FM – May 2020 – L2 – Q2 – Business valuations | Mergers and acquisitions

Value Staygood Ltd using the Price/Earnings ratio, Gordon growth model, and Discounted cash flow methods for a potential takeover by Restwell Ltd.

Question

Restwell Ltd (Restwell), a hotel and leisure company, is currently considering taking over a smaller private limited liability company, Staygood Ltd (Staygood). The board of Restwell is in the process of making a bid for Staygood but first needs to place a value on the company. Restwell has gathered the following data:

Restwell:

Weighted average cost of capital: 12%
P/E ratio: 12
Shareholders’ required rate of return: 15%

Staygood:

Current dividend payment (GH¢): 0.27
Past five years’ dividend payments (GH¢): 0.15, 0.17, 0.18, 0.21, 0.23
Current EPS: 0.37
Number of ordinary shares issued: 5 million

The required rate of return of the shareholders of Staygood is 20% higher than that of Restwell due to the higher level of risk associated with Staygood. Restwell estimates that cash flows at the end of the first year will be GH¢2.5 million and these will grow at an annual rate of 5%. Restwell also expects to raise GH¢5 million in two years’ time by selling off hotels of Staygood that are surplus to its needs.

Required:

Estimate values for Staygood using the following valuation methods:

i) Price/earnings ratio valuation. (6 marks)

ii) Gordon growth model. (8 marks)

iii) Discounted cash flow valuation. (6 marks)

Answer

i) Calculation of the value of Staygood using P/E ratios:

Staygood’s share price = 12 x 37p = GH¢4.44
(3 marks)
Note:
Any candidate who uses an adjusted P/E ratio in a 30% range should be given full credit.
We will assume that the market will expect Restwell to achieve a level of return on Staygood comparable to that which it makes on its own assets. Hence:
Total market value = 5m x GH¢4.44 = GH¢22.2m
(3 marks)

ii) To use the Gordon growth model we must find g and kₑ
Here g is given by:

Kₑ for Staygood is 20% higher than Restwell, therefore:
$K_{e} = 15% \times 1.20 = 18%$
Therefore:

Total market value = 5m x GH¢5.49 = GH¢27.46m