Equity Security & Equity Markets Chapter 8

Debt vs. Equity Debt: Equity: Contractual , obligation The Issuer can be sued for default of payments Equity: Right to eliminate dividends, even on preferred shares Can’t be sued for reduction or elimination of dividends

Equity Issue of shares is the result of incorporation Originally - IPO (Initial public offering) There are 2 general classes of corporate shares: Preferred shares Common shares

Equity Preferred shares: Common shares: Preferential dividends Or liquidation treatment Generally, voting right is suspended Many offer a fixes Dividend per quarter indefinitely Often cumulative Common shares: Residual claimants in the firm

Equity 4 dates associated with dividends: Dividends – generally is the only direct payment between a firm and its shareholders. 4 dates associated with dividends: Declaration date Ex-dividend date Record date Payment date

Equity Valuation Dividend Discount Model General case: D1 - forward (forecast) dividend in one period per share Can be = 0

Constant Growth DDM Also known as Gordon Growth Model (1962). Appropriate for : larger, profitable, mature, dividend paying companies

Constant Growth DDM 1) 2) 3) r – Market Capitalization Rate (MCR) g –growth rate, r > g 2) - forward dividend yield 3)

Constant Growth DDM Retention ratio: Payout ratio: 4) Dividends Earning Dividends Retained earning Retention ratio: generally: 0 ≤ b ≤ 1 Payout ratio: 4)

Constant Growth DDM Growth: Almost all corporate characteristics grow at g: Dividends Earning Book value of Asset (BVA) Book value of Equity (BE) Debt Sales Share price The principal exception to this list is your Wealth. the expected growth rate in your wealth per year per share – is expected ROR = r = MCR =D/P +g > g

Constant Growth DDM b, ROE - 2 determinant of growth 6) Recall: 5) - Sustainable growth b, ROE - 2 determinant of growth 6) Recall: - forward ROE per share

Constant Growth DDM 7) The price to forward Earnings Ratio: 8) Market to Book ratio:

Constant Growth DDM 9) Expected future corporate growth 10) Constant Growth Expected Return (CGER)

Constant Growth DDM Dividend Reinvestment with Constant Growth DDM Received dividends are use to buy new shares. Price that will be paid – Ex-dividend price at that time Number of shares in dividend reinvestment plan in n years:

New Share Issue Public companies: Private companies: General cash offer Rights issue Private companies: New equity issue

New Share Issue Rights offering In the rights offering the firm sells new shares to the existing shareholders (in the first instance). Existing shareholders can maintain their fractional ownership if they increase $ investment or they can sell their rights, then their fractional ownership falls & $ investment decreases.

Rights offering Characteristics: 1 right given by the firm per 1 share to existing shareholders (not sold) - Always Often it takes more than 1 right to buy a new share & cash (primary market price) You have this right (not the obligation) ~ 3 weeks (general)

Rights offering 3 important share prices: P – original secondary market price E – exercise price – subscription price - strike price Ex – Ex-rights share price (share of old + new when they all are traded together) = new price& cash (primary market price)

Rights offering You are not worse off as long as you do one of 2 things: Sell rights (fractional ownership falls + $ investment falls): Exercise the rights (maintain fractional ownership by increasing $ investment)

Rights offering Formula to relate the original price to the new price: NR – number of Rights

The hypothesis of Capital Market Efficiency (CME) (Informational Efficiency & Market Efficiency) Definition: Information is widely & cheaply available to all investors and all relevant information is reflected in share price Note: CME is a hypothesis and not a statement of fact The bulk of the empirical evidence is consistent rather than inconsistent with CME.

The hypothesis of Capital Market Efficiency Two principal aspect of CME: Hard to beat the “market” Hard to do worse that the market Conclusion: Diversify Do not overtrade