Chapter 5 Flashcards
Market value of any investment
Expected returns discounted at investors required rate of return
Ke (dividends constant)
D0/P0
P0
Price ex dividend
KE with dividend growth at g
ke = D0(1+g)/P0 + g
Dividend valuation model flaws
- g must be less than ke, if equal, share price becomes infinitely high. growth rate to perpetuity this high impossible
- In practice growth rates vary
During the period after announcement of dividend but before payment, prices…
Rise in anticipation of payment - share is cum div
When does a share go ‘ex-div’
Shortly before paid, anyone acquire afterwards will not receive the dividend
g can be calculated using which function
POWER
Input to power function
Most recent div/oldest dividend, 1/time period of growth
Garden growth model - g is calculated by
r * b
r = current accounting rate of return
b = proportion of profits retains
Accounting rate of return
profit after tax as percentage of opening capital employed (opening balance sheet values)
Issues with garden growth model
relies on accounting profits
assumes r and b are constants
inflation can distort accounting rate of return
assumes all new finance from equity
Issues with dividend valuation model - underlying assumptions
Assumes shares have value because of dividends - high tax rate investors likely prefer capital gains
Assumes dividends either don’t grow or grow constantly
Estimates of future dividends based on historical data - ignores future market conditions, investor confidence, economic conditions
Issues with dividend valuation model - data used
Share price is used, these can change daily and are not always rationally or efficiently
Issues with dividend valuation model - growth in future dividends
More likely linked to growth in earnings than to past dividends, but earnings do not feature?
Impact of a bonus issue on DVM estimate g
No cash - go back and adjust number of shares for bonus issue
Impact of rights issue on DVM estimate g
No adjustment necessary, as inflow of funds
Cost of equity - CAPM
ke = rf + 𝝱(rm-rf)
Estimating 𝝱 factors
Examine 𝝱 of quoted companies in similar business
however often other firms engaged in several lines of business, different gearing etc.
Cost of preference shares
Dividend / ex-div market value
Cost of debt (irredeemable/current market price=redemption price)
annual interest (starting 1y)/market price
Cost of debt redeemable at not current market price spreadsheet formula
RATE
RATE inputs
number of period
amount of interest paid in a period
(PV) of asset - market price
Future value
Gross redemption yield < couponrate
bonds issued at premium
Gross redemption yield > coupon rate
bonds issued at discount
Gross redepmtion yield = coupon
bonds issued at par
KD with tax
Interest * (1-T)/P0
Steps in determining convertible debentures
- calculate value of conversion option
- Compare conversion option with cash option choose higher
- use RATE to calculate pre tax YTM for redeemable
No tax effect
Calculating weights for WACC wherever possible should be based on
Market weights - mv for debt and equity
Assumptions to use WACC
- Historical debt/equity is not going to change
- Systematic business risk of the firm will not change
- Finance is not project specific
Problems with WACC
- Knowing which sources of finance to include (ST loans?)
- Loans without market value (take book value)
- Cost of capital for small companies - hard if unquoted and lack of liquidity from securities and being smaller makes more expensive to finance, also no share price
