Topic: Business Valuation Techniques

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FM – May 2017 – L3 – Q3 – Business Valuation Techniques

Compute Free Cash Flow to Equity and value per share using FCFE model.

Question

LA Ltd., a food packaging company, has operated as a private company for the past 10 years. The company has been growing rapidly over the last few years. The Directors are now considering listing the company on the stock market. Preparatory to this, the Directors are interested in determining a fair price per share for the company. Assume today is November 1, 2016.

The following information has been extracted from the most recent audited financial statements of LA Ltd:

Statement of Profit or Loss, October 31, 2016

₦million
Sales Revenue	15,790
Cost of Sales	(13,514)
EBITDA	2,276
Depreciation	(440)
EBIT	1,836
Interest Expense	(330)
Earnings Before Tax	1,506
Tax at 30%	(452)
Profit After Tax	1,054

Statement of Financial Position as at October 31:

Additional Facts

The Directors believe that the Free Cash Flow to Equity (FCFE) model should provide an appropriate valuation for the company’s shares.
An investment banker has provided the following estimates of cost of capital:
- Cost of equity: 15%
- Post-tax cost of debt: 4%
- WACC: 12.5%
The Directors believe that the FCFE will grow by 18% for the next 5 years and by 5% thereafter.
The company currently has 600 million shares in issue.

Required:

a. Calculate the free cash flow available to equity for the year ended October 31, 2016. (7 Marks)

b. Use the Free Cash Flow to Equity model to calculate the current value per share. (5 Marks)

c. What are the key advantages and disadvantages of stock exchange listing? (8 Marks)

Answer

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Tags: FCFE Model, Shareholder Impact, Stock Listing, Valuation
Level: Level 3

Topic: Business Valuation Techniques

FM – May 2021 – L3 – Q1 – Business Valuation Techniques

Evaluate the value of Zinco Limited using various valuation techniques and estimate the coupon rate for bond financing.

Question

Palemo Temidayo (PT) is a large engineering company listed on the stock market. The company is considering the purchase of Zinco, an unlisted company that produces a number of engineering components.
The board of directors is concerned about the appropriate price to pay for Zinco. As a starting point, it has been decided to provide a range of valuations based on different industry-recognized techniques.

Summarized financial statements of Zinco Limited for the last two years are shown below:

Statements of Profit or Loss for the years ended 30 June

	2020 (N’000)	2019 (N’000)
Sales Revenue	112,400	101,090
Opening Profit before exceptional items	6,510	4,100
Exceptional Items	(10,025)	–
Interest Paid (Net)	(1,400)	(890)
Profit/(Loss) before Tax	(4,915)	3,210
Taxation	(1,050)	(890)
Profit/(Loss) after Tax	(5,965)	2,320
Note: Dividend	1,000	500

Statement of Financial Position as at 31 March (N’000)

Additional Information Relating to Zinco:

If the acquisition succeeds, there will be revenue synergy leading to an increase in annual sales revenue of Zinco of 25% for three years, and 10% per year thereafter.
Non-cash expenses, including depreciation, were N4,100,000 in 2020.
Income tax rate is 30% p.a.
Capital expenditure was N5 million in 2020 and is expected to grow at approximately the same rate as revenue.
Working capital, interest payments, and non-cash expenses are expected to increase at the same rate as revenue.
Zinco has a patent with a current market value of N50 million. This has not been included in the non-current assets.
Operating profit is expected to be approximately 8% of revenue in 2021 and to remain at the same percentage in future years.
Dividends are expected to grow at the same rate as revenue.
The realizable value of inventory is expected to be 70% of its book value.
The estimated cost of equity is 12%.
The average P/E ratio of listed companies of similar size to Zinco is 30:1.
Average earnings growth in the industry is 6% per year.

Required:

a. Prepare a report that gives an estimate of Zinco using:
(i) Asset-based valuation (8 Marks)
(ii) P/E ratios (6 Marks)
(iii) Dividend-based valuation (6 Marks)
(iv) The present value of expected future cash flows (5 Marks)
(v) Discuss the potential accuracy of each of the methods used and recommend, with reasons, a value or range of values that PT might bid for Zinco. State clearly any assumptions that you make.

b. The directors of PT are considering issuing some ₦100 nominal value ten-year bonds to finance the purchase of Zinco. To make the bonds look attractive to potential investors, the bonds are to be issued at a discount of 10%. Based on PT’s credit rating, investors are expected to require a return of 7% per year from such bonds.

You are required:
To estimate the coupon rate that PT will have to pay on these bonds in order to satisfy the investors. (5 Marks)

Answer

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Tags: Asset-Based Valuation, Bond pricing, Discounted Cash Flow, Dividend valuation, P/E Ratio
Level: Level 3

Topic: Business Valuation Techniques

FM – May 2022 – L3 – Q1 – Business Valuation Techniques

Estimate VT's valuation using FCFE, CAPM, and terminal value assumptions for three-year cash flow forecasts.

Question

Vico Tony (VT) is a software design company established six years ago. The company is owned by five directors. Since establishment, the company has developed rapidly. VT finds it difficult to obtain bank finance and relies on a long-term strategy of using internally generated funds to finance expansion. The directors are therefore giving consideration to the possibility of floating the company on the stock market. As a first step, you have been appointed by the directors to advise on the current value of the business under their ownership.

The company’s most recent statement of profit or loss and the extracted balances from the latest statement of financial position are as follows:

During the current year:

Depreciation is charged at 10% per annum on the year-end non-current assets balance before accumulated depreciation, and is included in other operating costs in the statement of profit or loss.
The investment in net working capital is expected to increase in line with the growth in gross profit.
Other operating costs consisted of:

Sales and variable costs are projected to grow at 9% per annum and fixed costs are projected to grow at 6% per annum.
The company pays interest on its outstanding loan of 7.5% per annum and incurs tax on its profits at 30%, payable in the following year. The company does not currently pay dividends.

One of your first tasks is to prepare for the directors a forward cash flow projection for three years and to value the firm on the basis of its expected free cash flow to equity. In discussion with them, you note the following:

The company will not dispose of any of its non-current assets but will increase its investment in new non-current assets by 20% per annum. The company’s depreciation policy matches the currently available tax allowable depreciation. This straight-line write-off policy is not likely to change;
The directors will not take a dividend for the next three years but will then review the position taking into account the company’s sustainable cash flow at that time;
The level of loan will be maintained at ₦1.98 billion and interest rates are not expected to change.
For estimating the appropriate required return on equity, it is decided to make use of the capital asset pricing model (CAPM). The challenge, however, is that since the company is not quoted, an appropriate beta factor does not exist. You have found a listed company, Konputer Limited (KL) that is into software development. KL is also into computer hardware retailing. It has the following financial statistics:

About 60% of the market value of KL is attributed to the software development division, while 40% of the value is attributed to computer hardware retailing. The computer hardware retailing division has an equity beta of 0.8.
Risk-free rate is 4% and the market risk premium is 8%.
VT has maintained a long-term debt/(debt+equity) ratio of 20%.

Required:

a. Provide an estimate of the appropriate rate of return to be used for the valuation of VT. Round your answer to the nearest whole number. (7 Marks)
b. Prepare a three-year cash flow forecast for the business on the basis described above highlighting the free cash flow to equity in each year. (14 Marks)
c. Estimate the value of the business based on the expected free cash flow to equity and a terminal value based on a sustainable growth rate of 4% per annum thereafter. (Note: Irrespective of your answer in (a), assume required return of 17%). (5 Marks)
d. Advise the directors on the assumptions and the uncertainties within your valuation. (4 Marks)

Answer

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Tags: Business Valuation, CAPM, Financial Projections, Free Cash Flow to Equity
Level: Level 3

Topic: Business Valuation Techniques

FM – May 2023 – L3 – Q2 – Business Valuation Techniques

Analyze AHP’s intrinsic value using fundamental and technical analysis, apply the dividend valuation model, and evaluate EMH implications.

Question

You are a Financial Analyst at Tayo Research Group (TRG). You begin valuing Aba Hotels Plc (AHP), a thinly and infrequently traded stock currently selling at 217 kobo, cum 2021 dividend.

For estimating AHP’s required return on equity, TRG uses the capital asset pricing model (CAPM) approach, but you think its equity beta of 1.20 is not reliable because of the stock’s extremely thin trading volume. You have therefore obtained the beta and other pertinent data for Eko Hotel Plc (EHP) – (See Table 1), a midsized company in the same industry with high liquidity trading on the Nigerian Stock Exchange.

Table 1: Valuation Data for EHP

Parameter	Value
Asset beta	0.763
Debt beta	0.150
Debt ratio (D/D+E)	0.60
Effective tax rate (%)	30%

Summarised financial data for AHP is shown below:

Statement of Profit or Loss Account

Year	2019	2020	2021*
Sales (₦’000)	305,500	357,600	409,200
Taxable income (₦’000)	40,500	49,000	56,700
Taxation (₦’000)	(14,175)	(17,150)	(19,845)
Post-tax income (₦’000)	26,325	31,850	36,855
Dividend (₦’000)	(9,340)	(10,228)	(11,200)
Retained earnings (₦’000)	16,985	21,622	25,655

Statement of Financial Position

Year	2021*
Non-current assets (₦’000)	216,800
Current assets (₦’000)	158,000
Current liabilities (₦’000)	(104,800)
Net assets (₦’000)	270,000
Ordinary shares (₦0.50 par value)	80,000
Reserves (₦’000)	130,000
15% Bond 2026 (₦100 par value)	60,000

(*2021 figures are unaudited)

Other Relevant Information:

It has been estimated that the debt/equity ratio of AHP is 0.16 and the beta of its debt is 0.2.
The risk-free rate is 12% and the market risk premium is 5%.
AHP has an effective tax rate of 35%.
As a result of recent capital investment, stock market analysts expect post-tax earnings and dividends to increase by 25% for two years and then revert to the company’s existing growth rates.

Required:

a. Stock market analysts sometimes use fundamental analysis and sometimes technical analysis to forecast future share prices.
What are fundamental analysis and technical analysis? (4 Marks)

b. Using the dividend valuation model, estimate what a fundamental analyst might consider to be the intrinsic (or realistic) value of the company’s shares.
Comment upon the significance of your estimate for the fundamental analyst. (12 Marks)

c. Explain whether your answer to (b) above is consistent with the semi-strong and strong forms of the efficient markets hypothesis (EMH), and comment upon whether financial analysts serve any useful purpose in an efficient market. (4 Marks)

Answer

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Tags: CAPM, Dividend valuation, Efficient Markets, Fundamental Analysis, Technical Analysis
Level: Level 3

Topic: Business Valuation Techniques

FM – May 2023 – L3 – Q1a – Business Valuation Techniques

Evaluate ZL's valuation using multiple methods and recommend whether KK should acquire ZL. Discuss takeover regulation factors.

Question

KK, a company quoted on the Stock Exchange, has cash balance of ₦230 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 ZL, a company in a different industry that is quoted on the AIM (Alternative Investment Market). Although ZL 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 ZL, but they consider that its shares are worth ₦220 million in total.

Summarised financial data:

Economic data:

Risk-free rate of return: 6% p.a.
Market return: 14% p.a.
Inflation rate: 2.4% p.a., expected to remain stable.

Expected effects of the acquisition:

50 employees of ZL would immediately be made redundant at an after-tax cost of ₦12 million. Pre-tax annual wage savings are expected to be ₦7.50 million (at current prices) for the foreseeable future.
Some land and buildings of ZL would be sold for ₦8 million (after tax).
Pre-tax advertising and distribution savings of ₦1.50 million per year (at current prices) would be possible.
The three existing directors of ZL would each be paid ₦1 million per year for three years for consultancy services. This amount would not increase with inflation.

Required:

a. Calculate the value of ZL based upon:
i. The use of comparative P/E ratios (3 Marks)
ii. The dividend valuation model (4 Marks)
iii. The present value of relevant operating cash flows over a 10-year period (10 Marks)
iv. Provide an evaluation of each of the three valuation methods in (i) to (iii) above. (7 Marks)
v. Recommend whether KK should go ahead with the offer for ZL. (2 Marks)

Answer

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Tags: Consolidated Statement of Financial Position, Ethical considerations, Goodwill, Non-Controlling Interest, Pension obligations
Level: Level 3

Topic: Business Valuation Techniques

FM – May 2024 – L3 – SA – Q1 – Business Valuation Techniques

Evaluate the potential acquisition of Kenny Ltd (KL) by Bolade Plc, calculating share value using various valuation methods, assessing these methods, and outlining merger benefits.

Question

You are employed by Bolade Plc (BP), a very large printing firm with retail outlets across Nigeria. Its board is considering making an offer to buy 100% of the shares of Kenny Ltd (KL), a competitor of Bolade in Aba. KL’s financial year-end is 28 February, and its most recent financial statements are summarised below:

KL Income Statement for the Year Ended 28 February 2023

Item	₦m
Revenue	17.3
Profit before interest and tax	5.9
Interest	(0.3)
Profit before taxation	5.6
Tax at 21%	(1.2)
Profit after taxation	4.4
Dividends declared	1.1

KL Statement of Financial Position at 28 February 2023

Item	₦m
Non-current assets:
Freehold land and buildings (original cost ₦4.1m)	3.5
Machinery (original cost ₦8.8m)	5.3
Total Non-current assets	8.8
Current assets:
Inventories	3.0
Receivables	0.5
Cash and bank	2.8
Total Current assets	6.3
Current liabilities:
Trade payables	3.5
Dividends	1.1
Taxation	1.2
Total Current liabilities	(5.8)
Net Current assets	0.5
Net assets	9.3
Non-current liabilities:
10% bonds (redeemable 2031)	(3.0)
Net assets after non-current liabilities	6.3
Equity:
Ordinary shares of ₦1 each	2.1
Retained earnings	4.2
Total equity	6.3

Additional Information:

KL’s management had some of the company’s assets independently revalued in January 2023. Those values are shown below:

Asset	₦m
Freehold land and building	8.3
Machinery	4.1
Inventories	3.1

The average price/earnings ratio for listed businesses in the printing industry is 9, and the average dividend yield is 6% p.a.
The cost of equity of businesses in the printing industry, taking account of the industry average level of capital gearing, is 14% p.a.

KL’s finance department has estimated that the company’s pre-tax net cash inflows (after interest) for the next four trading years ending 28 February, before taking account of capital allowances, will be:

Year to	₦m
2024	4.6
2025	4.3
2026	5.2
2027	5.7

KL’s existing equipment has a tax written-down value of ₦3.6 million at 28 February 2023. The equipment attracts 18% (reducing balance) tax allowances in every year of ownership by the company, except the final year.

You should assume that KL will not be purchasing or disposing of any machinery in the years 2024-2027 and that it would dispose of the existing equipment on 28 February 2027 at its tax written-down value.

Bolade’s board estimates that in four years’ time, i.e., 28 February 2027, it could, if necessary, dispose of KL for an amount equal to four times its after-tax cash flow (ignoring the effects of capital allowances and the disposal value of the equipment) for the year to 28 February 2027.

Assume that the company income tax rate is 21% p.a.

Required:

Using the information provided, prepare a report for Bolade’s board by:

a. Calculating the value of one share in KL based on each of the following methods:

i. Net asset basis (historic cost)
ii. Net asset basis (revalued)
iii. Price/earnings ratio
iv. Dividend yield
v. Present value of future cash flows
(16 Marks)

b. Explain the advantages and disadvantages of using each of the five valuation methods in (a).
(8 Marks)

c. What are the possible benefits from the merger between Bolade Plc (BP) and Kenny Limited (KL).
(6 Marks)

(Total: 30 Marks)

Answer

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Tags: Acquisition, Business Valuation, Mergers, Synergy, Valuation Methods
Level: Level 3

Topic: Business Valuation Techniques
Series: MAY 2024

FM – Nov 2018 – L3 – Q3 – Business Valuation Techniques

Valuation of acquisition target using free cash flow forecast and P/E ratio analysis in the context of an acquisition.

Question

Lagelu Plc. (LP) is a very successful entity. The company has consistently followed a business strategy of aggressive acquisitions, looking to buy companies that it believes were poorly managed and hence undervalued. LP can be described as a modern-day conglomerate with business interests stretching far and wide.

Its board of directors has chosen the takeover targets with care. LP has maintained its price earnings (P/E) ratio on the stock market at 12.2.

LP’s figures show a profit after tax of ₦4,430 million, and it has 375 million shares.

Lam Technical (LT) is a well-established owner-managed business. It has had its ups and downs in financial terms, corresponding directly with the state of the global economy. Since 2001, its profits have fallen each year, with the 2017 results as stated below:

With economists predicting an upturn in the global economy, LT’s management team feels that revenue will increase by 6% per annum up to and including year 2021. The company’s operating profit margin is not expected to change in the foreseeable future.

Operating profits are shown after deducting non-cash expenses (including tax-allowable depreciation) of ₦650m. This is expected to increase in line with sales. However, the company has recently spent ₦1,050m on the purchase of non-current assets, and LT’s management believes this will need to increase by 10% per annum until year 2021 to enable the company to remain competitive.

LT is currently financed by debt and equity. It has maintained a constant debt-to-total-asset ratio of 40% and has no intention to change this financing mix in the near future.

The company has a cost of equity of 17% and a weighted average cost of capital of 12%.

Assume a tax rate of 25% in all cases.

Some of LT’s major shareholders are not so confident about the future and would like to sell the business as a going concern. The minimum price they would consider would be the fair value of the shares plus a 10% premium. LT’s Chief Financial Officer believes the best way to find the fair value of the shares is to discount the forecast Free Cash Flows to the firm, assuming that beyond the year 2021, these will grow at a rate of 3% per annum indefinitely.

Required:

a. Prepare a schedule of forecast Free Cash Flows to the firm for each of the years from December 31, 2018, to 2021. (5 Marks)

b. Estimate the fair value of LT’s equity on a per-share basis. (6 Marks)

c. LP intends to make an offer to LT based on a share-for-share swap. LP will exchange one of its shares for every two LT shares. Assuming that LP can maintain its price earnings (P/E) ratio of 12.2, calculate the percentage gain in equity value that will be earned by both groups of shareholders. (6 Marks)

d. What factors should the LT shareholders consider before deciding whether to accept or reject the offer made by LP? (3 Marks)

Answer

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Tags: Acquisition, Discounting Techniques, Free Cash Flow, P/E Ratio, Share Swap, Shareholders’ Equity, Takeover Decision
Level: Level 3

Topic: Business Valuation Techniques

FM – Nov 2023 – L1 – SC – Q5 – Business Valuation Techniques

Calculate convertible bonds' value as debt, assess market expectations, and analyze conversion inducements and dividend policy effects on convertible bonds.

Question

Ope plc has N10m 5 percent convertible bonds in issue. The option to convert into 40 N1 ordinary shares is open only for one more year; they must be either converted in one year’s time or left as ordinary bonds until nine years’ time when they will be redeemed at par. The current share price is ₦1.60, and the annual growth rate in share price is 15 percent per annum. The current required return on Ope’s equity is 25 percent, as its business is relatively risky.

The current yield on ordinary non-convertible bonds in similar companies is 11 percent. These interest rates are expected to remain constant.

Ife plc has 100,000 warrants outstanding, each entitling the holder to subscribe for one N1 ordinary share at 90 kobo anytime during the next 3 years. The current share price is 57 kobo, and capital growth is expected to be constant at 12 percent per annum in the future. The current price of the warrant is 10 kobo.

Required:

a. Calculate the current value of Ope’s convertibles as straight debt, i.e., ignoring the option to convert, and the value if conversion were to take place today. Would you expect the market value of the convertible to be above or below each of these amounts, and why? (5 Marks)

b. By how much should the share price of Ope Plc rise before holders would be induced to convert on the last possible date for conversion? (4 Marks)

c. Explain why the market value of a convertible bond is likely to be affected by the dividend policy of the issuing company. (4 Marks)

d. Based on the projected capital growth for Ife Plc, would you expect holders of
the warrants to exercise them before expiry? What is the minimum annual
growth -rate of the share price necessary to induce holders to exercise their
warrants?
(2 Marks)

Answer

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Tags: Convertible Bonds, Convertible Securities, Debt and Equity, Market Value, Valuation, Warrants
Level: Level 3

Topic: Business Valuation Techniques
Series: NOV 2023

FM – Nov 2022 – L3 – Q5 – Business Valuation Techniques

Calculate the equity value of APL using SVA and outline three methods for funding the MBO.

Question

Aderupoko Plc (ADP), a large listed media group, has been the holding company of Adamu Publishers Limited (APL) since 2015. The publishing company (APL) is 100% owned by ADP since inception.

Recently, the directors of APL informed ADP’s board of their readiness to make a management buy-out (MBO) of APL. Accordingly, ADP’s board decided to value APL using the shareholder value analysis method (SVA). ADP’s board estimates that APL has a four-year competitive advantage over its competitors (to 30 September 2024) and the following data regarding APL’s value drivers and additional financial information has been collected:

Year to 30 September	2021	2022	2023	2024	2025+
Sales growth (%)	5%	4%	3%	2%	0%
Operating profit margin	8%	9%	10%	10%	10%
Incremental non-current asset investment (% of sales increase)	5%	6%	3%	2%	0%
Incremental working capital investment (% of sales increase)	6%	5%	4%	4%	0%

Financial Information:

Sales for the current year to 30 September 2020: ₦80 million
Annual depreciation (equal to annual replacement of non-current asset expenditure): ₦2.0 million
Par value of 6% debentures in issue (current market value ₦95.00, nominal value ₦100): ₦10.0 million
Short-term investments held: ₦0.8 million
Company tax rate: 20%
Current WACC: 10%

Required:

a. Calculate the value of APL’s equity using SVA.

(12 Marks)

b. Outline three methods by which APL’s directors might raise the funds necessary for the proposed MBO of the company. (3 Marks)

(Total 15 Marks)

Answer

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Tags: Competitive Advantage, Equity, Funding Methods, MBO, SVA, Valuation
Level: Level 3

Topic: Business Valuation Techniques
Series: NOV 2022

FM – May 2017 – L3 – Q3 – Business Valuation Techniques

Compute Free Cash Flow to Equity and value per share using FCFE model.

Question

The following information has been extracted from the most recent audited financial statements of LA Ltd: