Fundamentals of Finance: Valuation Models, Shareholder Returns, and Market Efficiency

This document covers topics such as the constant growth dividend valuation model, its limitations, the required rate of return for shareholders, and the appropriate subscription price for new shares. It also discusses the net present value of investments, the relative attractiveness of cash profits, and the problems with profit maximization as a goal. Additionally, it explores the semi-strong form of market efficiency and its implications for financial managers.

FUNDAMENTALS OF
FINANCE

TABLE OF CONTENTS
TABLE OF CONTENTS................................................................................................................2
QUESTION 2..................................................................................................................................1
a) Constant growth Dividend Valuation Model of share valuation, defining each term of the
formula and showing how it is used............................................................................................1
b) Main limitations of the Dividend Valuation Model in its practical use for the valuation of
shares...........................................................................................................................................1
c) The required rate of return of Twilight plc’s shareholders......................................................2
d) The appropriate subscription price for the new issue of shares by Dayboo Limited..............3
QUESTION 3..................................................................................................................................3
a) The net present value of the Abel and Babel investments, and state which of them should be
preferred on this basis..................................................................................................................3
b) Abel and Cabel are both one-year investments, but Cabel offers double the cash profit of
Abel. Providing appropriate calculations, discuss the relative attractiveness of the extra cash
profit offered by Cabel.................................................................................................................4
c) Problems involved in using profit maximisation as the goal of a firm....................................5
QUESTION 4..................................................................................................................................6
a) Semi strong form efficiency market........................................................................................6
b) Difference between "semi-strong form" and the other two forms of stock market efficiency.
.....................................................................................................................................................7
c) Implications of the EMH over financial managers..................................................................7
d) Economic functions of capital markets...................................................................................7
QUESTION 5..................................................................................................................................8
a) Shareholders are not the only stakeholders in a firm – discuss some of the problems that
might arise if a firm were to ignore the interests of its other stakeholders..................................8
b) In spite of the above, finance theory still gives greater importance to the firm’s shareholders
than to its other stakeholders when stating the goal of the firm – explain why this is so...........8
c) The goal of shareholder wealth maximisation is often compromised by agency conflict
between shareholders and managers – explain what this means, giving examples of how such
conflict may arise.........................................................................................................................9

REFERENCES..............................................................................................................................11

QUESTION 2
a) Constant growth Dividend Valuation Model of share valuation, defining each term of the
formula and showing how it is used.
Dividend discount model is the quantitative method which is used for predicting share
prices of the company. it could be recognised as the present worth of all the future dividends
which will be paid by the company on discounting back to its present value. It attempt for
calculating fair value of the stock irrespective of its prevailing conditions of the market. It also
considers dividend payout and expected market returns. as per the model if value derived using
this method is greater than current traded stock prices of the share, then share are undervalued
and it is qualified for buying.
Dividend discount model is developed under assumption that intrinsic value of share
reflects present value of the future cash flows that are generated by the security. DDM model
could take number of variations.
Gordon Growth Model
GGM is commonly used variation of discount model. GGM is based over the assumption
that stream of the future dividends grows at constant rate in the future for infinite period of time.
the price of the share is computed using following formula.
P0 = D1/Re – G
Po is the current market price which is derived using the above formula.
D1 is the dividend that will be paid for next year.
R is the cost of equity capital that is computed using the CAPM model.
G in the formula is the rate of growth of dividend of company for the future periods
b) Main limitations of the Dividend Valuation Model in its practical use for the valuation of
shares
Limitations of the Dividend Discount Model
 The method is though highly used by the experts and analysts for the valuation of the
stocks and company. DDM includes difficulty of the accurate projections about the fact
which does not factor in the buybacks and one of the assumption is that only source of
dividend is dividends.
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 The limitation of the model is that this could be used only for the companies which pay
dividend at the rising rates. It could not be applied over the companies that are paying
dividends at constant rate.
 DDM could be also considered as conservative as it does not takes into account the
buybacks of the stocks.
 One of the major drawback of model is that it could not be used for the evaluation of
stocks that do not pay dividends and regardless of capital gains which are realised by
investing in stocks.
 It is also based over wrong assumption that return on investment is only value of the
stock which is provided through dividends
 It works only when dividends of the company are paying at dividend rate which is
constant throughout the future. It makes DDM does not makes it useful for the analysis
of companies as the dividends are paid at fluctuating rate in practical terms.
 The method is based over number of assumptions that makes the outcomes of different
incomparable as assumption by different analysts could be different. Some of the
assumptions that are made in DDM are growth rate of divined, required return on the
stocks.
 Slight error in any of the assumption will make the whole computation in error making
the outcomes inaccurate which makes the results irrelevant.
c) The required rate of return of Twilight plc’s shareholders.
Required rate of the return is minimum rate which investor are expecting from the
company over owning of stocks as the compensation for the given level of risks are associated by
holding stocks of company. Required rate in the corporate finance is used for analysing
profitability of the potential investment in the shares. If company do not provides required return
to the investor the share prices of the company are badly affected due to this.
Computation of the required rate of return of Dayboo limited
Computation of equity
R = D1/P0 +G
R = (28/502)+0.018
7.4%
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From the information given in the last paragraph the required rate computed of the
company is 7.4% which is adequate and not much higher. The return also shows that the
company do not involves high risks and which may attract large number of shareholders.
d) The appropriate subscription price for the new issue of shares by Dayboo Limited.
It is essential for the business to quote correct prices of the shares at the time of
subscription. The subscription prices for the share could be computed by the company using
dividend discount model. Using the valuation method subscription prices of the shares are
computed as below
Dividend discount model
D 0.4
D1 0.4072
R 7.40%
G 1.80%
P0 0.04072/(0.074-0.018)
0.73
It could be evaluated from the computation that the subscription of the share price should be
703 pence which is higher than the Twilight plc. Company may get the required level of
shareholders at this price.
QUESTION 3
a) The net present value of the Abel and Babel investments, and state which of them should be
preferred on this basis.
Computation of the net present value investment of Abel
Year Cash inflows
PV factor
@ 4%
Discounted
cash
inflows
1 39 0.962 37.5
Total discounted cash
inflow 37.50
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Initial investment 35
NPV (Total discounted
cash inflows - initial
investment) 3
Computation of the net present value investment of Babel
Computation of NPV
Year
Cash
inflows
PV factor
@ 4% Discounted cash inflows
4 43 0.855 36.756
Total discounted cash
inflow 37
Initial investment 35
NPV (Total discounted
cash inflows - initial
investment) 2
In the above calculations for computing NPV discount rate of 4% is used by the
management. As per this method the NPV of the Abel is 3 where the NPV of Babel is 2 that
show the project Abel is more preferable. Abel should be adopted by the company as the NPV is
higher of this investment.
b) Abel and Cabel are both one-year investments, but Cabel offers double the cash profit of Abel.
Providing appropriate calculations, discuss the relative attractiveness of the extra cash
profit offered by Cabel.
In this case Moogle limited is having 35 million which it is planning to invest for getting
adequate returns. Abel is having investment of 35 million which will be producing cash flows of
39 million in one year and profit from the investment will be 4 million. If the cash flows are
discounted using the rate of 4%. NPV of the project is 3 where the profit from is 4 million. The
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investment is providing good rate of return over the investment in one year. The project is giving
return of 11.42% that is adequate. The return could also be earned from similar kind of
investment as it is the basic rate of return.
On the other Cabel is also requiring investment of 35 million and in one year the
investment will be doubling the return as compared with Abel. The profits expected from the
investment are 8 million that is double of return of Abel. This shows that project will be
maximising the returns in one year. The investment takes considerable time in doubling the
return. Rate of return in this investment is 23% where in Abel it was 12%.
Investors are always attracted towards investments that provides higher return on their
investments. As the main motive of most of the investors is to earn maximum profit over their
investments they are attracted towards such investments that provide higher returns.
From the profitability motive investor will be choosing the Cabel for maximising the
returns. Abel also requires same amount of investment but the profits are half which makes the
less attractive. An investor has to analyse different factors before investing money in any project.
Project that give higher returns should be analysed adequately as there may be significant risks
associated with the investment that could affect the cash flows of the business.
It could be evaluated that the Cabel is more attractive as compared with the Abel due to
higher returns it is giving to the investor. However if the investor is not willing to take risk it
should adopt Abel as it the probability of success is higher of this project. Investor in cabel could
get seriously affected as the probability of success is very low of 25%.
c) Problems involved in using profit maximisation as the goal of a firm.
Though every company or organisation is established with the motive of earning profit
but making profits as only goal of the business could bring serious implications and risks for the
firm. Profits motivate the company and it employee in increasing their efficiency and
productivity. There are some problems with making profit maximisation as main goal of
business.
The problems associated in using profit maximisations as goal of company is as follows;
Firstly, goal of profit maximisation is stated as vague. There are number of definitions for
defining the profits like accounting profits are based over book values or the profit earned by
business in economic terms based over the market value.
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Second, when the money is earned the differences are ignored in the profit maximisation.
The goal do not distinguishes between pound today and getting pound one year after from today.
In the finance time value of money plays an important role for the growth for the valuation of
assets and liabilities of business.
Third, the differences of risks are ignored by the profit maximisation between the alternative
course of actions. When choice is given between the alternatives which have same scale of risk
but have different risks level, people generally take alternative with less risk. It makes the
investment having lower risk more valuable. Such differences of value are ignored in profit
maximisation
As in the given case cabel is providing double return from abel. The risk is also higher with
the higher return. Probability of success of Cabel is only 25% where it is the probability of
failure of Abel. Though the returns are lower but the chances of earning returns are more higher
in Abel as compared with Cabel.
QUESTION 4
a) Semi strong form efficiency market
This form of market suggest that the prices changes to the equilibrium level that are the
result of market information on the equity or security. The theory analyses how prices of the
stock increases and decreases with presence of the publicly available news or information. The
method also has weakness is that it is very difficult explain conditions that are affecting the
security prices over material non public information. It is easily applicable hypothesis from all
EMH hypotheses.
On 2nd may as the acquisition will create economies of scale, the share prices will not see
fluctuation in its prices unless the information is made public.
On 9th may press conference about the acquisition of Fly at 175 will increase the interest
of investors as they will become part of bigger group by purchasing the shares. Therefore the
prices will increase higher than 150.
On 15th may announcement of further cash flows will increase the share prices further as
brand image will grow due to the benefits arising in company.
b) Difference between "semi-strong form" and the other two forms of stock market efficiency.
Difference between weak, strong and semi strong market hypotheses
Weak form
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Weak form of EMH suggests that the stock prices of today reflect all data about the past
prices. it also states no form of the technical analysis could be effectively utilised for aiding the
investors to make trading decisions
Semi strong form
The form follows belief that as all the information which is public are used for
calculating the current prices of the stock, investors could not utilise the fundamental or technical
analysis for gaining higher returns.
Strong form
It states every information one available to public and one which is not publicly knows are
accounted completely in the current prices of stock and there is no information which could gove
the investor advantage over market.
c) Implications of the EMH over financial managers
If markets are strongly efficient, then implications for financial managers are
 The managers concentrate over maximising net present value of investment of the
company with the motive of maximising wealth of the shareholders.
 They are not requires to consider or worry about the past investments or actions and
current performance will be affecting the share prices of company.
 Managers are not required to adopt the strategies which are going to mislead market, like
timing of the new issue of shares, window dressing of accounts, change in market view
regarding cost of capital of the company
d) Economic functions of capital markets
Capital markets are referred as stock markets that play an important role in the growth of the
economy. In broader perspective the capital market is viewed as the market of financial asset
with the long time or infinite maturity, it plays an important role in the mobilisation of resources
and also their allocation over productive channels. It is used as the process of the economic
growth of the country that is facilitated by capital markets.
Capital markets helps in accelerating process of the economic growth. This reflects general
conditions of economy. The capital market help in allocation of the resources from people that
have surplus capital funds to people that are in great need for capital. It could be stated that
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capital markets helps in expansion of the industries and trade of private and public sectors both
leading to balanced growth of economy in the country.
Capital markets also promote saving habits in the people. Taxation and banking institution
provides facilities and the provisions to investors for saving money and getting adequate returns
over their savings higher than banks. In absence of the Capital market people might be investing
in the unproductive assets such as gold or land indulging in unnecessary spending.
QUESTION 5
a) Shareholders are not the only stakeholders in a firm – discuss some of the problems that might
arise if a firm were to ignore the interests of its other stakeholders.
A company consists of number of stakeholders that are interested in the success or failure
of business such as shareholders, employees, customers, suppliers and such other parties having
interest in the company. The major focus of the management is over the shareholders of
company as they are the owners and have invested money in the business.
Along with the shareholders there are also other stakeholders that are essential and
important for the business. Management is required to manage the conflicting interest of the
different stakeholders of the business. If the interest of stakeholders are not considered business
could be significantly affected. For instance, if the company does not focus over the needs and
requirements of the customers it will not be getting the required acceptance in market. It is
essential for the business to meet the demands of customers and to maintain healthy contact with
its customer base for the growth of business.
If does not maintain health relation with its suppliers it will not be able to win negotiations
or get benefits that could be availed by maintaining healthy relations which are essential for the
business.
b) In spite of the above, finance theory still gives greater importance to the firm’s shareholders
than to its other stakeholders when stating the goal of the firm – explain why this is so.
Shareholders are stakeholders of the corporation having significant rights and importance in
the business as compared with other stakeholders. Shareholders own a proportionate ownership
in the company through investment by making purchase of shares where stakeholders have
interest in the performance of business or its appreciation. The reason often means that
shareholders are relatively more importance as they provide the capital that is essential for the
business. They are the owners of the company and their concern is kept at priority. Other
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stakeholders would not exist if stakeholders had not provided the funds required for running
business.
Shareholder could be individual, institution or company which owns share in the company
and therefore have financial interest in the profitability of company. Management focuses over
maximising the wealth of the shareholders as they have their funds invested and other investor
do not have financial interest in the company. They are critical to the organisation and are
considered before taking major decisions related to company as every decision of the business
will have direct impact over shareholders of the company.
c) The goal of shareholder wealth maximisation is often compromised by agency conflict
between shareholders and managers – explain what this means, giving examples of how
such conflict may arise.
Agency problems arises when there is conflict of interest inherent in the relationship
where one party in the agency is expected of acting for the best interest of other. In the corporate
finance agency problems are defined as conflict of interests between management and
stockholders of company. managers act as agents are proposed for principal or the shareholders
and supposed of making decisions that maximises the wealth of the shareholders even there are
possibilities to the manager to maximise own wealth. Problems of agency arise when the
motivations or incentives present themselves to the agent not to act in best interest of the
principal.
Agency problems arises between the managers and owners due to the issues with
incentives and presence of the discretion in the objectives of the different parties. Managers may
be motivated for acting in manner that is for the good of business as whole and not for
shareholders particularly might cause issues. Interest of the corporate governance is also towards
mitigating conflicts of interest between the stakeholders. This occurs where the multiple interests
of the shareholders leads to conflict in the ability of managers to act in best interest of the
company.
For example, conflicts arise when the managers are focused towards growth of the business
where the shareholders are focused over short term profit maximisation with higher risks.
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