Flashcards in Lecture 6 Deck (30):

1

## Ordinary (common shares) (3)

###
- Voting rights

- Owners of the firm

- What shareholders receive depends on how well the company is managed

2

## Preference shares (4)

###
- Usually fixed rate of dividend each year

- No obligation to pay dividends

- Dividend for preference shares paid before anything else paid to ordinary shareholders

- No voting power

3

## Advantages of shares (2)

###
- No obligation to pay dividends

- Capital doesn't have to be repaid

4

## Disadvantages of shares (4)

###
- High cost to list firm

- Costly to produce return required by shareholders

- Loss of control

- No tax deductibility of dividends

5

## Asset valuation model =

### Market value of any investment asset is the present value of expected future cash flows (DCF model)

6

## Price of shares =

### Dividends / Discount rate

7

## Dividend discount model is based on

### Asset valuation model

8

## To calculate share price, need: (2)

###
- Future dividend amount

- Appropriate discount rate

9

## Zero growth model to calculate share price =

###
Dividends remain at the same level forever (Div 1 = Div 2 = Div n)

Po = Dividend / R

10

## Constant growth model to calculate share price =

###
Dividends grow at a constant rate (g) forever

Po = Div 1 / (r - g)

11

## Cost of capital =

### Rate of return a company must offer finance providers to encourage them to buy and hold financial securities

12

## Cost of debt determined by: (3)

###
- Prevailing interest rates

- Risk of default

- Benefit derived from the interest being tax deductible

13

## Traded debt =

### Easily bought / sold eg bonds

14

## Untraded debt =

### Cannot easily buy/ sell eg bank loan

15

## Rate of return on shares =

### Risk free rate + Risk premium (return rate firm needs to offer)

16

## Risk free rate gives a return sufficient to compensate for

### Impatience to consume and inflation

17

## Two methods to estimate risk premium =

###
- Gordon Growth model method

- Cost of preference share capital

18

## Gordon Growth model method

###
Earnings, dividends and reinvestment grow continuously each year (based on perpetuity formula)

P = D1 / (Ke - g) OR Ke = (d1 / P) + g

19

## Issues with gordon growth model method = (3)

###
- Can derive g in other ways

- Dividends differ between firms and their sizes

- Difficult to obtain accurate estimate of future growth rates

20

## Cost of preference share capital =

### Pp = d1 / Kp OR Kp = d1 / Pp (kp = cost of preference share) Pp = price of preference share

21

## Weighted average cost of capital (WACC) =

### Expected rate of return on a portfolio of all a firm's securities, adjusted for tax savings due to interest payments

22

## WACC formula

### (Cost of equity x weight of equity) + (cost of debt x weight of debt)

23

## Lowering WACC due to tax shield

### (Ke x We) + (Kdat x Wd)

24

## Kdat (cost of debt after tax) =

### Kd ( 1 - T)

25

## Which valued should be used to calculate WACC?

### Market values

26

## Short term debt is for

### Operating, not financing activites

27

## WACC with three of more types of finance (debt, common equity and preference shares)

### (Ke x We) + (Kdat x Wd) + (Kp x Wp)

28

## We =

### Ve / (Ve + Vd + Vp)

29

## Wd =

### Vd / (Ve + Vd + Vp)

30