SUMMARY > Valuation is the process that links risk and return to determine the worth of an asset/security. The key inputs in the valuation process are expected returns (cash flows), their timing / pattern and the risk (required return). > The value of a security is the present/discounted value of all future cash-flows associated with it over the relevant/specified period. Symbolically, > The value o

Combined Effect (Example)

EXAMPLE To illustrate the combined effect of the changes in the expected return and the required return in compute the value of the shares. Solution The net effect of the management decision which increased return (i.e. g from 7 to 9 per cent) as well as risk (i.e. K, from 16 to 17 per cent) is positive resulting in increase value of share. from Rs 33.3 10 Rs 37.5. As it increases the owners value, the decisi

Combined Effect

Combined Effect A financial decision typically affects both return and risk. Depending on the magnitude of change in these variables, the net effect on value can be assessed.

Changes in Risk (Example)

EXAMPLE Assume for the facts in that reflecting an increase  in risk the required rate increases 17 per cent. Compute the value of shares. Solution Thus, the value or shares has declined from Rs 33.3 to Rs 30 due to increase in the required return (K) without any corresponding increase in the expected return.

Changes in Risk

Changes in Risk Any action by the financial manager that increases risk will also increase the required return. It will result in reduction in value. Any action that decreases risk would contribute to an increase in value.

Changes in Expected Return (Example)

EXAMPLE For the facts in Example 4.7, assuming that the expected rate of growth would increase from 7 to 9 per cent due to proposal to upgrade technology, compute the value of the share. Solution Thus, value of shares has increased from Rs 33.3 10 Rs 42.9. The increase is caused by the higher expected future return-dividends as reflected in the increase in the growth rate.

Changes in Expected Return

Changes in Expected Return Any management action that would increase the level of expected return without changing risk (required return) would have a positive effect on share values/owners wealth and should, accordingly, be undertaken.


RELATIONSHIP AMONG DECISIONS, RETURN, RISK AND SHARE VALUES Any action of the financial manger that (i) increases the level of expected return (D,g) without changing risk (k,) should increase share value, (ii) reduces the level of expected return without changing risk should reduce share values. Likewise, any action that increases/reduces risk (required return) will reduce/increase share value. Since financial

Price/Earnings (P/E) Multiples/Ratio

Price/Earnings (P/E) Multiples/Ratio The P/E ratio/multiple reflects the amount investors are willing to pay for each rupee of earnings. Symbolically, where 1 - b = dividend pay ratio r = required rate of return ROE x b = expected growth rate The earnings per share (EPS) of the firm are multiplied by the average P/E ratio for the industry to estimate the value of the firm on the assumption that the investors va

Liquidation Value

Liquidation Value This approach to valuation of shares is based on the liquidation value per share (LVPS). If the total assets of Alert Ltd can be liquidated for Rs 52.5 crore, its LVPS = (Rs 52.5 crore - R.. 45 crore) + 10,00,000 = Rs 75. The minimum value of the firm would be Rs 75 per share. The LVPS is a more realistic measure than book value, But it ignores the earnings power of the assets of the firm. Mor