Chapter 10

Question 1

Equity types:

Answer 1

1. Ordinary shares
   -ownership of the company
   -paid after debtors and preference shareholders
   -can attend and vote in meetings
2. Quoted shares
   -listed on a stock exchange

Question 2

Investment and risk characteristics of equities:

Answer 2

1. Security
   -depends on the profitability of the company
2. Yield
   -long term real yield
   -higher than governement bonds
3. Spread
   -income (dividends) and capital volatile
4. Term -can be held in perpetuity
5. Dealing costs are linked to marketability
6. Marketability depends on the size of the company

Question 3

what makes quoted shares more attractive than unquoted shares? (5)

Answer 3

1. More marketable
2. more secure, meets stock exchange requirements
3. Easier to price, information is available
4. Greater divisibility
5. More information available due to disclosure requirements

Question 4

Why are market movements the biggest influence on a share’s price: (4)

Answer 4

1. most companies are affected by macro-economic factors and the political climate in a similar way to the market. e.g. interest rates rise, all firms’ borrowing is more expensive
2. most company’s costs are affected by similar factors
3. most investors are interested in equities as a whole and not specific equities (Investor sentiment often shifts towards or away from entire asset classes) because:
   ▪ The equity market appears attractive compared to another market.
   ▪ Investors have real liabilities.
   ▪ Regulation and tax breaks tend to favour equities.
4. Many investors invest passively across a broad range of equities rather than actively seeking out specific shares, because:
   ▪ They believe the costs of active management are not compensated for by sufficient extra return.
   ▪ They lack the expertise.

Question 5

Why use industry groupings to categorise shares? (2)

Answer 5

1. it is practical for analysts to specialise in one area because:
   a) factors affecting one company within an industry tends to affect the other companies in the same industry
   b) information for companies in the same industry will come from the same source
   c)no one analyst can be expected to be an expert in all areas
   d) Gives structure to the decision making process
2. Share prices of companies in the same sector tend to be correlated
   a) use the same resources
   b) similar input costs
   c) supply to the same markets and are similarly affected by demand changes
   d) similar financial structure (similarly affected by interest rates)
   e) exposed to similar legislation and regulation

Question 6

Practical problems with industry groupings: (2)

Answer 6

1. Some companies operate over several sectors (Conglomerate companies)
   -through mergers and acquisitions
   -multinational companies
2. the heterogeneity of companies within particular sectors
   -differ within the same sector (due to size)

Question 7

Reasons why a company may want to buy back some of its shares: (6)

Answer 7

1. excess cash it cannot use profitably returned to shareholders
2. excess cash may only have been earning a deposit rate of interest and so releasing cash may increase earnings per share
3. tax efficient way of returning capital to shareholders (income vs capital gains tax)
4. changing its capital structure from equity financing to debt financing
5. cost of debt may be cheaper for the company in the long-term
6. debt payments may be more stable than paying dividend payments

Question 8

Prime property has the following factors (6)

Answer 8

Prime property
CALL ST

1. Comparables - number of comparable property
2. Age/condition/use/flexibility
3. Location
4. Lease structure
5. Size
6. Tenant quality

Question 9

Investment and risk characteristics of direct property:

Answer 9

1.Security
o Void and default risk.
o Susceptible to political risk.

2. Yield
   o Long-term real returns (i.e., move in line with inflation)
   o Expected return higher than that on index-linked government bonds.
   o Stepped income stream.
   o Running yield varies with the type of property.
   o Can provide high utility (feel-good-factor) to the investor.
3. Spread
   o Long-term volatility of capital values but short-term stability due to infrequent valuations.

4.Term

5. Expenses
   o Obsolescence, deterioration, and refurbishment costs.
   o High dealing and management costs.
6. Marketability
   o Unmarketable
   o Large unit size. (high value asset -not a large market out there)
   o Indivisible.
   o Time
   o Dealing costs
   o Uniqueness. - property differs
   o Subjective valuations.

Question 10

Disadvantages of direct property investment: (5)

Answer 10

1. Size -unaffordable for most investors
2. Diversification - impractical as investor would need a pf of property
3. Lack of marketability
4. Value is not known until sale (estimate values can be expensive)
5. Expertise needed

Question 11

Risk associated with building and establishing a new property: (3)

Answer 11

o Delays in time to completion. (strikes, weather)
o Over-run in estimated building costs. (actual costs could exceed expected costs)
o The ability to find tenants at expected rental income once completed.

Question 12

Advantages of investment in property company shares compared with investment in
direct property: (11)

Answer 12

1. Access to larger properties (that individual investors could not have afforded)
2. Discount to NAV may exist - property shares may be a cheap way of exposure to property
3. Diversification within the property market
4. Divisibility
5. Economies of scale in the case of large property share companies (enjoy bulk discounts and lower costs per unit)
6. Expected return may be higher due to the extra volatility associated with gearing (debt) and the possibility of any discount to NAV narrowing.
7. Expenses associated with direct property avoided
8. expertise of property company managers
9. marketability better
10. Quoted prices make valuation easier (always know the value of your investment)
11. Tax advantages (possibly)

Question 13

Advantages of investment in direct property compared with investment in property company shares: (9)

Answer 13

1. Control over the type of properties you want to invest in
   2.. Diversification from equities
2. less prone to forced selling (property is illiquid and less likely to be forced to sell during market downturns)
3. Management fees avoided
4. Not exposed to high risk properties
5. Not exposed to extra volatility caused by gearing or the discount to NAV changing (the higher the gearing, the more sensitive the property shares are to interest rates)
6. tax advantages (possibly)
7. Utility value derived from owning a property
8. Lower Price Volatility in the Short Term as valuations are infrequent

Question 14

Define net asset value per share:

Answer 14

=net value of company’s assets/number of shares
-net of liabilities and intangible assets
-represents the company’s wind up value per share (upon wind up, intangible assets such as goodwill be unlikely be of value)

Question 15

Normally property shares stand at a discount to their underlying estimated current net
asset value:

Answer 15

o The discount to NAV reflects:
▪ Any differences between the way in which investors value shares and
the way they value property.
▪ Risk of loss on forced sale - cashflow requirements result in property
companies being more likely to be forced sellers of properties than
institutions undertaking direct property investment on their own
account.
o A smaller discount, or possibly even a premium, to NAV is possible where:
▪ The market has a positive view of developments giving the potential
for capital gains.
▪ The valuations underlying the NAV are consecutive.
▪ The property company has a good management track record.