FIN111 Lecture 9: Week 9 – Share Valuation

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31 May 2018

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Week 9 – Share Valuation

• Equity instrument giving the holder ownership rights in a firm

• Shareholders have the right to vote for the mangers of the firm and to receive profits

the firm makes

• There is no guarantee that the shares will increase in value (capital gain) or that

dividends will be paid.

Debt vs Equity

Debt (bond holders)

Equity (shareholders)

Interest, Principal (fixed) → interest earned is a

coupon

Dividends (variable)

Interest is tax-deductable

Dividends are not a cost of doing business, not tax

deductable

Legal recourse if interest of principal payments are

missed

No legal recourse if dividends not paid

Excess debt can lead to financial distresses and

bankruptcy

An all-equity financed firm cannot go bankrupt

First claim over assets in the vent of bankruptcy

Residual claim after all others have been repaid

No ownership

Ownership

No voting rights

Voting rights

The Market for Shares

• Equity securities are a compas etifiates of oeship

• Equities are the most visible securities on the financial landscape – more than $1.6

trillion public equity shares outstanding in Aus. at the end of June 2015

Secondary Markets

• Outstanding shares of a company are bought and sold among investors

• Any trade of a security after its primary offering is said to be a secondary market

transaction.

• Investors will pay a higher price for primary securities that have an active secondary

market because of the marketability

• Companies on the secondary market can sell new debt/equity issues at lower

funding costs

• Fo iestos pespetie, it poides marketability at a fair price for shares of

securities they own

• Almost all secondary equity market transactions take place on the Australian

Securities Exchange (ASX)

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• Markets are efficient when current market prices of securities traded reflect all

available information relevant to the security.

Four Types of Secondary Markets (in order of increasing market efficiency):

1. Direct Search

- Buyers/sellers seek each other out directly

- Sellers often rely on word-of-mouth communication to find buyers

- Difficult and costly

2. Broker

- Brokers bring buyers and sellers together to earn a fee, called a commission

- To provide investors with an incentive to hire them, brokers may charge a

commission that is less than the cost of a direct search.

- Aggressively seek out buyers and sellers and try to negotiate

- Increases market efficiency because brokers are in frequent contact with market

participants and are likel to ko hat ostitutes a fai pie

3. Dealer

- Provide this service by holding inventories of securities which they own

- Then buy new securities and sell from inventory to earn a profit

- They have capital risk – difference between bid price and offer price

4. Auction

- Buyers and sellers confront each other directly and bargain over price

Reading the Share Market Readings

• Most financial press, The Australian Financial Review, Wall Street Journal, The New

York Times provide share listings for major share exchanges, such as NYSE and

relevant regional exchanges

• Franking

- f – dividend is 100% franked – company has fully paid tax on the dividend

- p – the dividend is partly franked

- lak spae i the f o p olu idiates the diided is unfranked (no tax)

• Offer basic security market information:

- Price: bid, ask, last, high, low

- Dividend: last dividend, franked, partial

- Return: P/E, dividend yield

• 52 wk high/low → companies highest and lowest price in 52 weeks

• last sale → last price before closing

• + or - → changes

• quote buy/quote sell → highest bid price/highest ask price

• div c per share → annual dividend pay

• div times covered → the number of times the company profits cover latest dividend

• NTA → net tangible asset per share ratio

• Div Yld % → dividend yield. Annual div payout over current share price

• P/E ratio → current price per share over current earnings per share

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Ordinary and Preference Shares

Ordinary Shares

• Ordinary shares represent a basic ownership claim in a company

• Vote on all important matters that affect life of company, such as vote to elect board

of directors, capital budget, or proposed merger or acquisition

• Not guaranteed any dividend payments

• Loest pioit lai o opas assets i eet of isole

• Limited liability → losses limited to the amount of their investment

• Perpetuities in the sense that they have no maturity

• Can be retired only if management buys them in the open market from investors or

if the company is liquidated

Preference Shares

• Preference share owners are given priority over ordinary share owners with respect

to diideds paets ad lais agaist opas assets i eent of insolvency or

liquidation

• Preference share dividends are declared by the board of directors, and if a dividend

is not paid the lack of payment is not legally viewed as a default

• Legally a form of equity and paid by the issuer with after-tax dollars

• Even though preference shares are equity, owners have no voting privileges

• Most preference shares are not true perpetuities because their share contracts often

contain call provisions and can even include sinking fund provisions, which require

management to retire a certain percentage of the share issue annually until the

entire issue is retired.

• Dividends

- egadless of fis earnings

- stated percentage

- Dividend payments are paid with after-ta dollas sujet to taatio

Preference shares: debt or equity?

• Legally, preference shares are equity because they are the ownership of the

company

• Strong case that preference shares are a special type of bond because:

- They confer no voting rights

- Shaeholdes eeie a fied diided, egadless of opas eaigs

- If liquidated, shareholders receive a stated value (usually par) and not a residual

value.

- Preference shares often have edit atigs that ae siila i atue to those

issued to bonds

- Preference shares are some- times convertible into ordinary shares

- Most preference share issues are not true perpetuities

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Document Summary

Interest, principal (fixed) interest earned is a coupon. Dividends are not a cost of doing business, not tax deductable. Legal recourse if interest of principal payments are missed. Excess debt can lead to financial distresses and bankruptcy. First claim over assets in the vent of bankruptcy. Residual claim after all others have been repaid. Voting rights: equity securities are a compa(cid:374)(cid:455)(cid:859)s (cid:272)e(cid:396)tifi(cid:272)ates of o(cid:449)(cid:374)e(cid:396)ship, equities are the most visible securities on the financial landscape more than . 6 trillion public equity shares outstanding in aus. at the end of june 2015. Secondary markets: outstanding shares of a company are bought and sold among investors, any trade of a security after its primary offering is said to be a secondary market transaction. Securities exchange (asx: markets are efficient when current market prices of securities traded reflect all available information relevant to the security. Four types of secondary markets (in order of increasing market efficiency): direct search.

Related Questions

1) The subarea of finance where you need to value uncertain cash flows occurring at different points in time is:

a. investments

b. corporate finance

c. capital markets

d. bank management.

e. all of the above subareas

2) Which of the following statements is correct?

a. One advantage of forming a corporation is that equity investors are usually exposed to less liability than they would be in a partnership.

b. Corporations face fewer regulations than sole proprietorships.

c. One disadvantage of operating a business as a sole proprietor is that the firm is subject to double taxation, because taxes are levied at both the firm level and the Owner level.

d. It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship, extensive legal documents ace required.

e. If a partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her investment in the business.

3) Which of the following statements is correct?

a. Corporations generally face fewer regulations than sole proprietorships.

b. Corporate shareholders are exposed to unlimited liability.

c. It is usually easier to transfer ownership in a corporation than in a partnership.

d. Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation.

e. Less of a corporation's income is generally subject to federal taxes.

4) The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to:

a. Maximize its expected total corporate income.

b. Maximize its expected EPS.

c. Minimize the chances of losses.

d. Maximize the stock price per share over the long run, which is the stockâs intrinsic value.

e. Maximize the stock price on a specific target date.

5) Which of the following is correct?

a. In most corporations, the CFO ranks above the CEO.

b. By Law in most states, the chairman of the board must also be the CEO.

c. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person.

d. The CFO generally reports to the firm's chief accounting officer, who is normally the controller.

e. The CFO is responsible for raising capital and for making sure that capital expenditures are desirable, but he or she is not responsible for the validity of the financial statements, as the controller and the auditors have that responsibility.

6) The primary operating goal of a publicly-owned firm trying to best serve its stockholders should be to

a. Maximize managers' own interests, which are by definition consistent with maximizing shareholders' wealth.

b. Maximize the firmâs expected EPS, which must also maximize the firmâs price per share.

c. Minimize the firmâs risks because most stockholders dislike risk in turn, this will maximize the firmâs stock price.

d. Use a well-structured managerial compensation package to reduce conflicts that may exist between stockholders and managers.

e. Since it is impossible to measure a stock's intrinsic value, the text states that it is better for managers to attempt to maximize the current stock price than its intrinsic value.

7) Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and bondholders?

a. Compensating managers with stock options.

b. Financing risky projects with additional debt.

c. The threat of hostile takeovers.

d. The use of covenants in bond agreements that limit the firmâs use of additional debt and constrain managers' actions.

e. Abolishing the Security and Exchange Commission.

8) Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and managers?

a. Pay managers large cash salaries and give them no stock options.

b. Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover.

c. Beef up the restrictive covenants in the firmâs debt agreements.

d. Eliminate a requirement that members of the board of directors must hold a high percentage of their personal wealth in the firmâs stock.

e. For a firm that compensates managers with stock options, reduce the time before options are vested, i.e., the time before options can be exercised and the shares that are received can be sold.

9) Which of the following mechanisms would be most likely to help motivate managers to act in the best interests of shareholders?

a. Decrease the use of restrictive covenants in bond agreements.

b. Take actions that reduce the possibility of a hostile takeover.

c. Elect a board of directors tlta.t allows managers greater freedom of action.

d. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.

e. Eliminate a requirement that members of the board of directors have a substantial investment in the firmâs stock.

10) Which of the following is correct?

a. Potential conflicts between stockholders and bondholders are increased if a firm's bonds are convertible into its common stock.

b. Because bankruptcy requires that corporate bondholders be paid in full before stockholders receive anything, bondholders generally prefer to see corporate managers invest in high risk/high return projects rather than low risk/low return projects.

c. There is no good reason to expect a firmâs stockholders and bondholders to react differently to the types of assets in which it invests.

d. Stockholders should generally be happier than bondholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns.

e. Bondholders should generally be happier titan stockholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns.

11) You recently sold 100 shares of Microsoft stock to your brother at a family reunion. At the reunion your brother gave you a check for the stock and you gave your brother the stock certificates. Which of the following best describes this transaction?

a. This is an example of a direct transfer of capital

b. This is an example of a primary market transaction.

c. This is an example of an exchange of physical assets.

d. This is an example of a money market transaction.

e. This is an example of a derivative market transaction.

12) Which of the following statements is correct?

a. The NYSE does not exist as a physical location. Rather it represents a loose collection of dealers who trade stock electronically.

b. An example of a primary market transaction would be your uncle transferring 100 shares of Walmart stock to you as a birthday gift.

c. Capital market instruments include both long-term debt and common stocks.

d. If your uncle in New York sold 100 shares of Microsoft through his broker to an investor in Los Angeles, this would be a primary market transaction.

e. While the two frequently perform similar functions, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise large blocks of capital from investors.

13) Which of the following is a primary market transaction?

a. You sell 200 shares of IBM stock on the NYSE through your broker.

b. You buy 200 shares of IBM stock from your brother. The trade is not made through a broker--you just give him cash and he gives you the stock.

c. IBM issues 2,000,000 shares of new stock and sells them to the public through an investment banker.

d. One financial institution buys 200,000 shares of IBM stock from another institution. An investment banker arranges the transaction.

e. IBM sells 2,000.000 shares of treasury stock to its employees when they exercise options that were granted in prior years.

14) Money Markets are markets for:

a. Foreign currencies.

b. Consumer automobile loans.

c. Common stocks.

d. Long-term bonds.

e. Short-term debt securities such as Treasury bills and commercial paper.

15) You recently sold 200 shares of Disney stock, and the transfer was made through a broker. This is an example of:

a. A money market transaction.

b. A primary market transaction.

c. A secondary market transaction.

d. A futures market transaction.

e. An over-the-counter market transaction.

16) Which of the following statements is correct?

a. Hedge funds are legal in Europe and Asia, but they are not permitted to operate in the United States.

b. Hedge funds are legal in the United States, but they are not permitted to operate in Europe or Asia.

c. Hedge funds have more in common with investment banks than with any other type of financial institution.

d. Hedge funds have more in common with commercial banks than with any other type of financial institution.

e. Hedge funds are not as highly regulated as most other types of financial institutions.

17) Which of the following factors statements is correct?

a. The New York Stock Exchange is an auction market, and it has a physical location.

b. Home mortgage loans are traded in the money market.

c. If an investor sells shares of stock through a broker, then it would be a primary market transaction.

d. Capital markets deal only with common stocks and other equity securities.

e. While the distinctions are blurring, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties.

18) Which of the following statements is correct?

a. The term "IPO" stands for Introductory Price Offered, and it is the price at which shares of a new company are offered to the public.

b. IPO prices are generally established by the market, and buyers of the new stock must pay the price that prevails at the close of trading on the day the stock is offered to the public.

c. In a "Dutch auction," investors who want to buy shares in an IPO submit bids indicating how many shares they want to buy and the price they are willing to pay. The company determines how many shares it wants to sell. The highest price that enables the company to sell the desired number of shares is the price that all buyers must pay.

d. It is possible that the price set in an IPO is so high that investors will refuse to buy the number of shares that the company wants to sell. In this situation, the IPO is said to be oversubscribed.

e. It is possible that the price set in an IPO is so low that investors will want to buy more shares than the company wants to sell. In that case, the company will have to issue more shares than it wants to sell.

19) The stock market is thought to be efficient because:

a. There are many brokers working the exchange floors

b. Computers can make very fast calculations these days

c. There are many stock analysts following the same stocks

d. Stocks are available and are very inexpensive

e. Speed trading is now an acceptable trading technique

20) If the stock is priced correctly but with better management the firm could be worth even more, then the firm would be:

a. A potential target for a stock investor

b. A potential target for a private equity firm

c. A potential target for a bond fund

d. A potential target for the SEC

e. A potential target for share repurchases

FIN111 Lecture 9: Week 9 – Share Valuation

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