Financial Analysis Strategic

Questions: 1. You have been asked to value a small company formed from a subsidiary of a larger firm that has been acquired by its managers. They are financing their purchase using a loan guaranteed against their personal real estate property. Discuss the issues you would consider and the models you might employ in such a valuation. 2. Option pricing methods provide a means of assessing the potential (2).lt risk of a company and the recoverability of its debt from the investors point of view. Outline the general methodology of default risk assessment using option pricing and compare and contrast this approach with those using conventional accounting measures 3. The financial performance of a business is dependent, amongst other things, on the good governance and the expert judgement of its senior management and executive team. Discuss the extent to which this statement reflects your understanding of the good corporation. Answers: (1). In order to value the business of a company for the purpose of acquisition several methods have been provided in the Accounting Standards. Valuation can be done by price to earnings ratio (PE ratio), price to book ratio (PB ratio) or price to sales ratio (PS Ratio). According to (Marpe, et al. 2015) the purchasing company is required to follow the rules and principles laid in the International Financial Reporting Standards for determination and recognition of the purchase consideration. The given case is about valuation of a small company which was acquired by the manager of a larger firm using borrowed fund against the personal real estate property. Generally, the mode of financing the purchase consideration is by way of issuing stocks and securities though in the given case it is by way of loan fund (Chang 2015). The issues that may arise in the case of acquisition are as follows: The financial performance of the vendor company is to be analyzed and evaluated on quarterly or annual basis if available and to verify if the financial statements are audited and the period of audit (Evans 2015). To analyze the key financial ratios of the company is to be determined in order to evaluate if the ratios are meeting the standards of the relative industry (Furlan, Oberhofer and Winner 2015). These ratios can be capital ratios, current ratios, price earnings ratios, etc. Due diligence of the liabilities of the company in respect to long term loans and advances, borrowed fund, payment of interests thereon, payment of principal installments, contingent liabilities and the security or guarantee provided for such loan (Ao and Collins 2015). Due diligence should be carried out for the mortgaged property against the borrowed fund. It is required to be verified the ownership of the property, value of the property, legalization in the ownership etc along with the verification on the period of loan taken and installments due on such loan (Ben-David, Drake and Roulstone 2015). Another important aspect of due diligence is to analyze the assets of the company. Depreciation charged on such assets, any floating or fixed charge created on the assets of the company, conditions of the underlying assets and parity of market or fair value of assets with that of the recognition made in the books of accounts should also be checked (Ao and Collins 2015). Goodwill valuation is one of the important issues to be considered in the process of acquisition of business. The amount of goodwill already appeared in the financial statements is not considered instead it shall be determined as per the principles on valuation of Goodwill in IFRS. Goodwill is evaluated by considering future maintainable profit and intrinsic value of the company (Ben-David, Drake and Roulstone 2015). Other issues that are to be considered for acquisition are technology or intellectual property of the target company, present clients, third party confirmation in case of companys indebtedness are some of the relevant aspects (Scharf 2015). Apart from the issues mentioned above, there are few models defined in the accounting standards for the purpose of valuation. First method that can be used is price earnings ratio (PE Ratio). In this method the value is derived by dividing the current ordinary share price of the vendor company by the earnings on per securities (EPS). This ratio is used to evaluate if the target company is overvalued or undervalued as compared to the industrial standards (Ben-David, Drake and Roulstone 2015). Another method that can be used is price to book ratio (PB Ratio) or determination of net asset value of the company. This ratio is derived by measuring the organizations total assets with total liabilities and thereafter dividing the same by current share price of the company. This method is appropriate for the companies having real estate or other similar high valued property which concludes that if the ratio is less than one it means the target company is undervalued as per industrial standards and vice versa (Scharf 2015). Another important model that can be used is price to sales ratio which is used for the companies planning to enter into turnaround business strategy. This ratio is measured by dividend the current price of the companys securities by revenue generating per securities or total revenue generated by the company in current financial year. The over or under valuation determination is to be measured by comparing the industrial standards (Ben-David, Drake and Roulstone 2015). Apart from the above mentioned models, valuation can also be done by using discounted cash or dividend model, measurement of synergies for the purpose of payment of consideration, or other price multiples depending on the capital structure and payment method applying by the companies as per the agreed terms and conditions (Ao and Collins 2015). (2). Default risks means the uncertainty involved in an organizations ability to repay or meet the obligations lying with it. Since, long time many accounting experts and researchers are involved in determining the default risks involved in the organizations because the cost of failure whether direct or indirect are affecting the entire business industry. Upon research studies it was concluded that there exists two important methods of assessing the default risks of the company, credit scoring model and structural model. The credit-scoring model identified by Robert Merton and using the same for analysis of probability of default risk using a theory called option theory (Bennett, Gntay and Unal 2015). General methodology of option theory for the assessment of default risk is using the equity as an option call on the companys assets which states that the equity share holders of the enterprise have the right to buy the shares or assets from the debtors and not the obligation (Hatchondo and Martinez 2015). For this analysis the researchers required several assumptions and other factors like interest free rate of return of the company, market premium rate of the company etc. The advantages of using the option pricing theory over other theories in determining the default risks is that this theory reflects the information of market using the equity stocks of the firm while the hardships of the option pricing theory is using the number of unrealistic assumptions that are required to present and evaluate the model. Another model that was used for assessment of default risk was traditional approach or conventional accounting techniques. In this approach, the accounting expert or researchers pre- identify the factors and elements of financial statements of the enterprise, which indicates the performance in terms of its size, leverage, liquidity, profitability, cash and cash equivalent adequacy, efficiency, investments and financing adequacy (Crpey 2015). The traditional approach in credit score model has the limitation in respect to probability distribution resulting in errors in accuracy of the computations as this approach is conducted by considering the accounting variables that are dependent on one or more factors. Hence, in order to get the accurate and correct results for the measurement of the required ratios, the researchers need to use the correct dependent variables as per the organization and industrial norms that were quite difficult to obtain. On comparing the two techniques in measuring the default risk as per credit scoring model it can be said that the options pricing technique is a methodology that is used the accounting experts in the modern accounting technique using the most vital factor Equity. Whereas the conventional or traditional technique used the dependant variable of accounting factors in respect of elements of financial statements for the comparison between the relative industrial standards (Bessis and O'Kelly 2015). The results obtained in this technique was not accurate and error free hence it was difficult to measure the actual level of default risk in the company that was quite less in case of option pricing technique as the main factor used is the Equity of an entity as per the current market norms. (3). Good Corporation in the world of business and entrepreneurship helps to build, design, set, measure the compliance programs and ethical values along with the measurement of benchmark and assessment so that the business can take place in regular and smooth way. There are number of factors on which the performance of an enterprise is dependent and those are good corporate governance, management decision and performance of executive team apart from the regular production and sales of the products and services of the business (Grant 2015). Compliance of corporate governance is one of the important jobs that is required to be complied by all the organization in order to run the business efficiently and effectively. According to the norms in rest to the corporate governance, an enterprise is required to conduct its business for the benefit and advantage of its stakeholders rather than with only profit earning objectives. The framework of the corporate governance states that the business should be conducted to maintain the transparency, accountability and fairness responsibility of which lies to the management and board of directors of the organization (Revelli and Viviani 2015). Moreover, Good Corporation is also dependant on the judgments and decisions taken by the board of directors and management of the company. According to the provisions of the corporate laws, there are certain business deals that are exclusively conducted only with the decision taken by the board of directors. On the other hand, there are certain other business decisions that are mutually agreed and conducted by the management judgment and decision. Further, any business entity is required to follow the rules and principles of International Financial Reporting Standards for the purpose of recognizing and recording transactions in the books of accounts and financial statements (Call, Nyberg, Ployhart and Weekley 2015). It is very important and the responsibility of the management that the financial statements of a company show true and fair view for the users of the financial reports so that they can take a fair decision for the purpose of investment or any other business events in the respective company. it is the duty of the management to get the accounts of its company audited from time to time so that it can abide by the laws and regulations of the corporate laws as well as accounting standards. Apart from the compliance of corporate governance and responsibilities of the management, work of executive team of the organization is also vital. No business can be conducted without the man- power. Hence, executive team plays an important role in conducting a good corporation and for its growth and sustainability. There are two types of man- power generally hired by the organization- blue collared and white collared. 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