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Exercise 1: Corporate Valuation and Takeover: A Review

We have seriously questioned the traditional assumptions of perfect markets, the agency principle and the strength of real world efficiency that underpin comparative analyses of supposedly random prices and returns by rational, risk-averse investors. Nevertheless, they still provide indispensible, theoretical benchmarks for any framework of investment, postmodern or otherwise, first formalized as the Efficient Market Hypothesis (EMH) by Eugene Fama (1965)


Because of its pivotal role in the remainder of this study, you should refer to the details of the EMH explained in Part One of CVT and before we proceed:

Briefly define "efficiency" and consider the implications of the EMH for the purposes of valuation and takeover.

An Indicative Outline Solution

Shareholder wealth maximization is based upon the economic law of supply and demand in a capital market that may not be perfect but reasonably efficient (i.e. not weak).

Efficiency and its strength (weak, semi-strong or strong) are determined by the increasing speed with which the stock market and its participants assimilate new information into the price of financial securities, such as a share.

Historical evidence suggests that investor decisions and government policies are based on the assumption of semi-strong efficiency. Hence, the absence of tight market regulation.

Rational investors respond rationally to new information (good, bad or indifferent) and buy, sell, or hold shares in a market without too many barriers to trade.

The market implications of the EMH relevant to valuation and takeover can be summarized as follows:

- If efficiency is semi-strong, or strong, speculative investment is pointless without the advantage of "insider" information.

- In the short term "you win some and you lose some".

- In the long run, you cannot "beat the market". Investment is a zero sum game that delivers returns appropriate to their risk, i.e. what theorists term a "martingale".

- Yesterday's trading decisions based on prices and returns are independent of today's state of play and tomorrow's investment opportunities.

- If current share prices closely reflect current dividends and future profitability, agency theory can transform shareholder objectives into managerial policy.

- NPV maximization represents the optimum managerial investment criterion to maximize shareholder wealth.

- New share issues that incorporate a market premium or discount should be based on their "intrinsic" value and ignore market sentiment.

- Creative corporate accounting will not fool the market.

- Takeover policies are also a zero-sum game, unless predatory corporate management can identify quantifiable synergistic benefits and economies of scale.

Summary and Conclusions

Irrespective of whether markets are efficient, behavior is rational and prices or returns are random, every investor requires standards of comparison to justify their next trading decision. For example, has a firm's current price, dividend or earnings prospects risen, fallen, or remained the same, relative to the market, its competitors, or own performance over time? And how are they trending?

We have observed that the key to unlocking these questions presupposes an understanding of the nature of stock market efficiency. All the material contained in the CVT companion text builds on this and forms the basis of the remainder of this study.

So, let us conclude with a brief summary of the remainder of CVT for future reference before you read the following chapters.

Part Two (Chapters Two to Four) evaluates conflicting theoretical share valuation models relative to profitable stock market investment, even if markets are perfect.

Chapter Two presents a sequence of theoretical share price valuation models. Each enables current shareholders, prospective investors and management to evaluate the risk-return profiles of their dividend and earnings expectations and the market capitalization of equity.

But are dividends and earnings equally valued by investors who model share price?

Chapter Three deals explicitly with the relevance of the corporate dividend decision based on the pioneering work of Myron J. Gordon (1962). We analyzed its impact on current share price, the market capitalization of equity and shareholders' wealth, determined by the consequences of managerial policies to distribute or retain profits, which stem from their previous investment decisions and search for future investment opportunities.

Chapter Four then introduces an overarching theoretical and empirical critique of the irrelevance of dividend policy to the maximization of shareholder wealth by Modigliani and Miller (MM) whereby:

Dividends and retentions are perfect economic substitutes and a firm's distribution policy cannot determine an optimum share price and hence share price maximization.

Part Three translates conflicting theories of share valuation into practical terms with reference to real world share price listings, based on the capitalization of a perpetual annuity.

Chapter Five explains how stock market data relating to price, dividends (the yield and cover) and earnings (the P/E ratio) are analyzed by the investment community, supplemented by other informed sources to implement trading decisions (i.e. "buy, sell or hold").

Chapters Six and Seven evaluate various strategies for investment based on dividends, growth and whether we can "beat" the market.

Part Four then applies these market dynamics to corporate investment policies designed to maximize shareholder wealth.

Chapter Eight critically examines the specific case of a firm seeking a stock exchange listing and hence a market valuation for the first time.

Chapter Nine compares and contrasts rational shareholder objectives and various subjective, managerial motives for takeover activity.

Chapters Ten and Eleven analyze a series of comprehensive valuations for companies prey to takeover based on a rational consideration of long-run shareholder profitability compared with the irrational managerial motives of predator companies.

Chapter Twelve concludes our analyses with a survey of the current takeover scene and a guide to investment behavior based on a number of "golden" rules to investment explained throughout the text.

Selected References

1. Fisher, I., The Theory of Interest, Macmillan, 1930.

2. Jensen, M. C. and Meckling, W. H., "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure", Journal of Financial Economics, 3, October 1976.

3. Markowitz, H.M., "Portfolio Selection", Journal of Finance, Vol.13, No.1, 1952.

4. Tobin, J., "Liquidity Preferences as Behavior Towards Risk", Review of Economic Studies, February 1958.

5. Sharpe, W., "A Simplified Model for Portfolio Analysis", Management Science, Vol.9, No. 2, January 1963.

6. Fama, E.F., "The Behavior of Stock Market Prices", Journal of Business, Vol. 38, 1965.

7. Gordon, M. J., The Investment, Financing and Valuation of a Corporation, Irwin, 1962.

8. Miller, M. H. and Modigliani, F., "Dividend policy, growth and the valuation of shares", The Journal of Business of the University of Chicago, Vol. XXXIV, No. 4 October 1961.

Text Books

Strategic Financial Management, (SFM), 2008. Strategic Financial Management: Exercises (SFME), 2009. Portfolio Theory and Financial Analyses (PTFA), 2010. Portfolio Theory and Financial Analyses: Exercises (PTFA), 2010. Corporate Valuation and Takeover, (CVT), 2011.

Business Texts

Strategic Financial Management: Part I, 2010. Strategic Financial Management: Part II, 2010. Portfolio Theory and Investment Analysis, 2010. The Capital Asset Pricing Model, 2010.

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