Quite simply, the investors also have their own set of motivations and would only be willing to invest in a corporation’s equity or debt if it meets with their required rate of return. They may be willing to take a risk in investing in a particular firm if the returns from this are higher than that offered by US Treasury bonds with one year to maturity. Since the rate of return on these bonds are guaranteed by the US Government, they are thought to be a riskless investment, assuming that the US Government will never default on payment of the principal and interest on the due dates. Consequently in financial circles, the market rate on such US bonds is known in common parlance at the ‘risk free rate.’ The investors could put their money into such an investment and rest assured that they would earn this rate of interest without too much worry at all. Therefore in order to induce the investor to invest in the equity or debt of a particular corporation, that firm or business must offer a higher rate of interest. Investors know that they can increase the return on their investment by taking a chance on more risky securities than the US Treasury bonds, but how much risk they are willing to take is an individual decision depending on the company’s past performance, its financial stability and the actions and business acumen of its management. It also depends on the sales of the company’s products and the viability of their future plans. In any event, the investor can pull out his investment by selling the shares or bonds in the open marketplace at the going rate on any business day. In the case of stocks or equity investment, he can stand to gain or lose in respect of capital gains (current price per share versus the price at which he had originally purchased them) and dividends paid out (usually stated on a per share basis as well). In the case of bonds or debt securities, he gets a fixed rate of return called interest and can also expect his principal repayment on the date of maturity of such instrument. Usually we find that bonds are being offered at a discount in the debt marketplace which means below their par or face value. In this case the investor also stands to gain because he pays less than the face value for these bonds but can expect their full value to be paid back on the maturity date. Determining the Cost of Equity Capital under Different Theories To summarize, from the foregoing we have seen that the investor has certain requirements which he hopes will be met by investing in more risky securities than US Treasury Bonds or risk free investments. He will most likely make a decision to invest after looking at the company’s financial performance, its history of share prices and dividend payouts in recent years. Much also depends on the sales of the company’s products and the viability of management’s future plans. However from a theoretical standpoint, we have three different theories that seek to explain the reasoning behind an investment decision. These are (1) the Dividend Growth model; (2) the Capital Asset Pricing Model and (3) the Arbitrage Pricing Theory. Let us now look at each of these in turn. The Dividend Growth
Finance Module 3 Case Assignment Name of the Writer Name of the Institution Finance Module 3 Case Assignment Part I What is the Cost of Equity Capital for a Firm? A corporation that wants to expand in the marketplace naturally needs more finances and funding to undertake its plans for local, national or even international expansion and to this end it must also have a good strategy for marketing and distribution of its products and services…
They would also want to see income, expense and profit projections as well as a marketing plan. If they are convinced, they lend you capital. Or you could go to a bank to borrow debt repayable over a number of years. This includes interest as well as repayment of the principal.
This is because of the presence of inflation. Therefore, we must invest dollars we do not need now in profitable interest earning alternatives so that we keep pace with the rate of inflation, and the purchasing power of our investment is retained. Another explanation is that interest is the price for waiting, or deferring present consumption for that in the future.
A company can borrow from a bank or offer stocks and bonds in the open market. It can spend or invest the cash in current or future projects that will increase the worth of the firm and maximize the wealth of its owners. The process of deciding which projects to invest in and which not to is called Capital Budgeting (Brigham & Ehrhardt, 2010).
In a sole proprietorship or partnership, the number and type of relationship between the owners is defined and limited by law. However a public limited company has a separate legal existence from that of its owners and its liability to the shareholders and creditors is also limited to their ownership stakes in the company.
This estimate of asset valuation is the most conservative as it solely depends upon the book values of the assets. It is assumed that in the event of bankruptcy, the company is likely to receive at least this value of assets (Jaffe and Ross, 2004). If the above values are taken into consideration, it can be noted that M&S has performed well especially in terms of generating higher NAV per share.
IHG has been in business for nearly 3 decades and the management believes in steady growth and aims at 8% to 10% annual revenue growth in the long term.
However, the company is now presented with a prospective opportunity to invest in
omplished in two ways (1) through an increase in the market price of the stock and (2) through a return on investment in the form of dividends declared and paid out. Thus the shareholder gets a short term return through dividends and a long term return in capital gains when he
In a business, profits are usually increased by cutting on costs and increasing the revenue rates. In the given scenario, capital budgeting techniques have to be applied to ensure that the company undertakes the
mpany is facing a problem of capital rationing such that the company can pick either of these projects but it cannot accept both projects simultaneously. One of the projects is named as “onshore” project and the other one is “offshore”. Both these projects are expected
It is therefore a bad investment. In comparison to the industry value, the industry has a higher P/E ratio. This indicates that investors are anticipating higher performance as well as growth for other companies in the industry. Investors are willing to
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