What is the Total Return on Firm Investment?
The Theory of Fluctuations in Firm Investments applies to all firms with the exception of investment banking and insurance companies. It is also applicable to all government agencies and most private organizations. The theory of fluctuation states that certain assets will generally depreciate while others will generally appreciate. According to the theory, all subsequent losses are the result of previously unsuccessful investments. Thus, if the original investment is successful, subsequent losses are prevented; however, if it is a loss the previous performance was not good, then subsequent losses must be the result of investors choosing to do nothing about the original investment. Thus, all subsequent losses are attributed to misvaluation-induced errors.
Fluctuations in firm investments occur for numerous reasons. One of these reasons is the existence of a mispricing mechanism. Another cause is the existence of a bid/ask spread. A third cause is the existence of a break-even effect. A fourth cause is the existence of a disinflation effect. And a fifth cause is the presence of a capital market maker.
All these mechanisms cause firms to incur expenses for items such as fixed assets, purchased goods, and retained earnings. These costs are ultimately allocated to make up for the profit that would otherwise be realized by these firms. The allocation process results in allocations of value to various aspects of the firm. Most often, these allocations are made according to the existing distribution of net worth among current and former owners.
Value creation in firms is based on firms perceptions of their own value. The value creation process occurs when a firm determines what its value could be based on various criteria. One of these criteria is the current stock market value of the firm’s equity. The other criteria is the expected rate of return on the firm’s invested funds. Each of these factors has a different impact on a firm’s value.
The value of equity may also be based on the expectation of the firm’s retained earnings. It may be based on the expectation of capital appreciation. Another factor that can significantly affect the value of a firm is the availability of working capital. A company’s ability to convert short-term investments into long-term investments may also affect the value of equity. And the availability of credit may also affect the value of a firm.
The total value of a firm can be determined by multiple valuation procedures. But there are three ways in which to arrive at a firm’s value. The first way is through the use of the present value of the firm’s tangible assets. The second way is to use the replacement cost method. The third way to arrive at the value of equity is to use the present value of future cash flows associated with the firm and allocate these flows to the equity.
