Valuation Methods in Financial Management

This document discusses various valuation methods used in financial management, such as price/earnings ratio, dividend valuation method, and discounted cash flow method. It provides step-by-step calculations for determining the value of a firm using these methods. The document also explores the benefits and limitations of each technique. Additionally, it covers topics related to mergers and takeovers, as well as investment appraisal techniques like payback period, accounting rate of return, net present value, and internal rate of return.

Financial Management

TABLE OF CONTENTS
QUESTION 2 – MERGERS AND TAKEOVERS...................................................................3
Calculating the value of Trojan plc using the following valuation methods.........................3
d. Critical evaluation of various valuation techniques...........................................................4
QUESTION 3 – INVESTMENT APPRAISAL........................................................................7
1. Application of different investment appraisal techniques..................................................7
2. Benefits and limitations of different investment appraisal techniques............................10
REFERENCES.........................................................................................................................14

QUESTION 2 – MERGERS AND TAKEOVERS
Calculating the value of Trojan plc using the following valuation methods
a. Price/earnings ratio
Earnings per share = Distributable earnings /number of
shares
40.4/147
0.27
Market price per share 2.05
Price earnings ratio = Market price per share/Earning per
share
2.05/0.27
7.46
Value of the firm 7.46*40.4
301.38
b. Dividend valuation method
Market price = D(1+g)/(Ke-g)
As per CAPM,
Ke=Rf+(Rm-Rf)ß
=5+(11-5)*1.1
11.6
Market Price =13(1+0.02)/(.116-
0.02)
138.125
Value of the firm = Market Price *
number of shares
20304.38 pounds
c. Discounted cash flow method
Discounted cash flow

Net operating profit 40.4
Add: depreciation 0
Add: change in working capital 0
Less: change in capital
expenditure
0
Free cash flow 40.4
Discounting rate = WACC = 9%
Present value of cash flow = Annual cash flow /
discounting rate
Cash flow growth rate 2%
= 40.4(1+0.02) / (0.116-0.02)
= 429.25
Value of firm 4769.44 pounds
d. Critical evaluation of various valuation techniques
Price/earnings ratio
The P/E ratio is the assessment of market price per share in proportion to the earnings
per share. The EPS is determined using the performance data of past four quarters of the
company. The higher ratio suggests the higher expectation by means of the investor with
respect to higher profits in the future period in comparison to low P/E ratio. The relationship
between those two shows what the market is inclined to pay primarily based on the current
income earning level and also indicates if the market is overvaluing or undervaluing the
company (Leibowitz, Kogelman and Bova, 2019). An upward push in the earnings per share
will lead to the rise in the market price and the lower earnings per share (EPS) shows fall in
market rate per share. This ratio is very useful in evaluating the companies within the same
industry. But the high price earnings ratio is taken into consideration to be the risky
investments in comparison to the lower ones and this is because of the reason that higher ratio
indicates higher expectations.
In mergers and acquisitions, it is essential to analyse the ratios of the organizations in
a similar industry. This ratio can be misshaped by the organization which is completely
relying on how the organization has represented the things and depends on the accounting

guidelines which varies from nation to nation which can be counted as another issue. In case
of seasonal firms, it requires an increasingly more detailed examination and the lower P/E
proportion will mean cheap that is all off-base since it is precisely an inappropriate or the
wrong time to purchase such firms. The earnings per share (EPS) determined incorporates a
great deal of noises and may not represent the true picture of the performance of the business.
It additionally ignores the effect of debt obligation while focussing on market capitalization.
This ratio is mostly utilized for the investment valuation since it shows the expected price of
the share which is based on the organization's profit. Accordingly, every one of these issues
in relation to the P/E ratio should be dealt with carefully as it has a huge effect on the
organizations decision making process.
Dividend valuation method
This valuation technique is utilized in assessing the overall value of a stock which is
then contrasted with the market cost price at which the stock is exchanging. The primary
benefit of this strategy is that dividend will in general remain steady over some period of
time. Organizations utilizing this model, doesn't set up higher dividend desire on the grounds
that not meeting with similar will influences the stock price later. This strategy utilizes net
present value of the expected dividend for the purpose of estimating the stock (Piatti and
Trojani, 2019). It is determined by dividing dividend payment in the following period by the
difference between cost of equity and dividend growth rate. This strategy is straightforward
as it esteems the organization's stock without considering the economic situations.
The issues related with this technique is that it is hard to project accurately. It is also
known as dividend discount model. This method can be utilized in assessing the potential
dividend income however it has a few downsides. It can't assess those stocks which doesn't
pay dividend irrespective of the capital gain realized. It is based on the assumption that the
value of the stock is the return on investment. For valuation, it utilizes different estimations
presumptions, for example, rate of return, growth rate. For instance, dividend yield changes
over a period of time, if any projections made in the computation are somewhat in error will
result into determining the value either exaggerated or underestimated. It doesn't assess non-
profit factors, for example, brand loyalty, ownership of intangible assets. This valuation
technique is reliant upon the assumption that the dividend growth rate will stay steady and
known. It additionally assumes that the stock price is extremely sensitive to dividend growth
rate and furthermore it can't surpass cost of equity which isn't in every case valid. Be that as it

may, there were different attempts for overcoming these issues yet it will include a lot of
additional calculations relating to projections and are likewise subject to mistakes. Another
issue is that it disregards the impact of stock buyback which can be termed to be too
conservative in the estimation of stock worth.
Discounted cash flow method
The DCF strategy focusses on determining the current value of the asset or the
company. It depends on the assumption that the estimation of value today is more than what's
to come in future. This strategy is helpful in assessing the intrinsic value of the organization.
It requires a lot of details upon which the intrinsic value is estimated of the stock. The
advantages of this strategy are that it considers all the significant business presumption and it
doesn't require any comparable organization (Tripathi, 2017). It is the best and appropriate
method for analysing the mergers and acquisitions. This method can be used in calculating
internal rate of return and also allows sensitivity analysis. This strategy is very sensitive
method which depends on the assumption in respect to the perpetual growth rate and discount
rate.
In this technique, any minor error will cause the changes in the valuation and the fair
value determined won't be precise. This method functions admirably just in the circumstance
of having high level of confidence however the organization's activity lacks visibility it
creates which causes trouble in anticipating the business, costs identified with business
activity and capital investment. Predicting income for future years is exceptionally
troublesome, doing it perpetually which is required in discounted cash flow method
sometimes becomes impossible. This method is inclined to high mistakes. The serious
problem of this method is that the terminal value involves the total value, that is, 65-75% and
a slight variation in the terminal value will significantly affect the whole valuation. This
technique isn't appropriate for short term business as it focusses on making long term value.
It likewise depends on market demand, unanticipated uncertainties and so forth. Likewise,
estimating the future income high may bring about choosing the investment that would not be
able to pay off later on, affecting benefits.
In this way, from the above basic examination of different valuation strategies, it can
be very well said that the discounting cash flow method should be utilized by the
organization. Additionally, it ought to be utilized by financial experts with relevant
knowledge in the field as they are skilled in building budgetary models. It is the most

appropriate technique as it helps in showing signs of improvement and precise outcomes.
Alongside that, appropriate consideration and focus is required in determining and valuation
on the grounds that even a minor mistake will prompt wrong valuation which can influence
the presentation and working of the business.
QUESTION 3 – INVESTMENT APPRAISAL
1. Application of different investment appraisal techniques
a. The payback period
The payback period (PBP) shows the length of time it'll take to get the amount
invested within the undertaking. It determines the break-even point after which the project
starts earning profit. It is a very essential and smooth to use technique (Balabanov and et.al,
2017). It is usually favourable to have shorter payback period as it means that the
organization can recover the amount invested speedy so that it will be able to reinvest it in
another task. This technique also facilitates in taking quick decisions.
Compute the payback period (PBP)
Payback period (PBP)
PBP 3.79 years
From the above calculations, Lovewell limited is in the position to recover the amount
invested in 3.9 years which seem to be economically feasible because the money is recovered
within the half of the useful life of the asset, which also indicates the higher earning potential
of the business.
b. The Accounting Rate of Return
The accounting rate of return is the return which is expected from the investment in
turn of the capital contributed. This technique is utilized for assessing the profitability of the
project and is also helpful in comparing the multiple projects individually (Siziba and Hall,
2019). The ARR is feasible for the Lovewell Limited to acquire the machinery as the
£ 275,000
( £ 85,000−£ 12,500)
Initial investment
( Annual cash flow− Annual cash outflow)

accounting rate of return is higher than the cost of capital and thus, it is ideal for the
organization.
Compute the average investment
Average investment
£158,125
Compute the accounting rate of return
(ARR)
Accounting rate of return
ARR 45.85%
c. The Net Present Value
The net present value is one of the capital budgeting technique utilized for assessing
the project with respect to the cash flows. It is determined as the difference between the
present value of cash inflow and cash outflow. This technique is utilized for identifying the
profitability and gains associated with the project (Häcker and Ernst, 2017). The positive net
present value implies that the organization can proceed with the venture as the anticipated
income is more than the foreseen cost. The negative net present value shows that the expense
surpasses the profit which isn't favourable for the organization.
Initial investment +Salvage value
2
£ 275,000+( £ 275,000∗15 %)
2
£ 316,250
2
( Annual cash flow− Annual cash outflow)
Average investment
( £ 85,000−£ 12,500)
£ 158,125
£ 72,000
£ 158,125

Calculating NPV
Cost 2,75,000
Life 6 years
Cost of capital 12%
Net annual inflow Annual cash flow-Annual cash outflow
(85000-12500)
£72500
Net present value Present value of cash inflows - Present value of
cash outflows
Year Cash flow
in £
PV factor
@12%
Present value (PV) in
£
0 -2,75,000 1.000 -2,75,000
1 72500 0.893 64732.14
2 72500 0.797 57796.56
3 72500 0.712 51604.07
4 72500 0.636 46075.06
5 72500 0.567 41138.45
6 72500 0.507 36730.76
6 41,250 0.507 20898.53
NPV £43,976
From the above, it can be clearly seen that the NPV of the project is positive which
means that the Lovewell limited can invest in acquiring the new machinery because the
present value of cash inflow is much more than the cash outflow and is assumed to be more
profitable and thus, it is very feasible to make an investment.
d. The Internal Rate of Return
This technique is the investment appraisal which is used in estimating the profitability
in relation to the potential investment plan of the business (Magni, 2016). This is the rate at
which the net present value (NPV) is zero. This technique is very significant in taking the
business decisions with respect to the future growth and expansion.
Calculating internal rate of return using trial and error approach

Year Cash flow in £ PV factor @15% Present value (PV) in £
0 -2,75,000 1.000 -2,75,000
1 72500 0.870 63043.48
2 72500 0.756 54820.42
3 72500 0.658 47669.93
4 72500 0.572 41452.11
5 72500 0.497 36045.31
6 72500 0.432 31343.75
6 41,250 0.432 17833.51
NPV 17,209
Year Cash flow in £ PV factor @18% Present value (PV) in £
0 -2,75,000 1.000 -2,75,000
1 72500 0.847 61440.68
2 72500 0.718 52068.37
3 72500 0.609 44125.74
4 72500 0.516 37394.69
5 72500 0.437 31690.42
6 72500 0.370 26856.29
6 41,250 0.370 15280.30
NPV -6,144
IRR
17.18%
It can be computed from the above that the Lovewell limited should invest in
acquiring the machinery as the internal rate of return is 17.18% more than the 12% rate of
¿ 15+ net present value @15 %
net present value@ 15 %−net present value @18 % *(18-15)
¿ 15+ 17209
17209−(−6144)*3
¿ 15+ 17209
23353 *3

cost of capital which is not much higher and may not be able to add more value to the
investment. But then too, it is feasible to invest in acquiring the new machinery.
2. Benefits and limitations of different investment appraisal techniques
The Payback Period
It is the measure of time takes to create the money inflow from the investment made.
It determines point at the which company is in the position of no profit no loss and after it
starts earning income. It is determined by dividing cash invested in the project initially with
the income generated annually. The main advantage of this procedure is that it is very easy
and simple to compute and gives data on risk identified with the venture. It is an important
tool which is utilized in estimating the liquidity (Sinha and Datta, 2020). But on the other
side, this method does not take into account the time value of money and furthermore it is
progressively concerned about the liquidity and not the benefit. It doesn't consider the
incomes outside the payback period which may prompt misleading of data. Another
disadvantage is that it leans towards shorter payback period (PBP) without considering the
overall life of the investment. It can't draw any differentiation between the undertakings
having same payback period. Another significant point is, it doesn't think about residual value
of the asset after the completion of the project.
The Accounting Rate of Return
It is the expect rate of return on the investment made which is presented in
percentage. It is determined by dividing annual operating profit by the average investment.
Higher the accounting rate of return (ARR), the more it is beneficial for the company. ARR is
can be calculated used easily. It considers net operating income which is utilized by creditors
and investors for assessing the performance of the business organization (Gul, 2018). Be that
as it may, this method doesn't represent time value of money and focusses on net operating
income as opposed to cash inflow and furthermore it doesn't stay steady over the life of the
venture which results into making the project look desirable at one point and opposite in
another.. This technique cannot be utilized in comparing the undertakings with diverse life
expectancy. The timings and the patterns of money inflow is totally disregarded and doesn't
represent vulnerability and inflation. It additionally does not represent wealth and
performance. As a result of which it is generally utilized in short term projects. Accordingly,
it is ought to be utilized carefully.
The Net Present Value

This method is the most frequently and widely used discounting technique. It is
essentially the estimation of future incomes over the life of the venture or speculation which
is discounted to the present. It helps in assessing the value of the investment in regard to
income and profitability. This strategy considers the time value of money in regard to all the
incomes over the life of the venture and also accounts for the timing and patterns of the cash
inflow. It measures the total net worth of the firm which may result regarding the adjustments
in association with the investment (Gaweł, Rȩbiasz and Skalna, 2017). Dissimilar to, IRR it
doesn't based on the assumption that the incomes will be reinvested at IRR. This strategy
helps in distinguishing whether the specific venture will have the option to create enough
income that will surpass the expense of the undertaking. The positive net present value means
that the venture can be embraced and negative means it can't be attempted. This technique is
valuable in the event of picking just one investment proposal from the various by measuring
the benefits of each project and afterward choosing the right and high gainful venture.
But, this method experiences certain disadvantages. Computing NPV is a little mind-
boggling process and determining the right discounting rate is significant for calculating
present value. Along these lines, cost of capital represents different components which helps
in ensuring higher objectivity. It takes into consideration inflation and risk. In cases of
mutually exclusive investment proposals, NPV might give misleading outcomes. There is no
set rule for computing NPV and it is left at the decision of organizations which may prompt
wrong return. Shot term project with higher NPV may not support the earning per share and
also return on equity and probably won't work in the favour of the organization's investors.
The Internal Rate of Return
IRR is the discounting rate at which NPV is equivalent to zero. It is utilized to
measure and compare the rate of growth of different business plans and investment proposals
and this strategy is the basic measure used to choose which venture yield more significant
yields. IRR gives exact rate of return for every single undertaking in contrast with the
expense of venture. It gives a idea to the investors and lenders, the potential return related
with the venture. IRR likewise considers the time estimation of money and aides in assessing
exact return and furthermore it is extremely simple to determine and understand (Kim, Fallov
and Groom, 2020). This strategy helps in expanding the benefit and investor's wealth. This
technique additionally has a few restrictions. It depends upon the assumption that cost of
borrowing and lending will remain the same. It is totally based on estimation and requires the

use of the trial and error approach and disregards economies of scale. It requires the estimated
cost of capital for the purpose of making any choice. Another limitation is that it expects that
all the incomes can be reinvested in the market at the IRR and if the average rate of return in
too far off to the IRR then the productivity isn't reasonable.

REFERENCES
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