Financial Management: Valuation Methods and Investment Appraisal Techniques

This document provides an overview of different valuation methods used in financial management, including the price/earnings ratio, dividend valuation method, and discounted cash flow method. It also discusses various investment appraisal techniques such as the payback period, accounting rate of return, net present value, and internal rate of return. The document includes calculations and critical reviews of these methods, along with a recommendation for investment.

FINANCIAL
MANAGEMENT

TABLE OF CONTENTS
QUESTION 2.............................................................................................................................3
a)Price/earnings ratio.............................................................................................................3
b) Dividend valuation method................................................................................................3
c) Discounted cash flow method............................................................................................5
d) Critical review....................................................................................................................6
QUESTION 3.............................................................................................................................7
1. Calculation of different investment appraisal techniques..................................................7
2. Critical evaluation of benefits and limitation of different investment appraisal techniques
................................................................................................................................................9
REFERENCES.........................................................................................................................12

QUESTION 2
a)Price/earnings ratio
The P/E ratio is the measure which is used for assessing the value of the business
organization. The price here refers to the price of the stock of the company while earnings
means the net income which is being reported by the organization. For instance, if the stock
of the company is currently sold at the price of $24 per share while the organization reported
the EPS of $1.50, then the PER will be 16 (24/1.50).this is also referred to as multiples
(Rahmawati, Rahadi and Damayanti, 2018). This indicates that the investor is willing to pay
$24 for gaining $1.50 in earnings. Higher the ratio more favourable it is for the investors. The
PER of the similar organization within the same industry $8 which means the market value of
the company is $12 ($8* 1.5) which indicates the company is overvalued by $12 (24-12).
This, higher ratio depicts the stronger position of the entity while lower ratio requires to be
further investigated.
Determining the value of Trojan plc using price earnings ratio
Particulars Formula Amount
(in £m)
Distributable earnings 40.4
Numbers of shares outstanding 147
Market price per share (MPS) 3.89
Earnings per share (EPS)
Price earnings ratio of Aztec (MPS/EPS) 18.52
EPS of the Trojan 0.27
Value of the shares of Trojan (PER of Aztec * EPS of Trojan) 5.0004
Calculating the market value
Trojan plc
= Value of the shares of Trojan * Numbers of
shares outstanding
= 5.0004 * 147 735.06
Based on the above, it can be stated that the value of the Trojan plc is £735.06
million which is derived by using the PER. Under this, the market value is calculated through
multiplying the MPS with the number of shares.
b) Dividend valuation method
The DGM is used for the purpose of determining the fair value of the stocks of the
company which is based on the assumption that either dividend grows at the stable rate or at

different rate. It is useful in identifying whether the stock is under or over valued which
dependent upon the dividend GR assumption.This model is utilized for knowing the intrinsic
value of the stock which is based on the series of the dividends (Ferraro, 2017). This model
assumes that the dividend grows at the stable rate and thus, it is majorly useful for the
organization having stable growth rate. It mainly requires 3 inputs which are dividend per
share, GR and the expected rate of return. This model assumes that the company will exit
forever and will pay dividend to its investors at the constant rate. It determines the value
without taking into account other external factors or the prevailing market conditions.
Computation of the value of the company using dividend valuation method
Particulars Formula Amount (in
£m)
Details provided:
Latest dividend payment (Current dividend) 0.13
Growth rate (GR) = 0.10(1+g)^5
= 0.13
5.00%
0.05
Risk free rate (Rf) 5.00%
Beta (β) 1.10%
Number of shares 147
Return on market (Rm) 11.00%
For determining expected rate of return (K),
CAPM model will be used
According to CAPM, K is = Rf + (Rm-Rf)
* β
=5% + (11% -
5%) * 1.1%
5.07%
Market value per share
= 0.13 *
(1+5%)/(5.07%-
5%)
195

Evaluating the market value Trojan plc = Market price
per share *
Number of
shares
28665
With the help of dividend growth model, the value of the organization derived is
£28665 million. This determined by using the expected ROR which is derived through
applying the CAPM model and then the dividend GR is implemented
c) Discounted cash flow method
The DCF valuation is considered as the core tool for the purpose of valuing the
organization. This approach captures the major driving factor of valuation which is the value
representedas the present value of the future cash flows or the benefits.This method is taken
as the most popular and commonly used approach for the computation of the value of the
organization (Mercer and Harms, 2020). This approach can be applied on the valuing the
purchase of an asset or making an investment. DCF technique is utilizedby the privately held
organizations. It makes use of discounting rate for knowing whether the investment is worth
investing or not. This method is preferred because it makes use of discounting rate which is
not so in other methods.
Computation of valuation of the company using Discounted cash flow method
Particulars Formula Amount (in
£m)
Evaluating the free cash flow
Net income (NI) 40.4
Less: Increase in working capital -
Less: Capital expenditure -
Add: Non-cash expenses -
Free cash flow (FCF) 40.4
Discounting rate or WACC 9.00%
MPS = Free cash
flow /
Discounting
rate
448.89

Market value of Trojan plc = MPS *
Number of
shares
= 448.89 *
147
65986.67
The above table provides the value of Trojan plc which is derived using the DCF
valuation model. The value of the company is £65986.67.
d) Critical review
Besides number of benefits and advantages, these discussed valuation methods provide
but the fact cannot be denied that each of these methods are prone to some of the
disadvantages as well. As defined by Miciuła, Kadłubek and Stępień (2020) in terms of PER,
this ratio does not provide much useful information about the future of the company. It
provides investors nothing about the expected organization’s earning per share growth
prospects. In case the company is growing very quickly then it might make the investor
comfortable in purchasing the stock even if the PER is high along with the fact that the
growth in EPS will make the PER comes down. Along with that there is a challenge to know
whether the high multiple is the result of the expected growth or the overvaluation of the
stock. According to Trugman (2016) another limitation pertaining to PER is that there are
different accounting policies which is being followed and differs from one nation to another.
These variation in the policies affect the comparison between the two difficult and accurate.
Along with that, the buyback of the shares can cause rise in the earnings of the organization
which can lead to increase in the risk component. Investors optimism can result into inflated
price of the stock for the whole sector. Thus, at the time of recession, the value of shares
would be undervalued according to the PER and during inflation, income will be determined
using currency of that country and this causes rise in the PER.
As emphasized by Rak-Młynarska and Skobelska (2018) the disadvantages of utilizing
the dividend growth model (DGM) incorporate the trouble of precise projections, the way
that it doesn't factor in buybacks, and its crucial suspicion of pay just from profits. The
principal downside of the DGM is that it can't be utilized to assess stocks that don't provide
the dividends, paying little on the capital gains that could have arisenby putting resources into
the stock. The Gordon Growth Model's straightforward computations can end up being the
significant weakness as the model contemplates the quantitative figures and not the subjective
ones. The future changes can't be thought about which is the reason this model isn't highly
liked. Further stated by IYER (2017) the estimations are fundamentally on future

suppositions, which can be exposed to market changes dependent on the monetary or
economic conditions and different components which add to being one of the significant
drawbacks. The constraints to the model make it less attractive for the market and
organizations which has quick changing dividendtrends.
Just like other methods, DCF method is also having some limitations which cannot be
ignored. According to Li (2018) the most significant factor in computing the DCF estimation
of a stock is assessing the series of operating income projections. There are various innate
issues with profit and income forecasting that can create issues with DCF investigation. The
most predominant is that the vulnerability with income projection increments for every year
in the figureand DCF models mainly utilizes5 or even 10 years of evaluations. Little,
mistaken assumptions in the initial years of the model can result into variation in the
operating income projections in the later long periods of the model. Free income projection
includes anticipating capital uses for each model year. Once again, the level of vulnerability
increments with each extra year in the model.
As stated by Köseoğlu and Almeany (2020) capital expenditure can be to a great extent
discretionary; in a down year, an organization's administration may get control over capital
expenditure plans. Another major challenge is to determine the terminal valueas it represents
the large part of the total value. Along with that there are various methods for calculating the
discount rate and the GR. But the approaches very much theoretical and might work well in
reality and the real world situation. Other pitfall is that the GR of the company might change
even from one year to another or form decade to decade. Thus, based on the above, it can be
said that PER ratio is more appropriate measure for valuing the business.
QUESTION 3
1. Calculation of different investment appraisal techniques
a. Payback period
Year
Net
Cash
flow
Cumulative cash
flow
1 72500 72500
2 72500 145000
3 72500 217500
4 72500 290000
5 72500 362500
6 11375
0 476250

Payback
Period
3 + (275000 –
217500)
= 3 + (57500 /
72500)
3.8 years
b. Accounting rate of return
Year Cash flow Depreciation Annual
profit
1 72500 38958.3 33541.7
2 72500 38958.3 33541.7
3 72500 38958.3 33541.7
4 72500 38958.3 33541.7
5 72500 38958.3 33541.7
6 113750 38958.3 74791.7
Average 40416.7
Initial
value +
Scrap
value /2
(275000 +
41250)/2 158125
ARR 25.56%
c. Net present value
Year EBIT Discounting
factor @12%
PV of cash
inflow
1 72500 0.893
64732.1428
6
2 72500 0.797
57796.5561
2
3 72500 0.712
51604.0679
7
4 72500 0.636
46075.0606
8
5 72500 0.567
41138.4470
4
6 113750 0.507
57629.2900
3
Total present
value of cash
inflow
318975.564
7
Initial
investment 275000
NPV 43975.5647
d. Internal rate of return

Year Cash
flow
0 -
275000
1 72500
2 72500
3 72500
4 72500
5 72500
6 113750
IRR
17.17
%
From the above calculation it is clear that the investment is worth doing. The major reason
for this is the amount invested will be recovered in the time frame of 3.8 years. This suggests
that any cash generated after the time of 3.8 years will be profit for the company. Further
along with the payback period the ARR of the project is 25.56 % which is also quite good.
This means that on average basis this investment will yield 25.56 % of return. In addition to
this the NPV that is net present value of the investment is 43975.5647 which state that the
current value of the future profits is this much. It is good for the company as they can have
good amount of profit if they go for this investment. In the end the IRR that is internal rate of
return is 17.17 % and this states that this is the discounting rate at which total initial cash
outflow and the discounted cash inflow are equal to zero. Hence, with all these investment
appraisal techniques it is clear that it is advisable for the company to invest in the present
proposal of investment. This is economically feasible to invest in acquiring the machine as
this will assist the company in earning profit after the timeframe of 3.8 years. Also, this is
economically feasible as this will support the company in managing the investment in
effective manner as the depreciation is also low and if charged in accordance with the straight
line method which is beneficial for company. This is also recommended to the company to
invest in the project as this will increase the chances of company performing in much
effective and efficient manner. The reason underlying this fact is that the use of machinery
will increase the efficiency and working capacity of the company and this will result in
improved performance of the company.
2. Critical evaluation of benefits and limitation of different investment appraisal techniques
Payback period

As per the views of Advantages and disadvantages of payback period, (2020) that
major benefit of using the payback period is that this is easy for the company to use and
understand and take the decision of investing in particular project or not. The major reason is
that if the payback period is low or small then it is advisable for the company to invest in that
project and otherwise not. Furthermore, Szűcsné Markovics (2016) argues that the major
benefit of using the payback period method for capital budgeting is that this provides quick
solution to the company and they can easily and in fast manner can take decisions.
On the other side De Souza and Lunkes (2016) argues that the major drawback or
disadvantage of suing payback period method is that this method ignores the time value of
money. This means that the time value of money that is future value of money is ignored at
time of calculating the payback period. While on flip side Shaban, Al-Zubi and Abdallah
(2017) articulates that major drawback of using the payback period is that this neglects the
return of project over the investment. This is due to the fact that it is not necessary that if the
project payback is low then it will definitely yield more profits.
Accounting rate of return
As per the views of Shaffie and Jaaman (2016) the major benefit of using the
accounting rate of return is that this method includes the concept of net earnings that is profit
after tax and depreciation. Further another major benefit of using this method of capital
budgeting for investment appraisal is that this method assists in comparing two or more
projects with one another. In addition to this another major benefit of using the ARR method
is that this method tries to satisfy the interest of the owners of the company as this provides
the rate of return which the investment will yield.
On the contrary, Accounting rate of return method advantages and disadvantages,
(2020) argues that the major drawback of using the ARR method for capital budgeting is that
the result of this is different from ROI that is return on investment. Thus, the difference
between ROI and ARR can create issues in the process of decision making. Another major
drawback of using this method is that this ignores the time factor and this is the major
weakness of using this method. Furthermore with help of this method the fair rate of return
cannot be determined and this affects the management and its decision making process.
Net present value
As per the views of Willigers, Jones and Bratvold (2017) the major advantage of
using this method includes the time value of money and this is the major benefit of using this
method in investment appraisal technique. Under this method the computation of NPV is
done after considering the discounted net cash flow of the investment in order to determine

its viability. The major reason underlying the use of time value of money is that if time value
of money is not considered then profitability of project will have difference between the
inflow and outflow of the project. In addition to this another major benefit of using the NPV
is that this method assist in effective decision making as this will improve the process of
decision making to a great extent. With help of NPV it is assistive in evaluating the project in
very detailed manner and this will provide an effective view of the project and its
effectiveness. Hence, this will improve the decision making and this will help management in
taking more effective and efficient decisions and for betterment of company and its operation.
On the flip side, Kulakov and Kastro (2017) criticizes the fact that the major
drawback of using the net present value method for investment appraisal is that there are no
set guidelines for the calculation of the required rate of return. This is particularly because of
the reason that the whole calculation of the net present value is based over the discounting
rate only and if the discounting rate selected is not valid or appropriate then this will affect
the whole computation of NPV. Further another major drawback of using the net present
value is that this method is not suitable for comparing different project which are having
different sizes. The major reason underlying this fact is that the value of NPV is absolute and
not in percentage so it cannot be compared with any other project as there is not any common
base provided.
Internal rate of return
In accordance with the views of BASU (2019) the major advantage of suing internal
rate of return is that this considers the time value of money at time of evaluation of the
project. This is done in a way that it calculates interest rate at which the present value of cash
is being calculated and compared with the capital investment required. Further another major
benefit of using IRR is that this assists the manager in making rough estimate of the needed
rate of return. This is assistive as if the IRR is calculated then it will help in comparing it with
the hurdle rate and if IRR is far away from the estimated rate of return then manager can take
effective decisions.
On the flip side Herdjiono and Damanik (2016) argues that the major drawback of
using IRR as a method of capital budgeting is that the economies of scale is ignored in this
type of investment appraisal. Another major drawback of using IRR for evaluating the
investment appraisal is that there is a difference between the IRR and the rate of return. This
difference is very minute and because of this it is sometime used interchangeably. Thus, this
affects the working capacity of the company and the decision to choose any one of the
investment option is affected by this.

REFERENCES
Books and Journals
BASU, U.K., 2019. CAPITAL BUDGETING TECHNIQUE FOR BORROWING
PROJECTS. Hyperion International Journal of Econophysics & New Economy.
12(2).
De Souza, P. and Lunkes, R.J., 2016. Capital budgeting practices by large Brazilian
companies. Contaduría y Administración. 61(3). pp.514-534.
Ferraro, O., 2017. Business valuation: premiums and discounts in international professional
practice. In Financial Environment and Business Development (pp. 79-88). Springer,
Cham.
Herdjiono, I. and Damanik, L.A., 2016. Pengaruh financial attitude, financial knowledge,
parental income terhadap financial management behavior. Jurnal Manajemen Teori
dan Terapan| Journal of Theory and Applied Management. 9(3).
IYER, R., 2017. SYNERGIES IN BUSINESS VALUATION. CLEAR International Journal
of Research in Commerce & Management. 8(8).
Köseoğlu, S.D. and Almeany, S.S.A., 2020. Introduction to Business Valuation. In Valuation
Challenges and Solutions in Contemporary Businesses (pp. 1-23). IGI Global.
Kulakov, N.Y. and Kastro, A.N.B., 2017. New applications of the IRR Method in the
Evaluation of investment Projects. In IIE Annual Conference. Proceedings (pp. 464-
469). Institute of Industrial and Systems Engineers (IISE).
Li, W.S., 2018. Strategic Value Analysis: Business Valuation. In Strategic Management
Accounting (pp. 171-192). Springer, Singapore.
Mercer, Z.C. and Harms, T.W., 2020. Business valuation: an integrated theory. John Wiley
& Sons.
Miciuła, I., Kadłubek, M. and Stępień, P., 2020. Modern Methods of Business Valuation—
Case Study and New Concepts. Sustainability. 12(7). p.2699.
Rahmawati, D., Rahadi, R.A. and Damayanti, S.D., 2018. Business Valuation for Small
Medium Enterprise (Case Study: Piksel Indonesia). International Journal of
Business, Economics and Law. 17(2). pp.8-15.
Rak-Młynarska, E. and Skobelska, A., 2018. Company valuation–modern day
dilemmas. Zeszyty Naukowe Wyższej Szkoły Finansów i Prawa w Bielsku-Białej. (4).
pp.45-53.
Shaban, O.S., Al-Zubi, Z. and Abdallah, A.A., 2017. The Extent of Using Capital Budgeting
Techniques in Evaluating Manager’s Investments Projects Decisions (A Case Study
on Jordanian Industrial Companies). International Journal of Economics and
Finance. 9(12). pp.175-179.
Shaffie, S.S. and Jaaman, S.H., 2016. Monte Carlo on net present value for capital investment
in Malaysia. Procedia-Social and Behavioral Sciences. 219. pp.688-693.
Szűcsné Markovics, K., 2016. Capital budgeting methods used in some European countries
and in the United States. Universal Journal of Management. 4(6). pp.348-360.
Trugman, 2016. Understanding business valuation: A practical guide to valuing small to
medium sized businesses. John Wiley & Sons.
Willigers, B.J., Jones, B. and Bratvold, R.B., 2017. The net-present-value paradox: Criticized
by many, applied by all. SPE Economics & Management. 9(04). pp.90-102.
Online
Accounting rate of return method advantages and disadvantages. 2020. [Online]. Available
through: < https://accountlearning.com/accounting-rate-of-return-method-
advantages-disadvantages/>

Advantages and disadvantages of payback period. 2020. [Online]. Available through: <
https://efinancemanagement.com/investment-decisions/advantages-and-
disadvantages-of-payback-period#Simple_to_Use_and_Easy_to_Understand>