Business valuations, plans, dividends and growth

Question 1

What are the 4 methods of divestment?

Answer 1

• management buy-out
• management buy-in
• spin off (de merger)
• Trade sale

Question 2

What is management buy-out?

Answer 2

• existing management purchase either the trade and assets or the shares of the company
• funded by mixture of debt and equity
• equity from managers
• mixture of debt and equity from VCs
• debt from other financiers

Question 3

What is management buy-in?

Answer 3

• external management team purchase

- same as buy-out

Question 4

What is a spin off?

Answer 4

• shares of company ‘given’ to shareholders of parent
• group of companies split into separate entities, no cash changes hands
• used to avoid the conglomerate discount
• sometimes used as a defence against takeover of entire business

Question 5

What is a trade sale?

Answer 5

Standard sale of a sub to another company

Question 6

Why would a company choose to adopt a high dividend policy?

Answer 6

• due to the existence of limited investment opportunities
• traditionally marks strong CFs made by business
• signals confidence, raises stock market rating
• ‘bird in the hand theory’ - market values more highly a firm that pays dividends and issues shares to finance new investment rather than retention
• manager discipline - would need to seek out investment from the market for new investment, thus having to justify to potential investors rather than using internal funds

Question 7

What is the traditional viewpoint on dividends?

Answer 7

• constant stream is important
• cutting dividends may reduce shareholder wealth
• shareholders may prefer the certainty of a cash dividend now rather than the promise of higher dividends in the future

Question 8

What is MM;s dividend irrelevance hypothesis?

Answer 8

• pattern of dividends does not affect shareholder wealth
• as long as directors focus on investing in projects with a positive NPV, the increased dividend in the future will compensate for the cut now
• if shareholders need money, the can manufacture dividends by selling a few shares

Question 9

What are the assumptions of the MM hypothesis / real world problems?

Answer 9

• shareholders have perfect information, i.e. the dividend does not change their view on the company
• investors are indifferent between dividends and capital growth and if investors really needed money they would just sell shares. In practice, tax and transaction costs mean this is not the case
• company must have enough distributable profits to pay dividends

Question 10

What are the risks of changing dividend policy?

Answer 10

• investors favour dividends for tax, cash flow and other reasons. Change could cause disposal of shares and therefore drop in share price
• dividends resolve uncertainty and investors are traditionally not rational and prefer bigger dividends now
• dividends are a signal of the company’s performance in the absence of perfect information
• changes may adversely affect the shareholder (tax) and the company (share price)

Question 11

What is a scrip dividend?

Answer 11

• shareholders have a choice of taking dividend as shares
• not the same as a bonus issue
• shareholder can increase shareholding without broker fees or stamp duty
• company does not need to find the cash to pay, save tax

Question 12

Key considerations for dividend policy?

Answer 12

• dividend signalling
• preference for current income
• clientele effect
• cash

Question 13

How should companies address the issue of differing shareholder preferences on dividend policy?

Answer 13

• company must remain aware of the mix of shareholders they have
• make clear to shareholders what the dividend policy is and the effect of any changes being made

Question 14

Describe the relationship between dividend policy and the ‘agency problem’?

Answer 14

• managers and directors are not always acting in the best interests of the shareholders (although they should be)
• high dividend pay outs would leave less surplus cash for management to use. This means they would need to raise funds and therefore justify the projects they are looking to invest in

Question 15

What are the issues with the asset based valuation approach?

Answer 15

• does not include intangibles not on the balance sheet

- future earnings potential is ignored

Question 16

What are the issues with the dividend based valuation approach?

Answer 16

• estimating future dividends
• finding similar listed companies
• uncertainty in the discount applied for unmarketability if company is private
• simple method ignores dividend growth

Question 17

What are the issues with the earnings based valuation approach?

Answer 17

• erratic earnings may give misleading figure
• earnings can be manipulated
• PE EBITDA coming from similar listed company
• based on historic EPS
• difficult to estimate profit going forward

Question 18

What is SVA?

Answer 18

Concentrates on a company’s ability to generate value and thereby increase shareholder wealth. SVA is based on the premise that the value of a business is equal to
the sum of the present values of all of its activities.

Question 19

How is the value of the business calculated using SVA?

Answer 19

The value of the business is calculated from the cash flows generated by drivers 1-6 which are then discounted at the company’s cost of capital (driver 7). SVA links a business’ value to its strategy (via the value drivers).

Question 20

What are the 7 value drivers for SVA?

Answer 20

(1) Life of projected cash flows
(2) Sales growth rate
(3) Operating profit margin
(4) Corporate tax rate
(5) Investment in non-current assets
(6) Investment in working capital
(7) Cost of capital

Question 21

Problems with SVA (residual value)?

Answer 21

Company projections tend to show cash flows growing steadily upwards into an indefinite future. In the real world, economies falter, competition increases and margins decline.

The majority of a DCF value estimate comes from the ‘residual value’, the worth of the company at the end of the projection period. That, naturally, depends heavily on the cash flows estimate in the final year modelled – a result, logically, of the trend in the early years.

Question 22

Factors to consider with a rights issue

Answer 22

 Issue costs – these are high compared for equity with debt.
 Shareholder reactions – they may react badly if the firm regularly makes rights issues. They may sell their shares as a result, which will adversely affect the share price.
 Control – should not be affected by a rights issue unless a considerable number of existing shareholders sell their rights.
 Unlisted companies – shareholders may not be able to sell their rights (if unlisted) and so a rights issue would not be practical.

Question 23

Traditional view on gearing

Answer 23

• Low levels - risk relatively unchanged

High levels

• increased volatility of equity returns as debt paid first
• bankruptcy risk
• Ke, Kd and therefore WACC rises

Question 24

M&M no tax theory

Answer 24

• gearing and Ke increase proportionally
• increase in Ke offsets benefit of cheaper debt finance
• WACC remain unchanged

Question 25

Assumptions of M&M no tax theory

Answer 25

Perfect capital market
 no transaction costs
 no individual dominates the market
 full information efficiency
 all investors are rational and risk averse
 no tax

Question 26

M&M with tax

Answer 26

 debt interest is tax deductible so the kd is lower than before
 The increase in ke does not offset the benefit of the cheaper debt finance
 therefore the WACC falls as gearing increases.

Question 27

What is convertible loan stock?

Answer 27

Fixed return securities which may at the discretion of the holder be converted into ordinary shares of the same company.

Question 28

What are loan stocks with warrants?

Answer 28

Loan stocks which give the holder the right to subscribe at a fixed future date for ordinary shares at a predetermined price. Debt is not converted, but remains as such.

Question 29

Advantage of SVA

Answer 29

Values free cash flows of company, not distorted by accounting policies

Question 30

Advantage of P/E valuation

Answer 30

• Market measure valuing shares in comparison to other company takeovers
• looks at potential earnings and growth value of company

Question 31

How do you calculate the valuation of company using the EBITDA method?

Answer 31

(EBITDA x EBITDA multiple) - MV of debt + cash

Question 32

How do you do the dividend approach?

Answer 32

Dividend / yield

Question 33

Method for present value of cash flow valuation

Answer 33

• do an NPV using the cash flows provided
• add on any potential sell on value (make sure you discount)
• add together and divide by # of shares

Question 34

Disadvantages of discounted cash flow

Answer 34

Best method, however:

• estimating cash flows not easy - synergy benefits from two businesses
• acceptable discount rate
• time period of calculation

Question 35

Different methods of being remunerated for shareholding

Answer 35

Cash
Share-for-share
Loan stock-for-share

Question 36

Merits and issues of cash remuneration for shareholding

Answer 36

• certain amount

- tax

Question 37

Merits and issues of S-F-S remuneration for shareholding

Answer 37

• no tax issues
• uncertain amount received
• dealing costs

Question 38

Merits and issues of LS-F-S remuneration for shareholding

Answer 38

• more assured return than shares

- shareholders may prefer equity

Question 39

Advantages of asset based valuations

Answer 39

• minimum valuation, very little risk of over valuation
• good starting point as figures are easily available
• revalued version takes into account latest cost

Question 40

Advantages of dividend yield approach?

Answer 40

Good for a minority shareholding