PART 1 AND 2 NEEDED ONLY 26Chapter 1. Value Creation, Financial Statements, and
ID: 2618832 • Letter: P
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PART 1 AND 2 NEEDED ONLY
26Chapter 1. Value Creation, Financial Statements, and the Environment of Financial Reporting In general, the cost of equity for an individual firm ER)l increases with increases in the risk-free rate [E(Rl, increases in the firm's beta (B), and increases in the difference between the overall market return and the risk-free rate [ER)-ERy)]. The risk-free rate and the difference between the overall market return and the risk-free rate are the same for all firms; the beta is unique to each firm. Investments in firms with betas of zero are equivalent to investments inrisk-free securities with guaranteed returns, and investments in firms with betas of 1.0 are equivalent to investments in market index funds. To illustrate how the CAPM is used to estimate the cost of equity, consider investments in the common stocks of Microsoft and Cisco Systems. According to Hemscott, Ine., data reported by Factiva (a division of Dow Jones&Company;), as of November 25, 2005, Microsoft and Cisco had betas of 0.53 and 1.99, respectively. Using a risk-free rate of 5.0% (10-year government treasury notes) and an expected risk premium of 6% leads to the following cost of equity estimates for Microsoft and Cisco: Microsof Cisco 0.08 0.05+0.53 (0.06) 0.17-0.05+1.99 (0.06) Cisco has a higher cost of equity because it has a higher beta that is, historically the price of an investment in Cisco common stock has been more sensitive to market changes than the price of an investment in Microsoft. Because Cisco shareholders are bearing more risk holding Cisco stock, they can reasonably expect a higher ROE from Cisco's management. Using these estimates, to create value for its stockholders, Cisco's management must gener- ate an ROE of more than 17%, while Microsoft's management need only generate an ROE that is greater than 8% MEASUREMENT CHALLENGE-MEASURING BETA Although the CAPM is a Nobel Prize-winning innovation which are, of course, unobservable today. Furthermore, even in financial economics, it remains controversial. In part, the measarement of the historical values is subject to disagree- controversy arises in trying to apply the model. We can cal ment: What historical period should be used? Daily or weekly culate historical rates of return and historical betas, but the returns? And so on. Regardless, accounting reports are often model calls for inputs of future returns and future betas, used in estimating these expected future values CASE AND REVIEW QUESTIONS The Home Depot, Inc., Kingfisher plc, and Value Creation According to the analysis described in Figure 1-5, Lowe's created value for its sharehold- ers in 2006. You would like to know how Lowe's performance compares with its main competitor in the United States. The Home Depot, Inc. and a major home improvement retailer in the United Kingdom, Kingfisher ple. A brief description of each company follows (drawn from their annual reports), along with their balance sheets and income statements For comparison purposes, Lowe's balance sheets and income statements are also provided. Home Depot, Inc., was incoporated in 1978 and it is the world's largest home improve- ment retailer and the second largest retailer in the United States, based on net sales for theExplanation / Answer
1. Return on Equity= Net Income (or profits)/ Shareholders funds (Figure 1-5 is not visible) hence the financila statements of all the companies are not visible. But the formula for calcuation is the same for each of the three companies Lowe, Home Depot and Kingfisher
2. Value created= Change in market cap. Marke tcap of each company is given by the formula
No of Shares X Price of each share= Market cap
The market cap changes by two ways, a) Increase in price of shares and b) by issuing more shares i.e. increasing the outstanding shrares
Both the details are not available
2 (contd) Net income is an incomplete measre of value creation as an increase in net income doesn't necessarily lead to a proportionate increase in market cap.
Cash flow is not a measure of value creation as cash flow could be an outcome of increased borrowings, or due to sale of some fixed assets etc which could hurt the long term earnings potential of the company.
Hence, an increased cash flow is not necessarily leading to an increase in the company's market capitalization
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