Financial management helps company to select profitable investment projects for the company (Madura, 2018), that will add value to the company and strengthen capital structure by choosing suitable funding source (Wikes,2018). The first section involve question number one, where behavior of dividend payment is discussed along with valuation system using dividend. We calculated share value of Planet using dividend and show the effect of changing capital structure also. In the second section we see the different tools for investment appraisal along with some calculation of a case in different method. Finally, we discuss the advantages and disadvantages of appraisal techniques in a nut shell.
There are various methods and theories to evaluate the value of a company’s share. Dividend discounting model is one of those popular models. Dividend discount model evaluate the price of a share by future expected payment of dividend irrespective of current price or market condition (Brigham, 2017). We simply can assume the reason behind this theory, but there may be some drawback of this methods. If a company generate enough dividend, we simply assume that it has capabilities to generate handsome amount of profit which can be distributed among shareholders. So, that dividend is only factor is being considered in dividend discounting model. Net present value of dividend is the determiner of the price of share. We will see various type of dividend model below.
Many companies doesn’t increase or decrease dividend over the year rather a certain amount of dividend is given with a certain time interval which called zero growth model. This type of model is popular among those who need to generate regular current income. Constant growth model: Some companies increase the amount of dividend at a constant rate over the year. The model is being used such cases it called constant growth model (Pfeiffer, 2014). A formula is being used to calculate the value of stock where we need amount of dividend, cost of capital and rate of growth of the dividend to calculate the value.
Some company doesn’t follow zero growth or constant growth policy to pay dividend rather they give dividend according to earnings of that period. Stick to a certain dividend policy is difficult as earning is not predictable and fluctuate regularly and company is not following certain policy for that reasons. The model used for valuing such stock is known as multiple growth model (Clark, 2015).
We can calculate the current share price of the Planet’s share using various models, dividend discounting model is one of them that can be used. The following information is given in the question:
Current dividend 20p
Last four years dividend 13p, 14p, 17p and 18p respectively.
So, the dividend growth rates are:
To calculate the value of the stock using the dividend discount model the following formula will be used:
D1: Expected dividend of the next year which is D0 (1+g) where k indicates for cost of capital and g stands for growth rate:-
Dividend management is not so rare in real world. Many companies manage their dividend policy in various ways. Even dividend management is not illegal in some extent. Companies use dividend equalization funds to backup their dividend policy. When they fall short on a period, they use the fund to recover it. Even a company can give dividend when its in a loss. So, when we will evaluate the company, we will still get higher value as the company made dividend from dividend equalization fund.
When company introduce bigger amount of debt in its capital structure the risk exposure of shareholders increases with the amount of debt. So, when shareholder will increase the required rate of return it will impact on share price of the company (Clark, 2015). As we know that fair value of share is function of dividend, cost of capital (which in turn we say rate of return for shareholders) and growth rate. Here rate of return placed in denominator so when the size of denominator increases the value of share will decrease. Here is the calculation of share price when planet will increase debt in its capital structure.
Here we find that value of planet’s share has decreased in comparison to previous calculation. We assume all other things were remaining constant which means only rate of return was increased but dividend and growth was constant. We find the denominator as a result of deduction of rate of return and growth rate. As the rate of return were increase the size of denominator become large and overall value of the company is decreased. So, the share price of a company will decrease when amount of debt increases.
Companies investment pattern vary due to the growth potential of the company. Mature companies have less investment opportunities than growth companies. Many companies finance their investment from internal sources rather other sorts of financing which may hinder them from giving dividend in a regular manner. As dividend growth model focus its evaluation on dividend growth, those investing companies will not reflect their value in dividend growth model. Growth companies creating real value by investing various projects but unable to pay dividend regularly that doesn’t mean that it has low potential rather sometimes it has more potential than the companies which are giving dividend in growth manner (Pfeiffer, 2014).
We need a growth rate to calculate the value of a share under growth model. There is a fundamental flaw in determining the growth rate. We get the growth rate by multiplying retention rate with return on equity. There is a strong debate on generating growth rate in such a way. Because there may happen many cases with retention amount. In worst-case scenario company may fail to invest in favorable projects. In the bad case scenario company is failed to generate current return of equity and in the best-case company is generating more than current rate of return. In all cases described above, the growth rate is not same with the rate we are using for estimating value. Getting precise growth rate is tough but it distorts the real value significantly which putting overvalue or undervalue of a share. So, should consider this factor when using growth model for stock evaluation.
The easiest techniques to investment appraisal is accounting rate of return as the data required for evaluation is readily available from accounting information system.
Finance managers can easily compare the accounting return with the cost of capital of the company.
Investment is an important issue for companies for growth and smooth operation (Pandey, 2005). Sometimes companies invest for continuing business and sometimes it invests for expanding the business. Both investments are crucial for a company. Companies look for various projects which have economic feasibility and multiple appraisal tools help managers to identify them. Projects have different return pattern and some are mutually exclusive, project appraisal tools help to determine the most favorable projects for the company. In the following section we will calculate the value of new machine of Lovewell Limited using multiple appraisal techniques:
Payback period is one of the most common appraisal techniques for investment of a company. The name of the tools indicate that it mostly concerns with the time a project takes to payback the invested amount. It calculates the amount of time is needed to recover invested amount of money in a project. The shorter the payback period is the better the project is as it can generate positive value for the projects afterwards. The value of the projects of Lovewell Limited is as follows using payback period techniques.
Initially we invested 275000 which is cash outflow for the company so we denoted it with a negative sign. We calculated net cash inflow for every year by deducting outflow from inflow which is positive for every year in 6 years. After installing the machine Lovewell Limited can generate 85000 cash sales which is cash inflow and 12500 cost which is outflow and net inflow remain 72500 for each year except the 6th year. The machine has 15% residual value of purchase price and included in 6th year which make the cash inflow for that year is highest.
This project takes 3.79 years to recover the invested 275000 amount and generating positive cashflow for the rest of the time of its operation period. Even the highest amount of cashflow is generated in 6th year is not included in recovery period, all of the cashflow after 3.79 year has a positive value to the company. Lovewell Limited should purchase the machine for its operation based on our calculation using payback period.
Accounting rate of return is another tool for appraising investment for the organization. Companies need to establish a standard upon which it takes decision to whether the company will take the project or reject it (Pandey, 2005). Accounting rate of return is being compared with that standard rate of return and decision is made over it. Most of the time cost of capital is the standard for comparison if any exception is not stated. We get accounting rate of return from average investment and average profit for the year. Average profit is calculated from the sum of total profit divided by number of years. Average investment is determined by dividing the sum of initial investment minus book value of end of the period by 2. Then annualized profit is divided by annualized investment to generate accounting rate of return for that period. If the accounting rate of return is positive after deducting from the standard rate or cost of capital, the company should take the project.
Most Popular appraisal technique is Net Present Value (NPV). Probably every organization use this tool for project evaluation. This is widely accepted for gauzing net value addition to the organization from a project or investment. We know the concept of time value of money which is perfectly reflected in net present value technique. The net present value technique calculates the net amount of value would be added after taking a project (Wikes,2018). This technique discount all the cash inflow so that we can get the present value of all those amounts and sum up all the cash inflow to get the present value of total investment. When we get positive value after deducting the invested amount from net present value, the project added value to the company. So, we should take the projects which have positive value. Even we can take projects where NPV is zero which indicates neither value will increase nor the value will decrease.
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