The Investment, Financing, and Valuation of the Corporation - Coursework Example

Introduction to Corporate Finance Introduction In the matter of investment decisions, the analysts and market observers use concepts based on theoretical foundations as well as empirical studies. While the theoretical concepts advocate the methods by which the shares can be valued, the empirical studies help to determine how effectively the share valuation has been carried out. There are a number of theoretical models available which form the solid base for adapting the valuation model that most suits the particular situation. Irving Fisher, an eminent economist has made the outstanding contribution to the theory of finance. In his analysis of valuation of bonds Fisher has cited several empirical relationships, hat have contributed to the formulation of the valuation model evinced by him. The essential element of such a relationship exists in the significant correlation between prevailing rates of interests and the past changes in the bond prices which are averaged on a weighted basis. This results in the reflection of the effects on the price levels over longer duration of time. (Irving Fisher) Fisher separation is the foundation to the theory of finance. (Moneyterms) This formed the foundation on which the modern day Present Value theories have been established. Fisher's contribution to the theory of finance with respect to the valuation of shares is based on the basis of future earnings and the present value of the earnings on the shares. This paper analyses the propositions on which the share valuation model advocated by Fisher was based and also the newer models that help mitigating the difficulties faced in the Fisher's Model. Fisher Effect Fisher attributed the correlation between the prevailing rates of interest and the past changes in the prices of bonds which are averaged using a weighted index, to a not-so-perfect estimation about the expected inflationary tendencies and the resulting intention of the investor to extrapolate the likely future price level changes in the bonds so that the investor may be able to adjust the rate of interest to be earned on the bond in line with the anticipated changes in the prices of bonds. In other words Fisher based his theory of valuation on the behavioural mechanism which in turn depends on the recent history of the prices as well as the future estimations. This is known as 'Fisher effect' and is the model that Fisher advocated for use in the valuation of bonds. But it can be observed that the present day analysts use this proposition not only for bond valuation but also for the stocks. In the case of equities it is the forecast of the sustainable growth rate that replicates the interest rate factor of the bond valuation. The 'forecast growth rate' of stocks is the modern day innovation in the financial theory relating to the share valuation and trading. This stand of Fisher was substantiated by Robert F. Wiese. Wiese stated that "the proper price of any security, whether a stock or a bond, is the sum of all the future income payments discounted at the current rate of interest in order to arrive at the present value" John Burr Williams (1938) further describes this theory by stating, "A stock is worth the present value of its future dividends, with future dividends dependent on future earnings. Value thus depends on the distribution rate for earnings, which rate is itself determined by the reinvestment needs of the business." Propositions of Fisher's Model of Share Valuation The assessment made by Irving Fisher immediately after the crash in the share prices in the year 1929, described the following attributes as determinants of the share price movements in the market, since the share price in the market is determined largely by the discounted value of future earnings in the form of dividends from the respective stock. According to Fisher basically these attributes contribute to the upward changes in the price levels of stocks: (1) "Because the earnings are continually plowed-back into business instead of being declared as dividends" In this statement Fisher has assumed that in all cases the firms with earnings will plow back the profits and thus enhance the earning capacity of the firm. But this situation is subjected to the fact that not all firms will decide to plow back the earnings as such action will depend on the opportunities available for expansion and also the level of earnings of the firm. It is the case only with companies having high incremental returns on capita. These companies may decide to plow back their profits in to the business rather than declaring dividends and increase the dividend yield of the firm. Moreover it is a difficult proposition to ascertain when the return on capital will come to such lower levels that forces the directors to payout more in the form of dividends. After all there should be meaningful dividend payout of dividends at least at some part of the life of the shares. (2)." Because the expected earnings will increase on account of technical progress within the industry" The next proposition of Fisher assumes there will be progressive growth in the industry due to technological advancement in the industry. Any improvement in the production process is assumed to improve the productivity and result in higher earnings of the firm. This naturally tends to increase the value of the shares. But this hypothesis of permanent increase in the earnings can not be assumed to be true as a generalization in respect of all industries and all firms in the industry. The incremental earnings are result of a host of economic and internal factors and hence Fisher's model suffers from a basic deficiency in this respect. (3)"Because less risk is believed to attach to those earnings than formerly" Under this proposition Fisher has assessed that since there is going to be an increase in the earnings of the firm due to the plowing back of earnings and also due to the technological advancements, the risk element in the success of the firm would be much less in terms of the profitability of the firm and this in turn is sure to result in the increase of the share prices of the firm. Again since the first two propositions are countered against the practicality this proposition also looses ground and is far from reality. (4) "Because the 'basis' by which the discounting is made has been lowered" Here Fisher assumes that the cautious approach to the discounting of the future earnings is bound to increase the confidence in the minds of the investors who will be convinced to pay better prices for the shares in the market. This again is a subjective issue which depends largely on the individual investor's perspective about the earnings of the company. It cannot be again said each investment is made with a long term investment and growth in the earnings of the firm over the long run. This is especially true in the current days' stock market situation where short term phenomena are more predominant in deciding the investments. The change in the investor outlook as prevailed during the 1930's and in the present day context makes the model of Fisher out dated. Thus the assumptions concerning the magnitude of reinvestments, marginal increase in the earnings due to technological advancements, the diffused risk factor due to higher earnings and a lower discounting factor where there is a change in the investor's outlook towards long term holding make the Fisher's model, though conceptually acceptable, unusable in the present day's context and demanded more changes in the model to make it adaptable to the present stock valuation scenario. "Assumptions concerning the magnitude of payouts and when they might occur can have a huge impact on a model's current theoretical valuation." (Dolan Capital Management) Newer Models of Share Valuation As a general model that takes into account the present value of all of the expected future earnings form the share is given by the 'Dividend Discount Model'(Ross et al 2004) Several variations of this model have been developed to suit the requirements of the present day stock valuation context. In order to obviate the difficulties outlined above the theoreticians have started making use of a terminal price for the holding period in the dividend discount models, which is equivalent to the maturity price and date of the bond. Myron Gordon's model known as 'Gordon Growth Model' could easily connect the level of stock prices, current levels of dividend earnings of the stock and the discount rate. Gordon's model can also be converted from a classical model to a special one which takes into the price/earnings ratio for a meaningful valuation of the stock. (Myron J. Gordon, 1962) On assuming a constant earnings retention rate as opposed to the dividend payout rate, a constant growth in the earnings per share and constant discount rate then it is possible to derive a special case price/earnings ratio mode which is known as Gordon-Shapiro valuation Equation. Conclusion Despite the various limitations the Fisher's theory has as applicable to the modern day share valuation, the approach of Irving Fisher has formed the basis for an important development in the field of corporate finance. Based on the approach evinced by Fisher several models of share valuation have been evolved by theoreticians of later years. (Word Count: 1546) References: Dolan Capital Management 'A Primer on Equity Valuation' Irving Fisher, The Theory of Interest. (New York: Macmillan, 1930), p. 438. J.B. Williams, The Theory of Investment Value (1938). (Reprint: Amsterdam, The Netherlands: North Holland Publishing Company, 1964) Money Terms 'Fisher Separation' Myron J. Gordon, The Investment, Financing, and Valuation of the Corporation. (Homewood, Ill.: R.D. Irwin, 1962) Robert F. Wiese, "Investing for True Value", Barron's, (September 8, 1930), p. 5. Ross A. Stephen, Westerfield W. Randolph, and Jaffe Jeffrey (2004) 'Corporate Finance' Edition IV Tata Mc-Graw Hill Publishing Read More