How investors value firms in a PCM

Question 1

A capital gain (in general) is…

Answer 1

…an amount realised before taxes or from the sale of an asset (e.g. a stock) at a price higher than the cost of purchasing the asset

Question 2

In the two-period model, the capital gain is the…

Answer 2

…different between the market value of the firm in periods 2 and 1

Question 3

When the interest rate at which funds are borrowed is the same as the rate used to discount the firm’s cash flow, the size of the dividend is _______ in determining the size of the firm’s cash flow

Answer 3

Irelevant

Question 4

Do dividends determine the value of the firm?

Answer 4

No

Question 5

What determines the value of the firm?

Answer 5

The ability of the firm to generate revenue (cash flow) and whether it has made the optimal investment or not

Question 6

The ______ in a corporation determines the timing and size of dividends and is composed of _______

Answer 6

Board of directors, composed of shareholders

Question 7

How does uncertainty influence the board’s decision to pay dividends?

Answer 7

In the developing world, dividends are often paid to signal that the company is doing well, and to convince people that the company is able to borrow at the market rate. If you cannot pay dividends, it means that you cannot borrow at the market rate and you are not doing well.

Question 8

What may be the implication of an imperfect capital market (for a firm)?

Answer 8

Receiving little or no reward for saving and having to pay a high interest rate to borrow

Question 9

How many imperfect capital markets influence the board’s decision to pay dividends?

Answer 9

They may result in the board deciding not to pay out dividends because it would be cheaper in this case for the corporation to re-invest its earnings rather than borrowing at a high IR

Question 10

In the valuation model based on earnings and dividends, what is the budget constraint of the firm in the earnings part?

Answer 10

The capital they raise through issuing new shares (number issued multiplied by price) plus the cash flow (both in one period, e.g. period 2) is used to fund (i.e. equal to) the payment of dividends to shareholders of the last period, plus the investment in a productive activity

M(2)s(2) + X(2) = N(1)d(2) + I(2)

Question 11

What is the value of the firm based on earnings?

Answer 11

The sum of the discounted future net cashflow (can be shown mathematically)

Question 12

We can equate the price of a share (say in period 1) i.e. s(1) to…

Answer 12

The discounted sum of the dividend they receive in period 2, d(2), and the price of the share in period 2, s(2)

Question 13

Valuation based on dividends finds that…

Answer 13

The value of the firm is equal to the sum to infinity of the discounted future stream of dividends

Question 14

Is there any difference in the value of the firm depending on how it is valued, i.e. according to earnings/dividends/earnings per share

Answer 14

No difference

Question 15

What is a growth stock?

Answer 15

A share in a company that is expected to grow at a rate higher than the market, with the company usually not paying dividends because they wish to invest earnings in the SR to accelerate growth, and with investors often investing with the objective of achieving capital gains

Question 16

What is a growth firm?

Answer 16

A firm in which the expanding assets generate a rate of return greater than that of the market (i.e. internal return on investment greater than market rate)

Question 17

Is it possible to earn a return on a growth stock in a perfect capital market? Which shareholders benefit from the growth in the firm (founding or non-founding shareholders)?

Answer 17

It is possible to earn a return on a growth stock in a PCM but only a return equal to the market rate of return. Original shareholders within the firm enjoying growth in the assets greater than the market are able to raise funds both through the market and the stock market. They have no incentive to sell stocks for a price giving the new shareholder any excess return because they can borrow funds at the market rate. However, they must offer new shareholders a rate the same as the market rate so that they are indifferent between buying the stock and investing in the market.