Equity Financing and Valuation Models

Equity Financing Overview

  • Equity financing refers to raising capital through the sale of shares.
  • Two main types of equity:
    • Preference Shares (Preferred Stock):
    • Carry preferential rights on dividend payments and capital repayment.
    • Typically do not have voting rights.
    • Ordinary Shares (Common Stock):
    • Represent ownership in the company with voting rights.
    • Dividends may or may not be paid out.

Difference Between Debt and Equity Capital

  1. Cash Flows:
    • Debt: Cash flows are guaranteed.
    • Equity: Cash flows are not guaranteed.
  2. Duration:
    • Debt has a specific maturity date.
    • Equity has no defined maturity.
  3. Rate of Return:
    • Debt rate of return is easily determined.
    • Equity returns are difficult to predict.

Rights, Characteristics, and Features of Shares

Ordinary Shares
  • Meaning: Ownership interest of shareholders in the company.
  • Voting Rights:
    • Ordinary shareholders have voting rights.
  • Dividends:
    • Payments vary and are at the discretion of the board.
  • Repayment of Capital:
    • Repaid after preference shares in a winding-up situation.
  • Convertibility:
    • Ordinary shares may be converted under certain conditions.
Preference Shares
  • Dividend Payments:
    • Receive fixed dividends before ordinary shareholders.
  • Voting Rights:
    • Generally do not have voting rights unless specified.
  • Repayment:
    • Repaid in full before ordinary shares during liquidation.
  • Convertibility:
    • Typically non-convertible to ordinary shares unless specified.

Share Valuation Models

1. Zero Growth Model
  • Used when dividends are constant forever.
  • Formula:P0=DRP_0 = \frac{D}{R}
    • Example:
    • If a company pays a dividend of R12.50 every year with a required return of 14%, the price is:
      P0=12.500.14=R89.29P_0 = \frac{12.50}{0.14} = R89.29
2. Constant Growth Model (Gordon Growth Model)
  • Used when dividends grow at a constant rate.
  • Formula:
    P<em>0=D</em>0(1+g)R−gP<em>0 = \frac{D</em>0 (1+g)}{R - g}
    where D_0 = current dividend, g = growth rate, R = required return.
  • Example:
    • If a company just paid R8 in dividends with a growth rate of 5% and required return of 15%,
      P0=8(1.05)0.15−0.05=8.40.10=R84.00P_0 = \frac{8(1.05)}{0.15 - 0.05} = \frac{8.4}{0.10} = R84.00
3. Non-constant Growth Model
  • Used when dividends grow at varying rates initially before settling at a constant growth rate.
  • Example Steps:
    1. Calculate Present Value of dividends for each year until the growth rate stabilizes.
    2. At year 3, if future dividends are assumed to grow at a constant rate:
    • Find the value at that point using the Gordon Growth Model.
    1. Discount this value back to present value to find the stock price today.

Example of Non-constant Growth

  • Expected dividends:

    • Year 1: R0.60
    • Year 2: R0.78
    • Year 3: R1.01

  • Assume constant growth of 10% beyond year 3.

  • Value at Year 3:
    P<em>3=D</em>4R−gP<em>3 = \frac{D</em>4}{R - g}
    where D_4 is the dividend in year 4.

  • Total current value of shares is then the sum of discounted cash flows from both phases of growth.

Practical Application: Perry Motors Example

  • Current Dividend: R1.80
  • Required return: 12%
  1. Zero growth:
    P0=1.800.12=R15P_0 = \frac{1.80}{0.12} = R15
  2. Constant growth (5%):
    P0=1.80(1+0.05)0.12−0.05=R27P_0 = \frac{1.80(1+0.05)}{0.12-0.05} = R27
  3. Variable growth:
    • Calculate dividends for the first 3 years, then use constant growth for the 4th year to estimate the current stock price.