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    Share & Business Valuation Case Study Question and Solution

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    SarannyaRajendra
    OA is considering acquiring ML, a company quoted on the AIM market. Three methods are used to value ML: 1) Comparative P/E ratio valuation estimates ML's value at RM24.8 million, but this method does not account for the acquisition's impact and comparability issues exist. 2) Dividend valuation estimates ML's value at RM20.7 million, but assumes constant future dividend growth. 3) Discounting ML's post-acquisition operating cash flows of RM4.2 million annually at 11.6% yields a value of RM22.4 million. However, the discount rate calculation has limitations. While each method has disadvantages, discounting cash flows

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    Share & Business Valuation Case Study Question and Solution

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    SarannyaRajendra
    322 views6 pages
    OA is considering acquiring ML, a company quoted on the AIM market. Three methods are used to value ML: 1) Comparative P/E ratio valuation estimates ML's value at RM24.8 million, but this method does not account for the acquisition's impact and comparability issues exist. 2) Dividend valuation estimates ML's value at RM20.7 million, but assumes constant future dividend growth. 3) Discounting ML's post-acquisition operating cash flows of RM4.2 million annually at 11.6% yields a value of RM22.4 million. However, the discount rate calculation has limitations. While each method has disadvantages, discounting cash flows

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    OA is considering acquiring ML, a company quoted on the AIM market. Three methods are used to value ML: 1) Comparative P/E ratio valuation estimates ML's value at RM24.8 million, but this method does not account for the acquisition's impact and comparability issues exist. 2) Dividend valuation estimates ML's value at RM20.7 million, but assumes constant future dividend growth. 3) Discounting ML's post-acquisition operating cash flows of RM4.2 million annually at 11.6% yields a value of RM22.4 million. However, the discount rate calculation has limitations. While each method has disadvantages, discounting cash flows

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    322 views6 pages

    Share & Business Valuation Case Study Question and Solution

    Uploaded by

    SarannyaRajendra
    OA is considering acquiring ML, a company quoted on the AIM market. Three methods are used to value ML: 1) Comparative P/E ratio valuation estimates ML's value at RM24.8 million, but this method does not account for the acquisition's impact and comparability issues exist. 2) Dividend valuation estimates ML's value at RM20.7 million, but assumes constant future dividend growth. 3) Discounting ML's post-acquisition operating cash flows of RM4.2 million annually at 11.6% yields a value of RM22.4 million. However, the discount rate calculation has limitations. While each method has disadvantages, discounting cash flows

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    of 6

    Business Entity Valuation

    It is 2014. OA, a company quoted on the Malaysian Stock Exchange, has cash balance of RM23 million
    which are currently invested in short-term money market deposits. The cash is intended to be used
    primarily for strategic acquisitions, and the company has formed an acquisition committee with a remit to
    identify possible acquisition targets. The committee has suggested the purchase of ML, a company in a
    different industry that is quoted on the AIM (Alternative Investment Market). Although ML is quoted,
    approximately 50% of its shares are still owned by three directors. These directors have stated that they
    might be prepared to recommend the sale of ML, but they consider that its shares are worth RM22 million
    in total.

    Summarized financial data

    Sources OA (potential ML (potential


    investor) investee)
    of info RM’000 RM’000
    P&L Revenue 480,000 38,000
    CFS Pre-tax operating cash flow 51,000 5,300
    P&L/CFS Taxation (33%) 16,830 1,749
    CFS Post-tax operating cash flow 34,170 3,551
    OCI/CFS Dividend paid 11,000 842
    SFP Non-current assets 168,000 8,400
    SFP Current assets 135,000 4,700
    SFP Current liabilities 99,680 3,900
    203,320 9,200
    ====== ====
    Long term financing
    Ordinary shares (OA 23 sen par) 10,000 (ML 10 sen par) 500
    Reserves 158,320 5,200
    12% Debentures 2016 20,000 -
    10% Bank term loan 15,000 11% bank loan 3,500
    203,320 9,200
    ====== =====
    Current share price 785 sen 370 sen
    Earnings yield (EPS/Market price p.s.) 10.9 % 19.2 %
    Average dividend growth during the 7% pa 8 % pa
    last 5 years
    Equity beta 0.85 0.8
    Industry data
    Average P/E ratio 10:1 6:1
    Average P/E of companies recently 12:1 7:1
    taken over, based upon the offer price

    The risk free rate of return is 6% per annum and the market return is 14% per annum.

    The rate of inflation is 2.4% per annum and is expected to remain at approximately this level.

    Expected effects of the acquisition:


    i) 50 employees of ML would immediately be made redundant at an after tax cost of RM1.2
    million. Pre-tax annual wage savings are expected to be RM750,000 (at current prices) for the
    foreseeable future.
    ii) Some land and building of ML would be sold for RM800,000 (after tax).
    iii) Pre-tax advertising and distribution savings of RM150,000 per year (at current prices) would
    be possible.
    iv) The three existing directors of ML would each be paid RM100,000 per year for three years for
    consultancy services. This amount would not increase with inflation (reasons being
    consultancy fees are fixed in the contract, and the contract does not include impact of
    inflation)

    Required:

    a) Calculate the value of ML based upon:


    i) The use of comparative P/E ratios;
    ii) The dividend valuation model;
    iii) The present value of relevant operating cash flows over a 10 year period,
    and discuss the advantages and disadvantages of each of the valuation methods.
    iv) Recommend, whether OA should go ahead with the offer for ML.
    b) Explain what is meant by behavioral finance.
    SUGGESSTED SOLUTION

    (a) (i) P/E ratio

    Since ML operates in a different industry, the comparative P/E ratio valuation must be based upon the
    average P/E ratios in that industry. The P/E ratio 7:1 will therefore be used. (Justification must be based
    on facts in the Qs)

    Current share price 370 sen


    Earnings yield (EPS / Market price per share) 19.2%
    Earnings per share (EY x Market price p.s.) 71.04 sen (370 x 19.2% i.e. 0.192)
    Valued price per share (EPS x P/E ratio) 497.28 sen (71.04 x 7)
    Total units of OS RM500,000 / RM0.10 = 5m units
    Total value of ML RM24.864m (RM4.9728 x 5m OS shares)

    Problems with calculations

    The problem with this approach is that P/E ratios are based on historic performance, and take no account
    either of the likely impact of the takeover on the performance of the company, or of its current earnings
    projections. (You can add explanation on what if ML is higher/lower ranked in the AIM market to justify
    whether you want to add some value OR discount some value from the average P/E ratio of 7:1)

    Comparability of companies

    In this case, there is a further problem in that it is not known whether the recently taken over companies
    on which the ratio is based were sufficiently similar to ML in terms of size, rate of growth, type of
    activities and overall level of risk. It may well be that the average should be adjusted to take into account
    the particular situation of ML.

    (ii) Dividend valuation model

    The dividend valuation method (including growth) for share valuation is:

    d0 (1+g)
    po =
    ke – g

    In the case of ML:

    d0 = RM842,000

    g = 8% assuming that this rate of dividend growth will continue

    ke = can be estimated using the Capital Asset Pricing Model (CAPM):

    E(ri) = Rf + βi (E(rm) – Rf)


    Where: E(ri) = cost of equity

    Rf = risk free rate of return (6%)

    βi = beta factor (0.8)

    E(rm) = market rate of return (14%)

    E(ri) = 6% + 0.8(14% - 6%) = 12.4%

    RM842,000 (1 + 0.08)
    p = (0.124 – 0.08) = RM20.667m

    Weakness of dividend valuation model

    The main weakness of this approach is the method used to estimate the growth rate. This assumes that
    the historic rate of dividend growth will continue at a constant rate into the future, but the current rate of
    dividend growth is different from that of OA, and could well change following the acquisition. However,
    the model does attempt to relate the share price to the future stream of earnings from the business, and in
    this sense is more realistic than the comparative P/E ratio basis of valuation.

    (iii) Operating cash flows

    The first stage is to estimate what the operating cash flows will be following the acquisition.

    RM’000
    Current pre-tax operating cash flow 5,300
    Post-acquisition adjustments:
    Annual wage savings 750
    Advertising/distribution savings 150
    6,200
    Taxation (33%) 2,046
    Annual post tax cash flow 4,154

    The other cash flows in the account are: RM’000

    Year 0: Redundancy costs (after tax) (1,200)


    Sale of land and buildings (after tax) 800
    Year1-3: Consultancy payments of RM201,000(RM300,000 x 0.67) per
    year after tax

    Next stage is the determination of discount rate

    The discount rate used will be the existing weighted average cost of capital (WACC) for ML, although it
    must be recognized that this could be different after the acquisition since OA is a much larger company
    and its shares are quoted on the main market rather than AIM. The cost of equity has already been
    calculated above as 12.4% and the cost of debt is 11% as per the balance sheet. The following expressions
    will be used.
    WACC = keg VE + kd(1-T) VD
    (VE +VD) (VE +VD)

    Where : keg = cost of equity in geared company

    kd = cost of debt

    T = tax rate (33%)

    VE = market value of equity (5m x RM3.70 = RM18.5m)

    VD = market value of debt (RM3.5m)

    WACC = 12.4 % 18.5 + 11% (1-0.33) 3.5


    (18.5+3.5) (18.5+3.5)

    WACC = 11.60%

    This discount has been calculated on the basis of market values, and therefore will incorporate inflation.
    The cash flows (with the exception of the consultancy fees) all exclude inflation, and therefore either the
    nominal discount rate that has been calculated must be adjusted to the real rate, or the cash flows must be
    adjusted to include inflation.

    If we adjust the discount rate to exclude the expected 2.4% rate of inflation: 1.116 + 1.024 = 1.0898, i.e.
    the real rate to be used is 8.98% say 9.0%.

    PV of cash flow

    The present value of the cash flows can now be found.

    Year 1 Year 2 Year 3 Total


    RM’000 RM’000 RM’000 RM’000

    Gross payment to directors(after tax) 201 201 201


    11.6 say 12% discount factors 0.893 0.797 0.712
    PV Cash Flow 179 160 143 (482)
    Ongoing cash flows for 10 years at 9% 26,660
    (4.154 x 6.418)
    Income from land and buildings 800
    Redundancy costs (1200)
    Total PV of relevant operating cash flows 25,778

    Problems with calculations

    Although, this is theoretically the best method of valuation to use, the calculations are in reality quite
    crude. Any likely changes in the pattern of the cash flows following the acquisition are ignored, as are any
    strategic plans that the company may have for such a long time frame. 10 years is a long period over
    which to estimate cash flows, inflation rates and discount rates and there will inevitably be a large margin
    for errors in the figures.
    End of period

    In addition the question of what happens at the end of the 10 year period is not addressed. Is there an
    appropriate terminal value that could be used in the calculations to reflect the ongoing value of ML as a
    business?

    (iv) Comparison with the offer price

    Two of the valuation methods used, including the present value of operating cash flows (which is possibly
    the best of the three approaches) give a valuation greater than the proposed offer price of RM22m. If OA
    can successfully complete negotiations at this price, and if the acquisition of ML would be in line with the
    OA’s long-term strategic objectives, then it is recommended that the offer should go ahead.

    (b) Behavioral finances is an alternative view to the efficient market hypothesis. Speculation by
    investors and market sentiment is a major factor in the behavior of share prices. Behavioral finance
    attempts to explain the market implications of the psychological factors behind the investors decisions
    and suggest that irrational investor behavior may significantly affect share price movements. These
    factors may explain why share prices appear sometimes to over-react to past price changes.

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