University of Gloucestershire

SCHOOL OF BUSINESS AND LAW

Corporate Finance

Teacher: Palan Ambikai Submitted by:MD. Muhibbur Rahman Shujon Student ID: B0333RORO0412 Submission Date: 19-06-2013

Md. Muhibbur Rahman Shujon

B0333RORO0412

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Table of Contents
Part 1 ....................................................................................................................................................... 3 Introduction ......................................................................................................................................... 3 Investment appraisal should add value to the business entity ............................................................. 3 Calculation of payback period NVP and IRR ............................................................................. 4 Decision Making ......................................................................................................................... 4 Payback period ............................................................................................................................ 4

Internal Rate of Return (IRR): ................................................................................................................ 8 Part 2 ..................................................................................................................................................... 11 Evaluation of Share Price Valuation Models: ................................................................................... 11 Discounted Cash Flow Model: .......................................................................................................... 11 Dividend Discount Model: ................................................................................................................ 12 Net Tangible Asset per Share: .......................................................................................................... 12 Book Value per Share: ...................................................................................................................... 13 P/S Multiple: ................................................................................................................................. 14 Weighted Average Price: .................................................................................................................. 14 Recommendation: ............................................................................................................................. 15 Conclusion: ....................................................................................................................................... 15 Reference: ......................................................................................................................................... 16

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Part 1 Introduction Investment appraisal states the evaluation of the alternative investments, for choosing the one which is best among others for doing investment. Capital budgeting can also be said as investment appraisal. An organization has several alternatives for investment but unfortunately they have limited amount of money for investment. So in a situation like this the firm/organization has to appraise the opportunities for investment from a lot of various prospects to make the correct decision. It is not limited instead it has investment risk, currency risk, political risk, business strategies etc. Investment appraisal should add value to the business entity

Firms have to put in use of their capital and funds; moreover they have to borrow money from different sources for financing their investment alternatives. Therefore they have to pay and bear an cost, this is for the funds they are using the finance to invest in the project. When a company/firm decides to do an investment on any project, they have to appraise the possible/potential return of investment and they have to differentiate it with the cost of capital or cost of fund. While differentiating/comparing if it is found that the cost of capital is less than the rate of return, then they decides that they should move forward with the investment option. Whereas, while calculating it is found that the cost of capital is more than the rate of return then they should not move forward with that investment option. Moreover a firm/business can evaluate a project for investment in terms of the present value. Through this technique of evaluation, they can compare and contrast the net present value of the cash inflow with the present investment. If it is found that the present/initial investment is lower than the firm, it is better to accept the investment project. Sometimes investment appraisal not only restrained to pecuniary/monetary value, instead it also deals with business strategies. Therefore it is better for a business to choose an investment that matches with the firms ways of business strategies. As for an example, if a firm has two- investment project of which each is 6000, but the firm itself has 6000 to invest. In this kind of situation the analyst of the business should have to evaluate the two investment projects by their business strategies and have to choose the investment project which have better strategies as it will lead to a better and stronger financial future for the business. In any case monetary value and strategies, it is better for firms to evaluate an investment through its risks which are associated with the projects. Therefore a firm has to for an investment which have less risk in contrast to return. There are a number of risks that a firm has to face, mainly political, currency etc.

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Lastly it should be stated that it is better for the firm to be aware and careful about their investment alternatives which may or may not add value to the firm. As for an instance, there is an investment where the firm deals their business found that it is not a good investment found in terms of monetary return. But it can be seen that this investment provides the firm a better business strategy and moreover it makes popular business entity. Therefore from the above prospective it can be clearly seen that a business entity have to be aware that the alternative investments do add value to business entity. Calculation of payback period NVP and IRR Decision Making Payback period

Project A: Investment = 27000

Period (Years) 1 2 3 4 5 6

Net Cash Flows (000) 4.5 4.5 4.5 4.5 4.5 4.5

Cumulative Cash Flows (000) 4.5 9.0 13.5 18.0 22.5 27.0

Table 1: Payback Period for Project A Payback Period = (27000 / 4500) = 6 It can be seen after 6 years Project A will have 27000, therefore the project will have a payback in year 6 with its initial investment which was 27000, therefore its payback period will be 6 years.

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Project B Investment = 32,000

Period (Years) 1 2 3 4 5

Net Cash Flows (000) 5.5 6.0 8.5 8.5 5.0

Cumulative Cash Flows (000) 5.50 11.50 19.5 28.0

Table : Payback Period for Project B As it can be seen that after 4 years Project B have 28000, and the investment needs more 4000 to reach 32000 Payback Period= 4 years + {(4000 / 5000) * 365} days = 4 years + 292 days

Decision: Therefore it is clearly seen that Project B will be chosen, as it takes less amount of time period to payback the original investment.

Net Present Value(NPV)

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Project A:

Beginning investment is: 27000 and Cost of capital is: 11.5%

Period (Years) 1 2 3 4 5 6 Total DCF

NCF (000) 4.5 4.5 4.5 4.5 4.5 4.5

PV@11.5% 0.879 0.851 0.761 0.676 0.560 0.459

DCF (000) 3.955 3.829 3.423 3.042 2.520 2.0655 18.8345 (27.0) (8.166)

Initial Investment NPV

From the analysis Project A has to be avoided as the Net Present Value is negative.

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Project B:

Beginning investment is: 32000 and Cost of capital is: 11.5%

Period (Years) 1 2 3 4 5

NCF (000) 5.5 6.0 8.5 8.5 5.0

PV@11.5% 0.879 0.851 0.761 0.676 0.560

DCF (000) 4.835 5.106 6.469 5.746 2.8

24.956 Total DCF Initial Investment NPV Table : Net Present Value for Project B. Also Project B should also ne rejected as its NPV is negative. (32.000) (7.044)

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Internal Rate of Return (IRR): Project A:

Beginning investment is: 27000 Cost of capital is: 11.5%

We know,

R1 R2

= =

The rate which is used to gain the positive NPV ie NPV1 The rate which is used to find the negative NPV ie NPV2 Positive NPV Negative NPV

NPV1 = NPV2 = Here,

Our Negative NPV (NPV2) for Project A (from Table no 3)

(8.166)

So, to find positive NPV we have to assume a rate of Capital that is less than our current PV rate. The new PV rate is assumed as 5%.

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New NPV at 5%:

Period (Years) 1 2 3 4 5 6 Total DCF

NCF (000) 4.5 4.5 4.5 4.5 4.5 4.5

PV@5% 1.621 1.525 1.001 0.956 0.856 0.756

DCF (000) 7.2945 6.8625 4.5045 4.302 3.852 3.402 30.218

Initial Investment NPV Table : Positive NPV for project A So, Our Positive NPV (NPV1) for Project A = 3.2 Using IRR formula,

(27.000) 3.2

IRR = 5% + [3.2/{3.2-(-8.16)}]* (11.5%-5%) = 5% + {3.2/ (3.2 + 8.16)}* 6.5% = 5% + .2816*6.5% = 5% + 1.831% = 6.83

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Project B:

Beginning investment is: 32000 and Cost of capital is: 11.5%.

Lets assume 5% PV rate to find positive NPV it becomes:

Period (Years) 1 2 3 4 5 Total DCF

NCF (000) 5.5 6.0 8.5 8.5 5.0

PV @5% 1.653 1.524 0.868 0.827 0.484

DCF (000) 9.0915 9.144 7.378 7.0295 2.42 35.063 (32.000) 3.063

Initial Investment NPV Table : Positive NPV for Project B. So, Here our Positive NPV of Project B (NPV1) = 3.063 & Negative NPV of Project B (NPV2) Using IRR formula, IRR = 5% + [3.063/{3.063-(7.044)}]* (11.5%-5%) = 5% + (3.063/10.107)* 6.5% = 5% + 0.303*6.5% = 5% + 1.969% = 6.969% = (7.044)

(from Table 5)

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Part 2 Evaluation of Share Price Valuation Models: Share price valuations models are applied for pricing a company which is unlisted. Several methods for valuating share prices are used. Mostly they are compared with the companys financial statement and sometimes with the overall industry. As most of them are not listed it is hard to justify their performance. Therefore it can be seen that the prices shows below an average level. Models which are used to evaluate the price of stock are discussed below. Discounted Cash Flow Model:
This model is used to find out the share price valuation. In most cases the equity value per share is taken as share price of the firm (Bodie, Kane and Marcus, 2009).

The method is commonly used but sometimes under-pricing occurs because of the assumptions which are taken are sometimes much lower than the actual growth rates. Example 4: For example Company ABC wants to find out the value per share, they have used discounted cash flow method.

From the above table it can be determined that ABC has WACC 15% with terminal growth rate of 4%. The assumptions are stated in column 2. It shows that the number of shares are 100million with a equity value per share is 10.87, but as the company havent performed in the share market yet , the rates can be much lower than actual growth rate.

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Dividend Discount Model: This model is used secondly to find the stock price of a business. These are the present discounted value for dividends of a company. Dividend are part of the profit which are shared among shareholders of the company (Bodie, Kane and Marcus, 2009). The prices which are stated here are the expected value of the dividends which are supposed to be distributed among the shareholders. The model below might show under pricing because earning in the future may be higher than their expectations but can be less as well. Example 5: As for example it is taken that the dividend in the upcoming five years are as follows 2,2.5,2.75,2.9 and 3 . The terminal growth rate is 5% and equity to be 10%.

Therefore it is found out that the discounting dividend is 32.08 but from the cash was 10.87. Net Tangible Asset per Share: In Net Tangible Asset per share the liability and tangible assets are determined and it is divided by the number of shares to find the value per share which is used to fix the price. Example of tangible assets are current asset and non-current assets. Patent, goodwill and intangible assets are not part of tangible assets. Example 6: For assumption company ABC has an asset of 300 million and a non-current asset of 700 million with a long-term loan of 600 million and current liability of 1500million. Therefore the Net tangible asset per share will be :

Therefore from the table above the value per share is 25.

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Book Value per Share: Book value per share is an another model to determine value of shares. Here the value per share is found out by dividing the number of equity by the number of shares. Common equity, reserves and retained earnings are also considered to be a part of shareholders equity. The summations of the above values are divided by the number of shares (Ross, Westerfield and Jaffe, 2011). Due to the price movement in the market there is always a under pricing possibility.

Example 7: For assumption common equity is 400 million, retained earnings is 150 million and a reserve of 300 million and the number of shares 100 million.

So from the above table it is found out that the value per share is 44.5 P/E Multiple: P/E Multiple is also another model which is used to determine the price of the stock of a company. It is calculated by price per share which is divided by earnings per share. The price of the company is determined, ratios of the companies are taken and the ratios are multiplied by earnings per share through which prices are determined (Ross, Westerfield and Jaffe, 2011).
Example 8

From the above table we can see the way it is calculated.

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P/S Multiple: Another way to calculate stock price is by the ratio divided per share. (Ross, Westerfield and Jaffe, 2011)

Example 9: ABC has P/S of 4.25 and sales per share of 4.95. Therefore

Therefore all the methods above are used to find out the price of the shares, though all methods give variable result. Therefore companies these days use the Weight Average Price method. Still there is a chance of under-pricing, but WAP method is much better than the other methods used. Weighted Average Price:

From the above table it is stated that the avg price came to be 25.58. It is much more accurate than the other ones, although the qualitative forces are not taken into consideration, so there is still a small chance of under-pricing remains but it much accurate than the other methods used. .

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Recommendation:

i.

A firm is recommended to implement investment appraisal method before taking any decision.

ii.

NPV is the best method so decision should be based on its result as it increases the value.

iii.

While determining a share price, if possible all the qualitative factors should by analyzed .

Conclusion: Investment appraisal methods are the methods which are used in finding out the investment of a project, the reason is to add its value of the firm and increase its profitability and sustainability. To develop a business the firms should use these methods, and as there is always a possibility of under price, the qualitative factors should not be taken as a big factor. Therefore while determining the price of the stock of an unlisted company weighted average price method should be followed and premium shares should be issued.

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Reference: i. ACCA. (2008). Financial Management F-9, COMPLETE TEXT (Kaplan Publishing, UK). Page-57-135. ii. S.A. Ross, R.W. Westerfield, and J. Jaffe, 2008, Corporate Finance, Eighth Edition (McGraw- Hill Irwin, New York). S-cool. (2013). Investment Appraisal. [On Line]. Available from: http://www.scool.co.uk/a-level/business-studies/budgeting-costing-and-investment/reviseit/investment-appraisal. [Accessed: June 14, 2013]. The Student Room. (2013). Revision: Investment Appraisal. [On Line]. Available from: http://www.thestudentroom.co.uk/wiki/Revision:Investment_Appraisal. [Accessed: June 14, 2013]. Stephen A. Ross, Randolph W. Westerfield and Jeffery Jeff (2011) Corporate Finance (9th Ed.) McGraw-Hill, New York Zvi Bodie, Alex Kane and Alan J. Marcus (2009) Investments (8th Ed.) McGrawHill, New York Lawrence J. Gitman (2010) Principals of Managerial Finance 12th Edition Pearson 2010 viii. ix. McLaney and Atrill (2011) Introduction to Accounting 5th edition, Pearson 2011 Koen Milis, Monique Snoeck and Raf Haesen (March 6, 2012) Evaluation of the applicability of investment appraisal techniques for assessing the business value of IS services, Information Management, HUBrussel Stormstraat 2, 1000 Brussel, Belgium. Investopedia (2011) How to choose the best stock valuation Method? (online) (cited on February 21, 2011) available from www.ainvestopedia.com/articles/choosing-Valuation-methods.asp Ken Garrett (2012) Business Valuations (online) (cited on December 7, 2012) available from www.chinaacc.com/upload/liuxim5702720121207161043966979.pdf

iii.

iv.

v. vi. vii.

x.

xi.

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