ABSTRACT
Webegin our analysis by recalling from§5-10 that the present value of the future cash flows a firm expects to make under its existing investment opportunity set – that is, the recursion value of the firm’s equity – will be equal to the book value of its equity plus the expected present value of its stream of future abnormal earnings. This in turnwill mean that if one states the firm’s investment opportunity set in terms of a vector system of stochastic differential equations, it will normally be a relatively simple matter to determine the recursion value of its equity in terms of its current book value, its current abnormal earnings and the current value
of the information variable. Moreover, our analysis also shows that the adaptation value of a firm’s equity is functionally proportional to the recursion value of its equity. This has the important implication that once the recursion value of equity is known, it will normally be a relatively simple matter to determine the adaptation value of the firm’s equity. Furthermore, since the market value of a firm’s equity is the sum of its recursion value and its adaptation value, our analysis also shows that there will be a highly convex and non-linear relationship between the market value of the firm’s equity on the one hand and the variables comprising its investment opportunity set on the other.
