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FM – L2 – Q119 – Business valuations

Calculate offer price for SmallCorp using a forward P/E multiple of 8.0 based on expected earnings

Question

LargeCorp is considering a takeover bid for SmallCorp, another company in the same industry. SmallCorp is expected to have earnings next year of GH₵86,000. If LargeCorp acquires SmallCorp, the expected results from SmallCorp will be as follows:

	Year after the acquisition
	Year 1	Year 2	Year 3
Sales	GH₵200,000	GH₵280,000	GH₵320,000
Cash costs/expenses	120,000	160,000	180,000
Capital allowances	20,000	30,000	40,000
Interest charges	10,000	10,000	10,000
Cash flows to replace assets and finance growth	25,000	30,000	35,000

From Year 4 onwards, it is expected that the annual cash flows from SmallCorp will increase by 4% each year in perpetuity. Tax is payable at the rate of 30%, and the tax is paid in the same year as the profits to which the tax relates. If LargeCorp acquires SmallCorp, it estimates that its gearing after the acquisition will be 35% (measured as the value of its debt capital as a proportion of its total equity plus debt). Its cost of debt is 7.4% before tax. LargeCorp has an equity beta of 1.60. The risk-free rate of return is 6% and the return on the market portfolio is 11%.
Required:

(a) Suggest what the offer price for SmallCorp should be if LargeCorp chooses to value SmallCorp on a forward P/E multiple of 8.0 times.

(b) Calculate a cost of capital for LargeCorp.

Answer

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Tags: Acquisition, Business valuations, Cash Flows, DCF, Perpetuity, WACC
Level: Level 2

Topic: Business valuations

FM – L2 – Q69 – Discounted cash flow

Calculate NPV of replacing Product X with Product Y using DCF analysis, with given sales, costs, and 8% cost of capital.

Question

A well-established company in the region of the Volta River manufactures engines. One of its current products is Product X, for which sales will be 150,000 units in the year just ending (Year 1). However, after four more years, at the end of Year 5, Product X will no longer be permitted, when new government environmental regulations come into force. On or before that time, the company needs to introduce a new product to replace Product X.
A replacement product has already been developed. This is Product Y. A market research report has estimated that, if Product Y is introduced to the market now to replace Product X, annual sales of Product Y at a unit price of GH₵350 would be:

Annual sales (units)	Probability
100,000	0.2
80,000	0.5
50,000	0.3

The current selling price of Product X is GH₵250 per unit, and its variable cost of sales is GH₵180. There is no possibility of increasing the selling price.
The annual sales demand for Product X is expected to fall each year if it is kept on the market. The best estimate is that annual sales in Year 2 will be 10,000 units less than in Year 1, with a further fall in sales by 10,000 units each year until Year 5.
To prepare a production facility for manufacturing Product Y instead of Product X, an initial capital outlay of GH₵2,000,000 would be required. Annual fixed costs would increase by GH₵160,000. The variable cost of making and selling Product Y would be GH₵230 per unit.
The company’s cost of capital is 8%. Ignore inflation and taxation.

Required:
(a) Using DCF analysis, calculate the NPV of a proposal to replace Product X with Product Y from Year 2 onwards.

(b) Estimate the minimum annual sales for Product Y that would be required to justify the immediate replacement of Product X with Product Y. Assume that the estimates of annual sales of Product X are correct.

(c) Calculate the minimum reduction in the annual sales of Product X, in Year 2 and in each subsequent year that would be necessary before you recommended the immediate replacement of Product X with Product Y. Assume that the estimates of annual sales of Product Y are correct.

(d) List briefly the weaknesses or limitations in the financial analysis in part (a) to (c) above.

Answer

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Tags: DCF, Financial analysis, Limitations, NPV, product replacement
Level: Level 2

Topic: Discounted cash flow

FM – L2 – Q63 – DCF: Risk and uncertainty

Calculate NPV for two machines under different sales demand levels for Kofi Enterprises Ltd.

Question

Kofi Enterprises Ltd must purchase a new machine for making a new product. There is a choice between two machines, Machine A and Machine B. Each machine has an estimated life of three years with no expected scrap value.
Machine A costs N₦15,000 and Machine B costs N₦20,000.
The variable costs of manufacture would be N₦1 per unit if Machine A is used and N₦0.50 per unit if Machine B is used. The product will sell for N₦4 per unit.
The demand for the product is uncertain. Following some market research, the following estimates of annual sales demand have been made:

Annual demand (Units)	Probability
2,000	0.2
3,000	0.6
5,000	0.2

The sales demand in each year will be the same. For example, if the demand is 2,000 units in Year 1, it will be 2,000 units for every year of the project.
Taxation and fixed costs will be unaffected by any decision made.
Kofi Enterprises Ltd’s cost of capital is 6%.

Required:
(a) Calculate the NPV for each of investment options, Machine A and Machine B, for each of the possible levels of sales demand.

(b) Calculate the expected NPV for each of the investment options.

(i) Calculate the probability that the NPV of the project will be negative.

(ii) Calculate the minimum annual sales required for the NPV of the project to be positive.

Answer

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Tags: break-even analysis, DCF, investment appraisal, NPV, Probability, Sensitivity Analysis
Level: Level 2

Topic: DCF: Risk and uncertainty

Tag (SQ): DCF

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FM – L2 – Q119 – Business valuations

Calculate offer price for SmallCorp using a forward P/E multiple of 8.0 based on expected earnings

FM – L2 – Q69 – Discounted cash flow

Calculate NPV of replacing Product X with Product Y using DCF analysis, with given sales, costs, and 8% cost of capital.

FM – L2 – Q63 – DCF: Risk and uncertainty

Calculate NPV for two machines under different sales demand levels for Kofi Enterprises Ltd.

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FM – L2 – Q119 – Business valuations

Calculate offer price for SmallCorp using a forward P/E multiple of 8.0 based on expected earnings

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FM – L2 – Q69 – Discounted cash flow

Calculate NPV of replacing Product X with Product Y using DCF analysis, with given sales, costs, and 8% cost of capital.

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FM – L2 – Q63 – DCF: Risk and uncertainty

Calculate NPV for two machines under different sales demand levels for Kofi Enterprises Ltd.

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