November 15, 2010
One of the primary concerns of management and particularly for a finance manager is to maximize the wealth of the owners for whom the company is run. Creation of wealth is “measured by the share price of the stock, which in turn is based on the timing of returns (cash flows), their magnitude, and their risk” (Gitman, 2006, p. 15). A discussion of how Lowe’s values bonds, stocks, and cash flow to justify the current market price of debt and equity ensues. Various capital valuation models are discussed as the team determines the model that best supports Lowe’s. Basic premises, such as what is debt capital and what is equity capital, and key differences between the two provide additional insight into understanding the models discussed.
“Capital denotes the long-term funds of a firm. All items on the right-hand side of the firm’s balance sheet are sources of capital with the exception of the current liabilities,” (Gitman, 2006, p. 326). Debt capital encompasses all of the long-term borrowing of a company, which includes bonds. Equity capital is the long-term funds from the owners of the company and the stockholders. Equity capital is obtained for the company through retained earnings (internally) or by selling preferred or common stock (externally). Some differences between debt capital and equity capital occur between the characteristics of the voice in management, claims on income and assets, maturity, and tax treatment. Common stockholders and preferred stockholders are owners of a company and hold equity capital in it although creditors do not. The holders of common stock have voting privileges where they can help to select the company’s directors and to vote on special issues. Creditors and preferred stockholders “receive voting privileges only when the firm has violated its stated contractual obligations to them” (Gitman, 2006, p. 326). The claims of creditors come first, though, for income and assets before those of holders of equity. If the company goes into bankruptcy, when the assets are sold the employees and customers come first, the government and creditors come next, and last are the equity holders. When it comes to dividends or increases in stock price for an equity holder, he falls last on the list to receive any distribution from assets. This placement makes the expectations for returns greater. The risk for equity holders is high because the equity capital they provide for financing the company is not repaid like a debt would be. Equity is liquidated only when bankruptcy occurs making the risk even greater with the fluctuation in prices for stock when it happens. Finally, the interest payments to debt holders are tax-deductible expenses by the company while the dividend payments to common and preferred stockholders are not. Deducting taxes for interest lowers the cost of debt financing. This makes it a lower cost than the cost of equity financing. Meshing all of this information together is the priority of management to find the best opportunities for the company to create the wealth needed to operate effectively.
Common Stock Valuation
At the onset, the common stockholder expects that stock purchased in Lowe’s will increase in share value and dividends will be granted on a periodic basis. Security analysts, along with prospective stockholders, frequently review the stock prices to try to evaluate the company’s value. If an investor believes that Lowe’s stock is undervalued, he purchases additional shares. Likewise, if an investor believes that Lowe’s stock is overvalued, he sells. Zero-Growth Model
The zero-growth model assumes that there will be a constant dividend stream; that it is unchanging to perpetuity. Using the Zero-Growth Model, which is the simplest approach to dividend valuation, for Lowe’s stock, determine the rate of required return for the stock. This is done by taking the stock...
References: Compound Annual Growth Rate. (2010). Retrieved from Investopedia: http://www.investopedia.com/terms/c/cagr.asp
Gitman, L. (2006). Principles of managerial finance (11th ed.). Boston, MA: Pearson.
Lowes Companies, Inc. (2010). Retrieved from Yahoo Finance: http://finance.yahoo.com/q?s=LOW
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