Financial Management Assignment

This assignment delves into the concepts of dividend policy and investment appraisal techniques, analyzing Planet's dividend policy and Lovewell Limited's investment appraisal techniques. It examines the effectiveness of the dividend growth model and evaluates the strengths and weaknesses of various appraisal techniques, including payback period, accounting rate of return, net present value, and internal rate of return.

FINANCIAL
MANAGEMENT

Table of Contents
INTRODUCTION...........................................................................................................................1
QUESTION 1 – DIVIDEND POLICY............................................................................................1
(a) Fair price of Planet's Shares for 2018:...................................................................................2
(b) New Fair Price of Planet's Shares:.........................................................................................3
(c) Problems in Implementation of Dividend Growth Model for Fair Valuation of Shares.......4
QUESTION 3 - INVESTMENT APPRAISAL TECHNIQUES.....................................................4
1. Determination of feasibility of purchasing machine using various investment appraisal
techniques....................................................................................................................................5
(a) Payback Period......................................................................................................................5
(b) Accounting Rate of Return (ARR)........................................................................................5
(c) Net Present Value (NPV).......................................................................................................7
(d) Internal Rate of Return (IRR)................................................................................................7
2. Critical Evaluation of Appraisal Techniques .........................................................................9
CONCLUSION .............................................................................................................................10
REFERENCES..............................................................................................................................11

INTRODUCTION
Financial Management is an integrated function of business management that is
concerned with planning, organizing, directing and controlling the monetary activities of any
organisation. For any enterprise, it includes proper allocation of scarce resources in a wise
manner for carrying out production activities and other related operations (Alemis and Yap,
2013). This report aims to discuss the concept of Dividend Policy and Investment Appraisal
techniques in detail. Such evaluation has been done by carefully analysing the case of Planet and
Lovewell Limited respectively. Also, the report outlines problems related to dividend growth
model in valuing stock and evaluates the appraisal techniques like Accounting Rate of Return,
Internal Rate of Return and Net Present Value.
QUESTION 1 – DIVIDEND POLICY
Calculation of Annual Growth Rate for Planet's DPS
Year Dividend Per Share (DPS in '£') Growth (in %)
2014 0.13
2015 0.14 7.69%
2016 0.17 21.43%
2017 0.18 5.88%
2018 0.2 11.11%
The above table is representative of given information in a tabular format. It shows the
dividend per share for Planet in different years in an ascending order. The current year's dividend
per share is £0.20. In addition to this, year-on-year growth in dividend has been calculated in
order to ascertain steadiness in the company's policy for paying dividend to its shareholders
(Filip and Raffournier, 2014). This growth has been calculated by employing the following
formula:
Growth (%) = [(D1-D0) / D0]*100 where,
D1 = Dividend for current year
D0 = Dividend for previous year
After calculating the annual growth in dividend it can be observed that there is an
unsteady growth prevalent in Planet. The company recorded a 21.43% growth in dividend in
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2016 paying dividend to its shareholders at £0.17 as compared to 2015 which was £0.14 for the
same. This indicates that Planet's dividend policy does not follow a strict pattern of paying
dividend at a constant rate. The company tends to reward its investors with dividends without
any criteria of making minimum dividend rewards every year. Even though the company is
giving dividends at unsteady growth rate, the annual dividends are higher than the previous
showing profitability in the operational activities carried out by Planet.
Valuation of Stock such as Ordinary Shares of a company includes ascertaining the true
or intrinsic value of such stock class to ascertain the profitability and performance of the
business in the market. Intrinsic Value of a share is also known as 'Fair Price' (Finn, O’connell
and Fitzpatrick, 2013). In the given context, the fair price of planet's shares has been calculated
below for 2018 at various rates of shareholder return.
(a) Fair price of Planet's Shares for 2018:
In relation to Planet's Dividend Policy, the company has recently announced an dividend
per share of 20p or £0.20. Utilizing the information presented in the aforementioned table and
some additional data provided in this section, value of stock is ascertained on an annual basis.
Hereafter, the fair price for Planet's shares has been ascertained using Dividend or Gordon's
Growth Model. For calculation of fair price in this section the Rate of Shareholder's Return has
been taken at 14%.
As per Gordon's Growth Model, a constant growth rate is expected in order to calculate
the intrinsic value of a given stock class (Habib Uddin Bhuiyan and Islam, 2013). It assumes a
constant growth in dividends perpetually as a company exists for an indefinite period of time.
However, as the growth in Planet's case is unsteady, modifications have been made through
extrapolation. This means that the applicability of the method is extended to this situation by
assuming that existing trends will prevail in Planet's scenario too.
Under this model, value of stock is calculated using the following formula:
Value of Stock = D1 / (k-g) where,
D1 = Dividend for current year
k = rate of return
g = annual growth rate
The calculations have been provisioned below in order to estimate the share price:
For 2015: 0.14 / (0.14-0.0769) = 0.14 / 0.0631 = £2.22
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For 2016: 0.17 / (0.14-0.2143) = 0.17 / (-0.0743) = £2.29
For 2017: 0.18 / (0.14-0.0588) = 0.18 / 0.0812 = £2.22
For 2018: 0.20 / (0.14-0.1111) = 0.20 / 0.0289 = £6.92
In order to extrapolate the growth rate for Planet between 2014 and 2015 an estimate has
been made to know the overall growth in dividend per share for the relevant time period
(Hasnan, Rahman and Mahenthiran, 2012). Utilizing the aforementioned growth rate formula, it
is mentioned as under:
Average growth in dividend of Planet's Shares for 2014 to 2018= [(0.20-0.13)/0.13]*100
= 11.53%
This indicates that Planet's Dividend Per Share (DPS) tends to grown by 11.53% on an
annual basis. Hence, 11.53% is the annual growth rate of dividend experienced by business. In
order to find the price for company's common stock or shares, the following formula is
employed:
Fair Price of Shares = [(D1*(1+g)) / (k-g)] where,
D1 = Dividend for Current Year.
g = Annual Growth Rate of Dividend.
k = Rate of Shareholder Return.
Therefore, Intrinsic Value of Planet's Share in 2018 = [(0.20*(1+0.1153)) / (0.14-0.1153)]
= 0.22306/0.0247 = £9.03
(b) New Fair Price of Planet's Shares:
As the company has decided to increase its debt level, the top management has increased
their required rate of return from 14 percent to 15.4 percent. This increase takes into account the
financial risk associated with
its equity shares due to change in the capital structure of the business (Huber and Scheytt, 2013).
Once again, Dividend Growth Model has been employed in the similar way as mentioned above
to ascertain the New Share Price of Planet. These calculations have been shown as under:
Required rate of Return = 15.4%
Value of Stock = D1 / (k-g)
For 2015: 0.14 / (0.1540-0.0769) = 0.14 / 0.0771 = £1.82
For 2016: 0.17 / (0.1540-0.2143) = 0.17 / (-0.0603) = £2.82
For 2017: 0.18 / (0.1540-0.0588) = 0.18 / (0.0952) = £1.89
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For 2018: 0.20 / (0.1540-0.1111) = 0.20 / (0.0429) = £4.66
Once more the annual growth rate of DPS has been calculated as under:
Average growth in dividend of Planet's Shares = [(0.20-0.13)/0.13]*100 = 11.53%
Thus, the New Fair Price of Planet's Share for 2018 = [(0.20* (1+0.1153)) / (0.154-0.1153)]
= 0.22306/ 0.0387 = £5.76
(c) Problems in Implementation of Dividend Growth Model for Fair Valuation of Shares
Dividend Growth Model is one of the oldest valuation and most conservative methods
adopted by businesses (Lind and et.al, 2012). It was propounded by Myron J. Gordon in 1956.
The model includes many assumptions in order to simplify calculations and derive a meaningful
relationship between growth and price in terms of dividend. One such assumption is that there
has to be a constant growth rate prevalent in the business for a perpetual period of time. This
assumption is based on the concept of a company having an everlasting life. In regards to real
world, however, this assumption proves to be highly unrealistic.
While estimating the fair value of shares in Planet's situation, this weakness is strongly
highlighted. This is due to the fact that businesses tend to undertake more projects or
opportunities as they grow. As business growth is determined by the level of profits made by a
company and dividend paid thereof, this model tends to reject the idea of incremental growth
altogether. Also, critical incidents such as mergers and acquisitions which are a common
occurrence in real world have been ignored by this model that may affect the size and nature of
the business altogether (Linnerooth-Bayer and Hochrainer-Stigler, 2015).
In addition to this, dividend growth model's assumption of stability is also desecrated as
companies tend to have highly variable earnings during its course of life. Hence, such
fluctuations are completely ignored. Also, the share price estimated through employment of such
model is highly sensitive to growth rate. Miscalculating growth may lead to deceptive results that
can cause havoc if not identified soon enough by the Finance Manager.
QUESTION 3 - INVESTMENT APPRAISAL TECHNIQUES
Investment Appraisal Techniques refer to those activities which involve assessing the
feasibility and acceptability of a potential project or opportunity that an organisation considers to
undertake. These Appraisal Techniques help in drawing conclusions regarding whether a given
project must be taken up by the company or not. The four most widely used investment appraisal
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techniques include Payback Period, Accounting Rate of Return (ARR), Net Present Value (NPV)
and Internal Rate of Return (IRR). These have been discussed at length below in the context of
Lovewell Limited.
Lovewell is a food manufacturer who is contemplating a purchase of new machine worth
£275,000. Through this investment, Lovewell expects annual cash inflow of £85,000 by sale of
products and an annual cash outflow of £12,500. The estimated useful life of this machine is six
years whereas the depreciation is charged using Straight-Line Method (SLM).
1. Determination of feasibility of purchasing machine using various investment appraisal
techniques
(a) Payback Period
This technique of appraisal is one which ascertains the number of years a project may
take to create adequate cash inflows to cover the incurred costs and break-even for an
organization (Luby, 2012). The following table represents the Payback Period for Lovewell in
relation to the proposed Project:
Calculation of Payback Period for Lovewell Limited
Particulars (£)
Initial Investment (given) 275000
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Annual Cash Inflows (given) 85000 85000 85000 85000 85000 85000
Less: Annual Cash Outflows
(given)
12500 12500 12500 12500 12500 12500
Net Cash Inflows1 72500 72500 72500 72500 72500 72500
Payback Period2 3.79 years
1 Net Cash Inflows = Annual Cash Inflow – Annual Cash Outflow
2 Payback Period (in years) = Initial Investment / Net Cash Inflows
Recommendation:
A project is feasible if the number of years taken to reach break-even point is less. The
useful life of machine is 6 years and the break-even is achieved at 3.79 years. Thus, one can say
this project is not feasible for the business to invest in as it will generate sufficient cash flows
after 63.17% of the life of machinery is over.
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(b) Accounting Rate of Return (ARR)
Accounting Rate of Return or ARR is an appraisal tool that identifies the relationship a
proposed project has in regards to the investment requirements and the expected revenues to be
generated.
Calculation of Accounting rate of return for Lovewell Limited
Particulars (£)
Initial Investment
(given)
275000
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Annual Cash Inflows 85000 85000 85000 85000 85000 85000
Less: Annual Cash
Outflows
15500 15500 15500 15500 15500 15500
Net Cash Inflows 72500 72500 72500 72500 72500 72500
Less: Depreciation2 38958.33 38958.33 38958.33 38958.33 38958.34 38958.34
Net Cash Inflows after
depreciation
33541.67 33541.67 33541.67 33541.67 33541.66 33541.66
Average accounting
profit1
£33,541.66
Initial Investment £275,000
Accounting Rate of
return3
12.20%
1 Average Accounting Profit = (Net Cash inflows – Average Depreciation)/Number of Years
2Depreciation is charged as per straight line method.
3Accounting Rate of Return = Average Accounting Profit / Initial Investment
Working Notes:
Calculation for depreciation on new machine purchased by Lovewell Limited
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Cost of new
machine
275000 194791.67 155833.34 116875.01 77916.68 38958.34
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Less: Salvage
Value
41250 0 0 0 0 0
Net cost of new
machine
233750 194791.67 155833.34 116875.01 77916.68 38958.34
Less:
Depreciation
38958.33 38958.33 38958.33 38958.33 38958.34 38958.34
Carried forward
balance as cost of
machinery
194791.67 155833.34 116875.01 77916.68 38958.34 0
Average
Depreciation of
new machinery4
£38,958.33
4 Average Depreciation of New Machinery is equal to the depreciation charged per year as the
amount of depreciation is same across the useful life of machinery under straight-line method.
Recommendation:
As per this model, higher rate of ARR would be more favourable to the company. Since
this project furnishes a rate of 12.20% as ARR, it is feasible to undertake such purchase on part
of Lovewell.
(c) Net Present Value (NPV)
This method of appraisal is widely used by businesses as it considers future cash flows
discounted to ascertain the feasibility of a project or investment (McElroy and Van Engelen,
2012). For this purpose, weighted average cost of capital is chosen as the discounting rate to
estimate the present value of future cash flows. For the given case scenario, NPV has been
calculated as under:
Cash inflow (A) PV factor at 15%1 (B) Discounted Cash Flow (C)2
72500 0.870 63043.48
72500 0.756 54820.42
72500 0.658 47669.93
72500 0.572 41452.11
72500 0.497 36045.31
72500 0.432 31343.75
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Discounted Cash Flow £274,375
Less: Initial investment (£275,000)
NPV (£625)
1 Cost of capital of 15% furnished by the case is adopted as the discount rate for facilitating NPV
calculations.
Recommendation:
A project is undertaken by a company if the net present value of that project is positive.
This is only possible when Discounted Cash Inflows are more than the Initial Outlay or
Investment made by the business in a given project. For Lovewell, this is not true as the NPV for
undertaking purchase of new machine would prove to be a loss of £625. Hence, the project must
be rejected.
(d) Internal Rate of Return (IRR)
This methodology furnishes the common point where NPV for a given project is zero. By
this, one can ascertain that level of investment where outlay and discounted cash-flows are equal
(Nyamao and et.al, 2012). This technique also helpful in comparing the profitability of two or
more proposed projects that a business considers to undertake for deriving profits in future. This
has been calculated below by assuming a higher and lower discount rate in relation to Lovewell
Limited:
Particulars
Initial investment £275,000
Lower Discount Rate (A) 10%
Higher Discount Rate (B) 14%*
NPV at 10% discount rate1 £40,756.4
NPV at 14% discount rate2 £6,928.39
Difference in discount rates [(B)-(A)] 4%
Internal Rate of Return3 4.82%
1NPV at 10% discount rate has been assumed by using hit-and-trial method. As Cost of Capital
renders a negative NPV, a rate lower than 15% is preferable to achieve a positive value.
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2NPV at 14% discount rate is the higher discount rate, again, estimated through hit-and-trial
methodology.
3IRR=A+ [(Higher Discount Rate-Lower Discount Rate) *{NPVa / (NPVb - NPVa)}] where,
NPVb denotes NPV of purchasing machinery at higher discount rate of 14%.
Working Notes:
Estimating Higher and Lower Discount Rates using Hit-and-Trial Method:
(i) NPV at 10% discount rate (NPVa):
Cash inflow (A) PV factor at 10%1 (B) Discounted Cash Flow2 (C)
72500 0.909 65909.09
72500 0.826 59917.36
72500 0.751 54470.32
72500 0.683 49518.48
72500 0.621 45016.80
72500 0.564 40924.36
Discounted Cash Flow £315,756.40
Less: Initial Investment (£275,000)
NPV £40,756.4
(ii) NPV at 14% discount rate (NPVb):
Cash inflow (A) PV factor at 10%1 (B) Discounted Cash Flow2 (C)
72500 0.877 63596.49
72500 0.769 55786.40
72500 0.675 48935.43
72500 0.592 42925.82
72500 0.519 37654.23
72500 0.456 33030.02
Discounted Cash Flow £281,928.39
Less: Initial Investment (£275,000)
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NPV £6928.39
Recommendation:
As the NPV is negative, a rate of 15% is not feasible to be applied for this project. Hence
a rate of 10% and 14% is calculated to get a better understanding of the project. As the company
is able to achieve positive NPV at 14% rather than cost of capital, it is recommended to not
undertake the project.
2. Critical Evaluation of Appraisal Techniques
(a) Payback period: Benefits – Payback period method helps in revealing the payback period of an
investment. It is famous choice among the managers and the concept is highly simple to
understand and calculate. It can easily calculate without using a calculator or electronic
spreadsheet. The analysis helps in focus on risk to quickly money can be returned from
an investments (Swarbrooke and Page, 2012).
 Limitations – The limitation of this method that ignores the time value of money because
cash flows received during the early years of a project get a higher weight than cash
flows received in later years. It is ignoring cash flows received after payback period and
does not consider a project's return on investment.
(b) Accounting rate of return: Benefits – The accounting rate of return easy to calculate and simple to understand like
pay back period. There are considering profits or savings over the entire period of
economic life of the project. With the help of this method recognise the concept of net
earnings.
 Limitations – A true rate of return can not be evaluated on the basis of ARR and it is dis-
certain of the management. Many time this method neglect time factor which is primary
weakness of the average return method.
(c) Net Present Value: Benefits – The most important feature of the net present value method is that it is based
on the idea and NPV provides importance of time value of money. In the calculation of
NPV, both after cash flow and before cash flow over the life span of the project are
considered.
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 Limitations – This method difficult to calculate the appropriate discount rate and it can
not provide accurate decision if the amount of mutually exclusive projects are not equal.
(d) Internal rate of return: Benefits – The profitability of the project is recognised the whole economic life of the
project and in this way a true profitability of the project is evaluated. With the help of this
method pre determination of cost of capital is very difficult but at the time of IRR it can
be used.
 Limitations – This method assumed that the earnings are reinvested at the internal rate of
return for remaining life of the project. These involve tedious calculations. This method
provides importance to only profitability rather than to capital expenditure (Zimmerman
and Roberts, 2012).
CONCLUSION
It can be inferred from the calculations and recommendations made from the report that
financial management proves to be a useful function as far as investment appraisals and dividend
policy formulations are concerned. Constant growth rate is not a viable option in current
scenario. Hence, it is important to extrapolate models in order to infer suitable conclusions
regarding dividend policy as observed in Plant's case. Additionally, appraisal techniques such as
NPV and IRR help in understanding whether a business will even recover their investments or
not as compared to Payback Period and ARR. Thus, indicating that cash-flows are crucial factors
which facilitate important strategic decisions made by business, as seen in the case of Lovewell
Limited.
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