# Finance

There are various methods of valuing a company. Some of these methods include;

1. P/E ratio
2. Dividend valuation model
3. The Present Value of method among others.

The above valuation methods, however, have some advantages and disadvantages as will be seen later in this paper. Therefore it is important that the investors use the method that provide more relevant information and also correct valuation.

Price earning ratio (P/E ratio)

It uses the market price of the share and the earnings per share to determine the value of the company.

P/E ratio = MPS

EPS

The earnings per share of Mallard plc is obtained by dividing the post tax operating cash flow added with the savings/losses and any incomes that may accrue.

Therefore then adjusted post tax operating cash flow of mallard P/C will be;

Savings/ losses for current year                 £ ‘000’

Employee savings            (after tax)        502.5

Distribution savings          (after tax)        100.5

Redundancy costs                                     (1200)

Directors fees                                            (300)

Saleof buildings               (after tax)        800

(97)

Post tax operating cash flow                     3551

Less losses                                                 (97)

3454

EPS = adjusted post operating cash flow

Number of ordinary shares

Number of ordinary shares= 500,000 = share capital

0.1       Par value

=5,000,000 shares

Therefore, EPS= 3,454,000

5,000,000             = 0.6908

Consequently, P/E ratio = MPS

EPS

=3.70

0.6908                          =5 times

Dividend Valuation Model

There are two models in this method; the constant growth and the non-constant growth.

Constant growth model= DPS1

Ke-g

Where DPS1 = dividend per share in period 1.

Ke = cost of equity

g = dividend growth rate.

In Mallard plc case, the growth rate over the last 5 years is assumed to be the constant growth rate and hence, g=8%.

The DPS1 = DPS X growth rate

= 842,000

5,000,000 = £ 0.1684

Therefore, DPS1 = 0.1684 x 1.08%

= £ 0.181872

The cost of equity, ke, is determined using the capital asset pricing model (CAPM)

Ke= Rf +Be 9Rm-Rf)

Where Rf= Risk free rate

Be= beta of equity

Rm= returns of the market.

Rf =6% (given)

Rm= 14% (given)

Be= 0.8 (given)

Hence, ke = 6+ 0.8 (14-6)

=12.4%

Value of shares DPS1

Ke-g

=0.181872

12.4-8

= £ 4.13345

Present value model

The cash flow is discounted using the firm’s cost of capital. There are 2 methods of discounting i.e. discounting the cash flow related to equity using the cost of equity to determine the value of equity and discounting the cash flows to get the value of the firm using WACC. The discounting rates used can be nominal or real depending on the nature of cash flows (real or nominal).

The assumption in Mallard plc is that the cash flows shown of £3,551, 000 will remain the same over the 10 year period.

 period 1 2 3 4 5 6 7 8 9 10 post tax op 3551 3551 3551 3551 3551 3551 3551 3551 3551 3551 redundancy 1200 wage savings 502.5 502.5 502.5 502.5 502.5 502.5 502.5 502.5 502.5 502.5 sales of building 800 advert& distributions 100.5 100.5 100.5 100.5 100.5 100.5 100.5 100.5 100.5 100.5 directors fees -300 -300 -300 3454 3854 3854 4154 4154 4154 4154 4154 4154 4154

The discounting rate to be used is the weighted average cost of capital (WACC) calculated as follows.

WACC= KeWe + Kd (1-t) Wd

Where ke- cost equity

We –proportion of equity in capital structure.

Kd- cost of debt

Wd- proportion of debt in the capital structure.

Assumption: reserves in balance sheet is capital

= 12.4%x 500 + 11 %( 1-0.33) 3500

4000                                                  4000

= 8%

The above rate of 8% nominal i.e. not adjusted for inflation. The same applies to the cash flows calculated above.

Period     C.F      discounting factor (8%)          PV

1             3454    0.9259                                     3198

2             3854    (2.5771-0.9259) =1.6512        6364

3             3854

4             4154    (6.7101-2.5771) =4.1330=      17,168

5             4154

6             4154

7             4154

8             4154

9             4154

10           4154

PV £26,730,000

The discounting factor of 1.6512 is for period 2-3 while that of 4.1330 is for period 4-10

Critical examination of the methods

Price earnings ratio (P/E Ratio)

It is a valuation method that uses the current market price of the shares of the company over its earnings per share. It is an easy valuation method and is calculated as follows.

P/E = MPS

EPS

It really shows the confidence the investors have in the future performance of the company. In other words, how much the investors are willing to pay for shares of the company.

Generally, the higher the P/E ratio, the better the company because it takes a shorter duration for the investors to recover their monies (Equitymaster.com 2002)

This method, however, has some drawbacks which include that fact that it uses profits instead of cash flows and the benchmark to be used is also not clear.

This has led to the formulation of PEG which incorporates the growth rate in the calculation.

Mallard plc P/E ratio of 5:1 is below the industry average of 6:1. It is also less that the average P/E ratio of companies recently taken over of 7:1

Based on these, therefore, it appears Mallard plc is a less attractive as as investment option.

Dividend valuation model

This is a method of valuing companies using the dividends paid out.

The general model is as follows,

Po= D1+       D2+             …        +    Dn     +    Pn

(1+ke) 1   (1+ke) 2        (1+ke) n    (1+ke) n

Where P1= Dividend at period 1

Pn= price at period n

The redemption price (pn) is also included in the valuation of the shares. The value of the share is arrived at by discounting the dividends and the redemption price. The above formula has lead to the Gordon’s model which is as follows.

For a constant growth rate of dividends;

Po= Do (1+g)

Ke-g                                    (Globusz Publishing 2008)

Gordon’s model, however, has some disadvantages which include the sensitivity if the cost of equity is close to the constant growth rate and also the assumption that cost the equity be more that the growth rate.

The idea that the dividends will grow over the years may not be true and therefore leading to wrong valuation.

Based on the calculations, it indicates that the firm’s shares are under priced i.e. 370 pence as compared to 413 pence using (Gordon’s model) therefore, it is a good buy because when the market realizes that the shares are undervalued, the demand will increase hence a rise in the price.

Present value of cash flow

It is a valuation technique that uses cash flow (future) to determine the value of an investment. The essence is that the future cash flows are discounted to present terms using a discounting rate determined by the company. This method considers the time value concept of money i.e. what is the future cash flows worth now.

Discounted cash flow method also considers the time value of money i.e. the timing of the cash flows is considered.

Cash flows can either be annuities (where the amount received is same over the years) or single amount (where amounts vary over the years)

The single formula is

PV= Fv (single amount) x (1+r)-n

And the annuity amount formula is

PV= Fv (annuity) X 1-(1+r)-n

r

Where =r = discounting rate

n= period

(Solution matrix.com 2008)

Based on the discounted cash flow method, the company can acquire Mallard plc because it is worth £26,730,000 now compared to the initial investment of £22,000,000. The assumptions made may have caused the difference in values arrived at using the three methods.

Recommendation

Based on P/E ratio, Oakton plc should not acquire Mallard plc because its P/E ratio is lower. Also using the dividend valuation model, the total value will be 5,000, 000 x 4.13345= £ 20,667,250

Hence, Oakton should not pay £ 22,000,000 based on the two methods.

Use of cash or shares

An acquisition can be financed in several ways. Some of which include the use of cash, shares or debt or a combination of either two or all the three methods. In determining which method to use, the tax implications cost of debt and liquidity position of the company is considered.

In using cash, the company should consider whether there is enough cash to meet all other obligations of the company i.e. the company may use all the available cash to finance an acquisition to the detriment of the liquidity position of the company.

The use of an all cash acquisition also can beneficial in that the company will have total control i.e. without ceding shareholding.

If shares are to be used the amount of shares to be used in the acquisition should be considered i.e. if it is authorized by the regulators.

The management of Oakton plc should also consider if they want to cede their ownership of the company in using shares to finance the acquisition.

A merger occurs when two companies of almost the same size agree to work together. This is achieved by forming a company to take over the two companies. The company can adopt a new name with the issue of new shares.

An acquisition on the other hand, is when a big company takes over a relatively smaller company. In this use, the smaller company looses its identity to the larger company.

In either case, a merger or acquisition, there are some potential benefits that will accrue to the companies as seen below.

The most apparent benefit of the acquisition of Mallard plc by Oakton plc is the employee reduction and therefore leads to wage savings to the company. In this case, the acquisition will lead to the redundancy of 50 employees at Mallard plc.

The other benefit that will arise from this acquisition is that of diversification. The two companies are in different industries and therefore this leads to diversification. It is obvious that diversification reduces a company’s business risk and hence safeguarding and enhancing the shareholders wealth.

Mergers and acquisitions also lead to economies of scale. An economy of scale is achieved whereby the company is operating and producing on a large scale basis. When a company produces on a large scale basis, there is a reduced cost of production in the sense that the fixed costs are spread over a large number of goods and services.

The other potential benefit is the fact that the company is able to reach new markets thus improving the company’s profit and revenues. The acquisition may lead to the entry in to new markets which may be more profitable and therefore improving the company’s bottom line (profitability).

In a merger or acquisition, the company can also benefit from the acquisition of new technologies from the acquired company. Therefore with new technologies, the company is able to be efficient in its production and hence improved profitability.

The company can also benefit from an acquisition in the sense that it can acquire a company that is considered to have top quality management team and therefore to get the services of these management, the company is forced to acquire the while company.

Strategic alliances in form of mergers also portend another benefit to the company. If company wants to pursue a certain strategy that it cannot accomplish on its own, then it can contemplate an acquisition or a merger in order to achieve that strategy.

Problems in achieving synergy

Different companies usually have different company culture and norms. This means that in an acquisition or a merger, the combination of the combination of the two companies may create a clash of the cultures and therefore this can lessen the achievement of synergy.

The merging and integration different departments and operations of the two companies can be slow and hence take a longer duration of time. The longer it takes to integrate, the greater loses realized due to lack of cohesion and lost economies of scale.

The company should be able to integrate faster and thereby achieving economies of scale.

The intention of the merger is also another factor that may lead to non-achievement of synergy. If the merger was as a result of defensive strategy i.e. to thwart off a potential takeover, then it may not create necessary synergy that may achieve efficiency in its operations

The management intention of conquests may drive them to acquire companies that may not add value to the company. It is important that the acquisition or merger is driven by sound business strategy and decisions so as to avoid costly mergers and acquisitions.

Reasons for mergers and acquisitions

Mergers and acquisitions are not only done to achieve corporate diversification but also to realize a whole lot other benefits to the company as discussed below.

A company can merge or acquire another company solely for the purpose of increasing their shareholders wealth if the company is in a fast rising or a lucrative industry.

If a company wants to expand to new markets or territories it can acquire or merge with a company in that market and hence be present in that market without all the obstacles of establishing a new business.

Many small and fast growing companies face the threat of hostile take over by large companies more often and therefore to avoid being taken over, the company can adopt a defensive strategy by acquiring another small company so that it can appear to be big in value and hence thwart off takeovers.

An economy of scale is normally achieved after a merger or acquisition. Economies of scale also lead to reduced costs and improved efficiency.

Acquisition of new technology and new product line is another reason for merger and acquisition (Kontelnikov 2001)