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Chapter 6

Investors in
the Share Market

Websites:
www.ato.gov.au
www.asx.com.au

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-1
Slides prepared by Anthony Stanger
Learning Objectives
• Appreciate the range of investment choices
available for the investor
• Understand the process of buying and selling
shares, the risks involved, and the importance of
taxation when investing
• Describe indicators of financial performance
• Explain share pricing methods
• Consider the importance of share-market indices
and published share information

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-2
Slides prepared by Anthony Stanger
Chapter Organisation
6.1 Stock Exchange and Share-Market Investment
6.2 Buying and Selling Shares
6.3 Taxation
6.4 Financial Performance Indicators
6.5 Pricing of Shares
6.6 Stock-Market Indices and Published Share
Information
6.7 Summary

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-3
Slides prepared by Anthony Stanger
6.1 Stock Exchange and Share-Market
Investment
• Investors buy shares to receive returns from
dividends and capital gains (losses)
• Other factors encouraging investment in securities
quoted on a stock exchange (SX)
– Depth of the market
 Overall capitalisation of corporations listed on a SX
– Liquidity of the market
 Volume of trading relative to the size of the market
– Efficient price discovery
 Speed and efficiency with which new information is reflected
in the current share price

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-4
Slides prepared by Anthony Stanger
6.1 Stock Exchange and Share-Market
Investment (cont.)
• The SX offers a wide range of security types to the
investor
• Securities listed on the SX are categorised into
industry groups allowing investors a choice within
a range of economic sectors

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-5
Slides prepared by Anthony Stanger
6.1 Stock Exchange and Share-Market
Investment (cont.)
• Two types of risk impact on security returns
– Systematic risk
 Factors that generally impact on share prices in the market,
e.g. economic growth, and changes in interest rates and
exchange rates
– Unsystematic risk
 Factors that specifically impact on the share price of a
corporation, e.g. resignation of the CEO, technology failure,
board problems

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-6
Slides prepared by Anthony Stanger
6.1 Stock Exchange and Share-Market
Investment (cont.)
• Diversified investment portfolio
– A portfolio containing a wide range of securities
– Diversifies most of the unsystematic risk of the individual
securities
 Investors will not receive higher returns for unnecessarily
bearing unsystematic risk
– The remaining risk is systematic risk, which is measured
by beta
 Beta is a measure of the sensitivity of the price of an asset
relative to the market

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-7
Slides prepared by Anthony Stanger
6.1 Stock Exchange and Share-Market
Investment (cont.)
• Diversified investment portfolio (cont.)
– Expected portfolio return is the weighted average of
expected returns of each share
– Portfolio variance (risk) is the correlation of pairs of
securities within the portfolio

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-8
Slides prepared by Anthony Stanger
6.1 Stock Exchange and Share-Market
Investment (cont.)
• Investors may take one of two approaches
– Active investment approach
 Portfolio structure is based on share analysis, new
information and risk-return preferences
– Passive investment approach
 Portfolio structure is based on the replication of a specific
share-market index, e.g. industrial or telecommunications
sector index
• Some managed funds are index funds
– Portfolios are structured to fully or partially replicate a
specific share-market index

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-9
Slides prepared by Anthony Stanger
6.1 Stock Exchange and Share-Market
Investment (cont.)
• Investors need to consider asset allocation within a
share portfolio
 Risk versus return
 Investment time horizon
 Income versus capital growth
 Domestic and international shares
• Asset allocation may be
 Strategic
 Tactical

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-10
Slides prepared by Anthony Stanger
Chapter Organisation
6.1 Stock Exchange and Share Investment
6.2 Buying and Selling Shares
6.3 Taxation
6.4 Financial Performance Indicators
6.5 Pricing of Shares
6.6 Stock-Market Indices and Published Share
Information
6.7 Summary

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-11
Slides prepared by Anthony Stanger
6.2 Buying and Selling Shares
• Direct investment in shares
– Investor buys and sells shares through a stockbroker
 Discount broker, i.e. phone and Internet
 Full-service advisory broker
– Consideration of liquidity, risk, return, charges, taxation,
social security etc.
• Indirect investment in shares
– Investor purchases units in a unit trust or managed fund,
e.g. equity trust

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-12
Slides prepared by Anthony Stanger
Chapter Organisation
6.1 Stock Exchange and Share Investment
6.2 Buying and Selling Shares
6.3 Taxation
6.4 Financial Performance Indicators
6.5 Pricing of Shares
6.6 Stock-Market Indices and Published Share
Information
6.7 Summary

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-13
Slides prepared by Anthony Stanger
6.3 Taxation
• Pre-dividend imputation (prior to 1987)
– Dividends were taxed twice—first at company level (as
profits) and then at the investor’s marginal rate
• Dividend imputation (since 1987)
– Removed the double taxation of dividends
– Investors receive franking credit for the tax a company
pays on a franked dividend

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-14
Slides prepared by Anthony Stanger
6.3 Taxation (cont.)

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-15
Slides prepared by Anthony Stanger
6.3 Taxation (cont.)
• Capital gains tax on shares purchased
– Prior to 19/9/1985 tax free
– 19/9/1985–21/9/1999
 Taxpayer’s marginal tax rate applied if held less than 12
months
 Taxpayer’s marginal tax rate applied to indexed capital gain
if held over 12 months
– Since 21/9/1999
 50% discounted gain if held at least 12 months or
 Indexed capital gain or 50% discounted gain if purchased
19/9/1985–21/9/1999

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-16
Slides prepared by Anthony Stanger
Chapter Organisation
6.1 Stock Exchange and Share Investment
6.2 Buying and Selling Shares
6.3 Taxation
6.4 Financial Performance Indicators
6.5 Pricing of Shares
6.6 Stock-Market Indices and Published Share
Information
6.7 Summary

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-17
Slides prepared by Anthony Stanger
6.4 Financial Performance Indicators
• Potential investors are concerned with the future
level of a company’s performance

• Company’s performance affects both the


profitability of the company and the variability of
the cash flows

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-18
Slides prepared by Anthony Stanger
6.4 Financial Performance Indicators
(cont.)
• Indicators of company performance
– Capital structure
– Liquidity
– Debt servicing
– Profitability
– Share price
– Risk

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-19
Slides prepared by Anthony Stanger
6.4 Financial Performance Indicators
(cont.)
Capital structure
• Proportion of company assets (funding) obtained
through debt and equity
– Usually measured by debt to equity ratio (D/E)
 Higher debt levels increase financial risk, i.e. firm may not
be able to meet interest payments

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-20
Slides prepared by Anthony Stanger
6.4 Financial Performance Indicators
(cont.)
Capital structure (cont.)
• Proportion of company assets (funding) obtained
through debt and equity (cont.)
– Also measured by proprietorship ratio, which is the ratio
of shareholders’ funds to total assets
 Indicates firm’s longer-term financial viability/stability. A
higher ratio indicates less reliance on external funding

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-21
Slides prepared by Anthony Stanger
6.4 Financial Performance Indicators
(cont.)

Liquidity
• The ability of a company to meet its short-term
financial obligations
• Measured by current ratio
– Fails to consider the not very liquid nature of certain
current assets like inventory

Current ratio  current assets (maturing within one year)


current liabilities (due within one year)
(6.2)

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-22
Slides prepared by Anthony Stanger
6.4 Financial Performance Indicators
(cont.)

Liquidity (cont.)
• Measured by liquid ratio
• The higher the current and liquid ratios, the better
the liquidity position of a firm

Liquid ratio  current assets - inventory stock (on hand)


current liabilities - bank overdraft

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-23
Slides prepared by Anthony Stanger
6.4 Financial Performance Indicators
(cont.)
Debt servicing
• Ability to meet debt-related obligations, i.e. interest
and repayment of debt
• Measured by debt to gross cash flow ratio
– Indicates number of years of cash flow required to repay
firm debt

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-24
Slides prepared by Anthony Stanger
6.4 Financial Performance Indicators
(cont.)

Debt servicing (cont.)


• Measured by interest coverage ratio

Interest cover  earnings before finance lease charges, interest and tax
finance lease charges and interest
(6.4)

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-25
Slides prepared by Anthony Stanger
6.4 Financial Performance Indicators
(cont.)
Profitability
• Wide variation in the measurement of profitability
– Earnings before interest and tax (EBIT) to total funds
ratio
– Earnings per share (EPS)

EBIT to total funds ratio

 EBIT
total funds employed (shareholders' funds and borrowings)
(6.5)

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-26
Slides prepared by Anthony Stanger
6.4 Financial Performance Indicators
(cont.)
Profitability (cont.)
• Wide variation in the measurement of profitability
(cont.)
– EBIT to long-term funds ratio

EBIT to long- term funds ratio

 EBIT
long- term funds (i.e. total funds less short - term debt)
(6.6)

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-27
Slides prepared by Anthony Stanger
6.4 Financial Performance Indicators
(cont.)
Profitability (cont.)
• Wide variation in the measurement of profitability
(cont.)
– Return on equity (net income/equity)
– Higher ratios indicate greater profitability

Return on equity  net income


equity (shareholders' funds)
(6.7)

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-28
Slides prepared by Anthony Stanger
6.4 Financial Performance Indicators
(cont.)
Share price
• Represents investors’ view of the present value of
future net cash flows of a firm
• Share price performance indicators
– Price to earnings ratio (P/E)
 Share price divided by earnings per share
 A higher P/E indicates more growth in future net cash flows
– Share price to net tangible assets ratio (P/NTA)
 Measures the theoretical premium or discount a firm’s share
price is trading relative to its NTA

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-29
Slides prepared by Anthony Stanger
6.4 Financial Performance Indicators
(cont.)
Risk
• Variability (uncertainty) of the share price
• Two components
– Systematic risk (often referred to as beta)
 Arises from factors affecting the whole market, e.g. state of
the domestic economy and world economy
– Non-systematic risk
 Arises from firm-specific factors, e.g. management
competence, labour productivity, financial and operational
risks
 Can be eliminated in a well-diversified portfolio

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-30
Slides prepared by Anthony Stanger
Chapter Organisation
6.1 Stock Exchange and Share Investment
6.2 Buying and Selling Shares
6.3 Taxation
6.4 Financial Performance Indicators
6.5 Pricing of Shares
6.6 Stock-Market Indices and Published Share
Information
6.7 Summary

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-31
Slides prepared by Anthony Stanger
6.5 Pricing of Shares
• Share price is mainly a function of supply and
demand for a share
– Supply and demand are influenced mainly by information
– Share price is considered to be the present value of
future dividend payments to shareholders
– New information that changes investors’ expectations
about future dividends will result in a change in the share
price

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-32
Slides prepared by Anthony Stanger
6.5 Pricing of Shares (cont.)
• Estimating the price of a share
– General dividend valuation model


D t

P  t1 t
1rs 
0

P  current share price


0

Where D  expected dividend per share in period t


t
(6.8)
r  required rate of return
s

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-33
Slides prepared by Anthony Stanger
6.5 Pricing of Shares (cont.)
• Estimating the price of a share (cont.)
– Valuing a share with a constant dividend (D0)

D
P
0
0

rs
(6.9)

– Valuing a share with constant dividend growth (g)

1g
 
 
 
 

P D
 
 
0 0

r g


 s





(6.12)

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-34
Slides prepared by Anthony Stanger
6.5 Pricing of Shares (cont.)
• Cum-dividend and ex-dividend
– Dividends are payments made to shareholders,
expressed as cents per share
– Dividends are declared at one date and paid at a later
specified date
– During the period between the two dates, the shares
have the future dividend entitlement attached, i.e. cum-
dividend

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-35
Slides prepared by Anthony Stanger
6.5 Pricing of Shares (cont.)
• Cum-dividend and ex-dividend (cont.)
– Once the dividend is paid the shares are traded ex-
dividend
– Theoretically the share price will fall on the ex-dividend
date by the size of the dividend
 Example
Share price cum-dividend $1.00
Dividend paid 0.07
Theoretical ex-dividend price 0.93

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-36
Slides prepared by Anthony Stanger
6.5 Pricing of Shares (cont.)
• Bonus share issues
– Where a company has accumulated reserves, it may
distribute these to existing shareholders by making a
bonus issue of additional shares
– As with dividends, there will be a downward adjustment
in share price when shares go ex-bonus

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-37
Slides prepared by Anthony Stanger
6.5 Pricing of Shares (cont.)
• Bonus share issues (cont.)
– As no new capital is raised, there is no change in the
assets or expected earnings of the company
 Example—if a bonus 1:4 issue is made
Cum-bonus price $5.00
Market value of 4 cum-bonus shares $20.00
Theoretical value of 5 ex-bonus shares $20.00
Theoretical value of 1 ex-bonus share $4.00

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-38
Slides prepared by Anthony Stanger
6.5 Pricing of Shares (cont.)
• Share splits
– Involves division of the number of shares on issue
– Involves no fundamental change in the structure or asset
value of the company
– Theoretically the share price will fall in the proportion of
the split
 Example—5 for 1 split
Pre-split share price $50.00
Theoretical ex-split share price $10.00

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-39
Slides prepared by Anthony Stanger
6.5 Pricing of Shares (cont.)
• Pro-rata rights issue
– Involves an increase in the company’s issued capital
– Typically issued at a discount to market price
– Theoretically, the market price will fall by an amount
dependent on
 The number of shares issued
 The size of the discount

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-40
Slides prepared by Anthony Stanger
6.5 Pricing of Shares (cont.)
• Pro-rata rights issue (cont.)
– Example—market price cum-rights $1.00, with 1:5 rights
issue priced at $0.88

Cum-rights share price $1.00


Market value of 5 cum-rights shares 5.00
Plus new cash from 1:5 issue 0.88
Market value of 6 ex-rights shares 5.88
Theoretical ex-rights share price 0.98

Copyright  2007 McGraw-Hill Australia Pty Ltd


PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-41
Slides prepared by Anthony Stanger
6.5 Pricing of Shares (cont.)
• Pro-rata rights issue (cont.)
– A renounceable right is a right that can be sold before it is
exercised
 The value of the right is determined by Equation 6.13

Value of right  N (cum rights price - subscription price)


N 1
Where N is the number of shares required
to obtain the rights issue share, and the subscription
price is the discounted price of the additional share.
(6.13)

Copyright  2007 McGraw-Hill Australia Pty Ltd


PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-42
Slides prepared by Anthony Stanger
Chapter Organisation
6.1 Stock Exchange and Share Investment
6.2 Buying and Selling Shares
6.3 Taxation
6.4 Financial Performance Indicators
6.5 Pricing of Shares
6.6 Stock-Market Indices and Published Share
Information
6.7 Summary

Copyright  2007 McGraw-Hill Australia Pty Ltd


PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-43
Slides prepared by Anthony Stanger
6.6 Stock-Market Indices and Published
Share Information
• Stock-market indices
– Measure of the price performance of a share market or
industry sector, e.g.
 Performance benchmark index
• Measures overall share-market performance based on
capitalisation and liquidity
 Tradeable benchmark index
• A narrow index used as the basis for pricing certain derivative
products
 Market indicator index
• Measure of overall share-market performance

Copyright  2007 McGraw-Hill Australia Pty Ltd


PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-44
Slides prepared by Anthony Stanger
6.6 Stock-Market Indices and Published
Share Information (cont.)
• Market indicator indices
– Price-weighted, e.g. Dow Jones
 Weighting of a company proportional to its share price
– Capitalisation-weighted, e.g. S&P/ASX All Ords
 Weighting of a company proportional to market
capitalisation
– Share-price index measures capital gains/losses from
investing in an index-related portfolio
– Accumulation index includes share price changes and
reinvestment of dividends

Copyright  2007 McGraw-Hill Australia Pty Ltd


PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-45
Slides prepared by Anthony Stanger
6.6 Stock-Market Indices and Published
Share Information (cont.)
• Market indicator indices (cont.)
– Global industry classification standard (GICS) comprises
10 standard international industry sector indices, e.g.
energy, materials, industrials
• Published share information
– Newspapers and financial journals provide share-market
information to varying degrees of detail, e.g. Australian
Financial Review

Copyright  2007 McGraw-Hill Australia Pty Ltd


PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-46
Slides prepared by Anthony Stanger
Chapter Organisation
6.1 Stock Exchange and Share Investment
6.2 Buying and Selling Shares
6.3 Taxation
6.4 Financial Performance Indicators
6.5 Pricing of Shares
6.6 Stock-Market Indices and Published Share
Information
6.7 Summary

Copyright  2007 McGraw-Hill Australia Pty Ltd


PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-47
Slides prepared by Anthony Stanger
6.7 Summary
• Factors a share investor should consider
– Diversification, portfolio return and risk
– Active or passive investment
– Direct or indirect investment
– Taxation
– Company financial performance indicators
 Capital structure, liquidity, debt servicing, profitability, share
price, risk

Copyright  2007 McGraw-Hill Australia Pty Ltd


PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-48
Slides prepared by Anthony Stanger
6.7 Summary (cont.)
• Factors that influence a company’s share price
– Expected future dividends
– Bonus shares issues
– Share splits
– Pro-rata rights issues
• Various share-market indices exist that provide a
measure of the price performance of a sector or of
the market overall

Copyright  2007 McGraw-Hill Australia Pty Ltd


PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 6-49
Slides prepared by Anthony Stanger