Literature Review

Topics: Economics, Capital asset pricing model, Investment Pages: 22 (6913 words) Published: May 30, 2010
Revista Empresarial Inter Metro / Inter Metro Business Journal

Fall 2006 / Vol. 2 No. 2 / p. 39

By Jimmy Torrez Associate Professor Graduate School of Business Administration Rio Piedras Campus University of Puerto Rico Mohammad Al - Jafari Managing Director Jordan Deposit Insurance Corporation (JODIC) Amman Jordan Ahmad H Juma’h Professor School of Economics Metropolitan Campus Inter American University of Puerto Rico

Abstract This article discusses the ways and methods of corporate valuations that include the discounted cash flow models, the Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Models (APM), Tobin's q, sales accelerator and cash flow models of investment, and economic base performance measures such as Economic Rent and Excess Market Value. It seems that more innovated methods to detect changes in companies’ financial positions are needed. Also, managers’ financial experiences are essential for companies to compete in a world with a constant change. Introduction The corporate finance theories and practices have evolved since the 50’s from normative to positive approaches to explain why and how investors react to companies’ decisions and announcements with respect to companies’ financial and investment decisions. The ways and

Revista Empresarial Inter Metro / Inter Metro Business Journal

Fall 2006 / Vol. 2 No. 2 / p. 40

methods used to estimate companies’ values are essential issues in corporate finance. Several events during the last years have changed the validity of the models and methods of corporate valuations. The case of Enron is one of these events that make us reevaluate the classical and neoclassical methods. The aim of this article is to discuss the current corporate valuation methods. In considering the financial valuation models, the second section deals with the most basic levels of valuation that include discounted cash flow models, under these types the models of value the company is simply the net present value of some measure of future cash flow. To link between market risk and equity returns, the Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Models (APM) are frequently used in corporate valuation. A variety of investment decisions can add value to companies. The third section discusses the basic investment models that include a neo-classical model of investment. This type of model relates the desired capital stock to interest rates, output, and capital asset cost and tax policies. Tobin's q, sales accelerator and cash flow models of investment are measures used to explain the relation between investment and companies’ value. The Weighted Cost of Capital (WACC) concept is also used to explain how the value of a company to its shareholders can be manipulated by changing the proportion used among alternative methods of financing investment projects. There are several models that incorporate economic base performance measures. The forth section covers aspects with respect to the growth potential measures of companies’ value. Under this type of model the value of the company is determined by its ability to generate Economic Rents (ER). Economic Rent represents the economic profit that companies generate after deducting all costs including opportunity costs. It is predicted that when a company generates ER it will enjoy Excess Market Value (EMV). Excess market value is the added valuations a company receives relative to other companies with similar risk characteristics, but who do not generate ER.

Discounted Cash Flow Models
Valuation models based on the discounted cash flow concentrate on valuation by reference to one of several expected cash-flow proxies. These include dividends, cash flow and accounting earnings. In a perfect world these variables should produce identical results; however

Revista Empresarial Inter Metro / Inter Metro Business Journal

Fall 2006 / Vol. 2 No. 2 / p. 41

the empirical...
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