Question

1. What are the Discount For Liquidity and the Discount For Control. How do they affect a corporation’s valuation?

2. Consider three firms A, B, and C, all of which have the following financial costs:

r_e= 16%

WACC = 12%

i_L(interest rate on its liabilities) = 6%

            These three firms have the following profitability measures:

	A	B	C
ROA	14%	8%	5%
ROE	18%	12%	10%

For each of these three firms, answer the following questions:

1. Is the overall enterprise profitable?

2. Is the equity of the firm profitable?

3. Would each firm improve its profit if it increased its debt, that is increased its leverage?

Answer 1

1. Discount for liquidity is the discount which investors assign to the firm's securities if they are very illiquid. This is because the illiquid securites cause the higher volatility in the prices. Discount for control is the reduction in share prices which the minority investors apply because they do not have the control to affect some of the key decisions of the firm. These discounts result in lower valuation for the firm.

2.

Is the overall enterprise profitable?

Overall enterprise is profitable if ROA is greater than WACC (12%). Out of the given firms, only A is profitable and B, C are not profitable enterprises.

Is the equity of the firm profitable?

Equity is profitable if ROE is greater than re (16%). Out of the given firms equity of A is profitable and it is not profitable for B & C.

Would each firm improve its profit if it increased its debt, that is increased its leverage?

Profits will improve only if the ROA is greater than the interest rate on liabiliites (6%). Out of given firms, profits of A & B will improve after increase leverage but profits for C will not.