. In the absence of cash flow for less than two years then it cannot be
used for valuation.
Recommendation to Aztec plc- On the grounds of above mentioned three valuation
models, it can be suggested to board of Aztec plc that they should use Dividend valuation
model for valuation of Trojan plc. The rationale behind this that under DVM a detailed
analysis of share is done which makes easier to owner of companies to valuate a
particular company. While in rest of two methods including price earnings ratio and
discounted cash flow, there are a lot of drawbacks which makes valuation less effective.
As well as both of methods are suitable only for analysis of earnings and stock price
instead of share valuation.

Question 3: Investment appraisal techniques.
Overview- This question is based on application of different investment appraisal methods in
order to take correct decisions. As per the given scenario, Love-well plc is planning to buy a
new machinery whose cost is around 275000 pounds. Before making investment in this
machinery they want to do proper evaluation of machinery by help of different methods.
Calculation using different kinds of methods of investment appraisal along with
recommendations:
(a) Payback period: Under this method, there are two types of formulas which are mentioned
below:
Payback period: Initial investment / cash flow (When there is equal cash flow)
Payback period: Year before recovery of investment + amount to be recover/next years’
cash flow (When there is unequal cash flow)
Given data:
Investment £275000
Cash inflow (for six years) £85000
Cash outflow (for six years) £12500
The above data is indicating that there is equal cash flow for all six years, hence formula
will be accordingly:
Cash flow= Cash inflow - cash outflow
= £85000 - £12500
= £72500
Hence, payback period= £275000/£72500
= 3.79 years

Recommendation: In accordance of above done calculation, this can be find out that cost
of new machinery will be recovered in around 3.79 years. The machinery whose life is
around 6 years but its cost will be covered in almost half years of entire life. Hence,
Love-well plc should buy this new machinery in accordance of computed outcome under
payback period.
(b) Accounting rate of return:
Given information-
Step one:
Step two:
Step three:

Step four:
Recommendation: From above calculated value of ARR, this can be find out that new
machinery will produce return at the rate of 25.56%. This rate is higher in relation to
investment of 275000 pounds. Above company should by this new machinery because of
its higher rate of return.
(c) Net present value:
Cost of capital: 12 % (R1)
Recommendation: On the basis of above calculated value of net present value of
machinery this can be find out that value of machine is around 44034 pounds. In relation
to tiny investment of 275000 pounds, this value of NPV is fair enough to do the
investment. So manager of above Love-well plc should consider this machinery to
purchase.

(d) Internal rate of return (IRR)
Increase cost of capital at 20% (R2)
R1 = 12
R2 = 20
NPV1 = £44,033.75
NPV2 = -£ 20,118.75

Recommendation: From above calculation of IRR this can be suggested to Love-well plc’s
manager that they should purchase the machinery. It is so because internal rate of return is higher
which is of 17.52%. If above company will make investment in the new machinery, then they get
return at the rate of 17.52 which is fair enough in relation to cost of project.
2. Critical evaluation of benefits and drawbacks of investment appraisal methods.
(a) Payback period- It can be defined as a form of investment appraisal approach that is
associated with process of obtaining approximate time period to recover investment costs (Bakri
Bakri, 2019). Just two variables are needed in this approach which are cash flows and investment
value. This function of lower variables facilitates the analysis of kind of project. As for Love
well plc, this formula was introduced which specifies that their project costs would be recovered
in 3.79 years.
Merits Demerits
As stated in the above portion, this approach
is simpler to enforce, making it ideal for all
forms of businesses whether small or big. As
well as under such approach, project
effectiveness evaluation can be performed in
less time and expense. However, it may be
done by any individual in an organization,
since it does not demand any special
experience and skills in accounting (Onuorah,
2019).
It has certain disadvantages which render
results less accurate such as variables like
time value of money are overlooked under
this system. Despite of this, depending on
generated result is problematic for users,
because time value of money is one of the key
considerations to remember when assessing a
project.
(b) Accounting rate of return- It is another easy way of assessing investment proposals. Under
this a formula is used to calculate the rate of return from which a project can deliver profit in the
future. By help of this method, businesses take appropriate action to procure some financial
initiative on the grounds of determined result (Jagun, Daud and Samsudin, 2020). Similar to the

approach mentioned above, this often needs minimal knowledge to provide the final result. As
for Love-well plc, this method was used to calculate the expected yield rate of 25.56 percent.
Merits Demerits
This approach has a number of benefits which
makes it successful to use as under it
accounting revenues are used while net cash
flows for project assessment are used in other
approaches. As well as other good feature of
this method is that it is easy to use as it is
focused on formula implementation that
everyone inside the company may execute.
The ARR approach does not take into account
the time value element that is a significant
aspect. This makes outcome less accurate and
effective (Kabanda, 2019). Beyond this, cash
flows under it are totally neglected which is
not so beneficial in terms of a project's
performance evaluation.
(c) Net present value: This is described as a form of method used to measure a project's current
value. Under it, project current value is calculated by deducting investment sum from
accumulated cash flow of the respective years. Within it, the discounted cash flow valuation is
calculated using the expected Present Value (PV) element (Jagun, 2020). The process is
commonly regarded as NPV. This approach has been implemented in the sense of the Love-well
plc to assess the net present value of the planned machinery.
Merits Demerits
The main advantage of utilizing this approach
is that in the course of measuring project's
current value it includes time value of money
element (Boeri, 2019). It makes this more
powerful and productive approach relative to
the methods described above, as time value
element has been overlooked in the above
approaches. Another important aspect in this
approach is that calculating the current value
of the investment considers cash flows overall
The key downside to this approach is that it is
difficult to implement because of the cost of
capital related assumptions. As well as this
assumption, makes judgments less accurate
and unsuccessful. In addition to that, fixed
expenses for measuring current project value
are not included within it.

years.
(d) Internal rate of return: It can be defined as a form of approach that applies to the process of
determining a project's real cost of return. This mode is considered a type of approach that is too
difficult to use since proper financial knowledge and expertise is needed (Tariq and Khattak,
2019). As well as only those individuals who have adequate information regarding accounting
may apply this process. With regard to the above-mentioned business, accounting professionals
have applied this approach to know for the future about the productivity of new equipment.
Merits Demerits
The biggest benefit of this method is that it
delivers accurate outcomes that make it easy
for administrators to take effective action. In
addition, all important variables are included
before determining the performance of a
project.
The main demerit of this approach is that it
needs a lot of financial and account
information (JUSTICE, YEBOAH and
PIOUS, 2020). Because of which companies
require experience that renders this approach
costlier and time consuming. As well as it
cannot be applied in such ventures that are
limited or with fewer financial resources.
CONCLUSION
Based on the aforementioned project analysis, it can be stated that financial management
is one of the core components for the effective use of a company's financial resources. The study
articulates the Dividend valuation model must be regarded by Aztec plc, as it is more efficient
than other valuation models. In fact, they can take over to Trojan plc, since results are
appropriate in all valuation models. It can be inferred from the second section of the study that
Love-well plc should buy new equipment as certain forms of investment appraisal are delivering
favorable outcomes.

REFERENCES
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JUSTICE, A., YEBOAH, E.N. and PIOUS, O., 2020. Capital Budgeting as a Tool of
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