What is Corporate Valuation
The modern theory of valuation has developed on foundations laid by Modigliani and Miller (1958 and 1963), hereafter MM. MM showed in their 1963 paper that the value of the firm is affected by the financing of the firm because of the tax deductibility of debt interest payments. Recent works, for example, by Scott ((1976), Kim (1978 and 1982) and Morris (1984) have extended the theory to derive firm value maximization with respect to capital structure. A missing factor in these studies has been the impact of working capital decisions on valuation. Clearly, the asset side of the balance sheet also affects value. Bierman, Chopra and Thomas (1975), Stone (1978) and Morris (1984) have attempted to integrate working capital decisions within a valuation framework. However, explicit consideration of variables which influence the liquidity level of the firm in a valuation context has been given minimal attention. The purpose of this study is to examine the well established belief that “the value of a company is the discounted value of its future earnings, yet it is difficult to establish one unique and unarguable value for a company”.
In the finance literature, the term “liquidity” is widely used, but it is also one of the least well defined concepts. Liquidity is used to describe individual assets, portfolios and firms. According to Stone (1978, p. 2), while the liquidity of assets and portfolios has been unanimously defined as “the nearness to cash in terms of time, cost and certainty of conversion” the liquidity of firms is more difficult to define and measure. Due to problems in conceptual definition and measurement, liquidity is often linked to working capital. The finance literature is replete with characterizations of firm liquidity as the level of liquid assets (cash and marketable securities), the amount of networking capital (current assets less current liabilities) and financial ratios [Van Horne (1980) and Weston and Brigham (1981)], or by elegant measures incorporating cash flows [Bierman (1960) and Lemke (1970)] and the variability of cash flows [Emery and Cogger (1982)].
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The objective of having liquidity in the firm’s balance sheet, no matter how it is defined or measured, may be best characterized as the purchase of insurance from cash insolvency (precautionary liquidity in Keynesian terms) by providing a buffer for uncertainty in cash requirements. However, this insurance is obtained at the cost of expected profitability. The concept of protection from cash inadequacy can also be made a function of borrowed funds from pre-arranged and/or unused lines of credit (i.e., unused debt capacity) and the maturity composition of the firm’s obligations.
This study attempts to incorporate such factors into an analysis that shows the influence of liquidity on valuation. A recurring theme in the finance literature is the discussion of the trade—off between profitability and liquidity. Profitability is concerned with the overall objective of shareholder wealth maximization. Liquidity, on the other hand, is concerned with ensuring that the firm is able to satisfy all of its current financial obligations and possesses adequate funding to carry on the long range activities of the company. Traditional economic analysis discusses profitability in terms of product and factor markets. The composition of the firm’s assets is generally given little discussion. However, practitioners are aware that profitability is influenced by the proportion of net working capital assets to fixed assets. These two categories of assets are related to the factor markets in the following way.
A firm’s scale of production is determined by its volume of fixed assets, and net working capital is determined by the level of actual production. In turn, the liquidity, or solvency, of the firm is determined, to some extent, by the level of net working capital. More specifically, liquidity is determined by the timing of cash flows and the ability to borrow from other short-term sources.
Management’s policy in determining the level of net working capital to be maintained affects the rate of return of the firm. Generally, a conservative working capital policy will result in lower profitability than that of a less conservative policy. However, the benefit associated with a lower return is reduced risk. A conservative working capital policy is often associated with large cash or near cash balances, inventory holdings larger than necessary to assure continued production, and the offering of liberal credit terms (either implicitly or explicitly) to aid the sales effort. However, by following such a policy, the firm’s rate of return is less than if the excess working capital amounts were allocated to more productive investments. “Conservative“, as defined above, may be anything but conservative since liquidity is dependent on cash flows and not stock values. The desire to maximize profits has long occupied a dominant position in the theory of the firm, although variants such as satisfying profits [Simon (1964)] or local optimization of time-variant coalition generated goals [Cyert and March (1963)] have also been discussed.
A desire to maximize the present value of either profits or sales revenue through effective asset management has the impact of stimulating growth. However, growth is influenced by factors such as the firm’s dividend policy, capital structure, economies (or dis-economies) of scale and the level of liquidity of the firm. One difficulty with the dual goals of profitability and liquidity is that decisions that tend to maximize profitability tend to minimize liquidity. Conversely, focusing entirely on liquidity tends to reduce the potential profitability of the firm.
In a valuation context, assuming perfect capital markets, Van Horne (1980) has argued that the level of corporate liquidity is a matter of indifference to the equity holders. The argument is centered on the assumption that investors would manage their portfolios in such a way as to satisfy their utilities for liquidity. Consequently, the liquidity of individual firms would not be a factor enhancing the wealth of the shareholders. Implicit in the assumption of perfect capital markets is the belief that if the firm should become technically insolvent and unable to meet its current obligations, creditors can step in instantaneously and realize value either by liquidating the firm or by effecting a costless reorganization. However, when the assumption of perfect capital markets is relaxed, and market imperfections in the form of the possibility of bankruptcy and the attendant costs of bankruptcy are recognized, corporate liquidity becomes a characteristic affecting firm value. Bankruptcy costs are composed of the “shortfall” arising from the liquidation of assets at distress prices below their economic values and the various administrative expenses such as payments to liquidators, attorneys, experts and the like. Since these costs cannot be diversified away by the investors, the existence of these costs represents a burden to the shareholders. However, the firm can reduce the probability of bankruptcy, and hence the expected magnitude of these costs by maintaining adequate liquidity.
In a valuation framework, Stone (1978) has suggested that prudent investments in liquid resources enhance the value of the firm. The importance of liquidity in imperfect capital markets has also been recognized by Van Horne (1980). If the liquid reserve of the firm is defined as being composed of cash, marketable securities and the unused short-term borrowing capacity of the firm, an increase in liquidity will presumably enhance the value of the firm. The enhancement in value possibly arises on account of the reduction in the threat of bankruptcy, which in turn reduces the cost of debt of the firm. With a reduction in the probability of bankruptcy, the cost of equity should also be reduced. In imperfect markets, since the costs of bankruptcy cannot be diversified away by the shareholders, the total risk of the firm becomes a factor in pricing equity. Van Horne (1980) has noted that the greater the costs of bankruptcy and the greater the probability of its occurrence, the more concerned the investor will be with the total risk of the firm. As a result, investors will demand a higher required return for the company than dictated by the systematic risk of the firm. Although the systematic risk of the firm has been considered to be the only risk relevant in modern finance theory in the pricing of equity, this prescription assumes perfect capital markets. The specification of the adjustment required in the cost of equity on account of the bankruptcy costs is difficult in practice. However, increases in liquidity reduce the probability of bankruptcy, and hence the expected total costs of bankruptcy, and consequently the cost of equity. With a reduction in the costs of debt and equity, the value of the firm increases. This argument cannot be carried to an extreme since, beyond some prudent level of liquid assets, profitability declines, leading to lower value. Any increase in value cannot be considered to be a linearly increasing function of the liquidity level of the firm since risk reduction is universally accepted as being associated with reduced profitability. The liquidity level of the firm can be increased by increases in the level of cash, marketable securities, and in the unused debt capacity of the firm. However, increases in cash and marketable securities are accompanied by physical holding costs and the costs of opportunities foregone which reduce the expected earnings of the firm. In addition, an increase in the unused debt capacity of the firm may imply a reduction in the actual usage of debt, which may lead to reduced value of the firm. These considerations suggest that if liquidity affects value, it must do so at a decreasing rate (reflecting increasing costs of excess liquidity) until an optimum is reached. Beyond the optimum, costs of providing liquidity are greater than benefits derived. The reduction in value arises from the slowing of earnings growth because profitable long—term investment opportunities and capitalized tax shields are foregone. In effect, large liquid balances affect the future earning capacity of the firm, and hence valuation, in a detrimental fashion after a certain critical level of liquidity has been attained.