Financial Management: Investment Appraisal Techniques and Valuation Models

This report discusses practical solutions for financial management, including investment appraisal techniques and valuation models. It evaluates the effects of proposals on the company and the benefits and limitations of different investment appraisal techniques. The report also includes a valuation of Dragon Plc using different models such as price earning method and discounted cash flow method.

FINANCIAL
MANAGEMENT

Contents
INTRODUCTION...........................................................................................................................3
TASK...............................................................................................................................................3
Question No 2. Various Investment Appraisal Techniques and their recommendation..............3
a) Evaluation of projects considering the following models and their recommendations: -.......3
b) Evaluation of the effects of the proposal on the company: -...................................................6
c) Benefits and limitation of the different investment appraisal techniques used in decision
making.........................................................................................................................................6
Question No 3 Valuation of Dragon Plc. using different Valuation Models along with
Recommendation on Proposed Investment.................................................................................9
a) Price Earning Method: -..........................................................................................................9
b) Discounted Cash Flow Method: -............................................................................................9
c) Dividend Valuation Method: -...............................................................................................10
d) Problems associated with the above models along with recommendation to Kings Plc. with
respect to proposed acquisition..................................................................................................11
CONCLUSION..............................................................................................................................12
REFERENCES..............................................................................................................................13

INTRODUCTION
Financial management refers to preparation, categorising, guiding and monitoring of
financial activities in an establishment or an institute. It includes certain principles of
management which helps in operative and resourceful deployment of financial resources that is
useful in achieving goals and objectives to the corporate (Amel-Zadeh and Meeks, 2020). It is a
process of dealing with management of finance in an organisation in an effective way
considering time management also. This report includes practical solution with respect to
calculation of cost of capital taking into consideration historical value figures and market value
figures in capital structure. Further it involves practical approach with respect to recalculating the
cost of capital if an entity incorporates more debt in their capital structure and repurchase
ordinary shares from the market in order to cancel them. Another practical question is addressed
which consist of valuation of Dragon plc considering different models such as price earnings
ratio, Dividend valuation model etc.
TASK
Question No 2. Various Investment Appraisal Techniques and their recommendation.
a) Evaluation of projects considering the following models and their recommendations: -
1. The Payback Period: -
(Figures in Pound)
Year Annual Cash
Inflow
Annual Cash
Outflow
Annual Net
Cash flows
Cumulative
Cash
Inflows
0 -588300 NIL -588300 NIL
1 223600 32700 190900 190900
2 223600 32700 190900 381800
3 223600 32700 190900 572600
4 223600 32700 190900 -
5 223600 32700 190900 -
6 223600 32700 190900 -

6 (S.V) 88245 NIL 88245 -
Payback period will be: -
= 3 Years + (588300-572600) / 190900
= 3 Years + 15700/190900
= 3.08 Years.
Note: - Depreciation is the non-cash expense, since tax rate is not given in the question
hence it is ignored while decision making.
2. The Average Rate of Return: -
= Annual Average Profits / Cost of Investments * 100
= 205607.50 / 588300 * 100
= 34.95 %
Note: - Since average annual profits is not given in the question hence we have
considered average cash inflows as average profits.
3. The Net Present Value: -
Years Net Cash Inflows Discounting @ 10% PV of Cash Inflows
1 190900 .909 173528.10
2 190900 .826 157683.40
3 190900 .751 143365.90
4 190900 .683 130384.70
5 190900 .621 118548.90
6 190900 .564 107667.60
6 (S.V) 88245 .564 49770.18
PV of Cash Inflow
(A)
880948.78
PV of Cash Outflow
(B)
588300

Net Present Value
(A-B)
292648.78
The Internal Rate of Return: - It is the rate at which cash inflows and cash outflows
becomes indifferent to each other. (Belhadi, Kamble, and Queiroz, 2021). For calculating IRR,
we consider Trial and Error Method. For implementation of this method we assume 2 rates for
discounting that is 10% and 20 %.
Discounting @ 10 % and 20 %: -
Years Cash Inflows DF @ 10 % DF @ 20 % PV @ 10 % PV @ 20 %
1 190900 .909 .833 173528.10 173528.10
2 190900 .826 .694 157683.40 132484.60
3 190900 .751 .579 143365.90 110531.10
4 190900 .683 .482 130384.70 92013.80
5 190900 .621 .402 118548.90 76741.80
6 279145 .564 .335 157437.78 93513.58
PV of Cash
Inflow ( A )
880948.78 678812.98
PV of Cash
Outflow ( B )
588300 588300
NPV( A – B ) 292648.78 90512.98
Using Interpolation Technique: -
IRR = Lower rate + Lower Rate NPV/ (Lower Rate NPV – Higher Rate NPV) * Diff. in Rates
= 10 % + 292648.78 / (292648.78 – 90512.98) * 10
= 24.48 %
From the above rate we can conclude that 24.48% is the rate at which inflows and outflows
becomes indifferent to each other.
Recommendation: - After application of the above methods with respect to the acquisition
of machine, it can be concluded that machine must be acquired since when we apply NPV

method, the net present value is positive. Further when we apply Pay Back Period the pay back
arrives 3 years approx. which shows that the amount of investment we made at the beginning of
the year is recovered completely in 3 years itself. However, the life of the machine is 6 years,
therefore it is beneficial to acquire it from this method also. We also implement average rate of
return method to evaluate the proposal after taking certain assumptions, the ARR is 34.95%
which is considered to be good considering the proposal.
b) Evaluation of the effects of the proposal on the company: -
When STS limited repurchase some of its equity shares from the market using 40 % of the
cash outlay which is Pound 235320 (40% of 588300) then it will be regarded as a positive sign
because it means that STS believed that their shares are undervalued and they believed that the
price of the share will increase in future along with valuation of the entity. A repurchase of share
is also known as float shrink because it reduces the company’s number of freely trading shares.
Further when company pay cash dividend to its shareholders then it will increase the trust of
shareholders in the company. Payment of Dividend to equity holders on annual basis will
increase market share of the organisation is the stock market. However, it will make an impact
on the EPS of the company as due to buyback, the number of equity shares outstanding reduces
and it will ultimately affect the EPS by reducing it since the denominator while calculating the
same reduced. Repurchase of shares and payment of cash dividends to shareholders are the
alternate measures for the business concern to make payment to the shareholders, dividend
represents the current payment to an investor while the share buyback represents the future
payment. Further there is another implication of the above proposal that is payment of dividend
distribution tax to the government by the enterprise. However, as an overall consideration this
proposal can be considered to be better in building the net worth of the organisation over the
period of time. They do carry more uncertainty then payment of dividends as the buyback value
depends upon the stock future price.
c) Benefits and limitation of the different investment appraisal techniques used in decision
making.
Payback Period: It is used to calculate the time taken to recover the amount spent on the
investment of starting a new project (Bi and Wang, 2018). It is the amount of the initial

investment divided by the net cash inflows. The project with the shortest time period is selected
and make a decision.
Pros Cons
It is very unpretentious to estimate as it
ponders only the annual cash flows over the
years and the initial cost on the project
(Bielstein, Fischer, and Kaserer, 2018).
It ignores the value of time and earn an
additional return on it if it is reinvested.
When the rapid changes occur in the industry
due to the technical modifications, it is hard to
project the cash flows for future. In this
circumstance, the payback period helps in
ascertaining the chance of loss and helps in
reducing the risk.
In the case of the even and uneven cash flows
over the years, this method only takes into
consideration till the time the initial cost of
capital is recovered.
Accounting Rate of Return: It depicts the pace of the rate of yield anticipated on the
initial investment or on the resources which is distinguished with the value of the investment in
the commencement of the project. It divides the average value of the cash inflows by the average
investment of the organisation for deriving the return on the project over the anticipated project
life over the years.
Benefits Demerits
It is very unassuming to work out and to
comprehend the project’s life. But the ARR
thinks of the benefits it can give to the funds
of the investment for the whole existence of
the resources in the monetary terms.
The outcomes are unique assuming it
computes the rate of term on the investment
as well as the ARR. Therefore, it creates a
confusion in making decisions.
This technique is considering all the
profitability which the project gains over the
period of time and helps in measuring the
existing performance of the tasks.
It is irrelevant for the projects which is made
at the different time periods and also ignore
the factor called time.

Net Present Value: It is an investment performance measure broadly utilized in money
and business land. It means distinguishing between the present worth of the cash inflows and the
cash outflows (Howe, 2019). NPV lets a financial backer know whether the venture is
accomplishing an objective yield at a given beginning of the initial investment.
Benefits Demerits
It considers the risk factor of the project and
is concerned about the wealth of the
shareholder by taking the whole life of the
project in computing.
It is very troublesome to understand this
method by the manages s it is difficult to
predict the accurate discounting rate for the
project (Jory, Ngo, and Susnjara, 2020).
It considers the worth of time and money by
considering the discounted cash are
calculated, which in turn minimises the risk
and give a better forecasted result.
It is relied on the anticipation mainly and it
increases the possibility of error. The factors
which are assumed are the returns, prevent
factors and the investment costs.
Internal Rate of Return: It is a measurement utilized in monetary investigation to
assess the productivity of expected ventures. It is a rebate rate that makes the NPV of all incomes
equivalent to focus in a limited income investigation.
Benefits Demerits
It considering the factor called time and the
money and is easy to compute and
understand. It is considering when the IRR is
greater in with minimum acceptable costs of
the capital.
It is worrisome in the cases when the projects
of different time periods and the rate of return
is difficult to be presumed, which in turn is
hard to make choices (Khan, Pal, and Saeed,
2018).
It uses all the cash flows over the time period
of the time and considers the time value of the
money of the project. It helps in knowing the
return on the investment which has been done
originally.
It does not take into consideration the cost of
capital, which is significant as it can be
utilised to contrast the project on the basis of
different time durations.

Question No 3 Valuation of Dragon Plc. using different Valuation Models along with
Recommendation on Proposed Investment.
a) Price Earning Method: -
This method shows the association between the enterprise stock price and earning per
share. It is a very widespread ratio that gives the stockholder a better logic of the value of
the business concern (Marqués, García, and Sánchez, 2020). This ratio shows the
probability of the market and price per share an investor pays per unit on the current
earning of the company. Profits are important when valuation is made for the entity
because investors want to know that how profitable an enterprise is in current accounting
period and what profits they will generate in future. It can be interpreted as the number of
years it will take for the organisation to pay back the amount paid for each share.
Price earning ratio = MPS / EPS
P.E Ratio of the Kings Plc is as under: -
= 4.15 / .29
= 14.31 Times
Value of Dragon Plc. will be calculated using P.E Ratio of Kings Plc as under: -
= EPS of Dragon Plc * P.E Ratio of Kings Plc
= 40.40 / 145 * 14.31
= £M 3.99
b) Discounted Cash Flow Method: -
This method used by the organisation to value the proposed business model they want to
acquire. In this model the expected cash flows are discounted using cost of capital
(Cunha, Reis, and Teixeira, 2021). The present value of cash inflows is added together
and they will be considering as value of an organisation using this model. As an investor
this model is very useful as this model helps in calculating the present value of various
proposed investments and usually considered the who has the highest present value. The
investor considers those investments which provides highest net present value as it is less
risky compare to other projects.

It is given in the question that board of directors of king’s plc estimate that after tax
synergy benefit from the above takeover would be £5.25m annually. However, in this
question it is not given that how many years such benefit will last in order to discount
such cash flow using discount rate. We assume that such benefit last forever and discount
rate of Kings will be taken into consideration.
Valuation of Dragon Plc will be: -
= Annual Synergy Benefit / Cost of Capital
= 5.25 / 12 %
= £M 43.75
c) Dividend Valuation Method: -
It is a quantifiable method of valuing the price of an organisations share price which is
calculated on the assumption that the current fair value of the stock will be equals to the
sum of all the future dividends received by the company (Pehlivan and Öztemir, 2018). In
this question we considered gordens dividend growth model for valuation of the entity. It
is a very popular and straightforward alternative of the dividend discount model. This
model assumes that the dividend will grow at a constant rate forever and considers the
present value of the future dividends in order to determine the value. Because this method
assumes a constant growth rate, it is generally used when payment of dividend is made
consistently.
According to this model valuation can be done using Gordon’s model as under: -
Po = D1 / Ke - G
Here,
Po - Current Market Price per share
D1 - Expected dividend per share
Ke - Cost of Equity
G - Growth rate
Po = 14.35p / (11.80 % - 2.50 %)
= 14.35p / 9.30 %
= 154.30p or £ 1.543

Value of firm will be: -
= No of Equity Shares * Current market price per share
= 145 * £ 1.543
= 223.74
Working Notes: -
 Calculation of Ke using Capital Asset Pricing Model (CAPM): -
= Rf + B (Rm – Rf)
Here,
Rf - Risk free rate of return
B - Beta
Rm - Market rate of return
The difference between Rm and Rf is known as market risk premium.
= 5.50 % + 1.05 (6%)
= 11.80 %
 Calculation of Expected Dividend per share: -
D1 = Dividend Paid (Do) + Growth Rate (G)
= 14p + 2.50 %
= 14.35p
d) Problems associated with the above models along with recommendation to Kings Plc. with
respect to proposed acquisition.
Problems associated with these models are: -
 Price Earnings Ratio Model: The biggest problem with this model is that it only
considers EPS for valuation of company’s share. Another problem with this
method is that it does not consider growth rates (Pradhan, Arvin, and Hall, 2019).
Further this model is not advisable when company needs to compare with
different industries. This model is completely based of EPS which is sometimes
considers as misleading to the stakeholders.
 Discount Cash Flow Method: The main problems with this model is that it
requires large number of assumptions before implementation (Talbot, 2019).

Further to calculate the terminal value is difficult and it represents the large
portion in the total value. Another challenge is to determine weighted average
cost of capital.
Dividend Valuation Method: The main limitation of this model is that it assumes that the
growth rate of dividend remains constant. As it is very rare for the companies to show constant
growth rate in payment of dividend over the period of time due to their business cycle and
financial difficulty a business faces over the period (Thomas, Shooya, and Lissner, 2019). This
model is limited to those enterprises only having a constant growth rates over the period of time.
Recommendation: - It is recommended to the Kings PLC. that acquisition of Dragon Plc is
worthwhile since it provides positive synergy to the organisation. Further the valuation of the
enterprise is higher when we adopt dividend growth model for valuation. This model is best
amongst all the methods applied above as it provides accurate result to some extent.
CONCLUSION
This report includes practical solution with respect to calculation of cost of capital using
historical value of capital structure and market value capital structure. Further it involves
practical approach with respect to recalculating the cost of capital if an entity incorporates more
debt in their capital structure and repurchase ordinary shares from the market in order to cancel
them. Another practical question is addressed which consist of valuation of Dragon plc
considering different models such as price earnings ratio, Dividend valuation model etc. On the
basis of the above assignment we can conclude that Gordon model of valuation of company
share is a best method amongst all methods. This method provides reasonable output when taken
into consideration.

REFERENCES
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Howe, J., 2019. The impact of rural roads on poverty alleviation: a review of the literature. Rural
roads and poverty alleviation, pp.48-81.
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