Question

Describe, in words, the Law of One Price value for a common stock, including the discount rate that should be used.

Describe circumstances in which cutting the firm’s dividend will raise the stock price.

What discount rate do you use to discount the future cash flows of a stock?

What is the enterprise value of a firm?

Answer 1

(I) Law of one process for Common stock

The Law Of One Price (referred to as LOOP) is an economic theory which states that the price of identical goods or services or Securities in various markets must be the same after taking into consideration the currency exchange (i.e., when the prices are expressed in the same currency). The law applies mainly to securities traded on financial marketsmarkets.

-Law of one price drescribe that value of a common stock and all the similar stock in the market should be same after taking into consideration various market factors.

-The law of one price is based on few principles, which include free-market competition, the lack of trade restrictions, and price stability and neither the buyer nor the seller can control the common stock price.

- The LOOP primarily persists due to incentives for arbitration. If the prices of similar shares diverge across the markets, arbitration opportunities arise as a trader may buy a share at a lower price in a market and sell it at a higher price for a net profit instantly in another market. Economic theory notes that eventually, supply and demand mechanisms would converge prices across economies, thereby reducing arbitration incentives.

However, in reality, the law of one price does not always hold true. Say, if the trade of goods involves transactions costs or trade barriers, the law will not work.

Discount rate that equates the price of common stock in various markets should be taken to hold good the law of one price.

(II) Cutting firms dividend and price rise

- Generally a firm having constant and regular divided payment records attracts the investor.

-Companies that can grow their dividends are seen as stable and attract investors looking for income as well as capital gains. Sometimes, however, it can hurt a company's bottom line to distribute profits as dividends rather than retain earnings to solidify the company's financials. Companies may cut dividends in response to an economic downturn, a spate of negative earnings, or more serious threats to the company's health. Other times, the cut may be more strategic and orient towards future growth or allow for buybacks.

-in the following circumstances even if there is dividend cutting the stock price of the firm will increasing

a. When there is a future merger of acquisition is going to be taken place in the company

b. When the company retains it's dividend so as to prepare for a future project

c. When earnings are retained to introduce new products ans services so as to diversify the business

d. When dividend are being cut to completely pay off the debts of the company.

(III) Discount rate for future cash flow of a stock

DCF analysis finds the present value of expected future cash flows using a discount rate. Investors can use the concept of the present value of money to determine whether future cash flows of an investment or project are equal to or greater than the value of the initial investment.

- Expected return from the stock to be used as a discount rate to calculate the present value of future cash flow of a stock

(IV) Enterprise value of a firm

Enterprise value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market capitalization.

EV includes in its calculation the market capitalization of a company but also short-term and long-term debt as well as any cash on the company's balance sheet.

EV=MC+Total Debt−C

MC= Market capitalisation

C= cash