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  • Valuation of a firm is dependent on what excess return it is generating or will generate for its stakeholders. Value of the firm can be explained as:

    Value of the Firm = Book Value + Value of Excess Return on the historical and new investment

    It means the firm creates value for its stakeholders by generating excess return on the investment which it has made in the business. If the firm is not generating any excess return for its stakeholders (i.e. ROE = Ke or ROCE = WACC) then its value would be exactly equal to book value. In such situation it becomes indifferent for it to carry on or shut down its business.

    If the firm is generating return less than its cost of capital (i.e. ROE <Ke or ROCE < WACC) then it is destroying wealth of the stakeholders by carrying on the operation. In such situation, it makes more sense for it to shut down its operation and distribute the net worth among its stakeholders

    Value of  Company = Value of Asset in Place + Value of Growth Asset

    Its important to distinguish between excess return the firm is generating on its existing investment and excess return it is expected to generate on future return. Value of growth depends on the later part. Value of the firm will increase with the increase in future expected growth only in case of positive excess return on new investment.

  • Rizwan Khan

    How can we can project cost as a percentage of sales median of previous years used for future if we are doing this we are neglicting effect of operating leverage. ??