The value of a firm
One day, while searching for buyers of his business, Mr A got a proposal from Mr B. Mr A went back home and thought about the valuation Mr B gave. Mr A mentioned that he has taken some loan for his business which has not been fully paid yet. Mr B said that then he would pay the same as the valuation he has calculated; however, Mr A will only receive the money after payment of debt. Let us do a basic equity value example of comparing two companies on the basis of equity market value and finding the larger one. Here are the details of Company A and Company B —.
In this case, we have been given both the numbers of outstanding shares and the market price of shares. We note that market value of equity of Company A is more than equity market value of Company B.
Please have a look at the table below. The use of debt in the capital structure of a firm provides information about its future performance.
Ross [ 3 ] increasing debts carries good news while decreasing debt carries bad news about the future of a firm. Myers [ 7 ] argued that a firm can reap higher profits by maintaining higher Debt-to-Equity ratio i.
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But Stulz has shown that debt payments reduce the availability of funds for investment. Capital structure is affected by interest rate changes.
Value of a Firm | irogyrikewyx.tk
High interest rates make interest payments on loans to be high. Joseph found that stock returns changes as a result of changes in interest rates. Hyde states that with interest rate change, the interest payments and principle amount of a loan changes. Ju and Leland [ 8 ] have also shown the effect of interest on capital structure. On the management side, capital structure is affected by the Agency Problem and agency costs [ 7 ].
What is Equity Value?
Jensen and Mickling have introduced the concept of agency costs and have investigated its nature due the existence of debt and outside equity. Haris and Raviv [ 9 ] have shown that due to conflict the management might maximize its own value at the cost of the owners. Moreover they have argued that if cash flows are poor then creditors can force liquidation of the firm. Capital structure alters while moving from one industry to another and also changes with life stages of a firm. To make clear the concept of capital structure a lot of theories have been proposed. Myers and Majluf [ 7 ] has found that corporate insiders act in the best interest of shareholders and accordingly the firm prefers internal finance from retained earnings as against external one; even if external funds are needed the firm prefers debt to equity i.
The Pecking Order Theory. French and Fama [ 10 ] have found that many companies issue some form of equity each year. Every time leverage is moved from its settled position it comes back to its optimal point [ 7 ]. Frank and Goyal [ 11 ] have divided this to two parts i. The research methodology used was a causal research, employing quantitative analysis of secondary data.
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I have tried to show the causeand- effect relationship between debt and value of a firm, by ratio analysis. Ratio analysis over comes the problem of comparing the performance of companies with different sizes. For the purpose of the paper, to show that debt affects the value of a firm, a sample of hundred companies was taken randomly from nearly all companies of Pakistan listed at Karachi Stock Exchange KSE with the unit of analysis being a company listed at KSE. Secondary financial data of these listed companies was obtained from State Bank of Pakistan and Karachi Stock Exchange on yearly basis for six years [ 12 - 16 ].
Correlation and regression analysis was carried out, with capital structure being the independent variable and the firm value as a dependent variable, to show that whether the proposed relationship exists or not. ROE shows the return that the investors receive for their capital contribution to the firm. The investors are likely to invest as long as they receive good return. ROA measures the firm profit relative to its investment in assets and is an indication of whether the assets are under or over utilized. It is thus an indicator of operating performance.
EPS is derived when net profit is expressed on per share basis and provides a measure of what the market will pay for a share based on perception of future earnings of the firm [ 17 - 22 ]. There exists positive relationship between financial leverage and value of a firm. To draw conclusions easily in relation to the hypothesis already stated i. Debt affects the value of a firm; the results are presented in tabular form. The results show that a significant relationship exists between leverage and firm value in the market.
Also the results on a whole point out a positive relationship between leverage and value of a firm. Although the correlation among variables is weak but the overall results appear to be significant. The confidence level estimates a range in which the population mean is expected to fall. The sign of the parameter estimates show the direction of the relationship whether positive or negative. Positive sign shows direct relationship and the negative shows inverse one.
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Based on p-values the null hypothesis is either rejected or accepted. P-values are to be compared with the significance level, if p-value is less than significance level the null hypothesis is to be rejected otherwise accepted. Tables 1 and 2. But generally, it refers to the market value of a company. EV is a more comprehensive substitute for market capitalization and can be calculated by following more than one approach. Value of a firm is basically the sum of claims of its creditors and shareholders.
Therefore, one of the simplest ways to measure the value of a firm is by adding the market value of its debt, equity, and minority interest. Cash and cash equivalents would be then deducted to arrive at the net value. One of the reasons why the concept of EV has gained more importance than market capitalization is because the former is more inclusive. Another sound approach towards computing the value of a firm is to determine the present value of its future operating free cash flows. The idea is to draw a comparison between two similar firms.
By similar firms, we mean similar in size, same industry etc.