Question Tag: Book value

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  • 15 Marks

AFM – May 2019 – L3 – Q3a – Valuation of acquisitions and mergers

Use comparative analysis to value Alpha Ltd based on data from Beta Ltd and Gamma Ltd, and discuss factors for private company valuation.

At a meeting of the Directors of the Alpha Company Limited – a privately owned company – in May 1975, the recurrent question is raised as to how the company is going to finance its future growth and at the same time enable the founders of the company to withdraw a substantial part of their investment. A public quotation was discussed in 1974 but because of the depressed nature of the stock market at that time, consideration was deferred. Although the matter is not of immediate urgency, the Chairman of the company – one of the founders – produces the following information which he has recently obtained from a firm of financial analysts in respect of two publicly quoted companies, Beta Limited and Gamma Limited, which are similar to Alpha Limited in respect to size, asset composition, financial structure, and product mix.

The only information you have available at the meeting in respect of Alpha Limited is the final accounts for 1974, which disclose the following:
Alpha Limited
Share Capital (no variation for 8 years) 100,000 Ordinary GH¢1 Share
Post-Tax Earnings GH¢400,000
Gross Dividends GH¢100,000
Book Value GH¢3,500,000

From memory, you are of the view that the post-tax earnings and gross dividends for 1974 were at least one-third higher than the average of the previous five years.

Required:

i) Use the information provided to answer the Chairman’s question on what Alpha Ltd was worth in 1974.
ii) Discuss FOUR (4) factors to be taken into account in trying to assess the potential market value of shares in a private company when they are first offered for public subscription.

i) Valuation of Alpha Ltd

ii) Factors to Consider in Valuing a Private Company for Public Offering

  1. Opportunity Cost:
    Investors will compare the expected returns from the company’s shares with the returns from alternative investments. If the potential return on investment is not competitive, investors may not subscribe to the shares.
  2. Risk Perception:
    The perceived risk of investing in a private company will affect its valuation. Private companies generally carry higher risk, and this may result in a lower valuation due to risk premiums.
  3. Marketability:
    The ease with which shares can be traded once they are publicly listed will influence valuation. Less liquid shares may be valued lower due to the risk of being unable to quickly sell them when needed.
  4. Information Asymmetry:
    Investors may have limited information about the private company’s operations and finances, which increases uncertainty and can lead to lower valuation. Public companies generally provide more transparency, reducing this gap.
  • 20 Marks

FM – Nov 2020 – L2 – Q2 – Business valuations

Estimate the value of equity capital using different valuation methods: Book value, Replacement cost, Realizable value, Gordon growth model, and P/E ratio model.

The directors of Carmen Ltd, a large conglomerate, are considering the acquisition of the entire share capital of Manon Ltd, a private limited company that manufactures a range of engineering machinery. Neither company has any long-term debt capital. The directors of Carmen Ltd believe that if Manon Ltd is taken over, the business risk of Carmen Ltd will not be affected.

The accounting year of Manon Ltd ends on 31 December. Its Statement of Financial Position as at 31 December 2018 is expected to be as follows:

Manon Ltd’s summarized statement of profit or loss extract for the five years to 31 December 2018 is as follows:

The following additional information is available:

i) There have been no changes in the issued share capital of Manon Ltd during the past five years.
ii) The estimated values of Manon Ltd’s PPE and inventory and work-in-progress as at 31 December 2018 are:

Replacement cost (GH¢) Realizable value (GH¢)
PPE 725,000 450,000
Inventory and work-in-progress 550,000 570,000

iii) It is expected that 2% of Manon’s debtors at 31 December 2018 will be uncollectible.
iv) The cost of capital of Carmen Ltd is 9%. The directors of Manon Ltd estimate that the shareholders of Manon Ltd require a minimum return of 12% per annum from their investment in the company.
v) The current P/E ratio of Carmen Ltd is 12. Quoted companies with business activities and profitability similar to those of Manon Ltd have P/E ratios of approximately 10, although these companies tend to be much larger than that of Manon Ltd.

Required:

Estimate the value of the total equity capital of Manon Ltd as at 31 December 2018 using each of the following bases:

a) Book value (2 marks)
b) Replacement cost (4 marks)
c) Realizable value (4 marks)
d) The Gordon dividend growth model (5 marks)
e) The P/E ratio model (5 marks)

 

a) Book value = GH¢454,100

b) Replacement cost value = GH¢454,100 + (GH¢725,000 – GH¢651,600) + (550,000 – GH¢515,900) = GH¢561,600

c) Realizable value = GH¢454,100 + (GH¢450,000 – GH¢651,600) + (GH¢570,000 – GH¢515,900) – 14,900 = GH¢291,700
Note: GH¢14,900 = 2% x GH¢745,000 (bad debts). Bad debts are assumed not to be of relevance to balance sheet and replacement cost values.

d) Gordon Dividend Growth model value:
Lowest possible value, assuming zero growth (most prudent estimate):

e) P/E ratio model:

Comparable quoted companies to Manon Ltd have a P/E ratio of 10. Manon is much smaller and being unquoted, its P/E would be less than 10, but how much less?

If we take a P/E of 5:

Allow for student assumption of P/E ratio between 4 and 9 or 10.

 

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