Week 10 Flashcards
Sources of finance
Equity financing
Debt financing
Equity financing
Equity holders have a residual claim to the cashflows
generated by the assets of the company.
e.g. ordinary shares; preference shares
DEBT FINANCING:
Debt providers have a contractual right to the cashflows
generated by the assets of the company.
e.g. term loans (long-term bank loans); debentures;
bonds (government bonds and/or corporate bonds)
CHARACTERISTICS OF Debt vERSUs Equity
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Intrinsic value of an asset
The present value of the stream of expected cash flows discounted at an appropriate required rate of return
The value (or price) is determined by three elements:
- The required rate of return by investor
- The riskiness or uncertainty of expected cash flows
- The amount and timing of expected cash flows
A bond
A bond refers to a contract that is issued by either a government or a corporation (the issuer) promising to pay the holder:
(1)A pre-determined amount of interest payments;
and
(2) The face value at maturity.
A bond represents
A bond represents a form of interest-only direct
finance loan.
A bond pays
A bond pays fixed coupon payments at fixed intervals and pays the par value at maturity
Bond terminology
Par value (or face value)
Maturity date
Coupon rate
Coupon payments
Par value (or face value)
- The principal amount to be repaid on the maturity date.
Maturity date
The date at which the principal amount is payable.
Coupon rate
The annual coupon payments divided by the face value.
Coupon payments
- The fixed interest payments that are payable at fixed intervals
until the maturity date.
Valuation of Bonds
The value (or price) of a bond is determined by the present value of all the cash flows that the bond is expected to produce in the future up to and including the maturity date.
The expected cash flows for a bond consist of:
(1) All coupon payments (paid at fixed intervals until the maturity date);
and
(2) The principal amount or Face Value (paid at the maturity date).
Valuation of Bonds photo
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Time Path of the Value of a 10% coupon, $1,000 Par Value Bond When Interest Rates are 8%, 10% and 12%
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VALUATION OF BONDS
General Rule:
If the Coupon rate = Interest rate:
The bond will sell for its par value (i.e. par bond).
If the Coupon rate > Interest rate:
The bond will sell for a premium (i.e. premium bond).
If the Coupon rate < Interest rate:
The bond will sell for a discount (i.e. discount bond).
VALUATION OF BONDS CONCLUSION
Bond prices are inversely related to interest rate movements:
- If interest rates increase, bond prices will fall and thus sell at a discount; and - If interest rates decrease, bond prices will rise and thus sell at a premium.
The Relationship between Bond prices and interest rates
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SHARES
The main types of equity securities are ordinary shares
and preference shares.
Preference shares are:
A form of hybrid security;
Similar to bonds in that fixed dividends that must be paid to preference shareholders before dividends can be paid to ordinary shareholders;
Similar to ordinary shares in that preference shares have no fixed maturity date and there is no obligation for companies to pay dividends to preference shareholders:
Similar to ordinary shares in that preference shares have no fixed maturity date and there is no obligation for companies to pay dividends to preference shareholders:
- Companies can omit dividend payments to preference shareholders without fear of defaulting and pushing the company into bankruptcy.
Preference shares terms
Par value
Cumulative dividends
Maturity date
Priority to Assets and Earnings
Control of the Company (Voting Rights)
Convertibility:
Par value
Establishes the amount due to preference shareholders in the event of company liquidation event;
The preference dividend is generally set as a % of par value.
Cumulative dividends
A protective feature on preference shares that requires preference dividends not paid in previous periods to be paid to preference shareholders before dividends can be paid to ordinary shareholders.
Maturity date
In general, preference shares have no specific maturity date.
Priority to Assets and Earnings
Preference shareholders have priority over ordinary shareholders but not debtholders. Dividends must be paid on preference shares before ordinary shares.
Control of the Company (Voting Rights)
Preference shares are typically ‘non-voting’, with preference shareholders having neither the right to elect the Board of Directors nor vote on corporate issues.
Convertibility:
Many preferred shares include an option to convert to ordinary shares.
Valuation of preference shares perpetuity
With fixed dividend payments and no maturity date, preference shares can be valued like a perpetuity.
Valuation of preference shares formula
PV = D / r
where:
D = Fixed dividend payment for each year
(in dollars);
r = Required rate of return
(i.e. interest rate or discount rate).
Ordinary shares
Ordinary shares represent equity or claims to ownership of the company. Ordinary shares are variable-income securities
Ordinary shares represent equity or claims to ownership of the company.
Ordinary shareholders have residual claim to any earnings that remain:
(1st) only after interest payments are made to debtholders;
(2nd) only after corporate tax is paid to the government; and
(3rd) only after dividends are paid to preference shareholders.
Ordinary shares are variable-income securities:
Companies have no (contractual or implied) obligation to pay dividends to shareholders;
Dividend amounts are not fixed;
Dividends depend on earnings.
Ordinary shares terms
Maturity date
Priority to assets and earnings
Control of the Company (Voting Rights):
Maturity date
Like preference shares, ordinary shares have no specific maturity date.
Priority to assets and earnings
Both debtholders and preference shareholders have priority over ordinary shareholders. Both interest payments on debt and dividends on preference shares must be paid before dividends can be paid on ordinary shares.
Control of the Company (Voting Rights):
Ordinary shares come with voting rights, with ordinary shareholders having the right to elect the Board of Directors and vote on corporate issues such as shareholders’ proposals, mergers and changes to the company’s constitution.
Valuation of Ordinary Shares
The market value of a share is the present value of all expected cash flows to be received from the share, discounted at a rate of return that reflects the riskiness or uncertainty of the expected cash flows. The expected cash flows to be received from a share are all the future dividend payments for the share.
When you sell or buy an ordinary share
When you sell a share, you are selling the right to receive
all future dividends from that point onwards. Conversely, when you buy a share, you are buying the right to receive all future dividends from that point onwards.
THE Dividend DISCOUNT Model
But, how do we estimate all future dividends from now to infinity?
After all, since company performance and earnings will
necessarily vary over time, dividend payments are also
likely to fluctuate in the future.
THE DIVIDEND Growth MODEL
The valuation process is greatly simplified if we can
assume that dividends are expected to grow at a
constant rate over time (i.e. simply assume that
dividends will grow by the same percent each year).
This assumption creates the ‘dividend growth model’:
Divided growth model formula
PV = D / r - g
where:
D = Dividend payment (in dollars);
r = Required rate of return
(i.e. interest rate or discount rate);
g = Growth rate (of dividend).
Dividend
A dividend is a payment that is made out of a company’s (retained) earnings to its owners (or shareholders). Dividends are usually paid in the form of cash.
Types of cash dividends include:
regular dividends;
extra dividends;
special dividends;
liquidating dividends.
THE DIVIDEND PAYMENT PROCESS terms
Declaration date
Ex-dividend rate
Cum dividend
Record Date
Payment date
Declaration date
The date on which the company’s board of directors publicly announces the amount and the specifics (such as the payment date) of the next dividend payment.
Ex-dividend rate
The date on which the legal right to the next dividend payment no longer accompanies a share:
- shareholders that sell shares on or after the ex-dividend date will still be entitled to receive the next dividend payment, although the new owner will not;
- usually, shares that trade immediately after the ex-dividend date will be accompanied by a decline in the share price that is equivalent to the amount of the next dividend payment.
Cum dividend
The situation where the legal right to the next dividend payment accompanies a share:
- when investors purchase shares that are cum dividend, they are entitled to receive the
next dividend payment on the payment date; - conversely, when investors sell shares that are cum dividend, they will not be entitled to receive the next dividend payment on the payment date.
Record Date
The date on which the company determines the list of shareholders that will receive the next dividend payment. In Australia, the record date typically occurs 4 business days after the ex-dividend date.
Payment date
The date on which the company actually makes the dividend payments to the shareholders on its record.
MANAGMENT Dilemma
Fundamental question
Should a company use its retained earnings to:
Finance profitable investment opportunities?
or
Pay dividends to shareholders?
MANAGEMENT Dilemma dividend policy
A company’s dividend policy seeks to address this dilemma and communicate this information to its shareholders .
Theories of dividend policy
Fundamental Question:
Does dividend policy affect the share price of a company?
Two opposing viewpoints:
- Dividend Irrelevance Theory
- Dividend Relevance Theory
- Dividend Irrelevance Theory
Argues that the market value of a company is determined by the basic earning power and business risk of the company.
Therefore, the market value of a company depends only on the net income (or positive cashflows) produced by the company and not on how it splits its retained earnings between financing investments for future growth versus dividend payments to shareholders.
Dividend Irrelevance Theory contends that investors care only about the total returns they receive, and not whether they receive those returns in the form of dividends, capital gains or both.
- Dividend Relevance Theory
In contrast, Dividend Relevance Theory contends that a company’s dividend policy can affect its market value due to investor preferences for either dividends or capital gains:
A. Bird in hand theory
B. Tax preference theory
A. Bird in hand theory
Argues that investors would prefer to receive dividends today rather than receive capital gains in the future, because current dividend payments are more certain than future capital gains.
B. Tax preference theory
Argues that, since dividends are taxed immediately whereas capital gains are not taxed until the share is sold (with potentially indefinite deferral of tax), investors would prefer to defer tax by receiving capital gains in the future rather than receive dividends today and be taxed immediately.
POSSIBLE EFFECTS OF DIVIDEND POLICY ON COST OF EQUITY
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POSSIBLE EFFECTS OF DIVIDEND POLICY ON market share price
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Practical implications
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Residual Dividend Policy
A policy in which the company only makes dividend payments when there is retained earnings left over after having financed all profitable investment opportunities. The residual dividend policy dictates that dividend payments to shareholders should only be paid out of leftover earnings.
Residual Dividend Policy
Key implications
Minimizes the overall cost of capital for the company by reducing the need to raise capital through issuance of new equity.
But the ‘residual dividend policy’ will result in variation of dividend payments to shareholders due to fluctuations in retained earnings and the cost of pursuing profitable investment opportunities.
This variation of dividend payments sends conflicting signals to investors, that might, in turn adversely affect the company’s share price.
Constant Payout Ratio Dividend Policy
A policy in which the company distributes a fixed proportion of its earnings to shareholders in the form of dividend payments:
For example, a constant payout ratio of 30% means that, for every dollar of earnings, 30 cents will be paid out to shareholders as dividends.
Constant Payout Ratio Dividend Policy
Perfect implications
Although the dividend payout ratio is constant, the dollar value of dividend payments will fluctuate as earnings change over time. Again, this variation of dividend payments sends conflicting signals to investors, that might, in turn adversely affect the company’s share price.
. Stable Dollar Dividend Policy
A policy in which the company pays a fixed dollar amount of
dividend payments to shareholders each year such that the
annual dollar dividend is relatively predictable for investors.
. Stable Dollar Dividend Policy
Key implications
The stability and predictability of dividend payments sends a
positive signal to investors that will, in turn, help to attract more
investors maintaining or boosting the company’s share price.
Low Regular Dividend Plus Extras Dividend Policy
A policy in which the company pays a low regular dollar dividend to shareholders plus an extra (or special) year-end dividend in prosperous years when the company is performing well financially.
Low Regular Dividend Plus Extras Dividend Policy
Key implications
Represents a compromise between the ‘stable dollar dividend policy’ and the ‘constant payout ratio dividend policy’. Provides the company with flexibility while ensuring that shareholders eceive at least a minimum amount of dividend payments. By identifying year-end dividend as an ‘extra’, the company avoids signalling to investors that this is a permanent dividend, thus providing the company with flexibility to reduce or eliminate the year-end dividend in the future without adversely affecting its share price.
4 dividend policies
Residual Dividend Policy
Constant Payout Ratio Dividend Policy
Stable Dollar Dividend Policy
Low Regular Dividend Plus Extras Dividend Policy
Share repurchases
Also known as ‘share buy-backs’. Involves distribution of earnings by a company to its shareholders by purchasing its own shares from existing shareholders. There are two main forms of share repurchases in Australia:
On market repurchase
Off market repurchase
On market repurchase
Involves purchasing shares offered for sale by investors on the share market through normal share market trading mechanism.
Off market repurchase
Involves making a formal offer to purchase shares from all existing investors based on offer terms outlined in the offer document.
Off-market repurchases are not processed through the normal share market trading mechanism.
Share REPURCHASES
Primary Reasons for Share Repurchases:
(1) To distribute excess funds to shareholders:
(2) To adjust the company’s capital structure:
(3) To adjust the company’s capital structure:
(4) To protect or defend against a takeover attempt:
(1) To distribute excess funds to shareholders:
Especially when the company’s share price is perceived as under-valued.
(2) To adjust the company’s capital structure:
When the company has more equity than its target capital structure suggests.
(3) To adjust the company’s capital structure:
- Reduce the dilution effect that occurs when employee options are exercised,
thus ensuring no marked change to company’s overall issued capital.
(4) To protect or defend against a takeover attempt:
By
(a) driving up the share price and making it more costly for other parties to acquire the company; and
(b) concentrating the ownership of company shares
in the hands of company management to fend off the hostile takeover.
Advantages of share repurchases
(1) To distribute excess cash to shareholders:
2) To adjust the company’s capital structure:
(3) To adjust for employee share-based compensation:
(4) Signal to investors:
(1) To distribute excess cash to shareholders:
- This is achieved without increasing the amount of dividends.
2) To adjust the company’s capital structure:
- Effective method to change the company’s capital structure when there is
substantially higher proportion of equity than its target capital structure.
(3) To adjust for employee share-based compensation:
- Reduce the dilution effect that occurs when employee options are exercised,
thus minimizing the effect on the company’s share price.
(4) Signal to investors:
(4) Signal to investors:
- Allow company managers to signal to investors that they perceive the
company’s share price as under-valued, and thus represent a bargain.
Disadvantages of Share Repurchases:
Company might overpay for shares:
Irregular interval between share repurchases:
Company might overpay for shares:
This is especially so when substantial amounts of shares are repurchased
on the market, which might cause a marked increase in share price.
Irregular interval between share repurchases:
- Since the interval between share repurchases are generally irregular, participating investors cannot rely on the cash that they receive from share repurchases.
- As a result, some investors might prefer to receive cash through regular dividend payments rather than through share repurchases by the company.
