Analysis of Investment Appraisal Methods and Share Valuation Models

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Financial Management
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Table of Contents
Question 1........................................................................................................................................3
A...................................................................................................................................................3
B...................................................................................................................................................6
C...................................................................................................................................................8
Question 3......................................................................................................................................10
A.................................................................................................................................................10
B.................................................................................................................................................15
References:....................................................................................................................................17
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Question 1
A.
The fair value of shares can be defined as price agreed by both the seller and buyer in case it is
assumed that the company is selling the shares to the buyer. Valuation of shares is to be done to
determine the fair price of the shares. Valuation of shares is a technique which is used to
determine the fair or actual value of the share in the market (corporatefinanceinstitute, 2019).
Valuation of shares is computed to determine the performance of the company and it states
whether the company is performing as desired. There are several methods to calculate the fair
value of shares. Some of them are as follows:
 Income Approach: This method is used to determine the value of the share on the basis
of the ability of the company to generate desired economic benefits. After computing the
desired benefit in relation to cash flow or some other factors the company discounts or
capitalizes the same to present value. Following are some of the income-based methods
to calculate the fair value of shares:
i. Discounted Cash Flow Method- In this method the future cash flows are
discounted to the present value on the basis of the discounted rate.
ii. Price Earning Method- In price earning method, the company compares the price
of the share with the earnings of the share which helps in determining the fair
value of the share for the company as the same is based on the total earnings by
the company.
iii. Capitalization Method- In this method the fair value of shares is computed using
business value and the same is computed by dividing expected earnings by
capitalization rate.
 Assets Approach: This is the most common and popular method for valuation of share.
In this method, the company computes the net assets available and then divides the
computed net assets with a total number of shares. Net assets are calculated by
subtracting total outside liabilities of the company from the total assets of the company.
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Value of Share = Net Assets/Total Number of Shares
 Market-Based Approach: In a market-based approach the fair value of shares is
calculated on the basis of market conditions and taking market price into consideration.
This method is best suited for listed companies or public companies (cfainstitute, 2019).
Following are the approaches used in the market-based method:
o Earning Yield Method: This method is used to calculate the fair value of a
share on the basis of earnings expected in the future for the company. The
following formula is used for calculation of fair value:
Value per share = (Expected Rate of Earnings/Normal Rate of
Return)*Paid up Equity Value
o Dividend Yield Method: This method helps in calculating the fair value of a
share on the basis of dividend paid to the shareholders of the company. In this
method, the share price is calculated on the basis of dividend expected to be paid
during the year. Dividend yield method consists of Gordon’s model in which
growth along with dividend is considered in computing the fair value of shares.
This method is appropriate as it provides an adequate and corrected valuation for
share taking growth rate into consideration. The formula for the growth model is
as follows:
P = D1/ (Re-G)
Thus in the given case, Planet has announced an ordinary dividend and last year's
dividend is given. Also, the growth rate can be computed using given information thus
the new price of Planet's share is computed as follows:
Information Given
Particulars
Rat
e
Year 1 Dividend 13%
Year 2 Dividend 14%
Year 3 Dividend 17%
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Year 4 Dividend 18%
Year 5 Dividend 20%
Cost of Capital 14%
Calculation of Fair Price of a share
The fair price of Share = D1/(Ke-g)
Where,
D1 = Dividend Expected to be paid
Ke = Cost of Capital
g = Growth Rate
Calculation of Growth Rate
D1 = D0(1+g)^4
(1+g) = ∜(D0/D1)
(1+g) = ∜(20/13)
g = 0.1137 or 11.37%
Fair Price of Share = D1/(Ke-g)
Where,
Ke = 14%
g = 11.37% (Computed Above)
D1 = D0(1+g) = 20*(1.1137) = 22.26
Fair Value of Share = 22.26/(0.14-0.1137)
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Fair Value of Share = $ 846
B.
Planet Company now decides to increase the debt level in the company. Debt financing is a
process when the company issues bonds, debentures, and other interest-bearing instruments to
increase the interest expense of the company in order to obtain the capital of the company for
meeting its financial needs. Using debt financing as the source of obtaining finance company
increases the financial leverage of the company thus increasing the overall risk of the
shareholders of the company as the interest portion of the company is increased by the same
(bizfilings, 2019). This change also affects the overall cost of the company thus increasing the
same to 15.4 % in comparison to 14% in the previous case. Due to the change in the overall cost
of capital of the project, there will be a change in the price of Planet's share. The new price of the
share due to the change in the cost of capital is as follows:
Information Given
Particulars Rate
Year 1 Dividend 13%
Year 2 Dividend 14%
Year 3 Dividend 17%
Year 4 Dividend 18%
Year 5 Dividend 20%
Cost of Capital 15.40%
Calculation of Fair Price of a share
The fair price of Share = D1/(Ke-g)
Where,
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D1 = Dividend Expected to be paid
Ke = Cost of Capital
g = Growth Rate
Calculation of Growth Rate
D1 = D0(1+g)^4
(1+g) = ∜(D0/D1)
(1+g) = ∜(20/13)
g = 0.1137 or 11.37%
Fair Price of Share = D1/(Ke-g)
Where,
Ke = 15.40%
g = 11.37% (Computed Above)
D1 = D0(1+g) = 20*(1.1137) = 22.26
Fair Value of Share = 22.26/(0.1540-0.1137)
Fair Value of Share = $ 552
After the decision has been taken to increase the debt portion of the company it can be seen that
the fair value of the share has decreased from $ 846 to $ 552. Thus it can be seen that the
difference in the share price of the company is $294 before and after the change in the cost of
capital of the company. This change in the value of the share is due to the change in the capital
structure of the company as the debt is the company has been increased thus changing the cost of
capital as well as capital structure.
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C.
The dividend growth model is one of the methods of evaluating and determining the fair value of
the share for the companies paying a dividend. However, the method calculates the value of
share easily and accurately. But there are various limitations for using the dividend growth
model as the same is based on certain assumptions (managementstudyguide, 2019). Some of the
problems in calculating the fair value of share using the dividend growth model are as follows:
 Dividend growth model helps in computing the amount of fair value of shares for only those
companies which distributes a dividend to its shareholders. Companies not paying a dividend
to its shareholders cannot use this method for calculation of the value of the share.
 Also, another problem in using the dividend growth model is the consistency of the growth
rate. If the growth rate of the company is inconsistent or not constant then the problems
might occur in computing of value of the share. The growth rate in this concept is related to
the growing of dividend in the future.
 The dividend growth model is affected and is highly sensitive to the inputs used in the model
like growth rate, the required rate of return, etc. Thus for using the dividend growth model,
an organization needs to accurately forecast the inputs relevant for calculation. If the inputs
are not correctly forecasted then in that case the company will not be able to determine the
fair value of shares correctly.
 The dividend growth model is based on the perception that earnings and dividend paid by the
company have a direct relationship. This states that if the earnings of the company are high
then the dividend paid will also be high for the company. The given statement is not true in
real life business situation as sometimes the company's earnings are not more than it can
distribute the dividend but it does so by borrowing cash from the market to fulfill the
expectations of the shareholders. Also sometimes the company’s earnings are good but it
requires money for expansion or internal needs thus it might not pay a dividend.
 In dividend growth model the future changes cannot be taken into consideration and thus
making the model unsuitable for a dynamic environment. Also, the dividend growth model is
based on the quantitative figures and does not take qualitative factors of the organization into
consideration.
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Thus it can be said that Gordon's dividend growth model is a very useful model for computing of
fair value of shares but there are certain disadvantages of this model as stated above which
makes the organization choose a different technique for computation of the fair value of the
share.
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Question 3
A.
Investment appraisal – Investment appraisal is included tools and techniques which are used to
the evaluation process of the projects. It provides relevant information for a better assessment of
the financial performance of the project in the near future. Further, it guides management for
better decision making which enables to earn a positive margin and growth in the near future
from the operation and specific projects (Abor, 2017). Management can use various tools and
technique which enables them to identify the profitability of the project and also the life of the
project in which they need to bear the cost of the project in the near future.Here some of the tools
and technique of investment appraisal is discussed and analysis the financial information for
better understanding of principles and concepts of investment appraisal for investment decision
by management.
Payback Period for project
The payback time period is the minimum time in which a company can overcome its cost from
revenue which is achieved from business activities in the near future. It can identify as the break-
even point for the project on which company can achieve their initial cost of the project from
their regular revenue. It helps management to identify a time period in which they need to
survive the cost of the project after that project can provide effective earning from the project.
Discounted Payback
Period = Completed year + Remaining income for Cost of the project
Annual Income of Next year
Discounted Payback
Period = 4 + 52,080
55,730
From this analysis, it is identified that the company can recover its initial investment in 4.93
years which is a payback period for the company on normal cash flow from operations. As the
life of the project is 6 years and the company is able to recover its cost to 4.93. It means the
project takes a large time period to recover the cost and only provide profit in the last year for the
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company. It defines this project is not acceptable as it considers more period to recover their cost
from operating activities.
Accounting Rate of Return
Accounting rate of return is the technique which evaluates the profitability of the project for
better decision making of the company. It defines a rate of return which can be achieved in the
near future from the project (Lane and Rosewall, 2015). If the cost of capital is higher than the
average market rate of return or cost of capital for investment it means this project is not
acceptable as it is not able to cover the cost of the projects or not achieved the rate of return
which is expected by the inventor in the market.
ARR = Average Net profit X100
Average Investment
ARR = 55,730.00 X100
158125.00
ARR = 35.24%
Working Notes –
Average Investment =
Initial Investment + Salvage
Value
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Average Investment = 158125
The company conductedAccounting rate of return on financial data retrieve from a company
which finds 35.24% is the accounting rate of return.This indicates that the project had a positive
rate of return in the near future and further this rate is attractive enough to attract the inventor for
rising of the fund. This project can be profitable so ARR can be in favor of company so
management can adopt the business project on the basis of accounting rate of return.
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