Brigham and Gapensiki (2010) argued bankruptcy costs exist and they increase when equity is traded off for debt. So MM theory may not hold. According to MM the cost of equity rises, as the firm increases its use of debt financing. This implies that the risk of equity is dependent upon the risk of firm operations. MM theories can help firms understand that it is not only the capital structure and dividend policy that matter in firms strengths but other variables should be taken into consideration.
DIVIDEND GROWTH MODEL Valuation of a business consists of various processes that require a deep understanding of a business such as, forecasting performance, selection of an appropriate valuation model, which will in turn help to determine whether or not to purchase. THE CONSTANT DIVIDEND GROWTH MODEL This is also referred to as the Gordon Dividend Growth Model. Which fall in a class of models referred to as Dividend Discount Models (DDM). It is taken that the value of stock today is the present value of all future cash flows on that stock. Hence determining the price (intrinsic value) of stock is based on the discounted value of future cash flows.
A carefully build capital structure will contributes to a good market value. If a firm carries too much debt which increases the leverage will influence investors to retract their money. This will make the market value of a firm to decrease. Each of the funds in capital structure has its own cost to the firm. It is because debt and equity are provided by investors or also known as owners and creditors thus, the fund provider has their expectation and demands on the firm’s profitability and growth for long term.
Dividend growth model and P/E ratio are applicable to company that is listed in stock exchange whereas the free cash flow is usable for all type of company. Free cash flow model is more realistic way to estimate the business valuation compared to the other two as it take into account the real cash flow from future year discounted as cost of capital. Free cash flow is the only model that use discounted cash flow which is consistent with the concept of time value of money. Q3. Accrual accounting Accrual accounting is an accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur.
It expands portfolio theory and helps us to calculate the unexpected risk of asset. As long as we know the risk-adjusted expected return of the asset, we can assess the asset's price as correct. Although CAPM allows us to determine the rate of return required for any risky asset to determine its price, but CAPM is actually used primarily to evaluate common stock. Use the CAPM it may requires some assumptions, including the following: There is risk-free asset so that investors can lend or borrow at a risk-free rate of return. Investors agree on the expected rate of return and probability of these returns.
Stock valuation is the process of determining the current worth of an asset or a company. There are two types of valuation, which include fundamental analysis (FA) and technical analysis (TA). The example of the first one is top-down approach and bottom-up approach for the second. FA is the more enhance than TA as it involve the financial and economic analysis to visualize the movement of stock prices, while TA is more on forecasting future prices based on the inspection of past price movements while avoiding losses. Dividend Discount Model (DDM) is one of the example among TA.
CAPM is basically used to confirm the theoretically suited required rate of return to the asset when the asset is considered to be added towards a well performing existing portfolio. Capital Market Line is used for determining the return rate of specific efficient portfolios. Basically, this analysis depends on risk free return rate and amount of the risk involved within particular portfolio. Its formula is shown as: CML∶E (r)=rf+ σ (E (rM)- rf)/σM Capital market line is the result from a combination of market portfolio as well as risk free security or asset (which is L point). All the points along CML have greater risk and return profiles to any portfolio at efficient frontier, along with an exception of Market Portfolio that is the point on efficient frontier towards which the Capital market Line is tangent.
They might receive future dividends, earnings, or just an appreciated stock value. These ratios are helpful for investors to predict how much stock prices will be in the future based on current earnings and dividend measurements. For instance, a downward trend in earnings per share and dividend yield point to profitability problems and could even raise going concern issues. All of these issues point to a lower stock evaluation. There were three elements of market ratios which is Earning per Share, Dividend Per Share and Dividend Payout to
Convertible bonds are a specific form of bonds that at a specified in the terms of issuance moment or in a specified in the terms of issuance period entitle an investor to their conversion at a specified ratio (conversion ratio) into the issuer’s shares. They are issued by joint stock companies and they are an instrument of raising of capital, both equity capital and borrowed capital (Mamcarz 2013). As a source of capital raising by companies, they have numerous advantages. First of all, bonds, when compared with traditional bonds or bank loans, enable the issuers to raise cheap borrowed capital in return for the possibility to convert them into company shares. The issuer does not have to fear losing control over the company.
This is due to the importance of working capital to manufacturing firms which range from the purchase of raw materials, payment of accounts payable and finally credit management. Thus firms with high gearing ratios are usually forced to issue equity as a mechanism of counteracting the effect of debt on the operating cash flow in order to positively enhance their working capital which according to Nyabwanga, (2011) is the lifeline of a firm. This notion upholds the underlying principle of the pecking order theory as opined by Myers, (1984) since equity appears both at the beginning and the end of the capital structure of an