FINANCIAL INFORMATION SYSTEMS

Table of Contents

Question A 3

Question B 4

Question C 8

Question D 12

REFERENCES AND BIBLIOGRAPHY 16

Question A

Using SVA, calculate the estimated current share price of Clarke PLC on a spreadsheet

There are different approaches that can be used in the valuation of companies. One of these approaches is shareholder value added analysis, which utilises a value-based approach instead of the use of accounting figures to provide a value for a company (Berk & DeMarzo, 2013). There has been increasing focus on the use of shareholder value to determine the 'value' of companies and assets thereby minimising the reliance on accounting figures which do not provide as much information as to the value of companies given the static nature of accounting figures (Fiordelisi & Monferr, 2009).

The current share price of GM Foods based on the Shareholder Value Analysis approach is 0.493 per share (see spreadsheet for Question A). This provides a total value of the company of 493 million given that the firm has 1 million shares outstanding. For Sanmonto Chemicals PLC, the value resulting from the Shareholder Value Analysis is a data point in its potential negotiations with GM Foods. This will need to be triangulated with other valuation metrics that exist for GM Foods. The comparison of the result of this valuation can be compared with the current share price of the company, and the value based on other valuation methods such as industry price multiples and purchases made from recent acquisitions in the industry that can be considered as comparable to the target acquisition (Brealey, 2011).

The share price value of 0.493 per share for GM Foods is based on the assumptions made by Sanmonto as to the growth of the business including the changes in the financial ratios of GM Foods. The Shareholder Value Analysis is impacted by the forecasts made for annual sales growth, operating profit margins, incremental fixed investments, and changes in the working capital of the firm. Similarly, other variables that impact the valuation of the firm include the assumptions for cost of capital calculations such as the target capital structure. Other metrics also have an impact on the valuation but these other metrics are based on current levels or actual figures such as the corporate tax rates, the risk-free rate and the estimated beta of the company being valued. It is possible to change these assumptions also based on the view of the company, Sanmonto, of the figures that will be applicable in the future. For example, the beta of the company could be different if Sanmonto believed that the future volatility of the company would be different from the current volatility experienced by the company with the basis of the beta likely to be from previous historical volatility versus the market benchmarks.

The current share price of Clarke PLC based on the Shareholder Value Analysis approach is 0.493 per share (see spreadsheet for Question A).

Question B

From the following mutually exclusive scenarios using a spreadsheet, measure and comment upon each one's sensitivity to the share price.

' Sales growth rate

' Corporation tax rate changes

' Profit margin remains the same

The sensitivity analysis is presented in figure 1. The use of sensitivity analysis is a continuation of the analysis of SVA. The sensitivity analysis allows for measuring and ranking value drivers of the SVA based on the influence of each of the measures. This is achieved by changing the values of the measures and determining the changes in the dependent variable, which is the share price in this analysis. The independent variables tested are sales growth, corporation tax rate, and profit margin. Each of these independent variables is discussed further.

Figure 1: Sensitivity of Share Price (s) to Sales Growth Rate (g), Corporation Tax Rate (T) and Operating Profit Margin (m)

Sales Growth Rate (g)

Corporate Tax rate (T)

Operating Profit Margin (m)

Share price

(s)

Percentage Change (%) in (s)

Initial Case

4%

30%

7% increasing 2% every year

0.491

0%

Change (g) & (T)

3%

5%

7%

8%

10%

28%

31%

33%

35%

25%

No Change

No change

No Change

No Change

9% for 5years

0.4734

0.5247

0.5893

0.6077

0.2451

-4.01%

6.40%

19.5%

23.23%

-50.30%

Initial Case only (g) varied

3%

5%

7%

10%

30%

30%

30%

30%

No Change

No Change

No Change

No Change

0.4507

0.5372

0.6305

0.7836

-8.61%

8.94%

27.84%

58.89%

Back to initial case only (T) varied

4%

4%

4%

4%

25%

28%

31%

35%

No Change

No Change

No Change

No Change

0.5520

0.5169

0.4812

0.4328

11.94%

4.81%

-2.42%

-12.23%

Back to initial case only (m) is 9% for all the years

4%

30%

9%

0.0511

-89.62%

Sales growth rate increases to 5%

Sales growth rate is a key drive as 1% change in sales growth impacts the share price by 8.94% (see figure 2). Sales growth rate is important and impacts the performance and profitability of a company. Improvements in sales growth can lead to increases in dividends for shareholders and also increases in share price. Sales growth rate has greater impact on the share price than changes in corporation tax rates.

Figure 2: Sensitivity of Share Price (s) to Sales Growth Rate (g)

Initial Case

Only (g) varied

3%

4%

5%

7%

10%

30%

30%

30%

30%

30%

No Change

7%

No Change

No Change

No Change

0.4507

0.491

0.5372

0.6305

0.7836

-8.61%

0%

8.94%

27.84%

58.89%

Corporation tax rate changes increases to 31% and falls to 25%

Corporation tax impacts share price as part of the profits generated by companies are taxed at specific rates that contribute to government revenues. Lower corporation taxes leads to increased profits for the company to retain and therefore impacts share price positively. Similarly, an increase in tax rates lowers the profits retained by companies and leads to lower share price for companies. The sensitivity analysis in figure 1 shows that a 1% increase in the tax rate has an impact of 2.4% decrease in the share price. A reduction of the corporation tax rate to 25% increases the share price by 11.94% (see figure 3). The results indicate the impact of corporation tax rates on share prices.

Figure 3: Sensitivity of Share Price (s) to Corporation Tax Rate (T)

Back to initial case only (T) varied

4%

4%

4%

4%

4%

25%

28%

30%

31%

35%

No Change

No Change

7%

No Change

No Change

0.5520

0.5169

0.491

0.4812

0.4328

11.94%

4.81%

0%

-2.42%

-12.23%

Profit margin remains at 9% for the 5 years

As a measure, operating profit represents the ratio of the operating profit of the company versus the revenues. The sensitivity analysis in this scenario is that the profit margin remains the same. Based on this assumption while keeping other metrics similar such as the corporation tax rate and the sales growth, the share price decreases by -89.62%. This shows the significant impact that changes in the profit margin can have on the share price. The lack of growth in the profit margin brings about considerable reduction in value of the company. An alternative scenario were corporation tax is decreased to 25% with sales growth rate at 10% while profit margin is at 9% leads to a share price that is lowest by -50.30% (see figure 2). The results show the large impact of profit margins on the share price with profit margin as the most influential driver among the three metrics considered in this analysis.

Figure 4: Sensitivity of Share Price (s) to Sales Growth Rate (g) and Corporation Tax Rate

Change (g) & (T)

3%

5%

7%

8%

10%

28%

31%

33%

35%

25%

No Change

No change

No Change

No Change

9% for 5years

0.4734

0.5247

0.5893

0.6077

0.2451

-4.01%

6.40%

19.5%

23.23%

-50.30%

Back to initial case only (m) is 9% for all the years

4%

30%

9%

0.0511

-89.62%

Summary

Each of the scenarios presented in this question showed that the share price is impacted and has sensitivity to the metrics, which are adjusted. The scenarios discussed above showed that the share price is impacted with different assumptions included. While the assumption made for the sales growth rate, the assumption could be made differently and have a different trajectory which would result in a decrease in the share price of GM Foods.

It is also possible that the sensitivities of the share price are not only impacted by one variable at a time. In most cases, a number of variables would have an impact on the share price at the same time and not in a mutually exclusive manner as the scenarios above. In this case, the impact on the share price could be considerable. The sensitivity of the three variables when combined in one form or another is presented in figure 1. The initial base or the base case is also included for comparison of the results of the other scenarios where sensitivity to the variables is estimated.

Question C

It has been argued that SVA is flawed in that there are too many steps in the model and too many variables attached to them. Analyse this statement and in doing so evaluate the need for each step in the model.

Shareholder Value Analysis (SVA) is an approach that is commonly utilised in investment appraisal and in valuation exercises. The SVA relies on net present value methods in the conduct of the analysis in order to result in the assessment of investments and asset valuation. In SVA, the cash flows projected for the analysis are discounted to the present value and then compared with investment values for the analysis. For company valuations, the net present value is then divided by the number of shares in the company to get a per share value. The SVA technique was initially developed by Alpha Rapaport (1998). A key assumption in the use of the SVA is the existence of efficient markets where the market reflects all the available information immediately made public (Maditinos, Sevic et al. 2007)

There are different value drivers that impact the SVA analysis given the input requirements to the model of SVA for company valuations. These drivers are focused on by SVA given that these are the drivers considered to have the largest impact on the value of the company. These drivers include the following:

' Sales growth

' Operating profit margin

' Corporate tax rate (assumed to be the cash tax rate)

' Fixed assets

' Working capital

' Weighted average cost of capital

' Growth duration period (length of the planning horizon)

The value drivers all have an impact on the results of the SVA and therefore impact the value of the company analysed. As seen in the previous question, the value drivers can be changed incrementally to determine the sensitivity of the share price to changes to the value drivers. In the maximisation of shareholder value, the value drivers can be broken down into their elements in order for companies to identify aspects of the value drivers that can be managed.

The free cash flows in the SVA are calculated using the value drivers with the resulting cash flows discounted to the current period. This is then adjusted based on the investments made throughout the project, which are also discounted. The net present value provides the value of the company at the current period. The advantage of the SVA is that it enables managers to focus on the key activities that can truly have an impact on the value of companies. For example, these activities, which can drive the value of companies, include acquisitions and divestments, changes to capital structure, decisions on dividends, implementation of performance measures across the company, and compensation and rewards to the staff.

The approach to calculating the shareholder value using the SVA is as follows:

' Calculate business value by taking the present values of the cash flows during the planning period

' Add the marketable securities to obtain the corporate value

' Deduct the market value of external debts to obtain the shareholder value

' Divide the shareholder value by the total number of issued ordinary shares to get the estimated shareholder value per share

An advantage of the use of SVA over the use of accounting figures for valuation is that the SVA focuses on the profitability of the firm which incorporating the risk, cost of capital, and fixed and working capital requirements in the analysis. The key disadvantages of the use of the SVA are that the value drivers are also based on accounting figures and some analysts also overvalue companies. These disadvantages are discussed below.

' Reliance on accounting measures. The SVA tries to move away from extensive use of accounting in the analysis. However, the steps still require the use of accounting figures in the analysis, which then does not fully take away the use of accounting from the process. The accounting information is relied on when the historical figures are considered in order to assess the relevance of the assumptions made on the value drivers.

' Overvaluation of Analysts. There have been reports and recent studies indicating the analysts have been overvaluing companies with high estimates of sales growth and profit margins. These have significant impact on SVA as sales growth and profit margins are two of the key value drivers for SVA valuation.

Steps involved in SVA and its importance

1. Calculate Weighted Average Cost of Capital

The weighted average cost of capital is important for SVA, as this is needed in the discounting of the cash flows for the SVA. This is also the case for the terminal value calculation, which is needed, in the residual value. The WACC also incorporates the capital structure expected for the company. The calculation of WACC is as follows:

' Identify cost of debt and cost of equity

' Determine target percentage of debt and equity in the capital structure

' Identify the relative weighing of cost of equity and cost of debt by the relative proportion of debt and equity versus the overall capital structure

2. Calculate After Tax Cash Inflow

The cash flows should be calculated after taxes. This is calculated as follows:

After tax cash inflows = Increased sales * operating margin * (1 - tax rate)

3. Calculate Incremental Investment Needs

The incremental investment needs are needed in order to capture the growth of the business. These are needed for the resources of the company to fund the growth. This would be in addition to the regular capital expenditures that are already part of the company's forecasts. The calculation for incremental investments is presented below:

Incremental investment = Capital expenditure - Depreciation expense

4. Calculate Cumulative Present Value

The forecast cash flows should be discounted to understand the present value of the cash flows. An important aspect of the cash flows is the duration period of the cash flows. As it is impractical to continue forecasting cash flows over a specific period, the SVA uses a terminal value at the end of the defined period to represent the future cash flows after the defined period. The use of industry analysis is needed to understand the growth projections for terminal value calculations.

5. Calculate Business Value

The business value includes the present value of the cash flows with the debt and investments spend incorporated. Finally, the business values also include the terminal value or the residual value.

6. Calculate Share Price

The final step is the calculation of the share price which is the business value divided by the number of shares in the company.

The use of SVA is important in understanding the value of a company or an investment. The steps provided in this section shows that the SVA is not overly complex and extensive in the steps. This indicates that it is not overly cumbersome to execute and is a relevant and practical method to apply.

Question D

Analyse how genetic algorithms may improve managerial decision-making, highlighting both the benefits and weaknesses they possess.

A genetic algorithm is a programming approach that simulates biological evolution and is considered to be a problem solving strategy. Genetic algorithms and their application in financial analysis were developed in the 1960s. This was then further developed including the introduction of the evolution strategy designed to improve the next mutation over the next generation. Further evolution of genetic algorithms has led to the application of GA into mathematical problems (e.g. bin-packing and graph colouring) and in engineering issues (e.g. pattern recognition) as well as financial applications (Eiben, Van Der Hauw et al. 1998). GA has been found useful in financial services and used, for example, in trading, functional optimisation and budgeting. GA has also been developed in generating an optimal ecosystem and artificial life systems(Eiben, Van Der Hauw et al. 1998). In Economics, the use of GAs has been valuable in processing information in identifying solutions to problems(Subbaraj, Rengaraj et al. 2011). GA has been effective in strategic decision making and resolving conflicts with (Amiri, Abtahi et al. 2013) showing the utilisation of GA for corporate functional activities (e.g. information systems).

Operations of GA

There are different mathematical features that are utilised in the optimisation of GA. These include the following:

' Binary Representation: Utilised to help determine solutions (see figure 5)

' Objective Function: Used to arrive at optimal or near optimal solutions in short time periods

' Genetic Operations: Used for the following: selection; crossovers; and, mutation

Figure 5: Flowchart of a binary GA

Benefits of Using GA

There are several advantages in the use of GA in computation of solutions versus other forms of approaches. These advantages are the following:

' GA is intrinsically parallel and enable the approach to explore multiple possible solutions.

' GA can be applied to solve problems where there is an extensive number of possible solutions

' In crossover, GA is utilised to solve problems with functions that are unrelated or are discontinuous

' GA can be used in the analysis of many parameters in parallel

' GA is used to encode variables to identify solutions for experimental, numerical or analytical functions

' GA also makes random changes in the analyses of the performance of changes

Limitations of GA

While there are many advantages, GA also has some limitations that need to be considered. These limitations include the following:

' The identification of solutions through GA requires proper representation of problems

' The fitness function should be properly identified as this is needed in the solution as a determinant of the outcome

' The parameters needed should be carefully selected

' GA is unable to analyse incorrect fitness functions

' GA is also prone to premature convergence resulting in incorrect solutions

These few disadvantages do not necessarily lead to a failure of GA. The use and application of GA remains important in identifying solutions in financial markets and economic scenarios. For managers, GA provides a method and tool that supports quick decision-making and managerial responses to issues that are unexpected.

REFERENCES AND BIBLIOGRAPHY

Amiri, M., A.R. Abtahi, et al. (2013). "Solving a generalised precedence multi-

Objective multi-mode time-cost-quality trade-off project scheduling problem using a modified NSGA-II algorithm." International Journal of Services and Operations Management 14(3): 355-372.

Berk, J., & DeMarzo, P. (2013) "Corporate Finance", Pearson Education Ltd.: Harlow, U.K.

Brealey, R. A. (2011) "Fundamentals of Corporate Finance", McGraw-Hill Higher Education: Maidenhead, U.K.

Eiben, . E., J. K. Van Der Hauw, et al. (1998). "Graph coloring with adaptive evolutionary algorithms." Journal of Heuristics 4(1): 25-46.

Fama, E. F. (2001) "Efficient capital markets: A Review of theory and empirical work", Journal of Finance, 1 (3), 283-415.

Fiordelisi, F, & Monferr, S. (2009) "Measuring shareholder value in asset-based lending industries", Managerial Finance, Vol. 35 Iss: 10, pp.885 - 903

Maditinos, D., Z. Sevic, et al. (2007). "The use of traditional and modern value-based performance measures to evaluate companies' implemented and future strategies in the Greek capital market: the case of EPS and EVA." Journal f International Research Publications 2: 35-50.

Mahfoud, S. et al (1996) "Financial Forecasting using Genetic Algorithms", Applied Artificial Intelligence, 10 (5), 545-563

Pike, R., and Neale, B. "Corporate Finance and Investment: Decisions & Strategies (5th edn)", FT Prentice Hall: New York, U.S., 278-280.

Pilkington, M. (2005) "Financial Information Systems", Pearson Education Limited: Harlow, U.K. 3-38.

Subbaraj, P., R. Rengaraj, et al. (2011). "Enhancement of Self-adaptive real-coded genetic algorithm using Taguchi method for Economic dispatch problem." Applied Soft Computing 11(1): 83-92.

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