Financial Management: Investment Appraisal, Valuation, and Ratios

This report provides a comprehensive analysis of financial management, focusing on investment appraisal techniques and company valuation methods. It begins by examining various investment appraisal techniques, including the payback period, accounting rate of return (ARR), net present value (NPV), and internal rate of return (IRR), detailing their benefits and limitations. The report includes calculations for each technique based on a given investment scenario. Furthermore, the report explores company valuation methods, such as the price/earnings ratio, discounted cash flow (DCF) method, and dividend valuation model, highlighting the problems associated with each. The analysis includes detailed calculations and explanations, offering insights into how these techniques aid in financial decision-making. The report concludes by emphasizing the importance of these financial tools in enhancing organizational profitability and efficiency. Desklib provides access to this report and a wealth of other solved assignments and study resources for students.

Financial Management

Table of Contents
Introduction-................................................................................................................................................3
Question 2-..................................................................................................................................................3
Investment Appraisal Techniques-..........................................................................................................3
Question 3 – Mergers and Takeovers..........................................................................................................9
Conclusion-...............................................................................................................................................13
References-................................................................................................................................................13

Introduction-
Financial management can be defined as an activity which is concerned with planning and
controlling funds that are used by company. This area deals with the capital sources which help
in achievement of goals or objectives of the organization. In this report several investment
appraisal techniques are discussed and it is also understood that how these techniques help in
decision making. Decision making is very important for an organization in order to increase
profitability and efficiency. Apart from this financial ratios are also discussed in this report.
Analysis of financial ratios gives information about the financial performance of the company.
Ratios are very effective in evaluation of various things like- profitability, solvency, liquidity and
efficiency etc. Management uses financial ratios to check the performance of the company in the
long term and short term.
Question 2-
Investment Appraisal Techniques-
(a) Calculate the following using investment appraisal techniques-
Payback Period- Investment= £438,700 (given)
Cash flow = inflow – outflow
= £123,000- £25,500
= £97500
So, payback period is: 438700/97500 => 4.50 years or 4 years 6 months
Accounting Rate of return-
Year cash inflow
Cash
outflow
Net cash
flow
Depreciatio
n
Accounting
profit
1 123000 25500 97500 100681.65 -3181.65
2 123000 25500 97500 73497.60 24002.40
3 123000 25500 97500 53653.25 43846.75
4 123000 25500 97500 39166.87 58333.13
5 123000 25500 97500 28591.82 68908.18

6 123000 25500 97500 20872.03 76627.97
268536.78
Average accounting profit: 268536.78/6
= 44756.13
ARR: 44756.13/438700*100
= 10.20%
Working Notes:
Calculation of depreciation
Depreciation Expenses = (Net Book Value –
Residual value) X Depreciation Rate
Net book value: 438700
Residual value: 15% of cost 65805
Depreciation rate 27%
Year
Net book
value
Residu
al value Rate
Depreciati
on
1
438700.0
0 65805 27 100681.65
2
338018.3
5 65805 27 73497.60
3
264520.7
5 65805 27 53653.25
4
210867.4
9 65805 27 39166.87
5 171700.6
2 65805 27 28591.82

6
143108.8
0 65805 27 20872.03
Net present value (NPV)-
Year
Net cash
flow PV factor
Discounted cash
flow
1 97500 0.88 85800
2 97500 0.78 76050
3 97500 0.69 67275
4 97500 0.61 59475
5 97500 0.54 52650
6 97500 0.48 46800
388050
NPV= 388050-438700
=-50650
Internal Rate of return-
Year
Net cash
flow
0 -438700
1 97500
2 97500
3 97500
4 97500
5 97500
6 97500
IRR 9%

(b) Impact of the appraisal techniques –
Payback period- Payback period of this project is 4 years 6 months and total project time is
6 years. It means company is able to cover its cost in 4.5 years. After 4.5 years company will
be able to earn profits. So according to payback period company should definitely invest in
this project.
Accounting rate of return- Accounting rate of return of the given project is 10.20% it
means project is able to give higher returns. If company invests in this project then it put
positive impact and will improve financial performance of company. So, company should
invest in this project.
Net present value- Net present value is present value of all the future cash flows. As per the
calculations net present value of this project is negative means company needs to think again
before investing in it. Negative NPV shows that present value of cost is higher than present
value of sales.
Internal rate of return- IRR of this project is 9%. It means company should invest in this
project.
(c) Benefits and limitations of Investment appraisal techniques-
These techniques works as a planning process for an organization. It determines that
company should do long term investment or not. Like- Purchasing new machinery,
replacement of machinery and research& development project. There are several capital
budgeting techniques which are as follows-
Payback Period- It is defined as amount of time taken by an investment to recover its cost of
project is known as payback period. Payback period should be less than period of project. If
payback period is more than project period it means project is not worthy and there is no
profit in investing the project. Benefits of payback period is as follows-

 Calculation of payback period is very easy and simple. This is the main advantage as
it needs few inputs. Relatively, it is easy to calculate than other capital budgeting
methods. It also helps financial analyst to evaluate the best project.
 As it is already mentioned in above point that it is easy and simple to use so, it helps
analyst to make decisions very quickly regarding the project investment. It saves
time. This technique is effective for such companies which has limited resources and
want better decision-making in order to generate profitability.
 Whenever an organization faces uncertainty regarding the investment decisions this
method is very effective. Hence, it is useful in undertaking the project with short
payback period. It also reduces the chance of loss.
Limitations of payback period-
 Main disadvantage of this method is that it ignores time value of money. TVM plays
an important role in growth of the company. This method does not consider time value
of money. It also reduces its efficiency as the time passes.
 It is simple to use but it does not include normal business scenarios. Investment of
capital is not one time investment, it needs further investments. It leads to projects
which have irregular cash inflows in the company.
Accounting Rate of return-
It is also known as average rate of return. Accounting rate of return calculates the returns which
are generated from the net income of the proposed capital investment. It is a financial ratio which
is used in capital budgeting. This method also has its advantages and disadvantages-
Advantages of this method are below-

 It is very simple to calculate the overall return given by a project in future. Managers can
easily know about the potential of investment. It is very beneficial for knowing
profitability of the project.
 It considers only total profits instead of entire period of economic life of project.
 It can compare couple of projects.
 It is also useful in measurement of the current performance of the firm.
Disadvantages-
 If results of ROI and ARR are matched, then results are different which creates problem
in decision making.
 ARR is not able to determine fair return value on a project.
 This method only considers internal factors which affects the profitability of project.
 If investment on a project is done in parts then this method is not applicable.
 This method does not consider the number of periods in which profit has earned. For
example- If an investment gives 20% return in 10 years and another one is giving 18% in
6 years. Then according to ARR Profit earned in 10 years is better than 6 years. It is not
proper as long-term projects involve greater risk.
Net present Value-
It is also a way of decision making. It shows the present value of future cash flows, It is also
known as excess present value or investor’s method. This method calculates the return on a
project with consideration of time factor. It recognized that money earned today is worth more
the same money tomorrow.
In this method present value of all the cash inflows and cash outflows are calculated separately
by considering cost of capital or predetermined rate. Difference between cash inflow and cash
outflow is considered as net present value.
Advantages-
 Main advantage of NPV is that it considers time value of money it means worth of dollar
today will be more tomorrow. Its computation considers discounted net flow in order to
determine its viability.

 It plays important role in decision making. It not only evaluated same size projects but
also helps in identifying whether project is profitable or not.
Disadvantages-
 Total calculation of net present value is depends upon the required rate of return or
discount rate. There are no guidelines available to determine this rate. It leads to
discretion of companies and there could be instances that NPV is inaccurate because of
rate of return.
 One more disadvantage with NPV is, it cannot compare the projects of different sizes. As
NPV is a figure and not a percentage. Therefore, NPV of larger projects are automatically
higher than smaller size projects. Smaller projects may give higher return but overall
NPV might be lower.
 NPV does not include any hidden costs, sunk costs and other costs. This may impact the
profitability of the project.
Question 3 –
Mergers and Takeovers
Calculate the value of Dragon PLC using the following valuation methods-
Price/earnings ratio= Net income/total share outstanding
Net income= 42.4
Shares= 147
Price/earnings ratio= 42.4/147
= 0.29 Pence per share
b) Discounted cash flow method
Discounted cash flow method

Yea
r Net Income £m
PV
FACTOR@6%
Discounted cash
flow
1 42.4 0.94 39.856
2 42.8452 0.89 38.132228
3 43.2950746 0.84 36.36786266
4 43.74967288 0.79 34.56224158
5 44.20904445 0.75 33.15678334
6 44.67323942 0.7 31.27126759
213.35
(c) Dividend valuation method
P (Stock price) = D1/(r-g)
P1= 9/ (1.05-0.35)
= 9/0.7
= 12.85
P2: 10.5/0.7
= 15
P3: 11/0.7
= 15.71
P4: 12/0.7
= 17.14

P5: 14/0.7
= 20
Dividend valuation model: 12.85+15+15.71+17.14+20
= 80.7
Working Notes:
Growth rate: (1 – Dividend Payout Ratio) × Return on Equity
Growth rate: (1-1.33)*1.05
= 0.35%
Dividend Payout Ratio= Dividends/net income
Dividends: 9+10.5+11+12+14
= 56.5 Pence
= 56.5/42.4
= 1.33
(d) Problems associated with above valuation techniques-
Price/earnings Ratio-
This ratio is related to share price of a company to earning price per share. This ratio helps in
knowing that share is overvalued or undervalued. If P/E ratio is higher then, it means share is
overvalued and if it is lower, it means shares are undervalued. Higher P/E ratio means investors
needs to pay more money to buys the share today because expectations are high in future. An
average P/E ratio ranges from 13 to 15.
Lower P/E ratio indicates that price of shares are low compared to earnings and it may lead to
losing money. If P/E ratio is consistently lower then company is at high risk of bankruptcy.
Advantages-
This ratio is very easy to use and understand. People who do not belong to financial background
can also easily understand this ratio. It is very essential instrument for investors as it gives

information about value of company’s securities. P/E ratio is very meaningful than alone share
prices. P/E ratio is also useful in measuring performance of industry as well as performance of a
rival firm.
Disadvantages-
 P/E ratio is a subjective essence so investor does not know how many shares to be sold.
This irrational essence can be certified partly. Survey can be done for representation of
competitive shares.
 P/E ratio is only a relative basis which means it is only used as a benchmark. Only one
thing which is needed to be remembered that, if share price is less than benchmark that
doesn’t mean share is cheap sometimes benchmark is overvalued.
 P/E ratio can be misleadingly high or low which results in inflated earnings.
Discounted Cash Flow-
This is a valuation method; it is used for estimation of value of an investment on the basis of
expected future cash flows. This analysis gives information about how much money will be
generated in future by today’s projection. It is applicable for taking investment decisions. For
example- acquiring a new company, investment in technology and buying shares etc. If
discounted cash flow is more than cost of investment then it results in positive returns. Company
uses weighted average cost of capital for the discount rate.
This analysis is appropriate for an investor who is paying money today with expectations of
getting more money in the future. Investors can also use the concept of present value of money.
It determines that future cash flows of an investment are higher than initial investment or not.
Advantages-
 It determines the main factors of a company such as – equity cost, WACC, rate of
growth, reinvestment growth etc. Hence, asset or business worth can be estimated.
Discounted cash flow is depends upon free cash flows. Free cash flows are contrary to the
most valuation techniques. Free cash flow gives actual information means it eliminates
the arbitrary accounting policy and recorded earnings. Hence, free cash flow is real
reflection of the invested money.

 It helps in determining intrinsic value of the company.
 Calculation of DCF can be done on excel.
 It undertakes all the expectation of future of company.
Disadvantages-
 The main disadvantage of this method is that, it is very vulnerable in sales assumptions.
 It is very complex.
 This method requires very large number of assumptions which is not possible.
 Chances of errors are very high as this method needs many assumptions.
 If any changes made in assumptions then it will change whole calculation.
 It looks at valuation of company in isolation.
 Terminal value of a project is very hard to estimate and in result it represents large
portion of total value.
 As it needs high level of details this may result in overconfidence.
Dividend discount Model-
It is a quantitative method. This method is used for prediction of a company’s stock on the basis
of a theory means value of its present day price is worth the sum of all its future dividend
payments when it is discounted back to present value. It is helpful in calculating fair value of
stocks. Which does not consider prevailing market conditions. If value of dividend discount
value is higher than current share price, then stock is considered as undervalued and vice versa.
It is a very complex task for a company to estimates its future dividends. Certain assumptions are
made by analysts and investors, or investors try to identify trends on the basis of the past records
to estimate the future dividends. If a company has a fixed growth rate until the perpetuity, which
is also known as constant stream of identical cash flows for infinite amount of time with no fixed
date.
Dividend payout ratio can be defined as total amount of dividends payout to the shareholders
relative to the net income of the company. Range of an ideal dividend payout ratio is 35% to
55%.
Advantages-

 According to investors main advantage of dividend discount model is that there is no
subjectivity involved with this model. Logic of this model is very clear.
 Consistency is its advantage. It is based on the fact that no matter what will happen in
future but dividends will be consistent.
 This model does not require any kind of control.
 This model gives knowledge about maturity of business. If business is mature or growing
constantly then it means payments of dividends is regular.
 This model is the only option for measurement of the valuation for the minority
shareholders.
Disadvantages-
 Limited use of this model is, its main disadvantage. This model is only applicable for the
successful and stable companies.
 This model assumes that dividend payout is related to the earnings.
 This model has so many assumptions. Assumptions related to growth rate, interest rates
and tax rates. These assumptions make it complex. Hence, this model does not give
accurate result.
 Tax structure also affects this model.
Conclusion-
From the above report, it is learned that financial management is very important for an
organization. Various capital budgeting methods and calculations are discussed. Such as- net
present value, internal rate of return, payback period and accounting rate of return. All these
techniques help a business to take investment decisions. It is also learned that P/E ratio means
price to earnings ratio helps in determining value of shares. It is very important for an investor to
know that share price is undervalued or overvalued. It helps in decision making. Discounted cash
flow method also helps in making financial decisions. This method helps investor in estimating
future cash flow. It is very complex method to use as it has many assumptions. Dividend
discount method is also discussed its calculation is very simple but in real life it is hard for an
investor to calculate because it is a complex process. Hence, it can be said that financial
management techniques are very important for investors in decision making.

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