Tutorial 2 – Equity Markets

Problems

6-11 Caltex Australia Limited pays a constant dividend of

$0.60 cents per share. A fund manager is considering
purchasing the shares as part of an investment portfolio.
The fund manager requires a return of 15 per cent on the
investment. Calculate the price that the funds manager
would be willing to pay for the shares. (LO 6.5)

ANSWER

• If dividend payments are expected to remain constant,

such that D0 = D1 = D2 = …. Dn, the share price can be
calculated based on a perpetuity.
• The present value of a perpetuity is the cash flow
divided by the relevant discount rate:P0 = D0 / rs
• Caltex is expected to pay a constant dividend of $0.60
cents per share, and the funds manager’s required rate
of return is 15%, therefore:

𝑃0 = 0.60/0.15
= $4.00
6-12 The last dividend paid to shareholders by Vicinity
Centres was $0.10 per share. Assume that the board of
directors of the company plans to maintain a constant
dividend growth policy of 7.00 per cent. An investor, in
evaluating an investment in the company, has
determined that she would require a 12 per cent rate of
return from this type of investment. If the current price of
Vicinity shares in the stock market is $4.00, should the
investor purchase the shares? (Show your calculations.)
(LO 6.5)

ANSWER

• Vicinity is planning to maintain constant dividend

growth. Therefore, the next dividend paid will be the
last dividend multiplied by the growth rate:

𝑃0 = 𝐷0 (1 + 𝑔)/(𝑟𝑠 − 𝑔)
= 0.10 (1.07)/(0.12 − 0.07)
= $2.14

• At a current market price of $4.00 the investor should

not consider buying the shares based on this simple
analysis. Rather, to justify a purchase at $4.00, the
required rate of return must be lower or the growth
rate of the dividends must be higher.
6-13 AGL Energy Limited has declared a $0.33 cents per
share dividend, payable in one month. At the same time
the company has decided to capitalise reserves through a
one-for-three bonus issue. The current share price at the
close of business on the final cum-dividend date is
$16.15. (LO 6.5)

a. Explain the strategy adopted by the company. In your

answer, define the terms ‘cum-dividend’ and ‘ex-
dividend’.

ANSWER

• The company wishes to restructure its balance sheet

by converting reserves into ordinary shares through
the provision of bonus shares to existing
shareholders.
o assumption: dividend is not payable on bonus share
issue
o cum-dividend—the situation when a share price
incorporates an entitlement to receive a declared
dividend
o ex-dividend—the share price after a declared
dividend has been paid in cash to shareholders.
b. Calculate the theoretical price of the share after the
bonus issue and the dividend payment have occurred.

ANSWER

• Calculate the theoretical share price:

cum-dividend share price $16.15

dividend paid 0.33

ex-dividend price $15.82

cum-bonus/ex-dividend price $15.82

market value of 3 cum-bonus

shares $47.46

market value of 4 ex-bonus

shares $47.46

theoretical value of ex-

dividend/ex-bonus share $11.86
6-14 Alumina Limited has a share price of $2.82. The
company has made a renounceable rights issue offer to
shareholders. The offer is a three-for-ten pro-rata issue of
ordinary shares at $2.60 per share. (LO 6.5)

a. Explain the effect of the offer being renounceable.

ANSWER

• Rights issue—the issue of additional ordinary shares

to existing shareholders on a pro-rata basis relative
to their existing shareholding
• Renounceable—the right is listed on the stock
exchange and the shareholder is entitled to sell the
right to a third party rather than accepting the offer.
b. What is the price of the right?

ANSWER

𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑖𝑔ℎ𝑡
𝑁(𝑐𝑢𝑚 𝑟𝑖𝑔ℎ𝑡 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. Therefore:
3.3333($2.82 − $2.60)
𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑖𝑔ℎ𝑡 =
4.3333
$0.7333
=
4.3333
= 16.92𝑐𝑒𝑛𝑡𝑠
c. Calculate the theoretical ex-rights share price.

ANSWER

cum-rights share price $ 2.82

Market value of 10 cum-rights shares $28.20

plus:

new cash introduced through take-up

of 3 for 10 issue $ 7.80

gives:

market value of 13 ex-rights shares $36.00

therefore:

theoretical ex-rights share price $ 2.77

d. Explain why an actual ex-rights price of a share may
at times differ from the calculated theoretical price.

ANSWER

• The ex-rights price may not fall to its theoretical

value because of the informational content of the
rights issue. The increased equity base may indicate
increased growth and profitability thus allowing the
company to maintain its current dividend rate.
Questions

4-5 Discuss why a strong primary market is important for economic growth
within a country and explain how each of the main participants in the primary
issue of securities interacts with each other during the share issuance process.
(LO 4.3)

ANSWER

• A stock exchange facilitates the flow of funds, firstly, through the primary
market issue and, secondly, the secondary market trading of existing
securities.
• The primary market role of the stock exchange is to facilitate the raising of
capital by publicly listed corporations through the issue of new equity
based securities to investors.
• The primary market issue of new equity is the source of capital funds for
the corporation; these funds allow the maintenance and growth of a
business.
• Primary market issues facilitate the process of conversion of savings to
investment, which theoretically leads to an accumulation of capital
capacity, economic growth, increased production and higher levels of
employment.
• The interaction of the main participants in the securities issuance process is
depicted in Figure 4.1. Corporations occupy the central position in the
process, receiving funds from the issuance of securities. Underwriters and
advisors guide corporations through the issuance process and funds flow
through brokers from individuals, institutions and overseas investors with
surplus funds to invest. The process is facilitated by a stock exchange.
 4.6 a. Discuss the secondary market role of a stock exchange and its
importance to the corporation. Illustrate your answer by using examples.

ANSWER

• The secondary market role of a share market is to provide an organised

and efficient market where existing listed securities may be bought and
sold at current market prices.
• The current market price should reflect the performance outcomes and
forecast prospects of individually listed companies within the context of
the relevant industry sector, and the domestic and global economies.
• An efficient share market facilitates transfer of ownership amongst
investors and enhances liquidity in listed securities.
• Securities initially issued through the primary market may be
subsequently traded through the stock market as a secondary market
transaction.
• Secondary market transactions will include a range of securities listed on
the exchange, including ordinary shares, rights issues, preference shares,
instalment receipts, debentures and notes.
• Economic growth derives from primary market investment; however a
successful primary market requires the support of a deep and liquid
secondary market.
• An active secondary market encourages investors to purchase new
securities because the investors are confident they will be able to sell
those securities in the future in the secondary market quickly at the
current market price.
 b. What is meant by the liquidity of the share market? Explain why liquidity in
the secondary market is important both to shareholders and to the
corporation. (LO 4.4)

ANSWER

• Liquidity in the share market relates to the ability of the holder of a

security to buy or sell listed securities without unduly disturbing the
current market price of the shares being traded.
• The standard measure of share market liquidity is the ratio of the value of
turnover to market capitalisation. Market capitalisation is calculated by
multiplying the number of shares on issue by their current market price.
• Liquidity in the secondary market for shares encourages investors to
initially purchase new issues by corporations. Shareholders are confident
that shares may be easily and quickly sold without incurring a capital loss
as a direct result of the sale transaction (capital loss/gain may result from
other factors such as company performance outcomes).
• A liquid share market provides advantages to both the investor
(shareholder) and the corporation in that it facilitates the raising of long-
term capital while providing short-term liquidity to the investor.

5.11 JB Hi-Fi is expanding its retail operations and seeks to raise capital to do so.
The company advisers recommend the board of directors choose between a pro-rata
rights issue or a private placement. Explain each of these funding alternatives and
discuss the advantages and disadvantages of each alternative. (LO 5.5)

ANSWER

1. JB Hi-Fi has the advantage of an established positive reputation which will

enable it to raise further equity funding.
2. The choice is between a pro-rata rights issue and a placement; both relate
to the issue of additional ordinary shares.

Rights issue:

1. A pro-rata rights issue occurs when existing shareholders are given an

entitlement to subscribe for additional shares in the company.
2. In making a rights issue, the company must ensure that all shareholders
receive an equivalent opportunity to participate in the issue. This is
achieved by making the offer on the basis of a fixed ratio of new shares to
the number of existing shares held (pro-rata basis). For example, a 1:10
(one for ten) offer gives a shareholder the right to purchase one new share
for every ten existing shares held.
3. Often a rights issue is renounceable, that is, the shareholder is able to sell
the option (right) to another party, but some issues are non-renounceable
(cannot be sold).
4. An advantage of a rights issue is that the company retains its existing
shareholder base, and at the same time is able to raise additional equity
funding.
5. A rights issue must conform to the prospectus requirements of
the Corporations Act and this can be costly and time consuming.
6. The time lag between the pricing of the issue and the actual issue date
exposes the company to pricing risk, that is, the share price might fall below
the rights price.

Placements:

o A placement is an arrangement where a company may issue additional

shares, with shareholder approval, directly to selected institutional and
individual investors who are deemed to be clients of brokers, without the
need to register a prospectus.
o Subscriptions must be for not less than $500,000 and to not more than 20
participants.
 o The advantages to the company include the reduced compliance costs (no
prospectus, only an information memorandum), the quickness in which the
issue can be finalised, often at a lower discount to market price, and to
investors that are friendly to the company.
o A disadvantage to existing shareholders is ownership dilution; however
placements are restricted to a maximum of 15% of capital in any 12-month
period.

5.12 In some countries, such as Australia, it is common for corporations to offer

shareholders a dividend reinvestment scheme. (LO 5.5)

a. Explain how dividend reinvestment schemes operate and discuss their

significance as a source of equity funding.

ANSWER

• Dividend reinvestment schemes allow a shareholder to reinvest all or part

of their dividend entitlement in additional shares in the company.
• Dividend reinvestment shares are sometimes issued at a discount to the
market price, and with no brokerage or other costs.
• Dividend reinvestment schemes are an important source of equity
funding for many companies. Shareholders like the option to reinvest
their dividend income rather than taking the cash, particularly if the
company is successful.
• The company will typically issue such shares at the average market price
of the shares traded on the stock exchange for the five days following the
ex-dividend date; less a specified discount if applicable.
 b. Discuss the advantages of a dividend reinvestment scheme from the point
of view of the corporation and shareholders.

ANSWER

• The main attraction of dividend reinvestment schemes is that they enable

a company to make dividend payments and, assuming a sufficient
reinvestment rate, to retain sufficient equity funds to meet future funding
needs.
• Dividend reinvestment schemes allow existing shareholders to
progressively increase their shareholding in the company in small
increments (the amount of the dividend).
• At the same time, in countries such as Australia that allow dividend
imputation, the company is able to pass on tax franking credits to its
shareholders.

c. Under what circumstances might such schemes prove to be unattractive to the

dividend-paying company?

ANSWER

• There may be periods when company investment opportunities are

limited, such as in an economic downturn, and the additional funds raised
through a dividend reinvestment scheme are not required, and may dilute
earnings per share. Therefore, a company may need to suspend its
scheme from time to time.
7-14 a. Briefly outline the main contentions of the efficient market
hypothesis. In your answer, discuss the contentions of the efficient market
hypothesis within the context of technical analysis and fundamental analysis.

ANSWER

• Efficient market hypothesis contends that markets are information-

efficient and that share prices reflect all available information.
• If this is the case extra profits cannot be made from superior information.
• This suggests that the two fundamental analysis approaches will not
achieve higher results. However, there is a need to consider the ability of
market participants to understand, evaluate and interpret that
information.
• The efficient market hypothesis also argues that technical analysis is of no
value as it relies the repetition of past price patterns.
• Share markets are generally information-efficient and prices generally
follow the random walk process and reflect the current available
information.
• Above-normal profits are unlikely to be made by using current
information since it is likely to already be reflected in the price of the
share.
• Nevertheless, for some skilled analysts, and for those able to uncover not-
yet-public information, above-average rates of return may be available.

b. How can the hypothesis be tested? In your response, distinguish between

the weak, semi-strong and strong forms of efficiency. (LO 7.5)

ANSWER

• The strength of the efficient market hypothesis is related to the level of

efficiency of the markets; that is, how quickly is information absorbed by
the market and reflected in the share price
• There are three measures or levels of efficiency
 • Weak form efficiency—share prices changes are independent and not
based on historic data
• Semi-strong form efficiency—all publicly available information is fully
reflected in a share price
• Strong form efficiency—all publicly available information and private
research is fully reflected in a share price.

7-15 A key finding in behavioural finance is that investors tend to keep their losing
investments too long and sell their winning investments too soon. Use prospect
theory (or other elements of behavioural finance) to explain this behaviour. (LO 7.5)

ANSWER

• Prospect theory suggests that people are risk-seeking in the domain of

losses and risk-averse in the domain of gains.
• Following a period of time when the investor accumulates gains, the
investor becomes risk-averse and is inclined to try and protect or
consolidate those gains.
• Following a period of time when the investor experiences losses, the
investor becomes risk-seeking and is inclined to take more risk in order
to recover from the losses.
• This behaviour can explain why investors sell their winning investments
too soon and hold their losing investments too long. Following a ‘win’,
risk-aversion prompts a desire to consolidate the gain and protect it by
reducing the exposure to the risky asset. Conversely, following a loss,
risk-seeking prompts a desire to ‘double-down’ or at least hold onto to
the losing investment in the hope that the losses will be recovered.

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