Assignment on Stock Valuation and Capital Budgeting Techniques
Added on - 21 Apr 2020
Running Head: Stock Valuation and Capital Budgeting TechniquesFinancial Studies
Stock Valuation and Capital Budgeting Techniques1QUESTION 1Part A:Current Year Dividend20pEarliest Year Dividend13pLatest Year Dividend20pGrowth Rate9.00%Cost Of Equity14.5%Share Price (£)32.71Growth rate is calculated using excel:Formula:(End Value/Start Value) ^ (1/Periods) -1Share price is to be calculated using the Gordon’s model in excel:Fair price of the share=D1Ke- gPart B:If the cost of equity is changed to 15.4% from 14.5%, the new fair price of the share will be asfollows:As per Dividend discount Model:Growth Rate9%Cost Of Equity15.4%Share Price (£)28.11Part C:Dividend Growth Model or Dividend Discount Model is the financial model used to determinethe value of firm’s stock. Stock valuation is required to be undertaken to estimate the value of the
Stock Valuation and Capital Budgeting Techniques2firm for various decision making purposes. The said model was developed by Sir Gordon andhence it is also known as Gordon’s Model (Arnold, 2013). It uses dividend as the base tomeasure the share prices and therefore it is also called as dividend discount model. Under thismodel the stock valuation is done using the aggregate of present values of dividend payment thatare expected to be made by the company in all the years in future. The company’s stock is thuspriced on the basis of net present values of expected dividend payments. Though, the dividendgrowth model proves to be very useful approach in stock valuation, it suffers some of thelimitations which often makes it unreasonable to be practically employed. These problems arediscussed as below:As while making stock valuation only dividend factor is considered under dividendgrowth model, the other non-dividend factors are being ignored by this model. The non-dividend factors like brand loyalty, tangible assets ownerships and customer retentionhave direct or indirect influence on the firm’s value (Olweny, 2011).Moreover, dividend growth model also assumes that the firm’s dividend growth rateremain constant and known as well (Hiebert & Sydow, 2011).Also, the Gordon’s growth model asserts that the share price of the company ishypersensitive to the chosen growth rate of dividend and the dividend growth rate in anycase cannot be greater than the cost of equity which does not hold true in every situation.There is difficulty in making the appropriate projections regarding the dividend paymentsto be made by the company (Lazzati & Menichini, 2015).While the dividend discount model can be used effectively in the cases where firmdistributes its profits as dividend, the same model is unsuitable to the companies payingno dividend.Further, the price appreciation of shares contributing to capital gains is also ignored underthis model.Another problem with the dividend growth model is the use of several flawedassumptions. Even the slightest error in the assumptions and projections can lead to underor overvaluation of the company’s stock.It is also argued that the dividend growth rate model also ignores the stock buybackeffects whereas these effects can bring vast differences in the stock valuation. This
Stock Valuation and Capital Budgeting Techniques3indicates that the model is being over conservative in its approach of estimation of stockprices.Therefore, it can be concluded that even when dividend growth model proves to be a reliablemethod, there are some problems that are generally faced in its practical implementation.QUESTION 3Part 1:a)PAYBACK PERIODDiscounted payback period:YEARCASH FLOWSCASH FLOWSDCF@12%PRESENT VALUES OFCASHFLOWSCUMULATIVEPRESENTVALUES OFCASH FLOWS0Initial Investment-£ 275,000.001-£ 275,000.00-£275,000.001Cash Inflows£ 72,500.000.893£ 64,732.14-£2,10,267.862Cash Inflows£ 72,500.000.797£ 57,796.56-£1,52,471.303Cash Inflows£ 72,500.000.712£ 51,604.07-£1,00,867.234Cash Inflows£ 72,500.000.636£ 46,075.06-£ 54,792.175Cash Inflows£ 72,500.000.567£ 41,138.45-£ 13,653.736Cash Inflows£ 72,500.000.507£ 36,730.76£ 23,077.036Salvage ValueInflow£ 41,250.000.507£ 20,898.53£ 43,975.56Payback period= 5 +(-13,653.73)36,730.6= 5.37 YearsNote: since the cost of capital is given in the question it is more preferable to calculate thediscounted payback period in place of normal payback period as it would offer more appropriatepayback period.Analysis:The payback period of 5.37 years is quite large and it indicates that the project willtake maximum time to cover its cost and only thereafter it will start to generate returns. So thecompany must not consider the option of investing in the new machinery.