Value of business depends upon the expectations of the equity holders who set a level of expectations for a specific return on equity investments.

Value of a company is entirely related with the relation of actual rate of return (Ra) received by the equity holders with the expected rate of return (Re) by equity holders.

Actual dividend will be compared with the expectations of equity holders; If Ra is higher than the Re than value of business for share holders will be higher.

Illustration:

Company "XYZ Trading" is for sale with total asset value US$ 50,000; actual net Profit/Dividend paid to equity holder is US$ 7,500 and same will be paid in future. Company has asked for the bids to sell this company. (ignore taxation).

Calculate the value of company for Mr. A, Mr. B and Mr. C who have following expectations:

Mr. A has expectation to earn 20% return on his investment.
Mr. B has expectation to earn 15% return on his investment
Mr. C has expectation to earn 10% return on his investment.

Solution:

Since existing dividend is the base, we can calculate the value of business taking actual dividend as base with following formula:

Value = Dividend/Re

Value of Business for Mr. A	= US$ 7,500/0.20
	= US$ 37,500
Value of Business for Mr. B	= 7,500/0.15
	= US$ 50,000
Value of Business for Mr. C	= 7,500/0.10
	= US$ 75,000

Based on expectation, value of same business is different for different investors.

Mr. A

Mr. A wished to earn 20% of its investment; therefore, value of this business for him will be US$ 37,500.

This value of business for Mr. A is less than the actual value of assets because expected rate of return (Re) is more than the actual rate of profit earned (Ra) by Mr. A. Re > Ra

Hence, Business value is less than US$ 50,000 for Mr. A.

Mr. B

Mr. B wished to earn 15% of its investment; therefore, value of this business for him will be US$ 50,000.

This value of business for Mr. B is equal to original assets of the company because expected rate of return (Re) and actual rate of profit earned (Ra) are same. Re = Ra

Hence, Business value is same US$ 50,000.

Mr. C

Mr. C wished to earn 10% of its investment; therefore, value of this business for him will be US$ 75,000.

This value of business for Mr. C is higher than the original assets of the company because expected rate of return (Re) is less than the actual rate of profit earned (Ra). Re < Ra

Hence, Business value is high.

Conclusion

• Re> Ra : Value is low
• Re = Ra : Value is same to original
• Re < Ra : Value is high

Based on above impact of valuation, we should be realistic and should assume that

Re = Ra = Dividend

With this major assumption we will now discuss the factors related with the calculation of value of companies and effects of Gearing on net operating value of business for shareholders.