Ch.9

Question 1

What is a dividend yield?

Answer 1

The % of share price paid in dividends (per dividend)

Question 2

Should a company expect to pay more for debt or equity and why?

Answer 2

Equity: investors require a premium for the additional exposure to risk and uncertainty over future payments (also more liable to losses than debt-holders if company goes under)

Question 3

To what type of company will equity finance be attractive to and why? What might put them off equity finance? Why might they struggle to get equity finance?

Answer 3

Attractive to fast growing companies; can pay low/no dividend to allow fast growth in early years

Cons: can lead to loss of firm control

Also if not well-known company yet may struggle to attract investors

Question 4

Which type of companies may be more attracted to debt financing and why?

Answer 4

Medium/small firms who are not listed publicly because debt will be easier and quicker for them to obtain

Question 5

What type of debt is typically most expensive and why?

Answer 5

LT because need to pay a liquidity premium!

Question 6

Problem with ST debt?

Answer 6

Don’t want to become too dependent on it in case it isn’t renewed

Question 7

2 equity types, explain the rights they have?

Answer 7

Ordinary(common stocks) shares: dividend rights, voting rights, ownership, right to see annual report

Preference shares: Same rights as above, plus first claimant right on dividends and assets if firm liquidates (after debt-holders)

Question 8

2 advantages of share issues?

Answer 8

1) no obligation to pay dividends

2) capital does not have to be repaid

Question 9

2 disadvantages of share issues?

Answer 9

1) costly (return required to satisfy SHs, direct costs of issuing shares)
2) loss of control of firm

Question 10

What is short-selling?

Answer 10

The process of borrowing a security and selling it in the hope of buying it back at a lower price, and then returning it to the lender

Question 11

How does a short seller ‘cover’ their position?

Answer 11

By purchasing the shares back at a future date

Question 12

2 advantages of short selling?

Answer 12

1) Allows investors who believe a share is overvalued to profit of this
2) Helps to prevent an upward bias in share prices that would occur since shares would ONLY BE HELD BY INVESTORS OPTIMISTIC ABOUT THE SHARE (also can be used to help burst bubbles)

Question 13

Disadvantage of short-selling?

Answer 13

It is very risky! UNLIMITED LIABILITY since share price could rise an unlimited amount!

Question 14

Explain how to derive the fundamental arbitrage relationship?

Answer 14

1) Ex-dividend share has price P0
2) Expectation of price and dividend at end of this period: E(P1+D1)
3) Need to discount this by R1 (getting P1+D1 in say 6 months is not same as getting it now!)
4) Equilibrium occurs when price of share today = discounted value of expected future price and dividend

ie. P0 = E(P1+D1)/(1+R1)

Note: for risk-free assets (eg. some bonds) use the risk-free rate for discount (possibly with D1=0)

Question 15

According to the dividend pricing approach, when should one buy/sell a share?

Answer 15

BUY if discounted value of expected future price and dividend is GREATER than price of share today (P0)

SELL if discounted value of expected future price and dividend is LESS than price of share today (P0)

Question 16

Using the fundamental arbitrage relationship, derive the fundamental value of a share?

Answer 16

Notes P1S2

Question 17

What does the Gordon Growth Model assume?

Answer 17

That dividends will grow by a certain growth rate % each year of g%/yr

Question 18

What do both the GGM and the FV relationships assume?

Answer 18

That bubble term =0

Question 19

4 points to criticise the GGM on?

Answer 19

R constant and known (not realistic)
g known (is it? end of civilisation/financial crisis/bankruptcy???)
Assumes no tax is paid (unrealistic)
Precision required (small changes in g or R can drastically change outcomes)

Question 20

Explain Miller and Modigliani’s dividend irrelevance theorem? What does this contradict?

Answer 20

They show that under certain assumptions, reductions in dividends can lead to systematically higher values of g, leaving share prices UNAFFECTED

This is contrary to the dividend pricing approach, which suggests that increasing the current dividend leads to an increase in share price and vice versa

Question 21

What are the three measurements of required rate of return from investors?

Answer 21

Judgmental risk premium basis (nominal interest rate+risk premium)
GGM estimate of R (rearrangement of GGM eqn. as n tends to infinity)
CAPM estimate of R (risk-free interest rate + beta.market risk premium)

Question 22

3 advantages of financial ratios?

Answer 22

1) Useful for comparative assessments between similar firms
2) They provide a summary of key financial data (intra-industry comparisons)
3) Can help determine if stock is over/under-valued

Question 23

4 problems with financial ratios?

Answer 23

1) Different firms have different methods of calculating them and different reporting years
2) Allowance must be made for firm size
3) No weighting system exists to suggest which FRs are best for predicting success/failure of a company
4) The past is not necessarily a good guide to the future!!!

Question 24

What is the required rate of return?

Answer 24

Minimum level of return that an investor can achieve by investing in a ‘risk-free’ asset (tells us opp cost of investment)

Question 25

What does he GGM do?

Answer 25

It equates the value of a share to the present value of its future (expected) dividends.

Question 26

What does term 1 on the GGM do? What about the second term?

Answer 26

Sums the discounted value of future dividends from year 1->n

Second term calculates the discounted value of dividends from year n to infinity