Topic 4

Valuing shares and

long-term financing
Chapters 5 & 12
Department of Finance
Deakin Business School, T3 2017
1
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 2
Recap - Topic 3
C 1 M
• Bond Valuation P 0 = X [1 n
]+ n
r (1+ r ) (1+ r )
C C C C
F
Price  2  2  2  ...  2
r r r r
(1 )1 (1 ) 2 (1 )3 (1 ) 2n
2 2 2 2

• Coupon rate vs Coupon yield

• YTM: return of bond if buy and hold until maturity
• YTM>Coupon Rate, sell at discount
• YTM<Coupon Rate, sell at premium
• YTM=Coupon Rate, sell at par
Recap
• Types of Bonds
• Corporate Bond, Government Bond
• Fixed vs floating, Secured vs unsecured bonds
• Bond rating
• Higher bond rating (AAA), lower borrowing risk, lower r
• Terms Structure of Interest Rates
• Upwards-sloping: long yield > short yield (normal)
• Downwards-sloping: short yield > long yield (recession)
• Long-term Debt
• Public issue vs private issue
• Positive covenants vs negative covenants
• Cost of loan =
• loan maturity, loan size, borrow risk, cost of money
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
Valuation Basics
• The value of any asset equals the present value of
all its future benefits.
• Therefore, pricing an asset requires knowledge of
future benefits as well as appropriate discount rate.
• Generally, the greater the risk or uncertainty of an
asset’s future benefits, the higher the discount rate
investors will apply when discounting those benefits
to the future.

6
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.
7
Two Principles of Corporate Financing

Debt and equity have different pay‐off profiles for investors. 
As such they have different risks and suit different firms and 
investors.
5.2 Preferred share valuation
• Preferred shares have some features similar to debt
and other features similar to equity.
• Claim on assets and cash flow rank senior to
ordinary shares.
• Dividend payments are not tax-deductible.
• Preferred shares are held mostly by corporations.
• Promises a fixed annual dividend payment, though
this is not legally enforceable.
• Preferred shareholders usually do not have voting
rights.
9
Preferred share valuation
• A preferred share is an equity security that is
generally pay a fixed annual dividend indefinitely.
0 Dp Dp Dp …
rp

1 2 3

Asset value = PV of all future CFs

• Preferred share price = PV of dividends
PMT
Preferred share price = PV of perpetuity PV 
r

Dp • PS0 = Preferred share market price

10
PS 0 = • Dp = Next period’s dividend payment
rp • rp = Discount rate
Example:
Investors require an 11% return on a preferred
share that pays a $2.30 annual dividend.
What is the price?

Dp
PS 0 =
rp
$2.30
=
0.11
= $20 .90 / share 11
 Ordinary Share valuation
0 1 2 n

$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.

12
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 D1
P1

Return on D1  P1  P0
r
investment P0

D1  P1
Share value P0 
(1 r )1
D1 P1 13
P0  
(1  r ) (1  r )1
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=1
P1=11
D1  P1  P0 $1  $11 – $10
r r  20%
P0 $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
D1  P1 P0  14
P0  (1  0 . 20 )1

(1 r )1
 $10
Ordinary share value
P0 D1+P1 D2+P2 D3+P3 …
r

0 1 2 3
D1  P1 D2  P2 D3  P3
P0  P1  P2 
(1  r )1 (1  r )1 (1  r )1

P0 D1 D2 D3 …
r

0 1 2 3

15
 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

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 16
pay for this share?
 Example: One period
1
r = 10%

$0.91 D1 = $1
$13.64 P1 = $15
P = $14.55

Price = PV(dividends) + PV(sale price)
FV 1 15
PV  P0  Pr ice  
(1  i ) n (1  0.10) (1  0.10)
 0.91  13.64  14.55
D P
P0  1 11 1  15 17
OR
(1  r ) P0   14 . 55
(1  0 . 10 )
Valuation with two periods
• A two period model can be viewed as two one-period
models strung together.

1 2

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 18
willing to pay for this share today? What is the price at
the end of the first year?
Example: Two-period
1 2
r = 10%
$1 $1.1
???
??? $16
Price

PV 
FV Price = PV(dividends) + PV(sale price)
(1  i ) n
1 1.1  16
Today’s price P0  Pr ice    15.04
(1  0.10) (1  0.10) 2

Price at the end of Year 1

19
D2  P2 1 . 1  16
P1  P1   15 . 55
(1  r )1 (1  0 . 10 ) 1
Example: Multiple periods
0 1 2 3 4 5
r = 10%
$1 $1.1 $1.15 $1.3 $1.4
???
+ $20
???
Price
FV Price = PV(dividends) + PV(sale price)
PV 
(1  i ) n

1 1.1 1.15 1.3 1.4  20

Pr ice     
(1  0.10) (1  0.10) 2 (1  0.10) 3 (1  0.10) 4 (1  0.10) 5
 0.9091  0.9091  0.8640  0.8879  13.2877 20

 16.8578
 Example: Multiple periods
0 1 2 3 4 5

r = 10% $1 $1.1 $1.15 $1.3 $1.4

$20

1 1.1 1.15 1.3 1.4  20

Pr ice     
(1  0.10) (1  0.10) (1  0.10) (1  0.10) (1  0.10) 5
2 3 4

 16.8578

D1 D2 D3 D4 D5  P5
P0     
(1  r ) (1  r )
1 2
(1  r ) 3
(1  r ) 4
(1  r ) 5
21
D1 D2 D3 Dn  Pn
P0      
(1  r ) (1  r )
1 2
(1  r ) 3
(1  r ) n
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 D1 D2 D3 … Dn+Pn
r

0 1 2 3 n

D1 D2 D3 D4 Dn  Pn
P0       
(1  r ) (1  r )
1 2
(1  r ) 3
(1  r ) 4
(1  r ) n

D1 D2 D3 D 22
P0      
(1  r ) 1
(1  r ) 2
(1  r ) 3
(1  r ) 
Three dividend discounted models
• Zero Growth Model
• Constant Growth Model
• Variable Growth Model

23
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 D1 D2 D3 … D∞
r

0 1 2 3

perpetuity
D
PMT P0  24

PV  r
r
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 25
 Constant growth valuation
Dividends grow at a constant rate (g) forever.
D2(1+g)
D1(1+g) D1(1+g)(1+g)
D0(1+g)1 D0(1+g)2 D0(1+g)3
D0 D1 D2 D3 …
r

0 1 2 3

• If dividends grow at a constant rate forever, you can

value the share as a growing perpetuity, denoting next
year’s dividend as D1:
growing perpetuity D1 D0 (1  g )
CF1 P0 = =
PV0  rg rg 26
rg
• Commonly called the Gordon Growth Model.
Example: Constant growth
• Hewlett-Packard (HP) will pay an annual dividend of
$0.32 next year. If investors expect that dividend to
remain constant forever, and they require a 10%
return on HP shares, what is the share worth?
D1 $0.32
P0    $3.20
r 0.1
• What is the stock worth if investors expect HP’s
dividends to grow at 3% per year?

D1 $0.32
P0    $4.57
r  g 0.10  0.03
27
 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 NAB’s 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?
D1 D0 (1  g ) $1(1  0.06) 28
P0 = =   $26.5
rg rg 0.10  0.06
 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

D1 D2 D3 D 29
P0      
(1  r ) (1  r )
1 2
(1  r ) 3
(1  r ) 
 g4

Rapid growth phase Constant growth phase

0 g 1 g 2 g3 3 g4 Year ∞
1 2
D0 D1 D2 D3 D4 D∞
30
 Rapid growth phase Constant growth phase

0 g1 1 g2 2 g3 3 g4 Year ∞

D0 D1 D2 D3 D4 D∞
P3 Constant growth div

D4 D1
P0 =
P3 = rg
rg
P3
D1 D2 D3 P3
P0    
(1  r ) (1  r ) 2 (1  r ) 3 (1  r ) 3

 D4 
D1 D2 D3  rg  31
P0     
(1  r ) (1  r ) (1  r )  (1  r ) 
2 3 3

 
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%:
g1 = 20%
• What is the price in year 2? g2 = 15%
g3 = 5%
• What is the current price? D0 = $1
r = 20%
P2 = ? 32
P0 = ?
What is the price in year 2?
g1 = 20%
g2 = 15%
D0 =$1 D1 D2 D3 g3 = 5%
r=20% … D0 = $1
0 1 2 3
r = 20%
P0? P2? P2 = ?

g1 = 20% g2 = 15% g3 = 5%

• Estimate P2 = PV of future CFs  D3, D4, ….

33
D0 =$1 D1 D2 D3
r=20% …
0 1 2 3
P0? P2?

g1 = 20% g2 = 15% g3 = 5%

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
34
1 1.20 1.15 1.05
$9.66
0.20 0.05
What is the current price?

g1 = 20%
g2 = 15%
D0 =$1 D1 D2 D3 g3 = 5%
r=20% … D0 = $1
0 1 2 3
r = 20%
P0? P2=9.66 P0 = ?

g1 = 20% g2 = 15% g3 = 5%

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

D1 D2 P2
P0   
(1  r )1 (1  r ) 2 (1  r ) 2
35
 D1 D2 P2
P0   
Part 1: Calculate D1 and D2 (1  r )1 (1  r ) 2 (1  r ) 2
• 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) D2=1(1.20)(1.15)

0 g1 = 20% 1 g2 = 15% 2

Part 2: Calculate P0

1 1 1

1 1.20 1 1.20 1.15 9.66

1 0.20 1 0.20 1 0.20 36

1 0.9583 6.7083 $8.67
Three dividend discounted models
• Zero Growth Model D
P0 
r
• Constant Growth Model
D1 D0 (1  g )
P0 = P0 =
rg rg

• Variable Growth Model – Identify 2 phases

(Rapid growth rate and constant growth rate) 37
before start calculating the price.
Dividend Growth rate
• How to estimate growth?
• Growth rate g = retention rate × ROE
• Retention rate is also called reinvestment rate or plow-
back ratio
• ROE (Return on Equity) = Earnings/Book value of equity
• Historical data & forecast of the
company/industry growth potentials
• What if there are no dividends?
38
Stock Price Sensitivity to g
Stock price
50

45
D1 = $1
40
Required return,
35
r, = 12%
30

25

20

15

10

5
Dividend
0 2% 4% 6% 8% 10%
growth rate, g
39
Stock Price Sensitivity to r
Stock price
100

90

80
D1 = $1
70
Dividend growth
60
rate, g = 5%
50

40

30

20

10
Required
6% 8% 10% 12% 14%
Return, r
40
5.3 The free cash flow approach to
ordinary share valuation
• The net amount of cash flow remaining
Free cash flow after the company has met all operating
needs and paid for investments, both
(FCF)
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

Weighted return on all types of securities issued by
average cost of a company, where the weights equal the
capital (WACC) percentage of each type of financing in a 41
company’s overall capital structure.
 FCF1 FCF2
Vcompany   
(1  rWACC ) (1  rWACC ) 2

Vcompany = Vdebt + Vpreferred + Vshare

Vshare = Vcompany – Vdebt – Vpreferred
Vshare
P0 
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 company’s weighted average cost
of capital to derive the total value of the company
3. Subtract the values of the company’s debt and preferred shares from
the value of company to obtain the value of the company’s shares.
42
4. Divide the value of company’s shares by the number of shares
outstanding to calculate the value per share, P0 .
5.4 Other approaches to ordinary
share valuation
• The value of a company’s
Book value equity as recorded on the
company’s balance sheet.

Liquidation • The amount of cash that

remains if the company’s
value assets are sold and all
liabilities paid.
43
 • The amount investors are
Comparable willing to pay for each dollar of
earnings.
multiples
• 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
44
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.
Initial public • The first public sale of company
offering (IPO) shares to outside investors.
• An equity issue by a company that 45
Seasoned equity already has ordinary shares
offering (SEO) outstanding.
 Companies can choose an
investment bank through:

a negotiated offer a competitively bid offer

The contract to sell equity can be:

(Examples of Underwriting)

• The bank promises its best effort to sell the

best effort company’s securities. If the demand is
insufficient, the issue will be withdrawn.

• The bank underwrites the securities.

firm • Underwrite: purchasing shares from the 46
commitment company and reselling them to investors.
Primary Market vs Secondary
Market
• Share markets can be classified as either primary or
secondary.

• Shares are sold for the first time (i.e. IPOs) in the
primary market, but after that, trading occurs in the
secondary market (such as the Australian Stock
Exchange (ASX)).

• A stock exchange is a place where stock brokers

and traders can buy and/or sell stocks (also called
shares), bonds, and other financial securities. 47
Bid and Ask Prices
• If you go to a market maker (say, a dealer) to buy a
financial security (shares or bonds) in the secondary
market, the dealer may quote you both bid and ask
prices.
• The dealer may buy from you a security at $14.10
per share (bid price), and sell you the same security
at $14.20 per share (ask price). The bid-ask spread
is $0.10/share, compensating for his/her inventory
costs and risks taken.
• Ask Price > Bid Price.
• As a customer, you always trade at a disadvantage! 48
Topic 4 Part 2
Long-Term Financing
Chapter 12

49
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 51

Initial public offering (IPO) Seasoned equity offering (SEO)

12.3 The Initial Public Offering
• A company’s 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 52
• See advantages and disadvantages on pp.439-41
12.3 The market for initial Public
Offerings (IPO)
• US IPO market was larger than rest of world’s
combined.
• IPOs account for, on average, 30−45% of all
new equity raised each year.
• NYSE and NASDAQ compete for IPOs.
• IPO market is highly cyclical: biggest IPO
boom ever in the late 1990s.
• Market prone to industry ‘fads’: energy,
biotechnology, communications, and more
recently, social networking.
53
• Institutional investors most important IPO
investors: allocated 50−75% IPO shares.
12.3 IPO short-term underpricing
• Short-term returns surprisingly high, pattern of IPO
underpricing
• IPO underpricing: Initial return is positive
Issue price First day closing price

0 1
first day closing price


• Average initial return in the US is 15.3% for 1960-
1992 (Ibbotson et al., 1998); Australia is 16.4% for
1976-1989 (Lee et al., 1996); China is 213.4% for
1990-2006 (Chen et al. 2007).
• Possible reasons: Information asymmetry, bandwagon
54*
effects, lawsuit avoidance, etc
Long-term (after-market) IPO
performance
• Negative long-term returns for IPOs not encouraging
for investors in the US (-29%, 1975-1984), Australia
(-51%), France (-10%), Germany (-6%), etc
• Possible reasons: Divergence of opinion hypothesis,
earnings management, etc
• Positive long-term returns for IPOs in China (+28%),
South Korea (+43%), Malaysia (+33%), etc

55*
12.3 Advantages and
disadvantages of an IPO
• Advantages
• IPOs can raise large amounts of new capital
for growth.
• Publicly traded shares serve as currency for
acquisitions.
• Listed share (options) can be used to attract
top managers.
• Entrepreneurs enjoy personal wealth and
liquidity.
• IPOs serve as advertising for companies and
their products/services. 56
12.3 Advantages and
disadvantages of an IPO
• Disadvantages
• High financial costs, with no guarantee of success:
cash expenses of an IPO often approach $1 million.
• Managerial costs of planning and executing IPO.
• Companies need to focus on share price and deal
with shareholders.
• Have to disclose operating and sensitive data
publicly
• Must follow public company governance rules set
by ASIC
57
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.

Negative market reaction when SEOs

Reason are announced

SEO announcements convey negative info:

• Managers may consider share overvalued.

58
• SEOs could reveal that cash flows will be lower than expected.

Share issues made after IPOs: Rights issues & Private placements
12.4 Right Offerings (Issues)
• A rights issue is an issue of new shares to existing
shareholders.
• Preemptive rights: shareholders have first claim over
anything of value distributed by a corporation.
• Shareholders receive the right to subscribe for additional
shares in a fixed ratio to the number of shares already held.
• Give ordinary shareholders the right to maintain their
proportionate ownership in the corporation.
• Theoretically, if shareholders take up the amount they are
entitled then shareholder’s percentage ownership is not
59
diluted.
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.
60
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) 61
• End of Week 4 lecture

 Read Chapters 5 and 12 (relevant sections only)

and revise today’s 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

62