Strategic Corporate Finance - Essay Example

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