Dividend Valuation Model - Essay Example

Finance and Accounting Dividend valuation model assuming a dividend cover of 2, growth in dividend of10% per year in perpetuity and assuming a cost of capital of 20% terminology formula Terminal Value FCF ( t + 1 ) / wacc – g t + 1 first year after the forecast period WACC weighted average cost of capital g: growth rate normalized cash flow 45,000 Growth rate expected after the forecast period is 10% WACC 12% total ($ 45,000 x 1.01) / (.12 - .1) = $ 44554 / 0.02 = $ 2227700 It is important to note that the FCF = After Tax Operating Tax Cash Flow - Interest (1 - t ) - PD - RP - RD – E Where: 1. PD: the companys Preferred Stock Dividends 2. RP: the companys Expected Redemption of the Preferred Stock 3. RD: the company’s Expected Redemption of Debt 4. E: Expenditures for sustaining cash flows Dividend valuation model assuming a dividend cover of 2, a constant dividend in perpetuity and a cost of capital of 20% Triumph plc £‘000 Rustic plc £‘000 Market value of stocks (3x10)=30000 (1.62x8)=12,960 ROI 4,500, 2,952, Fixed assets 20,000 20,000 Current Assets 7,000 9,000 Current Liabilities -3,000 -5,000 Net assets 24,000 24,000 Long term debt @ 5% 4,000 8,000 Shareholders’ funds 20,000 16,000 Long-term investment 24,000 24,000 126, 000 108,960 Shareholder Value Added approach to estimation of cash flows for the first 5 years with and assumption of growth of dividends in year 6 onwards at an annual rate of 4% in perpetuity. The cost of capital is estimated at 20% Terminal Value = the NOPAT (t + 1) x (1 - g / ROIC) / wacc - g NOPAT: Net Operating Profits after Taxes ROIC: return on the invested capital total present values 7,526 terminal value 14,663 non operating assets value 500 total value of rustic plc 26688 less debt -2800 equity 19888 outstanding shares 3000 value per share 6.63 2. Compare the valuation methods used above Of the models listed above, the most optimal and theoretical approach for stock valuation is dividend valuation approach. 2.1Dividend discount model This model estimates the value of shares at discounted value based on the future dividends payment. It argues that the value of a share is worth the actual present value in terms of all the future dividends that a company will pay. This model is the most effective method for valuation because it places the values of shares on the real cash flows that the investors receive. On the other hand, the dividend discount valuation model is discounted cash flow based on the dividend forecasts over, many stages. Brown & Medoff, (1988), stated that the dividends that have not become ex dividends are not required for forecasting because they have just been announced. The forecast are also based on the detailed financial models running over 2 to 5 year. This model also assumes the constant growth rate. The method is useful when evaluating then value of a company in the short and medium term, however, in long term valuation, it may not be suitable but the management can only use this model if the shareholder agree to accept the assumptions that the dividend payout policies will be maintained for future calculations ( Jensen, &, Ruback, 1983, pp5–50).. The model has limitation that makes it less appropriate. For example, the model has imitations making it difficult to use for short term forecasting as opposed to the long run because the system dividends on the ability to while the order details of host companies have an attitude while most companies use the links because it is not subscribed. Most companies also understand that the models Is dependent on the input data. Finally, the divided discount model is also not preferred by other companies because the model omits cash flows (PWC, 2007, 1-50). 2.2. The shareholder value added approach This is the actual value that a company places on the stakes of accompany. For example, this model is useful for determining worth of a company’s shares or determining whether the investments expenses are justified. SVA model represents all the economic profits that are generated by a business over and above the minimum return that is required by providers of capital. The “Value” is only added when the general net economic cash flow actually more than the economic costs of the capital employed in the production of the operating profit. This model integrates the key financial statements into a meaningful measure (Calomiris, &, Hitscherich, 2007). The method is advantageous because it recognizes both the equity holder and debt financiers need for compensation for bearing risks. The method also ensures that inequalities in compensation are leveled. It is also highly flexible and therefore is important in decision making. It is also applicable in performance monitoring, market valuation, capital budgeting, and output. Other advantages include the greater accountability when investing new capital and other investments that are already in existence. The external bodies and the government can apply appropriate benchmarks while evaluating the performance. On the other hand, the management will have a closer focus on the shareholder value maximization Discuss the extent to which may be useful in negotiation with the management and shareholders of Rustic plc over the price that they may accept in a takeover While both the three methods listed above are effective in price determination, the stakeholder value added approach is much easy to use and is much more focused on the stakeholder as opposed dividend valuation model (Fama, & French, 1993, pp. 3-56). Discuss any other methods of valuation could be used in negotiation The management can consider the Gordon Model: this model is quite useful, for example, when determining the price of stocks of a company. Assumption must be included such as current rate of growth for dividends 10.95%, the D0 = $1.00 and the ke is 13%. Therefore: –        P0:= D0 (1 + g)/ke – g –        P0:= $1.00(1.1095)/0.13 - 0.1095 –        P0:= $1.1095/0.0205 = $54.12 However, this model is only applicable if the firm is paying dividends’ however; this might not work if then firm has an erratic history of growth rate 3.a)Discuss the risks that bidding companies face in undertaking acquisitions with reference historic and research evidence on takeovers. As many companies try to leverage their growth and competitive advantages, the find home in mergers and acquisitions, however, mergers and acquisition have inherent pitfalls that are faced by all partners in the engagement. However, the only way to overcome these risks is through proper risk management. There are many factors behind the current trends towards growth through acquisition. Therefore, as this paper analyses the final rationale product segment and same industry, it will also analyze the methodology and framework of dealing with the two companies financial and possible outcomes of the acquisitions. The dangerous gap encountered by major companies in information stems from the inability to evaluate various alternative decisions. This has always focused on the achievement of objectives. It is important for the companies planning an acquisition to affirm and quantify the main expected risks in the chosen alternatives. The proposed risks Risk-Chance Analysis should be considered as it present a goal-related as well as risk-related evaluation of the key alternatives. This is achieved without additional expenditures. a) Inability to create new synergies Two separate business entities are not likely to achieve a new synergy as they have distinctive culture, talent and business models, the success, creativity and productivity of acquiring company will become stifled and not complicated. It is always hard for companies to coexist making it hard for the acquiring companies to leverage its financial bases easily. The cultural difference in the two companies can hinder a cohesive team (Calomiris, &, Hitscherich, 2007, pp, 909-938). b) Financial risks Andrade, Mitchell, &, Stafford, (2001, pp 103-120) argues that acquiring companies have a lot of financial expenses. This may include them buyout, commission for the investment bankers an attorney, paying off the accumulated debt of the acquired company as well as foreign exchange risk, interest rate risk, commodity price risk and the credit risk the target company holds. On the other hand, the target companies may be having hidden derivative losses and other volatile derivative contract that may not be easy to discover prima facie. c) Legal risk There are many legal risks associated with mergers and acquisition, for example, there are obligations to adhere to wage and hourly laws that relate to the termination of the employees contract. Risk of conscious deception, Risks to corporate creditors and Risk of transactus interuptus Additionally, Friedman, (1953, pp. 157–203) states that there is research evidence on the risks that companies face when they bid and are awarded the bids for acquisition. For one, event risks bonds have varying impact on the wealth of shareholders. There is likelihood of impact o the shareholders wealth therefore these bonds are not supportive of the takeover device, but just serve the role of an anti acquisition device (Froot,&, Stein, 1998, 55–82). 3b) Research evidences On the other hand, research evidence shows that acquisition have inherent characteristics such as high rate of failures. For example, Microsoft and T-Mobile, then the engagement between Microsoft and commodore were not successful either. Microsoft experiences a higher possibility of failure when they realized that they could not achieve their objectives. Most companies rarely have enough understanding of the actual volatility of the business environment even when all factors were looking right. This was also increased by vendor dishonesty and very different ethical standards. a. High Divestiture rate Apart from high rate of failures, there are also low returns to both the investing companies and the shareholders. This stems from the costs and expenses that the company has to discharge post acquisition. Divestitures are the main component of mergers and acquisition as it is responsible for almost 35% of acquisitions transactions. Most of the companies that made acquisitions bids were interested in divesting from the acquired company. The only motivation for divestiture based on the historical evidences is that most of the acquired companies destroy the wealth of shareholder. The value of most companies is never certain therefore the market has become skeptical. Other r reasons for divestiture include poor unit performance; execute diversification and financial problems (Eckbo, &, Langhor, 1989. pp, 363–403). i) Sinking profits after acquisition In many acquisitions deal, most acquiring companies realize that the profits are sinking and shrinking. Post acquisition profitability is always hard to come by making many companies to reconsider their acquisition bids. This is a major concern especially considering the fact that the company has paid considerably for the acquisition (Barber, &, Lyon, 1997, pp41–372). ii) Low returns to shareholders, companies, and the role of investment bankers The value of a firm involved in acquisition is highly influenced by investment bankers. For example, there are investment bankers who are experienced in identifying firms that have high potential for better economic benefits. On the other hand, the investment bankers may have a superior bargaining power and help in bargaining for higher return ofm then shareholders. For example, Naspers Ltd and Digital Sky Technologies Ltd of Russia. Naspers acquired controlling shares in digital sky technologies. This was an acquisition of the year as the shareholder wealth has highly increased after the acquisition; this is based on the company ability to meet the following success factors (Dukes, Frohlich, &, Ma, 1992, 47–55). Success Measures Success measures % probability of success Achieving anti the anticipated purpose 30-45% Achieving strategic and financial objectives Read More