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generates after accounting for the required working capital and capital
have, the better it is. It is a financial term which truly determines that
portion of cash remains in the hands of a company after paying all its
building etc. and satisfying all its working capital needs like accounts
company. most of the projects are selected on the basis of their timing
2 – FCFE (EQUITY)
FCFE is a cash flow available for equity shareholders of the company. The
Significance of FCF
Free cash flow is important because it allows a company to pursue
opportunities that enhance shareholder value. Without cash, it's tough to
develop new products, make acquisitions, pay dividends and reduce
debt.
Some investors prefer using free cash flow instead of net income to
measure a company's financial performance, because free cash flow is
more difficult to manipulate than net income.
It is important to note that negative free cash flow is not bad in itself; on
the face of it. If free cash flow is negative, it could be a sign that a
company is making large investments. If these investments earn a high
return, the strategy has the potential to pay off in the long run.
Limitations of FCF
By their nature, expenditures for capital assets that will last decades
may be infrequent, but costly when they occur. Hence 'Free cash flow',
in turn, will be very different from year to year.
Investors must therefore keep an eye on companies with high levels of
FCF to see if these companies are under-reporting capital expenditure
and R&D.
Companies can also temporarily boost FCF by stretching out their
payments, tightening payment collection policies and depleting
inventories. And hence look for companies generating FCF on
sustainable basis.
Thus, to the company, the cost of capital is the minimum rate of return
that the company must earn on its investments to fulfill the expectations
of the investors.
debt and equity in the capital structure of a firm so that the business
business concern.
management also.
5. Dividend Decisions:
rate of return (r) and the cost of capital (k) i.e., r > k, r = k, or r < k which
optimum capital structure that is the proportion of debt and equity, The
objective of the firm should be to choose such a mix of debt and equity so
The capital structure of a firm normally includes the debt capital. Debt
institutions and banks etc. The amount of interest payable for issuing
For preference shares, the dividend rate can be considered as its cost,
since it is this amount which the company wants to pay against the
account.
The funds required for a project may be raised by the issue of equity
dividend or earnings.
business also entail cost. When earnings are retained in the business,
points, cost of capital is also used in some other areas such as, market
A 2 LAKHS 2 1
B 4 4 1
C 5 3 0.6
D 4 2 0.5
E 6 5 0.83
RISK
Systematic risk occurs due to macroeconomic factors. It is also
called market risk. it is beyond the control of a specific company
or individual All investments and securities suffer from such type
of risk. One can’t eliminate such a risk by holding more number of
shares Systematic risk impacts the entire industry rather than a
single company or security.
Unsystematic or “Specific Risk” are primarily the industry or
firm-specific risks that are there in every investment. Such risks
are also unpredictable and can occur at any time. Like, if workers
of a manufacturing company go on a strike resulting in the drop in
the stock price of that company.
Credit Risk:This type of risk arises when one fails to fulfill their
obligations towards their counter parties. Credit risk can be clas
sified into Sovereign Risk and Settlement Risk. Sovereign risk u
sually arises due to difficult foreign exchange policies. Settleme
nt risk on the other hand arises when one party makes the pay
ment while the other party fails to fulfill the obligations.
Diversified Portfolio
The assumption that investors hold a diversified portfolio,
similar to the market portfolio, eliminates unsystematic
(specific) risk.
Systematic Risk
CAPM takes into account systematic risk (beta), which is left
out of other return models, such as the dividend discount
model (DDM). Systematic or market risk is an important
variable because it is unforeseen and, for that reason, often
cannot be completely mitigated.
Those which are not efficient will however lie below the line. It
is worth mentioning here that CAPM risk return relationship is
separate and distinct from risk return relationship of individual
securities as represented by CML. An individual security’s
expected return and systematic risk statistics should lie on the
CAPM but below the CML.
In contrast the risk less end (R) statistics of all portfolios, even
the inefficient ones should plot on the CAPM. The CML will
never include all points, if efficient portfolios, inefficient
portfolios and individual securities are placed together on one
graph. The individual assets and the inefficient portfolios
should plot as points below the CML because their total risk
includes diversifiable risk.
Assumptions :
(i) The investors have homogeneous beliefs/expectations
R = E + bf + e
Thus, this model only states that the actual return on a security
equals the expected return plus sensitivity times factor
movement plus residual risk.
Multiple Factor Model:
Empirical work suggests that a number of variables should be
taken into account for asset pricing. The above mentioned
equation can, thus be expanded to:
But the basic question is what are these factors? They are the
underlying economic forces that are the primary influences on
the stock market. Several factors appear to have been identified
as being important. Some of these factors, such as inflation and
money supply, industrial production and personal consumption
do have aspects of being interrelated.
Intro of risk 1 pg
There is a positive relationship between the amount of risk
assumed and the amount of expected return. Greater the risk,
the larger the expected return and the larger the chances of
substantial loss.
Investments which carry low risks such as high grade bonds will
offer a lower expected rate of return than those which carry
high risk such as equity stock of a new company. A rational
investor would have some degree of risk aversion, he would
accept the risk only if he is adequately compensated for it.
The firm, which employs high fixed cost and the low variable
cost is regarded as high operating leverage whereas the
company which has low fixed cost, and the high variable cost is
said to have less operating leverage. It is fully based on fixed
cost. So, the higher the fixed cost of the company the higher will
be the Break Even Point (BEP). In this way, the Margin of
Safety and Profits of the company will be low which reflects that
the business risk is higher. Therefore, low DOL is preferred
because it leads to low business risk.
Financial Leverage
Dissolving Relationship
If a partner is looking to leave the company, business valuation will
give business owners a fair numerical value for him or her to be
bought out. The monetary worth of each stakeholder’s share in the
business will be identified through business valuation.
Decision-Making Tool
Because valuation takes into account current market conditions, many
business owners use it as a decision-making tool. Business valuation
will help business owners identify the ‘perfect time’ to market their
business. If it is not the right time yet, they can hold out for a later
time when the market changes.
Drive the Management
A routinary business valuation is a good regimen. It will gauge the
management’s performance and specify the facets of the business that
have to be changed or modified. More so, a business valuation will
enable the management to concentrate on important business matters
Listed Entities
According to IESE Business School, the results of a business
valuation can be used to compare the value obtained with the share’s
price on the stock market and to decide whether to sell, buy, or hold
the shares. It can also be utilized as a tool in making comparisons
between entities