Chapter 15 - the valuation of securities - theoretical approach

Question 1

What are the 2 factors that determine the amount a shareholder is prepared to pay ? (Constant dividend)

Answer 1

1. The dividends that they expect to receive in the future
2. The rate of return the shareholders require.

Question 2

what is the ex div valuation ?

Answer 2

When they have just paid this years dividend

Question 3

what is the cum div valuation

Answer 3

If someone buys shares just before the dividend therefore the price they pay will be higher by the amount of the dividend just about to be paid

Therefore;

The market value cum div = market value ex div + dividend just about to be paid

Question 4

how is equity valued (with a constant dividend)?

Answer 4

The market value of a shares is determined by the shareholders as it is the price they are prepare to pay

Question 5

how to value equity (non constant dividend)

Answer 5

The likely hood of a fixed dividend is rare, hopefully the dividend will grow as does the company

The full dividend valuation model which comes with any expected future stream of dividend is the following:

“The market value of a share is the present value of future expected dividends, discounted at the shareholders requires rate of return”

For example if a company pays 15c dividend and we need 12% rate of return then we can do the pertuity calculation to get the answer

Question 6

what is the formula for the market value of a share for constant growth?

Answer 6

Market value = D0 (1 + g) / (Re - g)

Where:

D0 - the current dividend
Re - the shareholders required rate of return
g= the expected rate of growth in dividends p.a

Question 7

How to use the constant dividend formula if the question asks something like “the dividend will remain constant at 0.20c for 2 years before growing 4% thereafter year year”

Answer 7

If it didn’t say the remain constant bit then we can just use the formula no problem

Therefore the formula only comes into play in the 3rd year

Year 1 - 0.20c
Year 2 - 0.20c
Year 3 - 20(1.04)

So the formula will gives us the value in 3 years time and not now so to work out we just do discounting

To do this work out the value using the formula as normal then discount the total

Question 8

How to value debt

Answer 8

In theory it is the same as the valuation of equity

The market value = present value of future expected receipts discounted at investors required rate of return

Much depends if it is redeemable or irredeemable debt

Question 9

What is irredeemable debt

Answer 9

Debt that isn’t repaid

To work out the market value of the debt, imagine it’s 10% interest (coupon rate) and investors current rate of return is 8%. Remember the nominal is £100 so the interest is £10. How much in perpetuity will the investor need to have to earn £10 with a rate of return of 8% ? £10 x 1/0.08 = £125. Meaning £125 x 8% gives £10

This is the ex int value (like ex div) to get the cum interest value add on the interest paid £10 to equal £135

Question 10

What is redeemable debt

Answer 10

Debt that is repaid

Imagine there is 8% debenture redeemable in 5 years time at a rate of 10% and the investors rate of return is 12%. Therefore how much is the £100 nominal worth ?
1-5 interest of £8 (8% nominal) discounted at annuity @12% for 5 years = 28.84

£110 ordinary present value factor @12% for 5 years = £62.37

Therefore together it’s £91.21 per nominal. If question asked for the total market value, let’s say the company issues £400,000 then it’s £400,000 x 91.21% (£92.21/£100) = £364,840

Question 11

What is the conversion premium

Answer 11

It is the current market value of the debt todays market value of the shares the would get.