Financial Management Assignment Evaluating Business Case Scenarios
Write a financial management assignment addressing the following parts:
Part A 400 words
a. Explain how the general dividend valuation model values a share.
b. Explain, compare and contrast the various capital budgeting methods such as the Net Present Value Method, the Payback Period, the Accounting Rate of Return and the Internal Rate of Return.
c. Discuss the two Modigliani and Miller propositions and the key assumptions underlying them and their relevance to capital structure decisions.
Part B 800 words
Your Board of Directors is considering acquiring a business in the same industry. The Board has not undertaken such a venture before. The CEO has come to you to ask you to prepare a Board report which clearly explains the 3 main methods of valuing a business. Include in your report the specific valuation methods the board should consider when making their decision on the company they should acquire. Assume this is a listed company and the company being acquired is a listed company. In the report identify and explain some other areas than valuation methods that should be considered by the directors when undertaking the acquisition of another organization
Financial Management AssignmentPart A
General dividend valuation model
The predicted profitability (earnings or cash flow) or the expected profit distribution to shareholders is frequently used to evaluate common equities (dividends). Several multistage growth rate models have been proposed to predict the evolution of a company's growth through time. The normal pay-out pattern, on the other hand, does not always match the assumptions of these models. A company's dividend is normally kept fairly steady, with increases made only if there is a high degree of confidence that the business can sustain the higher level and reductions made only as a last option. We also compute a lower limit for each of these estimations, as shown below. Each era is supposed to have a modest positive chance of the company going bankrupt.
As a result, for each period, there are three possibilities:
i) the dividend grows;
ii) the dividend is unchanged; or
iii) the company declares bankruptcy.
There is a middle ground where the company does not go bankrupt but temporarily reduces or stops paying dividends (Wafi, 2015). In this instance, the stock's value will be somewhere between the predicted value and the lower limit on value.
The analysts use various valuation models and information about the present and future earnings of the company to evaluate the fair value of shares. Further, this value was compared to the market value. A firm’s value is dependent upon its ability to generate cash flows & its unpredictability. The most essential premise of contemporary finance is that "the asset whose value is equal to the present value of allthe projected future cash flows is discounted at the needed return." There are several strategies for valuing common stock due to its complexity and significance.
The "dividend model" determines the stock value by discounting the projected dividends for the future cash. As a consequence, the true worth of shares is determined by anticipating the value of the cash dividend to be earned.
• there must be financial market efficiency
• the company’s distribution policy is fixed at a certain amount because of the continuation of dividends at a fixed rate
• discount rate is likely to change over time, and for the investment’s implementation, it depends upon the market
• Continuation of the company to infinity.
In finance, the “Discounted Cash Flow (DCF) Analysis”, uses the time value of money ideas to examine capital budgeting.
• The "Net Present Value model" calculates the difference between the present value of money coming in and leaving (Kengatharan, 2016). The capital investment is acceptable if the NPV is positive, and vice versa.
• The "PB model" calculates the time it will take to recoup the precise amount of money invested.
• The annualized rate of return (ARR) is derived by dividing the after-tax average income from investment income by its average book value.
• The Internal Rate of Return model calculates the rate of a capital investment at which it is justified, equating the investment cost to the present value of the project.
The PB does not consider the risk, cash flow, and the time value of money adequately. Hence it fails to make accurate project value assessments. Andalso, it fails to identify investment projects that will maximize profits, whereas the ARR has been chastised for ignoring time, the value of money, and risk (Bora, 2015). There are two types of investment criteria: discounting Cash flow criteria and the non- discounting cash flow criteria. NPV and IRR fall under the criteria of discounting model. While PB and RR fall under the non-discounting model.
The NPV and IRR are not the same n the following aspects.
Firstly, the NPV considers the reinvestment of the cash inflows at the needed rate of return, but on the other hand, the IRR considers the reinvestment of the cash inflows at the calculated IRR. When comparing mutually incompatible projects, reinvesting according to the NPV Model is more beneficial and it offers trustworthy findings.
Secondly,NPV evaluates profitability on absolute terms, but IRR evaluates profitability on relative terms. When there is a temporal difference and mutually exclusive conflict, using both capital budgeting decision approaches may result in contradicting results.
So, it is concluded that the IRR is better under certain instances and in others, NPV is better.But the superiority of NPV prevails in all cases.When projects are mutually exclusive and of varying sizes, NPV is the best option since it chooses the project that maximizes value.
The IRR rule, if applied to non-conventional projects will lead to multiple rates of return. And it does not work for many costs of capital conditions. In the case of mutually exclusive projects, the IRR rule can give misleading signals. The value additively principle is violated by the IRR rule and IRR is cumbersome. So, the NVP rule is always preferred over the IRR rule.
Modigliani and Miller make the following observations in their article:
• The worth of a firm and the cost of its capital structure don’t have any relationship.
• The cut-off rate for investment purposes is unrelated to the kind of financing that will be used.
The Theory of Modigliani and Miller was quickly changed to the major "theory of capital structure" following the release of Modigliani and Miller’s original work. The basic claim and the principles of "The M&M Theorem (1958)" propose that the market is completely efficient and there are no taxes, bankruptcy costs, or transactions in the market and all the participants can access plenty of information. M&M expanded its model in 1963 to incorporate the impact of taxes, bringing the theory closer to reality.
Key Assumptions in the "Modigliani-Miller Approach"
• The Irrelevance of the Capital Structure is the first proposition.
• The assumptions in this proposition are that the debt-equity ratio of the firm, or “Capital Structure,” does not impact the firm’s market value under specific situations.
• The second hypothesis is the rate of return on equity (ROE).
• The equity costs rise in lockstep with the debt-equity ratio in a firm's capital structure (Ahmeti, 2015). As the debt-equity ratio rises, so does the cost of equity.
• The third Hypothesis says that the dividend policy is irrelevant.
• The earning potential of a company along with the risk of its present assets determines a company’s overall market worth.
Capital Structure and the Modigliani-Miller Approach
The capital structure irrelevance hypothesis is based on assumptions about investor and capital market behavior. The capital structure of the business has little effect on the firm's worth, according to MM (YapaAbeywardhana, 2017). A perfect capital market is a place where the exchange of securities takes place and the insiders and the outsiders can make decisions based on all the important information that is accessible to them.There are no bankruptcy costs, taxes, or transaction costs in this market. And both the firms and the individual investors are allowed to borrow and lend for the same rate of interest. All three theories are relevant to understanding the capital structure. The capital structure irrelevance theorem and all other unrealistic assumptions have been proved to be the stepping stone for all the capital structure theories. The way a company raises funds by following a hierarchy has been explained by the pecking theory while maximization of value using the optimal debt-equity mix and the tax shield advantage have been explained by the trade-off theory.
Part B: Board Report
The purchase of other businesses in the same or related fields of activity is another way to expand (Yücel, 2016). In practice, company values are commonly determined before potential acquisitions. A continual appraisal of a firm is useful even if there is no intention of selling it since it informs the owners about the growth of their invested cash.
Three major approaches to valuing a company
i) The DCF Method (Discounted Cash Flow)
The "Discounted Cash Flow (DCF) approach" provides for the calculation of a company's worth at any point in time using a long-term financial plan. This technique is derived from the basic idea that the present value of future revenues equals the worth of the economic asset.
In DCF, three primary categories of approaches were identified. The first category is the market valuation of a firm's worth, which decides whether or not the company generates "shareholder value." "Market Value Added (MVA)," is an indicator that is calculated as the difference between market value and invested capital.
The second category includes approaches that are only dependent on current book values (Honková, 2017). For example,the so-called substance valuation approach' calculates the value of the business based on thecoston which all of the business assets are reproduced, adjusted for depreciation as per the company's age. Continuously measuring the worth of a company using this technique, on the other hand, is very difficult since it requires the presence of a genuine buyer ready to pay more than the actual value of net assets. DCF is the method using which the value of a company is assessed. The DCF analysis estimates the cash flows of the company and then those cash flows are discounted at a discount rate that is proportionate with the risk levels.
(ii) Analysis of Comparable Companies
Comparability is the essential feature in accounting data. It helps the acquirers to properly comprehend the target's underlying economic events and compare the targetcompaniestocomparable companies. It refers to whether two organizations’ accounting systems are comparable, i.e., if they create similar financial statements when faced with the same set of economic events by calculating how stock returns translate into profits.
The acquirer checks and contrasts the target's financial statements with those of the target's rivals to identify risk areas that need to be investigated further. Acquirers must improve their screening of possible targets and appropriately appraise the value of those that have more comparable financial statements. Financial statements that are publicly accessible are an important source of information for assessing and appraising prospective targets. According to this research, comparability broadens the range of information accessible to prospective investors (Chen, 2018). The public accounting information must be resorted to for the assessment of target companies because private information may be biased. Having accounting data that is more comparable to rival businesses aids management in determining the authenticity of confidential information.
Comparability broadens and improves the information set accessible to the acquiring business, making merger and acquisition choices easier.
"The enterprise value to profits before interest, taxes, depreciation, and amortization multiple," or enterprise value divided by earnings before interest, taxes, depreciation, and amortization. The most commonly used and misunderstood method of valuing. It is a valuable quantitative component that better explains market values and forecasts stock returns than operational profit. The value of the core activities minus non-operating assets (like excess cash and nonconsolidated subsidiaries) equals enterprise value. Enterprise value equals short- and long-term debt, debt equivalents, and other claims, minus excess cash and non-operating assets, plus the value of equity, equal enterprise value. The profits before interest and taxes or EBIT (Operating Profit) includingdepreciation and amortization charges,isknown as EBITDA(Mauboussin, 2018). Cost of Interest, investments, and taxes are important for sustaining or developing the firm.The EBITDA doesn’t include changes in capital expenditure, acquisitions, and net-working capital.
Other areas to be considered for valuation by the directors
Apart from the valuation methodologies, consider the motivation for the purchase, the business to be bought, the use of a third party as a mediator, familiarity with the management team, and the creation of a good integration plan when purchasing another firm. The debt and equity mix of a company's capital structure should be evaluated to see how it influences its market value.
Using EV/EBITDA incorrectly might lead to valuation errors. The justified multiple is primarily determined by the production of value, growth, and risk. Thoughtful investors spend time learning about the assumptions that go into the multiples they utilize. The "Discounted Cash Flow Approach" should be included in the board's company appraisal since it is theoretically the most exact method.
Yücel, M.G. and Görener, A., 2016. Decision-making for company acquisition by ELECTRE method. International Journal of Supply Chain Management, 5(1), pp.75-83.
Honková, I., 2017. Assessment of the DCF method in company valuation. Hradec Economic Days 2017.
Chen, C.W., Collins, D.W., Kravet, T.D. and Mergenthaler, R.D., 2018. Financial statement comparability and the efficiency of acquisition decisions. Contemporary Accounting Research, 35(1), pp.164-202.
Mauboussin, M.J., 2018. What Does an EV/EBITDA Multiple Mean. Bluemont Investment Research.
Ahmeti, F. and Prenaj, B., 2015.A critical review of Modigliani and Miller’s theorem of capital structure. International Journal of Economics, Commerce and Management (IJECM), 3(6).
YapaAbeywardhana, D., 2017. Capital structure theory: An overview.Financial management assignment Accounting and finance research, 6(1).
Kengatharan, L., 2016. Capital budgeting theory and practice: a review and agenda for future research. Applied Economics and Finance, 3(2), pp.15-38.
Bora, B., 2015.Comparison between net present value and internal rate of return. International Journal of Research in Finance and Marketing, 5(12), pp.61-71.
Wafi, A.S., Hassan, H. and Mabrouk, A., 2015. Fundamental analysis models in financial markets–review study. Procedia economics and finance, 30, pp.939-947.