Investment Appraisal Techniques and Mergers and Takeovers

This document provides insights into investment appraisal techniques and mergers and takeovers in financial management. It discusses the calculations, effects, and evaluations of different techniques. It also explains the price/earnings ratio and discounted cash flow method for valuation purposes.

Financial Management

TABLE OF CONTENTS
Question 2 - Investment Appraisal Techniques.........................................................................3
(a) Calculations regarding investment appraisal...............................................................3
(b) Discussing the effect of proposal on Super Tasty Limited..........................................5
(c) Evaluating the benefits and limitations of each investment appraisal technique........6
Question 3 – Mergers and Takeovers.........................................................................................9
a) Price/earnings ratio............................................................................................................9
b) Discounted cash flow method (DCF)..............................................................................10
c) Dividend valuation method..............................................................................................11
d) Critical analysis................................................................................................................12
REFERENCES.........................................................................................................................14

Question 2 - Investment Appraisal Techniques
(a) Calculations regarding investment appraisal
Years cash inflow
Cash
outflow
depreciatio
n EBIT
Net Cash
inflow
1 123000 25500 118449 -20949 97500
2 123000 25500 86467.7 11032.3 97500
3 123000 25500 63121.6 34378.4 97500
4 123000 25500 46078.8 51421.2 97500
5 123000 25500 33637.3 63862.7 97500
6 123000 25500 24555.31
72944.6
9 97500
i. Payback Period
Years Net Cash inflow Cumulative Cash flow
1 97500 97500
2 97500 195000
3 97500 292500
4 97500 390000
5 97500 487500
6 97500 585000
Payback
period
4
48800
0.500513
Payback
period 4.5 years
The payback period explains when an initial investment will be recovered in terms of
years. From the above mentioned table it can be evaluated that Super Tasty Limited will

recover its initial investment of 438700 in 4.5 years. The indications are showing positive
outcome according to the Payback period of capital appraisal technique.
ii. Accounting Rate of Return
Initial Investment 438700
Life of machine 6
Depreciated
amount
62149.1
6
Average
investment
250424.
6
Average EAT 97500
ARR 0.39%
This is calculated for the purpose of identifying the expected rate of return n
investment. The above illustrated table shows the 0.39% of ARR.
iii. Net Present Value
Years Net Cash inflow
PV factor
@13%
Discounted cash
flow
1 97500 0.884955752 86283.18
2 97500 0.783146683 76356.80
3 97500 0.693050162 67572.39
4 97500 0.613318728 59798.57
5 97500 0.542759936 52919.09
6 97500 0.480318527 46831.05
Sum of discounted
cash flow 389761.10
Initial investment 438700

Net Present value -48938.9
By analyzing all the techniques of investment appraisal it can be evaluated that Super
Tasty limited (STL) will not receive greater economic value by acquiring this particular
machine. In addition to this, from the point of view of net present value method machine not
provide positive result so acquiring would not be good for financial position of Super Tasty
Limited.
iv. Internal Rate of Return
Years Cash flow
0 -438700
1 97500
2 97500
3 97500
4 97500
5 97500
6 97500
IRR 9%
Internal rate of return is one of the effective tool utilized by number of large organization for
having better decision making skill. It takes the tie value of money into accounting while
presenting the end outcome. The result has been calculated for 6 years so IRR obtained 9% is
showing good indication for purchasing the machine.
By considering all four methods calculation of capital appraisal technique it can be
assessed that company would be benefited if it acquires the mentioned machine. In
addition to this, recommendation for the particular case can be firm should consider
all aspect while selecting the machine.
(b) Discussing the effect of proposal on Super Tasty Limited
The proposal is about using the 40% of capital for mentioned investment above to
repurchase equity and remaining funds for paying cash dividends. Financial director
proposed this offer to STP in order to make business procedure effective. Company get

consultation from the financial director for achieving the business objectives in effectual
manner by considering all influencing factors. Capitalization structure should be
formulated by company in such a manner that it can fulfill its internal as well external
financial requirements. Utilization of 40% of 438700 in order to repurchase equity and
spending 60% on giving cash dividends to shareholders. The main objective of
organization is to maximize profitability along with shareholders wealth so that better
reputation can be gained in market. The stakeholder’s satisfactions increase the
institutions’ scope of growth in industry and enables it to acquire competitive advantages.
Another objective behind doing this is that it will not require the company to pay
dividend on the equity shares it repurchased which will help it in retaining more from its
profits which can be further utilized in the investment requirements of the business. Also,
it will result into making it easy for the company in paying dividend to its investors in a
better way or at higher percentage which will build up good and positive image in front of
them. This is the most important factor which might make this proposal acceptable as it is
beneficial for the company. Thus, this step results int bringing in various benefits to the
business which cannot be avoided leading to making it can acceptable and viable deal. In
nutshell, this proposal will lead to effectively managing the cash flow of the business as
the company will no longer required to pay dividend on certain percentage of its equity
shares.
The proper segregation of capital in equity and retained earnings for providing
dividends, continuing business operations largely contribute in gaining success. There are
several factors which leads business to accept mentioned proposal it depends on the
financial position of organization that it will be benefited or not. The advantages of
keeping 40% equity capital will be no repayment requirements, lower risk, etc. STP
would be able to attract more investors by offering them trustworthiness that company is
contributing for shareholders growth along with organizational development. Productivity
and profitability of Super Tasty limited will be increased by accepting the mentioned
proposal.
(c) Evaluating the benefits and limitations of each investment appraisal technique
Investment Appraisal Techniques (IAT) play crucial role in making investing decisions
effective. There are various components which influences the decisions making criteria of
organizations (Mohan and Narwal, 2017). While utilizing each of the technique related to
CA company should pay attentions of pros and cons for knowing scope and limitations.

In addition to this, limitation should be provided focus due to its adverse impact on
company’s growth. the following are benefits and limitations:
Payback Period (PP)
It is one of the important tool of CA which requires most focus of business as helps
organization to understand the time period for recovering its invested capital (Lefley,
2018). PP has its own advantages and disadvantages which requires the attentions for the
purpose of reaching accurate decision regarding project selection.
Advantages
 The of the biggest benefit of implementing PP method in company is related with
its unique characteristics of being simple to use and understand. It uses the input
for providing the accurate outcome
 Useful in cases of uncertainty that face rapid changing circumstances. In addition
to this, uncertainty lead to make difficult for identifying the management of
organization in making evaluation of unequal cash inflows. Thus utilization of it
reduces chances of loss through obsolescence.
 Payback period provide preference to liquidity which aid company to know
amount of money it going to recover in specified span of time.
Disadvantages
 It ignores the time value of money so not all cash flows are covered under this
technique of capital appraisal.
 Reality is neglected which unable firm to estimate the actual profitability.
Return on investment is as well ignored by PP which is biggest limitation of
this tool.
Net Present Value (NPV)
It comprises the worth of cash flows received in future which provides
transparency to organization regarding its accomplishment of business objectives.
Benefits and dreawbacks are mentioned below:
Benefits
 Unambiguous measure is provided by NPV helps in comparing marginal
forestry investment for particular project.
 Straightforward calculations can be computed with help of this technique.
 Time value of money is recognized by NPV which provides assistance in
making choice among multiple alternatives.

Limitation
 It assumes the single discount rate for the whole life of the investment.
 Inappropriate assumption related to estimation of accurate future cash flow is
assumed which is adversely impact the company’s progress.
 In appropriate decisions are taken on the basis of improper information
provided by net present value.
Accounting Rate of Return (ARR)
ARR is used in capital budgeting is way of comparing the profit investor
expect and amount need to invest. Every procedure has its own pros and cons
that creates its own identity which are as follows:
Pros
 It is very easy to calculate and understand so that correct decision can
be identified with help of this procedure
 Net earnings concept is given preference in ARR method of capital
appraisal technique.
 Comparison between multiple project becomes easy due its simple
presentation nature.
 Current performance of firm can be assessed with help of ARR
Cons
 Time factor is ignored which is primary weakness that results in
unawareness of time value of money.
 Fair rate of return cannot be determined by ARR.
Internal Rate of Return (IRR)
IRR is used as capital budgeting technique to estimate the time
value of money even if cash flow is even or uneven (Magni and
Marchioni, 2020). The following are benefits and limitations:
Benefits
 It is simple to interpret by its proper visualization nature
 No requirement of finding hurdle is present here

Limitations
 Economies of scale is ignore by IRR
 Contingents projects are being neglected by this technique
Question 3 – Mergers and Takeovers
a) Price/earnings ratio
The PER is considered to be the most popular method in respect to valuing the
business. As per this approach, the price is basically determined through the way of using P/E
ratio of the other similar company into the same business within the industry. The ratio is
computed by dividing the current market price of the share with its EPS, which is earnings
per share. This ratio shows the willingness of the investor in making an investment into the
company’s earnings. Under this, the entity which is having the higher earning growth
prospects is usually has a high PER which is mainly due to reason that the firm is in the
position to pay higher return to its investors in regard to the investment made by them
(Hendrawan and Salim, 2017). This is in the form of dividend or increase in the price of the
shares or both. This could be explained with the help of an example, like a company is having
the P/E ratio of 15 which means it is selling 15 times of its income or the investors are ready
to pay £15 for every £1 of present or the future earnings of the company. Under the case of
mergers and acquisitions, using the PER for the purpose of valuation, it is very useful and
meaningful as it can utilized in making a comparison among the ratios of the other similar
business entities or can be used against the historical values.
Computation of valuation of the company using price earnings ratio
Particulars Formula Amount
(in £m)
Distributable earnings 42.4
Market price per share (MPS) 4.15
Earnings per share (EPS) 0.29
Numbers of shares
outstanding 147
Price earnings ratio of King
Plc (MPS/EPS) 14.39
EPS of the Dragon plc 0.29
Value of the shares of
Dragon (PER of Kind Plc * EPS of Dragon 4.15

Determining the market
value Dragon plc
= Value of the shares of Dragon * Numbers
of shares outstanding
= 4.15 * 147 610.05
It can be inferred from the above that the value of Dragon Plc is £610.05as it can be
seen in the above table. The MV is being determined through the way of multiplying the no.
of shares with the price per share of Trojan plc.
b) Discounted cash flow method (DCF)
The DCF method is used for estimating the value of the business entity which is
based upon its cash flows. Through this technique the worth of the investment today is
determined by the discounting it using the discounting rate or WACC rate. This helps in
determining the present value of the future expected cash flows. This method is right for all
types of the organization as the aim of this valuation method remains the same, that is, the
amount which is invested today with the expectation that it will generate higher return in
future (Gajek and Kuciński, 2017). The core objective behind using this method is that the
ability to concern in creating and expanding the cash inflow for its investors. In case of
merger and acquisitions, this method is generally utilized for deriving the company’s worth
through the way of estimating the future cash inflows. If it is used rightly, the it is the most
valuable approach since it is not dependent upon the past and is also less influenced by the
outside factors and little complex in understanding.
Computation of valuation of the company using Discounted cash flow
method
Particulars Formula Amount (in
£m)
Evaluating the free cash flow
Net income (NI) 42.4
Less: Increase in working capital -
Less: Capital expenditure -
Add: Non-cash expenses -
Free cash flow (FCF) 42.4
Discounting rate or WACC 12.00%

MPS
= Free cash
flow /
Discounting
rate
353
Market value of Dragon plc
= MPS *
Number of
shares
= 353 * 147 51940
It can be concluded from the above that the value of Dragon plc is £51940 under the
discounted cash flow approach.
c) Dividend valuation method
This method of valuation is based on the assumption that the amount of dividend
along with the price of the stock is growing at the constant rate and in other terms, the
dividend paid by the business entity will grow or expand at the constant rate. This approach is
considered to be appropriate for the businesses which tends to rise its dividend at a fixed
percentage each year. this technique is very easily to apply and suitable for the organizations
having established dividend pay-out ratios. The investors of the company can analyse the
organizations against different enterprises with the assistance of this model (Almabekova,
Kuzmich and Antosik, 2018). Utilizing this model, requires current profit paid as dividend,
the normal expected rate of return along with the growth rate. It really sets up the relationship
among these 3. Other than the above expressed supposition, there are different assumptions
too, that is, organization's growth rate is steady, monetary influence stays as before and the
organization's free cash flow (FCF) is delivered as the dividend.
Computation of valuation of the company using Dividend valuation
method
Particulars Formula Amount (in
£m)
Information provided:
Latest dividend payment (Current
dividend) 0.14
Growth rate (GR) 2.50%
Risk free rate (Rf) 5.50%
Beta (β) 1.05%
Number of shares 147
Return on market (Rm) 6.00%

For determining expected rate of return
(K), CAPM model will be used
According to CAPM, K is = Rf + (Rm-
Rf) * β
=5.5% + (6% -
5.5%) * 1.05% 5.51%
Market value per share
= 0.14 *
(1+2.5%)/
(5.51%-2.5%)
4.77
Evaluating the market value Dragon plc
= Market price
per share *
Number of
shares
700.81
The above table clearly shows the value of Dragon plc using the dividend valuation
approach. The value comes out to be £700.81 as in this, the expected rate of return was
determined with the help of CAPM approach and then for determining the market value per
share, dividend growth model is applied.
d) Critical analysis
According to Sijabat and Suarjaya, (2018) the P/E ratio represents the market price
of the shares of the company which is divided by its earnings per share and it is also
considered as the multiples of earnings. As it has been mirrored that profit of firm affected
towards shifting degree through which an association is been financed and in which it pays
for income tax, a few experts had turned towards various P/E proportion which eliminates an
impact of the company's capital structure and tax obligation on their income. In any case, this
strategy presents bending sway on the profits of bookkeeping rules and strategy in regard to
devaluation on intangible resources and amortization of the intangible resources, like for
utilizing value income produced prior to charging interest, deterioration, amortization and
taxes. This proportion found as well-known because of good connection between EBITDA of
enterprise and its income. It requires positive benefit of bookkeeping income,

notwithstanding, for the organizations that works at losses, the analyst needed to discover
options in contrast to the bookkeeping profit.
Stancu, Obrejabraşoveanu, Ciobanu and Stancu (2017) defined that DDM is a
quantitative approach that is being utilized for the purpose of predicting the organization’s
stock price based upon the theory that its present price worth is the summation of the future
payments of the dividends when it is discounted back to the current or the present value. This
model is considered to be conservative and needn't bother with development presumptions
for making esteem. The growth rate of the dividend for the stock being assessed could be
higher that return rate. In any case, it just deals with the stocks that delivers profits as some
independent ventures does not deliver profits which mirrors that this model of valuation
couldn't be utilized for recognizing their worth. There are different variables which could
impact stock valuation throughout the time like maintenance of client’s base, reliability of
brand and furthermore intangible resource possession has potential for expanding
organization's worth. Thusly, if development pace of profit is steady, such kind of non-profit
variables could change valuation of firm. This implies valuation procedure when processed
precisely, probably would not produce the ideal outcomes.
In respect to DCF method, Tan (2017) is of the view that this model is being based
upon the fundamental assumption that the value of the firm equivalent to the current value of
the future related cash flows which is being generated from the firm’s operations. It is then
discounted at the rate which is depicts the risks attached to such cash flows. On the other
side, DCF is extremely sensitive to the assumption of perpetual growth rate and the discount
rate. This valuation model works well under the case when there is high degree of confidence
in respect to the cash inflows. But, in case the business operation’s lack visibility the it
becomes difficult to predict the sales. Also, DCF method is also suspectable to errors if it is
not accounted for in respect to the inputs. Also, the terminal value comprises of far too much
value of the total value of 65 to 75 per cent and any small variation in the assumption on
regard to the terminal year would have a huge impact over the final outcome. Therefore,
based on the critical analysis, it can be said that the PER is the most suitable technique for
valuing the business.

REFERENCES
Books and Journals
Almabekova, O., Kuzmich, R. and Antosik, E., 2018. Income approach to business valuation:
Russian perspective. Zagreb International Review of Economics & Business. 21(2).
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Gajek, L. and Kuciński, Ł., 2017. Complete discounted cash flow valuation. Insurance:
Mathematics and Economics. 73. pp.1-19.
Hendrawan, R. and Salim, D. F., 2017. Optimizing Active and Passive Stocks Portfolio
Formed Tobin’s Q and Price Earning Ratio Model Stocks on Kompas Index-100
Period 2012-2017. Internasional Jurnal of Applied Busisness and Economic
Reseach (ISSN: 0972-7302).
Lefley, F., 2018. Dispelling the Myth Around the Financial Appraisal of Capital
Projects. IEEE Engineering Management Review, 46(1), pp.47-51.
Magni, C. A. and Marchioni, A., 2020. Average rates of return, working capital, and NPV-
consistency in project appraisal: A sensitivity analysis approach. International
Journal of Production Economics. 229. p.107769.
Mohan, V. and Narwal, K. P., 2017. Capital budgeting practices: State of the art. Asian
Journal of Research in Banking and Finance, 7(4), pp.57-74.
Sijabat, F. D. and Suarjaya, A. A. G., 2018. Pengaruh DPR, DER, ROA Dan ROE Terhadap
Price Earning Ratio Pada Perusahaan Manufaktur. E-Jurnal Manajemen. 7(7).
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Stancu, I., Obrejabraşoveanu, L., Ciobanu, A. and Stancu, A. T., 2017. ARE COMPANY
VALUATION MODELS THE SAME?-A COMPARATIVE ANALYSIS
BETWEEN THE DISCOUNTED CASH FLOWS (DCF), THE ADJUSTED NET
ASSET, VALUE AND PRICE MULTIPLES, THE MARKET VALUE ADDED
(MVA) AND THE RESIDUAL INCOME (RI) MODELS. Economic Computation
& Economic Cybernetics Studies & Research. 51(3).
Tan, Z., 2017. Application of Discounted Cash Flow Model Valuation–Wal-Mart. Available
at SSRN 3100702.