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Models in Corporate Finance

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Information about Models in Corporate Finance
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Published on March 1, 2014

Author: sureshnain

Source: authorstream.com

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PowerPoint Presentation: MODELS IN CORPORATE FINANCE SURESH NAIN INDIAN INSTITUTE OF FINANCE GREATER NOIDA Models in Corporate Finance: Models in Corporate Finance Capital A sset Pricing Model (CAPM) The arbitrage pricing Theory (APT) Zero Growth Model Constant Growth Model Walter Model Gorden Model Baumol model Miller Orr Model WALTER MODEL: WALTER MODEL The model proposes a relation between the returns on the firms investment or internal rate of returns (r) and its cost of capital or required rate of returns (k). The firms dividend policy should be optimized according to relationship of r and k (a) if r > k the firm should retain its earnings because it can earn well on its investment. PowerPoint Presentation: It can provide better returns than single shareholders can manage to do so. When r > k, than price per share increase as dividend payout ratio decrease. Where r > k they are called growth firms. Optimum d/p ratio is 0. Firms should plough back the entire earnings within the firms. The market value of the share will be maximized. PowerPoint Presentation: (b) If a firm cannot earn profitably when r < k the shareholders will be able a higher returns by using the funds elsewhere When r < k , the price per share increase as dividend payout ratio increase. In this case a d/p ratio of 100% would give optimum dividend policy. (c) If r = k , it is a normal firm. It is a matter of indifference whether earnings are retained or distributed. So all d/p ratio between 0 to 100 market price of share will remain constant. Assumptions: Assumptions Financing is done through retained earnings, external financing is not used. R and k are constant with additional investment business risk does not change. There is no change in the key variable, earnings per share (E) and dividend per share (D) The firm has a perplual life. Walter Model: Walter Model Model specification :: Model specification : Where P = market price per share D = dividend per share E = earning per share r = firms rate of returns ( average ) Ke = firms cost of capital or capitalization rate (k) Scale used : Ratio scale Criticism of Walters Model: Criticism of Walters M odel r is assumed to be constant but this is not realistic because when increased investment are made by the firm r also change. No external financing By assuming Ke as constant, Walter model ignores the effect of risk on the value of the firm. This model does not explain the behavior of share when r = k. BAUMOL MODEL: BAUMOL MODEL William J. Baumol his model in 1952 on the same basis as an economic order quantity model for purchase of optimum number of units of inventory. He suggested that the point where the carrying cost is equal to the transaction cost it is the optimum level of cash balance. Assumptions: Assumptions The requirement of cash is estimated in advance. The cash payments are steady and do not have any change. It assumes the transaction cost but not cost of production. Model specification :: Model specification : Where C = optimum cash balance u = No. Of units t = transaction cost i = rate of interest Limitations of the model: Limitations of the model Measurement of transaction cost is very difficult because every marketable security has a different rate of return and different maturity period. Transaction cost cannot be same for all investments. Baumol assumes that a firm uses cash at a constant rate. Cash outflow of a firm cannot be regular or constant. MILLER ORR MODEL: MILLER ORR MODEL Miller Orr model expands Baumol model and projects that the cash balance fluctuates and when the balance is high, it should be transferred into marketable securities. When cash is low marketable securities should be sold. They explain the model trough two control limits, the upper limit and the lower limit. PowerPoint Presentation: Graph Explanation: When cash balance reaches point `A', the upper limit, company will invest the surplus to bring down the cash balance to return point. When cash balance touches down point `B', the lower limit, the company would liquidate some of its securities to increase the balance back to return point. These limits depend upon variance of cash flow, transaction cost and interest rate. Upper Limit = Lower Limit + 3Z Return Point = Lower Limit + Z Average Cash Balance = Lower Limit + 4/3 Z Model specification :: Model specification : Where b = fixed cost of security transaction = variance of daily net cash flow i = interest rate per day on marketable securities The optimal value of h = 3z

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