Chapter 17 Business Valuations Answer 1 (a)(i) Price/earnings ratio method valuation Earnings per share of Danoca Co = 40c Average

sector price/earnings ratio = 10 mplied value of ordinar! share of Danoca Co = 40 " 10 = #4$00 %um&er of ordinar! shares = ' million (alue of Danoca Co = 4$00 " 'm = #)0 million (a)(ii) Dividend gro*th model Earnings per share of Danoca Co = 40c Proposed pa!out ratio = +0, Proposed dividend of Danoca Co is therefore = 40 " 0$+ = )4c per share

[2 marks]

[1 mark]

f the future dividend gro*th rate is e"pected to continue the historical trend in dividends per share- the historic dividend gro*th rate can &e used as a su&stitute for the e"pected future dividend gro*th rate in the dividend gro*th model. Average geometric dividend gro*th rate over the last t*o !ears = ()4/ )))1/) = 1$04' or 4$', (Alternativel!- dividend gro*th rates over the last t*o !ears *ere /, ()4/)/$/) and +, ()/$//)))- *ith an arithmetic average of (+ 0 /)/) = 4$',) [1 mark] Cost of e1uit! of Danoca Co using the capital asset pricing model (CAP2) = 4$+ 0 1$4 " (10$+ 3 4$+) = 4$+ 0 (1$4 " +) = 1/, [1 mark] (alue of ordinar! share from dividend gro*th model = ()4 " 1$04')/(0$1/ 3 0$04') = #)$4' (alue of Danoca Co = )$4' " 'm = #14$5' million [2 marks] Discussion: 1. 6he current mar7et capitalisation of Danoca Co is #1+$'m (#/$/0 " 'm).6he price/earnings ratio value o Danoca Co is higher than this at !2"m - using the average price/earnings ratio used for the sector. ). Danoca8s o*n price/earnings ratio is 9$)'. 6he #i erence $etween the two price/earnings ratios ma% in#icate that there is scope or improving the inancial per ormance o Danoca Co ollowing the ac&uisition . f Pho&is Co
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has the managerial s7ills to effect this improvement- the compan! and its shareholders ma! &e a&le to &enefit as a result of the ac1uisition. /. 6he #ivi#en# growth mo#el value is lower than the current market capitalisation at #14$5'm. 6his represents a minimum value that Danoca shareholders *ill accept if Pho&is Co ma7es an offer to &u! their shares. 'n realit% the% woul# want more than this as an inducement to sell. 6he current market capitalisation of Danoca Co of #1+m ma% re lect the $elie o the stock market that a takeover $i# or the compan% is imminent and- depending on its efficienc!- ma! indicate a fair price for Danoca8s sharesat least on a marginal trading &asis. Alternativel!- either the cost of e1uit! or the e(pecte# #ivi#en# growth rate use# in the #ivi#en# growth mo#el calculation coul# $e inaccurate - or the difference &et*een the t*o values ma% $e #ue to a #egree o ine icienc% in the stoc7 mar7et. [) marks]

4.

'.

(&) Calculation of mar7et value of each converti&le &ond E"pected share price in five !ears8 time = 4$4' " 1$0+'' = #+$10 Conversion value = +$10 " )0 = #1)) [1 mark] Compared *ith redemption at par value of #100- conversion *ill &e preferred 6he current mar7et value *ill &e the present value of future interest pa!ments- plus the present value of the conversion value- discounted at the cost of de&t of 5, per !ear. 2ar7et value of each converti&le &ond = (4 " 4$100) 0 (1)) " 0$51/) = #1)/$94 [2 marks] Calculation of floor value of each converti&le &ond 6he current floor value *ill &e the present value of future interest pa!ments- plus the present value of the redemption value- discounted at the cost of de&t of 5, per !ear. :loor value of each converti&le &ond = (4 " 4$100) 0 (100 " 0$51/) = #109$)0 [2 marks] Calculation of conversion premium of each converti&le &ond Current conversion value = 4$4' " )0 = #94$00 Conversion premium = #1)/$94 3 94$00 = #/4$94 6his is often e"pressed on a per share &asis- i.e. /4$94/)0 = #1$5' per share [1 mark]

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(c) *eak orm e icienc%: 1. ;toc7 mar7et efficienc! usuall! refers to the *a! in *hich the prices of traded financial securities reflect relevant information. <hen research indicates that share prices ull% an# airl% re lect past in ormation - a stoc7 mar7et is descri&ed as *ea7=form efficient. ). nvestors cannot generate a$normal returns $% anal%sing past in ormation such as share price movements in previous time periods- in such a mar7et- since research sho*s that there is no correlation &et*een share price movements in successive periods of time. ;hare prices appear to follo* a >random *al78 &! responding to ne* information as it &ecomes availa&le. [1 + 2 marks] ,emi-strong rom: 1. <hen research indicates that share prices ull% an# airl% re lect pu$lic in ormation as well as past in ormation- a stoc7 mar7et is descri&ed as semi= strong form efficient. ). nvestors cannot generate a$normal returns $% anal%sing either pu$lic in ormation. such as pu$lishe# compan% reports. or past in ormation - since research sho*s that share prices respond 1uic7l! and accuratel! to ne* information as it &ecomes pu&licl! availa&le. [1 + 2 marks] ,trong rom: 1. f research indicates that share prices ull% an# airl% re lect not onl% pu$lic in ormation an# past in ormation. $ut private in ormation as well - a stoc7 mar7et is descri&ed as strong form efficient. ). Even investors with access to insi#er in ormation cannot generate a$normal returns in such a market. 6esting for strong form efficienc! is indirect in nature- e"amining for e"ample the performance of e"pert anal!sts such as fund managers. ;toc7 mar7ets are not held to &e strong form efficient. [1 + 2 marks] ,igni icance o semi-strong orm e icienc%: 1. 6he significance to a listed compan! of its shares &eing traded on a stoc7 mar7et *hich is found to &e semi=strong form efficient is that an% in ormation relating to the compan% is &uickl% an# accuratel% re lecte# in its share price. ). /anagers will not $e a$le to #eceive the market $% the timing or presentation o new in ormation- such as annual reports or anal!sts8 &riefingssince the mar7et processes the information 1uic7l! and accuratel! to produce
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fair prices. /. /anagers should there ore simpl% concentrate on making inancial #ecisions *hich increase the wealth o sharehol#ers. [2 + 0 marks] ACCA /arking ,cheme

Answer 2 (a) Calculation of share price 6?P Co dividend per share = +4 " 0$' = /)c per share ;hare price of 6?P Co = (/) " 1$0')/(0$1) 3 0$0') = #4$90 2ar7et capitalisation of 6?P Co = 4$90 " /m = #14$4m

[1 mark] [2 marks] [1 mark]

(&) @ights issue price 6his is at a )0, discount to the current share price = 4$90 " 0$9 = #/$94 per share [1 mark] %e* shares issued = /m// = 1m Cash raised = 1m " /$94 = #/-940-000 [1 mark] 6heoretical e" rights price = A(/ " 4$90) 0 /$94B/4 = #4$'+ per share [1 mark] 2ar7et capitalisation after rights issue = 14$4m 0 /$94m = #19$)4 3 0$/)m = #15$4)m 6his is e1uivalent to a share price of 15$4)/4 = #4$49 per share [2 marks] 6he issue costs result in a decrease in the mar7et value of the compan! and therefore a decrease in the *ealth of shareholders e1uivalent to 9c per share.

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(c) Price/earnings ratio valuation Price/earnings ratio of 6?P Co = 490/+4 = 5$' [1 mark] Earnings per share of C@C Co = 44$9c per share Dsing the price earnings ratio method- share price of C@C Co = (44$9 " 5$')/100 = #/$/+ 2ar7et capitalisation of C@C Co = /$/+ " 1m = #/-/+0-000 [2 marks] (Alternativel!- earnings of C@C Co = 1m " 0$449 = #449-000 " 5$' = #/-/+0-000) (d)(i) 1. n a semi=strong form efficient capital mar7et- share prices reflect past and pu&lic information. ' the e(pecte# annual a ter-ta( savings are not announce#- this information *ill not there ore $e re lecte# in the share price o 123 Co4 ). n this case- the post ac&uisition market capitalisation of 6?P Co will $e the market capitalisation a ter the rights issue. plus the market capitalisation o the ac&uire# compan% 5C67 Co8. less the price pai# or the shares o C67 Co- since this cash has left the compan! in e"change for purchased shares. t is assumed that the mar7et capitalisations calculated in earlier parts of this 1uestion are fair values- including the value of C@C Co calculated &! the price/earnings ratio method. Price paid for C@C Co = /$94m 3 0$/)m = #/$')m 2ar7et capitalisation = 15$4)m 0 /$/+m 3 /$')m = #15$5+m 6his is e1uivalent to a share price of 15$5+/4 = #4$44 per share /. 6he market capitalisation has #ecrease# rom the value ollowing the rights issue &ecause 6?P Co has paid #/$')m for a compan! apparentl! *orth #/$/+m. 6his is a further decrease in the *ealth of shareholders- follo*ing on from the issue costs of the rights issue.

(d)(ii) 1. f the annual after=ta" savings are announced- this information *ill &e re lecte# &uickl% an# accuratel% in the share price of 6?P Co since the capital market is semi-strong orm e icient. ). 6he savings can $e value# using the price/earnings ratio metho# as having a present value of #5)0-000 (5$' " 4+-000). 6he revise# market capitalisation o 123 Co is there ore !19:)9m (15$5+m 0 0$5)m)- e1uivalent to a share price of
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/.

#4$+) per share (19$49/4). 6his makes the ac&uisition o C67 Co attractive to the shareholders of 6?P Co- since it o ers a higher market capitalisation than the one follo*ing the rights issue. Each shareholder of 6?P Co *ould e"perience a capital gain of 14c per share (4$+) 3 4$49).

n practice- the capital mar7et is li7el! to anticipate the annual after=ta" savings &efore the! are announced &! 6?P Co. (e) 6here are a num&er of factors that should &e considered &! 6?P Co- including the follo*ing. ;earing an# inancial risk 1. <&uit% inance will #ecrease gearing an# inancial risk - *hile #e$t inance will increase them. ). Eearing for 6?P Co is currentl! +9$', and this *ill #ecrease to )=> i e&uit% inance is use#- or rise to 121> i #e$t inance is use# . 6here ma! also &e some ac1uired de&t finance in the capital structure of C@C Co. 6?P Co nee#s to consi#er what level o inancial risk is #esira$le- from &oth a corporate and a sta7eholder perspective. 1arget capital structure /. 6?P Co needs to compare its capital structure after the ac1uisition *ith its target capital structure. f its primar! financial o&Fective is to ma"imise the *ealth of shareholders- it should seek to minimise its weighte# average cost o capital 5*ACC8. 4. n practical terms this can &e achieve# $% having some #e$t in its capital structure- since #e$t is relativel% cheaper than e&uit%- *hile avoiding the e"tremes of too little gearing (<ACC can &e decreased further) or too much gearing (the compan! suffers from the costs of financial distress). Availa$ilit% o securit% '. De&t *ill usuall! nee# to $e secure# on assets $% either a i(e# charge (on specific assets) or a loating charge (on a specified class of assets). 6he amount of finance needed to &u! C@C CG *ould need to &e secured &! a fi"ed charge to specific fi"ed assets of 6?P Co. 'n ormation on these fi"ed assets and on the secured status of the e"isting 9, loan notes has not $een provi#e#.
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<conomic e(pectations +. f 6?P Co e(pects $uo%ant economic con#itions and increasing pro ita$ilit% in the uture- it *ill &e more prepare# to take on i(e# interest #e$t commitments than if it &elieves difficult trading conditions lie ahead. Control issues 5. A rights issue will not #ilute e(isting patterns o ownership an# control unli7e an issue of shares to ne* investors. 6he choice &et*een offering ne* shares to e"isting shareholders and to ne* shareholders *ill #epen# in part on the amount o inance that is nee#e# - *ith rights issues &eing used for medium=siHed issues and issues to ne* shareholders &eing used for large issues. ssuing traded de&t also has control implications ho*ever- since restrictive or negative covenants are usuall! *ritten into the &ond issue documents. <or7ings Current gearing (de&t/e1uit!- &oo7 value &asis) = 100 " '-000/5-/00 = +9$', Eearing if e1uit! finance is used = 100 " '-000/(5-/00 0 /-940) = 4', Eearing if de&t finance is used = 100 " ('-000 0 /-940)/5-/00 = 1)1, ACCA /arking ,cheme

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Answer 0 (a) @ights issue price = )$' " 0$9 = #)$00 per share [1 mark] 6heoretical e" rights price = (()$'0 " 4) 0 (1 " )$00)/'=#)$40 per share [2 marks] (Alternativel!- num&er of rights shares issued = #'m/#)$00 = )$'m shares E"isting num&er of shares = 4 " )$'m = 10m shares 6heoretical e" rights price per share = ((10m " )$'0) 0 ()$'m " )$00))/1)$'m = #)$40) (&) Current price/earnings ratio = )'0//)$4 = 5$5 times [1 mark] 0$)' Average gro*th rate of earnings per share = 100 " ((/)$4/)5$5) 3 1) = 4$0, Earnings per share follo*ing e"pansion = /)$4 " 1$04 = //$5 cents per share [1 mark] ;hare price predicted &! price/earnings ratio method = //$5 " 5$5 = #)$+0 [1 mark] ;ince the price/earnings ratio of Dartig Co has remained constant in recent !ears and the e"pansion is of e"isting &usiness- it seems reasona&le to appl! the e"isting price/earnings ratio to the revised earnings per share value. (c) Discussion o share price comparisons: 1. 6he propose# $usiness e(pansion *ill &e an accepta$le use o the rights issue un#s i it increases the wealth o the sharehol#ers. ). 6he share price pre#icte# $% the price/earnings ratio metho# is !2:?" . 6his is greater than the current share price o !2:="- &ut this is not a vali# comparison- since it ignores the e ect o the rights issue on the share price. 6he rights issue has a neutral e ect on sharehol#er wealth - &ut the cum rights price is changed &! the increase in the num&er of shares and &! the trans ormation o cash wealth into securit% wealth from a shareholder point of vie*. /. 6he correct comparison is with the theoretical e( rights price - *hich *as found earlier to &e #)$40. Dartig Co shareholders *ill e(perience a capital gain due to the &usiness e"pansion of !2:?" + 2:)" @ 2" cents per share. ?o*everthese share prices are one %ear apart and hence not #irectl% compara$le. [0 + ) marks] Calculation o e ect on sharehol#er wealth an# comment: 1. f the dividend !ield remains at +, per !ear (100 " 1'$0/)'0)- the dividend per share for )009 *ill &e 1'$+p (other estimates of the )009 dividend per share are
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).

possi&le). Adding this to the capital gain of )0p gives a total shareholder return of /'$+p or 14$)4, (100 " /'$+/)40). 6his is greater than the cost o e&uit% o 1"> and so sharehol#er wealth has increase#. [1 + 2 marks]

(d) n order to use the dividend gro*th model- the e"pected future dividend gro*th rate is needed. ?ere- it ma! &e assumed that the historical trend of dividend per share pa!ments *ill continue into the future. 6he geometric average historical dividend gro*th rate = 100 " ((1'$0/1)$9)0$)' 3 1) = 4, per !ear. [2 marks] (Alternativel!- the arithmetical average of annual dividend gro*th rates could &e used. 6his *ill &e ('$' 0 0$0 0 5$4 0 /$')/4 = 4$1,. Another possi&ilit! is to use the Eordon gro*th model. 6he average pa!out ratio over the last 4 !ears has &een 45,so the average retention ratio has &een '/,. Assuming that the cost of e1uit! represents an accepta&le return on shareholders8 funds- the dividend gro*th rate is appro"imatel! '/, " 10, = '$/, per !ear.) Dsing the formula for the dividend gro*th model from the formula sheet- the e" dividend share price = (1'$0 " 1$04)/(0$1 0$04) = #)$+0 [2 marks] Discussion: 1. 6his is 10 cents per share more than the current share price of Dartig Co. 6here are several reasons *h! there ma! &e a difference &et*een the t*o share prices. 6he uture #ivi#en# growth rate for e"ample- ma! #i er rom the average historical #ivi#en# growth rate- and the current share price ma! factor in a more reasona&le estimate of the future dividend gro*th rate than the 4, used here. ). 6he cost o e&uit% of Dartig Co ma! not $e e(actl% e&ual to 1">. 2ore generall!- there ma! &e a degree of inefficienc! in the capital mar7et on *hich the shares of Dartig Co are traded. [2 marks] (e) Discussion o agenc% pro$lem: 1. 6he primar! financial management o&Fective of a compan! is usuall! ta7en to &e the ma"imisation of shareholder *ealth. n practice- the managers of a compan! acting as agents for the principals (the shareholders) ma! act in *a!s *hich do not lead to shareholder *ealth ma"imisation. 6he ailure o
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managers to ma(imise sharehol#er wealth is re erre# to as the agenc% pro$lem. ). ,harehol#er wealth increases through pa%ment o #ivi#en#s an# through appreciation o share prices. ;ince share prices reflect the value placed &! &u!ers on the right to receive future dividends- anal!sis of changes in shareholder *ealth focuses on changes in share prices. 6he o&Fective of ma"imising share prices is commonl! used as a su&stitute o&Fective for that of ma"imising shareholder *ealth.

/.

6he agenc% pro$lem arises $ecause the o$Aectives o managers #i er rom those o sharehol#ersI &ecause there is a divorce or separation of o*nership from control in modern companiesJ and &ecause there is an as!mmetr! of information &et*een shareholders and managers *hich prevents shareholders &eing a*are of most managerial decisions. [) + = marks] Discussion o share option schemes: 1. Gne *a! to encourage managers to act in *a!s that increase shareholder *ealth is to offer them share options. 6hese are rights to &u! shares on a future date at a price *hich is fi"ed *hen the share options are issued. ,hare options will encourage managers to make #ecisions that are likel% to lea# to share price increases (such as investing in proFects *ith positive net present values)- since this will increase the rewar#s the% receive rom share options . 6he higher the share price in the mar7et *hen the share options are e"ercised- the greater *ill &e the capital gain that could &e made &! managers o*ning the options. ). ,hare options therefore go some *a! to*ards re#ucing the #i erences $etween the o$Aectives o sharehol#ers an# managers. ?o*ever- it is possi$le that managers ma% $e rewar#e# or poor per ormance if share prices in general are increasing. t is also possi$le that managers ma% not $e rewar#e# or goo# per ormance if share prices in general are alling. t is #i icult to #eci#e on a share option e(ercise price an# a share option e(ercise #ate that *ill encourage managers to focus on increasing shareholder *ealth *hile still remaining challenging- rather than &eing easil! achieva&le. [) + = marks]

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ACCA /arking ,cheme

Answer ) (a) <eighted average cost of capital (<ACC) calculation Cost of e1uit! of K:P Co = 4$0 0 (1$) " (10$' 3 4$0)) = 4$0 0 5$9 = 11$9, using the capital asset pricing model [2 marks] 6o calculate the after=ta" cost of de&t- linear interpolation is needed After=ta" interest pa!ment = 100 " 0$05 " (1 3 0$/) = #4$40

[1 mark]

After=ta" cost of de&t = ' 0 ((10 3 ') " 4$51)/(4$51 0 14$'4) = ' 0 1$0 = +$0, [0 marks] %um&er of shares issued &! K:P Co = #1'm/0$' = /0 million shares 2ar7et value of e1uit! = /0m " 4$) = #1)+ million [1 mark] 2ar7et value of &onds issued &! K:P Co = 1'm " 44$54/100 = #14$)11 million [1 mark] 6otal value of compan! = 1)+ 0 14$)11 = #140$)11 million <ACC = ((11$9 " 1)+) 0 (+$0 " 14$)11))/140$)11 = 11$), [2 marks]

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(&)(i) Price/earnings ratio method Earnings per share of %E% = 90c per share Price/earnings ratio of K:P Co = 9 ;hare price of %E% = 90 " 9 = +40c or #+$40 %um&er of ordinar! shares of %E% = '/0$' = 10 million shares (alue of %E% = +$40 " 10m = #+4 million

[2 marks]

?o*ever- it can &e argued that a reduction in the applied price/earnings ratio is needed as %E% is unlisted and therefore its shares are more difficult to &u! and sell than those of a listed compan! such as K:P Co. f *e reduce the applied price/earnings ratio &! 10, (other similar percentage reductions *ould &e accepta&le)- it &ecomes 5$) times and the value of %E% *ould &e (90/100) " 5$) " 10m = #'5$+ million (&)(ii) Dividend gro*th model Dividend per share of %E% = 90c " 0$4' = /+c per share [1 mark] ;ince the pa!out ratio has &een maintained for several !ears- recent earnings gro*th is the same as recent dividend gro*th- i.e. 4$',. Assuming that this dividend gro*th continues in the future- the future dividend gro*th rate *ill &e 4$',. ;hare price from dividend gro*th model = (/+ " 1$04')/ (0$1) 3 0$04') = '0)c or #'$0) (alue of %E% = '$0) " 10m = #'0$) million [0 marks] (c) A discussion of capital structure could start from recognising that e1uit! is more e"pensive than de&t &ecause of the relative ris7 of the t*o sources of finance. E1uit! is ris7ier than de&t and so e1uit! is more e"pensive than de&t. 6his does not depend on the ta" efficienc! of de&t- since *e can assume that no ta"es e"ist. <e can also assume that as a compan! gears up- it replaces e1uit! *ith de&t. 6his means that the compan!8s capital &ase remains constant and its *eighted average cost of capital (<ACC) is not affected &! increasing investment. 1ra#itional view o capital structure: 1. 6he traditional vie* of capital structure assumes a non-linear relationship $etween the cost o e&uit% an# inancial risk . As a compan! gears up- there is
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initiall% ver% little increase in the cost o e&uit% an# the *ACC #ecreases &ecause the cost of de&t is less than the cost of e1uit!. ). A point is reached- ho*ever- *here the cost o e&uit% rises at a rate that e(cee#s the re#uction e ect o cheaper #e$t and the *ACC starts to increase. n the traditional vie*- therefore- a minimum *ACC e(ists and- as a result- a ma(imum value o the compan% arises. [1 -2 marks] /B/ an# capital structure: /. 2odigliani and 2iller assume# a per ect capital market an# a linear relationship $etween the cost o e&uit% an# inancial risk . 6he! argued thatas a compan! geared up- the cost o e&uit% increase# at a rate that e(actl% cancelle# out the re#uction e ect o cheaper #e$t . *ACC *as therefore constant at all levels o gearing an# no optimal capital structure - *here the value of the compan! *as at a ma"imum- could &e found. 4. t *as argued that the no-ta( assumption made &! 2odigliani and 2iller *as unrealistic- since in the real worl# interest pa%ments were an allowa$le e(pense in calculating ta"a&le profit and so the e ective cost o #e$t was re#uce# $% its ta( e icienc%. '. 6he! revise# their mo#el to include this ta" effect and sho*ed that- as a resultthe *ACC #ecrease# in a linear ashion as a compan% geare# up . 6he value o the compan% increase# &! the value of the >ta" shield8 and an optimal capital structure woul# result $% gearing up as much as possi$le. [2 + 0 marks] /arket imper ections: +. t *as pointed out that market imper ections associate# with high levels o gearing- such as &an7ruptc! ris7 and agenc! costs- *ould limit the e(tent to which a compan% coul# gear up. 5. n practice- therefore- it appears that companies can re#uce their *ACC $% increasing gearing- while avoi#ing the inancial #istress that can arise at high levels of gearing. [1 + 2 marks] Cther relevant #iscussion: 9. t has further &een suggested that companies choose the source o inance *hich- for one reason or another- is easiest or them to access (pecking or#er theor%). 6his results in an initial pre erence or retaine# earnings- ollowe# $% a pre erence or #e$t $e ore turning to e&uit%. 4. 6he vie* suggests that companies ma% not in practice seek to minimise
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their *ACC (and conse1uentl! ma"imise compan! value and shareholder *ealth). [1 + 2 marks] Comment on #e$t inance or cash o er: 10. 6urning to the suggestion that de&t could &e used to finance a cash &id for %E%the current and post ac1uisition capital structures and their relative gearing levels should &e considered- as *ell as the amount of de&t finance that *ould &e needed. <arlier calculations suggest that at least !=9m woul# $e nee#e# ignoring an! premium paid to persuade target compan! shareholders to sell their shares. 6he current #e$t/e&uit% ratio o DE3 Co is ?"> (1'm/)'m). 6he #e$t o the compan% woul# increase $% !=9m in or#er to inance the $i# an# $% a urther !2"m a ter the ac&uisition - due to ta7ing on the e"isting de&t of %E%- giving a total o !F0m. gnoring other factors- the gearing woul# increase to 072> (4/m/)'m). 11. K:P Co *ould need to consi#er how it coul# service this #angerousl% high level o gearing an# #eal with the signi icant risk o $ankruptc% that it might create. t *ould also nee# to consi#er *hether the $ene its arising rom the ac&uisition of %E% *ould compensate or the signi icant increase in inancial risk an# $ankruptc% risk resulting from using de&t finance. [2 + 0 marks] ACCA /arking ,cheme

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Answer = (a) Divi#en# %iel# is calculate# as the #ivi#en# #ivi#e# $% the share price at the start o the %ear4 )009I dividend !ield = 100 " /9$'/540 = '$), [1 mark] )004I dividend !ield = 100 " 40$0/9/' = 4$9, [1 mark] 6he capital gain is the difference &et*een the opening and closing share prices- and ma! &e e"pressed as a monetar! amount or as a percentage of the opening share price. )009I capital gain = 9/' 3 540 = 4'c or 1)$9, (100 " 4'/540) )004I capital gain = +49 3 9/' = (195c) or ())$4,) (100 " 3195/9/') [1 mark] [1 mark]

6he total shareholder return is the sum of the percentage capital gain and the dividend !ield- or the sum of the dividend paid and the monetar! capital gain- e"pressed as a percentage of the opening share price. )009I total shareholder return = 100 " (4' 0 /9$')/540 = 19$0, ('$), 0 1)$9,) [1 mark] )004I total shareholder return = 100 " (3195 0 40)/9/' = 315$+, (4$9, 3 ))$4,) [1 mark] (a)(i) 1he return on e&uit% pre#icte# $% the CA3/ 1. 6he actual return for a shareholder of L;C Co- calculate# as total sharehol#er return- is ver% #i erent rom the return on e&uit% pre#icte# $% the CA3/. ). n 2""9 the compan! provi#e# a $etter return than pre#icte# an# in 2""F the compan! gave a negative return *hile the CA3/ pre#icte# a positive return.

;eneral #iscussion o returns: /. Mecause the risk- ree rate o return is positive and the e&uit% risk premium is either Gero or positive- and &ecause negative e&uit% $etas are ver% rarethe return on e&uit% pre#icte# $% the CA3/ is invaria$l% positive.
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4.

6his reflects the realit! that shareholders *ill al*a!s *ant a return to compensate for ta7ing on ris7. n practice- companies sometimes give negative returns- as is the case here. 6he return in 2""9 was greater than the cost o e&uit%- &ut the figure of 10, 1uoted here is the current cost of e1uit!J the cost o e&uit% ma% have $een #i erent in 2""9. [1 + 0 marks]

(a)(ii) Cther comments 1. L;C Co had turnover growth o 0> in 2""9- &ut did not generate an% growth in turnover in 2""F. ). <arnings per share grew $% ):1> in 2""9- &ut ell $% 9:0> in 2""F. /. Divi#en#s per share also grew $% ):1> in 2""9 - &ut unli7e earnings per share#ivi#en# per share growth was maintaine# in 2""F . t is common or #ivi#en#s to $e maintaine# when a compan% su ers a set$ack - often in an attempt to give reassurance to sharehol#ers. 4. 6here are other negative signs apart rom stagnant turnover an# alling earnings per share. 6he sharehol#er will $e concerne# a$out e(periencing a capital loss in 2""F. ?e *ill also $e concerne# that the #ecline in the price/earnings ratio in 2""F might $e a sign that the market is losing con i#ence in the uture o H,7 Co. f the sharehol#er was aware o the proposal &! the finance director to suspen# #ivi#en#s- he *ould &e even more concerne#. t might &e argued that- in a semi-strong orm-e icient market- the in ormation woul# remain private. ' H,7 Co #esires to conserve cash $ecause the compan% is e(periencing li&ui#it% pro$lems- ho*ever- these pro$lems are likel% to $ecome pu$lic knowle#ge fairl! 1uic7l!- for e"ample through the investigations of capital mar7et anal!sts.

'.

+.

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(&) ?istorical dividend gro*th rate = (40//5)0$' 3 1 = 0$04 or 4, per !ear [1 mark] ;hare price using dividend gro*th model = (40 " 1$04)/(0$1 3 0$04) = +4/c or #+$4/ [2 marks] n three !ears8 time- the present value of the dividends received from the fourth !ear on*ards can &e calculated &! treating the fourth=!ear dividend as D 1 in the dividend gro*th model and assuming that the cost of e1uit! remains unchanged at 10, per !ear. Appl!ing the dividend gro*th model in this *a! gives the share price in three !ears8 timeI ;hare price = 50/(0$1 3 0$0/) = 1-000c or #10$00. :or comparison purposes this share price must &e discounted &ac7 for three !earsI ;hare price = 0$5'1 " 10$00 = #5$'1. [0 marks] Comment on share prices: 1. 6he current share price o !?:)9 is less than the share price o !?:F0 calculate# $% the #ivi#en# growth mo#el - in#icating perhaps that the capital market $elieves that uture #ivi#en# growth will $e less than historic #ivi#en# growth. ). 6he share price resulting rom the propose# three-%ear suspension o #ivi#en#s is higher than the current share price an# the share price pre#icte# $% the #ivi#en# growth mo#el . ?o*ever- this share price is $ase# on in ormation that is not pu$lic and it also relies on uture #ivi#en#s an# #ivi#en# growth $eing as pre#icte#. t is ver% unlikel% that a pre#iction as
P. 17

tentative as this will prove to $e accurate. [1 + 2 marks] (c) 3ractical links $etween the #ecision areas: 1. nvestment decisions- dividend decisions and financing decisions have often &een called the #ecision triangle o inancial management. 6he stud! of financial management is often divided up in accordance *ith these three decision areas. ?o*ever- the% are not in#epen#ent #ecisions. $ut closel% connecte#. [1 + 2 marks] 6elevant illustrations: ). :or e"ample- a decision to increase #ivi#en#s might lea# to a re#uction in retaine# earnings and hence a greater nee# or e(ternal inance in order to meet the re1uirements of proposed capital investment proFects. ;imilarl!- a decision to increase capital investment spending *ill increase the need for financing- *hich could &e met in part &! reducing dividends. [1 + 2 marks] /B/ an# investment an# inancing #ecisions: /. 6he 1uestion of the relationship &et*een the three decision areas *as investigated &! 2iller and 2odigliani. 6he! sho*ed that- if a per ect capital market *as assumed- the market value o a compan% an# its weighte# average cost o capital 5*ACC8 were in#epen#ent o its capital structure. 4. 6he market value therefore #epen#e# on the $usiness risk of the compan! and not on its inancial risk. 6he investment #ecision- *hich determined the operating income of a compan!- *as therefore shown to $e important in #etermining its market value- *hile the inancing #ecision- given their assumptions- *as sho*n to &e not relevant in this conte(t. '. 'n practice- it is recognised that capital structure can a ect *ACC an# hence the market value o the compan%. [2 + 0 marks] /B/ an# #ivi#en# #ecision: +. 2iller and 2odigliani also investigated the relationship &et*een dividend polic! and the share price of a compan!- i.e. the mar7et value of a compan!. 6he! sho*ed that- if a per ect capital market was assume#- the share price of a compan! did not #epen# on its #ivi#en# polic%- i.e. the dividend decision *as irrelevant to value of the share. 5. 6he market value o the compan% an# there ore the wealth o sharehol#ers were shown to $e ma(imise# when the compan% implemente# its optimum
P. 18

investment polic%- *hich *as to invest in all proFects *ith a positive %P(. 6he investment decision *as therefore sho*n to &e theoreticall! important *ith respect to the mar7et value of the compan!- *hile the dividend decision *as not relevant. [2 + 0 marks] Cther relevant #iscussion: 9. 'n practice- capital markets are not per ect and a num$er o other actors $ecome important in discussing the relationship $etween the three #ecision areas. 4. 3ecking or#er theor%- for e"ample- suggests that managers #o not in practice make inancing #ecisions with the o$Aective o o$taining an optimal capital structure- &ut on the $asis o the convenience an# relative cost o #i erent sources o inance . @etained earnings are the preferred source of finance from this perspective- *ith a resulting pressure for annual dividends to &e lo*er rather than higher. [1 + 0 marks] ACCA /arking ,cheme

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Answer ? 6he approaches to use for valuation areI (1) ()) (/) 518 %et asset valuation. D(2. PE ratio valuation. Iet asset valuation

6arget is &eing purchased as a going concern- so realisa&le values are irrelevant. #000 %et assets per accounts #(1-94) 3 5+9) 1-1)4 AdFustment to freehold propert! #(900 3 4+0) /40 AdFustment to inventor! ('0) (aluation 528 DV/ 1-414

6he average rate of gro*th in 6arget8s dividends over the last 4 !ears is 5.4, on a compound &asis. 9' (10g)4 = 11/.1 hence g = 5.4, 6he estimated value of 6arget using the D(2 is thereforeI (aluation =
11/-100 1.054 = #1-'49-)9) 0.1' 0.054

508

3< ratio valuation

A suita&le PE ratio for 6arget *ill &e &ased on the PE ratio of Predator as &oth companies are in the same industr!. PE of Predator =
50 #4./0 4/0 or =1'.0) #)0.04m )9.+/

6he adFustmentsI Do*n*ards &! )0, or 0.)0- i.e. multipl! &! 0.90. (1) 6arget is a private compan! and its shares ma! &e less li1uid. ()) 6arget is a private compan! and it ma! have a less detailed compliance
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environment and therefore ma! &e more ris7!. A suita&le PE ratio is therefore 1'.0) N 0.90 = 1).0) (multipl!ing &! 0.90 results in the )0, reduction). 6arget8s PA6 0 AdFustment for the savings in the director8s remuneration after ta"I #19/-000 0 (#40-000 N +5,) = #)04-900 6he estimated value is therefore #)04-900 N 1).0) = #)-')1-54+ A#vice to the $oar# Gn the &asis of its tangi&le assets the value of 6arget is #1.4 million- *hich e"cludes an! value for intangi&les. 6he dividend valuation gives a value of around #1.+ million. 6he earnings &ased valuation indicates a value of around #).' million- *hich is &ased on the assumption- that not onl! *ill the current earnings &e maintained- &ut that the! *ill increase &! the savings in the director8s remuneration. Gn the &asis of these valuations an offer of around #) million *ould appear to &e most suita&le- ho*ever a revie* of all potential financial gains from the merger is recommended. 6he directors should- ho*ever- &e prepared to increase the offer to ma"imum price. Answer 7 (a)(i) Malance sheet value = #4'4-100. (a)(ii) @eplacement cost value = #4'4-100 0 #(5)'-000 3 +'1-+00) 0 #(''0-000 3 '1'-400) = #'+1-+00 (a)(iii) @ealisa&le value = #4'4-100 0 #(4'0-000 3 +'1-+00) 0 #('50-000 3 '1'-400) 3 #14-400 = #)41-500 Mad de&ts are ), " #54'-000 = #14-400. Mad de&ts are assumed not to &e relevant to the statement of financial position and replacement cost values.
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(a)(iv) 6he dividend gro*th model value depends on an estimate of gro*th- *hich is far from clear given the *ide variations in earnings over the five !ears. 1. 6he lo*est possi&le value- assuming Hero gro*th- is as follo*s. (alue cum div =
#)'-000 + #)'-000 = #)//-/// 0.1)

).

t is not li7el! that this *ill &e the &asis ta7en. Ooo7ing at dividend gro*th over the past five !ears *e haveI )004 dividend = #)'-000 )000 dividend = #)0-'00 f the annual gro*th rate in dividends is g (1 0 g)4 = )'-000/)0-'00 = 1.)14' 1 0 g = 1.0'09 g = 0.0'09- sa! ',
D1 0 current dividend Ke g
)'-000 (1 + ',) + #)'-000 0.1) 0.0'

6hen- 2( cum div = =

/.

= #400-000 Dsing the Eordon8s Ero*th model- *e haveI Average proportion retained =
1)-900 + 44-)00 +19-/00 +1/-400 + )5-000 = 0.44' (sa! & = 0.') //-/00 + ++-900 + 4/-/00 + /9-400 + ')-)00

@eturn on investment this !ear = '/-)00 / average investment =

'/-)00 A 4'4-100 + ( 4'4-100 )5-)00)B )

= 0.1)09 (sa! r = 1),) 6hen g = 0.' " 1), = +, ;o 2( cum div =

#)'-000 1.0+ + #)'-000 = #4++-++5 0.1) 0.0+

(a)(v) P/E ratio model Compara&le 1uoted companies to 2anon have P/E ratios of a&out 10. 2anon is much smaller an &eing un1uoted its P/E ratio *ould &e less than 10- &ut ho* much lessP
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f *e ta7e a P/E ratio of '- *e have 2( = #'/-)00 " ' = #)++-000. f *e ta7e a P/E ratio of 10 " )//- *e have 2( = #'/-)00 " 10 " )// = #/'4-++5. f *e ta7e a P/E ratio of 10- *e have 2( = #'/)-000 (&)(i) 6he statement of financial position value 6he statement of financial position value should not pla! a part in the negotiation process. ?istorical costs are not relevant to a decision on the future value of the compan!. (&)(ii) 6he replacement cost 6his gives the cost of setting up a similar &usiness. ;ince this gives a higher figure than an! other valuation in this case- it could sho* the ma"imum price for Carmen to offer. 6here is clearl! no good*ill to value. (&)(iii) 6he realiHa&le value 6his sho*s the cash *hich the shareholders in 2anon could get &! li1uidating the &usiness. t is therefore the minimum price *hich the! *ould accept. All the methods (i) to (iii) suffer from the limitation that the! do not loo7 at the going concern value of the &usiness as a *hole. 2ethods (iv) and (v) do consider this value. ?o*ever- the realiHa&le value is of use in assessing the ris7 attached to the &usiness as a going concern- as it gives the &ase value if things go *rong and the &usiness has to &e a&andoned. (&)(iv) 6he dividend model 6he figures have &een calculated using 2anon8s Ke (1),). f ()) or (/) *ere follo*ed- the value *ould &e the minimum that 2anon8s shareholders *ould acceptas the value in use e"ceeds scrap value in (iii). 6he relevance of a dividend valuation to Carmen *ill depend on *hether the current retention and reinvestment policies *ould &e continued. Certainl! the value to Carmen should &e &ased on 4, rather than 1),. Moth companies are ungeared and in the same ris7 class so the different re1uired returns must &e due to their relative siHes and the fact that Carmen8s shares are more mar7eta&le.
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Gne of the main limitations on the dividend gro*th model is the pro&lem of estimating the future value of g. (&)(v) 6he P/E ratio model 6he P/E ratio model is an attempt to get at the value *hich the mar7et *ould put on a compan! li7e 2anon. t does provide an e"ternal !ardstic7- &ut is a ver! crude measure. As alread! stated- P/E ratio *hich applies to larger 1uoted companies must &e lo*ered to allo* for the siHe of 2anon and the non=mar7eta&ilit! of its shares. Another limitation of P/E ratios is that the ratio is ver! dependent on the e"pected future gro*th of the firm. t is therefore not eas! to find a P/E ratio of a similar firm. ?o*ever- in practice the P/E model ma! *ell feature in the negotiations over price simpl! &ecause it is an easil! understood !ardstic7. (c) 6he range *ithin *hich the purchase price is li7el! to &e agreed *ill &e the minimum price *hich the shareholders of 2anon *ill accept and the ma"imum price *hich the directors of Carmen *ill pa!. E"amining the figures in part (a)- the range is #)41-500 (realiHa&le value) to #'+1-+00 (replacement cost).

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