Question Tag: Dividend Growth

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  • 20 Marks

AFM – Nov 2017 – L3 – Q3 – Valuation of acquisitions and mergers

Calculating the valuation per share for minority and complete takeover of Fasco and Boscan, and discussing limitations of the approach.

Zed Ltd is considering the immediate purchase of some, or all, of the share capital of one of two firms—Fasco Ltd and Boscan Ltd. Both Fasco Ltd and Boscan Ltd have one million ordinary shares issued, and neither company has any debt capital outstanding.

Both firms are expected to pay a dividend in one year’s time—Fasco’s expected dividend amounting to 30p per share, and Boscan’s being 27p per share. Dividends will be paid annually and are expected to increase over time. Fasco’s dividends are expected to display perpetual growth at a compound rate of 6% per annum. Boscan’s dividend will grow at the high annual compound rate of 33⅓% until a dividend of 64p per share is reached in year 4. Thereafter, Boscan’s dividend will remain constant.

If Zed is able to purchase all the equity capital of either firm, then the reduced competition would enable Zed to save some advertising and administrative costs, which would amount to GH¢225,000 per annum indefinitely, and, in year 2, to sell some office space for GH¢800,000. These benefits and savings will only occur if a complete takeover is carried out. Zed would change some operations of any company completely taken over, the details are:

  • Fasco – No dividend would be paid until year 3. Year 3 dividend would be 25p per share, and dividends would then grow at 10% per annum indefinitely.
  • Boscan – No change in total dividends in years 1 to 4, but after year 4, dividend growth would be 25% per annum compound until year 7. Thereafter, annual dividends would remain constant at the year 7 amount per share.

An appropriate discount rate for the risk inherent in all the cash flows mentioned is 15%.

Required:
a) Calculate the valuation per share for a minority investment in each of the firms, Fasco and Boscan, which would provide the investor with a 15% rate of return. (6 marks)

b) Calculate the maximum amount per share which Zed should consider paying for each company in the event of a complete takeover. (8 marks)

c) Comment on any limitation of the approach used in part (a), and specify the other major factors which would be important to consider if the proposed valuations were being undertaken as a practical exercise. (6 marks)

Valuation per share for a minority investment

Using the dividend valuation model (DVM), the value of ordinary shares is given by:

 

c) Limitations of the Approach

  • Dividend Growth Assumptions: The dividend valuation model assumes that dividends grow at a constant rate indefinitely, which may not hold in real-life scenarios. Boscan’s variable dividend growth complicates the model.
  • Market Conditions: The model does not account for the short-term market factors or price-earnings ratio that may affect stock prices.
  • Synergies: The assumed synergies and cost savings may not materialize in practice, affecting the overall valuation.

Other factors to consider include:

  • Management changes after acquisition.
  • Competitive responses in the market.
  • Financing options and capital structure post-acquisition.
  • 12 Marks

CR – Aug 2022 – L3 – Q4b – Business Valuation

This question requires computing the valuation of Tinto Ltd using three different methods: the net assets method, the price-earnings ratio method, and the dividend growth method.

Tinto Ltd produces handicrafts for both local and foreign markets. The company was incorporated several years ago. The shareholders of Tinto Ltd would now like to realize their investment. In order to arrive at an estimate of what they believe the business is worth, they have identified a long-established quoted company, Dingo Ltd, which has a similar business but produces for the European market only.

Summarized financial statistics for the two companies for the most recent financial year are as follows:

Tinto Ltd Dingo Ltd
Issued shares (million) 8 20
Net assets value (GH¢ ’million) 14.4 30
Earnings per share (GH¢) 0.35 0.28
Dividend per share (GH¢) 0.20 0.24
Debt: Equity ratio 1:7 1:6.5
Share price (as quoted on the stock market) – GH¢ – 1.60
Expected rate of growth in earnings/dividends 5% 5%

Additional Information:

  1. The net assets of Tinto Ltd are the net book values of tangible non-current assets, including working capital. However:
    • A recent valuation of the buildings was GH¢1,500,000 above book value.
    • An investment held, which is designated as Equity Financial Asset at Fair Value through Profit or Loss with a carrying value of GH¢1,000,000, is fair valued at GH¢1,100,000.
    • Due to a dispute with one of their clients, an additional allowance for bad debts of GH¢750,000 could prudently be made.
    • An item of plant with a carrying value of GH¢800,000 is assessed to have a value-in-use of GH¢760,000 and fair value less cost to sell of GH¢780,000.
  2. Growth rate should be assumed to be constant per annum. Tinto Ltd’s earnings growth rate estimate was provided by the marketing manager, based on expected growth in sales adjusted by normal profit margins. Dingo Ltd’s growth rates are gleaned from press reports.
  3. The dividend yield of Dingo Ltd approximates its cost of equity.

Required:

Compute a range of valuations for the business of Tinto Ltd, using the information available and stating any assumptions made. Use the following methods for the valuation:

i) Net assets method (5 marks)
ii) Price-earnings method (3 marks)
iii) Dividend growth method (4 marks)

(Note: Ignore tax implications.)

i) Net Assets Method

To value Tinto Ltd using the Net Assets Method, the adjustments to the net assets based on the information provided are as follows:

Adjustments to Net Assets of Tinto Ltd Amount (GH¢ million)
Net assets per financial statements 14.40
Revaluation surplus on buildings +1.50
Fair value adjustment on financial assets +0.10
Allowance for bad debts -0.75
Impairment of plant -0.02
Revised Net Assets 15.23

Thus, the value of the business using the Net Assets Method is GH¢15.23 million.

ii) Price-Earnings Method

To value Tinto Ltd using the Price-Earnings (P/E) Method, the earnings and the appropriate P/E ratio must be calculated and adjusted for risk and marketability.

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