Topic 4

Valuing shares and

long-term financing
Chapters 5 & 12
MPF753 Finance T3 2015
Department of Finance
Note that pages mark with * are originally prepared by Dr Mong Shan Ee and
currently adopted/modified by Dr Tunyarputt Kiaterittinun and those mark
with (^) are prepared by Dr Tunyarputt Kiaterittinun

Recap Topic 3
Main principle of Valuation
Bond valuation
Relationship between YTM & coupon rate
Relationship between Bond prices & interest
rates
Term structure of interest rates
Characteristics & cost of long term debt
financing
Types of long term debts

Learning outcomes
After studying this topic, you will be able to
describe
Share valuation
Dividend discount models, free cash flow
approach, book value, liquidation value,
comparable multiples)

Investment banking functions

Long term financing (Initial public offering
(IPO), Seasoned equity offering (SEO), Rights
Offering, Private placements)

5.1 The essential features of

preferred and ordinary shares
Shareholders are owners of the company
Ordinary shareholders are residual claimants.
No claim to earnings or assets until all senior
claims are paid in full.
High risk but historically also high return.

Shareholders have voting rights on important

company decisions.
4

 Preferred shares have some features similar to

debt and other features similar to equity.
Dividends are predetermined (Fixed/Floating)
Preferred shareholders usually do not have voting
rights.
Dividend payments are not tax-deductible.
Preferred shares have no maturity date.

Claim on assets and cash flow rank senior to

ordinary shares.

Preferred shares are held mostly by corporations.

Preferred share valuation

A preferred share is an equity security that is
generally pay a fixed annual dividend indefinitely.
0

rp

Dp
1

Dp

Dp

Asset value = PV of all future CFs

Preferred share price = PV of dividends
Preferred share price = PV of perpetuity

PS 0 =

Dp
rp

PV

PMT
r

PS0 = Preferred share market price

Dp = Next periods dividend payment
rp = Discount rate

Example:
Investors require an 11% return on a preferred
share that pays a $2.30 annual dividend.
What is the price?

PS 0 =

Dp
rp

$2.30
=
0.11
= $20.90 / share

Ordinary Share valuation

0

$D1

$D2

$Dn
$P

???
+ ???

Share Value

Shares cash flows: Dividends ($D) and

Share price ($P) once sold
The share value is the PV of its future cash flows.
8^

Share price = PV of dividends + PV of expected sale price

 Suppose that an investor buys a share today for price

P0, receives a dividend equal to D1 at the end of one
year, and immediately sells the shares for price P1.
1

P0

Return on
investment
Share value

D1
P1

D1 P1 P0
r
P0

P0 =

D1 + P1
(1+ r )1

D1
P1
P0

1
(1 r ) (1 r )1

Example: Assume that I buy a share for $10 and at

the end of the year, I receive a dividend of $1 and sell
this share for $11. What is my return on investment?
1

P0=10

D1 + P1 - P0
r=
P0

D1=1
P1=11

$1 $11 $10
r
20%
$10

Assume that you are considering the purchase of a

share and you expect it to pay $1 dividend next year.
You believe that you can sell the share for $11 at the
end of the year. If you required a return of 20%, what is
the current share price?
$1 $11
P0
D1 + P1
1
(
1

0
.
20
)
P0 =
(1+ r )1
$10

10^

Ordinary share value

P0

D1+P1

D2+P2

D3+P3

P0

P0
0

D1 P1
(1 r )1

P1

D2 P2
(1 r )1

D1
1

D3 P3
(1 r )1

P2

D2
2

D3

3
11

Valuation with one period

Value of an asset is present value of its future cash flows
the future dividend and the end of period share price
1

P0 = ?

D1
P1

Example: Assume that you are considering the purchase

of a share of BHP and you expect it to pay $1 dividend in
one year. You believe that you can sell the share for $15
at the end of the year. If your required rate of return is
10%, what is the maximum price you would be willing to
pay for this share?

12^

Example: One period

r = 10%
$0.91

D1 = $1

$13.64
P = $14.55

P1 = $15

Price = PV(dividends) + PV(sale price)

FV
PV
(1 i ) n

OR

D1 P1
P0
(1 r )1

1
15
P0 Pr ice

(1 0.10) (1 0.10)
0.91 13.64 14.55

1 15
P0
14.55
(1 0.10)

13^

Valuation with two periods

A two period model can be viewed as two one-period
models strung together.

P0 = ?

D1

D2
P2

Example: Assume that you are considering to hold the

BHP share for two years. The share will pay dividends of
$1 next year, and $1.1 the following year. After receiving
the second dividend, you plan on selling it for $16. If your
required rate of return is 10%, how much would you be
willing to pay for this share today? What is the price at
the end of the first year?

14^

Example: Two-period
r = 10%
???

$1

$1.1
$16

???
Price

FV
PV
(1 i ) n

Todays price

Price = PV(dividends) + PV(sale price)

1
1.1 16
P0 Pr ice

15.04
2
(1 0.10) (1 0.10)

Price at the end of Year 1

P1

D2 P2
(1 r )1

1.1 16
P1
15.55
1
(1 0.10)

15^

Example: Multiple periods

0

r = 10%

???
???
Price

FV
PV
(1 i ) n

$1

$1.1

$1.15

$1.3

$1.4

$20

Price = PV(dividends) + PV(sale price)

1
1.1
1.15
1.3
1.4 20

(1 0.10) (1 0.10) 2 (1 0.10) 3 (1 0.10) 4 (1 0.10) 5

16^
0.9091 0.9091 0.8640 0.8879 13.2877
16.8578

Pr ice

Example: Multiple periods

0
r = 10%

$1

$1.1

$1.15

$1.3

$1.4
$20

1
1.1
1.15
1.3
1.4 20

(1 0.10) (1 0.10) 2 (1 0.10) 3 (1 0.10) 4 (1 0.10) 5

16.8578

Pr ice

D3
D5 P5
D1
D2
D4
P0

1
2
3
4
(1 r ) (1 r )
(1 r )
(1 r )
(1 r ) 5
D3
Dn Pn
D1
D2
P0

1
2
3
(1 r ) (1 r )
(1 r )
(1 r ) n

17^

This is called.Dividend discount model

Asset value = PV of all its future CFs
Cash flows from share: Dividends and Sale price
SP= PV(expected dividends) + PV(expected sale price)
P0
0

D1
1

D2
2

D3
3

Dn+Pn
n

D3
Dn Pn
D1
D2
D4
P0

1
2
3
4
(1 r ) (1 r )
(1 r )
(1 r )
(1 r ) n

D3
D1
D2
D
P0

1
2
3
(1 r )
(1 r )
(1 r )
(1 r )

18^

Three dividend discounted models

Zero Growth Model
Constant Growth Model
Variable Growth Model

19

Zero growth valuation

Dividends have a growth rate of ZERO forever
Thus, dividend payments remain constant forever:
D0 = D1 = D2 = D3 = . . . = D

With the constant value D for each dividend payment,

the ordinary share valuation formula reduces to the
simple equation for a perpetuity:
P0
0

D1

D2

perpetuity

PMT
PV
r

D3

D
P0
r

20

Example: Zero growth

Suppose company ABC is expected to pay a
$0.50 dividend every year and the required
return by investors is 10%.
What is the share price?

D
P0
r
$0.50
P0
$5
0.10

21

Constant growth valuation

Dividends grow at a constant rate (g) forever.

D0
0

D2(1+g)
D1(1+g)(1+g)
D0(1+g)3

D0(1+g)1

D1(1+g)
D0(1+g)2

D1

D2

D3

If dividends grow at a constant rate forever, you can

value the share as a growing perpetuity, denoting next
years dividend as D1:
growing perpetuity
CF1
PV0
rg

D0 (1 g )
D1
=
P0 =
rg
rg

Commonly called the Gordon Growth Model.

22

Example: Constant growth

Suppose Victoria, Inc. is expected to pay a $2
dividend in one year. If the dividend is expected to
grow at 5% per year and the required return is 20%,
what is the price?

D1
$2
P0

$13.33
r g 0.20 0.05
Suppose NABs current dividend is $1. If the dividend
is expected to grow at 6% per year and the required
return is 10%, what is the price?

D0 (1 g ) $1(1 0.06)
D1
=

$26.5
P0 =
rg
rg
0.10 0.06

23

Variable growth model

Dividends change at a rapid growth rate before
level off to a constant growth rate
E.g.

g4

Asset value = PV of all its future cash flows

D3
D1
D2
D
P0

1
2
3
(1 r ) (1 r )
(1 r )
(1 r )

24^

g4

Rapid growth phase

0

D0

g3

Constant growth phase

3

g4

Year

D1

D2

D3

D4

25^

Rapid growth phase

0
D0

g1

1
D1

g2

2
D2

Constant growth phase

g3

3
D3
P3

g4

Year
D

D4
Constant growth div

D4
P3 =
rg

P0 =

D1
rg

P3
P0

D3
P3
D1
D2

(1 r ) (1 r ) 2 (1 r ) 3 (1 r ) 3

D4
rg
D3
D1
D2
P0

2
3
3
(1 r ) (1 r ) (1 r ) (1 r )

26^

Example: Variable growth model

Suppose a firm is expected to increase dividends
by 20% in one year and by 15% in the second year
After that dividends will increase at a rate of 5% per
year indefinitely
If the last dividend was $1 and the required return
is 20%:
What is the price in year 2?
What is the current price?

g1 = 20%
g2 = 15%
g3 = 5%
D0 = $1
r = 20%
P2 = ?
P0 = ?

27

What is the price in year 2?

D0 =$1

r=20%

D1

D2

P2?

P0?

g1 = 20%

D3

g2 = 15%

g1 = 20%
g2 = 15%
g3 = 5%
D0 = $1
r = 20%
P2 = ?

g3 = 5%

Estimate P2 = PV of future CFs D3, D4, .

1
0 =

2 =

28*

D0 =$1

r=20%

D1

D2

P2?

P0?
g1 = 20%

D3

g2 = 15%

g3 = 5%

3
2 =

Part 1: Calculate D3
D3 = D0(1+g1)(1+g2)(1+g3) = 1(1+ 0.2)(1+0.15)(1+0.05)
Part 2: Calculate P2
3
1(1.20)(1.15)(1.05)
2 =
=
= $9.66

0.20 0.05

29*

What is the current price?

D0 =$1

r=20%

D1

D2

P2=9.66

P0?

g1 = 20%

D3

g2 = 15%

g1 = 20%
g2 = 15%
g3 = 5%
D0 = $1
r = 20%
P0 = ?

g3 = 5%

Estimate P0 = PV of future CFs D1, D2 and P2

D1
D2
P2
P0

1
2
(1 r ) (1 r ) (1 r ) 2
30*

P0

D1
D2
P2

(1 r )1 (1 r ) 2 (1 r ) 2

Part 1: Calculate D1 and D2

D1 = D0(1+g1)
= 1(1+ 0.2)
D2 = D0(1+g1)(1+g2) = 1(1+ 0.2)(1+0.15)
P2 = $9.66
D0=$1

D1=1(1.20)

g1 = 20%

D2=1(1.20)(1.15)

g2 = 15%

Part 2: Calculate P0
1
2
2
0 =
+
+
2
(1 + ) (1 + )
(1 + )2
1(1.20) 1(1.20)(1.15)
9.66
=
+
+
2
1 + 0.20
(1 + 0.20)
(1 + 0.20)2
= 1 + 0.9583 + 6.7083 = $8.67

31*

Three dividend discounted models

Zero Growth Model

D
P0
r

Constant Growth Model

D1
P0 =
rg

D0 (1 g )
P0 =
rg

Variable Growth Model Identify 2 phases

(Rapid growth rate and constant growth rate)
before start calculating the price.

32

Growth rate
How to estimate growth.
Growth rate g = retention rate ROE
Historical data
What if there are no dividends?

33

5.3 The free cash flow approach to

ordinary share valuation
Free cash flow
(FCF)

Weighted
average cost of
capital (WACC)

The net amount of cash flow remaining

after the company has met all operating
needs and paid for investments, both
long-term and short-term.
Represents the cash amount that a
company could distribute to investors
after meeting all its other obligations.

The after-tax, weighted average required

return on all types of securities issued by
a company, where the weights equal the
percentage of each type of financing in a
companys overall capital structure.

34

Vcompany

FCF1
FCF2

2
(1 rWACC ) (1 rWACC )

Vcompany = Vdebt + Vpreferred + Vshare

Vshare
P0

= Vcompany Vdebt Vpreferred

Vshare
Number of shares outs tan ding

Steps:
1. Estimate the free cash flow that the company will generate over time.
2. Discount the free cash flow at the companys weighted average cost
of capital to derive the total value of the company
3. Subtract the values of the companys debt and preferred shares from
the value of company to obtain the value of the companys shares.
35
4. Divide the value of companys shares by the number of shares
outstanding to calculate the value per share, P0 .

5.4 Other approaches to ordinary

share valuation
Book value

Liquidation
value

The value of a companys

equity as recorded on the
companys balance sheet.

The amount of cash that

remains if the companys
assets are sold and all
liabilities paid.
36

Comparable
multiples

The amount investors are

willing to pay for each dollar of
earnings.
P/E ratios differ between and
within industries.

Pr ice per share

P / E ratio
Earnings per share

Share value Avg. P / E of comparable firms

EPS of the firm you are valuing
37

5.5 The investment banking

functions and the primary market
Trading
Key investment
banking activities

Asset management
Corporate finance

Investment banks assist companies with the process of

raising long-term debt and equity in capital markets.
38

Companies can choose an

investment bank through:

a negotiated offer

a competitively bid offer

The contract to sell equity can be:

(Examples of Underwriting)

best effort
firm
commitment

The bank promises its best effort to sell the

companys securities. If the demand is
insufficient, the issue will be withdrawn.

The bank underwrites the securities.

Underwrite: purchasing shares from the
company and reselling them to investors.

39

Topic 4 Part 2

Long-Term Financing
Chapter 12

40

12.1 Basic choices in long-term financing

Long-term financing
Ordinary shares
Preferred shares
Long-term debt

The dominant source of new financing for companies

across the world is internally generated cash flows.

Two main types of external capital raising

Initial public offering (IPO)

41

Seasoned equity offering (SEO)

12.3 The Initial Public Offering

A companys first equity issue made available to the
public.
This issue occurs when a privately held company
decides to go public
Also called an unseasoned new issue.
Why do companies go public?

New capital
Future capital
Mergers and acquisitions
See advantages and disadvantages on pp.439-41

42

12.4 Seasoned Equity Offerings (SEOs)

An equity issue by a company that already has
ordinary shares outstanding.
SEOs infrequent for most US and non-US companies.

Reason

Negative market reaction when SEOs

are announced

SEO announcements convey negative info:

Managers may consider share overvalued.

43
SEOs could reveal that cash flows will be lower than expected.
Share issues made after IPOs: Rights issues & Private placements

12.4 Rights Offerings (Issues)

A rights issue is an issue of new shares to existing
shareholders.
Shareholders receive the right to subscribe for
additional shares in a fixed ratio to the number of
shares already held.
Theoretically, if shareholders take up the amount
they are entitled then shareholders percentage
ownership is not diluted.
44

12.4 Private placements

Sale of a security directly to one or a group
of accredited investors.
Accredited investors in private placements
are financially sophisticated.
Corporations, institutional investors, wealthy
individuals, pension and mutual funds, and
venture capitalists are among accredited
investors.
45

 End of Week 4 lecture

Read Chapters 5 and 12 (relevant sections only)

and revise todays lecture slides and your notes
Remember to do your scheduled Aplia homework
Form a team and start working on your Assignment
Part 2
Prepare Chapter 6 for next week

46