Melan is considering the acquisition of the entire share capital of Nelson, an unquoted company. Neither company has any long-term debts. The director of Melan believes if its company acquires Nelson, the business risk of Melan will not be affected.

Nelson has a financial year end of 31 December. Its statement of financial position as on 31 December 20X9 is expected to be as follows.

Statement of Financial Position Information

Non-current assets

Property, plant, and equipment (net of depreciation) 1,303,200

Current assets

Inventories 1,348,000

Trade receivables 1,490,000

2,838,000

Total assets 4,141,200

Equity and liabilities

Equity

Ordinary shares of 0.50 100,000

Reserves 808,200

908,200

Current liabilities

Trade payables 1,507,200

Bank overdraft 1,725,800

3,233,000

Total equity and liabilities 4,141,200

The following additional information is also available.

• For the financial year ending 31 December 20X9 Nelsons profit after tax is estimated at 134,400 and dividends at 80,000.
• The estimated values of Nelsons non-current assets and inventories as on 31 December 20X9 are as follows.

Replacement cost Realisable Value

Property, plant, and equipment 1,450,000 900,000

Inventories 1,100,000 1,140,000

• It is estimated that 2 per cent of Nelsons trade receivables as on 31 December 20X9 will be uncollectable if the company is liquidated.
• Melan and Nelson have cost of capital of 9 per cent and 12 per cent, respectively.
• The current P/E ratio of Melan is 12.
• Quoted companies with business activities and profitability similar to those of Nelson have P/E ratios of approximately 10, although those companies are larger than Nelson.

Required:

1. Calculate the value of the total equity of Nelson as on 31 December 20X9 using each of the following basis:

1. the net asset basis of valuation (historical basis)
2. the net asset basis of valuation (liquidation basis)
3. the dividend valuation method if the level of dividends as on 31 December 20X9 is expected to remain unchanged for the foreseeable future
4. the dividend valuation method if the level of dividends as on 31 December 20X9 is expected to grow at a constant rate of 4 per cent per annum in perpetuity.
5. the P/E ratio method (10 Marks)

2. Explain the role and limitation of the valuation methods you have used and the values you have calculated in part (a) in the process of estimating the value of Nelson by Melan (maximum 350 words). (15 Marks)

Ignore taxation.