Business Finance BAO5534: Equity Valuation and Capital Budgeting

This report provides an overview of equity valuation and capital budgeting decisions. It begins by explaining the process and framework of equity valuation, including concepts like book value, market value, intrinsic value, and liquidation value. Various valuation methodologies are discussed, such as balance sheet values, discounted cash flow (DCF), and comparable approaches, with a focus on the dividend discount model. The report then delves into capital budgeting decisions, highlighting their importance and the types of information required for evaluation, including cash flow estimation, capital structure, and economic value. Techniques like Net Present Value (NPV) and Internal Rate of Return (IRR) are mentioned as tools for evaluating project feasibility. This document is a comprehensive overview of key financial concepts.

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Task 1
Process and framework of equity valuation
The term valuation refers to the computation of the estimation of the worth of an asset or a
security or a business by an existing or a prospective investor. The investors are interested in
knowing the valuation of the security or a business before purchasing the portion of the said
assets or security. The valuation exercise involves the valuation of tangible assets such as
plant, machinery, equipment, furniture, as well as that of intangible assets such as patents,
copyrights, good will. It is however significant to note that the valuation process is a
subjective process and involves a number of assumptions. Some of the concepts that are used
in the valuation of the equity stock are explained as follows.
Book Value: Book Value is the accounting record of the assets, as are shown in the balance
sheet. The valuation is used as part of the going concern principle of accounting. The
valuation is arrives by deducting the accumulated depreciation from the purchase cost of an
asset.
Market value: Market value refers to that value in the market at which an asset or an equity
security of a company can be sold. The valuation can be assigned only to the tangible assets
and securities, as the intangible assets are not sold in the market.
Intrinsic/Economic value/ discounted value: This is arrived by application of an an
appropriate discount rate and then discounting the incremental cash flows. The discounting
rate is one as decided by an investor. The decision of the choice of the discount rate is
dependent on the discretion of the expertise and analysis of the investor. This is also stated to
be the maximum value at which a business can be acquired.
Liquidation value: This is calculated only at the time of the liquidation of the entity. It is
represented by the price at which each of the individual asset can be sold, when the business
is liquidated. It is valued after deducting all the external liabilities. This is the least valuation
of the stock.
Comparison and analysis: The investor makes a comparison of the value of the stock using
various methodologies and the prices at which shares are traded. In addition, the investor
indulge in the analysis of the financial statements of the entity, and that of the macro
environment including the competitors data to arrive at a decision.

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Thus, it can be stated that depending upon the type of valuation, one or more of the concepts
are used.
Valuation Methodologies
The key assumption that is being applied in the case of equity valuation is that it is dependent
upon the fundamentals of the firm’s underlying business. Some of the valuation
methodologies of the valuation of the equity stock are described as follows. There are three
main approached prescribed for the valuation of the equity stock that is the balance sheet
values, discounted cash flow (DCF), and the comparable approach. While the balance sheet
values refers to the computation of the value of the stock referring to the book
value, liquidation value, and replacement value methods; the discounted cash flow
methodology involves the dividend discount models, constant growth model, and free cash
flow models. The comparable approach or the relative approach is referred to as the
calculation of the various ratios such as the price to book value ratios, price to earnings ratios,
price to sales ratios and others.
Dividend discount valuation model
The dividend discount model represents that the value of a stock is equal to the sum of all the
future dividends of an enterprise. Out of all the models, the most popular one is referred to as
the Gordon Growth Model. Some of the key assumptions on which the said model operates
are described as follows.
First is the approximation of the values of the future dividends. The payout ratio of the
dividend may not be the same and depends on a number of incidental factors, which makes it
difficult to arrive at the figures of the future dividends.
Second key assumption is the determination of the discount rate for future payments. This
rate is described as rate at which the amounts received from the investments are reinvested.
The investments here refer to the investments in stock, as well as in debt. Thus, this rate is
difficult to compute.
The formula for the dividend discount model is listed as follows.

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Here, P is the present value of the stock,
Div = dividends that are paid out to the investors for a given year,
R= the required rate of return expected by the investors in light of the risk associated of the
said investment.
The key steps of the formula are listed as follows. Firstly, the future dividends are calculated
as per the current dividend rate and applying the rate of inflation. Secondly, the rate of return
as determined by the investor as per risks involved in the investment is used to discount all
such future dividends that are expected to be received. The price or the value of the equity
stock is the sum of all such discounted present values.
Comparison of Various Methods
While the first set of the methods are focussed on the values of assets or securities as
represented in the financial statements or the markets, the second method involves the use of
growth rate and discount rate. The third method involves mix of various components of first
method to compute the various ratios.
The first set of techniques take into account the various elements of the books of accounts is
done. Thus, the first method involves the use of the either the past figures or the current
figures. Analysis is done by comparing the data of the competitors. The strength lies in the
simplicity. In addition, there is the accuracy of information as obtained form company data or
the stock market. The disadvantage of the method is that these do not take into consideration
the possible future evolution or the time value of money. In addition, another disadvantage is
that the factors like capability of the human resources, organisational problems, and the
current industrial scenario are not taken into account.
The second method involves the computation of discounting rate and applying the same to
various formulas. Some of the formulas are dependent upon the divided, while some on
profits or earning per share to equity shareholders. The strength of method is that these
provide the closest estimate of a stock’s intrinsic value. While the growth rate and
discounting rate are computed taking into consideration the current market risks and
scenarios, these methods are subjective. Two investor for same category of stock may have

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two different viewpoints, thus this is a disadvantage. The disadvantage is that these are
difficult to operate and are lengthy set of procedure.
The last method involves the calculation of ratios for price, earning per share, return obtained
and others. The similar thing in all three methods is that these take into consideration the
markets risks and growth attributes. The strength of the method is that it is easiest to perform.
Another major advantage is that when there is no change in the control of the company, the
method is most sought upon to evaluate the viability of the stock.

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Task 2
Introduction and importance of the capital budgeting decisions
Capital budgeting decisions or the investment appraisal process refers to the decisions with
respect to the investment in the capital assets of the company. The capital assets refer to the
building, plant, machinery, land, equipment or any other long-term assets. The capital
budgeting decisions involve a large amount of the expenditure, known as the capital
expenditure. These decisions are of strategic importance and are taken by the senior
management to maximise the company’s future profits.
The capital decisions of the company are significant because of the two chief reasons as
explained below. Firstly, these decisions are irreversible (Baker and English, 2011). Thus,
once the projects have started, it is impossible to go back or cease them, because these
involve a number of incidental decisions with respect to finance, roles, responsibilities, and
others (Banerjee, 2017). Thus, the projects involve a high risk of failure. Secondly, these
decisions involve a huge amount of investments, in the form of time, money, and resources.
Thus, it would be right to state that capital decisions of an entity are of long-term strategic
implications. This is also because the viability of the decisions lies in the fact that the
potential revenues created from such decisions, must be capable enough to cover the various
costs of the past years to arrive at such projects. These decisions are of acute importance
because the companies are able to manage only one project at a time.
The capital investment decisions involve varied kinds of decisions, which are listed as
follows. Firstly, the buying, renting, leasing, or the hiring decisions for an asset. Secondly,
the decisions with respect to the expanding the existing production processes. These
decisions are of significance in the events of increase in the demands of the products or
services, or the strategy to tap new markets. Thirdly, the decisions involving the replacement
of an existing machinery, vehicle, and plant with a similar asset, in order to avoid the repair
charges also fall in the category of the capital decisions. These decisions are important
because the frequent repairs and down time of the assets, cover the revenues, efficiency of the
labour force. These are essential to keep the cost of the products in check.
In order to arrive at a capital decision, the finance managers of an entity must follow a
strategic approach that involves a number of steps (Baum and Crosby, 2014). These are the
identification of the objective of the entity, research about the new investment opportunities,

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classification of the project as per the financial budget, computation of cash flows, selection
of the project and monitoring of the same. It must be noted that capital decisions must be
arrived taking into account the various other factors as well, such as the legal, technological,
environmental aspects (Berman, Knight and Case, 2013).
Some of the major techniques that are being used by the senior management and the finance
department to evaluate the financial and economic feasibility of the projects are the Net
Present Value method, Internal Rate of Return Method, Accounting rate of return method,
Payback period and others (Bierman and Smidt, 2012). The choice of the technique is
discretion of the management and is done based on the nature, size and the complexity of the
business operations. Each of the techniques comprise some benefits and weaknesses, the
same must be evaluated as well.
Type of information required to evaluate the capital budgeting
decisions
There are a number of techniques that aid the managers to evaluate the capital budgeting
decisions. Some of the popular techniques are the Net Present Value (NPV), Internal Rate of
Return, Payback Period, Profitability Index and others. Each of the techniques makes use of
the different information and different sets of assumptions. However, some of the common
information required is stated as follows.
There are a number of important information that are required to be evaluated in order to
arrive at the capital budgeting decisions. Prima facie, the major information that affects the
capital budgeting decisions are the Structure of Capital, Availability of Funds, Need of the
project, Accounting methods, Taxation policy, Lending terms of financial institutions,
Economic value of the project, Capital Return and others.
The first and foremost important information required is the estimation of the cash flows of
the entity. The cash flows can be further broken down into three categories namely the initial
cash flows, the annual cash flows and the terminal cash flows. The initial cash flows include
the purchase price of the asset, the inflow of the loan and others (Bierman and Smidt, 2012).
The annual cash flows include the revenues and cost of the products or services, repair
charges, instalments of the loan and other such reoccurring expenses and incomes. The
terminal cash flows involve the exchange prices or the scrap value of the assets (Goyat and

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Nain, 2016). It is important to note that some of the techniques take the annual profits into
consideration.
The second major information that is required to be computed is the cost of the capital. Some
of the techniques involve the use of the cost of capital. The calculation of the discounting rate
is essential so as to use the same for finding the present values of the cash flows. The two
primary methods that can be used for the calculation of the discounting rates are Weighted
Average Cost of Capital (WACC) and the Capital Asset Pricing Model (CAPM). In order to
estimate the weighted average cost of capital, effective rate of return of each category of
investors is computed, that is the equity investors and the debt investors (Pogue, 2010). The
capital asset pricing model is majorly focussed on the cost of equity and considers the market
risks and rate for the calculation of the same.
The explanation of the WACC and the CAPM is as follows. Weighted Average Cost of
Capital refers to the collective average cost of various sources of capital, as availed by the
entity (Ross, et. al, 2014). The different sources of capital of a company are the debt, equity
shares, and preference shares. The weighted average cost of capital is further determined by
the division of the effective cost of capital of each category by the proportion of the book
weights or the market weights. The formula for WACC is stated as follows.
K = Ke(V e / ¿+V d ) + Kd(V d / ¿+V d)
Where,
K = WACC
V e= Market value of equity
V d = Market value of debt
Ke= Cost of equity
Kd= After tax cost of debt
The formula for the computation of the cost of debt is stated as follows
Kd = K (1-t),
Where K = Current Rate of Interest in the market
t = Tax rate

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The Capital Asset Pricing Model (CAPM) is the description of the relationship between the
expected return for assets and the systematic risks. The assets referred to herein are the equity
shares (Scott, 2012). The capital asset pricing model is further used to calculate the cost of
the equity. The formula to compute the cost of equity as per the capital asset pricing model is
stated as follows.
Ke = Rf + ¿- Rf ¿ β,
Where Rf =Risk free rate of return
Rm - Rf = Premium on market risk
β=¿ Co efficient of unsystematic risk
It is significant to note that the choice of the market weights of the book weights is an
important issue in the WACC computation.
One of the other information that forms the part of the calculation procedure are the
depreciation rate. These are essential because as depreciation is not an actual cash flow of the
entity, the adjustment for the same is required to be done to the cash flows, to compute the
viable present values.
Net Present Value (NPV) technique
One of the chief and most popular techniques to calculate the feasibility of investment
proposals is the net present value technique. One of the major considerations of the technique
is the time value of money. The two major assumptions on which the NPV techniques relies
is that firstly that the cash flows arising out of a project are immediately reinvested. In
addition the rate of return that is generated out of such investments is equal to the cost of
capital as initially used in present value analysis. The second major assumption on which the
technique is based is that the inflows and the outflows of cash occur at the end of the period,
except for the initial cash flows.
The methodology of the technique is listed as follows. Firstly, the various set of cash flows
are computed, that is the initial, terminal, and the annual cash flows. These are computed
with due regards to the depreciation rate, changes in expense structure, scrap value and
others. The cash flows are then discounted with the appropriate discounting rate and the same
are compared. Thus, present values of cash inflows and cash outflows are calculated to arrive
at the NPV.

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The formula for computation of NPV is listed as follows.
NPV=∑
i=1
n CFi
(1+ d)i
= CF0 + CF 1
(1+k )1 + CF 2
(1+k )2 + …. + CF 3
(1+k )3
where:
k = discount rate,
CFi = net cash flow from year i,
CF0 = initial investment, and
n = number of years.
The selection of the projects based on NPV is described as follows.
In case there is only one project, it must be accepted only when the NPV is positive, which
means negative NPV calls for the rejection of the project. Where there are two or more
mutually exclusive projects, the project with the highest NPV would be selected.
The major advantage of the NPV technique is that it takes presennt valeus computation, thus
considers the time value of money. The second major advantage of the techniques is that it
takes into account both pre and post theproject cash flows of the investment proposals.
However, inspite of the benefits, there are certain disadvantages as well. The foremost
weakness of the technique is that the method is a complex set of procedure an requires an
expert to perform the computations of discounting rate, and other elements. In addition to
this, another major weakness is that determination of the discountig rate is subjective decision
of management and difficult to compute. The inappropriate computation of the discounting
rate would lead the project decisions to be misleading. Another weakness of the technique of
NPV is that the same may not be useful in the case of the projects with unequal lives.
Internal rate of return technique
The internal rate of return method is the further extension of the NPV method. This is also
mentioned to as the economic rate of return. The rate is the representation of the overall
interest earned on the capital employed in relation to an venture scheme at various points of
time. Thus, it can be stated that it is the the effective interest rate of a project concerned. It is

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that rate at which the net present value of all the cash outflows of a project becomes equal to
the net present value of the cash inflows. Therefore the net effect of the computation is that
the annualized effective compounded rate of all the costs and the revenues of the proposal is
computed. The techniques is useful in the case of selection amomng the mutually exclusive
projetcs. It is important to note that the computation of the IRR cannot be done analytically. It
is calculated by the use of the trial and error method or by using the software programmed to
calculate IRR.
In order to arrive at the IRR of a project the following computation formula must be used.
IRR= 𝑑l + NPV at Dl
NPV at Dl−NPV at Dh❑
× difference∈discount rates,
Where dl = lower discount rate and
dh = higher discount rate.
In order to arrive at the decision, involving the technique of IRR, the following is noteworthy.
It must be noted that the higher the IRR of a project, the highre the desirability of the project.
When the projects are compared to each other, the projetc with the highest IRR is selected
and the rest are rejected (Tulvinschi, 2014). While selectung one of the projects among the
many in terms of the IRR, it is assumed that the costs of investment is equal among the said
various projects.
The major advantage of the technique is that it conaiders the time value of money. However a
few disadvantage also exist. The foremost disadvantage is that the same project can have a
multiple number of IRRs. In this event, the selection of the project becomes an issue. The
second major disadvantage of the technique is that the intermediate cash flows that are arising
out of the projects are reinvested at the rate that is exactky equal to that of the IRR. Thus, the
decisions based only on IRR can be misleading. Another major disadvantage of the technique
is that the same is complex just like NPV.
Calculation of NPV and IRR
As per the Excel file attached

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Discussion and Recommendation
It is recommended to the entity to enhance their marketing actvities so as to reach the
optimistic scenario of of demand and revenues that is at the rate of 225000 shirts. This is
because of the positive NPV and the high IRR in case of the optimistic sceanrio, as opposed
to the expected scenario.
As per the calculatiom, if the optimtistic scenario is achieved by the entity, the entity will
earn revenue on 225000 shirts. In the expected scenario, the number of shirts on which
revenue woule be earned would be the 200000 shirts. It is essential to note that the major
reasons for the dropping of the cash inflows in the case of expected scenario are the constsnt
rising inflation in the direct and the indirect costs of the production. While the sales are
increasing at the rate of 3 percent, the expenses aer increasing at a higher rate. The dierct
expenses are increasing at the rate of five percent, the indierct expenses are increasing at the
rate of 10 percent. Thus, if the company is not able to attatin the demand of 225000 shirts,
and operates as per the expected demand, the company will suffer the negative NPV.
The differnce cash flows as highlighted in the report shows the collective amount of
increased revenues, and marginally increasing expenses, leading to the positive NPV in the
optimistic scenario.
Therefore as per the decisions of NPV and IRR it is recommended that the company must
engage in advertising, marekting activities to attarct more consumers. This would lead to the
increase in the demand to reach to the optimistic level, only then the overall costs of the
production would be covered by the entity, over the period of ten years.

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References
Baker, H. K. and English, P. (2011) Capital Budgeting Valuation: Financial Analysis for
Today's Investment Projects. New Jersey: John Wiley & Sons Inc.
Banerjee, B. (2017) Financial Policy and Management Accounting. Delhi: PHI Learning Pvt.
Ltd. p. 302.
Baum, A. E., and Crosby, N. (2014) Property Investment Appraisal. UK. John Wiley & Sons
Inc.
Berman, K., Knight, J., and Case, J. (2013) Financial Intelligence, Revised Edition: A
Manager's Guide to Knowing What the Numbers Really Mean. Boston: Harvard Business
Review Press, p. 212.
Bierman Jr, H., and Smidt, S. (2012) The capital budgeting decision: economic analysis of
investment projects. 9th ed. Oxon: Routledge.
Fabozzi, F. J., & Drake, P. P. (2009). Capital Budgeting Techniques. Handbook of Finance.
Hoboken, NJ: John Wiley & Sons, Inc.
Goyat, S., and Nain, A. (2016) Methods of Evaluating Investment Proposals. International
Journal of Engineering and Management Research (IJEMR), 6(5), p. 279.
Pogue, M. (2010) Corporate Investment Decisions: Principles and Practice. New York:
Business Expert Press.
Ross, S. A., Westerfield, R. W., Jaffe, J., and Kakani, R. K. (2014) Corporate Finance. 8th ed.
New Delhi: Tata McGraw Hill Education Pvt Ltd.
Scott, P. (2012) Accounting for Business: An Integrated Print and Online Solution. Oxford:
Oxford University Press.

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Tulvinschi, M. (2014) The Profitability – An Attribute of Financial and Accounting Nature in
the Decision to Invest. USV Annals of Economics and Public Administration, 14(1), p. 171.

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