Company Valuation and Problems with Valuation Techniques

This document provides information on valuing a company using P/E ratio and Dividend growth model. It also discusses three problems associated with these valuation techniques and recommends which value(s) Ringo Plc should use.

SRN number
BP0223949
Finance online exam

Question 1 (34 marks) – Company Valuation
Ringo plc is planning to take over a smaller private limited company, Stellar Ltd, and needs to
value the company.
Ringo plc has gathered the following data:
Ringo Plc
Weighted Average Cost of Capital (WACC) 14%
Price/earnings (P/E) ratio 12
Shareholders’ cost of equity 16%
Stellar Ltd
Current dividend payment 27p
Past 5 years’ dividend payments (earliest first) 15p, 17p, 19p, 21p, 23p
Current earnings per share (EPS) 38p
Number of ordinary shares in issue 4 million
Requirements:
Given the information provided above, estimate values for Stellar Ltd using the following
valuation methodologies:
P/E ratio and;
Dividend growth model (16 marks)
Discuss THREE problems associated with using the above valuation techniques and recommend
which value(s) Ringo Plc should use. (18 marks)

Solution:
(a) Valuation methods:
(i) P/E ratio: Share price / earnings per share
Earnings per share: 38 p
Share price: 1 Pound (Assumed)
PE ratio: 1 pounds/38 pence
= 2.63
(ii) Dividend growth model:
Value of stock: D1/(K-G) + D2/(K-G) +D3/(K-G) +D4/(K-G) +D5/(K-G)
= 15/ (10-8) +17(10-8) +17(10-8) +19/ (10-8) +19/ (10-8) +21/ (10-8) +23/ (10-8)
= 15/2+17/2+19/2+21/2+23/2
=7.5+8.5+9.5+10.5+11.5
= 47.5
Working Note-
Growth rate:

27-15 12
27-17 10
27-19 8
27-21 6
27-23 4
40/5= 8%
Estimated rate of return: 10% (Assumption)
(b) Three problems in valuation methods:
(i) P/E ratio:
1. This valuation model does not provide any detailed information about earnings per share
growth. Due to this, it becomes difficult for investors to take viable actions.
2. It cannot be applied in those companies which faced loss in previous years. The reason behind
this is that it focuses on earnings instead of bear loss during financial years.
3. In addition, under this formula debt is not ignored and it is important to know that for
company valuation both debt and equity need to considered equally.
(ii) Dividend growth model:

1. One of the key issue under this model is that it can be applied in those companies which are
paying consistent dividend since many years. This cannot be applied in small companies who do
not pay regular dividend.
2. Along with, under this model various kind of assumptions are made related to tax rate, interest
rates etc. Due to which outcome becomes less reliable.
3. The last drawback of this model is that it is controlled by large shareholders who buy huge
number of shares and have ability to change in financial data that are used for valuation.
Question 2 (34 marks) – Project Appraisal
Lennon Plc plans to invest £2m in new machinery to produce Product Z.
Sales revenue from Product Z would be £1,800,000 and production costs would be £750,000 in
the first year. Annual inflation after the first year is expected to be as follows:
Sales revenue inflation: 10% p.a.
Production cost inflation: 5% p.a.
Advertising costs in the first three years of production would be £150,000 p.a. and quality
control costs would be 200,000 p.a. for the life of the project.
At the end of four years, production of Product Z will cease. The equipment used to make
Product Z is expected to have a scrap value of £400,000.
Lennon Plc pays tax on profit at 19% p.a. in the same year it arises and has a cost of capital of
12%.

Solution:
(a) NPV: Discounted cash flow-investment
Investment: 2 million or 2000000
Year Net cash flow PV factor Discounted cash flow
1 700000 0.892 624400
2 842500 0.797 671472.5
3 1001125 0.712 712801
4 1577581 0.635 1001764
Total: 3010437
NPV: 3010437-2000000
= 1010437 Pounds
Working Note:
Calculation of net cash flow-
Year Cash inflow Cash outflow Net cash flow
1 1800000 750000+150000+200000 700000
2 1980000 787500+150000+200000 842500
3 2178000 826875+150000+200000 1001125
4 2395800+400000 868219+150000+200000 1577581

(b) Calculation of IRR:
IRR: R1+ {NPV1/NPV1-NPV2} *(R2-R1)
R1: 12%
R2: 20%
NPV 1: 1010437
NPV 2: Computed below-
Net cash flow PV factor Discounted cash flow
1 700000 0.833 583100
2 842500 0.694 584695
3 1001125 0.579 579651
4 1577581 0.482 760394
Total: 2507840
NPV 2: 2507840-2000000
= 507840
IRR: 12%+ [1010437/ (1010437-507840)] * (20-12)
= 12% +(1010437/502597) *8

= 12%+ (2.01*8)
= 12%+16.08%
= 28.08%
(c) Use of NPV and IRR as project appraisal techniques.
NPV: This method measures efficiency of a project by computing current value of a project. It
has some advantages which makes NPV as project appraisal method such as:
 This method consists time value factor which makes investment proposal analysis more
effective and reliable.
 It can be applied in any type and size of project. There is no any restriction under this
method and due to which it becomes easier for users.
IRR: It is defined as a form of method that is used for computing estimated rate of return on
investment. This approach has some features that make it an effective appraisal approach such
as:
 IRR method is simple to use as it needs some financial information that is entered in
formula to measure efficiency of a project.
 As well as under this method, cost of capital rate is not needed which makes it an
effective way to assess efficiency of financial projects.
Recommendations: Lennon plc should buy new machinery because under both methods of
investment appraisal, measured value is acceptable. Like the NPV of machinery is of 1010437
which is viable and positive. Along with IRR is of 28.08% that is higher and acceptable.

Question 3 (32 marks) – Production Decisions
Lennon Plc’s management accounts show the following information for products R, S & T
which it produces:
In the next year, due to factory capacity constraints only 200,000 machine hours & 100,000 labor
hours will be available, and the material supplier has assured Lennon Plc of unlimited supplies.
Requirements:
Identify the limiting factor – is it materials, labor hours, or machine hours? Your workings
should clearly show the excess or shortage. (8 marks)
Using your answer to part (a), determine the optimal production plan which will maximize
contribution. Your workings should clearly show the order in which products R, S & T should be
produced and also the respective quantities. (12 marks)
Calculate the maximum contribution based on the optimum production plan determined in part
(b) above. Show all workings. (8 marks)
If fixed costs for product S are £120,000; calculate the breakeven point (BEP) for product S in
units. (4 marks)
Solution:
(a) Limiting factor:
The limiting factor is labor hour. This is so because needed labor hours are 139000 while
available labor hours are 100000. So there is shortage of 39000 hours.

Working Note:
For material
Description Product R Product S Product T Total
Direct material 4 5 3
Maximum sales demand 20000 25000 8000
Direct material require 80000 125000 24000 229000
Available material 229000
Shortage/excess -
For labor hours
Description Product R Product S Product T Total
Direct labor hour 2 3 3
Maximum sales demand 20000 25000 8000
Direct labor hour require 40000 75000 24000 139000
Available labor hours 100000
Shortage 39000
For machine hours
Description Product R Product S Product T Total
Machine hour per unit 4 3 2
Maximum sales demand 20000 25000 8000
Machine hour require 80000 75000 16000 171000

Available machine hours 200000
Excess 29000
(b) Production plan:
Production plan for materials:
Product Demand Material require Available material Remaining
R 20000 80000 229000 -
S 25000 125000 149000 -
T 8000 24000 24000 -
Production plan for labor hours
Product Demand Labor hour require Available labor hours Remaining
R 20000 40000 100000
S 25000 75000 60000
T 8000 24000 0
Production plan for machine hours
Product Demand Machine hour require Available machine hours Remaining

R 20000 80000 200000 29000
S 25000 75000 120000
T 8000 16000 45000
(c) Calculation of maximum contribution:
Maximum contribution for material:
Product R Product S Product T
Sales 900000 1500000 440000
Less: variable material cost 80000 125000 24000
Contribution 720000 1375000 416000
Maximum contribution for labor:
Product R Product S Product T
Sales 900000 1500000 440000
Less: variable labor cost 40000 75000 24000
Contribution 860000 1425000 416000

Maximum contribution for machine hour:
Product R Product S Product T
Sales 900000 1500000 440000
Less: variable machine hour cost 80000 75000 16000
Contribution 820000 1425000 424000
(d) Breakeven point:
BEP: Fixed cost / contribution per unit
Contribution per unit: selling price-variable cost per unit
= 60-(25+21)
= 60-46
= 14
BEP: 120000/14
= 8571 Units