Rosewell plc, a hotel and leisure company, is planning to take over a smaller private limited company, Stayfit Ltd, and needs to place a value on the company. Rosewell has gathered the following data:

Rosewell

Price/Earnings ratio 12

Cost of capital 15%

Stayfit

Current dividend payment 27p

Dividend growth rate per annum 12.47%

Current EPS 37p

Number of ordinary shares in issue 5 million

It is estimated that the cost of capital of Stayfit is 20% higher than the cost of capital of Rosewell, owing to the higher risk of Stayfits operations. Rosewell estimates that cash flows at the end of the first year will be 2.5 million and these will grow at an annual rate of 5% in perpetuity. Rosewell also expects to raise 5 million in two years time by selling off hotels of Stayfit that are surplus to its needs. The market will expect Rosewell to achieve a level of return on Stayfit comparable to that which it makes on its own assets.

Required: (a) Given the above information, estimate values of Stayfit using the following valuation methods: (i) Price/Earnings ratio valuation; (ii) Dividend growth model; (iii)Discounted cash flow valuation.

(b) Discuss the problems associated with the application of the above valuation techniques. Which of the value(s) would you recommend the board of Rosewell to use? Please justify your recommendations.

(c) Critically discuss the potential economic reasons that Rosewell plc would like to take over Stayfit Ltd.