Topic 4

Question 1

Where does share equity come from?

Answer 1

Ordinary shares and
Retained earnings

Question 2

Key Features of Ordinary Shares

Answer 2

• value is market driven
• buyers become part owners of the company with limited liability
• can be bought back by the company
• most shares are listed and traded on ASX

Question 3

Key Features of Preference Shares

Answer 3

• have preference over ordinary shares in regard to dividends
• fixed dividend rate either % or $
• if liquidation they are paid before ordinary shares
• typically no voting rights

Question 4

DEBT vs EQUITY

Answer 4

• equity can influence management
• debt has to be paid (interest) dividends don’t have to be
• debt has an end date
• bank has priority in liquidation
• debt is a legal agreement
• debt is tax deductible

Question 5

Dividend Growth Model

Answer 5

Value of a share is based on the present value of its future dividends (need to calculate next years share if not given)

Question 6

What happens when R & G change?

Answer 6

If rate increases, growth decreases and vis versa

Question 7

Variable Growth Dividend Model

Answer 7

Growth rates tend to be constant for well established firms, young firms tends to have higher initial growth

Question 8

Free Cashflow Valuation Model

Answer 8

Useful if a firm does not pay a dividend or has no dividend history

Question 9

How do you estimate the dividend growth rate?

Answer 9

1. use historical dividends (CAGR) be careful with how many periods there are
2. industry average
3. sustainable growth rate

Question 10

Cost of ordinary share capital

Answer 10

Value of a share is based on the present value of future cashflows
uses the DIVIDEND GROWTH MODEL which assumes that dividends grow at a constant rate
- can also be called constant growth valuation model

Question 11

Advantages to dividend growth model approach

Answer 11

Easy to use and understand

Question 12

Disadvantages to dividend growth model approach

Answer 12

• Only applicable to companies paying dividends
• Assumes dividend growth is constant
• Cost of equity is very sensitive to growth estimate
• Ignores risk

Question 13

What is the Capital Asset Pricing Model? (CAPM)

Answer 13

The cost of equity is the return required by investors to compensate them for the company’s non-diversifiable risk - measured by beta b

Question 14

What is Unsystematic Risk?

Answer 14

A business or industry’s specific risk (eg. strikes, lawsuits …)
Diversifiable risk

Question 15

What is Systematic Risk?

Answer 15

Also known as market risk, uncertainty that impacts the entire market or a segment of the market (eg. war)
Non-diversifiable risk

Question 16

Interpreting the Beta

Answer 16

• higher the beta the more risk
• the coefficient for the market is 1
• a beta of 0.5 means that for ever 1% change in the market the share price will change by 0.5%
• positive beta moves in the same direction to the market
• negative beta moves in the opposite direction to the market

Question 17

Advantages to CAPM

Answer 17

• adjusts for risk
• applicable in a wider range of circumstances (eg firms that dont have dividend growth)
• widely used to calculate the cost of equity

Question 18

Disadvantages to CAPM

Answer 18

• 2 estimates (market risk premium and beta)
• Past data is used to estimate the beta
• accuracy

Question 19

CAPM vs BUILD UP MODEL

Answer 19

• CAPM is more widely used
• Build up model combines multiple risk factors
• CAPM requires the business to be listed
• Build up model is a more tailored approach

Question 20

What is the Build up model?

Answer 20

Breaks down the cost of equity into different components