Question

Potter plc (Potter) is preparing to make a bid to buy a rival unlisted company, Weasley Ltd ( Weasley), which operates in the same business sector. Relevant financial information for both companies is as follows: Potter Weasley PIC £m 46 Ordinary share capital (nominal value £1) 7% bonds, redeemable at par in four years' time Potter has an equity beta of 1.2. The risk-free rate of return is 2.5% and the average return on the market is 7.5%. The 7% bonds are trading at £94 per £100 ex-interest. The ex-diy share price of Potter is £2.75 per share and its P/E ratio is 7. Potter believes that its P/E ratio will remain unchanged following the acquisition. The current earnings per share of Weasley is £2.30 and the company maintains a dividend pay-out ratio of 30% every year. Its earnings and hence dividends have grown at an average rate of 3.5% per annum in recent years. Weasley has a cost of equity of 9%) Corporation tax is payable at a rate of 20%. Required WACC (a) Calculate the weighted average cost of capital of Potter Plc. (13 marks) (b) Calculate the value of Weasley Ltd using the following valuation methods: (0) P/E ratio method (ii) Dividend growth model. (6 marks) (c) Discuss the validity of the assumptions that underlie the valuation methods used part (b) and the suitability of using each method to value the company's shared (6 marks) (Total 25 marks)

Answer 1

WACC Cost of debt * Weight of debt* (1-tax rate) + Cost of equity * Weight of equity Cost of debt 7% Market value of debt 94/100 *13,000,000 = 12,220,000 Tax rate 20% Cost of equity risk free rate + Beta *(market return-risk free rate) 2.5+1.2*(7.5-2.5) 8.50% Market value of equity 46000000*2.75 126,500,000.00 Total capital 138,720,000.00 Weight of debt 12220000/138720000 0.0881 Weight of equity 126500000/138720000 0.9119 WACC 7*0.0881*(1-0.2) + 8.5*0.9119 8.24 %

value of stock according to PE ratio method Since weasley operates in the same sector so its PE ratio should be similar to potter P/E ratio Earning per share 2.3 Price 2.3*7 16.1 price of stock according to dividend method Earnings * Payout ratio* (1+ growth rate)/(cost of equity - growth rate) (2.3*0.3*1.035)/(0.09-0.035) 12.98

C) The price to earning ratio is calculated by dividing the price per share by earning per share. The basic assumption behind using price to earning ratio to value a company share is that the two companies' business model are same and they are comparable with each other. Price to earning ratio is used in relative method of valuation. If the two business being compared are not in the same business or their business segment is very different then price to earning ratio might not be suitable. The basic assumption behind using a dividend valuation model is that the company pays dividend and its dividend payment is predictable and also its growth rate is less than the cost of equity. This method will not be suitable to value companies which are not paying dividend.