LECTUREPEDIA - Ajarn Paul Tanongpol, J.D.; M.B.A.;B.A.; CBEST
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II.

FIRM’S FINANCIAL DECISIONS

In a publicly traded company, the value of the firm depends largely on how much capital the firm can raise through the capital market. The attractiveness of the firm is the capital market depends on its dividend potential. Investors buy the firm’s stock in hope to gain returns through dividend payment during the time when the security is held or making profit when the security is sold. Therefore, under conventional thinking, the current wealth of the investor is defined as:

                                                                                                              [8]

W         =          current wealth;

sV        =          individual’s ownership interest of the firm; and

V          =          value of the firm.

            Equation [8] assumes the current wealth of the investor comes from one source: investment in the firm. If the stream of income of the investor depends only on dividend payment by the firm, investment decision depends on the value of the firm. The value of the firm is defined as:

                                                                                                  [9]

            The value of V is not fixed or predetermined number because firms will declare dividend when it makes profit. Therefore, equation [9] expresses the expected value of the firm, not the actual value of the firm. As explained in the earlier section, the expectation of income not adjusted for the exogenous shock is not rational. It is not rational because such an assumption is based on perfect market condition. This assumption does not reflect market reality. At the national level, for instance, the release of information concerning the GDP, interest rate or certain economic policies will affect the capital market. At the industry level, and entry of competitors will also affect the company’s financial performance. For these reasons, equation [9] must be modified to reflect real market conditions:

                                                                 [10]

        =           as explained in equation [5].

            The individual’s wealth under equation [8] is rewritten as:

                                                                                                            [11]

or         .

The value of the firm to its current owners is the present value of the dividend that will be paid on the old shares (signified by D_t):

                                                                                              [12]

T          =          future time period after which all dividends are zero ()

            Equations [8] to [12] introduce exogenous variables into the valuation of investor’s wealth and that of the firm. Equation [12] is an improvement over the irrational assumption of the natural occurrence of income through dividend payment. However, this improvement still does not eliminate the inadequacy of the definition of wealth of the individual investor. The conventional definition of the individual’s wealth confines the valuation of wealth to the value of the firm and the investor’s share in the firm. This definition underscores the limitation of conventional financial modeling.

            Wealth by definition must include all of the individual’s assets. Asset is defined as economic possession. Economic possession is the power to control, use, and dispose of interests being possessed in a ready market. Therefore, wealth comprises tangible and intangible possessor rights. All that can be touched and felt are tangible. Possessory rights  in res that has no physical form, such as intellectual property rights or the right to receive income under a contract, are intangible. Therefore, in additional to the possessory expectation to receive dividend payment from the firm, the definition of wealth must include other tangible and intangible rights.

Where , a is tangible and b is intangible rights. These rights are not ownership of stock in the firm. Therefore, equation [11] should be rewritten as:

A.        THE SINGLE PERIOD CASE

Present value of the firm in one-period of dividend paid:

                                                                                                           [13]

       =          dividends on currently outstanding shares at time 0;

       =          dividends on currently outstanding shares at time 1;

      =          income (revenues less expense) at time 0;

      =          income including money received from the sale of its assets at time 1;

       =          investment

Therefore;

                                                                                                      [14]

          =          inflow

           =          outflow

In financing terms, the above expressions can be rewritten as:

                                                                                                   [15]

      =          retained earning

                   =          new money

To express the above notation in terms of dividends:

                                                                                                      [16]

The more money raised () the more dividends () will be paid.[1] The cash flow for the firm (), therefore, is expressed as:

                                                                                                    [17]

At time 1, the dividend paid to the original owner is:

                                                                                                    [18]

By substituting  and , the following expression is derived:

                                                                                                   [19]

It is said that dividend policy is not relevant because the payment of dividend does not affect the value of the firm. This assertion is the underlying assumption of equation [19]. However, in the capital market, dividend payment and the prospect of dividend payment affects investor’s decision whether to invest in the firm. This decision directly affects the firm’s value because the capital in the firm; thus, the rise in capital allows the firm more operating capacity. Increased capacity ultimately leads to increase in revenue, profit, and dividend payment. For these reasons, even in a single period calculation of dividend payment when the stock is purchased at , it is uncertain when the firm will declare dividend at time .

By convention, equations [16, 17, 18 & 19] assume that dividends will be paid from the capital raised through the capital market, i.e. selling of the firm’s share. However, in practice, dividends are paid if the firm makes profit from its operations. The money raised through the capital market is considered as a capital inflow, but not operational income or revenue. New capital raised through the stock market () actually is a liability because the money is given to the firm with the expectation that the firm will use it to make profit. The firm is also under the obligation to maximize the shareholder’s wealth. Wealth maximization cannot be achieved by taking from Paul to pay Peter.

The conventional dividend valuation appears counter productive because equations [16, 17, and 18] includes the money raised () through selling of the firm’s shares in the capital market as part of the corpus from which dividend is drawn. This practice would expose the firm to unnecessary risk and reduces the firm’s financial capabilities. The firm is exposed to the risk of under utilization of its capital. The firm is not using its financial resources to its fullest potential. New investors who invest in the firm do so with the expectation that the firm will use that money, along with the money raised through other means, such as bonds and debenture, to invest in projects or expands its operations. These expectations are frustrated if the firm uses the money received from new investors to pay dividends to older shareholders in the firm. As the result, future operations of the firm are relegated to a secondary position of importance. By including  in the dividend calculation, dividend payment to existing shareholders stands in a position of an over-rider in a multi-level marketing (MLM) scheme. It would be financially more productive if the dividend equation is rewritten as:

                                                                                                      [20]

where ; therefore, . Dividend is rewritten as:

                                                                                                            [21]

            The modification treats the new money  as part of income . Income must include from operations plus money raised from investors: . However, this new money  should not be used as part of the corpus from which dividends will be paid; therefore, it () must be deducted from ; thus, .

B.        INVESTMENT POLICY

                                                                                              [20]

                                                                                          [21]

In order to maximize the value of the firm, we should maximize :

                                                                                                       [22]

     =          income of the firm with no investment () at time 1. This value includes the value of the firm’s liquidating value.

            Equation [22] is derived from equations [20] and [21] contains internal constraints. The maximization of corporate wealth is constrained by investment (). In equation [22], the firm will achieve its objective if investment is minimized. However, with minimal investment, the firm will not grow. This riddle is answered at the end of this section.

            Although equation [22] represents the conventional model in finance, its over-simplification begs the question of how value is defined in terms of income and investment. The valuation under equation [22] considers only tangible assets. Income is a finite number. Investment income is also determinable with reasonable certainty. However, other valuable assets, such as brand assets, intellectual property rights, strategic competencies, and human capital are not included in the firm’s valuation under equation [22]. To be more pragmatic and reflective of market reality, the valuation of the firm must be redefined to comprise of two components of assets: tangible and intangible, which are determinable with mathematical certainty, namely

Where  as stated in equation [22], and  or ; therefore, .

            Recall our earlier discussion of exogenous variable as a modifier for investor’s expectation, the same application may be used in the redefinition of valuation; thus,

By simplification, we can rewrite the wealth valuation as:

, or .

            This redefinition of firm valuation is a single period case is not irrational. It is undeniable that intellectual property rights and brand assets are valuable intangible assets for the firm. It is also rational to further assert that these intellectual rights can be equated to monetary value with reasonable certainty.

C.        THE MULTIPLE-PERIOD CASE

                                                                                      [23]

       =          firm’s income stream,

                                                                     [24]

Assume that at time 0 income is  and future investment income is  which are independent of investment policy. The maximization of the firm’s value becomes:

                                                                                          [25]

            The firm valuation of multiple periods under equation [25] is acceptable as a fundamental concept in finance. However, to be more pragmatic it must be adjusted in the same line of reasoning as in the single period case. By including intangible assets in the firm valuation, it is stated that:

; the statement can be restated as:

                                                                                         [26]

            The notation:, optimizes the firm’s wealth or value, but it does not maximize it. In order for the firm to maximize its wealth, it must account for tax savings on its income.

Last modified: 11/11/08