FINANCIAL ANALYSIS



Financial Analysis

Financial Analysis

Purpose of the Study

The purpose of the study is to assess different models used for the calculation of cost of equity and find out the best possible option for the purpose. Cost of Capital or equity shows the cost the company has to pay on its mode of financing. It could be either debt or equity or combination of both. The company calculates Weighted Average Cost of Capital for calculating the total cost of debt and equity. This weighted average cost of capital is used as a discount rate to find out the value of investment.

Part I

Dividend Discount Model

Dividend discount models are built to determine the intrinsic value of a share of a common stock under specific conditions as to the expected growth pattern of future dividends and the appropriate discount rate to employ. According to investors, whether institutional or individual, may wish to take a decision concerning the purchase of shares in a firm, selling of the current holding or adding to the existing portfolio. The dividend valuation model is usually used to estimate the value of a company's shares (Grinold, 2004). The model is generally represented as ; where Po is the current value of the share, D1 is the expected next future dividend payment, k is the discount rate and g is the expected growth in dividends. The basis of the dividend discount model is basically the use of present value analysis. As such, the fair value of a stock-market share is the present value of the expected future stream of dividends, defines the intrinsic value of a share as the present value of all dividends to be paid upon/ earned by it. The dividend discount model (DDM) has been used to value shares under conditions of no growth in dividends, constant growth in dividends and multiple growths in dividend. The DDM is based on the assumption that there is no attribute bias; that is, stocks preferred under the model do not have certain specific attributes. Jacobs and Levy in 1988 found out that the DDM's expected return are related to equity attributes such as low (price-earnings) P/Es, dividend yield and book value- to- price ratio (Hirschey, 2003).

CAPM Model

The CAPM postulates a linear relationship between the systematic risks (beta) and the expected return. The CAPM can be good or bad depending on economic times due to the height of the market yield recorded. Securities with high beta and high market returns tend to be profitable. Because the relationship between return demanded and prices is inverse, these systems offer a higher expected return and will be offered at a lower price.

CAPM calculates the expected rate of return considering the systematic risk of an asset. CAPM is the excess of risk free return to the product of beta of an asset and risk premium [CAPM= rf+Beta (rm-rf)]. Rf represents the risk free rate while rm is the return of market.

Arbitrage Pricing Theory

Arbitrage pricing theory, also known as the Arbitration (APT - arbitrage pricing ...