### 1.

**Role of Investment Ratios in Business Valuation**

Investment ratios play a vital role in business valuation as they provide a quantitative basis
for evaluating a company’s financial health, profitability, and potential for future growth.
They help investors and analysts assess the company’s ability to generate returns, manage
risks, and sustain operations over the long term. Key functions include:

- **Comparison**: Ratios allow for comparison between companies within the same
industry or sector to identify relative strengths and weaknesses.
- **Trend Analysis**: They help in evaluating historical performance trends, which can
guide future expectations.
- **Decision-Making**: Investment ratios assist in making informed decisions regarding
buying, holding, or selling investments.

By analyzing these ratios, investors can determine whether a business is overvalued,

undervalued, or fairly priced.

---

### 2. **Valuation Methods to Determine Investment Value**

#### **Dividend Ratios**

Dividend ratios measure the relationship between a company’s dividends and other
financial metrics, indicating its dividend policy and its ability to return value to shareholders.

Key ratios include:

- **Dividend Yield**:
\[
\text{Dividend Yield} = \frac{\text{Annual Dividend per Share}}{\text{Market Price per
Share}}
\]
This ratio shows the return an investor can expect from dividends relative to the stock
price.
- **Dividend Payout Ratio**:
{Dividend Payout Ratio} = {Total Dividends}}{{Net Income}}
\]
It highlights what portion of earnings is distributed as dividends, providing insights into
earnings retention for growth versus returns to shareholders.

#### **Earnings Per Share (EPS)**

EPS reflects the profitability of a company on a per-share basis. It is calculated as:

{EPS} = {Net Income - Preferred Dividends}}{\text{Weighted Average Shares Outstanding}}

\]
A higher EPS indicates better profitability and earnings available to equity shareholders,
making it a key measure of financial health and a critical input in other valuation models.
#### **Price-Earnings (P/E) Ratio**
The P/E ratio compares a company’s stock price to its EPS:
\[
\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{EPS}}
\]
It reflects investor expectations for future growth. A higher P/E may indicate growth
prospects but could also signal overvaluation, while a lower P/E might point to
undervaluation or slower growth expectations.

#### **Investment Value Ratios**

These ratios measure the attractiveness of an investment based on profitability, returns,
and efficiency. Examples include:
- **Return on Investment (ROI)**:
\[
\text{ROI} = \frac{\text{Net Return on Investment}}{\text{Cost of Investment}}
\]
It evaluates the profitability of investments relative to their costs.
- **Net Present Value (NPV)** and **Internal Rate of Return (IRR)**:
These discounted cash flow measures are used to assess the intrinsic value of investments
and compare them against benchmarks or alternative opportunities.

---

### 3. **Free Cash Flows in Shareholder Value Analysis**

#### **Definition of Free Cash Flow (FCF)**

Free Cash Flow represents the cash a company generates after accounting for operating
expenses and capital expenditures, indicating its ability to generate surplus funds for
distribution to shareholders or reinvestment. It is calculated as:
{FCF} = {Operating Cash Flow} - {Capital Expenditures}

#### **Application in Shareholder Value Analysis**

1. **Valuation Basis**: FCF is a cornerstone of the **Discounted Cash Flow (DCF)**
valuation model, where the present value of projected FCFs is used to estimate the intrinsic
value of a company.
2. **Measure of Financial Health**: Positive and growing FCF signals a company’s capacity
to generate wealth, reduce debt, pay dividends, and repurchase shares, directly contributing
to shareholder value.
3. **Performance Indicator**: FCF reflects operational efficiency and prudent capital
management, ensuring returns exceed the cost of capital.
4. **Strategic Decision-Making**: Companies with strong FCF are more flexible in pursuing
growth opportunities, acquisitions, and strategic investments, boosting long-term
shareholder returns.

#### **Conclusion**
By focusing on FCF, analysts and investors can gauge a company’s ability to create and
sustain value, aligning corporate strategy with shareholder interests.
### 4. **Project or Investment Appraisal**
**Project or Investment Appraisal** refers to the systematic evaluation of a proposed
project or investment to determine its feasibility, profitability, and potential contribution to
the organization's goals. It helps decision-makers allocate resources efficiently and minimize
risks. Techniques like Net Present Value (NPV), Internal Rate of Return (IRR), and Payback
Period are used to assess investment opportunities.

#### **Key Factors to Consider in Project/Investment Appraisal**:

1. **Financial Metrics**:
- **Profitability**: NPV, IRR, and Payback Period.
- **Cash Flow**: Sufficient positive cash flows to cover costs and ensure liquidity.
- **Risk and Return**: Balancing potential returns against the associated risks.
2. **Cost of Capital**: The cost of funding the project, including interest rates and equity
costs, must be factored into the appraisal to ensure returns exceed the cost of capital.
3. **Market Conditions**: External factors such as demand, competition, inflation, and
economic stability.
4. **Strategic Alignment**: The investment should align with the company’s strategic
objectives and growth plans.
5. **Regulatory and Environmental Factors**: Compliance with laws, regulations, and
environmental sustainability considerations.
6. **Operational Feasibility**: Assessing whether the company has the technical, human,
and operational capacity to execute the project.
7. **Time Horizon**: The expected timeline for returns and project completion, with
consideration for long-term versus short-term gains.
8. **Alternative Opportunities**: The opportunity cost of choosing one project over others.

---

### 5. **Capital Rationing Strategies and Prioritizing Limited Funds**

Capital rationing occurs when a firm has limited financial resources and must choose
between competing projects. The goal is to maximize returns or value creation within the
constraint of available funds.

#### **Steps in Capital Rationing**:

1. **Identify Projects**: Develop a list of potential investment opportunities.
2. **Estimate Cash Flows and Returns**: Use tools like NPV, IRR, or profitability index to
assess each project.
3. **Rank Projects**: Prioritize projects based on their profitability, strategic importance,
and feasibility.
4. **Allocate Capital**: Assign available funds to the highest-ranking projects.

#### **Strategies Used in Capital Rationing**:

1. **Profitability Index (PI)**:
- A measure of the value created per unit of investment:
\[
 \text{PI} = \frac{\text{NPV}}{\text{Initial Investment}}
\]
- Projects with higher PI values are prioritized.

2. **NPV Maximization**:
- Allocate resources to projects with the highest NPV first until the budget is exhausted.

3. **Linear Programming**:
- Optimization techniques are used when projects have interdependencies or complex
constraints to find the best mix of investments.

4. **Divide-and-Conquer Approach**:
- Break large projects into smaller components to identify feasible portions that align with
budget constraints.

#### **Challenges in Capital Rationing**:

- **Opportunity Costs**: Foregoing potentially profitable projects due to resource
limitations.
- **Uncertainty**: Market volatility and unforeseen circumstances can impact returns.
- **Stakeholder Priorities**: Balancing profitability with corporate social responsibility or
shareholder preferences.

#### **Example of Capital Rationing Application**:

If a company has $1 million to invest and faces three projects with the following details:

| Project | Investment Required | NPV | Profitability Index (PI) |

|---------|----------------------|-----|--------------------------|
|A | $500,000 | $150,000 | 1.3 |
|B | $400,000 | $120,000 | 1.4 |
|C | $600,000 | $180,000 | 1.3 |

- The company might select **Project B** first (highest PI) and then allocate remaining
funds to **Project A** to maximize returns within budget.

By effectively applying capital rationing strategies, firms ensure that their limited funds are
deployed on projects that yield the highest value and align with their strategic goals.
Ratios:
Profitability:
Return on Capital Employed = operating profit/capital employed1 x 100
Gross profit margin = gross profit/sales x 100
Net Profit Margin = operating profit/sales x 100
Sales to Capital Employed= sales/capital employed1

Liquidity and solvency:

Current Ratio = current assets/current liabilities: 1
Acid Test = current assets – closing stock /current liabilities: 1

Efficiency:
Creditor days = Creditors/cost of goods sold x 365
Debtor days = Debtors/sales x 365
Stock turnover = closing stock2/cost of goods sold x 365

Investment:
Gearing = Debt3/capital employed1 x 100
Interest cover = EBIT/interest payments