Lecture 3 - The Time Value of Money - Valuing Shar

Inthecomingweeks,wearegoingto:•Usethetimevalueofmoneyconceptsdiscussedlastlectureinassetvaluationexercises;and,•Indoingthis,wewillseethatwecanvalueanyassetbysimplycalculatingthepresentvalueofallitsexpectedfuturecashflows.Thisweek,wearegoingtoapplythetimevalueofmoneyideatovaluingshares.Butfirst,itisimportanttoconsiderthefollowingquestions:•Whatisacorporation?•Whataresharesandwhataretheirkeycharacteristics?;and,•Whatcashflowsareassociatedwithshares?Havingunderstoodtheanswerstothesequestions,wecanthendiscusssharevaluation.Acorporationisacompanythatis:•AlegalentityestablishedundertherelevantCorporationsLaw.InAustralia,thisistheCorporationsAct2001;•Ownedbyshareholders,whoaresonamedbecausetheirownershipisrepresentedbysharesinthecorporation’scapital;•Separateanddistinctfromitsowners.Thismeansithasmanyofthesamerightsandresponsibilitiesanindividualdoes,includingtherightto:•Ownandtradeassets;•Enterintocontractswithotherentities;and,•Sueand/orbesuedinitsownname.•Hasanindefinitelife.Thismeansthatitsoperationsarenotaffectedbythedeathorretirementofitsowners.TheCorporationsAct2001differentiatesbetween:•Proprietarycompanies,whichcannotoffertheirsharesforsaletothepublic;and,•Publiccompanieswhich,asthenamewouldsuggest,caninvitemembersofthepublictopurchasetheirshares.Publiccompaniesmaybelistedonastockexchange.Listingallows:•Thecompanytoraiselargeamountsofcapital(funding)withrelativeease;and,•Ownershipofshares,whichistypicallywidelydispersedamongstmanyshareholders,tobeeasilytransferredbetweenshareholderswithoutaffectingthecompany’soperations.Whilemuchofwhatwewillsayisapplicabletootherformsofbusiness,ourfocuswillbeontheseso-calledpubliclylistedcompanies.Thesecompaniescanberunbymanagerswhodonotownsharesinthecompany.Thatis,therecanbeaseparationofownershipandcontrol.Further:•TheshareholderselectaBoardofDirectors(“Board”),whodeterminecorporateobjectives;•TheBoard,inturn,hiresmanagerstoensurethecompanyachievestheseobjectivesonbehalfoftheshareholders;•TheBoardreportsbacktoshareholdersregardingoperationsof/decisionsmadeinrelationtothecompany;and,•TheBoardiselected/reelectedbytheshareholders,usuallyatthecorporation’sAnnualGeneralMeeting.Theseparationofownershipandcontrolintroducesthepotentialforconflictsofinterestbetweenmanagersandshareholders.Theseconflicts,inturn,giverisetoagencycosts,orcostsresultingfrommanagersactingintheirownbestinterestsratherthanthoseoftheshareholders.Shareholdersinthesefirmswillgenerallyeitherhavenoliabilityorlimitedliabilityfortheliabilitiesincurredbythecorporation.Theeasiestwaytounderstandthedifferencebetweenthetwoisbywayofanexample....ImagineABCcompanyissuesnewsharesatapriceof$3.00pershare.Further,thecompanydecidestoaskshareholderstoinitiallypay$2.00pershare,withtheremaining$1.00tobepaidatalaterdate.IfABCisalimitedliabilitycompany:•Shareholdersonlyhavealegalrequirementtopaythe$1.00owingoneachshare;and,•So,themaximumlosstoshareholdersintheeventthecompanyfailedwouldbe$3.00.If,instead,ABCisanoliabilitycompany:•Shareholdershavenolegalrequirementtopaythe$1.00owing,althoughnotdoingsowouldmeanshareholdersforfeittheirshares;and,•Therefore,intheeventthecompanyfailedbeforeshareholdershadpaidthe$1.00owing,theirmaximumlosswouldbe$2.00pershare.Asowners,shareholdershaveanumberofrightsbestoweduponthem,including:•Therighttovoteonhowthecorporationwillbecontrolled.Asnotedpreviously,shareholdersexercisethisrightbyelectingtheBoard,whoisresponsiblefordetermininghowthecompanywillberun;•Aclaimtoafractionofthecashflowsremaininginthecorporationafterallotherclaimshavebeendeducted(ieintheformofdividends);and,•Selltheirstockswhentheysochoose.Generallyspeaking,shareholderscanowntwomaintypesofsharesinacorporation:•Ordinaryshares:Anequitysecuritythatgivesitsholdertherighttovoteandtherighttoany(variable)dividenddeclaredbytheboardofdirectors.However,ordinaryshareholdersranklastintheeventofliquidation;and,•Preferenceshares:Anequitysecurityisgivenpriorityoverordinarysharesfor(fixed)dividendsandintheeventofliquidation.However,thesesharesgenerallyhavenovotingrightsattachedtothem.Shareholdersreceive2typesofgainsfromowningshares,namely:•Dividends:Asnotedearlier,mostcompaniespaydividendsperiodically;and,•CapitalGains:Theincreaseinthesharepriceoverthetimeashareholderownstheirshares.Asdiscussedearlier,thereisa3-stepapproachtoassetvaluation,namely:1.Identifyallthecashflowsyouexpectwillbegeneratedbytheassetaswellaswhentheyoccur;2.Findthepresentvalueofeachcashflowthatwasidentifiedin1;and,3.Sumthepresentvaluesofallcashflowcalculatedin2.Keepingthisinmind,let’scommenceourdiscussionofsharevaluationbymakingtwosimplifyingassumptions,namely:•Thecompanyissuingthestocks,andthereforethestocksthemselves,haveaninfinitelife;and,•Everymarketparticipantagreesabouttheamount,timingandriskoftheshares’expectedfuturecashflows(iedividendpayments).Theseassumptionsmeaneveryonewillarriveatthesamevalueforagivenshare.Wewilldiscusswhathappenswhenwerelaxtheseassumptionslaterinthelecture.Keepingtheseassumptionsinmind,imagineastockthathasjustpaidadividend,D0,andwhoseexpectedfutured