Valuation Techniques in Financial Management

This document discusses various valuation techniques in financial management including price/earnings ratio, dividend valuation method, and discounted cash flow method. It provides a critical evaluation of each technique and suggests the use of discounted cash flow method. The document also includes a discussion on different investment appraisal techniques such as payback period, accounting rate of return, and net present value.

Financial Management

Question 2
a) Price/earnings ratio
MPS £3.89
EPS £0.21
P/E ratio of Aztec (A) 18.52
Distributable earnings £40.4
number of shares 147
EPS of trojan (B) £0.27
Value per share of Trojan (A * B) £5.0004
Total market value £735.06
Statement showing valuation using price earnings ratio
b) Dividend valuation method
Current dividend (D) £0.13
Risk free rate of return (Rf) 5%
Return on the market (Rm) 11%
Beta (ß) 1.10%
As per CAPM, the required rate of return = Rf + (Rm-Rf) *ß
= 5% + (11% -5%) * 1.10%
Required rate of return (K) 5.07%
Growth rate 2%
Market price per share = D*(1+g) / (K-g)
= 0.13 * (1+2%) / (5.07% - 2%)
MPS £4.32
Total market value £635.04
Statement showing valuation using Dividend valuation method

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%
PV of cash flow = Annual cash flow/discounting rate
Cash flow growth rate 2%
Market value per share = 40.4 / 9%
£448.89
Total market value £65986.67
Statement showing valuation using Discounted cash flow method
d. Critical evaluation of various valuation techniques
Price/earnings ratio
This ratio explains the comparison of MPS to the EPS. The EPS is calculated using
the last four quarters performance of the company. The higher ratio indicates the greater
return prospect by the investor in regard to the greater income in the coming years in the
future. in comparison to low P/E ratio. The relationship between these two indicates what the
market is willing to pay based on the current level of earnings and also shows if the market is
over or under valuing the company (Alim and Maqbool, 2020). A rise in the EPS leads to the
rise in the market value and the lower earnings per share shows fall in MPS. This ratio is very
useful in comparing the companies in the same industry. But the high price earning ratios is
considered to be the risky investments as compared to the lesser ratio and this is because of
the reason that rise ratio signifies high prospects.
In the situation of M&A, it is very important to compare the ratios of the
organizations within the same industry. These ratios can be distorted by the company
depending upon the how company has accounted for the items and is based on the accounting
principles and practices which varies from country to country which adds another problem
(Janda, 2018). In case of cyclical business entities, it requires a more detailed investigation
and the less P/E ratio would might mean low-priced that is all wrong because it is precisely
the wrong time to buy these types of firms. The earnings per share calculated includes a lot of
noises and might not represent the actual performance of the corporate. It also ignores the
impact of liability while focussing on price capitalization. This method is used mostly used

for the purpose of valuation of investment because it indicates the expected price of the share
based on the company’s earnings. Thus, all these problems in relation to P/E ratio needs to be
taken care of will using it as it has huge impact on the business decision making.
Dividend valuation method
This technique is employed in judging the general estimation of a stock which is then
distinguished with the market cost at which the share price is exchanging. The main benefit
of this method is that dividend tends to stay consistent over a period of time. Companies
using this model, does not set up unnecessary high dividend expectation because not meeting
with the same affects the stock price later (Bruner, 2017). This method uses NPV of the
projected dividend for valuing the shares. It is derived by distributing dividend to be paid in
the subsequent time period divided by (cost of equity (Ke) less dividend growth rate (GR).
This method is very easy to understand as it values the company’s stock deprived of seeing
the market conditions.
The major problem associated with this strategy is that it is very difficult to forecast
accurately. It is additionally referred as DDC (dividend discount model). This practice can be
applied in judging the potential profit pay but this approach has certain disadvantages. It can't
evaluate those stocks which doesn't convey dividend regardless of the capital increase
recognized from it (Mellen and Evans, 2018). It is dependent on the presumption that the
estimation of the share value is the ROI. For esteem figuring, it utilizes different estimations
presumptions, such as, development rate, required ROR. For example, benefit yield changes
after some time, if any projections made in the calculation are to some degree in blunder will
realize choosing the estimation of stock either overstated or underestimated. It doesn't judge
non-profitable factors, such as, brand faithfulness, possession for resources (Anuradha and
Jyothi, 2017). This valuation method is based upon the suspicion that the profit development
rate will remain consistent and known. It also acknowledges that the stock price is very
sensitive to dividend’s rate of growth and moreover it can't outperform cost of equity (Ke)
which isn't for each situation legitimate. In any case, there were various undertakings in order
to overcome these issues yet it will incorporate a lot of additional calculations identifying
with projections and are also inclined to mistakes. Another problem is that it ignores the
effect of stock buyback which can be named to be unreasonably traditionalist in the
assessment of stock worth.
Discounted cash flow method

The DCF strategy decides the current approximation of the advantage or the
association subject to the estimation of money it can make in future. It relies upon the
assumption that the estimation of money today is more than what's to come. This technique is
useful in evaluating the characteristic estimation of the association. It requires a great deal of
information dependent on which worth is evaluated of the stock (Dec, 2019). The benefits of
this strategy are that it thinks about all the noteworthy business supposition and it doesn't
require any indistinguishable association. It is the good and appropriate technique for
investigating the M&A. It might be used in processing IRR and moreover allows sensitivity
examination. This methodology is incredibly sensitive procedure which relies upon the
presumption related to unending development rate and the discounting rate.
In this procedure, any slight error will make the assessment change and the reasonable
value decided won't be exact. This method capacities outstandingly fine in the condition of
having serious extent of certainty, however, the association's movement needs perceivability
which it makes trouble in anticipating the business, costs identified with business activity and
capital speculation. Determining income for future years is irksome, doing it never-endingly
which is required in DCF procedure, sometimes become inconceivable (Natolski and Werner,
2017). This technique is slanted to high misstep. The difficult issue of this method is that the
terminal worth contains total worth, that is, 65-75% and a minor assortment in the terminal
year will fundamentally influence the overall valuation. This methodology isn't fitting for
shorter term undertakings as it revolves around creation of longer term value. It moreover
relies upon market demand, unforeseen impediment and some more. Also, assessing the
future salary high, might realize selecting the investment that won't have the alternative to
take care of later on, influencing benefits.
Thus, from the above critical analysis of various valuation methods, it can be stated
that DCF method should be used by the company. Also, it should be used by the
professionals with expertise in the field of finance as they are very capable in creating
monetary structures and representations. It is the best suited method because it supports in
getting better and accurate results. Along with that proper care and focus needed in
forecasting and valuation because a small mistake will lead to inaccurate assessment which
can affect the performance and functioning of the corporates.

Question 3
1. Application of different investment appraisal techniques
a. The payback period
It indicates the amount of time frame it will take to recover the money that was
invested at the starting. It is actually the length of time at which the investment reaches the
point of no profit no loss (Gianakis, 2017). It is a very important technique; shorter the period
means more attractive investment. This helps business in taking quick decisions.
Compute the payback period (PBP)
Payback period (PBP)
3.79 years
͹ ͹͉ʹ ͷ ǡͲͲͲ
ሺ͉ ͺͷǡͲͲͲെ͉ ͳʹ ǡͷͲͲሻ݅݊ܫ݅݊ܫ݈ܽ݅ ݐݐݐݐݐݐݐݐݐݐݐݐݐݐ ͹ ͹ ͹͹͹͹݅݊ܫ݁ ݏ ݁ ݐ ݒݐ
ሺ  ݈ܽ݅ ݑݑݑݑݑݑݑݑݑݑݑݑݑݑ ͹͹ ͹͹ ͹ ݓ െ  ݈ܽ݅ ݑݑݑݑݑݑݑݑݑݑݑݑݑݑ݈ܽ݅ ݄ݏ  ͹ ͹͹͹ ͹ݑݐ ݓሻ
From the above it can be said that the company, Lovewell Limited is able to recover
its money in 3.79 years which is economically feasible for it as nearly takes half of the
project life of the machine and also highlights the higher earnings in the future.
b. The Accounting Rate of Return
ARR is the percentage of earnings in return that is anticipated from the proposal in
comparison to the initial cost of investment. It is the investment evaluation metrics which is
utilized for determining the viability associated with the investment (Mehdi, Ihsan and
Bashir, 2019). This is mainly used for comparing the numerous investment proposals as it
provides expected return from each project. It is better to make an investment in obtaining
machinery as the return on investment is much higher then cost of capital, thus, it is
recommended to invest in the proposal.

Compute the average investment
Average investment
£158,125͹͹͹͹݅݊ܫ݅݊ܫ݈ܽ݅  ͹ ͹ ͹͹͹͹݅݊ܫ݁ ݏ ݁ ݐ ݒݐ͹͉͉͉͉͉͉͉͉͉͉͉͉͉͉ ͹ ͹͹ ͹ ͹݈ܽ݅݁ݑ ݒ
ʹ
͹ ͹͉ʹ ͷ ǡͲͲͲ͹ ሺ ͹ ͹͉ʹ ͷ ǡͲͲͲכ Ψͳͷ ሻ
ʹ͹͉͵ ͳ ǡʹ ͷͲ
ʹ
Compute the accounting rate of return
(ARR)
Accounting rate of return
ARR 45.85%
ሺ  ݈ܽ݅ ݑݑݑݑݑݑݑݑݑݑݑݑݑݑ݈ܽ݅ ݄ݏ  ͹ ݓ െ  ݈ܽ݅ ݑݑݑݑݑݑݑݑݑݑݑݑݑݑ݈ܽ݅ ݄ݏ  ͹ ͹͹͹ ͹ݑݐ ݓሻ͹ ͹͹͹͹͹ ݁ ݈݁ܽ݅ ͹ ͹ ͹͹͹͹݅݊ܫ݁ ݏ ݁ ݐ ݒݐ
ሺ͉ ͺͷǡͲͲͲെ͉ ͳʹ ǡͷͲͲሻ͉
ͳͷͺ ǡͳʹ ͷ
͹ ͹͉ʹ ǡͲͲͲ͉
ͳͷͺǡͳʹ ͷ
It is feasible to invest in acquiring new machine because the return from it is much
higher in comparison to cost of capital, thus, it is recommended to invest in the proposal.
c. The Net Present Value
It is the investment appraisal technique which represents the relation between the PV
of cash inflows and PV of cash outflow over the life of the asset (Benallou and Aboulaich,
2017). It is used for determining the profits associated with the projected investment. The
positive NPV indicates that investment can be made as projected earnings exceeds the
anticipated cost.

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 Amount in
£
PV factor
@12%
Present value (PV) in
£
0 Outflow (cost) -2,75,000 1.000 -2,75,000
1 Net annual cash
inflows
72500 0.893 64732.14
2 Net annual cash
inflows
72500 0.797 57796.56
3 Net annual cash
inflows
72500 0.712 51604.07
4 Net annual cash
inflows
72500 0.636 46075.06
5 Net annual cash
inflows
72500 0.567 41138.45
6 Net annual cash
inflows
72500 0.507 36730.76
6 Scrap value 41,250 0.507 20898.53
NPV £43,976
Since, the NPV is £43976 which indicates that the company can make an investment
in buying the asset because the earnings from it exceeds the cost and it is assumed that it will
be profitable. Thus, it is feasible enough to invest.
d. The Internal Rate of Return

This technique is utilized in assessing the profits in association to the respected
investment. IRR is basically a discounting rate which makes NPV of the project equal to
zero. It is important for businesses to look at IRR for taking decisions in relation to the
business expansion and growth prospects.
Computing the IRR using trial and error method
Year Cash flow Amount in
£
PV factor
@15%
Present value (PV) in
£
0 Outflow (cost) -2,75,000 1.000 -2,75,000
1 Net annual cash
inflows
72500 0.870 63043.48
2 Net annual cash
inflows
72500 0.756 54820.42
3 Net annual cash
inflows
72500 0.658 47669.93
4 Net annual cash
inflows
72500 0.572 41452.11
5 Net annual cash
inflows
72500 0.497 36045.31
6 Net annual cash
inflows
72500 0.432 31343.75
6 Scrap value 41,250 0.432 17833.51
NPV £17,209
Year Cash flow Amount in
£
PV factor
@18%
Present value (PV) in
£
0 Outflow (cost) -2,75,000 1.000 -2,75,000
1 Net annual cash
inflows
72500 0.847 61440.68
2 Net annual cash
inflows
72500 0.718 52068.37

3 Net annual cash
inflows
72500 0.609 44125.74
4 Net annual cash
inflows
72500 0.516 37394.69
5 Net annual cash
inflows
72500 0.437 31690.42
6 Net annual cash
inflows
72500 0.370 26856.29
6 Scrap value 41,250 0.370 15280.30
NPV £-6,144
17.18%
IRR െͳͷ ͹ ͹ ͹ ௧͹ ͹ ͹ ͹ ͹ ͹௦௧ ͹ ͹͹ ͹௩௨ Ψ̷ଵହ͉͹ ͹ ௧͹ ͹ ͹ ͹ ͹ ͹௦௧ ͹ ͹͹ ͹௩௨ Ψ͉ଵହ̷  ͹ ͹ ௧͹ ͹ ͹ ͹ ͹ ͹௦௧ ͹ ͹͹ ͹௩௨ Ψ͉ ଵ଼ *(18-15)െͳͷ ͹ ͹ ͹ ͹ ͹ଵଶଽ͹ ͹ ͹ ͹ଵଶଽ̷  ሺ̷ ͹ ଵସସሻ
*3െͳͷ ͹ ͹ ͹ ͹ ͹ଵଶଽ
ଶଷଷହଷ
*3
From the above it can be said that it is beneficial for the company to purchase the new
machine which is based on the complete evaluation carried out above. The internal rate of
return is 17.18% which is approximately 17% more than the cost of capital of 12% which is
not much higher and may not be able to add more value to the investment. But then too, it is
feasible to make an investment the new machinery.
2. Benefits and limitations of different investment appraisal techniques
The Payback Period
It refers to the quantity of time takes to produce the money in regard to from the
investment made. It marks as the earn back the original investment point in the cash flow. It
is determined by dividing starting investment with income created. The significant preferred
position of this method is that it is the basic and simple to ascertain and provides data on the
threat identified with the investment (Agbeye, 2019). This is a good approach which is used
in measuring the liquidity. While on the other side, this technique ignores time value of
money and furthermore it is progressively determined about the liquidness and not benefit. It

also ignores the incomes external to the payback (PB) time frame which may prompt
deluding of data. Other problem of it is that it favours smaller PBP without taking into
account the general existence or life of the investment. It can’t draw any distinction between
the projects having equal PBP. One more important fact is, it does not consider residual
amount of the asset after the completion of the project.
The Accounting Rate of Return
ARR is the expect arrival on the speculation that is communicated in rate. It is judged
by dividing the annual operating benefit by the normal venture. More the ARR, it is well on
the way to be beneficial. It is very simple to be used. It includes only operating earnings
which is utilized by lenders and speculators for judging the presentation of the organization
(Namanda, 2017). In any case, this method does not signify time estimation of cash and
spotlights on the operating income as opposed to money flowing inward and along with that
it doesn't stay constant over the useful life of the project which brings it looks alluring at once
and unwanted at another. This technique can't be utilized in comparing the projects with
distinctive life expectancy. The time and the pattern of the money flowing inward is
completely ignored and doesn't represent vulnerability and price increases. It likewise doesn't
signify riches and execution. In regard to it generally made useful in shorter undertakings. In
this way, it is required to be used carefully.
The Net Present Value (NPV)
NPV strategy is the most often utilized investment technique. It is basically the
estimation of future cash inflow over the life of the venture or speculation which is limited to
the current value. It helps in evaluating the estimation of the interest as to income and
productivity. NPV reflects the time estimation of cash on account to all the incomes over the
life of the investment and additionally represents the planning and various trends of the
income. It gauges the total complete resources of the firm which may result concerning the
modifications in relationship with the venture (Ghiyasi, 2018). Not at all like IRR, NPV
method doesn't expect that the return will be further reinvested. This procedure helps in
perceiving whether the particular endeavour will have the choice to create enough pay that
will outperform the cost of the undertaking. The positive outcome of the NPV of the venture
can be attempted and the other one can't to be incorporated. This technique is helpful if there
should be an occurrence of choosing only one proposal from the multiples, by approximating
the benefit of every task and later selecting the extremely valuable investment.

But this technique suffers from certain drawbacks. Calculating the net present value is
a complex process and determining the discounting rate is actually very important for
calculating present value. Therefore, cost of capital is accounts for various factors which aids
in guaranteeing maximum fairness. It includes inflation and other risk factors. Under the
situation of mutually exclusive ventures, NPV might give deluding outcomes. There is no
defined guidelines for computing NPV and is dependent upon the willingness of the
organizations which may prompt wrong return. Shorter life project with higher NPV might
not be able to boost the EPS and the ROE and probably will not be able to work in the
expectation of the entity’s investors.
The Internal Rate of Return
It is the discounting rate, under which the net PV of the proposal becomes equal to the
0. It is employed to gauge and look at the development pace of diverse undertakings and
venture plans and the method is the regular mode which is used to select which project
produce more noteworthy yields. IRR provides precise ROR to every solo project in
distinction with the expense of project (Barjaktarovic and et.al, 2016). It gives a plan to the
stakeholders the potential return in association with the undertaking. IRR moreover reflects
the time estimation of cash and aides in judging exact return and furthermore it is difficult to
compute and comprehend. This system aids in expanding the benefit and stakeholder's
prosperity. This strategy likewise has some limitations. If the CF pattern is unconventional it
might give multiple IRR resulting into misleading figures. It rests on the possibility that cost
of borrowing and lending is the alike. It is totally founded on estimation and requirements for
trial and error approach and neglects economies of scale. It requires the evaluated cost of
capital for settling on any choice. Additional constraint is that it accepts that all the incomes
can be put into the market at the rate of IRR and if the normal pace of return in too distant
from the IRR then the benefit is not legitimate.

REFERENCES
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