Security Valuation A Capsule For Quick Revision

The subject “Strategic Financial Management” for CA Final Exam basically involves applying the knowledge and techniques of financial management to the planning, operating, and monitoring of the finance function in particular as well as the organization in general. So, strategic management basically involves planning the utilization of a company’s resources in such a manner it brings maximum value to the shareholders in the long run.

  • Knowing what an asset is worth and what determines its value is a pre-requisite for making intelligent decisions while closing investments for a portfolio or deciding an appropriate price to pay or receive in a business takeover and in making an investment, financing, and dividend choices when running a business.
  • While some assets are easier to value than others, for different assets, the details of valuation and the uncertainty associated with value estimates may vary. However, the core principles of valuation
  • always remain the same.
  • The minimum rate of return that the investor is expected to receive while making an investment in an asset over a specified period of time.
  • The rate at which the present value of future cash flows is determined.
  • The discount rate equates the present value of future cash inflows to its cost i.e. cash outlay.
  • The Equity risk premium is the excess return that investment in equity shares provides over a risk-free rate of return, such as a return from tax-free government bonds. This excess return compensates investors for taking on the relatively higher risk of investing in equity shares of a company.
  • The Equity Risk Premium can be derived from Capital Asset Pricing Model (CAPM), which is as follows:

Rx = Rf + βX (Rm - Rf) Where:

RX = Expected return on equity share of company X Rf = Risk-Free Rate of Return

βx = Beta of Company X i.e. Systematic Market Risk of the Company Rm = Expected Return of Market or Market Portfolio or Return from Market Index

The equity risk premium is basically the excess of a Security’s Return over a Risk-Free Rate Return and accordingly, the CAPM can be remodeled as follows:

Equity Risk Premium = Rx - Rf = βx (Rm - Rf)

The (Rm - Rf) portion is called Market Risk Premium.

  • Nominal cash Flow is the number of future revenues the company expects to receive and expenses it expects to pay out, without any adjustments for inflation.
  • Real Cash Flow shows a company's cash flow with adjustments for inflation.
  • Free Cashflow to equity is used for measuring the intrinsic value of the stock for equity shareholders. The cash that is available for equity shareholders after meeting all operating expenses,  interest, net debt obligations, and re-investment requirements such asworkingcapitalandcapitalexpenditure.Itiscomputedas:

FreeCashFlowtoEquity(FCFE)=NetIncome-CapitalExpenditures +Depreciation - Change in Non-cash WorkingCapital+NewDebtIssued-DebtRepayments

  • Unbiased Expectation Theory: As per this theory long-term interest rates can be used to forecast short-term interest rates in the future on the basis of rolling the sum invested for more than one period.
  • Liquidity Preference Theory: As per this theory forward rates reflect investors’ expectations of future spot rates plus a liquidity premium to compensate them for exposure to interest Rate Risk.
  • Preferred Habitat Theory: As per this theory the Premiums are related to supply and demand for funds for various maturities – not the term to maturity and hence this theory can be used to explain almost any yield curve shape.

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