Question

1. Why is share valuation more difficult than bond valuation? Be sure to identify the risks and uncertainties faced by shareholders that do not affect bond holders.

2. Discuss the following statements:

1. The debate surrounding shareholder and stakeholder theory is really just a matter of law.
2. The price we are willing to pay now to compensate for future climate damages is determined largely by the discount rate that is used.
3. People care only about maximizing their wealth, and don’t care about their impacts on society through their investments.

Answer 1

Share valuation is more difficult than bond valuation

In case of share the return a shareholder receives in the form of dividend. Whereas in case of bond the return a bond holder will receive is known as interest against agreed coupon rate.

The dividend is paid on net income of the firm after the adjustment of depreciation, interest payment, tax payment and if preference holders exist and if the firm declares dividend then the preference shareholders to be paid earlier before making the payment of shareholders. ice

It is from aforesaid statement we notice that before calculating net income distributable for dividend the interest has already been considered after the deduction of interest from earnings before interest and tax amount there are several steps to overcome.

Therefore, the presence of complexity should be there in valuing the net earnings of the firm which is one of the base of share valuation as the value of the firm depends on the value of the wealth of the shareholders that value of wealth is correlated with the net income of the firm.

In case of share valuation generally two to three models carry valid importance.

Illustration of share valuation model and comparing it with bond

1. Constant growth model

This model is made up with an assumption that the dividend will grow at the same rate up to indefinite future. The constant growth considers time value of money. The rate of growth is taken from the past records of dividend earnings. But this model does not forecast about the future dividend and future selling price.

On the contrary the coupon rate of a bond is fixed. The bond holders know how much they will get at the end of the bond terms or maturity. The share holders if depend on constant growth model by assuming certain rate of growth and predict the future earnings it should not result proactive because declaration of dividend per period is not mandatory. A firm can retain the net income for its future use and may not declare dividend.

There are several external factors in the market which restrain the firm’s smooth operation and affect its profit earnings which are not as risky in case of bond as the interest payment is mandatory form the part of the firm to the bond holder.

2. Multiple growth model

The rate of growth may vary from period to period so an alternative share valuation model is developed on the basis of two growth segments.

a) During initial period the growth rate will be varied say up to N periods

b) Subsequently the growth will be considered as constant i.e. N to infinity

As opposed to the bond valuation the time taken in the share valuation is up to infinity. However, in case of bond there is a fixed period of holding the bond.

Moreover, in case of share valuation the term risk is inherently associated with the return.

Some shares are highly risky for investment. Some shares carry moderate risk taking capability and some shares are low risky. It depends upon the risk taking capability and perception of the share holder that how much they will take up the risk.

In case of bond since the rate of coupon is fixed therefore and it is paid to the bond holders after the maturity so the return is termed as risk free return. Although purchasing power risk is there for the investment against long term bond and that type of risk is the difference between the current market interest rate and the coupon rate. Although this difference is not as risky as the investment made in the risky shares where, the price is fluctuated heavily due to volatile market condition

3. Multiplier approach

The valuation of share can be done by adopting several multiplier and one such multiplier is known as Profit earnings ratio(P/E ratio).

P/E ratio = Share price Earning per share

Here the investors’ gauge about P/E ratio is an important factor depending on the value of the shares in the market.

As for example if the earnings price per share is $10 and the investors comprehend that the appropriate P/E ratio in the current market should be 20. Then the price of the share is $10ˣ20

is $200.

However, the main problem is to determine the correct P/E ratio. It is calculated on subjective basis and considering the fundamental factors of the economy. If the expected growth rate is higher the risk would be lower and vice-versa.

Comparison between the two under the light of systematic and unsystematic risk

In the bond valuation we see the presence of systematic risk i.e. purchasing power risk. However, in the case of share valuation both systematic and unsystematic risks remain present. When the investors buy a high risky share they expect to receive risk free return together with risk premium for taking up the risk which is not found in case of bond return. Here when the market rate is greater than the coupon rate a bond holder seeks to sell the bond at a lower price if he holds long term bond as for holding such bond for a long term he will lose the increased rate of interest. Since the difference between the market interest rate and coupon rate is not that much as it is found in risk premium relating to share price therefore, calculation of risk is very important factor in case of share valuation which is not found in case of bond valuation.

Answer 2a

Debate surrounding shareholders and stakeholders

Shareholder of a firm is called an investor who holds the share of the firm and achieves the right of ownership up to the part of that holding.

Stakeholders of firm are those who are directly or indirectly bearing some interest with the firm. It may include creditor, society, Government, employees etc.

Debate 1

In case of shareholders, as a manager of the firm he has to increase the wealth of the shareholder.

Again at the same time he has to check the degree of interest of the shareholders so that the stakeholders of the firm can be deprived. Here, the manager either has to follow the normative theory or to go through the business ethics and has to choose what is correct for a particular situation when such crisis arises.

2.

The capital contribution by the shareholders provides the ownership right which impliedly give them the power to dictate where to use such capital in order to increase their wealth.

If the above is the right of the shareholders in view of the analysis of stakeholders’ right it is found that the duty of the manager is not only to use the capital for the interest of the shareholders’ choice but to use the fund in such so that all the parties associated with the firm get benefited for it.

3.

As per the theory of stakeholders the management of the firm should look towards the goal of profit maximisation which may lead to protect the two aspects of the stakeholders and these are:

The ethical rights of all stakeholders are not infringed and in case of decision taking purposes the legitimate interest of the stakeholders should be procured.

Although in terms of capital budgeting theory the financial goal of the firm is to maximise the wealth of the shareholders

Therefore, the aforesaid points are relevant for debate relating shareholders and stakeholders.

Answer 2b

The price we are willing to pay now to compensate for future climate damages is determined largely by the discount rate that is used.

No one even predict the future accurately. The market always faces two types of risk one is systematic and the other is unsystematic.

Facing systematic risk is inevitable and it is measured by beta. While the unsystematic risk can be decreased by diversification. However, the systematic risk which is measured by data cannot be diversified. Hence uncertainty always lies in the market. When time value of money is considered to know real worth of the money due to the presence of uncertainty in the market we have express the time value of money by applying discount rate on the return amount of the investment sum otherwise the systematic risk which brings uncertainty in the market cannot be justified.

The presence of inflation put a great damage to the worth of the money hence the worth of dollar decreases and to justify the real return of the money invested for a certain period of time such discounting factor is used.

Answer 2C

People care only about maximizing their wealth, and don’t care about their impacts on society through their investments.

When a firm cater its product to the society it creates positive impact. However the negative impact lies on putting the interest to maximise the wealth of the shareholders by increasing earnings over the years are to be balanced. So the balance between the positive impact and the negative impact of the firm can be made in order to remove the negativity in the society by adopting the method of social responsibility which enables the firm to create more value to the society along with the value to its shareholders.

There are several issues the firm should look upon apart from the interest of the shareholders. These are climate changes, resource shortage, inequalities which actually may lead to hamper the society where the firm also belongs. Therefore, the firm should look into these issues and prepare proactive plans to add more values into the society.