seminar5materials / P4AFM-SQB_PDF_j08 / P4AFM-SQB-As_j08

STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(iii)Further information

In using this approach it is essential that the earnings figure and the PE multiple adopted are realistic.

To verify the earnings figure most of the information already requested to support the dividend valuation approach would be helpful.

In addition, more detail on the extraordinary items is essential. As significant and growing amounts are involved for three consecutive years, it is legitimate to question if they are truly extraordinary, or if they are simply being used to massage reported earnings. It could well be prudent to base our valuation on earnings after extraordinary items, resulting in a total value of £91.8m on a PE ratio of 6. Directors’ salaries may also need to be classified as distributions rather than expenses.

Further information on the size, operating gearing, products and markets of the listed companies from which the PE ratio has been derived would be helpful. It would also be useful to know how extraordinary items have been dealt with in calculating their multiples.

4Asset valuation

(i)Valuation

The above approaches value the company by attempting to assess the value of its future earnings stream. An asset valuation approach takes the view that a collection of assets is being bought and that this needs to be managed to achieve future earnings. There is no guarantee that existing managers will stay and therefore future earnings could be in doubt, whereas asset value is relatively certain.

As detailed in Appendix 3 this gives a valuation of £1.59 per share. Note that this is after deducting the present value of the “debenture” obligations that the firm is carrying.

(ii)Suitability

Asset valuation is usually regarded as most suitable for a controlling interest as minority holders would not be in a position to realise asset values. The figure presented could be viewed as a break-up value of the business (net realisable value) and the minimum the owners are likely to accept, or a cost of setting up the business from scratch (replacement cost) by buying individual assets.

Whichever view is taken it must be remembered that goodwill is excluded from these figures. Much here will depend upon the company’s past trading record, its market position, the quality of its management and the likelihood of their remaining after the takeover as well as your own managerial skills in the domestic appliances business. Although various procedures are available to value goodwill (e.g. a super profits approach), they are very subjective and the price you are prepared to pay on top of asset value is a matter of judgment and negotiation. It is worth noting, however, that asset value is considerably below the PE ratio valuation.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(iii)Further information

Asset values are subjective and further independent verifications of the fixed asset figures would be welcome, particularly in the light of the current state of the property market. Details of any disposal costs would also be helpful.

The figure included for net current assets is very much a guess and a detailed breakdown of their composition would be useful. Details of raw materials, work in progress and finished goods would be particularly helpful, especially when taking a net realisable value view of the business, as inventory is often of little value on disposal.

5Conclusion

(a)Valuation

As stated in the introduction, the figures provided are estimates and should be considered a framework for negotiation.

If you are able to take a majority stake, asset value will most likely form the minimum valuation. Even so, the existing owners of Bertram are unlikely to sell without considering future earnings potential.

For a minority interest the PE ratio approach applied to the earnings after extraordinary items would probably give the most realistic valuation as it avoids the problems of estimating future dividend growth.

It should be appreciated that you are likely to pay a higher price per share for a controlling interest than for a minority stake.

(b)Further information

Much of the necessary further information has already been requested. However, several other items also need to be considered.

(i)Is the acquisition of Bertram for strategic reasons or is it purely an “asset-stripping” investment? In the former case synergistic effects would need to be considered in more detail; in the latter case, asset values are more pertinent.

(ii)Are the directors of Bertram likely to defend the acquisition? This could lead to a higher price.

(iii)What is the quality of the management team of Bertram and how easily could they be replaced by BIG’s existing staff? It is only through the management team that you can secure future earnings.

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(38.804)

———–

63.571

———–

Notes

(1)Net current assets valued at 50% of book value. This is very much a guess and much will depend upon their make-up.

(2)Present value of debenture holders’ claim is the present value of future interest and principal payments at market interest rates

(3)You will not require the warehouse. Therefore, it should not be purchased but left for the existing owners to dispose of. Alternatively, you could pay £5m more which could be recouped by a subsequent sale.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 18 BIGUN PLC

(a)Report front page

To The Directors, Klein plc From Anna Liszt

Date Today

Subject Cost of acquisitions to Klein plc

Contents

1Terms of reference

2Summary

3Klein plc

4PTT Ltd

5Conclusions

6Appendix

1Terms of reference

The following report estimates the values of Klein plc and PTT Ltd.

2Summary

The following table gives some estimates of the possible value of the two companies.

Because these valuations are based on estimates they must be seen as a guide only. Details of these calculations are given in the appendix.

3Klein plc

The P/E ratio approach for Klein plc is the best estimate available; being based on actual earnings and the observed P/E ratio, it gives the actual market value at March 19X3. Note, however, that the situation of Klein might have changed significantly since that date. The dividend valuation approach gives a higher valuation for Klein, but the assumption that investors expect past growth to continue into the future is questionable.

The asset valuation is of little worth, no indication being given of current values, goodwill, etc.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

4PTT Ltd

PTT is not a quoted company and therefore any estimate of its value will be somewhat arbitrary.

The dividend valuation of £12.96m is probably the best estimate but, once again, caution must be exercised due to the difficulty in estimating growth.

The P/E ratio approach is suspect as the multiple of Klein plc (a quoted company) has been used. It is usually considered that non-quoted firms should have much lower P/E ratios and a reduction of up to 50% on this valuation is possible.

For similar reasons as those given for Klein plc theassetvalueofPTTLtdisoflimited use.

5Conclusions

All of the above figures should be seen as educated guesses. The final price paid will depend upon how much each party wishes to sell and how badly Bigun plc wishes to buy. The estimates of £10.15m and £12.96m for Klein and PTT respectively are probably the best guide but premiums of up to 25% on opening market price are not uncommon, rising to 50% plus if the bid is contested.

6 Appendix

Klein plc

(1)P/E ratio approach

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Total value of equity of PTT Ltd

=£3.67 × 2.8m

=£10.28m

(b)Packages to be offered by Bigun plc

The packages that may be offered partly depend upon the sum of money involved. Let us assume that both companies are bid for at a total cost of £10.2m + £13.0m + a premium, say, £26m.

The following packages could be used.

A cash offer

This has the advantage that all parties are assured of the sum received. However, it could put the shareholders in the victim companies in a capital gains tax paying position. Further, Bigun plc has only £5m of cash, and borrowing or an equity issue would be required to raise the remainder of the cash.

A loan stock for share exchange

Bigun plc could offer to exchange loan stock in return for the shares of the victim companies. This would give the victim shareholders a fairly safe income stream and not expose them to immediate capital gains tax. It would, however, prevent them from participating in future profit growth and this might not be popular.

From the viewpoint of Bigun plc it would cause a significant increase in gearing which might be of concern to existing investors.

A share-for-share exchange

Bigun plc could offer to exchange new shares for the existing shares in Klein and PTT. At a current market price of £2.98 (EPS 16.21p × P/E ratio 18.4), and a bid of £26m, this would require the issue of approximately 8.7m shares. The current EPS of Bigun plc is 16.21p, whereas the incremental EPS on the new shares is only

This would result in a reduction in EPS (and possibly market value) of Bigun shares.

Overall each of the various packages presents problems. Bigun shareholders might not be happy with a cash offer because of liquidity problems, whereas the use of loan stock could drive gearing to an unacceptable level. An equity issue could result in a reduction in EPS though much would depend upon the combined earnings of the three companies. A compromise solution often adopted would be to use a mixture of the above packages, for example a cash and equity offer.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 19 DEMAST LTD

(a)

Growth by acquisition is said to allow companies to expand much more rapidly than by organic growth. Rapid increases in size may offer:

Economies of scale in production, marketing, R & D and finance. A reduction in the company’s risk, and cost of capital.

Greater market share and market power. In some markets to operate effectively requires the achievement of a “critical mass” size.

Additionally acquisitions may allow:

Improvements in gearing.

Purchase of patents, brands or skilled management.

Synergistic effects.

Entry into a new market quickly.

Acquisition of undervalued assets or companies, as is the stated strategy of BZO International. This may encompass the removal of relatively inefficient management.

However, there is evidence that many acquisitions are financially unsuccessful. There is often some abnormal return for the shareholders of the target company (in the form of high prices received for their shares), but very little for the bidding company’s shareholders. Acquisitions often experience difficulties in integrating the operations of the companies concerned (unless asset-stripping is the motive for the acquisition).

(b)

Demast is an unlisted company, with no market price. Ideally the valuation of the company should be based upon the expected net present value of future cash flows, but accurate estimates of this value will rarely be available in an acquisition situation. Valuation could in practice be based upon either assets or earnings. For Nadion, which is likely to be purchasing Demast as a going concern, an earnings valuation is appropriate. BZO International has a strategy of acquiring what are perceived to be undervalued companies. If the intention is to quickly dispose of all or part of the company, the realisable value of Demast’s assets would provide a useful guide, but if asset stripping is not to occur an earnings valuation would once again be recommended.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Asset valuations

No precise estimate of the realisable value of assets is possible. Net asset value, adjusted for a 10% decrease in the value of inventory, is £5,950,000 or 149 pence per share. This, however, ignores important factors including:

(i)Land and buildings have not been revalued since 1989. In the light of the subsequent recession and fall in commercial property prices, the realisable value could be less than the book value of £4 million.

(ii)No information is provided regarding the difference between book and realisable values of other fixed assets.

(iii)The patents are not valued in the Statement of Financial Position. These could have substantial value if they have a number of years to run.

Earnings valuations

Two common methods of “earnings” based valuations are the P/E ratio and the dividend valuation model.

P/E – As Demast is not listed a P/E valuation must be based upon the P/E of a similar company. The only available information for a company in the same industry is for Nadioli, a much larger company.

The EPS of Demast is 80.5 pence

EPS of Nadion is 58 pence

If this is used for Demast the estimated value per share is

5.52 × 80.5p = 444 pence

Although Nadion is listed and much larger than Demast, the much higher growth rates of Demast might justify the use of the similar P/E to Nadion.

Dividend valuation model

All of these estimates are subject to considerable margins of error.

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