Valuation of the shares of Europa Inc
Table of Contents
ACKNOWLEDGEMENT
--------------------------------------------------------------------------------Page
2
EXECUTIVE SUMMARY
------------------------------------------------------------------------------Page
3
PART A
Section 1 – Valuation of the
shares of Europa Inc. -------------------------------------------Page 4
A.
Net Assets valuation
method-------------------------------------------------------------Page 4
B.
Dividend Valuation Model
--------------------------------------------------------------Page 5
C.
Calculation of Price to Earnings
ratio -------------------------------------------------Page 7
D.
Summary of calculations
----------------------------------------------------------------Page 8
Section 2 – Comment on the
results of the three different valuations ---------------------Page 8
Section 3 – Assessing the
reliability of the three methods of share valuation ------------Page 9
A.
Dividend Growth Model
----------------------------------------------------------------page 9
B.
Price/Earnings Ratio
---------------------------------------------------------------------page 9
C.
Asset valuation method
------------------------------------------------------------------page10
Conclusion
--------------------------------------------------------------------------------------------------Page
10
PART B
Section A
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11
Section B
-------------------------------------------------------------------------------------------Page
12
1. Objectives of the company----------------------------------------------------------Page
13
2. EPS increase --------------------------------------------------------------------------Page
14
3. Nature of the business ---------------------------------------------------------------Page
14
4. Product Life Cycle -------------------------------------------------------------------Page
14
5. Unique Assets -----------------------------------------------------------------------Page
14
6- Increasing Production efficiency and quality ------------------------------------Page
15
7. Tax
benefits ---------------------------------------------------------------------------Page
15
8. Sharing merger risk -----------------------------------------------------------------Page
15
9- Sharing complementary resources -------------------------------------------------Page
15
Section C
-----------------------------------------------------------------------------------------Page
13
1. Role of diversification -----------------------------------------------------------------Page
13
2. Lose as a result of takeovers ----
------------------------------------------------------Page 14
3. The implications for corporate governance
-----------------------------------------Page 14
References
--------------------------------------------------------------------------------------------------Page
15
ACKNOWLEDGEMENT
I would like to thank my professors
Mr. Nabil Baydoun for all the lecture Note and Ms. Tasneem Hussain Tutorials
that provided guidance in writing this assignment. This assignment would not be
accomplished without their support.
EXECUTIVE SUMMARY
This is required assignment for
TBS 907- Financial Strategy, a core subject for the MBA program at the
University of Wollongong Dubai. It contain of two parts – first part is about
two companies, Manu plc and Europa Inc in which Manu plc.is considering making an offer for the shares of the
privately owned Europa Inc. in addition ,Relevant financial
information of the two companies is provided using which this assignment is
expected to include :three valuation techniques to estimate a value techniques , Comment on the different valuations produced by the three
methods ,Assess the extent to which the three methods of
valuation you have used provide reliable estimates of economic value.
Second part of the assignment is about two companies, Compro Inc. and
Vendo Ltd. who are considering merging together. However, for the merger to be
successful Compro Inc would have to issue new ordinary shares in exchange for
the existing share of Vendo Ltd. This assignment requires an indication of what
should be the basis of the ratio of issuing new shares by Compro Inc. in
exchange of existing share of Vendo Ltd. It also identifies the various factors
which might influence the director’s of Compro Inc. to bid for Vendo Ltd. such
that their main aim is increasing share holder value. This assignment also
provides an insight into other motives that might have a hand in decision
making we ll see also mergers in areas
of diversification, corporate governance and loss of shareholders of the
acquirer company because of the take over.
PART A
Section 1 – Valuation of the shares of
Europa Inc.
There are three
valuation techniques to estimate a value or range of values for the shares. Most common of these are:
a)
Net
Present Value method
b)
Dividend
Valuation Model
c)
Calculation
of Price to Earnings ratio
d)
Net
Assets valuation method
As we know the NPV method is the most accurate.
However, we cannot use it for the valuation of Europa Inc. as necessary
information in terms of cash flows is not provided for Europa Inc. We do
however; have information that will help us value Europa Inc.’s shares using
the other three methods.
1.
Net Assets valuation method
In order to calculate the value of shares
using this method we require the values of Europa’s Assets - both Fixed and
Current Assets and the value of Current Liabilities and Long term Debt.
Asset valuation = Total Assets – Liabilities
The difference between Assets and Liabilities
is Owner’s Equity.
Sometimes the value of the
business will be greater than the value of the net tangible assets. The
difference is known as goodwill. Goodwill represents the fact that the business
can earn more money than a newly established business because it already has a
customer base (Canberra Business Advisory Service,
author unknown,2004) .
Asset valuation can be done
on the basis of replacement cost, historical cost, break up value or market value
of the assets. Market value is preferred as it reflects the current and almost
accurate value of the assets. Hence, the market value of Land & Buildings
is considered for Europa in valuating its assets.
Calculation as per asset valuation method
Information given
Land & Buildings 2,000,000
Plant & Machinery 2,800,000
Current Assets:
Total Book value 2,100,000
Less: loss on sale of inventory
180,000
---------------
Less: Debtors that not likely to be
recovered 44,000 1,876,000
-------------- ---------------
Total Assets 6,676,000
Less Liabilities 1,600,000
--------------
5,076,000
Note: There is no Long term debt for Europa
Inc.
Therefore, the asset valuation of Europa is
5,076,000
Number of shares of Europa is 540,000 ¸ .25
cents = 2,160,000
Value per share = 5,076,000 ¸
2,160,000 = $2.35 per share
2.
Dividend Valuation Model
These methods of share valuation are based on the premise that the
market value of ordinary shares represents the sum of the expected future
dividend flows, to infinity, discounted to present value (lse:Dividend
Valuation Models,2006)
In order to arrive at the current value of the
shares of Europa Inc using this model, we need to first find the cost of equity
of Europa Inc. The formula to calculate the Cost of Equity using the Dividend
Growth Model is:
|
Po
Where
Ke
= Cost of Capital
D1 =
next year’s dividend
Po =
Current price
g =
growth rate of dividend
D1 =
Current Dividend (1 + growth rate)
No.
of shares
In this case, we have to first find the cost
of equity for Manu plc, as it is given that Europa Inc.’s cost of equity is 20%
higher than that of Manu plc.
Calculation of Cost of Equity for Manu plc
D0 = 600,000 / 4,000,000 = $ 0.15
D1 =
600,000(1.08)
4,000,000
D1=
$ 0.162
Po =
$ 3.50
g =
8%
Ke
for Manu plc = 0.162 +
0 .08
3.50
Ke for Manu plc = 12.6%
Therefore, K e for Europa plc = 0.126 ´ 1.20 = 15.12%
Now, we have to determine the current price,
i.e., Po for Europa Inc.
Po = D1
Ke -
g
D0 = 200,000 / 2,160,000 = 0.09$,
D1 = 200,000(1.10)
2,160,000
= $0.10
Po = 0.10
(0.1512 – 0.1)
=
$1.95 per share
also Note that the ,Number
of shares for Europa = 540,000 / 0.25 = 2,160,000 shares
which result in Total price to be paid = 2,160,000 * 1.95 = 4212000 $ = $ 4.2 Million
3.
Calculation of Price to Earnings Ratio
The P/E method is one of
the most common ratios used in the valuation of a share. It can be seen
as reflecting the amount of time (number of years) required for an investor to
cover the purchase price of the share from the net profits (after tax) of the
company. The P/E converts profits and share prices of companies to a
comparable base. (Glynn, Accounting for Managers, P166)
Price/Earnings
Ratio =
|
Current Market
Price per share
|
Earnings Per
Share
|
Source
:(Pierson, Howard, P680)
EPS for Manu = Dividend / No of shares
=
1,400,000 / 4,000,000
=
$ 0.35
Current MP per share = $3.50
Therefore, P/E Ratio for Manu = 3.50 / 0.35 = 10
%
EPS for Europa = 500,000
2,160,000
= $0.231
Therefore, price per share for Europa = 0.231 ´ 10 = $ 2.31
Total amount to be paid
by Manu is 2.31 * 2,160,000 = $ 4989600
= $
5 Million
4.
Summary of calculations
Method
|
PE method
|
Dividend
valuation
|
Asset valuation
|
Price per share
|
USD 2.31
|
USD 1.95
|
USD 2.35
|
Value in million
|
USD
5.0
|
USD
4.2
|
USD
5.08
|
Table 1
Section 2 – Comment on the results of
the three different valuations
The three different methods of share valuation
produce three different results, as shown in Table 1 above. The asset based
valuation considered the market values where available and otherwise the book
values of the assets and liabilities to arrive at the value of the company. The
dividend valuation method and the P/E Ration method are on the other hand
income based and can be considered more reliable than the Asset valuation
method. Also, there could be an amount of goodwill depending on the credibility
of Europa Inc. which is not provided and hence is not included in Asset
valuation.
Also it is assumed that the cost of equity of
Europa will be 20% higher than that of Manu plc. This assumption is not
justified and the value of Europa Inc. could be higher or lower than estimated.
This creates a doubt on the accuracy of the Dividend Valuation Model as well.
In calculating the Earnings per share for Manu
and Europa we have considered the Profit available after Tax. However, Manu can
also choose to calculate EPS based on pre tax profits.
Section 3 – Assessing the reliability
of the three methods of share valuation
a.
Dividend Growth Model
This model is based on such features which
assumed that the dividend growth rate is constant at 10% for Europa Inc.
and 8% for Manu plc. However, this is not guaranteed and dividend growth rates
may differ from year to year.
This model required an enormous amount of
“speculation” in trying to forecast future dividends. Even when applied to
steady, reliable, dividend paying companies, plenty of assumptions about their
future still need to be made. It is also important to note here that Europa
Inc. still has a considerable amount saved as Retained Earnings which could be
used to pay more dividends(investopedia,2006).
The cost of equity of Europa Inc. is stated as
20% higher than that of Manu which is quite unrealistic considering the small
size and small asset base of Europa.
b.
Price/Earnings Ratio
The features of this model are This method can
be considered realistic as it relates the current earnings per share to the
current market price of the company , It is assumed that risk differences
between companies can be elicited from the discount rate ,Profit after tax is
sued to calculate the Earnings per Share for Europa Inc. However, it could also
be done using pre-tax profits. ,The P/E Ratio arrived at for Manu plc was 10
times and the same is applied for Europa, assuming they are in the same
industry with similar conditions. It is important to note here that from the
data given, Europa Inc seems to be much smaller company than Manu plc and hence
using the same P/E Ratio for Manu might not be appropriate, This method is
however, simple to compute for most stocks and is widely available, making
comparisons across stocks simple.
c.
Asset valuation method
The features of this method includes that
$200,000 worth of inventory is expected to yield only $20,000 , Only 20% of $
55,000 worth of debtors is expected to be good. The company does not explain
the reasons for thinking so , Land & Buildings are over valued at $2M
although the book value for these is only $1.2M. The market value is considered
for share valuation as this reflects the actual value of the asset rather than
historical cost portrayed in the books, Replacement cost is considered for
Plant & Machinery as opposed to Book value or market value as Europa Inc.
is expected to continue operating after take over by Manu plc, This method is
more useful when the buyer intends selling off the assets of the acquired
company. However, in the case of Europa Inc it is not clearly mentioned if this
is the intention of the new management. We go with the assumption that Europa
will continue to remain in business , This method also fails to consider an
amount for Goodwill which is an intangible asset. The credibility of the
company’s management or just the CEO could be one reason why the company is
worth some goodwill in the market and in the case of Europa Inc., this
possibility is ignored.
Conclusion
A model is only as good as the assumptions it
is based upon. Further more, the inputs that produce valuations are always
changing and are susceptible to error. The challenge is to make the selected
model as applicable to reality as possible, which means using the more reliable
assumptions possible. In reality, calculating the present value of future cash
flows is the ideal method of valuating a company. However, since necessary
information to calculate the same is not provided, the results of the three
valuation methods used should only be considered as rough estimates of share
valuation for Europa Inc.
PART B
Section A
Compro Inc. and Vendo Ltd., are considering a
merger which they believe will be mutually beneficial. However, for this new
ordinary shares will have to be issued in Compro Inc. in exchange for the
existing shares of Vendo Ltd , this part requires us to estimate the ratio in
which the new shares in Compro Inc. should be offered in exchange of the
existing shares in Vendo Ltd.
We have :
▫
Both Compro Inc. and Vendo Ltd. are fully leveraged
i.e. they are fully equity financed.
▫
The cost of equity for both the companies is 20%.
▫
The post tax savings as a result of the merger are
expected to be $ 40M in the first year, increasing by 10% annually thereafter
in perpetuity.
▫
Also, the proceeds from the sale of redundant assets
immediately after the merger are estimated to be $ 200M.
Calculations
Company
|
No. of shares in issue
(millions)
|
Current Share Price
|
Present value of the
company
|
Compro Inc.
|
600
|
$5.00
|
3 Billion
|
Vendo Ltd.
|
300
|
$ 4.00
|
1.2 Billion
|
Present value of a Perpetuity = Cash flows/
rate of return
= 40M
0.10
= $ 400 Million
Therefore, the total gain from this merger is
400M+ 200M (from sale of assets) = 600M
Situation in which all benefits of the merger
accrue to the pre-merger share holders of Compro Inc.
Total Value of Compro Inc. after the merger
will increase to 3.6 Billion
This means the value per share of Compro Inc.
= 3.6Billion ¸ 600M
shares = $ 6
Vendo Ltd’s capital ¸ Share
price of Compro Inc = the Number of shares of Vendo Ltd.
i.e, 1.2Billion ¸ $6 = 200M
The current no. of shares in Vendo Ltd. is
300M
Therefore, the ratio should be 200M/300M = 0.67
This means that the ratio of share offer
should be approximately 67:100 i.e., 66 shares of the merged company should be
offered for every 100 shares of Vendo Ltd.
Situation in which all benefits of the merger
accrue to the pre-merger share holders of Vendo Ltd.
Total Value of Vendo Ltd. after the merger
will increase to 1.8Billion
The existing value per share of Compro Inc. =
$5
Number of shares = 1.8Billion / $5 = $ 360
Million
Therefore, the ratio should be 360M/300M = 1.2
This means that the ratio of share offer
should be approximately 120:100 i.e., 120 shares of the merged company should
be offered for every 100 shares of Vendo Ltd.
Section B
Factors
that influence the level at which the directors of Compro Inc. pitch their bid
for Vendo Ltd., assuming they act solely in the interests of their
shareholders.
1. Objectives
of the company
If the
objective of the Compro Inc. is to expand its business over time and enter new
markets and industries, the Director’s of Compro Inc. might be acting in the
interests of their share holders by merging with Vendo Ltd. as this merger
would definitely expose them to newer markets and probably result in more
growth.
2. EPS
increase
if the merge & acquisitions that
offered for the two company produce grater outcome , this may higher the
income which result in EPS
3. Nature
of the business
If the
nature of business of Vendo Ltd. is the same as Compro Inc. a merger between
the two could create synergies which would be beneficial to both the companies.
Synergies could be in terms of availing economies of scale, access to a larger
supplier base, access to a larger customer market etc. This would also increase
profitability of Compro Inc. by a higher percentage than it would hope to
achieve on its own. A merger in such a case creates value of the share holders
of Compro Inc.
4. Product
Life Cycle
If
Compro Inc. is at present in the mature stage of its business where future
growth is not expected due to various reasons studied, diversification of its
business by joining hands with Vendo Ltd. could be beneficial for the share
holders of Compro Inc, especially if Vendo Ltd. is still in the growing stages
of its Product Life Cycle.
5. Unique
Assets
If
Compro Inc. and Vendo Ltd. are in the same line of business and if the
Director’s of Compro have perceived that Vendo Ltd. possesses a certain asset,
for example technology, personnel etc due to which it yields higher
profitability, it could merge with Vendo Ltd to have access to these assets.
However, it is important that this merger creates value for the share holders.
6-
Increasing Production efficiency and quality
when two companies merge they will
be able to share their knowledge , expertise and R&D in order to enhance
there final product ; which will allow them to control share price and setup
the market share
7. Tax benefits
A tax
incentive for the share holders of Compro Inc could be another reason why its
Directors would consider the merger with Vendo Ltd. The merger could result in
more capital gains for the existing shareholders of Compro Inc. and thereby
reduce the amount of tax payable by them on dividends received.
‘Commenting
on why 83% of mergers apparently fail to generate benefits for share holders,
it was suggested that many firms concentrate too heavily on the business and
financial mechanics and overlook the personnel- related issues’ (Pike &
Neale, 2003, p.779)
8. Sharing merger risk
when
Vendo receive their share in the
new company in which will result sharing
risk of the new merged company
9- Sharing complementary resources
Sharing complementary resources
means to gain access to complementary resources and capabilities, each company
could have unique resources that may benefit a lot the other firm in having a
more efficient production. (Brealey, 875)
Section C
1.
Role of diversification
Diversification is an important reason
companies choose to merge with another company as diversification usually means
growth and expansion for the company. Diversification could be of various
types:
a.
Product line diversification
b.
Geographical diversification
c.
Risk diversification
In Product line diversification, a company
merges with another company so that it can increase its product lines and can
benefit from an improved distribution system, take advantage of common markets
for the products, buy bargains and get more discounts etc. A company might
merge with another company also due to its geographical location. Companies
would diversify cross-border to access the most competitive and efficient
markets. The company could also be following a strategy for diversifying its
activities in an unrelated business to minimise its risk exposure. It could be
a planned merger to diversify its portfolio. The merger could facilitate the
consolidation of asset management and provide better means and reputation to
access to financial markets. Large companies are considered as less subject to
risk which may have a favourable impact on the cost of borrowing of the firm.
2.
The observation that shareholders of the acquirer
companies tend to lose as a result of takeovers
The shareholder’s of the acquirer company, in
this case, Compro Inc. are in a situation where the take over of Vendo Ltd. and
the resultant issuing of new shares could dilute their Earnings per Share and
thus reduce the amount of dividends they receive. It would increase the number
of share holders in the company and reduce the controlling powers of the
existing share holders. There is a risk that the share holders of Compro Inc.
will lose their ownership value.
3.
The implications for corporate governance
Corporate governance is concerned with the
resolution of collective action problems among dispersed investors and the
reconciliation of conflicts of interest between various corporate claimholders. (MARCO BECHT ,Corporate Governance and Control)
refers to the
institutional, policy and management framework of the company.
Cross-border mergers allow firms to alter the
level of protection they provide to their investors, because target firms
usually import the corporate governance system of the acquiring company. (ARTURO
BRIS , Evidence from Cross-Border Mergers)
In an event where there is a hostile bid from
another company for Vendo Ltd, and the offer made by Compo Inc. is friendly and
reasonable to Vendo Ltd., it could agree for the merger. Corporate governance
also includes the culture of the existing management and how compatible this
culture is with that of the merged company.
Most often Director’s are guilty of favouring a merger out of
self-interest and personal gains rather than on any substantial benefits to the
share holders.
References
- Myers, B., 2003, 7th Edition, Principles of Corporate Finance, McGraw Hill, United States. p. 80
- Peirson, G., Brown, R., Howard, P., 2003, Business Finance, 8th Edition, McGraw-Hill Australia, p.452-453, 459, 669- 670, 674- 675, 680-681,685
- Pike, Bill, 2003, 4th Edition, Corporate Finance and Investment, Prentice Hall, p. 777-779
- Corporate Governance Convergence by Contract: Evidence from Cross-Border Mergers, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=321101
- Corporate Governance and Control, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=343461
- Directors' Recommendations in Takeovers: An Agency and Governance Analysis
Darren Henry. Journal of Business Finance
& Accounting. Oxford: Jan-Mar 2005.Vol.32, Iss. 1/2;
pg. 129, 31 pgs
8. Richard A.
Brealey, Stewart Myers
, 2002 , Principles of Corporate Finance , McGraw (United States)
