Valuation Techniques in Financial Management

This document discusses various valuation techniques in financial management such as price/earnings ratio, dividend valuation method, and discounted cash flow method. It also critically analyzes these techniques and their limitations. The document provides examples and calculations for each technique. The second part of the document focuses on investment appraisal techniques including payback period, accounting rate of return, net present value, and internal rate of return.

FINANCIAL MANAGEMENT

Table of Contents
QUESTION 2...................................................................................................................................3
a) Price/earnings ratio.................................................................................................................3
b) Dividend valuation method.....................................................................................................3
c) Discounted cash flow method.................................................................................................4
d) Critically analysing the different business valuation techniques............................................4
QUESTION 3...................................................................................................................................7
1. Application of various investment appraisal techniques.........................................................7
2. Benefits and limitation of different investment appraisal techniques...................................10
.......................................................................................................................................................12
REFERENCES..............................................................................................................................13

QUESTION 2
a) Price/earnings ratio
The price earnings ratio is the which is widely used in evaluating the value of the firm
under mergers and acquisitions. A complete evaluation it carried out below based on the given
scenario.
Statements showing valuation under- price earnings ratio
Market price per share £3.89
Earnings per share £0.21
P/E ratio of Aztec (A) 18.52
Distributable earnings £40.4
Number of shares 147
Earnings per share of Trojan (B) £0.27
Value per share of Trojan (A*B) £5.09
Total market value £748.36
From the above data it is clear and evident that the if the company will go for the merger and
acquisition on bases of P/ E ratio then this will include the total market value of £748.36. This
states that when the company will go merger on basis of the price earning ratio then the value
paid to the company will £748.36.
b) Dividend valuation method
This method determines the value of firm by using the expected rate of return. This
approach is based on certain assumption.
Statements showing valuation under Dividend valuation method
Current dividend (D) £0.13
Risk free rate (Rf) 5.00%
Return on market (Rm) 11.00%

Beta (β) 1.10%
Growth rate 2.00%
As per CAPM,
The expected rate of return (K) = Rf + (Rm - Rf) * β
= 5% + (11% - 5%) * 1.1%
5.07%
Market price share = D * (1+g)/(K-g)
= 0.13 * (1+2%)/(5.07%-2%)
£4.32
Total market value = 4.32 * 147
£635.04
With the help of the above data it is illustrated and evaluated that of the company will go for the
merger and acquisition on the basis of the dividend valuation method then the cost or total
market value will be £635.04. This means that if the company will go for the merger on the basis
of dividend yield method then company will have to pay less.
c) Discounted cash flow method
Under this valuation technique, the market price of the stock is identified using the
discounting rate and the free cash flow of the company.
Statements showing valuation under Discounted cash flow method
Computation of free cash flow Amount in £
Net Income 40.4
Add: Non-cash expenses -
Less: Increase in working capital -
Less: Capital expenditure -
Free cash flow 40.4

Discounting rate 9.00%
Market price per share = Free cash flow / Discounting rate
448.89
Total market value = 448.89 * 147
£65986.67
With the analysis and interpretation it is clear that of the company goes with the discounted cash
flow method then this will be more costly for the company. The market value of merger and
acquisition on basis of the discounted cash flow method is that this will also include the cash
flow on the discounted value.
d) Critically analysing the different business valuation techniques
Price/earnings ratio
The price to earnings ratio is the one which assist the company in measuring the current
share price related to the earning per share (Bekaert and Hodrick, 2017). This is also known as
earning multiple or the price multiple as this increases the earning per share for the company.
This P/E ratio is being used by the analysts and investors in order to determine the relative value
of the shares of the company in comparison to the other brands and competitors. The high P/E
ration indicates that the stocks of the company are overvalued of the investors are expecting the
high growth for the company (Finkler, Smith and Calabrese, 2018). On the other side the P/ E
ratio can be calculated by dividing the market value price per share with the earning per share of
the company.
The earning price per share is the value of money which is allocated to the company
common stock which is an indicator for the company and the financial health of the company.
The major issue being faced by P/ E ratio is that this does not tell about the details of the balance
sheet and also the quality of the earning of the company are not listed out figured out by the help
of the P/ E ratio. The another major impact of the P/ E ratio is that sometimes it can be inflated
and sometimes deflated based on the prevailing market conditions. Thus, if the market condition
will be decreasing then the market value of the share will also degrade. Another important
problem being encountered by the company at time of using the P/ E ratio is the impact of

cyclical firms that is the boom and recession period. If the period is of boom then the EPS will be
high and in contrast to this if the period is of recession then the EPS will be low as compared to
period of boom.
Dividend valuation method
The dividend growth model is used by the business organization for the purpose of
evaluating the intrinsic value of the firm. This approach determines the fair value of the stock of
the company which is based on the assumption that dividend grows at the constant rate. Another
assumption is that it financial leverage of the company is stable or the business doesn't have any
financial leverage. Also, the company's free cash flow will be paid out as dividend at the constant
growth rate (Bond and et.al 2017). This model is used to determine whether the stock is
overvalued or undervalued as it is based on the assumption the dividend grows at the constant
rate of g which is then subtracted from the required rate of return (K). this technique has its own
pros and cons. The main advantage of this technique is that it is very easy and simple to calculate
and understand. This simplicity makes this approach preferable. It can not only be used for the
purpose of analysing the intrinsic value but is also used in the reverse analysis such that growth
rate implied in the current market price can be determined. This is suitable for the businesses
having stable business operations. Also, it is best suited for the business entities having limited
expenses with large cash flow.
In contrast to the above stated advantages, there are certain limitations as well. The major
drawback is that it is based on the assumption that the business organization will be having stable
growth rate of dividend. It is very difficult to maintain the constant rate because of the existence
of the external influencing factors like change in market conditions and other financial
difficulties (Gacus and Hinlo, 2018). This approach is not suitable for the organizations having
financial leverage or having unstable cash flow. There are chances that this technique might give
negative outcome in case, the expected rate of return is lower than the dividend growth rate.
Another limitation is that it does not consider the future changes which makes it less preferable.
All these drawbacks make this model less favourable for the market for the market and the
business organizations.
Discounted cash flow method
The discounted cash flow method is used to value the business entity in a direct manner
by considering the company's worth is equivalent to the present value of the cash flow that it will

generate in future. It is considered as the most precise method of valuation but it is little complex
and also it is based upon certain assumptions which are uncertain in nature. This technique is
mostly used by the organizations for calculating the intrinsic value of the company (Schumacher
and Klönne, 2018). It is considered as a forward-looking approach as it is mainly focussed on the
future and is less dependent upon the historical data. It is least affected by the accounting
practices because it is depending upon the cash flow generation. This approach allows the
company to make changes in the valuation such as the new cost-cutting program which leads to
increase in margins.
On the other hand, there are certain pitfalls of this method. The accuracy in the valuation
under this method is highly dependent upon the quality of assumption in respect to the free cash
flow, discounting rate or the terminal value. Also, the value derived is sensitive to the data used
which results into different valuation as carried out by number of analyst as it is completely
based upon the judgement of the future prospects of the business (Cifuentes, 2016). The terminal
value represents the larger percentage of the total value determined under discounted cash flow
method. This causes the enterprise value as it is mainly dependent upon the assumptions of
terminal value. This method works well under the situation when there is high degree of
confidence with respect to the future cash flows. The discounted cash flow method sometimes
becomes difficult in case of predicting the future cash flow trends. This method is not useful for
early stage business enterprises.
Based on the above analysis, it can be concluded that discounted cash flow method is
more appropriate method for valuation. It is similar to price earnings ratio but it takes into
consideration other factors like inflation which results into bringing more accurate outcome.
QUESTION 3
1. Application of various investment appraisal techniques
a. The Payback Period
Computation of payback period
Initial investment £275000
Annual cash inflow £85000
Annual cash outflow £12500
Payback period = Initial investment /( Annual cash inflow –

Annual cash outflow)
= 275000/(85000-12500)
3.79 years
From the above data it can be interpreted that the initial investment was of £275000 and on the
basis of the payback period is 3.79 years. This illustrates that the when the company invests the
amount of £275000 then this amount can be recovered by the time frame of 3.79 years. It is
essential for the company to calculate the payback period as this will suggest that how the
company will recover all its amount and if the payback period is less than it means that the
amount will be recovered very soon.
b. The Accounting Rate of Return
Computation of accounting rate of return
Initial investment £275000
Salvage value £41250 (275000 * 15%)
Annual cash inflow £85000
Annual cash outflow £12500
Average investment = (Initial investment + Salvage value)/2
= (275000+41250)/2
£158125
Accounting rate of return (ARR)
= (Annual cash inflow – Annual cash outflow)/Average
investment
= (85000-12500)/158125
ARR 45.85%
With the help of the above data it is clear that the ARR of the investment option is 45.85 %
which states that on basis of average the if the company will invest in the project then they will

get a return of around 45.85 %. This is good as the company is able to earn the total of 45.85 %
of the total amount which is invested by the company.
c. The Net Present Value
Computation of net present value
Net cash inflow = 85000-12500
= £ 72500
Year Cash flow per year
Discounting
factor @12% Present value
0 -275000 1.00 -275000.00
1 72500 0.89 64732.14
2 72500 0.80 57796.56
3 72500 0.71 51604.07
4 72500 0.64 46075.06
5 72500 0.57 41138.45
6 113750 0.51 57629.29
Net present value of cash
inflow £318975.56
Net present value £43975.56
With the help of the above data it is clear that the net present value is also a good method of the
assessing the fact that which investment option is better for the investment. With the help of the
above method that is net present value the return of investing is £43975.56 which is very good
for the company and its growth. Under this method the per year cash flow is discounted as the
current rate and then in according to it try to calculate the present value of the cash.
d. The Internal Rate of Return
Trial and error approach has been used for evaluating internal rate of return

Year Cash flow per year
Discounting
factor @15% Present value
0 -275000 1.00 -275000.00
1 72500 0.87 63043.48
2 72500 0.76 54820.42
3 72500 0.66 47669.93
4 72500 0.57 41452.11
5 72500 0.50 36045.31
6 113750 0.43 49177.26
Net present value of cash
inflow £292208.51
Net present value £17208.51
Year Cash flow per year
Discounting
factor @18% Present value
0 -275000 1.00 -275000.00
1 72500 0.85 61440.68
2 72500 0.72 52068.37
3 72500 0.61 44125.74
4 72500 0.52 37394.69
5 72500 0.44 31690.42
6 113750 0.37 42136.59
Net present value of cash
inflow £268856.49
Net present value - £6143.51
Internal rate of return (IRR) = 15% + ( NPV @15% / (NPV @15% - NPV

@18%) ) * (18% - 15%)
= 15% + (17208.51 / (17208.51 - (-6143.51)) *
3%
IRR 17.21%
From the above interpretation and analysis it is clear that the IRR is also a good method of
calculating the fact that which method of investment will be more beneficial for the company to
choose from. Thus, with the help of the IRR method it is concluded that the rate of return is
17.21%. This means that if the company will invest in the project on basis of the IRR method
then the company will have less income as compared to the other methods discussed above.
2. Benefits and limitation of different investment appraisal techniques
All the different types of investment appraisal techniques are very helpful for the
business in order to analyse that which investment options are better for the company (Ward and
Forker, 2017). This is due to the reason that company has various alternatives and it is very
essential for the company to choose the best alternative for the investment.
Payback period- this is a method which help the company in calculating the time within the
which the cash flow of income of particular project is covered according to the initial invested
amount.
Advantages
 The major advantage of using this method is that this is very simple to use and easy to
understand. This is basically because of the reason that this method is easier to calculate
as compared to the other capital budgeting methods. This is due to the reason that this
method assists the company in ascertaining the amount which they have invested in the
project.
 Another benefit of using this method is that this is useful in case of uncertainty and it is
because of the fact that there are many different changes taking place in business
environment and this affect the cash inflow and outflow of the cash.
Disadvantages
 The major drawback of this method is that this ignores the time value of the money and
this is more important in the business (Brusca, Gómez‐villegas and Montesinos, 2016).

The time value of money states that the money which is coming early is of more value
than the money which will come later. Another limitation of this method is that this method fails to consider all the cash flows
which are coming in the subsequent year.
Accounting rate of return- this is another method in which the company calculates the return
which is generated from the net income of the capital investment option proposed (Davidova and
Latruffe, 2020). This is the average net income which the asset can expect to generate in
accordance with the cost levied in order to get that asset.
Advantages
 The major advantage of using the ARR method is that this assist the company in easily
calculating the return which will come back after the project is being executed. This
includes the saving or the total profit for the entire period of economic life of project.
 Another major benefit of using the ARR method is that this recognizes the concept of net
earnings or the income after tax and depreciation and this assist the company in having
better approval of cost.
Disadvantages-
 The major limitation of this type of investment appraisal technique is that if one
calculates the ROI and the other time the ARR is calculated then both are different and it
is not proper and creates problem and difficulty in taking decision. Another drawback is that the fair rate of return cannot be calculated on the basis of the
ARR method as the discretion of the management.
Net present value- this is a method wherein the company calculates the value of a sum of the
money which in contrast has some future values which are presently within the market. This is
an intrinsic valuation which is used across accounting and finance department in order to
determine the value of the whole business and its profitability.
Advantages
 The major advantage of this type of calculating the investment appraisal option and then
select the best option which will yield maximum (Ashmarina, Zotova and Smolina,
2016). The major advantage of this is that this includes the time value of the money and
also takes into account the discounted cash flow of investment.
Disadvantages

 The major drawback of using the net present value method is that this is difficult to use as
this does not provides for the appropriate discount rate and this will affect the working of
the company to a great extent (Ferguson and Morton-Huddleston, 2016). Another major limitation of this method is that may not give for proper and correct
decision to be taken for the better working of the company and its decision.
Internal rate of return- this is another method of investment appraisal which is used to calculate
the profitability of the investment option and then to select the one in which gives maximum of
profits. This is the discounting cash flow practice which will provide for the rate of return which
the project will yield.
Advantages
 The major advantage of this method is that this is much easy and simpler to execute and
interpret the amount coming.
 Another advantage is that there is no need of calculating the hurdle rate so this makes the
calculation of IRR much easier.
Disadvantages
 The major drawback of this method is that this ignores the economies of scale and this
will affect the benefit which is undertaken with help of economies of scale
(Antonopoulos and Hall, 2016).
 Another drawback is that this might sometimes have a dependent or contingent projects
as in some project the execution of the project is dependant over the other project which
is compulsory.

REFERENCES
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