Dividend Growth Method of Share Valuation, Capital Asset Pricing Model and Arbitrage Pricing Theory - Assignment Example

Finance & Investment a. Briefly explain the dividend growth method of share valuation The intrinsic value of a share is the present value of all the future benefits expected to be received from that share. The market price of a share and its intrinsic value are the two basic inputs necessary for the investment decision. A share whose current market price is higher than its intrinsic value would be considered as overpriced and if the current market price is lower than its intrinsic value would be considered as underpriced. Generally the investor would be advised to purchase the share if the current market price of the share is lower than its intrinsic value i.e. when the share is underpriced. The valuation model used to estimate the intrinsic value of a share is the present value model. There are two assumptions about the dividend growth rate patterns are: Dividends grow at a constant rate in future (Constant Growth assumption). Dividends grow at varying rates in future (Multiple Growth assumption). Constant Growth Model: Constant Growth Model is also known as Gordon’s Share Valuation model. It is assumed that dividends will grow at the same rate (g) into the indefinite future and that the discount rate (r) is greater than the dividend growth rate (g). Therefore the dividend received after one year, D1 = D0 (1+g)1 where D1 = dividend received after one year D0 = Current dividend g = dividend growth rate r = discount rate Therefore the present value model for share valuation may now be written as: D0 (1+g)1 D0 (1+ g)2 D0 (1 + g)n P0 = + + ….. + (1+ r)1 ( 1+ r )2 (1 + r)n When ‘n’ approaches infinity, this formula can be simplified as: D1 P0 = ( r - g ) KEVIN, S (2006). Portfolio Management. 2nd ed., p.68. Prentice- Hall of India, New Delhi. Multiple Growth Model: The constant growth assumption may not be realistic in many situations. The growth is dividends may be at varying rates. In this model, the future time period is divided into two different growth segments such as the initial extraordinary growth period and the subsequent constant growth period. That is the flow from period 1 to N which will call V1, and the flow from period N+1 to infinity referred to as V2. The present share value, P0 = V1 + V2 The growth rates during the first phase of extraordinary growth are likely to be variable from year to year. Then, D1 D2 Dn V1 = + + ……. + (1+r) (1+r) (1+r) This may be summarised as: N Dt V1 = ∑ t=1 (1 + r )t In the second phase the dividend growth rate is assumed to be constant. Therefore, second phase dividends would be: DN+1 = DN (1+g)1 DN+2 = DN (1+g)2 and so on. The present value of the second phase stream of dividends from period N+1 to infinity can be calculated using Gordon share valuation model as: Dn (1 + g) (r – g ) Therefore the second phase dividend stream viewed at ‘zero’ time may be expressed as: DN (1+ g) V2 = (r - g) (1 + r)N Therefore the present value of the share is P0 = V1 + V2 KEVIN, S (2006). Portfolio Management. 2nd ed., p.69 - 70. Prentice- Hall of India, New Delhi. b. Discuss what modifications would have to be made to this model if it were to be used to value the freehold of rented property subject to three-yearly rent reviews. Free hold property is an asset, the owners of such property requires appropriate evidence about their ownership of the property. The freehold property is a fixed assets held by the owner itself. In this context, it is viewed that whenever the portion of assets increases, then the profitability of the company also goes on increasing. If there is an appreciation in assets, it will automatically leads to increase in profitability of the company as a whole; as a result, increase in profit leads to increase in dividend also. So, it is very clear that there is a direct relation between the increment of assets and there by a corresponding increment of profits, and finally in dividend also. Moreover, whenever a person becomes the real owner of a freehold property, such a person has the right to undertake either to sell or to provide lease of such property. “Taxpayers may seek to infer that the wording "holding investments" connotes passive ownership and argue that extensive personal involvement by the deceased/transferor in the business cannot be classed as "holding investment”. (SVM27580 - Share Valuation Manual: Business Property Relief and Agricultural Property Relief) There is relation between the valuation of shares and household property in the context of accounting and taxation. Moreover, while making purchase of a house property, it is necessary to taken in to fact about the income level, existing condition of the property etc. “Leaseholders who own the freehold of the block through the means of a limited company have more freedom to deal with the flat because if they don't like the lease, they can change it. However, even if the flat you are thinking of buying does come with share of freehold, changing the lease might not be so easy.” (Property Buying and Selling 2007). The valuation of free hold property and shares for increasing the growth rate of dividend is an essential concept. Likewise, the concept of three yearly rent reviews are also important in this regard. c. Many financial analysis capitalize future earnings rather than dividends when valuing shares. Explain the rationale of this method and discuss its merits and limitations compared with those of the dividend valuation model- As far as the economists and financial analysts are taken in to consideration, in case of a company, future earnings are much more beneficial than dividends. Earnings of a company means, its financial viability, or the profits so derived due to the running of the company. Net Income, that is the expenditure so incurred should be deducted from its total income. In this particular concept, total income means the gross income derived by the company, as a whole. There is a slight difference between the total/gross income and the net income. Gross/ total income means, the ultimate amount of profit attained by the company, where as net income means, out of the sum of gross or total income, a certain portion should be deducted for meeting or recovering the amount of expenditure so incurred. So, in the accounting point of view, there are different concepts are using for describing the term net income and total income. The balance of income so remained, only after meeting all expenditure, which should be recovered from the gross or total income is the net income. “In business, what remains after subtracting all the costs (namely, business, depreciation, interest, and taxes) from a company’s revenues. Net income is sometimes called the bottom line. also called earnings or net profit.” (Net Income 2007). Net income means out of the total revenue, the total amount of expenditure should be deducted. Therefore, the total amount of expenditure incurred by the company, is deducted from the total or gross income of the company, so after meeting this expenditure, the balance amount of income is typically known as net income. The earnings or the amount of profit, a portion of which should be distributed among the shareholders are dividends. So, the primary preference should be given to earning capacity of a company rather than its dividend portfolio. The dividend shall be distributable only out of the amount of profits. Earnings of a company means the amount of profits so earned by the company during an accounting period. Out of the profits earned, a portion should be distributed among the shareholders on the basis of their proportion. Even though both profits and dividend is closely related, majority of the companies should support the earning capacity rather than the dividend rate. Dividend valuation model is very essential for improving the overall capacity of an organization. Every company should require to pay dividend out of the earnings. “Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met. These company's usually attempt to maintain balance in their debt/equity ratios before making any dividend distributions, which demonstrates that such a company decides upon dividends only if there is enough money leftover after all operating and expansion expenses are met.” (How and Why Do Companies Pay Dividends? 2003). The major benefits of applying dividend valuation method is that to maximize the overall profitability and dividend growth. The dividend paying companies are mostly of less fluctuatable in nature. The investors are giving high focus on their returns. Moreover, by using discounted valuation model, stress should also give to cost of equity. In addition to this, this technique should evaluate and improves the ROE and EPS of a firm. Moreover, this concept is also giving stress for perpetuity model or OPT (Option Pricing Theory). As a result of this concept, it is possible to maximize the Gross profits of the company. So, consequently, it is possible to increase the overall profit of the entity. It is usually derived by way of deducting the cost of goods sold or all related direct expenditure from the total sales attained by the company. Generally it is depicted as- Sales_ Cost of Goods sold= Gross Profit. Therefore, it is possible to attain a maximum effort towards the profit margin. In addition to this, it is possible to measure the profitability of a firm with the help of gross profit. So, gross profit is the difference between sales and cost of sales (i.e. Opening stock + purchases_ closing stock). The dividend valuation model having its own limitations like any other methods. Mainly, it very difficult to make an evaluation of the fixed income bearing securities. Especially, the equity shareholders dividend declaration is very crucial. Likely, several concepts like ROI, percentage of dividend of both equity and preference shares etc are significant. Dividend also varying as fixed and variable wise. In case of fixed income bearing securities, it is necessary to taken in to consideration about the market value, and expected rate of dividend also. There is always a risk factor related with the concepts of return and dividend, because it is essential to consider the time value of money. Every investors are expecting a reasonable return, but this concept is not providing cent percent guarantee. In order to implement these difficulties, it is necessary to make a well-planned managerial policies and forecasting of financial projects to ensure the technical feasibility and financial viability of the entity. Question 2: (a ) The calculation for the beta of Cemtex's Shares: The equation used for the calculation is; rim σi σm βi = σm2 Where rim = Correlation coefficient between the return of Cemtex's shares and the returns of the market index. σi = Standard deviation of returns of Cemtex's shares. σm = Standard deviation of returns of the market index. σm2 = Variance of the market returns. Here given that, σi = 2.5%, rim = 0.5, σm = 20%. There fore σm2 = (20)2 = 400. 0.5 x 2.5 x 20 25 βi = = 400 400 The beta of Cemtex’s shares, βi = 0.0625 (Kevin, p. 27, 2006). The calculation for the Expected return on Cemtex's Shares: The equation used for the calculation is; Ri = Rf + ( Rm – Rf ) β Where: Ri = Expected rate of return on Cemtex's shares Rf = Risk free rate of return. Rm = Expected rate of return on market portfolio. Here given that, Rf = 9%, Rm = 25%, βi = 0.0625 Ri = 9 + ( 25 – 9 ) x 0.0625 = 9 + 1 The expected rate of return on Cemtex’s shares, Ri = 10 (Kevin, P.137-140, 2006). (b) The degree of correlation between asset returns is critical for: Reducing portfolio risk In order to calculating the risk of a portfolio of securities, the risk of each security that contains in the portfolio has to be considered. That is the risk of a portfolio depends on how the returns of a security move with the returns of other securities in the portfolio and contribute to the overall risk of the portfolio. We can reduce total risk through diversification without sacrificing portfolio return. It is important to consider the impact of correlation on portfolio risk in order to understand the mechanism and power of diversification. When Security Returns perfectly positively correlated: Here the correlation coefficient between the two asset return will be +1. The return of the two securities then move up or down together. So here portfolio variance is σp = x1σ1 + x2σ2. For example consider the standard deviations of security P and Q are 50 and 30 respectively. The proportion of investments in P and Q are 0.4 and 0.6 respectively. Then portfolio standard deviation may be calculated as: σp = (0.4) x (50) + (0.6) x (30) = 38. So here, the diversification provides only risk averaging and no risk reduction because the portfolio risk cannot be reduced below the individual security risk. When Security Returns perfectly negatively correlated: Here the correlation coefficient between the two-asset return will be -1. The two returns always move in exactly opposite directions. So here portfolio variance is σp = x1σ1 - x2σ2. Applying this equation in the above example, σp = 2. Here, although the portfolio contains two risky assets, the portfolio has no risk at all. Thus, the portfolio may become entirely risk free when security returns are perfectly negatively correlated. When Security Returns uncorrelated: Here the correlation coefficient between the two asset return will be 0. So here portfolio variance is σp = √ x1σ1 + x2σ2 . Applying this equation in the above example, σp = 26.91. Here the portfolio standard deviation is less than the standard deviations of individual securities in the portfolio. Therefore, diversification reduces risk and is a productive activity. Indicating the expected price of an asset: Covariance and correlation used to identify the degree to which two variables move together. It can use to identify the movements of stock prices, i.e. whether they move in the same direction, opposite directions, or independently of one another. It can also used to check whether a stock price moves in agreement with the stock market. The degree of correlation between asset returns is critical for indicating the expected price of an asset because it is the statistical measure that indicates the interactive risk of a security relative to others in a portfolio of securities. The expected price of a security is depends on the risk and return of that security. The most important risks associated with a portfolio are individual security risk and interactive risk. Therefore, the degree of correlation between asset returns is critical for indicating the expected price of an asset. (Kevin, P.137-140, 2006). (Risk and Return: Diversification. 2000). Comparison between Capital Asset Pricing Model and Arbitrage Pricing Theory: Capital Asset Pricing Model (CAPM) specifies the relationship between expected return and risk for all securities and all portfolios. CAPM is based on Security Market Line (SML), which is a straight line joining between risk free asset, which has a beta coefficient of zero, and the market portfolio, which has a beta coefficient of one. The equation of CAPM in order to find expected return on security i is: Ri = Rf + ( Rm – Rf ) β Where: Ri = Expected rate of return on security i Rf = Risk free rate of return. Rm = Expected rate of return on market portfolio. Arbitrage Pricing Theory (APT) is a factor model of return and risk. It is based on complex mathematical and statistical theory. Arbitrage is a strategy of making benefits from the variations between two or more markets. Arbitrager makes a risk free profit by using hedging techniques. (Kevin, p.137-140, 2006). (Eugene and Michael 2004). CAPM APT Capital Asset Pricing Model is really extension of the portfolio theory of Markowitz. CAPM is based on certain assumptions regarding the behaviour of investors. It gives the nature of the relationship between the expected return and the systematic risk of a security. It is a simple linear relationship. It need to measure market portfolio correctly. CAPM is demand side model. Approaches: Estimate the risk-free rate, Rf Estimate the current expected market risk premium, (Rm – Rf ) Estimate the stock’s beta coefficient, Bi. CAPM can be used for evaluating the price of securities such as under priced, overpriced, and correctly priced. If the expected return on a security calculated according to CAPM is lower than the actual or estimated return offered by that security, is known as under priced security. If the expected return on a security calculated according to CAPM is more than the actual or estimated return offered by that security, is known as overpriced security. If the expected return on a security calculated according to CAPM is equal to the actual or estimated return offered by that security, is known as correctly priced security. Limitations: This theory is unrealistic for any average investor, who goes by the fundamental factors influencing the company, its earnings, and dividend and bonus record. Empirical tests of the model have not proved very useful. The model is built ex-ante factors while in reality the expectations of the future vary from person to person. The CAPM is in fact not testable exactly as the exact composition of the market is known and is used in testing. We do not know precisely how to measure any of the inputs requires to implement the CAPM. Arbitrage Pricing Model (APT) is a generalization of CAPM. It based on the factor model of return and risk. APT is less restrictive in its assumptions. It gives the relationship between the various factors which are related to return and risk It gives reasonable descriptions of return and risk. Correct measurement of market portfolio is not required. APT is supply side model. Approaches: Arbitrage is a strategy of making benefits from the variations between two or more markets. Suppose an investor has to select many securities in order to invest a fixed amount. So based on his needs, he can create an impure factor portfolios. For this purpose he has to divide the expected return into: risk free rate of return, and the expected premium return per unit of sensitivity to the factor. Now the investor has to split his fixed amount into two parts such as risk free, and pure factor. Limitations: Arbitrage Pricing Theory does not identify relevant factors. It could not explain what factors influence returns, nor does it even indicate how many factors should appear in the model. The factors may change over time. The APT is in an early stage of development, and there are still many unanswered questions. (Lesson 29: Markowitz Model) Works cited EUGENE, Brigham F., and MICHAEL, Ehrhardit C. (2004). Financial Management Theory and Practice. Arbitrage pricing theory. P. 273. 10th ed., Thomson South-Western. How and Why Do Companies Pay Dividends? (2003). Dividend Paying Methods, Residual. [online]. Investopedia. Last accessed 6 September 2007 at: http://www.investopedia.com/articles/03/011703.asp KEVIN, S (2006). Portfolio Management. 2nd ed., P.138-140. Prentice- Hall of India, New Delhi. KEVIN, S (2006). Portfolio Management. 2nd ed., p.27. Prentice- Hall of India, New Delhi. Lesson 29: Markowitz Model. Arbitrage Pricing Theory. P.5.Rai University. 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Last accessed 6 September 2007 at: http://www.hmrc.gov.uk/manuals/svmanual/SVM27580.htm VECCHIO, John Del, (2000). Dividend Discount Model. Inputs in to the DDM. [online]. Fool.com. Last accessed 6 September 2007 at: http://www.fool.com/research/2000/features000406.htm Net Income. (2007). Definition 1. [online]. Investor Words.com. Last accessed 17 September 2007 at: http://www.investorwords.com/3247/net_income.html KEVIN, S (2006). Portfolio Management. 2nd ed., p.69 - 70. Prentice- Hall of India, New Delhi. KEVIN, S (2006). Portfolio Management. 2nd ed., p.68. Prentice- Hall of India, New Delhi. Read More