Business Valuation

16.
0 Business Valuations SAUD TARIQ

CFAP 4 Business Finance Decisions (BFD)

ST&Co

Business Valuations
Business
Valuations
Nature Shares Valuation Valuation of

and Valuation of debts preference
Purpose Methods shares
When Asset-based Income/ Dividend Discounted Irredeemable

valuations valuations earnings valuation cash flow debt
required based method basis
methods
What Redeemable
information Historic P/E ratio No growth debt
required basis method
Replacement Earning Constant Convertible

basis yield growth debt
method
Realisable
basis

When valuations are required
A share valuation will be necessary:
(a) For quoted companies, when there is a takeover bid and the offer price is an estimated
fair value in excess of the current market price of the shares.
(b) For unquoted companies, when:
(i) The company wishes to go public and must fix an issue price for its shares.
(ii) There is a scheme of merger.
(iii) Shares are sold.
(iv) Shares need to be valued for the purposes of taxation.
(v) Shares are pledged as collateral for a loan.
(c) For subsidiary companies, when the group’s holding company is negotiating the sale of
the subsidiary to a management buyout or to an external buyer.
(d) For any company, where a shareholder wishes to dispose of his or her holding.
(e) For any company, when the company is being broken up in a liquidation situation or the
company needs to obtain finance, or re‐finance current debt.
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Information requirements for valuation
There is wide range of information that will be needed in order to value a business.
(a) Financial statements: statement of financial positions, income statements, statements of
shareholders equity for the past five years.
(b) Summary of non‐current assets list and depreciation schedule.
(c) Aged accounts receivable summary.
(d) Aged accounts payable summary.
(e) List of marketable securities.
(f) Inventory summary.
(g) Details of any existing contracts, e.g. leases, supplier agreements.
(h) List of shareholders with number of shares owned by each.
(i) Budgets or projections, for a minimum of five years.
(j) Information about the company’s industry and economic environment.
(k) List of major customers by sales.
(l) Organization chart and management roles and responsibilities.

Market Capitalisation:
Market capitalisation is the market value of a company's shares. This is the share price multiplied by the
number of issued shares.

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Shares Valuations (refer sketch on previous page again)
1. Asset‐based valuations

 Under this method of valuation, the value of a share in a particular class is equal to the net tangible
assets attributable to that class, divided by the number of shares in the class.
 Intangible assets (including goodwill) should be excluded, unless they have a market value (for
example patents and copyrights, which could be sold).
 Goodwill, if shown in the financial statements, is unlikely to be shown at a true figure for purposes
of valuation, and the value of goodwill should be reflected in another method of valuation (for
example the earnings basis).
 Development expenditure, if shown in the financial statements, would also have a value which is
related to future profits rather than to the worth of the company's physical assets.
Question 1)
The summary statement of financial position of Hatim Co is as follows:
Non‐current assets $ $
Land and buildings 160,000
Plant and machinery 80,000
Motor vehicles 20,000
260,000
Goodwill 20,000
Current assets
Inventory 80,000
Receivables 60,000
Short‐term investments 15,000
Cash 5,000 160,000
Total assets 440,000

Equity and liabilities
Equity
Ordinary shares of $1 80,000
Reserves 140,000
4.9% preference shares of $1 50,000
270,000
Non‐current liabilities
12% loan notes 60,000
Deferred taxation 10,000 70,000

Current liabilities
Payables 60,000
Taxation 20,000
Proposed ordinary dividend 20,000 100,000
440,000
What is the value of an ordinary share using the net assets basis of valuation?
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Solution:

If the figures given for asset values are not questioned, the valuation would be as follows.
$ $
Total value of assets less current liabilities 340,000
Less: Intangible asset (goodwill) 20,000
Total value of assets less current liabilities 320,000
Less: Preference shares => loan 50,000
Loan notes 60,000
Deferred taxation 10,000 120,000
Net asset value of equity 200,000

No. of ordinary shares 80,000

Value per share $2.50

Use of net asset basis
The net assets basis of valuation might be used in the following circumstances.
i. As a measure of the 'security' in a share value. A share might be valued using an earnings basis.
This valuation might be higher or lower than the net asset value per share. If the earnings basis is
higher, then if the company went into liquidation, the investor could not expect to receive the full
value of their shares when the underlying assets were realised.
The asset backing for shares thus provides a measure of the possible loss if the company fails to
make the expected earnings or dividend payments. Valuable tangible assets may be a good reason
for acquiring a company, especially freehold property which might be expected to increase in
value over time.
ii. As a measure of comparison in a scheme of merger
iii. As a 'floor value' for a business that is up for sale. Shareholders will be reluctant to sell for less
than the NAV. However, if the sale is essential for cash flow purposes or to realign with corporate
strategy, even the asset value may not be realised.

Advantages:
 Easy to use method
 Based on Audited information
 Natural method, business’s worth is based on its Net Assets
Disadvantages:
 Values of B/S are not fair values
 There can be multiple values of one company based on different accounting policies which are
acceptable
 Some liabilities are not even recorded in balance sheet and are only disclosed in notes
 Potential investors look at cash flow potential, customer base and earnings not at the assets. Seller
sells the goodwill of the business rather than just assets, it does not account for the goodwill of the
business.
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Net Asset Based Valuation (Market Values Based)
Rs m
*Assets (Market Value) XXX
Liabilities (Market Value) XXX
Net Equity XXX
No of Shares XXX
Per Share Value XXX Price Floor or Minimum Floor

* Need to exclude goodwill and fictitious assets like deferred tax asset from assets.
Advantages:
 Based on fair values
 Consider it as a minimum price for your business

Disadvantages:
 Individual assets would not be sold at their Market values; rather it would be sold at Forced Sale
Values (FSV).
 Market values are not always fair values although a better approximation than historical cost
 Goodwill is not reflected in this method neither the cash generating capacity of business

2. Income/earnings based methods
Price Earnings (P/E) ratio method
 This is a common method of valuing a controlling interest in a company, where the owner can
decide on dividend and retentions policy. The P/E ratio relates earning per share to a share’s
value. Formula: P/E = Market price per share / Earnings per share (EPS)
 This can then be used to value shares in unquoted companies as:
Market value (or market capitalization) of company = total earnings × P/E ratio
Value per share = EPS × P/E ratio
Using an adjusted P/E multiple from a similar quoted company (or industry average).
 The basic choice for a suitable P/E ratio will be that of a quoted company of comparable size in
the same industry.
High P/E ratio may indicate:
(a) growth stock – the share price is high because continuous high rates of growth of earnings are
expected from the stock.
(b) no growth stock – the PE ratio is based on the last reported earnings, which perhaps were
exceptionally low yet the share price is based on future earnings which are expected to revert to a
‘normal’ relatively stable level.
(c) takeover bid – the share price has risen pending a takeover bid.
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(d) high security share – shares in property companies typically have low income yields but the shares
are still worth buying because of the prospects of capital growth and level of security.
Low P/E ratio may indicate:
(a) losses expected – future profits are expected to fall from their most recent levels
(b) share price low – as noted previously, share prices may be extremely volatile – special factors, such
as a strike at a manufacturing plant of a particular company, may depress the share price and hence
the PE ratio.
Advantages:
 It is simple and easy to use method
 Based on Market Bench mark which is market P/E ratio
 It incorporates earning potential and goodwill which was excluded in previous valuation model.

Disadvantages:
 If a P/E ratio trend is used, then historical data will be being used to value how the unquoted
company will do in the future. Subjectivity is involved, past does not always serves as a good guide
for future.
 A single year’s P/E ratio may not be a good basis, if earnings are volatile, or the quoted company’s
share price is at an abnormal level, (for example expectation of a takeover bid).
 Forecasting EPS is subjective as it involves assumptions
 The value of a listed company is more than an unlisted company. Downgrading the listed
company’s P/E is subjective.
 Finding a quoted company with a similar range of activities may be difficult. Quoted companies are
often diversified.
 The quoted company may have a different capital structure to the unquoted company.
 Market bench mark, P/E is not always fair value

Question 2)
Tiger wishes to make a takeover bid for the shares of an unquoted company, Zebra. The earnings of
Zebra. The earnings of Zebra over the past five years have been as follows.
2006 $50,000 2009 $71,000
2007 $72,000 2010 $75,000
2008 $68,000
The average P/E ratio of quoted companies in the industry in which Zebra operates is 10. Quoted
companies which are similar in many respects to Zebra are:
(a) Elephent, which has a P/E ratio of 15, but is a company with very good growth prospects.
(b) Fox, which has had a poor profit record for several years, and has a P/E ratio of 7.
What would be a suitable range of valuations for the shares of Zebra?
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Solution:
(a) Earnings. Average earnings over the last five years have been $67,200, and over the last four
years $71,500. There might appear to be some growth prospects, but estimates of future
earnings are uncertain. A low estimate of earnings in 2011 would be, perhaps, $71,500.

A high estimate of earnings might be $75,000 or more. This solution will use the most recent
earnings figure of $75,000 as the high estimate.
(b) P/E ratio. A P/E ratio of 15 (Elephent’s) would be much too high for Zebra, because the growth
of Zebra earnings is not as certain, and Zebra is an unquoted company.

On the other hand, Zebra’s expectations of earnings are probably better than those of Fox. A
suitable P/E ratio might be based on the industry’s average, 10; but since Zebra is an unquoted
company and therefore more risky, a lower P/E ratio might be more appropriate: perhaps 60%
to 70% of 10 = 6 or 7, or conceivably even as low as 50% of 10 = 5

The valuation of Zebra’s shares might therefore range between:
High P/E ratio and high earnings: 7 × $75,000 = $525,000; and
Low P/E ratio and low earnings: 5 × $71,500 = $357,500.

Other Points to be considered:
 For examination purposes, you should normally take a figure for the P/E ratio that is around one‐half
to two‐thirds of the industry average, when valuing an unquoted company.
 When one company is thinking about taking over another, it should look at the target company's
forecast earnings, not just its historical results.
 Make sure the earnings you use are future maintainable earnings. One‐off income or expenses must
be excluded.
 Use of a bidder's P/E ratio: A bidder company may sometimes use its higher P/E ratio to value a target
company. This assumes that the bidder can improve the target's business, which may be a dangerous
assumption to make. It may be better to use an adjusted industry P/E ratio, or some other method.

Earnings yield method
Another income based method is the earnings yield method.
EPS
Earnings yield = x 100%
Market price per share
This method is effectively a variation on the P/E method (the earnings yield being the reciprocal of the
P/E ratio), using an appropriate earnings yield effectively as a discount rate to value the earnings:
Earnings
Market value =

Earnings yield

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Question 3)
Burhan Ltd has earnings of $300,000. A similar listed company has an earnings yield of 12.5%.
Rizwan Ltd has earnings of $420,500. A similar listed company has a P/E ratio of 7.
Estimate the value of each company.
Solution:
1
Burhan Ltd: $300,000   $2,400,000
0.125
Rizwan Ltd: $420,500 × 7 = $2,943,500

3. Dividend valuation model (DVM) (already covered in WACC)
The dividend valuation model is based on the theory that an equilibrium price for any share is:
(a) The future expected stream of income from the security.
(b) Discounted at a suitable cost of capital.
Equilibrium market price is thus a present value of a future expected income stream. The annual income
stream for a share is the expected dividend every year in perpetuity.
The basic dividend‐based formula for the market value of shares is expressed in the DVM (assume no
growth) as follows:
D D D D
Market value (ex div) P0    ...  

(1  K e ) (1  K e ) 2
(1  K e ) Ke
If the dividend has constant growth, dividend growth model can be applied:
D0 (1  g ) D0 (1  g ) 2 D0 (1  g )  D0 (1  g ) D1
P0    ...  
 
(1  K e ) (1  K e ) 2
(1  K e ) Ke  g Ke  g
Where: D0 = Current year’s dividend
g = Growth rate in earnings and dividends
D0(1+g) = D1 = Expected dividend in one year’s time
Ke = Shareholders’ required rate of return
P0 = Market value excluding any dividend currently payable

Advantages:
a) A cash method, subjectivity of profits is eliminated
b) Time value of money is also there along with earning potential
c) Suitable for small share holders whose objective for investment is regular stream of cash
dividends

Earnings yield method (Cont..d)
E0 (1  g ) E0 (1  g ) 2 E0 (1  g )  E0 (1  g ) E1
P0    ...  
 
(1  K e ) (1  K e ) 2
(1  K e ) Ke  g Ke  g
Discount all future earnings by appropriate discount rate

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4. Discounted cash flow basis
This method of share valuation may be appropriate when one company intends to buy the assets of
another company and to make further investments in order to improve cash flows in the future.

Method:
(a) Identify relevant free cash flow (i.e. excluding financing flows)
(i) operating flows
(ii) revenue from sale of assets
(iii) tax
(iv) synergies arising from any merger.
(b) Select a suitable time horizon.
(c) Calculate the PV over this horizon. This gives the value to all providers of
finance, i.e. equity + debt.
(d) Deduct the value of debt to leave the value of equity.
Note: Detailed Questions of Free Cashflows are covered in the next chapter
(Chapter 16)
Advantages Weaknesses
 Theoretically the best method  It relies on estimates of both cash flows and
 Can be used to value part of a company discount rates – may be unavailable
 Difficulty in choosing a time horizon
 Difficulty in valuing a company’s worth beyond
this period
 Assumes that the discount rate, tax and inflation
rates are constant through the period

Question 9)
The following information has been taken from the income statement and statement of
financial position of ST&Co:
Revenue $350m
Production expenses $210m
Administrative expenses $24m
Tax allowable depreciation $31m
Capital investment in year $48m
Corporate debt $14m trading at 130%
Corporate tax is 30%
The WACC is 16.6%. Inflation is 6%.
These cash flows are expected to continue every year for the foreseeable future.

Required: Calculate the value of equity.
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Solution:
Operating profits = $(350m – 210m – 24m) = $116m
Tax on operating profits = $116m × 30% = $34.8m
Allowable depreciation = $31m (assumed not included in production or administration
expenses)
Tax relief on depreciation = $31m × 30% = $9.3m
Therefore net cash flow = 116m – 34.8m + 9.3m – 48m = $42.5m
The real discount rate is: 1.166 / 1.06 = 10%
The corporate value is = $42.5m / 10% = $425m
Equity = $425m – $(14m × 1.3) = $406.8m
Note: because the cash flow is a perpetuity we have used the real cash flow and the real
discount rate.

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Question 10)

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Solution:
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Valuation of Debt and Preference Shares (Already covered these concepts in WACC)
We have looked at how to calculate the cost of debt and other financial assets. The same formulae can
be re‐arranged so that we can calculate their value.

Formulae
The formulae for the various types of finance are as follows:
Type of finance Market value
Irredeemable debt without tax i
P0 
Kd
Irredeemable debt with tax i  (1  T )
P0 
Kd
Redeemable debt MV = PV of future interest and redemption

receipts, discounted at investors’ required
returns (Recall NPV Concept in Business Finance
handout)
Preference shares D
P0 
Kp

Where:
P0 = ex‐div market value of the debt or share
i = annual interest starting in one year’s time
Kd = company’s cost of debt, expressed as a decimal
Kp = cost of the preference shares

Question 11) Irredeemable debt
A company has issued irredeemable loan notes with a coupon rate of 7%. If the required
return of investors is 4%, what is the current market value of the debt?

Solution:
7
Market value =  $175
4%

Question 12) Preference shares
A firm has in issue $100, 12% preference shares. Currently the required return of
preference shareholders is 14%. What is the value of a preference share?
Solution:
Market value of preference share:
D $12
P0    $85.71
K p 14%

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Q1) Business valuation methods and WACC
Recent financial information relating to Close Co, a stock market listed company, is as follows.
$m
Profit after tax (earnings) 66.6
Dividends 40.0
Statement of financial position information:
$m $m
Non‐current assets 595
Current assets 125
Total assets 720
Current liabilities 70
Equity
Ordinary shares ($1 nominal) 80
Reserve 410
490
6% bank loan 40
8% bonds ($100 nominal) 120
160
720
Financial analysts have forecast that the dividends of Close Co will grow in the future at a rate of 4% per
year. This is slightly less than the forecast growth rate of the profit after tax (earnings) of the company,
which is 5% per year. The finance director of Close Co thinks that, considering the risk associated with
expected earnings growth, an earnings yield of 11% per year can be used for valuation purposes.

Close Co has a cost of equity of 10% per year and a before‐tax cost of debt of 7% per year. The 8% bonds
will be redeemed at nominal value in six years’ time. Close Co pays tax at an annual rate of 30% per year
and the ex‐dividend share price of the company is $8.50 per share.

Required:
(a) Calculate the value of Close Co using the following methods:
(i) net asset value method;
(ii) dividend growth model;
(iii) earnings yield method. (5 marks)
(b) Discuss the weaknesses of the dividend growth model as a way of valuing a company and its shares.
(5 marks)
(c) Calculate the weighted average after‐tax cost of capital of Close Co using market values where
appropriate. (8 marks)
(d) Discuss the circumstances under which the weighted average cost of capital (WACC) can be used as
a discount rate in investment appraisal. Briefly indicate alternative approaches that could be
adopted when using the WACC is not appropriate. (7 marks)

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Q2) P/E method, dividend valuation model and WACC

Corhig Co is a company that is listed on a major stock exchange. The company has struggled to maintain
profitability in the last two years due to poor economic conditions in its home country and as a
consequence it has decided not to pay a dividend in the current year. However, there are now clear signs
of economic recovery and Corhig Co is optimistic that payment of dividends can be resumed in the future.
Forecast financial information relating to the company is as follows:

Year 1 2 3
Earnings ($000) 3,000 3,600 4,300
Dividends ($000) Nil 500 1,000

The company is optimistic that earnings and dividends will increase after Year 3 at a constant annual rate
of 3% per year.

Corhig Co currently has a before‐tax cost of debt of 5% per year and an equity beta of 1∙6. On a market
value basis, the company is currently financed 75% by equity and 25% by debt.

During the course of the last two years the company acted to reduce its gearing and was able to redeem
a large amount of debt. Since there are now clear signs of economic recovery, Corhig Co plans to raise
further debt in order to modernise some of its non‐current assets and to support the expected growth in
earnings. This additional debt would mean that the capital structure of the company would change and it
would be financed 60% by equity and 40% by debt on a market value basis. The before‐tax cost of debt of
Corhig Co would increase to 6% per year and the equity beta of Corhig Co would increase to 2.

The risk‐free rate of return is 4% per year and the equity risk premium is 5% per year. In order to stimulate
economic activity the government has reduced profit tax rate for all large companies to 20% per year.

The current average price/earnings ratio of listed companies similar to Corhig Co is 5 times.

Required:

(a) Estimate the value of Corhig Co using the price/earnings ratio method and discuss the usefulness of
the variables that you have used. (4 marks)
(b) Calculate the current cost of equity of Corhig Co and, using this value, calculate the value of the
company using the dividend valuation model. (6 marks)
(c) Calculate the current weighted average after‐tax cost of capital of Corhig Co and the weighted
average after‐tax cost of capital following the new debt issue, and comment on the difference
between the two values. (6 marks)

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HW: Q3)
THP Co is planning to buy CRX Co, a company in the same business sector, and is considering paying cash
for the shares of the company. The cash would be raised by THP Co through a 1 for 3 rights issue at a 20%
discount to its current share price.

The purchase price of the 1 million issued shares of CRX Co would be equal to the rights issue funds raised,
less issue costs of $320,000. Earnings per share of CRX Co at the time of acquisition would be 44∙8c per
share. As a result of acquiring CRX Co, THP Co expects to gain annual after‐tax savings of $96,000.

THP Co maintains a payout ratio of 50% and earnings per share are currently 64c per share. Dividend
growth of 5% per year is expected for the foreseeable future and the company has a cost of equity of 12%
per year.

Information from THP Co’s statement of financial position:
Equity and liabilities $000
Shares ($1 par value) 3,000
Reserves 4,300
7,300
8% loan notes 5,000
Current liabilities 2,200
Total equity and liabilities 14,500

Required:

(a) Calculate the current ex dividend share price of THP Co and the current market capitalization of THP
Co using the dividend growth model. (4 marks)
(b) Assuming the rights issue takes place and ignoring the proposed use of the funds raised, calculate:
(i) the rights issue price per share;
(ii) the cash raised;
(iii) the theoretical ex rights price per share; and
(iv) the market capitalization of THP Co. (5 marks)
(c) Using the price/earnings ratio method, calculate the share price and market capitalisation of CRX Co
before the acquisition. (3 marks)
(d) Assuming a semi‐strong form efficient capital market, calculate and comment on the post
acquisition market capitalisation of THP Co in the following circumstances:
(i) THP Co does not announce the expected annual after‐tax savings; and
(ii) the expected after‐tax savings are made public. (5 marks)
(e) Discuss the factors that THP Co should consider, in its circumstances, in choosing between equity
finance and debt finance as a source of finance from which to make a cash offer for CRX Co. (8
marks)
(Total 25 marks)

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Solutions ‐ Business Valuations
Q1) Business valuation methods and WACC
(a)
Net asset valuation
In the absence of any information about realisable values and replacement costs, net asset value is on a
book value basis. It is the sum of non‐current assets and net current assets, less long‐term debt, i.e. 595
+ 125 – 70 – 160 = $490 million. [1 mark]

Dividend growth model
Total dividends of $40 million are expected to grow at 4% per year and Close Co has a cost of equity of
10%.
Value of company = (40m x 1∙04)/(0∙1 – 0∙04) = $693 million [2 marks]

Earnings yield method
Profit after tax (earnings) is $66∙6 million and the finance director of Close Co thinks that an earnings
yield of 11% per year can be used for valuation purposes.
Ignoring growth, value of company = 66∙6m/0∙11 = $606 million [2 marks]

Alternatively, profit after tax (earnings) is expected to grow at an annual rate of 5% per year and
earnings growth can be incorporated into the earnings yield method using the growth model.
Value of company = (66∙6m x 1∙05)/(0∙11 – 0∙05) = $1,166 million
Examiner’s note: full credit would be gained whether or not growth is incorporated in the earnings yield
method.

(b)
The dividend growth model (DGM) is used widely in valuing ordinary shares and hence in valuing
companies, but there are a number of weaknesses associated with it. (Already seen in WACC Chapter)
(c)
Market value of equity
Close Co has 80 million shares in issue and each share is worth $8∙50 per share.
The market value of equity is therefore 80 x 8∙50 = $680 million [1 mark]

Cost of equity
This is given as 10% per year.

Market value of 8% bonds
The market value of each bond will be the present value of the expected future cash flows (interest and
principal) that arise from owning the bond. Annual interest is 8% per year and the bonds will be
redeemed at their nominal value of $100 per bond in six years’ time. The before‐tax cost of debt is given
as 7% per year and this is used as a discount rate.

Present value of future interest = (8 x 4∙767) = $38∙14
Present value of future principal payment = (100 x 0∙666) = $66∙60
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Ex interest bond value = 38∙14 + 66∙60 = $104∙74 per bond [2 marks]
Market value of bonds = 120m x (104∙74/100) = $125∙7 million [1 mark]

After‐tax cost of debt of 8% bonds
The before‐tax cost of debt of the bonds is given as 7% per year.
After‐tax cost of debt of bonds = 7 x (1 – 0∙3) = 7 x 0∙7 = 4∙9% per year [1 mark]

Value of the 6% bank loan
The bank loan has no market value and so its book value of $40 million is used in calculating the
weighted average cost of capital.

After‐tax cost of debt of 6% bank loan
The interest rate of the bank loan can be used as its before‐tax cost of debt.
After‐tax cost of debt of bank loan = 6 x (1 – 0∙3) = 6 x 0∙7 = 4∙2% per year [1 mark]

Calculation of weighted average after‐tax cost of capital (WACC)
Total value of company = 680m + 125∙7m + 40m = $845∙7m
After‐tax WACC = ((680m x 10) + (125∙7m x 4∙9) + (40 x 4∙2))/845∙7 = 9∙0 % per year
[2 marks]
Examiner’s note: the after‐tax cost of debt of the 8% bonds could have been calculated using linear
interpolation, although the result would be close to 4∙9%.

(d)
The weighted average cost of capital (WACC) is the average return required by current providers of
finance. The WACC therefore reflects the current risk of a company’s business operations (business
risk) and way in which the company is currently financed (financial risk). When the WACC is used as
discount rate to appraise an investment project, an assumption is being made that the project’s
business risk and financial risk are the same as those currently faced by the investing company. If this
is not the case, a marginal cost of capital or a project‐specific discount rate must be used to assess the
acceptability of an investment project. [1 – 2 marks]
Business risk
 The business risk of an investment project will be the same as current business operations if the
project is an extension of existing business operations, and if it is small in comparison with current
business operations.
 If this is the case, existing providers of finance will not change their current required rates of
return.
 If these conditions are not met, a project‐specific discount rate should be calculated, for example
by using the capital asset pricing model.
[2 – 3 marks]
Financial risk
 The financial risk of an investment project will be the same as the financial risk currently faced by a
company if debt and equity are raised in the same proportions as currently used, thus preserving
the existing capital structure. If this is the case, the current WACC can be used to appraise a new
investment project.
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 It may still be appropriate to use the current WACC as a discount rate even when the incremental
finance raised does not preserve the existing capital structure, providing that the existing capital
structure is preserved on an average basis over time via subsequent finance‐raising decisions.
 Where the capital structure is changed by finance raised for an investment project, it may be
appropriate to use the marginal cost of capital rather than the WACC.
[2 – 3 marks]
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ST&Co

Q2) P/E method, dividend valuation model and WACC
(a) Price/earnings ratio valuation
1. The value of the company using this valuation method is found by multiplying future earnings by a
price/earnings ratio. Using the earnings of Corhig Co in Year 1 and the price/earnings ratio of
similar listed companies gives a value of 3,000,000 x 5 = $15,000,000. [2 marks]
2. Using the current average price/earnings ratio of similar listed companies as the basis for the
valuation rests on two questionable assumptions.
(a) First, in terms of similarity, the valuation assumes similar business operations, similar
capital structures, similar earnings growth prospects, and so on. In reality, no two
companies are identical.
(b) Second, in terms of using an average price/earnings ratio, this may derive from
companies that are large and small, successful and failing, low‐geared and high‐geared,
and domestic or international in terms of markets served. The calculated company value
therefore has a large degree of uncertainty attached to it. [2 marks]
3. The earnings figure used in the valuation does not include expected earnings growth. If average
forecast earnings over the next three years are used ($3∙63 million), the price/earning ratio value
increases by 21% to $18∙15 million (3∙63 x 5). Although earnings growth beyond the third year is
still ignored, $18∙15 million is likely to be a better estimate of the value of the company than $15
million because it recognises that earnings are expected to increase by almost 50% in the next
three years.
(b)
Value of company using the dividend valuation model
The current cost of equity using the capital asset pricing model = 4 + (1∙6 x 5) = 12% [1 mark]
Since a dividend will not be paid in Year 1, the dividend growth model cannot be applied straight away.
However, dividends after Year 3 are expected to grow at a constant annual rate of 3% per year and so
the dividend growth model can be applied to these dividends. The present value of these dividends is a
Year 3 present value, which will need discounting back to year 0. The market value of the company can
then be found by adding this to the present value of the forecast dividends in Years 2 and 3.

PV of year 2 dividend = 500,000/1∙122 = $398,597 [0.5 marks]
3
PV of year 3 dividend = 1,000,000/1∙12 = $711,780 [0.5 marks]
Year 3 PV of dividends after year 3 = (1,000,000 x 1∙03)/(0∙12 – 0∙03) = $11,444,444
[2 marks]
3
Year 0 PV of these dividends = 11,444,444/1∙12 = $8,145,929 [1 mark]
Market value from dividend valuation model = 398,597 + 711,780 + 8,145,929 = $9,256,306 or
approximately $9∙3 million [1 mark]

(c)
Current weighted average after‐tax cost of capital
Current cost of equity using the capital asset pricing model = 12%
After‐tax cost of debt = 5 x (1 – 0∙2) = 5 x 0∙8 = 4% [1 mark]
Current after‐tax WACC = (12 x 0∙75) + (4 x 0∙25) = 10% per year [1 mark]
Weighted average after‐tax cost of capital after new debt issue
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ST&Co

Revised cost of equity = Ke = 4 + (2∙0 x 5) = 14% [1 mark]
Revised after‐tax cost of debt = 6 x (1 – 0∙2) = 6 x 0∙8 = 4∙8% [1 mark]
Revised after‐tax WACC = (14 x 0∙6) + (4∙8 x 0∙4) = 10∙32% per year [1 mark]
HW: Q3)
(a) Calculation of share price
THP Co dividend per share = 64 × 0∙5 = 32c per share [1 mark]
Share price of THP Co = (32 × 1∙05)/(0∙12 – 0∙05) = $4∙80 [2 marks]
Market capitalisation of THP Co = 4∙80 × 3m = $14∙4m [1 mark]

(b) Rights issue price
This is at a 20% discount to the current share price = 4∙80 × 0∙8 = $3∙84 per share [1 mark]
New shares issued = 3m/3 = 1m
Cash raised = 1m × 3∙84 = $3,840,000 [1 mark]
Theoretical ex rights price = [(3 × 4∙80) + 3∙84]/4 = $4∙56 per share [1 mark]
Market capitalisation after rights issue = 14∙4m + 3∙84m = $18∙24 – 0∙32m = $17∙92m
This is equivalent to a share price of 17∙92/4 = $4∙48 per share [2 marks]
The issue costs result in a decrease in the market value of the company and therefore a decrease in the
wealth of shareholders equivalent to 8c per share.

(c)
Price/earnings ratio valuation
Price/earnings ratio of THP Co = 480/64 = 7∙5 [1 mark]
Earnings per share of CRX Co = 44∙8c per share
Using the price earnings ratio method, share price of CRX Co = (44∙8 × 7∙5)/100 = $3∙36
Market capitalisation of CRX Co = 3∙36 × 1m = $3,360,000 [2 marks]
(Alternatively, earnings of CRX Co = 1m × 0∙448 = $448,000 × 7∙5 = $3,360,000)
(d)(i)
1. In a semi‐strong form efficient capital market, share prices reflect past and public information. If
the expected annual after‐tax savings are not announced, this information will not therefore be
reflected in the share price of THP Co.
2. In this case, the post acquisition market capitalisation of THP Co will be the market capitalisation
after the rights issue, plus the market capitalisation of the acquired company (CRX Co), less the
price paid for the shares of CRX Co, since this cash has left the company in exchange for
purchased shares. It is assumed that the market capitalisations calculated in earlier parts of this
question are fair values, including the value of CRX Co calculated by the price/earnings ratio
method.

Price paid for CRX Co = 3∙84m – 0∙32m = $3∙52m
Market capitalisation = 17∙92m + 3∙36m – 3∙52m = $17∙76m
This is equivalent to a share price of 17∙76/4 = $4∙44 per share

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3. The market capitalisation has decreased from the value following the rights issue because THP
Co has paid $3∙52m for a company apparently worth $3∙36m. This is a further decrease in the
wealth of shareholders, following on from the issue costs of the rights issue.

(d)(ii)
1. If the annual after‐tax savings are announced, this information will be reflected quickly and
accurately in the share price of THP Co since the capital market is semi‐strong form efficient.
2. The savings can be valued using the price/earnings ratio method as having a present value of
$720,000 (7∙5 × 96,000). The revised market capitalisation of THP Co is therefore $18∙48m
(17∙76m + 0∙72m), equivalent to a share price of $4∙62 per share (18∙48/4).
3. This makes the acquisition of CRX Co attractive to the shareholders of THP Co, since it offers a
higher market capitalisation than the one following the rights issue. Each shareholder of THP Co
would experience a capital gain of 14c per share (4∙62 – 4∙48).
In practice, the capital market is likely to anticipate the annual after‐tax savings before they are
announced by THP Co.

(e) There are a number of factors that should be considered by THP Co, including the following.
Gearing and financial risk
1. Equity finance will decrease gearing and financial risk, while debt finance will increase them.
2. Gearing for THP Co is currently 68∙5% and this will decrease to 45% if equity finance is used, or
rise to 121% if debt finance is used. There may also be some acquired debt finance in the capital
structure of CRX Co. THP Co needs to consider what level of financial risk is desirable, from both a
corporate and a stakeholder perspective.

Target capital structure
3. THP Co needs to compare its capital structure after the acquisition with its target capital structure.
If its primary financial objective is to maximise the wealth of shareholders, it should seek to
minimise its weighted average cost of capital (WACC).
4. In practical terms this can be achieved by having some debt in its capital structure, since debt is
relatively cheaper than equity, while avoiding the extremes of too little gearing (WACC can be
decreased further) or too much gearing (the company suffers from the costs of financial distress).

Availability of security
5. Debt will usually need to be secured on assets by either a fixed charge (on specific assets) or a
floating charge (on a specified class of assets). The amount of finance needed to buy CRX CO
would need to be secured by a fixed charge to specific fixed assets of THP Co. Information on
these fixed assets and on the secured status of the existing 8% loan notes has not been provided.

Economic expectations
6. If THP Co expects buoyant economic conditions and increasing profitability in the future, it will
be more prepared to take on fixed interest debt commitments than if it believes difficult trading
conditions lie ahead.

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ST&Co

Control issues
7. A rights issue will not dilute existing patterns of ownership and control, unlike an issue of shares
to new investors. The choice between offering new shares to existing shareholders and to new
shareholders will depend in part on the amount of finance that is needed, with rights issues being
used for medium‐sized issues and issues to new shareholders being used for large issues. Issuing
traded debt also has control implications however, since restrictive or negative covenants are
usually written into the bond issue documents.
Workings
Current gearing (debt/equity, book value basis) = 100 × 5,000/7,300 = 68∙5%
Gearing if equity finance is used = 100 × 5,000/(7,300 + 3,840) = 45%
Gearing if debt finance is used = 100 × (5,000 + 3,840)/7,300 = 121%
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16.

0 Business Valuations SAUD TARIQ

Nature Shares Valuation Valuation of

When Asset-based Income/ Dividend Discounted Irredeemable

Replacement Earning Constant Convertible

Redeemable debt MV = PV of future interest and redemption

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