Question

Write a corporate management report in which you explore the factors that influence the valuation of the equity of a company. Be sure your report includes the following:

Assume the CAPM is used to form the weighted average cost of capital (WACC). Form a discussion on the CAPM in which you describe each of the following issues.

o Determine how diversification is important in the formation of the CAPM. The discussion should focus on the topics of total risk, systematic risk, and unsystematic risk.

o Define and provide numerical illustrations for the CAPM. Show how the model adjusts across different inputs and the consequence for valuation.

o Research and defend the validity of the CAPM given the academic literature. Based upon this model, explain the ways that managers can form initiatives to enhance the value of the corporation. Provide numerical illustrations of these initiatives based upon modifying the assumptions in the model and re-calculating the final value. For example, demonstrate how increasing or decreasing the sales growth rate will affect the bottom line valuation of common equity.

Answer 1

The Key Factors that Influence the valuation of the equity:

Investors should evalute company's value drivers by comparing them to industry peers. For example, one can start with historical price -to- EBITDA, multiples as follows.

• Profitability
• Growth
• Risk
• Market analysis
• Management
• Customers
• Vendors
• Lack of products
• Financial Position/Strength of Balance sheet
• IP/legal risks.
• Infrastructure
• Internal controls.

Determine how diversification is important in the formation of the CAPM. The discussion should focus on the topics of total risk, systematic risk, and unsystematic risk?

CAPM deals with the risks and returns on financial securities and defines them precisely, if arbitrarily. The rate of return an investor receives from buying a common stock and holding it for given period of time is equal to the cash dividends received plus capital gain during the holding period divided by the purchase price of the security.

Unfortunately, the perfect negative relationship between the returns on these two stocks is very rare in the real world. To some extent, corporate securities move together, so complete elimination of risk through simple portfolio diversification is impossible. However, as long as some lack of parallelism in the return of securities exist, diversification will always reduce risk.

Types of Risks:

1. Systematic Risk
2. Unsystematic Risk

Systematic Risk: It aslo known as market risk or undiversifiable risk is the uncertainity inherent to the entire market or market segment. It is also referred to as volatality, systematic risk consists of the day to day fluctuations in a stock prices.

Unsystematic Risk: It is also known as specific risk or diversifiable risk. It is type of uncertainity that comes with the company or industry you invest in. Unsystematic risk can be reduced through diversification.