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Financial Economics by Guofu Zhou, Edwin H. Neave, Frank J. Fabozzi

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4

HOW INVESTORS VALUE FIRMS

In this chapter we consider how investors value firms under certainty in a perfect capital market. We show that the value of a firm whose managers follow the market value rule is given by the sum of (1) the present value of cash flows to be generated by the firm's existing assets plus (2) the present value of cash flows to be generated from future growth opportunities. This result holds true even when the growth opportunities have not yet been initiated. The equivalence of earnings and dividend approaches to valuing the firm is also established as a part of the general valuation result. In addition, the question of who benefits from investments yielding returns in excess of market rates is explored. We consider the meaning of a growth stock and the restricted circumstances under which it is possible for stockholders to earn returns in excess of market rates of interest. We discuss returns on investments when an investor's planning horizon might differ from the term to maturity of the investment in which the funds are invested, a matter of concern both in valuing assets and in relating interest rates over time periods of different length.

All the foregoing results are of considerable importance to understanding financial decisions in more complex circumstances, because they show who benefits from wealth-creating new investments that a firm undertakes and when the benefits are realized. Although the results are established under certainty, they also help ...

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