- Length: 7 pages
- Sources: 1
- Subject: Economics
- Type: Case Study
- Paper: #7341099

Financial management is all about managing the finance of the company by making various investing, financing (debt financing or equity financing) or distributing (Dividend) decisions. The finance managers of a company are constantly involved in making various financial calculations so as to come up to those fundamental financial management decisions. (Correia et al., 2007)

Financing the projects of the company can be done by debt financing, equity financing or a combination of both types of finances. Debt and Equity finance can be obtained in many ways and the valuation of both debt and equity market values of the company can be done using various methods. Each of the method used is based on equations containing certain variables, one of which is definitely market value of equity. These equations analyze and use the relationship between certain variables, (for instance the relationship between earnings of a company, dividends paid by the company and market value of the equity of the company) to determine the value of any one of these provided the values of other variables are given. (Chandra, 2011)

There are many differences between debt and equity financing, risks associated to both forms and financing and the rights of the lenders of debts and owners of the company (equity holders). Where equity finance holders bear more risk as compared to debt financers, the required rate of return of the equity holders is greater than the debtors of a company. Financial management concepts also identify various methods to calculate the required rate of return of debtors and equity holders. The required rate of return of debtors is also known as Cost of debt (Kd) and the required rate of return of equity holders is also called Cost of Equity (Ke). (Ehrhardt & Brigham, 2011)

In this paper we will analyze the methods identified and used by financial managers in determining the market value of equity. Equity can be of many types including ordinary shares, preference shares etc. While determining the value of equity many factors are considered including the required rate of return of the equity holders, risk of equity as well as market risk faced by the company's shares and equity. The following methods of equity valuation are generally used by any company:

1. Price Earnings Ratio

2. Dividend Discount Model

a) Zero / no growth in dividend

b) Constant growth in dividend

c) Constant rate forever / Dividends growing in perpetuity

d) Differential growth in dividend

3. Discounted Cash Flow Techniques (Khan & Jain, 2007)

Khan and Jain, (2007) also explained that some of the above mentioned methods are quite simple while others are difficult and complex. It is the responsibility of the financial managers to decide which method is the most suitable method for valuation in the given scenario.

Determining the value of equity using price earnings ratio

This approach of determining the market value of equity is also called earnings multiplier approach and it comes under the ambit of the valuation methods that determine the relative value of equity. This method is usually used for comparison purposes to compare the performance of the company with other companies or industry as a whole. This type of valuation is a lot easier and can be done much quickly as compared to valuation under other methods. (Correia et al., 2007)

Any company uses this method only if absolute valuation methods cannot be used or if the managers are in a hurry to come to a suitable conclusion. The value of equity under this method is calculated by using the following formula:

(Correia et al., 2007)

Where Po is the estimated price, E1 is the estimated earnings per share and Po/E1 is the justified price earnings ratio. Companies use this method of valuation because this ratio focuses on the earnings of the company to determine its price, that is, the market value of equity of any company under this method is dependent upon the earnings of that company. This method can only be used for valuation and comparison purposes if the company is generating positive earnings, the company is publically traded and comparable amounts values are accessible, and the quality of the company's earnings is strong and reliable. (Chandra, 2011)

Determining the value of equity using dividend discount model

This method of determining the value of equity (market value) is one of the most basic absolute valuation method by which the 'intrinsic' or 'true' value of the equity of a company is calculated. Under this method the present value of all the dividends paid by the company till infinity using the expected rate of return of equity holders (Ke) is determined, which is considered to be the current market value of the company's stock. The value of the company's equity calculated under this method is based on the dividends paid by the company and the rate of growth in the dividends of the company. Most of the financial management scholars argue that using dividend as a basis to determine the market value of equity is quite justifiable. Because usually dividends are the only actual cash flows that are going to the shareholders / equity holders of any company. (Ehrhardt & Brigham, 2011)

This method is usually used by companies to determine the relationship between their earnings and dividend payout ratios. Since, establishing into any industry as a blue chip company, requires a company to pay out dividends in a ratio that is consistent to its earnings ratio, this method can easily be used by the blue chip companies to value their stock. Further, companies having a constant or determinable dividend payout ratio can also use this method to effectively and efficiently determine the value of their stocks. (Chandra, 2011)

There are various dividend discount models, based on the rate of growth of dividend. One of these assumed that the dividend per share grows at a constant rate. Another assumes that the rate of growth is similar to the earnings rate. There is another one that assumes that dividend remains constant over the years and there is no growth. Under each of the method the dividends till a determinable period are discounted to reach to a present value, which is considered as the current market value of equity. (Khan & Jain, 2007)

Under various methods the following formulae are derived to calculate one of the missing variables in the equation:

1. Zero / no growth in dividend: (Ehrhardt & Brigham, 2011)

2. Constant growth in dividend @ of g: (also known as Gordon's growth model) (Ehrhardt & Brigham, 2011)

3. Formula for perpetuity is same as that of zero / no growth in dividends. (Ehrhardt & Brigham, 2011)

4. Under the variable growth approach, different present values are determined using different formula to reach up to a cumulative net present value representing the current market value of the equity on which differential dividend is paid. (Ehrhardt & Brigham, 2011)

By the above discussion it can be said that by determining the relationship between the dividends and market value of equity, the financial managers can now easily determine at which growth rate the market value of the company will be highest, which is the best possible investment decision for the company, and with the change in the risk profile of the company and in the expected rate of return of the shareholder, what should be the best possible investment decision and dividend payout ratio. (Kishore, 2009)

Determining the value of equity using discounted cash flow method

This method is used when a company does not pay any dividend or the pattern of payment of dividends is irregular. This method also comes under the ambit of absolute valuation method. Under this method instead of discounting the dividends, free cash flows of a company are discounted to calculate and determine the value of a company. This method is only useful if the free cash flows of a company for a certain period are stable, determinable and positive. (Correia et al., 2007)

Use of the above discussed valuation techniques and other methods in the financial management

As per the above detailed discussion it can be said that financial management techniques and methods as well as the equations based on the relationships between certain variables are very important and critical tools and help finance managers in many ways. (Kishore, 2009)These methods can be used by the managers in:

1. determining the value of their company's stock by using various valuation techniques, (Khan & Jain, 2007)

2. comparing the value of the company's stock with that of other companies or industry as a whole, so as to determine whether the stock of a certain company is over or undervalued, (Khan & Jain, 2007)

3. determining the effect…