IP - Tutorial 4 Questions

Why may companies prefer to issue equity rather than raise a bank loan?

To reduce their gearing ratio.

Why might investors prefer buying equity to corporate bonds?

To gain greater potential rewards.

When can ordinary shareholders receive dividends?

Only from distributable reserves.

Why were American Depositary Receipts (ADRs) created?

To attract US investors to non-US shares.

Why are secondary markets essential for new equity issues?

New investors need to know they can sell their shares.

Why is issuing new shares dilutive?

It increases the number of shares in an unchanged business.

What does TERP stand for ?

Theoretical ex-rights price

What is the TERP calculation?

(value of existing shares held + cost of new shares) / number of shares held after the issue

How do you work out the value of a right?

TERP - rights issue price

What is an Initial Public Offering (IPO)?

When a company issues public shares for the first time

What is the aim when pricing a new share issue?

To achieve the highest price possible while leaving scope for a modest post-issue premium.

What is the aim of a share buyback?

To improve earnings per share (EPS).

Which common equity valuation method differs from the intrinsic valuation methods?

The Price-Earnings (P/E) Multiple, because it is a relative valuation method.

What does the Dividend Discount Model (DDM) measure?

Cash returns to shareholders.

What does the Discounted Cash Flow (DCF) model measure?

The present value of forecast business cash flows.

Why do academics prefer intrinsic valuation models?

They make the best available estimate of a firm's fundamental equity value today.

What does the Residual Income Valuation Model (RIVM) measure?

Forecast value added.

Why might Company Y have a higher forward P/E ratio than Company X (16.5× versus 13.5×)?

Company Y has higher forecast earnings per share (EPS) growth.

For which types of companies is the Price-to-Book (P/B) ratio most relevant?

Manufacturing and minerals companies.

Why is the Price-to-Sales (P/S) ratio of limited use for equity valuation?

Sales are a poor indicator of profit and value.

Which combination of assumptions will definitely reduce equity valuation?

A higher discount rate and a lower perpetual growth rate.

In DCF equity valuation, how is Free Cash Flow to the Firm (FCFF) discounted and what does it determine?

FCFF is discounted at the Weighted Average Cost of Capital (WACC) to determine Enterprise Value. Net debt is then deducted to calculate Equity Value.

In a 1-for-5 rights issue, how many new shares can a shareholder holding 4,000 shares purchase?

800 new shares, calculated as 4,000 ÷ 5.