Chapter 7: equity vlauations part 1

Question 1

what do equity securities represent?

Answer 1

claims on businesses with residual claims to earnings after tax and to assets upon dissolution and the participation in growth and profitability of the business

Question 2

How can equity securities be valued based on approaches using the

Answer 2

1. PV of expected future dividends - dividend discount models 2. or relative valuation models

Question 3

Equity securities include what types of shares

Answer 3

preferred and common shares - may pay dividends form after-tax earnings at the discretion of the BOD

Question 4

how are equity securities (shares) different than bonds

Answer 4

bonds are most often finite in life, equities are like corporations and are assumed to have an infinite life so long as the underlying corporation is a going concern

Question 5

what does CBCA stand for

Answer 5

Canada Business Corporations Act

Question 6

What does CBCA indicate regarding shares

Answer 6

corporations must have at least one share class with the following rights 1. rights to residual earnings after-tax and all legal obligations to other claimants have been satisfied 2. rights to residual assets upon dissolution or liquidation 3. rights to exert control over the corporation by voting to elect a BOD, accept f.s, appoint auditors, and approve major issues such as takeover bids and corporate restructurings

Question 7

What are the shares called that exhibit all 3 characteristics indicated by CBCA?

Answer 7

common shares

Question 8

define preferred shares

Answer 8

have priority over common shares and represent a different share class

Question 9

what are the characteristics of preferred shares

Answer 9

1. pays a fixed, annual or quarterly dividend which is not legally enforceable by shareholders if not declared by the BOD 2. have priority over the common share class to dividends and assets upon dissolution 3. have no voting rights, except if dividends are in arrears 4. have no maturity date 5. often have a cumulative feature, where dividends in arrears must be paid in full before common shareholders can receive a dividend 6. often called a fixed income investment because the regular annual dividend is fixed (or set) at the time the shares are originally issued and does not change after the shares are issued

Question 10

When do you use the discount rate k

Answer 10

when equities are valued using discount cash flow methods - should reflect the current level of interest rates, based on the risk-free rate, plus a risk premium that represents the riskiness of the investment

Question 11

why can straight preferred shares be viewed as perpetuities

Answer 11

because of the perpetual, constant dollar dividend they offer

Question 12

what does this diagram show

Answer 12

shows that the price of a preferred sare is the annual dividend amount divided by the investor’s required rate of return

Question 13

Describe the common share valuation: dividend discount model

Answer 13

model used to determine the intrinsic value of a stock by summing up the present value of all future dividends

• this model can be taylored in many different ways to suit