Time value of money - valuing shares

Question 1

value of any asset can be calculated simply by finding

Answer 1

the present value of all its cash flows.

Question 2

how does corporation differ from other forms of business organization

Answer 2

1. Ownership is usually widely dispersed;
2. Shareholders have no right to be involved in the daily running of the corporation; and,
3. Shareholders have limited or no liability for the liabilities incurred by the corporation.

Question 3

Characteristics of the Corporation

Describe how ownership is widely dispersed among the shareholders?

Answer 3

1. Ownership in the corporation can be easily transferred between different shareholders in the secondary market
2. can be transferred between shareholders without interfering with the operation of the corporation itself

Question 4

Characteristics of the Corporation

describe

Absence of Shareholder Rights to Be Involved in the Daily Running of the Corporation

Answer 4

1. The objectives of the corporation are determined by the board of directors;
2. The board of directors is elected / reelected by the shareholders, usually at the corporation’s Annual General Meeting; and,
3. The board of directors reports to shareholders regarding operations of / decisions made in relation to the company.

Question 5

Characteristics of the Corporation

Limit to the Liability of Shareholders for Debts Incurred by the Corporation

Answer 5

Unlimited liability is not capped at a maximum amount and exists regardless of the amount of investment each owner has personally made.

If the business is unable to meet any financial obligations or settle any outstanding liabilities, the owner’s personal assets can be seized to satisfy the debts.

This is in contrast to a limited liability structure where owners’ losses cannot exceed the total amount invested in the business.

Question 6

Characteristics of the Corporation

Limit to the Liability of Shareholders for Debts Incurred by the Corporation

Answer 6

Company ABC lists a new share issue on the market at a price of $3.00. The company decides to ask shareholders to initially pay $2.00 per share, with the remaining $1.00 to be paid at a later date.

–If ABC is a limited liability company, shareholders only have a legal requirement to pay the $1.00 owing on each share. So, the maximum loss to shareholders in the event the company failed would be $3.00; or,

–If ABC is a no liability/unlimitd company, shareholders have no legal requirement to pay the $1.00 owing (though not paying the $1.00 would mean shareholders forfeit their shares). Therefore, in the event the company failed before shareholders had paid the $1.00 owing, their maximum loss would be $2.00 per share.

Question 7

Shareholders in the Corporation

what rights do shareholders of a company have?

Answer 7

The right to vote on how the corporation will be **controlled. ** They exercise this right in electing the company’s board of directors, who is responsible for determining how the company will be run;

–A claim to a fraction of the cash flows remaining in the corporation after all other claims have been deducted (ie in the form of dividends); and,
–Sell their stocks when they so choose.

Question 8

Shareholders in the Corporation

what 2 shares can shareholders own in a company?

Answer 8

–Ordinary shares: An equity security issued by a corporation that gives its holder the right to vote and the right to any (variable) dividend declared by the board of directors. However, ordinary shareholders rank last in the event of liquidation; and,
–Preference shares: An equity security issued by a corporation that is given priority over ordinary shares for (fixed) dividends and in the event of liquidation. However, these shares generally have no voting rights attached to them.

Question 9

Cash Flows Associated with Shares

Shareholders receive what 2 types of gains from owning shares?

Answer 9

–Dividends: As noted earlier, most companies pay dividends periodically; and,

–Capital Gains: The increase in the share price over the time a shareholder owns their shares.

Question 10

when calculating the theoretical price of a share in a world of certainty, what 2 assumptions are made?

Answer 10

1. The stock (and therefore the company it gives ownership in) has an infinite life; and,
2. Every market participant is in agreement about the dividend payments that are to be made by the company in the future.

Question 11

Calculating the Theoretical Price of a Share

the theoretical price of the stock at time zero (immediately after D₀ is paid), P0 is

Answer 11

simply the present value of all future flows calculated using the investors required rate of return on the share, r_e

Question 12

compact notation of Theoretical Price of a Share

Answer 12

Question 13

Calculating the Theoretical Price of a Share

consider two special cases?

Answer 13

constant dividends; and, the

case of constantly growing dividends

Question 14

Calculating the Theoretical Price of a Share

Special Case 1: Constant Dividends

Formula

Answer 14

Question 15

Calculating the Theoretical Price of a Share

Special Case 1: Constant Dividends

Answer 15

In this instance, future dividends are constant, meaning **D_t = D for all values of t. **

–e.g. preference shares, which promise a constant dollar dividend in each period; and,

• If dividends are constant in value, are paid at the end of each period, and the share has an infinite life, the dividend stream is an ordinary perpetuity

Question 16

A company has issued preference shares promising a constant dollar dividend of $4 p.a. in perpetuity. The theoretical price of the share if the investor’s required rate of return is 10% p.a. is calculated as follows:

Answer 16

Question 17

. Calculating the Theoretical Price of a Share

Special Case 2: Dividends with Constant Growth

Answer 17

dividends paid to shareholders will grow indefinitely at a constant rate of g% per period.

Further, if the dividend just paid was D₀, and dividends are to be paid each period

Question 18

the theoretical price of stock of dividends with constant growth

what would happen if the dividend growth rate is high?

Answer 18

the higher the dividend growth rate, the greater the share value

BUT it the dividend growth rate (g) cannot be greater than R_e (the required rate of return)

Question 19

the theoretical price of stock of dividends with constant growth

Answer 19

Ordinary share price = dividend in year 1 / required rate of return - growth rate

Question 20

Calculating the Theoretical Price of a Share

A company has just paid a dividend of $0.50 per share. Dividends are expected to be paid annually and to grow indefinitely at a rate of 5% p.a. Given this information, the theoretical price of the stock if the required rate of return is 8% p.a. is given by:

Answer 20

Question 21

Theoretical Share Price Versus Observed Share Price

Relaxing the Assumptions

why are the two assumptions previously made unrealistic?

Answer 21

we live in a world of uncertainty

• We cannot be certain that a company will exist indefinitely; and,
• There is not always certainty or agreement regarding the size or timing of dividends that a company will pay in the future

Question 22

Reading Share Prices in the Financial Press

Day’s High and Low

Answer 22

highest and lowest traded price for the stock on the most recent trading day

Question 23

Reading Share Prices in the Financial Press

P/E Ratio X

Answer 23

The last trading price on the most recent trading day scaled by the company’s earnings per share

price that market places on $1 of a firm’s earnings = share price/ earnings per share

Question 24

Reading Share Prices in the Financial Press

EPS ¢

Answer 24

•A company’s earnings per share. Earnings figures are as provided by the company in interim and annual reports and are calculated based on a 12 month window; and,

Question 25

Reading Share Prices in the Financial Press

Div Yld %

Answer 25

•A company’s dividends scaled by the last trading price of its shares on the most recent trading day and multiplied by 100.

Dividend figures are as provided by the company in interim and annual reports and are calculated based on a 12 month window;

Question 26

Reading Share Prices in the Financial Press

DPS ¢

Answer 26

Dividends per share paid by the company in cents.

• Dividend figures are as provided by the company in interim and annual reports and are calculated based on a 12 month window.
• if all of the most recent six-monthly dividend is franked this is marked by an f. If part of the dividend is franked this is marked by a p.
• Franking is an idea that relates to the tax paid on the dividend

Question 27

Reading Share Prices in the Financial Press

Quotes Buy and Sell

Answer 27

•last quotes of the prices at which people were willing to buy and sell the stock at respectively on the most recent trading day (and, therefore, the prices you could have sold and bought the stock at respectively).

For example, based on these quotes, if you wanted to buy shares in Adelaide Brighton, you would have had to pay $3.08 per share and if you wanted to sell shares you would have received $3.07 per share;

Question 28

Reading Share Prices in the Financial Press

Vol 100’s

Answer 28

number of shares that were traded in the most recent trading day in units of a hundred.

Question 29

Reading Share Prices in the Financial Press

+ or –

Answer 29

the move in the last sale price from the second most recent trading day’s close to the most recent trading day’s close

Question 30

Reading Share Prices in the Financial Press

Last Sale

Answer 30

–the last sale price for the stock on the most recent trading day;

Question 31

Reading Share Prices in the Financial Press

Company Name

Answer 31

company’s full name

Question 32

Reading Share Prices in the Financial Press

ASX Code

Answer 32

unique identifier assigned to the company by the Australian Stock Exchange

Question 33

Reading Share Prices in the Financial Press

52 Week High and Low

Answer 33

–the highest and lowest traded price for the stock during the last year and give some indication of the variability of the stock;

Question 34

features of ordinary share

Answer 34

• share of ownership gives owner ordinary rights to any ordinary dividiends and rights to vote on the election of directors, mergers and other major events
• future amount of ordinary share dividends are more uncertain as it is uncertain whether a company will make sufficient profit, and the amount will be determined by board of directors of a company each year

-reduced by using a valuation model that specifies constant growth rate of ordinary dividend amount, consistent with the expected growth in company’s earnings

Question 35

describe the decision as to determing whether a preference share is redeemable or irredeemable as a decision a company makes before offering preference shares to investors

Answer 35

• reedemable preference shares: pay constant dividend until shares are redeemed by company; finite life (have a maturity date)
• irredeemable preference shares: constant dividend amount (assuming sufficient profits) is paid forever (until company is liquidated)

Question 36

describe the decision as to determing whether a preference share is cumulative or non-cumulative as a decision a company makes before offering preference shares to investors

Answer 36

• Companies can only pay the fixed preference dividend amount for a year if sufficient profit is made
• holders of cumulative preference shares will be entitled to receive the cumulative value of any missed dividends once the company earns sufficient profits
• non-cumulative preference shareholders are not entitled
• company cannot pay dividends to ordinary shareholders, unti it has paid all unpaid preference dividends

Question 37

what 3 decisions does a company make before offering preference shares to investors?

Answer 37

1. Specify the fixed amount of prefence dividend that will be paid in the future
2. preference share dividends cumulative or non-cumulative
3. whether preference shares are reedemable or irredeemable

Question 38

all rights accruing to sharehodlers are in proportion to the

Answer 38

number of shares they hold

Question 39

shareholders right

what happens at the annual meeting?

Answer 39

managers and shareholders answer questions from shareholders

shareholders vote on the election of directors and other proposals

Question 40

in the event of a liquidation, what happens?

Answer 40

aafter assets are used to satisfy claims of creditors, the remainig assets will be divided among shareholders, based on their proportion of share holdings

Question 41

what does the board of directors decide in regards to shares?

Answer 41

the timing and amoung of each dividend

Question 42

preference shareholders are not entitled to

Answer 42

vote on directors or other important matters

Question 43

what is the dividend yield?

Answer 43

percentage return the investor expects to earn from the dividend paid by the share

Question 44

what is capital gain?

Answer 44

difference between the expected sale price and the original purchase price for the share; the amount investor earns on the share