Financial Management: Valuation Techniques and Investment Appraisal

This document discusses valuation techniques and investment appraisal in financial management. It explores the advantages and limitations of different methods such as price earnings ratio, discounted cash flow model, and dividend valuation model. The document also provides recommendations for the board of Aztec on which method to use. Suitable for students studying financial management.

Financial Management
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INTRODUCTION
Financial management includes the scheduling, coordination, monitoring and regulation of
financial operations, such as the acquisition and use of the company's funds. It implies adapting
the general management principles to the company's financial capital (Hoque, 2017). In this
assessment, we have to address two problems and it is based on merger & takeover and
investment appraisal techniques. There are several functions which are used for different purpose
such as estimation of capital requirement, capital composition, source of funds, investment of
funds etc.
MAIN BODY
Question 2
a. Price Earnings Ratio
Price earnings ratio: It is the connection between the share price of a company and the
earnings per share (EPS). It is a common ratio which gives shareholders a better understanding
of the firm's value. The P / E ratio reflects market expectations and is the price that is expected to
pay per amount of current earnings.
Aztec PE ratio = Share price / EPS
= 3.89 / 0.21 = 18.52
Trojan Plc = 40.4 / 147
= 27.48
Share price of Trojan Plc = 18.52 * 27.48
= 5.08
Total market value = 147 * 5.08
= 746.76
Here it is assumed that the market expects Aztec to produce a return on Trojan's assets on its
own assets comparable to that on.
Dividend valuation model: Dividend discount model (DDM) is a way of valuing an
organization's stock price based on the assumption that its stock is worth all the effort of all its
future dividend payout, compared to its value (Hashim and Piatti-Fünfkirchen, 2018). To put it
another way, securities are used to calculate based on the capital cost of the future distributions.
To calculate of dividend require the dividend model values for both g and r such as:
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G = (13 / 10) = 1.14 %
Alternatively
g = 4 √ (13 / 10) = 1.14%
The cost of equity using CAPM
Ke = 5 + (1.10 * (11 – 5)) = 11.60%
Po = 0.116 – 0.114 = 0.002
Total market value = 147 * 0.002 = 294m
Discount cash flow method Discounted cash flow (DCF) is a valuation instrument used to
calculate the value of an investment based on its expected cash flows. The DCF evaluation
attempts to quantify the worth of modern spending based on forecasts of how much income it
would produce in the present. This applies both to monetary donations from creditors as well as
to company owners wanting to make changes to their companies, such as purchasing new
appliances.
Discount cash flow method by using WACC of Aztec
Present value of earnings = 40.4 * 1.02 / (0.09 – 0.02)
= 588.68
Present value of assets sale = 21 million / 1.09
= 19.27
Present value of synergy = 5 / 0.09
= 55.56
Total present value of Trojan Plc = 588.68 + 19.27 + 55.56
= 663.51
b. Critically discuss the problems associated with valuation techniques and recommend the
board of Aztec to use
It is critically analyzed that to solving these problems required to analysis of different
advantage and disadvantages of these techniques such as:
Price earnings ratio
Advantage: P / E analyses a future growth prospects by taking into account the firm's
circumstances and contrasting them to past results. This also dictates what the investors are
created for. PE ratios help shareholders assess the potential for growth before investing in the
business. The ratios indicate businesses that can be impacted by drastic price change. High PE
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contributes to the company's selloff while low PE shows the company's continued production.
Enable shareholders to know how much they want to pay for the stock in exchange for every
dollar. We may rely on this knowledge to classify undervalued inventories.
Disadvantages: Price-earnings may not take into account debt / financial arrangement
when measuring the financial reports. Specific accounting practices hinder PE similarities
between different businesses and various countries (Mitchell and Calabrese, 2019. Such
measures include the approaches used for depreciation, amortization, and taxation. Competitive
nature of shares makes it hard to know what price earnings we will sell to render P / E in fact
subjective. The speeding up or stock buy-backs will raise the company's profits but this can lead
to higher risk cost for doing it. The loss-making businesses cannot use the PE ratio because it
cannot assess losses at the early stages of business growth.
Discounted cash flow model
Advantage: The discounted cash flow model has a major benefit as it decreases
expenditure to a single figure. When the net present value is favourable, it is assumed the
investment will be a source of profit; if it is unfavourable, the investment will be a sucker. This
helps decisions about individual investments to be up-to-down (Dwiastanti, 2017). Additionally,
the approach helps you to make choices between substantially different investments. Investment
decisions are the most precise and reliable tool. Assuming that the measurement calculations are
somewhat correct, no other approach does the job of determining which investments yield
optimum value.
Disadvantages: DCF's most significant limitation is the fact that it needs a number of
assumptions to be made. Cash flows in the near future may depend on different factors, such as
demand for the economy, business dynamics, unexpected problems and much more. Measuring
unrealistic potential cash flows may lead to making decisions about an investment that does not
pay off later, destroying earnings. Earning money flows too low, that can bring in lost chances of
making an investment look high priced. Deciding on a rate of return for your version can be a
gamble, and your version may need to be adequately predicted for compensation.
Dividend valuation model:
Advantage: The dividend valuation model will not allow a wealth creation assumption
for development. The rate of dividend growth for the stocks being measured cannot be greater
than the rate of return, or else the equation could not work. It means they are using this model to
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forecast what potential dividends will be, depending on what appears to be the present dividend.
While using this valuation model, choosing a way to invest is simpler, because you will be able
to retain the investment value) (Siminica, Motoi and Dumitru, 2017). At the same time, you can
gain income from the dividends you receive, which helps you to increase your portfolio's total
value, particularly if you've invested in several dividend stocks from a variety of industries.
Disadvantages: By comparing small-cap shares to large-cap securities, it is the smaller
companies that have done better across long periods of time. Many small companies aren't in a
position to afford a dividend, which ensures that their worth cannot be calculated using this
valuation model. This can be used on the dividend paid stocks. If shareholders were only focused
on this particular model, they could miss a number of chances to create value to their portfolio.
There are a number of variables that can affect a stock's price over time. Consumer satisfaction,
brand loyalty and even the possession of intangible assets all have the ability to improve the
company's worth. Unless the growth rate of the dividend is constant and established, those non-
dividend variables will potentially affect the company's value. That means the valuation
approach cannot yield desired results, even when measured correctly.
From the above analysis, it is recommended that company should follow P/E ratio for the
valuation of their shares. It helps the management to make their strategic decisions in order to
enhance organizational productivity or profitability.
Question 3
Payback period:
It is the capital budgeting approach that is used to determine further expenditure and to
enable the client to understand or select the best choice. Payback period is the duration during
which the company is able to retrieve the amount paid (Skimmyhorn, 2016). Low payback
period is advantageous to the company because it helps to restore initial investment and also to
start making returns on it. With the guidance of the company's inveterate assessment strategy
managers who can make informed decisions about potential investments. Measuring the overall
project risk is very critical for the organisations, so managers choose the project that involves
lower risk compared with other projects. Calculation of payback period for the machine is as
follow:
Formula:
Payback period = Initial investment / cash inflow
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Accounting Rate of Return (ARR):
ARR measured in absolute terms that mean the estimated rate of return on investment or
the assets acquired by the business (Danes, Garbow and Jokela, 2016). This is one of the easiest
or quickest investment assessment strategies that is widely used by the company for project
choice. This is determined by calculating average earnings from the initial cost. ARR is the type
of capital budgeting that does not recognize both the time value of money and the cash flows.
The greater the return is advantageous to the client, meaning because on the other hand, the
company is getting the higher returns, the low return is not competitive. In this way, company
compares the returns of various initiatives as well as further management makes the necessary
decisions. The estimation of ARR for the duration of 6 years in which they earn the correct
return is shown below listed table. the firm's executives have to develop their actions
accordingly and determine whether or not to pick this project for the further investment. Further
calculations are as follow:
Formula:
Accounting rate of return = Average annual profit / Initial investment * 100
ARR = 33541.67 / 275,000 * 100
= 12.19 %
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Working notes:
Net Present Value (NPV): NPV refers to the proposal's net present value; this is one of the
key tools that companies use to make decisions. It involves the intense cash inflow analysis that
happens at various periods of time. Present cash flow value dependent upon current and future
time value. Furthermore, the discounted element is the most significant component relevant for
evaluating and assessing the net present price at the time of measurement. NPV assists in
determining each year's estimated cash flow together with the discounted duration. Outcome will
be positive or negative. Therefore more management must recognize or determine whether or not
to pick the project for investment. Further calculation mentioned in the below table:
Formula:
Net Present Value (NPV) = Discounted cash inflow / Initial investment
NPV = 318,700 – 275,000
= 43,700.
Internal Rate of Return (IRR): IRR is one of the basic techniques of investment
evaluation, which should be used among most organisations to determine their proposal and to
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insure that they're either successful or not (Brooke, 2016). Internal rate of return focused on a
discounted duration determining the present value and thus defining the cash flow for the
particular project. Before making a final decision about potential investment through managers,
it is important to recognize corporate preferences and evaluate their investment using the method
of capital budgeting and take further steps accordingly. When making strategic investment
decisions, management evaluate the IRR and better the return is advantageous to the business
that offers both productivity and future growth. Business is able to assess the risk with the aid of
measuring IRR, since higher returns entail huge risk. Low returns, on the other hand, have low
risk, so company can take decisions and develop plans for the future accordingly. Calculation of
IRR, is as follow:
Formula:
IRR = Lower Discounted Rate + PV of Lower Discounted Rate – Initial investment / PV of High
Discounted Rate – PV of LDR (HDR – LDR)
Present value @ 12%
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Interval Rate of Return (IRR) = 12 + ( 318,703 – 275,000 ) / ( 254,881 – 318,703 ) * ( 20– 12 )
= 12 + 43,703 / -63,881 * ( 8 )
= 12 + (-0.68) * 8
= 12 – 5.44
= 6.56 %
Recommendation: Net present value of the company is 43700 which is positive that means
investment in this machinery is beneficial for Lovewell company. IRR of this project is 6.56%
that is also good enough to invest in new machinery or maximise the productivity as well as
profitability of the business. With the help of above mention results, managers able to make
decision in favour of this project that is beneficial for the organization to invest in the new
machinery for the better production. The company's NPV is 43,700 which are favourable which
means spending in this machinery is profitable for the business of Lovewell. The IRR of this
investment is 6.56 per cent, which is also sufficient to invest in new equipment or increase
market efficiency and profitability. Using the findings described above, managers will make
decisions in favour of this initiative, which is advantageous for the company to invest in the new
equipment for good production.
Critically evaluate the benefits or limitations of different investment appraisal techniques:
Payback period:
Benefits: It is one of the basic methods of measuring the project to decide whether
project is selected or not and it is profitable for the client. Managers may pick the best allocation
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to invest, with the aid of this tool. Such as a short recovery time would be selected because it
helps the business recover more quickly from the original investment.
Limitations: Managers should ignore unfavourable NPV while making important
decisions, as it won't be beneficial at all. This approach does not recognize time value of money
and would instead be based on minimal turnaround time whether any project will have the same
cash flow as other decisions.
Accounting rate of return:
Benefits: ARR lets the businesses make their investment options. High returns are good for
the business and competitive (Baños-Caballero, García-Teruel and Martínez-Solano, 2016).
Before reaching any decisions, management determines project ARR by choosing the most
appropriate one. This approach recognizes accounting importance that is frequently found in
proposal-making process by administrators.
Limitation: Average return rates disregard portfolio cash flow that is focused on reported
income and also calculate using average profit. It will further affect different activities needed to
be handled. Time value of money is ignored in this investment assessment techniques the affect
as well as the entire outcome or profitability of the project.
Net Present Value (NPV):
Benefits: The majority of companies use NPV to determine their investment and decide
whether or not the corporation will spend in this project. Favourable value of selected and
negative NPV will be refused as it is not profitable for the organization to continue in such
project. This investment assessment methodology takes into account time value of capital and
creates more prospects in front of corporations. For managers it is important to make their
choices based on the NPV interest.
Limitations: Managers may use this tool to assess their feasibility or to compete with other
plans, but cannot be only if all project cash capital flows were the same. If the initial outlay is
different, then there is no reason to evaluate or make assumptions because it does not yield exact
results. Net present value impacted by discounted rate when it changed and it excludes economic
factors such as inflation.
Internal Rate of Return (IRR):
Benefits: IRR used only to define the returns that company receives after spending in
particular ventures, and then to make additional decisions appropriately. It will ease management
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decision making to choose the company's most profitable project (Antonopoulos and Hall, 2018).
Managers make high-return choices, and they determine what project helps companies optimize
their earnings.
Limitations: IRR will not recognize economies of scale that influence the outcomes. It is
measured using hit & check method that does not yield reliable results. This also impacts
executive’s decision-making processes. Additionally, there is no such disparity between loans or
borrowings. Due to the shift in reduced rate, each project may have varying returns, and it is
difficult for executives to take investment decisions.
CONCLUSION
From the above analysis, It had been stated that financial management is really important to
the organisation's financial position. It is the structure that focuses on the enterprise and any
element or operation of the enterprise. Management develop strategy by emphasizing company
and functional efficiency. Company adopts the investment appraisal approach in order to make
financial decisions, that they quantify the various factors for the assessment. It includes, payback
time, rate of return accounting, IRR, NPV etc. Those are the capital budgeting approaches that
help management to make their decisions about future expenditure for the company's growth.
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REFERENCES
Books & Journals
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