Week 4 Everything Flashcards

1
Q

Equity financing

A

Equity holders have a residual claim to the cashflows generated by the assets of the company. e.g. ordinary shares; preference shares.

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2
Q

Debt financing

A

Debt providers have a contractual right to the cashflows generated by the assets of the company. e.g. term loans (long-term bank loans); debentures; bonds (government bonds and/or corporate bonds)

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3
Q

Sources of Finance

A

Equity financing

Debt financing

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4
Q

CHARACTERISTICS OF Debt vERSUs Equity

A

27/3/19

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5
Q

Intrinsic value of an asset

A

The present value of the stream of expected cash flows discounted at an appropriate required rate of return

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6
Q

The value (or price) is determined by three elements

A
  1. The required rate of return by investor
  2. The riskiness or uncertainty of expected cash flows
  3. The amount and timing of expected cash flows
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7
Q

Bonds

A

A bond refers to a contract that is issued by either a government or a corporation (the issuer) promising to pay the holder a pre-determined amount of interest payments; and the face value at maturity. A bond represents a form of interest-only direct finance loan.

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8
Q

Bonds terminology

A

Par value (or face value)

Maturity date

Coupon rate

Coupon payments

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9
Q

Par value (or face value)

A

The principal amount to be repaid on the maturity date.

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10
Q

Maturity date

A

The date at which the principal amount is payable

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11
Q

Coupon rate

A

The annual coupon payments divided by the face value.

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12
Q

Coupon payments

A

The fixed interest payments that are payable at fixed intervals until the maturity date.

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13
Q

Bonds terminology linked together

A

A bond pays fixed coupon payments at fixed intervals and pays the par value at maturity

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14
Q

Valuation of Bonds

A

The value (or price) of a bond is determined by the present value of all the cash flows that the bond is expected to produce in the future up to and including the maturity date.

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15
Q

The expected cash flows for a bond consist of:

A

(1) All coupon payments (paid at fixed intervals until the maturity date);
(2) The principal amount or Face Value (paid at the maturity date).

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16
Q

Valuation of Bonds formula

A

27/3/19

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17
Q

Valuation of bonds formula

C

A

Coupon payment for each period (in dollars)

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18
Q

Valuation of bonds formula

r

A

Required rate of return (i.e. interest rate or discount rate)

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19
Q

Valuation of bonds formula

t

A

Number of periods to the maturity date

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20
Q

Valuation of bonds formula

FV

A

Face value of bond paid at the maturity date

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21
Q

VALUATION OF BONDS

GENERAL RULE

A

If the Coupon rate = Interest rate:
The bond will sell for its par value (i.e. par bond).

If the Coupon rate > Interest rate:
The bond will sell for a premium (i.e. premium bond).

If the Coupon rate < Interest rate:
The bond will sell for a discount (i.e. discount bond).

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22
Q

VALUATION OF BONDS CONCLUSION

A

Bond prices are inversely related to interest rate movements. If interest rates increase, bond prices will fall and thus sell at a discount; and If interest rates decrease, bond prices will rise and thus sell at a premium.

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23
Q

The Relationship between Bond prices and interest rates

A

27/3/19

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24
Q

SHARES

A

The main types of equity securities are ordinary shares and preference shares.

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25
Q

Preference shares

A

A form of hybrid security. Similar to bonds in that fixed dividends that must be paid to preference shareholders before dividends can be paid to ordinary shareholders. Similar to ordinary shares in that preference shares have no fixed maturity date and there is no obligation for companies to pay dividends to preference shareholders. Companies can omit dividend payments to preference shareholders without fear of defaulting and pushing the company into bankruptcy.

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26
Q

Preference Shares terminology

A

Par Value

Cumulative dividends

Maturity date

Priority to Assets and Earnings

Control of the Company (Voting Rights)

Convertibility

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27
Q

Par Value

PREFERENCE SHARES

A

Establishes the amount due to preference shareholders in the event of company liquidation event. The preference dividend is generally set as a % of par value.

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28
Q

Cumulative Dividends

PREFERENCE SHARES

A

A protective feature on preference shares that requires preference dividends not paid in previous periods to be paid to preference shareholders before dividends can be paid to ordinary shareholders.

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29
Q

Maturity Date

PREFERENCE SHARES

A

In general, preference shares have no specific maturity date

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30
Q

Priority to Assets and Earnings

PREFERENCE SHARES

A

Preference shareholders have priority over ordinary shareholders but not debtholders. Dividends must be paid on preference shares before ordinary shares.

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31
Q

Control of the Company (Voting Rights)

PREFERENCE SHARES

A

Preference shares are typically ‘non-voting’, with preference shareholders having neither the right to elect the Board of Directors nor vote on corporate issues.

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32
Q

Convertibility

PREFERENCE SHARES

A

Many preferred shares include an option to convert to ordinary shares.

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33
Q

valuation of Preference shares formula

A

PV = D / r

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34
Q

D

A

Fixed dividend payment for each year (in dollars)

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35
Q

r

A

Required rate of return (i.e. interest rate or discount rate).

36
Q

perpetuity

A

With fixed dividend payments and no maturity date, preference shares can be valued like a perpetuity.

37
Q

ABC Ltd. paid $1.10 dividend to its preference shareholders. The expected rate of return on similar preference shares is 10%. What is the price of ABC Ltd.’s preference share?

A

By applying the formula,

PV = D / r
PV = $1.10 / 0.10
PV = $11 per preference share.

38
Q

Ordinary shares

A

Ordinary shares represent equity or claims to ownership of the company

39
Q

Ordinary shareholders have residual claim to any earnings that remain:

A

(1st) only after interest payments are made to debtholders;
(2nd) only after corporate tax is paid to the government; and.
(3rd) only after dividends are paid to preference shareholders.

40
Q

Ordinary shares terminology

A

Maturity Date

Priority to Assets and Earnings

Control of the Company (Voting Rights)

41
Q

Maturity Date

ORDINARY SHARES

A

Like preference shares, ordinary shares have no specific maturity date

42
Q

Priority to Assets and Earnings

ORDINARY SHARES

A

Both debtholders and preference shareholders have priority over ordinary shareholders. Both interest payments on debt and dividends on preference shares must be paid before dividends can be paid on ordinary shares.

43
Q

Control of the Company (Voting Rights)

ORDINARY SHARES

A

Ordinary shares come with voting rights, with ordinary shareholders having the right to elect the Board of Directors and vote on corporate issues such as shareholder’s proposals, mergers and changes to the company’s constitution.

44
Q

Valuation of Ordinary Shares

A

The market value of a share is the present value of all expected cash flows to be received from the share, discounted at a rate of return that reflects the riskiness or uncertainty of the expected cash flows.

45
Q

The expected cash flows to be received from a ordinay share

A

The expected cash flows to be received from a share are all the future dividend payments for the share.

46
Q

SELLING AN ORDINARY SHARE V BUYING A SHARE

A

When you sell a share, you are selling the right to receive all future dividends from that point onwards. Conversely, when you buy a share, you are buying the right to receive all future dividends from that point onwards.

47
Q

THE DIVIDEND GROWTH MODEL (ORDINARY SHARES)

A

The valuation process is greatly simplified if we can assume that dividends are expected to grow at a constant rate over time (i.e. simply assume that dividends will grow by the same percent each year). This assumption creates the ‘dividend growth model’

48
Q

THE DIVIDEND GROWTH MODEL FORMULA

A

PV = D / r - g

49
Q

D

A

Dividend payment (in dollars)

50
Q

r

A

Required rate of return (i.e. interest rate or discount rate)

51
Q

g

A

Growth rate (of dividend)

52
Q

Cunnington Ltd has just paid an ordinary dividend of $0.90. This dividend is expected to grow at an annual rate of 6 percent indefinitely. If the required rate of return is 12 percent,
what is the value of the share?

A

By applying the formula,

PV = D / r - g
PV = $0.90 / (0.12 – 0.06)
PV = $15 per ordinary share.

53
Q

Dividends

A

A dividend is a payment that is made out of a company’s (retained) earnings to its owners (or shareholders). Dividends are usually paid in the form of cash.

54
Q

Types of cash dividends include:

A

regular dividends

extra dividends

special dividends

liquidating dividends

55
Q

THE DIVIDEND PAYMENT PROCESS

A

DECLARATION DATE

EX-DIVIDEND DATE

RECORD DATE

PAYMENT DATE

56
Q

Declaration date

A

The date on which the company’s board of directors publicly announces the amount and the specifics (such as the payment date) of the next dividend payment.

57
Q

Ex-dividend date

A

The date on which the legal right to the next dividend payment no longer accompanies a share. Shareholders that sell shares on or after the ex-dividend date will still be entitled to receive the next dividend payment, although the new owner will not. Usually, shares that trade immediately after the ex-dividend date will be accompanied by a decline in the share price that is equivalent to the amount of the next dividend payment.

58
Q

Cum dividend

A

The situation where the legal right to the next dividend payment accompanies a share. When investors purchase shares that are cum dividend, they are entitled to receive the next dividend payment on the payment date. Conversely, when investors sell shares that are cum dividend, they will not be entitled to receive the next dividend payment on the payment date.

59
Q

Record date

A

The date on which the company determines the list of shareholders that will receive the next dividend payment. In Australia, the record date typically occurs 4 business days after the ex-dividend date.

60
Q

Payment date

A

The date on which the company actually makes the dividend payments to the shareholders on its record.

61
Q

Should a company use its retained earnings to:

Finance profitable investment opportunities?

Pay dividends to shareholders?

A

A company’s dividend policy seeks to address this dilemma and communicate this information to its shareholders.

62
Q

Does dividend policy affect the share price of a company?

Two opposing viewpoints:

A

Dividend Irrelevance Theory

Dividend Relevance Theory

63
Q

DIVIDEND IRRELEVANCE THEORY

A

Argues that the market value of a company is determined by the basic earning power and business risk of the company. Therefore, the market value of a company depends only on the net income (or positive cashflows) produced by the company and not on how it splits its retained earnings between financing investments for future growth versus dividend payments to shareholders. Dividend Irrelevance Theory contends that investors care only about the total returns they receive, and not whether they receive those returns in the form of dividends, capital gains or both.

64
Q

DIVIDEND RELEVANCE THEORY

A

Dividend Relevance Theory contends that a company’s dividend policy can affect its market value due to investor preferences for either dividends or capital gains

65
Q

Dividend Relevance Theory contends that a company’s dividend policy can affect its market value due to investor preferences for either dividends or capital gains

A

‘Bird-in-Hand’ Theory

‘Tax Preference’ Theory

66
Q

‘Bird-in-Hand’ Theory

A

Argues that investors would prefer to receive dividends today rather than receive capital gains in the future, because current dividend payments are more certain than future capital gains.

67
Q

‘Tax Preference’ Theory

A

Argues that, since dividends are taxed immediately whereas capital gains are not taxed until the share is sold (with potentially indefinite deferral of tax), investors would prefer to defer tax by receiving capital gains in the future rather than receive dividends today and be taxed immediately.

68
Q

POSSIBLE EFFECTS OF DIVIDEND POLICY ON COST OF EQUITY

A

27/3/19

69
Q

POSSIBLE EFFECTS OF DIVIDEND POLICY ON market share price

A

27/3/19

70
Q

PRACTICAL IMPLICATIONS of dividend theories

A

27/3/19

71
Q

4 Dividend policies

A

Residual Dividend Policy

Constant Payout Ratio Dividend Policy

Stable Dollar Dividend Policy

Low Regular Dividend Plus Extras Dividend Policy

72
Q

Residual Dividend Policy

A

A policy in which the company only makes dividend payments when there is retained earnings left over after having financed all profitable investment opportunities. The residual dividend policy dictates that dividend payments to shareholders should only be paid out of leftover earnings.

73
Q

Residual Dividend Policy key implications

A

Minimizes the overall cost of capital for the company by reducing the need to raise capital through issuance of new equity. But the ‘residual dividend policy’ will result in variation of dividend payments to shareholders due to fluctuations in retained earnings and the cost of pursuing profitable investment opportunities. This variation of dividend payments sends conflicting signals to investors, that might, in turn adversely affect the company’s share price.

74
Q

Constant Payout Ratio Dividend Policy

A

A policy in which the company distributes a fixed proportion of its earnings to shareholders in the form of dividend payments. For example, a constant payout ratio of 30% means that, for every dollar of earnings, 30 cents will be paid out to shareholders as dividends.

75
Q

Constant Payout Ratio Dividend Policy

Key implications

A

Although the dividend payout ratio is constant, the dollar value of dividend payments will fluctuate as earnings change over time. Again, this variation of dividend payments sends conflicting signals to investors, that might, in turn adversely affect the company’s share price.

76
Q

Stable Dollar Dividend Policy

A

A policy in which the company pays a fixed dollar amount of dividend payments to shareholders each year such that the annual dollar dividend is relatively predictable for investors.

77
Q

Stable Dollar Dividend Policy

Key implications

A

The stability and predictability of dividend payments sends a positive signal to investors that will, in turn, help to attract more investors, thereby maintaining or boosting the company’s share price.

78
Q

Low Regular Dividend Plus Extras Dividend Policy

A

A policy in which the company pays a low regular dollar dividend to shareholders plus an extra (or special) year-end dividend in prosperous years when the company is performing well financially.

79
Q

Low Regular Dividend Plus Extras Dividend Policy

Key Implications

A

Represents a compromise between the ‘stable dollar dividend policy’ and the ‘constant payout ratio dividend policy’. Provides the company with flexibility while ensuring that shareholders receive at least a minimum amount of dividend payments. By identifying year-end dividend as an ‘extra’, the company avoids signalling to investors that this is a permanent dividend, thus providing the company with flexibility to reduce or eliminate the year-end dividend in the future without adversely affecting its share price.

80
Q

Share REPURCHASES

A

Involves distribution of earnings by a company to its shareholders by purchasing its own shares from existing shareholders.

81
Q

Two main forms of share repurchases in Australia:

A

On-market repurchase

Off-market repurchase

82
Q

On-market repurchase

A

Involves purchasing shares offered for sale by investors on the share market through normal share market trading mechanism.

83
Q

Off-market repurchase

A

Involves making a formal offer to purchase shares from all existing investors based on offer terms outlined in the offer document. Off-market repurchases are not processed through the normal share market trading mechanism.

84
Q

Primary Reasons for Share Repurchases:

A

To distribute excess funds to shareholders:

To adjust the company’s capital structure:

To adjust for employee share-based compensation:

To protect or defend against a takeover attempt:

85
Q

Advantages of Share Repurchases:

A

To distribute excess funds to shareholders:

To adjust the company’s capital structure:

To adjust for employee share-based compensation:

Signal to investors:

86
Q

Disadvantages of Share Repurchases:

A

Company might overpay for shares

Irregular interval between share repurchases