- 20 Marks
Question
a) Governments take certain measures with a view to influencing aggregate demand in their economy.
Required:
i) Distinguish between fiscal policy and monetary policy. (2 marks)
ii) Explain TWO adverse effects a contractionary fiscal policy could have on businesses. (4 marks)
b) Papa’s Skin Ltd is an Accra-based clothing company owned and managed by its two founders. The company has been selling to only domestic consumers in Ghana since inception. The founders think it is time to extend the operations of the company to foreign markets, particularly those in neighbouring West African countries. Moving into foreign markets requires additional financing and capabilities, which the company does not have. The owners have agreed on ceding 40% stake in their company to a strategic investor who would provide the additional financing and capabilities needed to compete successfully in the international business environment. However, they are not sure of what range of prices to accept for the shares they would give up.
Below is a summary of financial data for Papa’s Skin Ltd for the recent financial year:
- Issued shares: 2 million
- After-tax profit: GH¢9,600,000
- Total dividends: GH¢1,920,000
- Property, plant and equipment: GH¢50,500,000
- Current assets: GH¢25,300,000
- Long-term borrowings: GH¢9,100,000
- Current liabilities: GH¢11,100,000
The following information is relevant to the position and value of Papa’s Skin Ltd:
- The assets of Papa’s Skin Ltd were valued just after the recent financial statements were published. Inventories and trade receivables, which are included in current assets, were written down by GH¢80,000 and GH¢95,000 respectively. Property, plant and equipment were valued at GH¢52,400,000.
- Papa’s Skin Ltd falls into the fabrics and clothing industry. The average P/E ratio for listed equity stocks in the industry is 10. The average required return on listed equity stocks in the industry is 16%.
- Marketability of shares in Papa’s Skin Ltd is limited as its equity stock is not listed on the stock exchange. Consequently, investors demand a marketability risk premium of 7% above the industry average required return on equity in order to invest in the equity stock of Papa’s Skin Ltd.
- Earnings and dividends of Papa’s Skin Ltd are expected to grow by 5% every year to perpetuity.
Required:
i) Estimate an appropriate required rate of return on the equity stock of Papa’s Skin Ltd. (2 marks)
ii) Estimate a range of suitable considerations for a 40% stake in Papa’s Skin Ltd using the net assets method, P/E ratio method, and dividend valuation method. (12 marks)
Answer
a) Fiscal Policy vs. Monetary Policy
i) Distinction Between Fiscal Policy and Monetary Policy
- Fiscal Policy: Involves the use of government spending and taxation to influence the economy. Fiscal policy is typically aimed at achieving macroeconomic goals such as controlling inflation, reducing unemployment, and encouraging economic growth by influencing aggregate demand.
- Monetary Policy: Involves the management of the money supply and interest rates by a central bank to influence the economy. Monetary policy aims to maintain price stability, control inflation, and achieve high levels of employment.
ii) Adverse Effects of Contractionary Fiscal Policy on Businesses
- Reduction in Sales Revenue and Profit: A contractionary fiscal policy, which involves increasing taxes or reducing government spending, can lead to a decrease in aggregate demand. This reduction in demand can result in lower sales and, consequently, lower profits for businesses.
- Reduction in Reinvested Profits: Higher taxes reduce the amount of disposable income available to businesses, limiting the funds available for reinvestment. This can force businesses to seek external financing, which may come at a higher cost.
b) Valuation of Papa’s Skin Ltd
i) Appropriate Required Rate of Return on the Equity Stock of Papa’s Skin Ltd
The average required rate of return on industry-listed stocks is 16%. Given the limited marketability of Papa’s Skin Ltd’s shares, investors require a marketability risk premium of 7%.
Required Rate of Return = Industry Return + Marketability Risk Premium
= 16% + 7% = 23%
ii) Range of Suitable Considerations for 40% Stake
- Net Assets Method:
| Item | Amount (GH¢) |
|---|---|
| Property, Plant & Equipment | 52,400,000 |
| Current Assets | 25,125,000 |
| Long-Term Borrowings | (9,100,000) |
| Current Liabilities | (11,100,000) |
| Net Assets | 57,325,000 |
Value per share = Net Assets / Number of shares
= GH¢57,325,000 / 2,000,000 = GH¢28.66
- P/E Ratio Method:
| Item | Amount (GH¢) |
|---|---|
| After-tax Profit | 9,600,000 |
| Number of Shares | 2,000,000 |
| Earnings per Share (EPS) | 4.8 |
| Justified P/E Ratio | 5 |
| Value per share | 24 |
- P/E Ratio = Industry P/E ratio × 0.5
= 10 × 0.5 = 5 - Value per share = EPS × Justified P/E Ratio
= GH¢4.8 × 5 = GH¢24
- Dividend Valuation Method:
| Item | Amount (GH¢) |
|---|---|
| Dividend per Share (DPS) | 0.96 |
| Required Return on Equity | 23% |
| Growth Rate of Dividends | 5% |
| Value per Share | 5.6 |
- Value per share = (DPS × (1 + g)) / (Required Return – g)
= (GH¢0.96 × (1 + 0.05)) / (0.23 – 0.05) = GH¢5.6
- Summary of Valuation Methods
| Method | Value per Share (GH¢) | Total Equity Value (GH¢) | Consideration for 40% (GH¢) |
|---|---|---|---|
| Net Assets Method | 28.66 | 57,320,000 | 22,928,000 |
| P/E Ratio Method | 24 | 48,000,000 | 19,200,000 |
| Dividend Valuation Method | 5.6 | 11,200,000 | 4,480,000 |
Conclusion: The valuation of Papa’s Skin Ltd for a 40% stake could range between GH¢4,480,000 and GH¢22,928,000 depending on the method used.
- Tags: Business Valuation, Fiscal Policy, Monetary Policy, Required Rate of Return
- Level: Level 2
- Topic: Business valuations
- Series: MAY 2016
- Uploader: Joseph