FINS1612 Chapter Notes - Chapter 6: Systematic Risk, Modern Portfolio Theory, Cash Flow
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Financial Institutions, Instruments and Markets
8th edition
Instructor's Resource Manual
Christopher Viney and Peter Phillips
Chapter 6
Investors in the share market
Learning objective 6.1: Consider the role of an investor in the share market, appreciate the wide
range of investment choices that are available, and understand risks associated with investments
in shares of listed corporations
• Securities quoted on a stock exchange provide investors with an enormous range of investment
opportunities.
• A corporation makes no promise of a return to ordinary shareholders, so the higher level of risk
attached to these securities creates an expectation in the investor of a higher level of return, on
average, over time.
• A stock exchange brings buyers and sellers together to form an efficient, deep and liquid market
in securities.
• A share in a listed company, in part, entitles an investor to receive a return on the investment in
the form of any dividends paid and any capital gain or loss accumulated on the current market
value of the share.
• Risks associated with share investments are described as systematic and unsystematic.
Systematic risk exposures affect the price of most shares listed on a stock exchange, to a greater
or lesser extent. Unsystematic risk specifically impacts on the share price of individual stocks.
• Portfolio theory demonstrates that, by holding a diversified share portfolio, unsystematic risk can
be substantially reduced. The remaining systematic risk is measured using a beta coefficient.
This is a statistical measure of the sensitivity of a share price relative to an average share listed
on a stock exchange.
• Investors will consider the cash-flow and investment characteristics of a particular share. An
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investor may adopt an active or a passive share investment approach.
• The active approach might use fundamental analysis or technical analysis to structure a portfolio
to meet the investor’s personal risk and return preferences.
• With a passive approach, an investor will seek to replicate the structure, and therefore the return,
of a specific share-market index.
• Within a diversified share portfolio the investor will consider the correlation of risk and return
between shares.
• Finally, the allocation of shares within the portfolio will be both strategic, in that it meets the
investor’s personal preferences, and tactical, in that it will be monitored and managed to take
account of new information that comes to the market.
Learning objective 6.2: Detail the process for buying and selling of shares
• An investor buying or selling shares can take a direct investment approach or an indirect
approach.
• With the direct approach an investor will select the shares to be included in a portfolio. The
transaction will usually be carried out through a stockbroker.
• A stockbroker accepts buy or sell orders from investors and acts as the agent in placing the
orders into the stock exchange’s trading system.
• The share trading system used by the ASX is known as ASX Trade and the transfer and
settlement system is known as CHESS. Settlement occurs in T + 3 business days.
• A broker may be a discount broker that executes transactions but does not provide investment
advice. A full-service broker will execute buy and sell orders, but will also provide investment
advice and some other financial services.
• With the indirect investment approach, an investor does not select the stocks to be held in a
portfolio; rather the investor purchases units in a managed fund such as a public unit trust.
Learning objective 6.3: Understand the importance of taxation in the investment decision process
• Taxation will impact on the net return received by an investor. Taxation regimes vary
considerably between countries. However, two major taxes that may be imposed on the return of
a shareholder are income tax and capital gains tax.
• An investor needs to consider the level of income tax payable. For example, is income taxed at a
flat rate or a marginal rate? Are realised capital gains taxed or not, and at what rate?
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• For example, in Australia the marginal tax rate ranges up to 45 per cent, plus a 1.50 per cent
Medicare levy. Generally, fifty per cent of a realised capital gain is also taxed at the taxpayer’s
marginal income tax rate.
• However, there is a tax benefit available to Australian shareholders known as dividend
imputation. The dividend imputation system enables corporations to pay franked dividends to
shareholders, whereby the company tax paid on profits can be passed as a franking credit to the
shareholder. This reduces the amount of tax payable by the shareholder.
Learning objective 6.4: Identify and describe various indicators of financial performance
• When analysing a share investment opportunity, an investor should consider a range of financial
performance indicators.
• Measures of a company’s liquidity, such as the current and liquid ratios, provide an indication of
the company’s ability to meet its short-term financial obligations.
• The long-term financial viability of a company is indicated by the company’s capital structure, as
measured by the debt-to-equity ratio or the proprietorship ratio.
• Past profitability may be measured by different earnings ratios. These include the earnings
before interest and tax (EBIT) to total funds ratio, the EBIT to long-term funds ratio and the
after-tax earnings on shareholders’ funds ratio.
• Another important indicator is the company’s ability to ensure its solvency by being able to meet
its short-term financing commitments. This is frequently measured through the ratio of debt to
gross cash flows, or through the ratio of EBIT to total interest.
• An investor may also rank companies on the basis of the market’s current valuation of the
business and its prospective earnings stream. Indicators of market valuation are obtained through
the price to earnings (P/E) ratio and the ratio of share price to net tangible assets.
Learning objective 6.5: Apply quantitative methods to the pricing of shares
• Investors are interested in estimating the current market price of a share. The price may be said
to be a function of the supply and demand for a stock. This is influenced by future earnings
expectations.
• The price of a share is theoretically the present value of its future dividend streams. New
information that changes future earnings forecasts will also change the share price.
• The future dividend payments of a corporation may be constant over time; in this case, the
dividend payment is simply divided by the required rate of return to estimate the share price.
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